From trauma at TU Delft to collapse of the Euro

This discussion continues with the exchange of Flassbeck & Lapavitsas versus Storm.

My own position is as follows. Holland creates its own unemployment since 1970 by a wrong policy on taxes and premiums. Holland has the entrenched government policy of “solving” this by wage moderation and exporting its own unemployment to other nations. I present my alternative analysis since 1990. Economists at TU Delft have been arguing against this policy of wage moderation for decades too. They overlook the cause in taxes and premiums, and focus on technology. Schumpeterian innovation requires higher wages to get rid of obsolete technology. Now that Germany has had wage moderation too (because of the fall of the Berlin Wall and the Mark = Mark policy) the discussion on wage moderation moves to center stage for the survival of the Euro. Servaas Storm at TU Delft enters the European discussion again with arguments about technology, and again neglecting taxes and premiums, and neglecting the censorship of science by the Dutch government (what this weblog is about). Storm has an innovation in his analysis by including banking, and how international credits drive international trade, yet, he seems to neglect the phenomenon that trade surpluses generate funds that look for opportunities, often by providing credits that generate more surpluses. Thus Dutch and German wage moderation would be causally more important than bank credits.

PM. See also former IMF director Johannes Witteveen’s lecture on the Dutch export surplus and a need for an investment policy. There is also my discussion in 2009 with a chart of the Dutch export surplus in 1971-2010 (forecast). This is already 8 years ago.

Let me restate some basic economics for some readers who lack this.

Basic macro-economics

  • Let real national output (GDP) be y and the price level be p.
  • Let labour input be x and the wage be w.
  • Then labour productivity is λ = y / x and the Labour Income Quote is LIQ = w x / (p y).
  • Let there be a Cobb-Douglas production function: y = β x^α, with β containing capital and technology.
  • When producers maximize their profits π = p y w x subject to labour input x, then we can derive:
  • The first order condition: dπ / dx = 0 gives p β α x^(α – 1) – w = 0.
  • Or the wage can be set at w = p β α x^(α – 1) = p α y / x = p α λ, since the national labour supply is given as x.
  • This w = p α λ is the rule mentioned by Flassbeck & Lapavitsas: let wages grow with labour productivity and the agreed target of inflation of 2%.
  • From w = p α λ we can derive α = w x / (p y) or α = LIQ.
  • Unit labour costs are ULC = w x / y = w / λ = p LIQ. Thus alternatively w = p LIQ λ or w = ULC λ.

The assumption of the Cobb-Douglas function seems somewhat specific, but given the relatively small changes that we are considering the approximation is often so good that we almost seem to have a definition. The LIQ has the character of a structural parameter α, at least for annual changes.

If prices p and wages w and labour input x remain the same from one year to the other, and productivity rises by rate g, so that  =  (1 + g) y[-1], then α = LIQ = w x / (p y) = w x / (p (1 + g) y[-1]) = LIQ[-1] / (1 + g) = α[-1] / (1 + g). For example, if α[-1] = 80% and g = 2% then α ≈ 78%. In this case α would be stable if wages would rise by 2% too.

The w = p α λ condition is not in the EMU rules. The Eurozone countries apparently are less aware of the notion of “national bargaining” (as in the Dutch Polder model) and have been hesitant to include national wage agreements in the EMU and Stability & Growth Pact (SGP) and its updates. (Check for the word “wage” on this wiki page.)

Another possible rule might be a tax of 5% on the three year cumulative trade surplus (which may be seen as 15% for a single year), to be invested in productive capacity in the deficit countries via national investment banks. Such a tax would not be on export items (like a tariff) but levied on the Eurozone member governments of surplus countries. (At this applet, set the color bar to a score of 0, and slide over the years.)

It is unavoidable to think about such rules. Holland has been moderating its wages long before Germany did. The policy put pressure on the exchange rate of the guilder, but this was resolved by joining the Euro. Holland still is a small country and the impact wasn’t much felt. Now, Europe must explain to Germany that a raise of German wages is required, whatever they fear about inflation. It should help Germany to grow aware that my analysis (see DRGTPE) allows full employment at stable prices, not only by exports but also by stimulating the domestic market.

Shifting the blame

Both North and South Europe deviated from w = p α λ. Some Northerners blame the South, and some accept some blame themselves.

  • Sinn and Schäuble argue that Southern Europe should moderate their wages like Germany.
  • Bofinger and Flassbeck & Lapavitsas argue that Germany (and Holland) should raise their wages.

