Rejoinder to Flassbeck and Lapavitsas

In response to my critical analysis of German wage moderation and the Eurozone crisis, Heiner Flassbeck and Costas Lapavitsas spell out their version of what is roughly the neoclassical textbook model of a currency union. 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. Let me be clear: the issue for me is not which side to this debate—those who accuse Germany of beggaring-its neighbors by undercutting wages or those who praise Germany for being super cost-competitive—is right. Both sides are mistaken in thinking that the simple textbook model can be credibly used to argue that Eurozone imbalances were driven by (exogenous) losses or gains in unit labor cost competitiveness. It is a myth—or, as Marx would perhaps have it, a fetish: a reified totem which stands in the way of understanding what is really happening. It is high time to ditch this myth for at least the following five reasons.

Where Are the Big Banks?

Firstly, the model presented by Flassbeck and Lapavitsas has a distinctly pre-Hilferding (1910) flavor to it, as in their take, Eurozone capitalism still has to enter the stage of “monopoly finance.” What role do big banks, gross cross-country financial flows, and the ECB play in Flassbeck and Lapavitsas’ analysis? The answer is none. Their exclusive focus is on exports and imports of goods and services, and their silence on banks, financial flows and interest rates reflects a view that the “financial sector” of the Eurozone is just passively adjusting to whatever happens in the real economy. Their view comes out clearest when they compare the Eurozone countries (each one lacking an own national currency) to a country having its own currency, so as to argue that in the latter case, trade surpluses (or deficits) can only be temporary, because after a while an automatic appreciation (depreciation) of the “equilibrium” exchange rate would bring down the surplus (deficit).

In the real post-Hilferding world, however, there is no such textbook automatism, because the impact of trade flows on the exchange rate is—generally—overwhelmed by the impact of cross-border gross financial flows, which (importantly) are mostly unrelated to trade (Akyüz 2014; Bortz 2016). This holds true for the Eurozone as well: billions of euro lent by German banks to (financial) firms in Ireland and Spain, and by French banks to (financial) enterprises in Greece, Ireland, Portugal and Spain were unrelated to the financing of trade (see O’Connell 2015). It is exactly these gross financial flows from the Eurozone core to the periphery, mostly coming from powerful too-big-to-fail banks (O’Connell 2015), which played the central role in bringing about the imbalances and destabilizing the zone, a role recognized by Professor Bofinger (2016) and by the so-called Consensus Narrative (2015)—but left unmentioned and un-analyzed by Flassbeck and Lapavitsas whose “diagnosis” of the Eurozone crisis thus resembles Hamlet without the Prince of Denmark.

What About Oligopolistic Competition?

Secondly, Flassbeck and Lapavitsas entertain a rather tenuous notion of competition between firms, which, they argue, is centered around reducing unit labor costs by means of productivity gains. They write that “supply side conditions are pretty much given for all [enterprises] since market forces tend to equalize the prices of intermediate goods and the cost of capital” [italics added] and hence more innovative firms (those which manage to cut unit labor costs) tend to be more profitable and grow, while less innovative ones lose market share and ultimately perish.

This is remarkable. To make their argument work, they presume that (global) competition ensures factor price equalization across countries—which is something most neoclassical trade economists would doubt on empirical grounds—and which theoretically requires one to assume perfectly competitive markets. It must be noted that Wren-Lewis (2016) falls back on exactly the same assumption. This implies that according to Flassbeck, Lapavitsas and Wren-Lewis, firms don’t have price-setting power, share the same production technologies, and produce more or less similar (homogenous) goods. All this is unrealistic: in the real world, price-setting oligopolistic firms operating massive global production chains engage in product differentiation, branding, etc. and produce goods that are very different in terms of their complexity, quality and embodied technology (see Felipe and Kumar 2011; Janger et al. 2011).

What Flassbeck and Lapavitsas fail to see is the Eurozone’s material conditions : 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). German firms are price-setters and dominate their niche markets, while Greek and Portuguese firms instead compete with low-cost Asian producers—on costs (but not just labor costs)—and get pushed out from their markets by their Chinese competitors (Straca 2013). The upshot is that real-life competition in oligopolistic markets cannot be reduced to just unit-labor-cost competition—whatever the textbooks want us to believe. And if one insists on focusing on unit labor costs, then there is no reason why one should not also look at unit capital costs (or profit margins), as is argued by Felipe and Kumar (2011); oligopolistic firms might as well compete on profit margins.

