Home > Uncategorized > Bart van Ark, chief economist of the ‘Conference Board’, debunks Macro Real Unit Labour Costs

Bart van Ark, chief economist of the ‘Conference Board’, debunks Macro Real Unit Labour Costs

In 2005, Bart van Ark, at present chief economist of the Conference Board but at that time employed at the Rijksuniversteit Groningen, published together with Edwin Stuivenwold and Gerard Ypma a study called ‘Unit labour costs, productivity and international competitiveness‘ (a joint publication with the Conference Board). Though Unit Labour Costs are useful as a micro metric to compare for instance cheese factories they are unfit as a macro indicator of competitiveness of countries because of all kinds of conceptual problems, aggregation problems, composition problems and, indeed, ‘macro’-problems ,macro in the sense that in a situation with low but positive inflation and a growing economy a stable RULC requires (not : causes!) a continuously increasing surplus (decreasing deficit) of the current account as there will be increasing macro domestic underconsumption problems. Van Ark et all try hard to be positive about the RULC but of course ran into these same problems (though they do not identify the macro problems, consult Felipe and Kumar about these):

A specific characteristic of unit labour cost measures is that the numerator, which reflects the labour cost component of the equation, is typically expressed in nominal terms, whereas the denominator, which is output or productivity, is measured in real or volume terms. This implies that, when comparing unit labour cost levels across countries, the level of wages or labour compensation is converted at the official exchange rate: it represents the cost element of the arbitrage across countries. In contrast, output or productivity relates to a volume measure as it resembles a quantity unit of output. Hence for level comparisons output needs to be converted to a common currency using a purchasing power parity (i.e. the same set of output prices, M.K.) instead of the exchange rate, so that comparative output levels are adjusted for differences in relative prices across countries… (T)he precise interpretation of a change in ULC or a difference in ULC levels across countries always depends on the source from which the change originates. For example, an increase in labour costs can result from upward wage pressure or from a slowdown in productivity growth. The upward wage pressure may be largely an external phenomenon triggered by an appreciation of a country’s currency, or it may have a domestic cause due to, for example, a shortage on the labour market. A productivity slowdown may be caused, for example, by a rise in the sectoral share of services sector, as seen in many developed (industrialized) countries. Services productivity usually grows more slowly than manufacturing productivity, whereas the development of labour cost is often less diverse across sectors. Even for tradables, the ULC index should not be interpreted as a comprehensive measure of competitiveness for several reasons. Firstly, ULC measures deal exclusively with the cost of labour. Even though labour costs account for the major share of inputs, the cost of capital and intermediate inputs can also be crucial factors for comparisons of cost competitiveness between countries (see also Felip and Kumar, 2011, M.K.). Secondly, the measure reflects only cost competitiveness. In the case of durable consumer and investment goods, for example, competitiveness is also determined by other factors than costs, notably by technological and social capabilities and by demand factors. Improvements in product quality, customization or improved after-sales services are not necessarily reflected in lower ULC. In the literature on competitiveness inspired by Michael Porter, attention is given not only to factor inputs, but also to demand conditions, the presence of local suppliers and clusters, and an environment that encourages investment, innovation and competition. Thirdly, measures of cost competitiveness may be distorted by the effects from, for example, bilateral market access agreements, direct and indirect export subsidies and tariff protection. Unit labour cost measures also do not have the same coverage as some of the broader composite competitiveness indicators which have gained much popularity in recent years. These broader indicators include measures of economic performance, innovative capacity, structural change, improved living standards and social conditions… (T)he unit labour cost series are based on measures of GDP, value added and labour compensation from the national accounts… Total labour compensation in the national accounts does not only include gross wages and salaries of employees payable in cash or in kind, but also other costs of labour that are paid by employers, including employers’ contributions to social security and pension schemes (whether public or private) including imputed social contributions providing unfunded social benefits. However, an important disadvantage of the national accounts measure of labour compensation is that it refers to employee compensation only. It does not include the compensation of self-employed persons which is by definition part of “other income” in the national accounts. Strikingly all charts (see the article, M.K.) show that the relative levels of labour productivity exhibit a much greater stability than the series of labour compensation (and, as a result, also of unit labour cost). The reason for this is obvious as the productivity measures are compared in terms of volume measures, using a specific PPP for manufacturing products. In contrast, labour compensation is expressed in nominal terms, and converted into US$ with the nominal exchange rate… The development of the relative levels of labour compensation is generally strongly related to the nominal exchange rate… there remain significant differences in unit labour cost levels even in a tradable sectors such as manufacturing. In addition to the short term exchange rate movements, such differences may be partly related to differences in industrial structure… The comparisons of productivity and unit labour cost for the aggregate economy and even for a broad sector such as manufacturing, hides important details at industry level. In international trade, some countries will develop comparative advantages in particular industries. When productivity and labour cost levels differ between industries, this may impact the aggregate comparison of unit labour cost even if there are no differences between countries at industry level. The upshot of this brief overview of comparative levels of productivity, labour cost and unit labour cost in these four major industrialized countries, is the large diversity in terms of comparative performance. The earlier conclusion that – at the aggregate level – productivity and labour cost basically move in tandem – so that ULC levels are more similar countries – is not confirmed when looking at more detailed industry level. Part of these differences may be due to differences in industrial structure (as is the case, for example, within machinery and equipment), but industryspecific characteristic may also inhibit trade between countries. Finally, measurement issues concerning price indices and PPPs to obtain volume measures may also affect the results at moredetailed level . It should be stressed that an exclusive focus on productivity, labour cost and unit labour cost measurement cannot of course fully explain (changes in) trade patterns and differences in economic performance between countries. Firstly, at country level, it is difficult to speak of “competitiveness” as strictly speaking one should always distinguish between industries with and without a comparative advantage relative to other countries. A focus on industry level detail is therefore very important. Secondly … competitiveness covers a much range of aspects than just relative cost and productivity, in particular in the longer run. In its broadest interpretation it may include various aspects of economic performance and efficiency, such as improvements in product quality, a firms’ capacity to innovate and to adapt consumer preferences, but also the functioning of the macroeconomic, institutional and policy environment, the quality of financial intermediation, the flexibility of factor markets, etc. While competitive gains are primarily realized at the level of individual firms producing goods and services, governments have an important role to play to facilitate this process. In these light policies with regard to a country’s trade regime cannot be seen in isolation of other policy measures, such as labour and product market reforms, education and innovation policies. For example, on the one hand an excessive and long run emphasis on wage moderation may threaten a country’s productivity growth rate as it might discourage innovation and investment in human capital. On the other hand, in particular in developing countries, a very strong emphasis on efficiency improvement might cut into the employment base of mainly low-skilled people creating a large pool of low-productivity jobs in the informal sector of the economy, which in turn can threaten the productivity performance of the economy in the long run. Clearly a balanced strategy that leads to the creation of more productive and better paid jobs is the vehicle towards improved competitiveness that can also be sustained in the long run”>Unit Labour costs, productivity and international competitiveness’ (a joint publication from the Groningen growth and development centre and the Conference board).