As Storm states:

“Their main point is that there would not have been large unsustainable current account imbalances within the Eurozone, and consequently no sovereign debt crisis in the deficit countries, if all member states had kept their nominal wage growth equal to labor productivity growth plus 2% (the inflation target). Professor Wren-Lewis (2016) has been making the same point. In this account, this delicate equilibrium has been deliberately upset by nominal wage moderation in mercantilist Germany, with a growing German trade surplus just being the flipside of the growing trade deficit in Southern Europe. It is rather ironic, in my opinion, that a similar logic is used by mainstream observers such as Sinn (2014) or even Mr. Schäuble himself, with this difference: Sinn and Schäuble argue that the current account imbalances were caused by a failure of the crisis countries to follow Germany’s successful example in cutting down their unit labor costs.”

Towards a collapse of the Euro

Sinn and Schäuble want to control inflation and they lack instruments to make sure that Southern Europe adheres to the EMU rules. Thus Sinn and Schäuble take the hard line that it is up to Southern Europe to choose themselves:

  • either unemployment because of high wages
  • or internal devaluation, and subsequent unemployment because of deficient internal demand.

Hence we can understand Flassbeck & Lapavitsas:

“Germans ought to know better than all others about the difficulties caused by wage divergences in a currency union. The deviation of East German wages as measured in international currency, following the German Monetary Union of 1990, destroyed East German industry and forced a transfer union. Unfortunately, for the EU and the EMU the option of a transfer union is simply not available. As long as Germany persists with its policy of wage moderation, the only future for the EMU is collapse.”

Check how I criticised Angela Merkel for her deceit at the German elections in 2013. Given German policies on wage moderation, standard economic theory allows her the choice between a transfer union or a breakup, but she kept silent about this. Of course there is my amendment to the theory of the optimal currency area, see MPRA or RWER, but as long as German policy makers do not indicate that they understand his amendment, we must conclude that they disinform their electorate.

How does Storm handle this ?

How does Storm handle this reference to basic economics ? He misstates the argument, and then rejects it.

“(…) that Eurozone imbalances were driven by (exogenous) losses or gains in unit labor cost competitiveness (…) is a myth (…)”

Storm’s problem is on causality: “what drives what”. Yet this is not quite what this discussion is about. What Storm calls a myth are basically accounting rules.

  • Use GDP = Y = p y = C + I + G + X – M, with consumption C, investments I, government G, exports X and imports M.
  • The current account CA = X – M is also the increase in foreign assets FA = X – M (NY FED).
  • National income, employment and wage translate into LIQ and λ. This is mere accounting.
  • Compare two situations for the same country with only a difference in M. In the first situation there is Y1 with a surplus on the current account, or M < X. In the second situation there is Y2 with a deficit or M > X. Thus Y1 > Y2. Assume the same output price p and working force x so that y1 / x > y2 / x, or λ1 > λ2. The productivity with a surplus is higher than with a deficit. For example, in the second case the country worked as hard as usual, but also imported a car by borrowing from abroad. Mere accounting causes that observed productivity drops. Similarly we have w x / y1 < w x / y2 or ULC1 < ULC2, or that the deficit situation has higher unit labour costs.

Economics is about causality and not about accounting, but it is important to be aware of accounting effects. Regressions with statistical data that contain these accounting effects must be judged carefully.

In above example of importing a car, causality seems to run from first importing to secondly a statistical observation on productivity. This is Storm’s view. But this is not the only causal possibility. Sinn and Schäuble might argue that higher productivity might have been feasible if the car hadn’t been imported but e.g. produced in the country itself with a creditor in the country itself. Thus there seems to be more complexity than Storm allows for (though he already makes a complex case). And Sinn and Schäuble might state more clearly that they also plea for the demise of the German car industry.

Storm’s five arguments

Storm has five arguments that we may indicate shortly. Apparently he repeats himself at points, but this is okay since we look at the arguments and not their number.