Empirical Evidence

Thirdly, Flassbeck and Lapavitsas offer no empirical evidence in support of their claims. Let me highlight four empirical “facts” which run counter to their main claim. Firstly, relative unit labor cost elasticities of export/imports tend to be much smaller (in absolute size) than the corresponding price elasticities, due to the fact that (a) wage costs constitute just about 22% of total production costs; and (b) price-setting firms do pass on only about half of higher wage costs onto higher prices (Storm and Naastepad 2015). This means that a high export price elasticity of −1.2 corresponds to a much smaller unit-labor-cost elasticity of export demand of (roughly) —0.13. Hence, to push up (real) exports by a meagre 2% nominal wages would have to decline by as much as 15% (assuming unchanged productivity). This looks much like the tail is wagging the dog.

Secondly, there is clear evidence to show that in countries like Spain the trade deficit increased because of faster import growth, while export growth stayed constant. If this is so, the question is why (higher) relative unit labor cost would one-sidedly impact imports and not exports?

Thirdly, if one wants to identify the impact of relative unit labor costs on trade, one should filter out other influences on trade and most prominently the impact of income and demand growth. But doing so will show that world income growth already completely explains export growth and domestic income growth fully explains import growth for most economies concerned (Bussière et al. 2011). Put differently, the income effect is mostly found to overwhelm any cost-competitiveness impact, especially in the longer run (see Schröder 2015 for elaboration).

Finally, following good writing practice, I have kept the most important finding until the end: unit labor costs in the crisis countries started to increase only following a preceding deterioration in their trade accounts (Diaz Sanchez and Varoudakis 2013; Gabrisch and Staehr 2014). This indicates that rising unit labor costs were the consequence, rather than the cause, of the growing imbalances. It is difficult to see it otherwise. The empirical evidence speaks volumes—against the unit-labor cost myth (for concurrent arguments, see also: Felipe and Kumar 2011; Wyplosz 2013; Diaz Sanchez &Varoudakis 2013; Gabrisch & Staehr 2014; Janssen 2015; Schröder 2015).

What About Incomes and Aggregate Demand?

Fourthly, what is salient about the analysis of the Eurozone imbalances by Flassbeck and Lapavitsas is that it includes no role for (or reference to) “aggregate demand” or “income.” Theirs is an example of unwarranted reductionism in which the exports of, say, Germany (which constitute the imports of, say, Spain) depend solely on the relative unit labor costs of Germany vis-à-vis Spain.

This cannot be true. Clearly, Germany’s exports to Spain will also depend upon Spanish aggregate demand, if only because a considerable part of Spanish imports consists of capital goods (machines and equipment) and intermediates (high-tech materials and components) and therefore is complementary in nature (Bussière et al. 2011). Let us assume that a country’s exports E depend on world income W and its relative unit labor costs c, while its imports M depend on domestic income Y and relative unit labor costs c. We can then write the following general expression (in logarithms) for that country’s trade balance (see Fagerberg 1988):

where the world-income elasticity of exports by country i; the income elasticity of imports by country i; the relative-unit-labor-cost elasticity of exports by country i; and the relative-unit-labor-cost elasticity of exports by country i.

Using this equation it is straightforward to see that Flassbeck and Lapavitsas, but also Wren-Lewis, who all focus on relative unit labor costs, are missing an important part (if not all) of the action. Their claim is that if relative unit labor costs in the Eurozone are constant ( c = 1 and ln c = 0), the trade balance will not change. It follows from equation (1) however that this only occurs under very special conditions, namely when the export growth of a country induced by world income growth is equal to the import growth of that country induced by domestic income growth. There is absolutely no reason why these special circumstances would generally apply and hence, under normal and realistic conditions, one must expect trade balances to either improve or to deteriorate—depending on whether the export growth induced by world income growth exceeds the import growth induced by domestic demand growth or not.

Let me now become more specific and consider Spain which specializes in mid- to low-tech exports goods, the world demand for which is not very income-elastic (is rather low); at the same time, Spain’s imports high-tech capital goods and sophisticated intermediates (from Germany) for which the income elasticity () is rather large. As a result, for Spain >. This implies that even when Spain grows at the same pace as the world (or Eurozone) economy, its trade balance must deteriorate, because its import growth exceeds export growth.

