Opening remarks by Deputy Governor Stefan Gerlach at the Eurosystem Competitiveness Network Meeting

“Competitiveness and restoration of growth in Ireland”¹

Good morning ladies and gentlemen, I am very pleased to welcome you all to Dublin.

The range of topics discussed at this meeting and the agendas of the different work-streams within the Network show what a multi-faceted concept “competitiveness” is. The breadth of policy objectives that fall under this general heading also demonstrates the challenges that restoring competitiveness poses for policymakers in Ireland and elsewhere.

The immediate threats of the financial crisis have now begun to moderate. This allows us to starting thinking about longer term policies to support growth and employment both in the Euro area as a whole and within individual countries. Improving competitiveness is a precondition returning to growth which in turn is necessary for reducing debt-to-GDP ratios in highly indebted countries. This is of course of enormous importance to us here in Ireland.

In the broadest terms, we can think of competitiveness as the capability of a firm or a country to provide goods and services more efficiently, more cheaply or of higher quality relative to other firms or countries supplying the same market. Of course, the analogy of competitiveness at the firm level can only be pushed so far at the country level – after all, no country is aiming to put another out of business – but the fundamental idea of competitiveness as a relative concept applies at all levels.

Ireland’s economic trajectory over the past decades has seen some large swings. Beginning from economic stagnation in the 1980s to the spectacular growth rates of the “Celtic Tiger” era, this then continued on past a catch-up growth phase to develop into a credit bubble, which ended in the present crisis. The earlier growth phase owed much to Irish government policies, particularly in education, that helped to produce large increases in labour productivity. Industrial policies focused successfully on encouraging export-oriented foreign direct investment and Irish productivity growth consistently outpaced other advanced economies. By the middle of the last decade, Irish labour productivity was close to US levels.

Employment rose steadily from 1.1 million in the late 1980s to 2.1 million in 2007. Combined with steady improvements in productivity, the Irish economy delivered a period of extraordinary growth: From 1987 to 2007, economic growth averaged 6.3 per cent per year. Unfortunately, Ireland’s position in 2007 was not nearly as strong as it appeared to many outsiders or to the government of the time and the later years of the Irish boom saw the build-up of dangerous imbalances.

Comparing competitiveness across countries raises issues of measurement. I am therefore pleased to see that much work in the Network focuses on examining and improving the comparability of various indicators of competitiveness. Some examples from Ireland of how composition changes can influence comparability illustrate the difficulties that can arise.

Unit labour costs are one of the most frequently used indicators of competitiveness, and are attractive due to their simplicity and availability of data. Irish relative unit labour costs rose by over 42 per cent between 2001 and 2008 and declined by 14.2 per cent during 2009 and 2010. These large cumulative increases in unit labour costs were indicative of growing imbalances in the Irish economy and their more recent improvement is a positive development. However, work here at the Central Bank has shown that changes in relative unit labour costs needs to be interpreted with caution.² 

One particular concern is that headline unit labour cost developments may partly reflect large shifts in the sectoral composition of the economy. These could lead to the impression of a marked improvement in competitiveness at the national level, without any such improvements in competitiveness at the sectoral level. For example, I mentioned the headline decline in relative unit labour costs in the business sector was 14.2 per cent in 2009 and 2010. A reasonably large proportion of this improvement however has been driven by compositional effects as the relatively low productivity construction sector shrank. There was still a substantial improvement of about 8.4 per cent in unit labour costs over this period which I do not want to underplay. However, it is clear that the influence of sectoral shifts deserve attention.

Real effective exchange rates are often used as proxies for price and cost competitiveness and form part of the surveillance scoreboard in the new EU Macroeconomic Imbalances Procedure. However in Ireland, these standard measures are unduly influenced by the broad chemicals sector, which only accounted for 11.7 per cent of employment in the industrial sector in 2009. The very high levels of recorded productivity in sectors such as chemicals, and others dominated by foreign multinationals, heavily influence productivity measures for manufacturing overall. Because of this, these measures need to be interpreted with caution.

One measure of competitiveness is current account outcomes. The period after the introduction of EMU saw a widening of current account imbalances inside the Euro area. With the elimination of exchange rate premia, there was a marked increase in the amounts of credit flowing towards governments, business and households in peripheral countries. This was particularly noticeable in countries that had previously had long histories of inflation and depreciation such as Ireland.

The result of this new and widespread availability of low-cost credit was that households and businesses in Europe’s periphery took on larger amounts of debt than had been possible prior to EMU. Ratios of private sector debt to GDP rose steadily during the years leading up to the crisis in Portugal, Ireland, Spain and Greece. The increased availability of credit also fed into large increases in house prices and wage inflation in these countries. These imbalances still persist and the competitive position of the peripheral countries is proving difficult to bring back in line with that of the core Euro members.

As I noted earlier, this issue of regaining competitiveness is of particular relevance to Ireland. The past few years has seen a significant and much needed re-orientation of the Irish economy away from output generated by domestic demand and back towards net exports. Indeed the roles played by investment and net exports have been reversed in the sense that in 2007, investment was 25% of GDP and net exports was 10% while in 2012 investment is 10% of GDP and net exports is 25%. This adjustment mainly reflects the collapse in construction but it also reflects a surprisingly strong export performance in difficult conditions.

Given that domestic demand is likely to be weak for a number of years coming in part from the need for fiscal consolidation and high levels of debt across the economy, continued export growth will be the key to growth in the economy as a whole. For that continued improvement, competitiveness wage costs are necessary.

Ireland’s labour market has always been more flexible than most other Euro zone countries. With the economy being so weak and unemployment at much too high levels, the labour market has reacted with wage restraint and, in many cases, wage cuts. The latter has been reinforced by the significant public sector wage cuts. This has helped to reverse some of the substantial erosion of competitiveness in the immediate pre-crisis period. However, I would again caution against using measures such as unit labour cost comparisons as structural changes in the Irish economy mean that they overstate the level of improvements which have occurred. Despite muted inflation in recent years, Ireland remains an expensive place to live and this acts as a serious constraint on competitiveness.

Although price stability is the appropriate objective for monetary policy, low inflation poses challenges for countries attempting to regain a competitive position. Real wage reductions cannot be achieved by the stealthily eroding effect of inflation but must instead come about by the slower and more difficult path of wage moderation. This is a particularly demanding task in countries also facing problems of high private and public debt. Wage moderation must also occur in the public sector, not only to improve the budget balance, but because this can also influence wage costs in the private sector, and thus has indirect competitiveness-improving effects.

Of course, adjustment cannot be made solely on the cost side and must be complemented with measures to improve productivity. Attention must also be paid to other factors. Labour supply, education, innovation, infrastructure, institutional quality and ease of doing business all contribute to making an economy competitive.

Structural reforms have been much discussed in Europe for many years to improve these elements but much more needs to be done and delay is not an option. Action must be taken to increase flexibility in labour and product markets and to enhance contestability in previously protected sectors. Streamlining of tax systems and bureaucracy will allow firms to enter markets more easily and lower costs to expansion and innovation.

These initiatives will not have overnight results but the experience of this crisis has shown us the importance of addressing the root cause of competitiveness problems and demonstrated that superficial remedies often provide only temporary relief. Understanding how best to implement and evaluate policies to restore Europe’s competitiveness and growth should be a priority and the work of this Network is a valuable contribution to this process.

Thank you very much for your attention.

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¹ I am very much indebted to Martina Lawless for her help in preparing these remarks. 

² O’Brien and Scally, “Cost Competitiveness and the Export Performance of the Irish Economy”, Quarterly Bulletin No. 3, 2012