by Edward Lambert
Editor's note: Originally published on July 23, 2014
John Bluedorn and Shengzu Wang wrote a post on the IMF blog called, Euro Area: An Unbalanced Rebalancing? They talk about the unbalanced Current Account trade balances within Europe where creditor nations continue with large surpluses, even though debtor nations are moving toward surpluses themselves. They give reasons of competitiveness, increased saving and low investment. Their final conclusion is wrong because they do not incorporate the effects of effective demand.
Many debtor economies have seen their unit labor costs decline, improving competitiveness and boosting their current accounts… the bulk of competitiveness improvements in debtor economies has been accompanied by declining domestic demand and rising unemployment.
Unit labor costs are just labor share divided by the price index. So when unit labor costs fall in a low inflation environment, labor share is falling too. Also, effective demand is falling. So it is no surprise that domestic demand is falling and unemployment is rising. (Unemployment rises when labor share falls, as an economy moves down the labor supply curve.
We see that effective demand is falling in Europe.
At the same time, many creditor economies have had large and persistent surpluses, driven by both higher saving and lower investment
As labor share falls, domestic consumption decreases. The difference between domestic consumption and production gives national saving. So lower labor share is driving the Current Account surpluses in Europe.
Restrained domestic demand (high saving and low investment) is part of the story behind the persistent surpluses in the creditor economies.
The low investment is a result of low effective demand among labor / consumers.
The Wrong Conclusion
Large and persistent surpluses in creditor economies contribute to a stronger euro, making it tougher for euro area debtor economies to adjust.
To make the rebalancing more robust, policies are needed to boost investment in creditor economies and structural reforms to raise productivity in all euro area economies (through further liberalization of product and service markets and reforms to make labor markets more flexible). These would raise potential growth across the board and help output gaps close faster.
First, productivity is constrained by effective demand (link). So boosting productivity through increased investment is like expecting to pass through U.S. customs without a Visa. You have to have the Visa first which represents raising effective demand.
Second, making labor markets more flexible will only create more capacity to lower unit labor costs, which will exacerbate the weak effective demand underlying the great Current Account surpluses in Germany and the high unemployment in the periphery.
Third, potential growth would not rise since productivity cannot be increased against the effective demand limit.
Fourth, the goal should not be closing the output gaps and raising potential output. The goal should be lowering unemployment, which is caused by weak domestic demand.
Fifth, the output gap will close faster only because effective demand is falling which pushes potential output down. Ultimately a country ends up with higher unemployment. We see examples of high unemployment in many countries.
The Right Conclusion
The problem is low labor share. So the solution is higher labor share. However, if there are larger forces pushing unit labor costs down globally, then there really isn’t any solution. But actively lowering unit labor costs makes the situation even worse.