Exactly the reverse holds true for Germany which caters high-tech capital and consumer goods to the fastest growing destinations (e.g., China and, until recently, Russia). Hence, the export demand for Germany’s high-tech manufactures has a high world-income elasticity, while most of Germany’s imports are complementary (and increase in line with domestic production and demand) (Bussière et al. 2011). Accordingly, for Germany < and hence its trade surplus tends to grow—even when Germany is growing at the same pace as the world (or the Eurozone). These asymmetric growth patterns are the direct consequence of structural differences in productive specialization (Simonazzi et al. 2013). They go unacknowledged in the account of Flassbeck and Lapavitsas and of Wren-Lewis.

Higher Wages and Higher Inflation in Germany Will Not Help.

Finally, Flassbeck and Lapavitsas argue in favor of higher German wages (and higher German inflation), just like Wren-Lewis (2016), in the mistaken belief that this will lower Germany’s cost competitiveness, reduce its trade surplus, and thereby rebalance the Eurozone as a whole. 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.

Higher German wage growth and higher German demand simply do not constitute a recovery strategy for the Eurozone, as is shown by the (direct and indirect) value-added spillover effects of German growth on value added in other European countries, which occur through direct and indirect backward production linkages operating in global production chains. Specifically, if German growth results in higher production and value-added generation in the U.S., and if U.S. firms source intermediates and components from South Korea, and if in turn South Korean firms use inputs produced in Italy or Spain, this circuitous indirect impact of German growth on value added in Italy or Spain is included in the total value-added spillover effects reported in Table 1. The estimated value-added spillovers of German growth are, in other words, very comprehensive estimations. The value-added spillovers have been calculated using the full world input-output data matrix for 2011 from the World Input-Output Database (WIOD), which includes 35 sectors (including 14 manufacturing industries) in 40 countries (including all 27 members of the European Union as of 1 January 2007). The estimates provide a sobering “reality check” on what German growth can do for the economic recovery 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, 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 already shows that a focus on just the Eurozone is a narrow one, because most of the trade and value added spillovers of German growth happen outside the zone. Of the value-added created by German growth within Europe, almost 57% (€ 3.99 billion) is extra income in Austria, Belgium, France and the Netherlands, another 20% (€ 1.4 billion) in Poland, the Czech Republic, Slovakia, and Slovenia, and the remainder (€ 1.66 billion) in Southern Europe. To make my main point: the combined value-added spillover of German growth in the Czech Republic, Slovakia, and Slovenia (with a combined population of 17.9 persons) is larger in absolute terms than the corresponding combined value-added spillover in Greece, Portugal and Spain (with a combined population of 68.4 million people). German growth significantly raises GDP growth in the Netherlands, Belgium, Austria, as well as in Poland, the Czech Republic, Slovakia and Slovenia—but there is hardly any noticeable growth spillover in Greece, Italy, Portugal and Spain (Table 1). Reflating Germany by raising German wages, demand and growth would be nowhere near enough to bring about a turn-around in Southern Europe. It is wishful thinking, and it ignores fundamental asymmetries in production, technology and specialization which together constitute the material conditions of the Eurozone system.

The Real Issues (Again)

All this talk about labor-cost competitiveness diverts attention away from the real problem of the Eurozone: 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). This centrifugal process has been fueled and strengthened not just by the surge in cross-border capital flows following the introduction of the euro, but also by the common currency itself as well as by the centralized and uniform interest rate policy of the ECB which up to 2008 was perhaps appropriate for stagnant and low-inflation Germany, but was undeniably out-of-sync with inflation levels in Southern Europe (see Lee and Crowley 2009; Nechio 2011; O’Connell 2015; Storm and Naastepad 2015). Cheap credit in the South created unsustainable asset bubbles and facilitated untenable debt accumulation which fed into higher growth, lower unemployment and higher wages—but (totally in line with market rates of return) all concentrated in the non-dynamic and often non-tradable sectors of their economies. 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.

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. Hence, the real questions are: how to bring about structural convergence between member countries of a common currency area (so far lacking any meaningful supranational fiscal policy mechanisms) in terms of productive structures, productivity levels, and ultimately incomes and long-term living conditions? What is the appropriate interest rate for the structurally divergent “core” and “periphery” if it has to be one-size-fits-all? And how can banks, the financial sector, and capital flows be made to contribute to a process of convergence (rather than divergence)? There are no simple answers and it is easy to yield to sheer “pessimism of the intellect.” But unless progressive economists source the “optimism of the will” and start seriously addressing the real issues, rather than rehashing myths about unit-labor cost competitiveness, the future of the Eurozone looks very bleak indeed.

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