Though unit labour costs are a useful yardstick to compare for instance competitivety of cheese factories (at least when they produce the same kind of cheese!) it is unfit as a macro indicator of competitiveness because of all kinds of conceptual problems, aggregation problems, composition problems and, indeed, ‘macro’-problems in the sense that in a situation with low but positive inflation and a growing economy a stable RULC requires (not : causes!) a continuously increasing surplus (decreasing deficit) of the current account as there will be increasing macro domestic underconsumption problems. Van Ark et all try hard to be positive about the RULC but of course ran into these same problems (though they do not identify the macro problems, see Felip and Kumar):

A specific characteristic of unit labour cost measures is that the numerator, which reflects the labour cost component of the equation, is typically expressed in nominal terms, whereas the denominator, which is output or productivity, is measured in real or volume terms. This implies that, when comparing unit labour cost levels across countries, the level of wages or labour compensation is converted at the official exchange rate: it represents the cost element of the arbitrage across countries. In contrast, output or productivity relates to a volume measure as it resembles a quantity unit of output. Hence for level comparisons output needs to be converted to a common currency using a purchasing power parity (i.e. the same set of output prices, M.K.) instead of the exchange rate, so that comparative output levels are adjusted for differences in relative prices across countries…

(T)he precise interpretation of a change in ULC or a difference in ULC levels across countries always depends on the source from which the change originates. For example, an increase in labour costs can result from upward wage pressure or from a slowdown in productivity growth. The upward wage pressure may be largely an external phenomenon triggered by an appreciation of a country’s currency, or it may have a domestic cause due to, for example, a shortage on the labour market. A productivity slowdown may be caused, for example, by a rise in the sectoral share of services sector, as seen in many developed (industrialized) countries. Services productivity usually grows more slowly than manufacturing productivity, whereas the development of labour cost is often less diverse across sectors.

