Little insulation against excessive wage rises

While some of the rhetoric in anticipation of a new pay agreement is of 'payback time' for workers, there is no cushion to soften blow of immoderate wage increases.

As the Programme for Prosperity and Fairness nears the end of its run, the social partners are staking out the ground in anticipation of negotiating a new agreement. Yet again, some of the rhetoric is infused with the notion of "payback time". A typical formulation is that workers should be compensated for the sacrifices they have made, or rewarded for the moderation they have shown under previous agreements.

A variation on the same theme is that employers can well afford to grant chunky wage increases on the grounds that they have been making huge profits and have become extraordinarily competitive.

In a similar vein, it has been argued that the competitiveness gains made by the Irish economy recently insulate it from adverse currency movements, such as a sharp fall in the value of sterling.

This prompts one to ask how competitive has Ireland become and how vulnerable is the economy to adverse movements in exchange rates, or in relative rates of wage inflation for that matter.

The first thing to be said here is that conventional measures suggest that Irish manufacturing has indeed enjoyed an enormous gain in competitiveness since the mid-1990s.

According to an analysis published last month by the IMF*, the improvement registered between 1995 and 2001 was as much as 45 per cent. By any standards, that is astonishing.

What such conventional indices of competitiveness capture is the change in unit labour costs in Ireland relative to our main trading partners, measured in a common currency. Some of the deficiencies of these measures are obvious. For example, they are based on labour costs alone and they are confined to the manufacturing sector, for reasons of data availability. But the most egregious deficiencies, and the ones that make such measures truly treacherous tools of analysis, are not obvious at all, and seem unfamiliar to many commentators who cite and draw inferences from them.

According to such indices, Ireland can gain competitiveness for any one or a combination of three reasons: (i) labour costs here may rise more slowly than elsewhere; (ii) labour productivity in Ireland may increase more rapidly than elsewhere, and/or (iii) Ireland's exchange rate may depreciate. As a matter of fact, the main contribution to the apparent improvement in competitiveness that occurred between 1995 and 2001 came from the second source - a powerful surge in measured productivity in Irish manufacturing. However, much of this productivity surge is a chimera, reflecting as it does the peculiar composition of value-added in sectors dominated by multinational firms.

The chemicals sector is a classic example of this phenomenon. According to the 2000 Census of Industrial Production, the value of output per employee in this sector was €510,400. This compares with an equivalent figure of less than €100,000 in the rest of manufacturing. Is it really the case that Irish chemical workers are on average adding value of over half-a-million euros per head? Of course not. The value of the output that they are involved in producing also reflects (and to a much greater degree) the costs of researching, developing and marketing the products in question, activities that for the most part are carried out elsewhere. The productivity numbers do not recognise this. This becomes an especially serious problem for the conventional measures of competitiveness when the chemicals sector is growing rapidly, as it has been in recent years: output quadrupled between 1995 and 2001.

So, the big gains in Irish competitiveness indicated by conventional measures are largely attributable to the big increases in the output of products like Viagra in recent years. If this is the case, using such measures hardly makes much analytical sense. This is all the more so since the sectors that are distorting such measures of competitiveness are not very employment-intensive. Again, consider the case of chemicals: it now accounts for over one-third of Irish manufacturing output, but less than 9 per cent of manufacturing employment.

Moreover, output and employment in sectors such as chemicals are likely to be quite insensitive to short-term movements in wage competitiveness. In other words, labour costs are not a decisive influence on the decision of companies such as Pfizer to vary the output of their Irish plants.

All of this strongly argues for the conventional measures of competitiveness to be extensively modified before they can be sensibly used for analytical purposes. Two types of modification seem necessary. First, sectors such as chemicals should be excluded from the calculations. Second, in so far as our primary concern is jobs rather than output (or, at least manufacturing output as measured by the CSO), the indices should be based on employment weights rather than output weights.

When this is done, the cheerful picture painted by the unsophisticated analysis is replaced by an entirely more sobering one. Excluding chemicals, and using employment rather than output weights, the IMF calculates that Irish competitiveness improved by little more than 5 per cent between 1995 and 2000, but deteriorated by over 15 per cent in 2001. Last year's deterioration reflected principally the combined effect of wage inflation well ahead of our main trading partners and a sharp slowdown in productivity growth. What this more refined analysis also indicates is that what modest improvement in competitiveness occurred between 1995 and 2000 was more than fully accounted for by favourable currency movements.

The main conclusions are clear. From the perspective of the vast bulk of manufacturing firms in Ireland and their employees, there is no big competitiveness cushion available for use as insulation against immoderate wage increases or adverse currency movements. On the contrary, Irish manufacturing is vulnerable on both these fronts. In so far as it makes sense to speak of such insulation, it exists only for firms that have little need for it.

* IMF Country Report on Ireland, August 2002