I have used the graph below in another context but I thought some might find it interesting and at least it made me think. A first guess is that I will use it for a Latvia-bashing purpose but that is not the idea (although it would work…).

The graph should be read as a measure of development of competitiveness. For those not so familiar with the notation, REER is the Real Effective Exchange Rate. Unit labour costs are labour costs per unit of production – if wages increase 15% but production only 5% unit labour costs are up by 10%. The development of unit labour costs are then adjusted for the development in nominal exchange rates in trading partner countries and weighted by the share of such countries in one country’s overall foreign trade.

A few examples: The UK has seen a decline in REER over the period in question, reflecting the app. 20% depreciation of the British pound against the euro and British competitiveness has thus increased. Denmark has lost competitiveness, partly because wages have risen faster than productivity but mainly because of depreciating currencies in two large trading partner countries, namely Sweden and the UK. Latvia, well… – a massive real appreciation almost exclusively due to the wage explosion of the ‘fat years’ where wage increases outpaced productivity by a long way.

Cumulative change in REER Unit Labour Cost Index 2004Q1- 2009Q2

Source: Eurostat

But what I am mainly interested in here is the development in Germany. It is the only euro country to have managed a real depreciation i.e. having managed slower labour cost development than productivity increases and the interesting part is that this is nothing new – it is eerily reminiscent of the pre-euro days where various currencies were regularly devalued against the Deutschmark for exactly the same reason, namely that Germany managed cost control better than anyone else and thus kept gaining competitiveness.

Nothing much has changed – German economic policy is still dominated by tough inflation hawks such as Jürgen Stark* or Otmar Issing, current and former members of the ECB Executive Board to name just two.

The rest of us just cannot match the inflation discipline of the Germans but in a eurozone with irrevocably fixed exchange rates we can no longer devalue to regain competitiveness, thus the superior German export engine just keeps humming.

There is a lot of talk these days about whether Greece might leave the eurozone (they won’t, of course) – but should the eurozone be broken up, a better split would actually be between Germany and the rest. Only Germany really fits into the labour cost obsessed and inflation obsessed eurozone but what is a monetary union with just one country?

Just a couple of lines regarding the lesson for Latvia. To join the eurozone and benefit from membership Latvia has to demonstrate inflation discipline and fiscal discipline of hitherto unseen proportions. The country is currently involved in that via the ‘internal devaluation’ where wages and thus unit labour costs are being depressed. To me, the jury is still out there on whether this will succeed – then again, I give it a much better chance than in Greece. But why not be on the safe side and offer a Latvian passport to Jürgen Stark?

* I have once met him – ‘inflation hawk’ are somehow not strong enough words to characterize him.

And just to pre-empt a couple of comments:

1) The loss in competitiveness for Latvia looks enormous – does all of that have to be rolled back? No – most likely the lat was undervalued back in 2004 but how much down unit labour costs have to go is much debated i.e. at which level is the lat neither undervalued nor overvalued?

2) True, Germany may have been undercompetitive (having had an overvalued euro) in 2004 as a result of reunification and thus needing to regain cost competitiveness but they are still the only ones who can really master it. Witness Italy, Portugal, Spain – and Greece, of course.