European Competitiveness Pact: A breakthrough or a Red Ocean doom?

The European Competitiveness Pact is the latest proposal raising havoc among European Union members. Spearheaded by Germany and France it has been portrayed as a remedy to problems behind EU periphery’s debt crisis but also as precondition to much needed easing of their bailout terms in what has been bluntly dubbed as the “Grand Bargain”.

Sounds like euphemism in a way: what should have been an ambitious plan to push forward development and growth across European Union, it is mainly limited to restrictive fiscal policy, let alone promoted as a restrictive, punitive deal that causes public resentment. Furthermore, the introduction of a common policy apart from taking away power from national governments, a sensitive issue, risks creating uniformity across EU member states to the extent that doesn’t exist even in the US. This may increase correlation among European economies and take away a useful internal decoupling mechanism.

A. Decoding the ‘Great Bargain”

According to the original document circulated (and its unofficial translation), the Competitiveness Pact aims at achieving:
1 price competitiveness (eg, stability of real labor cost, realigning labor cost according to development of productivity);
2. Stability of public finance (explicit and implicit public debt);
3. Minimum rate for investments in research, development, education and infrastructure of x% of gross domestic product (value to be decided).

Going deeper into specific measures, the Pact proposes:
1. Abolition of wage/salary indexation systems;
2. Mutually recognize education diplomas and vocational qualifications for the promotion of mobility of workers in Europe;
3. Create a common basis for corporate income tax;
4. Connect pension system to demographic developments (ie, average age of retirement);
5. Oblige member states to commit to tight debt control through clauses in their constitutions;
6. Establish a national crisis management regime for banks.

Much can be said about each one of these metrics, the culprits targeted and their potential effectiveness. The common corporate tax basis for example is directed to Ireland’s low corporate tax rate (Irish claim is key to their growth), wage indexation is practiced in Portugal, Belgium, Greece as is lose fiscal policy and high indebtedness (but then again not only by them).

Trying to decode motivations behind the Pact one can appreciate Germany’s concern over allowing certain economies to roll back into the same crisis and require further bailouts in the future (much discussion has been done on moral hazard these days). On the other hand one should also be critical of these measures’ results and effectiveness.

In this posting we’ll focus on wage levels; after all deficits, public debt, social security and taxes are all related and have reached their limitations in several countries. Analyzing the labor cost we will address certain misconceptions and through that show why this Pact might be missing the mark in raising competitiveness where needed.

B. Labor Cost and Productivity across Europe: Myths and Reality

Comparing labor costs across Europe and other developed countries it’s clear that wages in the European South are much lower, both on gross and net basis.

Another interesting finding is that divergence between the Northern and Southern Europe figures is much higher on gross salary basis than on GDP per capita or net salary figures. This could be due to higher salary deductions in Northern Europe as well as higher levels of self-employment or unreported economic activity in the South. Even in the case of potential tax and social security contribution evasion the solution can’t only be lowering labor cost but rather taking corrective actions where needed, to boost state income and reduce liabilities over a period of time.

Wage level is not the main parameter affecting competitiveness; equally important is what’s produced with this labor cost. Looking at labor productivity across Europe, US and Asia we can see that Southern Europeans are working more hours than their Northern counterparts; contrary to stereotypes and prejudices repeated on various occasions. At the same time however they produce much less of what produced in Northern Europe in terms of output value (GDP per hour worked). Productivity is probably even lower from official figures if illegal labor is taken into the equation.

Low productivity can be attributed to inefficient production methods, low value added products, as well as restrictive legislation and other structural problems. Looking at the Greek economy for example, it is being characterized by services while Germany’s by high value added/export oriented technology sector. Greece is also suffering by a non-conducive to businesses legal framework and economic environment, as international rankings show. What’s the reason for that is a separate discussion, but it’s not a labor cost problem.

