Why the European Debate on Competitiveness is going nowhere

Workers of the Euro Area, disunite!

International competitiveness – a concept for nations

At the level of nations, competitiveness is a difficult concept, as it suggests a false analogy between enterprises and countries. Countries, however, do not compete with other countries in the same way as companies do. Trade among countries is not about profit but about the international division of labour and can benefit all by raising productivity and increasing the joint economic product.

A meaningful concept of competitiveness at the national level defines a competitive country as one that can maintain high rates of growth and employment in the medium term. This concept focuses on the country’s ability to provide its citizens with high and rising standards of living in the medium and long run. Competitiveness in this sense depends on the quality of a country’s economic and political institutions and the extent to which they are supportive of employment, productivity growth, innovation and the ability to adjust to changing circumstances.

            The public debate is often reduced to the question on how to gain competitiveness through cost and price advantages against other countries. But the best known policy strategies for gaining competitiveness - real wage cuts or exchange rate depreciation – are not consistent with the definition of competitiveness for a country as defined above. These measures reduce the standard of living in the long run in return for a comparative advantage only in the short run.

            The Kaldor Paradox already tells us that in the long run growing market shares and increasing relative costs or prices tend to go hand in hand. In other words cost cutting cannot be a recipe for a successful country-level strategy. Dehasa (2006) emphasised that instead of cost cutting  economies of scale in production and distribution, product differentiation, technology are more efficient to compete in foreign markets for heterogeneous goods and services. This so-called monopolistic competition is today a well established tool in modern economics.

Competing inside the euro area

            Inside the euro area, competitive performance of its member states is now an issue on the policy agenda (see EU Economic Review Nov 2006 and EP’s Monetary Dialogue with the ECB, Oct 2006). Several commentators warned that divergent competitiveness trends of member countries might ultimately challenge the union. Countries that increased their relative competitiveness against other member states through cost cutting will find it hard to defend their position politically. At a rally in support of employees at a Volkswagen plant in Brussels - where 3000 jobs will be lost by 2009 -, representatives of Germany’s IG-Metall metalworkers union were hard pressed to defend a strategy to save jobs in VW in Germany that was perceived to be responsible for the closure of the Volkswagen plant in Belgium.

            Germany’s real effective exchange rate has fallen significantly relative to other EMU member states (see chart), which means that Germany has improved its relative competitiveness significantly and persistently in the last few years. Germany has become the most competitive country on this scale, irrespective of whether the real effective exchange rate is based on unit labour costs or CPI. Germany depreciated its real effective exchange rate (based on unit labour costs) from 100 in 2000 to 89 by the end of 2006, showing an improvement in cost competitiveness against other 11 members of the Euro Area of 11 percentage points.

            Germany was successful in negotiating real wage reductions at corporate level and to improve productivity per worker and per hour. Relying on wage reductions at a time when domestic consumption is weak poses the risk of a vicious cycle as demand itself depends on wages and employment (Dehesa 2006). Furthermore Stahn (2006) showed that improvements in German export performance was due to the growth in export markets more than to cost cutting.

If competitiveness is perceived solely through cost-cutting behaviour, EMU member states could indeed engage in a race to the bottom that will benefit none of its members.

            A more comprehensive way to measure competitiveness for nations is provided by the Global Competitiveness Index of the World Economic Forum. This business survey has more than 200 questions on short but also long term aspects of national competitiveness including questions on the quality of its institutions and regulations. The table below summarises the position of the Eurozone member states in top 50 group for 2006 and the change relative to 2005.

            This ranking gives a slightly different picture of Germany than the real exchange rate depreciation would suggest. Although Germany is still performing well and remains among the Top 10, it lost competitiveness since 2005. This would contradict the quick impression one receives from its improved cost competitiveness.

            The rest of the Eurozone is not performing well either. Austria, Portugal, Italy and France lost in competitiveness with France the highest looser among all member countries. Only Finland, which has been in the top 3 for several years, and the Netherlands and Luxembourg could improve their position relative to 2005.

Source: World Economic Forum

            What could policy makers possibly do to encourage product differentiation and technology innovations? The answer is structural reforms. Some of these reforms are already part of the Lisbon Agenda. Reforms for completion of the single market and financial market integration are other key ingredients. They all take time to implement and face political opposition at a time when the general public is wary of reforms. What is still lacking is a broad understanding that reliance on cost and price competitiveness leads to nowhere.