Industrial development in a post-crash world- Part 5: The crisis in the Eurozone: what role did production play?

The widespread belief that divergences in the Eurozone were driven by ‘unit labour costs’ is mistaken. We need to focus instead on the specific production structures and specialisations of ‘peripheral’ states and their relationship with wider processes of global economic integration

When the Eurozone crisis started in Greece, mainstream policy institutions were primarily concerned with fiscal profligacy.  The crisis was due to governments that had “spent beyond their means” and this had translated into high fiscal deficits and public debt. But as the crisis spread to other Eurozone countries, including those with fiscal surpluses before the crisis (i.e. Ireland and Spain) the private sector figured with increasing prominence in mainstream accounts. Now, it was not only a crisis of state expenditure but also one of private sector competitiveness.

In mainstream analyses, the problem facing crisis ridden countries was a divergence between labour productivity and wages, with wages rising faster than productivity, ultimately translating into higher unit labour costs and therefore also a declining competitiveness. Unit labour costs (ULC) can be defined as “the ratio of a worker’s total compensation … to labour productivity”.It concerns the relationship between wages and fringe benefits on the one hand, workers’ efficiency in producing goods and services, which reflects the intensity of work as well as the state of technology, on the other. The ULC diagnosis has been a powerful analysis, with harsh consequences in the world of labour. It provided the theoretical foundation for the strategy of internal devaluation, which was at the heart of the structural adjustment programmes in Portugal, Greece and Ireland.

Heterodox interpretations have dismissed the notion that the Eurozone crisis was a crisis of fiscal profligacy, and have rejected austerity and internal devaluation as appropriate policy tools. They have looked to the private sector to explain the current account imbalances that developed between core and peripheral countries, in the Eurozone. This indicates a relational approach on trade and financial flows between core and peripheral countries rather than a methodologically nationalist perspective. However, most post-Keynesians and Marxists have shared the same focus on ULC. The euro was the “original sin” that led to the crisis, and it represents a fixed exchange rate regime. With wage repression driving German competitiveness, peripheral countries could not address their growing ULCs and current account deficits through currency devaluation.  

Thus, as highlighted by Storm and Naastepad (2015), there is an analytical core that unites economists right across the theoretical and political spectrum. The focus on ULC provides the theoretical justification for the strategy of internal devaluation, but it also informs the radical left-wing proposal that peripheral countries should exit the monetary union, of which the most well-known proponent is Costas Lapavitsas.

The neglected role of product specialisation

The use of ULC as a proxy for competitiveness was criticised early in the crisis, but this has not prevented its popularity at European policy level, in academia and on the left. The critiques highlight methodological, historical and logical inconsistencies.

First, the ULC argument looks at the rate of change in the relationship between labour costs and productivity in peripheral countries relative to Germany, usually from 1995. In so doing, it fails to take account of the fact that the actual wages in countries like Portugal and Greece are much lower than in Northern European economies.  

Second, the ULC argument assumes that labour costs are the only costs that determine competitiveness. As noted by Storm and Naastepad “[w]hat matters in international competition is the ‘gross output price’ of a product or service”. This includes intermediate inputs, labour and the profit margin.

Third, the ULC argument about the Eurozone’s imbalances rests on the premise that peripheral crisis ridden countries are in direct competition with Germany. This is closely related to an assumption that countries that trade compete with one another. As pointed out by Smith, the view that peripheral countries must resort to savage cuts in wages, rests on the false premise – that Germany is Greece’s, and other peripheral countries’ “principal rival”. 

Fourth, in assuming that Greece and Portugal compete with Germany, the proponents of the ULC argument generally abstract from posing concrete questions about production in EMU countries. By focusing on ULC developments in the aggregate, they disregard the fact that core and peripheral countries have different patterns of product specialisation, provide different products to the global market, and therefore compete on different markets.

The case of Portugal

Rather than focussing on ULCs, it is vital to study production, export specialisation and indexes of technological complexity to understand the Eurozone’s imbalances. This necessitates in-depth case study research which contextualises the historical development of specific sectors and branches of production and investigates what exactly is produced and exported. In the case of Portugal, the textile and clothing sector, as well as shoe wear, are of critical importance. In 1990, these sectors still accounted for approximately 37% of exports. The 2000s were not only marked by the introduction of the euro, but also by China’s entry into the WTO in 2001 and the EU’s expansion to Central and Eastern Europe in 2004. These international developments are usually not discussed in the literature on the Eurozone crisis. However, these shifts are critical in understanding the de-industrialisation of the Portugese economy, particularly if we adopt a sectoral perspective.

Portugal’s current account deficit was driven by the fact that imports increased faster than exports in the 1990s. The 2000s represented a turning point in this regard. Total manufacturing volume consistently  increased from 1955 until 2002, after which it began to decline sharply. Reflecting this contraction in production, the early 2000s marked a turning point also with regards to exports. The share of manufacturing goods in total exports declined from 86% to 76% between 2003 and 2008. Only from then was there an overall deindustrialisation of Portuguese exports.

To what extent was this driven by China’s entry into the WTO and the EU’s expansion to the East? Was the overall tendency towards deindustrialisation driven by competitive pressures in textiles and clothing? The answer is yes, but it is not the full story. The former event seems to have had an immediate impact, but it is important to note that the deindustrialisation of Portuguese textiles and clothing goes much further back than China’s entry into the WTO. In the words of the Association for Portuguese Textiles and Clothing the sector has faced “several competitive shocks” over a prolonged period. In the 1990s, the effect of deindustrialisation in textiles and clothing was softened by the rise of other manufacturing sectors. By the 2000s, a new set of dynamics were at work. Portugal went from an investment surge to an investment slump. Virtually all branches of manufacturing were in a state of stagnation or  decline. There was no booming sector that could substitute for the continuing decline of textiles and clothing.

This suggests that Portugal’s trade balance was affected by an alteration in its productive structure and its subsequent contraction. There was something else going on than an increase in ULC relative to Germany. Thus, the analytical framework that has underpinned mainstream competitiveness policies is inadequate. The same can be said about the theoretical basis of the left-wing strategy of exiting the EMU. There are indeed many problems with the euro, including the fact that it is inherently a fixed exchange rate, but in the attempt to reshape monetary policy, it is essential to account for what harms were caused by the euro and what were caused by other factors.