A straightforward expression of lower competitiveness can be found in the South’s much lower R&D expenditure. Undoubtedly these are economies that are coming from different starting points and move with different speeds. In the absence of no intervention these differences will persist in the future.

To be fair, the European Union has been trying for years to promote economic development across its members. The 2000 “Lisbon Strategy for Growth and Jobs” called for increase in innovation and employment over a ten year period. A minimum 3% R&D expense target across all Europe was set then which was not finally attained even by highly developed economies. The program also didn’t reach its employment targets. Some reasons for that was the difficulty in steering centrally planned policies through national governments and politicians that may have different priorities or capabilities.

Maybe the reason of this failure lies in the root of the European economic system that favors public investment and crowds out private investment discouraging this way productivity gains; the usual objection to Keynesian policies.

This phenomenon can be more evident in countries that are trying to catch up and usually lack a robust private sector: investment might end up in public projects of questionable utility that although may help in increasing wages and GDP, they don’t contribute in raising competitiveness and promoting long term sustainable development and growth.

In any case R&D investment, on its own, is not a panacea. To be effective it requires the existence of research infrastructure, know-how and a sizeable pool of R&D personnel, otherwise it will be money thrown out of the window raising more excuses against good intentions. Moreover it requires the existence of a business environment that will nurture innovation which cannot happen in economies that lack respective infrastructures. Researchers cannot produce in vacuum; students won’t be inspired without real life stimulus, role models and most importantly opportunities to work and grow professionally. Automobile research for example makes sense when carried out close to an established production base where scientists can have immediate access to automobile production, testing facilities and specialists to exchange views on a frequent basis. Marshal plan worked where there was an infrastructure to leverage; on the other hand, much higher foreign aid has failed elsewhere. Apart from technical infrastructure the financing capability should be there as well: next to Silicon Valley’s vibrant startup community stands a robust venture capital sector capable to lend a helping hand.

Finally, under current dire fiscal conditions in Europe’s debt-ridden periphery it is probably difficult to allocate 3% of GDP to R&D. Even if this is possible, R&D as a percentage of GDP might result in a meaningless number in absolute terms once applied over an already low GDP number. Three percent of a low GDP economy, might not yield the same results as three percent of a much larger GDP economy. It might simply not be sufficient for meaningful research to be carried out these days, especially when a low productivity country is struggling to catch up. For example it may be required to pay comparatively higher salaries to attract researchers to relocate there. Mutual recognition of diplomas that is proposed under the Pact can increase mobility but the real factor for that is employment opportunities; human capital will flow to where opportunity lies, causing underdeveloped regions a “brain drain”).

C. Management Perspective: Competitiveness Pact as a Red Ocean Doom

Going back to the Pact: what is then trying to achieve when it comes to labor cost?

In a typical European state run economy the public sector sets the stage for salary levels; these salaries may be even higher than those in the private sector due to collective bargaining or other inefficiencies. The consequence is that there’s limited propensity for people to “go the extra mile” once there’s secured and descent income in the public sector. That results in an inefficient, marginal private sector that is unable to compete internationally and lead countries out of the crisis. Since the corporate sector is not competent enough to productively invest in R&D; the government should again step in to support such efforts; a vicious cycle.

By lowering salary levels we are simply continuing to produce the same albeit at lower cost. Sounds like a typical Porter’s Cost Leadership strategy for those familiar with management literature; or referring to a newer terminology a “Red Ocean” doom. When applying this strategy the objective is to outperform the rivals in capturing a larger share of an existing market; in which case competition turns bloody.

That brings to mind a movie quote; it always does. As a manager that I respect used to say: movies have in them anything you need to know. Even if not, still a quote helps in making a point. So here’s what “Larry the Liquidator” from the “Other People’s Money” movie said at a proxy fight over an underperforming company:
And you know the surest way to go broke? Keep getting an increasing share of a shrinking market. Down the tubes. Slow but sure.
You know, at one time there must’ve been dozens of companies makin’ buggy whips. And I’ll bet the last company around was the one that made the best goddamn buggy whip you ever saw. Now how would you have liked to have been a stockholder in that company?

