Addressing internal adjustment in the euro area

Bruegel research fellow, Zsolt Darvas discusses the findings of his policy contribution Compositional effects on productivity, labour cost and export adjustments andthe working paper Productivity, labour cost and export adjustment: Detailed results for 24 EU countries.

Sectoral shifts, such as shrinkage of low labour productivity and the low-wage construction sector, can lead to apparent increased aggregate average labour productivity and average wages, especially when capital intensity differs across sectors.

For 11 main sectors and 13 manufacturing sub-sectors, we quantify the compositional effects on productivity, wages and unit labour costs (ULCs) based and real effective exchange rates (REER), for 24 EU countries.

Compositional effects are greatest in Ireland, where the pharmaceutical sector drives the growth of output and productivity, but other sectors have suffered greatly and have not yet recovered.

Our new ULC-REER measurements, which are free from compositional effects, correlate well with export performance.

Among the countries facing the most severe external adjustment challenges, Lithuania, Portugal and Ireland have been the most successful based on five indicators, and Latvia, Estonia and Greece the least successful.

There is evidence of downward wage flexibility in some countries, but wage cuts have corrected just a small fraction of pre-crisis wage rises and came with massive reductions in employment even in the business sector excluding construction and real estate, highlighting the difficulty of adjusting wages downward.