Adjustment and Consequences

To restore the confidence of the world’s investors in the Euro, both IMF officials and ECB leaders pledged that Europe would defend its currency. While this entailed rescuing the highly indebted European economies, it also conditioned the receipt of financial assistance on the adoption of stringent reforms. The IMF recommended the implementation of austerity programs. The degradation of the Eurozone’s integrity was not uniquely traceable to Greece’s book cooking and past financial imprudence, though the dominant narrative espoused by its creditors would come to portray it as such. The European Council interpreted the sovereign debt crisis as a consequence of financial profligacy of some of its members. Countries like Germany were net creditors, exporting more than they imported, while countries with current account deficits tended to be net debtors and imported more than they exported.[i] While some may view a surplus of imports as inherently bad, it should not be forgotten that countries often export in order to import goods or services they cannot produce.  Referring to Figure 1, Germany’s current account surplus reflected a higher level of national savings over investment spending and strong international demand for its exports. Since the year 2002, Germany consistently ran current account surpluses. Notably, countries such as Spain frequently run current account deficits, symptomatic of a greater import volume and greater spending than savings. In both cases, the domestic economy was liable to pay foreign economies. Implementing measures to realign unit labor costs (ULC) with productivity in peripheral countries were seen as key to reducing obligations to creditor countries like Germany. Since Germany joined the Eurozone, it experienced minimal nominal wage growth. This gave the “less competitive” European economies the appearance of greater competitiveness, but may have done little to actually repair the damage done by the financial crisis.





The Eurozone crisis revealed the Euro’s fundamental flaw. In keeping with Robert Mundell’s optimum currency area theory, an inflexible monetary union with unintegrated member economies needs a fiscal safety valve to adjust if any of its member economies began to diverge from the others. Otherwise stated, if an exogenous shock adversely impacts a member economy then other member economies should buffer the impact by providing fiscal support. When member economies are integrated, there is little risk of any shocks and no need to establish an adjustment mechanism. However, from the Euro’s inception, no correction mechanism was implemented to ensure convergence of its member economies. Political fears about the creation of moral hazard and a totalitarian European government precluded the provision of a fiscal safety valve and any moves toward political integration. [i] The Eurozone thus grew into an unwieldy chimera of a currency union with no fiscal transfers and only nominal political integration, leaving it vulnerable to any asymmetric shocks. As a result, the political leadership interpreted the Greek sovereign debt crisis as a cause of the Euro’s existential crisis rather than an outgrowth of its structural imbalances. They recommended policies that would attempt to solve the Greek problem but would neglect to restructure the ungainly construction of the Eurozone extant at its outset. This inadvertently exacerbated disparities between the core and peripheral economies and would further prolong the fallout of the Eurozone crisis. This paper aims to explore the assumptions that led to the prognosis of the Eurozone crisis as one of labor cost competitiveness. It will deconstruct the economic logic that links unit labor costs (ULCs) and  “international competitiveness”, detailing the devastating policy consequences for the peripheral economies with a focus on Greece. Finally, it considers options for re-structuring the Eurozone to buttress it against future economic crises.

The leading narrative of the Eurozone crisis framed it as a crisis of labor cost competitiveness. According to the IMF and core country leadership, differences among Eurozone economies in their current account balances reflected divergences in their relative unit labor costs (RULCs). What are unit labor costs (ULCs) and how could a microeconomic unit of analysis have any import at the macroeconomic level? The Organization for Economic Cooperation and Development’s (OECD) definition of unit labor cost (ULC) is the average cost of labor per unit of output. Unit labor costs represent the link between productivity and the cost of labor in producing output. An increase in an economy’s unit labor costs means labor receives increased compensation for their contribution to output. However, a rise in unit labor costs over the rise in labor productivity can threaten the economy if other costs do not adjust. Countries with current account deficits accumulated foreign liabilities, leading to the sovereign debt crisis.

In this narrative, countries with current account deficits rely on imports and battle burgeoning expenditures because of inflated worker compensation. In particular, Greece’s excessive debt obligations were not only indicative of hedonistic fiscal policies, but also a reflection of its dysfunctional labor market. Because an excess proportion of their production costs was dedicated to compensating labor, the price of their goods needed to account for this. When Greek goods competed with others in the international market, consumers would likely choose a less expensive substitute good whose price more accurately reflected labor’s contribution. As a result, Greece, a country with inflated labor compensation was at a competitive disadvantage relative to a country with lower labor costs.

In this conception of the problem, the solution lay in reducing labor’s share of profit. Traditionally a central government could simply restore its competitiveness through currency devaluation, but within a currency union, such a policy measure is impossible. Instead, a country institutes internal devaluation – the process of boosting export competitiveness by slashing domestic prices via wage cuts and increasing labor market flexibility. Since a country cannot change world prices of its own accord, it adjusts its own to render itself more competitive. Internal devaluation is a deflationary policy focusing on the supply-side of the Eurozone crisis. This perspective aims to increase labor market flexibility in countries such as Greece and aims to remedy its higher unemployment rates and low turnover. If a country’s labor market is rigid in the midst of a recession, then in the absence of a fiscal stimulus, there will be no impetus for the labor market to become more competitive. While internal devaluation is not an expansionary policy, policymakers predicted that increasing cost competitiveness through labor market reforms would boost a country’s exports to the extent that it would no longer need financial assistance.