Then you might wonder what market is European periphery competing in? Without getting into detail, economies are not that extrovert, they are more into services. In whatever they produce there are other countries that have far lower cost structures and will continue to do so for the foreseeable future. In the absence of higher value added output the proposed Competitiveness Pact seems like an attempt to perpetrate the same model in the South albeit at lower cost; a losing strategy not to mention the social and wider economy consequences of that. Even China has recently outlined plans to move from low cost production to high technology and new energy. US has made that shift long time ago with clear indications that the workforce should be retooled and education geared towards science and technology.

So is this Competitiveness Pact simply a damage control exercise? ie solidifying a Euro nanny-state where the periphery will be at perpetual life support/lower gear compared to developed EU states?

There can be another explanation right out of the Austrian School of Economics though: by lowering wages and increase unemployment through structural reforms a creative disruption might be created that will force unleash the economy’s potential to grow out of the crisis. Based on the above, this sounds like a risky strategy if not wishful thinking. Societies can’t jump start or adjust to new circumstances quickly; it would have been nice but can’t redeploy the workforce in new sectors. As the saying goes: “can’t teach an old dog new tricks”. Have to invest in education and transition over time to avoid social crises.

D. So where’s the solution? The Blue Ocean?

There are various ways to represent risk created by debt. Leverage can be quantified by the ratio of debt to GDP or debt to national wealth (problem is that the latter is difficult to measure). On the other hand the risk of debt servicing (liquidity risk) can be represented by the interest expense to total income. A country might be highly leveraged but at the same time might have significant property or ability to increase income (increasing taxes or curbing tax evasion being one).

The most commonly used leverage ratio of debt to GDP (solvency ratio), can be reduced by reducing the nominator (debt) or increasing the denominator (GDP). Ruling out bankruptcy as a solution, which wouldn’t benefit anybody (bondholders, Eurozone countries or global markets, even recently US expressed their concern over that), public debt can be reduced over time by cutting down deficits, restructuring the debt to lower interest expense or buying back some or spin it off through privatizations. Austerity can have its limitations though: after two years of austerity that caused the economy to contract, Ireland saw its deficit to increase and is realizing its bailout program might be unworkable. It now aims to renegotiate terms. Same might happen elsewhere.

Leverage can on the other hand be reduced by increasing GDP. Growth is of paramount importance not only to decrease that risk but also to ensure long term prosperity and competitiveness in today’s globalized economy. In other words, instead of a Cost Leadership strategy that would aim to reduce debt (ie the ratio’s denominator) the solution could be growing out of the crisis (increasing GDP, the nominator) by diversifying into new markets and high value added products. These new opportunities are called Blue Oceans under the respective strategy model.

To enable such transformation it would first be useful to remedy structural problems to provide the necessary breathing room for the private sector to flourish. Then the question would come to which industries to invest in? Looking at R&D expenditure around the world it seems that EU is investing proportionately more on pharmaceuticals, automobiles, aerospace, chemicals and communications. This is not coincidental; there are many dominant companies in these sectors, mainly in Northern Europe. On the other hand the US invests proportionately more on technology and software.

Europe’s periphery, apart from Spain, lacks to a large extent heavy industry. Therefore it would be wise to invest in less capital intensive industries such as software or niche technologies, even services (why not some outsourcing as well; there can be opportunities in certain niches). Ireland is following this path. Green technology is another sector that can be developed which brings the additional benefit of reducing imports.

Finally, going back to the decoupling argument, this investment could also have a positive effect elsewhere: considering the high growth and overheating of the German economy it could be possible to transfer certain production and research to the South and provide employment opportunities for scientists and professionals there.



One response to “European Competitiveness Pact: A breakthrough or a Red Ocean doom?

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