The Wilder View

EA Infernal Devaluation Progressing

The EU answer to rebalancing portfolio and trade flows within the Euro area (EA) without currency devaluation is recession and deflation. They call this ‘internal devaluation’ – shifting relative prices by reducing domestic demand in the debtor countries, thereby shifting the terms of trade. Marshall Auerback calls it ‘infernal devaluation’. Marshall’s right.

Today we got more evidence that infernal devaluation is progressing. EA unit labor costs (ULC) – average cost of labour per hour workers – increased 0.2% in the third quarter, slowing the annual pace from 3.1% to 2.7%. While the slowdown was to be expected, given the deterioration of domestic demand, the elevated level of growth in ULC suggests that wages in Europe are stickier than what is needed to effectively drive the terms of trade via internal devaluation. Better put: downward pressure in European wages moves more like molasses than water; it will take severe recessions in some of the debtor countries to drive relative prices down sufficient enough to feasibly shift the terms of trade.

The table below lists the average annual ULC gains/losses relative to the EA overall. Germany’s moving on par with the EA, averaging -0.05% (rounded to 0 in the Table) annual relative ULC growth. Germany should be seeing relative appreciation. Spain and Italy are seeing average annual relative depreciation, -0.6% and -0.3%, respectively, per quarter. This is consistent with what is ‘supposed to happen’ in Italy and Spain to shift relative capital and trade flows. However, Netherlands and Finland are matching pace, big exporters that theoretically should be turning importers. France is seeing relative appreciation, +2.2% average annual relative ULC gains; but they were already running CA deficits. Austria and Belgium experienced relative annual price gains, +0.65% and 0.99%, respectively; but they’re too small to matter. Greece and Ireland (Greek data is truncated at Q2 2011) successfully devalued. But at what cost? Their unemployment rates that are now multiples of what they were before the crisis.

As a point of reference, the average annual depreciation of US ULC relative to that of the EA is -2.1%. Not only are EA countries losing competitiveness to key developed players, the US for example, but they’re fighting a battle to the bottom within the EA. This is a lose-lose situation.

I hear through unnamed sources that Sarkozy and Merkel are planning (another) Summit next month – I cannot validate this through really anything except word of mouth. They’re meeting to discuss the impact of the contractionary austerity policies on EA economic growth. Duh.

The denial regarding the infernal impact of their deflationary policy is truly remarkable.

2 Responses to “EA Infernal Devaluation Progressing”

phraathitDecember 17th, 2011 at 9:02 pm

This explains probably why the Euro is now depreciating opposite the US-Dollar. A weaker Euro increase the external price competitiveness. However, other countries in Asia like China are following suit. They do not want to reduce their competitive advantage opposite Europe. This will cause stress for the US, because they cannot afford a strong US-Dollar position as well.

No wonder, that Christine Lagarde warns on a devaluation race next year.

A general US-Dollar appreciation will stall the US recovery and risk of further deflation.

Patrick_VBDecember 19th, 2011 at 3:08 pm

Hello Rebecca,
Even though you define your concept of ULC, it could lead to problems of interpretation, as Unit Labour Costs (ULC) are usually defined as the cost of labour per unit of output (e.g., total labour costs / GDP). The data you are referring to is not the usual ULC, but a measure of Nominal hourly labour costs. In discussing the rapid progression of hourly nominal wages, it is then also important to stress that the latest reading of annual HICP inflation for the Euro Area was 3.0%, implying that real hourly wage costs are currently falling in the euro area. As the euro currency has generally been depreciating against the USD over the last months, this means that the Euro Area is increasing its price competitiveness in USD terms (one would have to check if this is also the case in effective exchange rate terms).

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