If the Eurozone crisis was a labor cost competitiveness crisis, then Germany’s labor market policies offered a potential solution for deficit countries. As seen in Figure 2, from 1995 to 2013 Germany actually lowered its unit labor costs in contrast to other countries’ rising unit labor costs, which fostered the idea that this was the source of its competitiveness. While there exists no standard definition of international competitiveness, economists usually define it in terms of current account surpluses. However, this is not a very meaningful definition in the context of a monetary union. The reason for this being that the current account balances tend to reflect capital inflows/outflows among member states rather than the relation of imports and exports to foreign economies.[ii]

Economists also do not find that ULCs function as meaningful indicators of international competitiveness. Felipe and Kumar (2014) indicate that there is no reverse statistical relationship between lower ULCs and export growth. Storm et. al (2014) also find that unit labor costs represent only “…16% of manufacturing gross output price, whereas intermediate inputs costs account for 72% of total costs and the profit share is 12%.”[iii] Given that unit labor costs constitute only a small portion of a good or service in an international market, it does not make sense to fixate on this indicator to improve overall international competitiveness.

The literature on international competitiveness offers a multiplicity of definitions of competitiveness; with some like Felipe and Kumar (2014) citing Paul Krugman, a prominent macroeconomist, in his claim that countries do not compete in world markets in the same sense that firms compete in domestic markets, thus international competitiveness is a flawed concept. The fact that different economies compete using the same currency further compounds the abstractness of this metric. Both supporters and opponents of deflationary policies in Greece have reached consensus on this. However, they differ on its policy implications for rebuilding after the Eurozone crisis.

Supporters of deflationary policy, i.e. leaders of core economy countries and IMF officials point to the structural inefficiency of Greece’s labor market before the crisis. Concerns about Greece’s organizational capabilities prompted these leaders to prescribe top-down policies that ignored Greek cultural institutions. They premised their policy recommendations on the assumption that increasing labor flexibility would equilibrate productivity to national levels.[iv] The Greek austerity measures “…particularly focused on wage reductions, public expenditure cuts and flexibilization of wage agreements…”[v] This included policies such as up to a 22% reduction in the minimum wage. Dimoulas (2014) draws attention to the two most important influences shaping the Greek labor market: Mediterranean clientelism and Western capitalist rationalism. These forces resulted in a dualist Greek labor market structure that favored “insiders” by providing them with well-paid employment and generous social welfare packages, but offering minimal protections to “outsiders” like farmers and private-sector workers. Education and healthcare provisions were universally generous, resulting in high out-of-pocket costs for those employed in the public/formal sector. Advocates of internal devaluation aimed to reduce public sector expenditures on these programs but did not take note of the interrelations between the “insiders” and the “outsiders”. Through the informal sector of the economy (estimated to comprise a quarter of Greek GDP) those who officially received social welfare benefits extended them to their connections that did not. Many Greeks, whether unemployed or informally employed thus enjoyed a relatively high standard of living. Post-crisis, public sector employees could no longer extend their benefits to their connections, leaving many uncovered and unemployed. Following the implementation of labor market restructuring policies, forms of employment readily available pre-crisis such as self-employment or family help work contracted, while transient forms of employment, especially part-time jobs increased.[vi] The intent of the troika was to increase employment opportunities by facilitating hiring and firing of workers. Labor market flexibility policies increased unemployment by 25% from 2009-2013. Furthermore, these policy measures shifted the normal forms of employment from full-time work to part-time work. Since the Greek government can no longer increase its expenditures, the austerity programs consigned the Greek people to languish in unemployment and insecurity.

If the austerity measures did not benefit Greek constituents, what economic logic could top economists at the IMF and the ECB have employed to arrive at more favorable policy outcomes? Stockhammer and Sotiropoulos (2014) argue that policymakers should have implemented inflationary policies. Inflationary policies would not exert downward pressure on economic fundamentals and would allow for continual growth throughout the Eurozone while still rebalancing current accounts. They note that Euro member states followed two different, interrelated models of economic growth. Peripheral economies grew while increasing their debts and experienced price bubbles. Demand drove growth in core economies via the rapid expansion of net exports, particularly in Germany. European financial integration allowed for debt-led growth, which in essence was the flow of capital from countries such as Germany and France into the peripheral economies. Examining this account of the Eurozone crisis reveals that Germany was not cost competitive in contrast to Greece, but rather because of it. Current account surpluses in core economies returned to peripheral economies where they would finance increasing household debt. Since the two types of growth in the Eurozone economies were mutually constitutive, it makes little economic sense for the burden of adjustment to fall upon the deficit countries. Forcing these countries to cut their wages will only aggravate the disparities between the core and peripheral economies, without addressing the fundamental structural imbalance.

[i] Klaus Armingeon and Lucio Baccaro. 2012. “Political Economy of the Sovereign Debt Crisis: The Limits of Internal Devaluation.” Industrial Law Journal 41, no. 3: pg 256. Business Source Complete, EBSCOhost (accessed January 23, 2016).

[ii] Servaas Storm and C.W.M. Naastepad. 2014. “Europe’s Hunger Games: Income Distribution, Cost Competitiveness and Crisis.” Cambridge Journal of Economics. 39 (September), pg. 96. doi:10.1093/cje/beu037.

[iii] Ibid. 967.

[iv] Maria Tsampra and Pantelis Sklias. 2015. “Labor Reforms and Recovering from the Crisis.” Procedia Economics and Finance 33 (2015), pg. 50.

[v] Ibid. pg 50.

[vi] Ibid. pg 50.

[i] Artish Ghosh and Ramakrishnan Uma. 2012. “Current Acount Deficits: Is there a Problem?” International Monetary Fund Finance & Development, March 28.