  1. Banks in Northern Europe lent to customers in Southern Europe, assuming that loans in Euro were safe anywhere. (Comment: True. However, if there hadn’t been surpluses on the Northern current accounts, then these banks would have had less funds. We are not speaking about a single year, but a prolonged period of surplus funds looking for “investment” opportunities.)
  2. German firms, producing high-tech, high value-added, high-priced and mostly very complex manufacturing goods, do not directly compete with Spanish, Portuguese, Greek or even most Italian firms, which are specializing in lower-tech, lower value-added, low-price and less complex goods (Simonazzi et al. 2013).” (Comment: This is not relevant, since differences in quality are corrected by differences in wages, whence we compare w1 / λ1 and w2 / λ2.)
  3. Four empirical “facts”. (a) Elasticities. (b) In Spain imports grew while exports were unaffected. (c) World income explains exports, and national income explains imports. (Costs might have a one-time effect but then are stable.) (d) There were first the imbalances and only later the worse ULCs. (Comment: Basically agreed on (a)-(c). However, this (d) is the same as (1). We are not speaking about a single year, but about a prolonged period of imbalance and funds looking for profit.)
  4. A more theoretical discussion of (3c), with the example of (2). “These asymmetric growth patterns are the direct consequence of structural differences in productive specialization (Simonazzi et al. 2013).” (However, see (2). Obviously, the EMU doesn’t have an exchange rate regime to correct sustained imbalances. Apparently governments must impose what otherwise would have been done by exchange rate markets.)
  5. “Higher Wages and Higher Inflation in Germany Will Not Help.”

Storm on point 5:

“German exports and imports, as I argued above, are not very sensitive to changes in relative unit labor costs, however, and hence there will be only a limited amount of expenditure switching (away from German products and toward foreign goods), as has also been convincingly shown by Schröder (2015). Let me repeat for clarity’s sake that I am strongly in favor of higher nominal wage growth (in excess of labor productivity growth plus 2%) in Germany. It will definitely help Germany. But it will not help the crisis-countries of the Eurozone.”

“The assumption is that German GDP increases by € 100 billion (which means German GDP is growing at 3.7%). Through global production chains, [my emphasis] German growth creates € 29.5 billion of income in the rest of the world and about € 7 billion in the selected European countries listed in Table 1.”

This looks at production chains (Germany, USA, Korea) ! This may well be. But higher German wages would also mean higher German imports for consumption.

Storm’s view on the real issues (again)

Storm repeats what he regards as the real issues:

“(…) the common currency and monetary unification have led to a centrifugal process of structural divergence in terms of structures of production, employment and trade (as explained in my earlier notes).”

“German wage moderation mattered a lot, not through its supposed impact on cost competitiveness, but via its negative impacts on (wage-led) German growth and inflation, which in turn prompted the ECB to lower the interest rate in the first place.” (Comment: This “negative impact” is TU Delft slang for the idea that low wages reduce the need for Schumpeterian innovation.)

“The consequent crisis of the Eurozone is a deep crisis of inadequate aggregate demand in the short run and unmanageable structural divergence between major member states in the long run.”

I wonder. If Germany provided the European industrial zone and Southern Europe provided the European vineyards, olive trees and universities, then this might still work and everyone might be happy, provided that the prices of cars, wine, olive oil and Ph. D. doctorates would be right. Wage levels in Southern Europe might still be lower, but with a purchasing power parity (PPP) living standards might still be quite comparable. Sinn and Schäuble might like an argument that EU support for investments in Southern Europe should not be competitive to the German car industry (see here on the restauration of the Colosseum).

But this is not the full story. The Po valley has fine cars and machinery too. Italy itself has a North-South problem. Spain has the difference between Catalunya and Andalusia. And Germany has Laender who don’t do as well as Bayern.

Closing this review

This exchange started with Bofinger’s argument that German wages should be raised. This argument is fine. It will stimulate Germany’s domestic economy and imports. The obvious ceiling is provided by risks of unemployment and inflation, but the rule of a wage rise with productivity and the target of 2% inflation is fine too. Germany also has some catching up to do.

It is correct that German exports might not be much affected, and thus neither employment in the exporting sector, because the productivity growth in the exporting sector likely is larger than this growth in the domestic sector. But the rise of imports would still help in reducing the surplus on the external account.

Storm’s arguments on competitiveness & wage moderation are a different subject. This is basically the subject of investments and regional development, and the role of banking. Germany is advised to focus on domestic investments.

Economic analysis would be served by having another indicator alongside GDP, namely a correction of GDP for borrowed funds. The X – M correction works fine for foreign assets, but a correction for domestic borrowing would be helpful too. If one buys a domestic car with credit, then this domestic car really has been produced, but it would be indicative to know whether 10% or 25% of GDP would be from credit.

Overall I can repeat that my analysis of 1990 is still very relevant for understanding and solving the Great Stagflation since 1970. There are DRGTPE dating before the 2007+ crisis and CSBH after it. DRGTPE already has a chapter on the distinction between the exposed and sheltered sectors, and CSBH has a refinement of that argumentation.

It is unfortunate that our fellow economists at TU Delft have been neglecting that analysis since 1990, whence they still lack the full picture. But every day starts with a new sunrise.

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