Even for tradables, the ULC index should not be interpreted as a comprehensive measure of competitiveness for several reasons. Firstly, ULC measures deal exclusively with the cost of labour.
Even though labour costs account for the major share of inputs, the cost of capital and intermediate
inputs can also be crucial factors for comparisons of cost competitiveness between countries (see also Felip and Kumar, 2011, M.K.). Secondly, the measure reflects only cost competitiveness. In the case of durable consumer and investment goods, for example, competitiveness is also determined by other factors than costs, notably by technological and social capabilities and by demand factors. Improvements in product quality, customization or improved after-sales services are not necessarily reflected in lower ULC. In the literature on competitiveness inspired by Michael Porter, attention is given not only to factor inputs, but also to demand conditions, the presence of local suppliers and clusters, and an environment that encourages investment, innovation and competition. Thirdly, measures of cost competitiveness may be distorted by the effects from, for example, bilateral market access agreements, direct and indirect export subsidies and tariff protection. Unit labour cost measures also do not have the same coverage as some of the broader composite competitiveness indicators which have gained much popularity in recent years. These broader indicators include measures of economic performance, innovative capacity, structural change, improved living standards and social conditions… (T)he unit labour cost series are based on measures of GDP, value added and labour compensation from the national accounts… Total labour compensation in the national accounts does not only include gross wages and salaries of employees payable in cash or in kind, but also other costs of labour that are paid by employers, including employers’ contributions to social security and pension schemes (whether public or private) including imputed social contributions providing unfunded social benefits. However, an important disadvantage of the national accounts measure of labour compensation is that it refers to employee compensation only. It does not include the compensation of self-employed persons which is by definition part of “other income” in the national accounts.

Strikingly all charts (see the article, M.K.) show that the relative levels of labour productivity exhibit a much greater stability than the series of labour compensation (and, as a result, also of unit labour cost). The reason for this is obvious as the productivity measures are compared in terms of volume measures, using a specific PPP for manufacturing products. In contrast, labour compensation is expressed in nominal terms, and converted into US$ with the nominal exchange rate… The development of the relative levels of labour compensation is generally strongly related to the nominal exchange rate… there remain significant differences in unit labour cost levels even in a tradable sectors such as manufacturing. In addition to the short term exchange rate movements, such differences may be partly related to differences in industrial structure…

The comparisons of productivity and unit labour cost for the aggregate economy and even for a broad sector such as manufacturing, hides important details at industry level. In international trade, some countries will develop comparative advantages in particular industries. When productivity and labour cost levels differ between industries, this may impact the aggregate comparison of unit labour cost even if there are no differences between countries at industry level. The upshot of this brief overview of comparative levels of productivity, labour cost and unit labour cost in these four major industrialized countries, is the large diversity in terms of comparative performance. The earlier conclusion that – at the aggregate level – productivity and labour cost basically move in tandem – so that ULC levels are more similar countries – is not confirmed when looking at more detailed industry level. Part of these differences may be due to differences in industrial structure (as is the case, for example, within machinery and equipment), but industryspecific characteristic may also inhibit trade between countries. Finally, measurement issues concerning price indices and PPPs to obtain volume measures may also affect the results at moredetailed level .

It should be stressed that an exclusive focus on productivity, labour cost and unit labour cost
measurement cannot of course fully explain (changes in) trade patterns and differences in economic
performance between countries. Firstly, at country level, it is difficult to speak of “competitiveness”
as strictly speaking one should always distinguish between industries with and without a comparative
advantage relative to other countries. A focus on industry level detail is therefore very important. Secondly … competitiveness covers a much range of aspects than just relative cost and productivity, in particular in the longer run. In its broadest interpretation it may include various aspects of economic performance and efficiency, such as improvements in product quality, a firms’ capacity to innovate and to adapt consumer preferences, but also the functioning of the macroeconomic, institutional and policy environment, the quality of financial intermediation, the flexibility of factor markets, etc. While competitive gains are primarily realized at the level of individual firms producing goods and services, governments have an important role to play to facilitate this process. In these light policies with regard to a country’s trade regime cannot be seen in isolation of other policy measures, such as labour and product market reforms, education and innovation policies. For example, on the one hand an excessive and long run emphasis on wage moderation may threaten a country’s productivity growth rate as it might discourage innovation and investment in human capital. On the other hand, in particular in developing countries, a very strong emphasis on efficiency improvement might cut into the employment base of mainly low-skilled people creating a large pool of low-productivity jobs in the informal sector of the economy, which in turn can threaten the productivity performance of the economy in the long run. Clearly a balanced strategy that leads to the creation of more productive and better paid jobs is the vehicle towards improved competitiveness that can also be sustained in the long run

Categories: Uncategorized
  1. BFWR
    July 26, 2013 at 6:38 pm

    The relevant micro labor figure is demand minus all taxes and deductions. The relevant macro figure is total prices (costs). Economic theory is problematic to the extent it misses or abstracts out costs. In fact incorrect assessment of cost is responsible for all “emergent qualities”. Money is basically accountancy, and accountancy is most basically cost accounting. Compare the various cost accounting figures and decipher their relevancies and you’ll be able see what the basic problem is: Creating sufficient effective individual demand….and maintaining that sufficiency. Think citizen’s dividend and compensated retail discount.

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