Economic View: In the long run, productivity makes the difference

It is the time of year when the Government launches with great fanfare its competitiveness White Paper. The tome released today will no doubt be another relentlessly upbeat interpretation of the message that we must all try a bit harder.

It is worth stepping back, however, and asking what it means to talk about an economy's competitiveness. A bit of reflection shows that it cannot mean the same as a company's competitiveness, although that is how many people think of it. Indeed, the first of the annual White Papers was subtitled: "Helping Business To Win".

For a company, there are some straightforward indicators of competitive strength. They would include sales growth and market share, cost ratios and profit margins. These measures work as indicators because they can be compared easily for competing companies.

Countries, on the other hand, do not compete with each other in the same way. Not only is it harder to measure, say, levels of costs or shares in export markets, it is not obvious how to interpret the results. Unlike companies, countries do not go out of business. As the Stanford University economist Paul Krugman puts it: "Countries have no well-defined bottom line."

Is Germany now less competitive because it has high labour costs? As the table shows, its hourly wage costs are well ahead of those in other countries. Perhaps, but these also reflect the rewards for past productivity gains. Germans are more prosperous as a result of past hard work, and even if the economy is in trouble now, it is hard to argue that more productive labour should not be more expensive.

More fundamentally, international competition helps rather than harms countries as a whole. Although groups within a country can lose out through trade, the economy as a whole always benefits. More trade means higher exports, employment and growth, along with cheaper imports to the benefit of consumers.

It is only when an overvalued exchange rate means a country has a big trade deficit for an extended period - as the US did in the early 1980s - that the employment and growth effects of trade are negative. Moreover, it is hard to dislodge the mercantilist notion that exports are good, imports bad. From the point of view of economic well-being this is wrong. Imports are good too - think how depleted our lives would be without cheap electronics. I for one would not feel better off without my microwave, stereo, home computer and washing machine.

So how should a country's competitiveness be assessed? Its trade position vis a vis other countries is obviously one possibility, although it ought to be the entire current account balance, including interest, profit and dividend earnings and services trade as well as the headline-grabbing visible trade balance.

However, most industrial countries have run trade deficits or surpluses that, averaged over a long period of time, have amounted to very small proportions of their GDP. The reason is that persistent imbalances tend to be corrected by exchange rate movements.

Looking at the nominal exchange rate alone would paint a dire picture of Britain's economic performance. The pound might have risen a pfennig or two recently, but over the long term its history is one of unremitting decline. In 1970 a pound bought nearly DM9 worth of German goods. However, a fall in sterling does not boost exports if it is mirrored in higher domestic inflation. The exchange rate adjusted for inflation rates here and abroad has not sunk as dramatically, for British inflation has been higher on average than that of our competitors.

The Bank for International Settlements this week published its estimates of real exchange rates calculated using growth in labour costs per unit of output rather than price inflation. This measure of competitiveness has changed only a little for the UK during the past five years, as the chart shows.

Although it did improve in September 1992, the gain was far less dramatic than in Italy, whose nominal exchange rate tumbled at the same time. The reason is that unit labour costs rose in the UK in 1994 and 1995, whereas they declined in most other industrial countries.

Unit labour costs in the UK fell 0.2 per cent in 1993, but were flat the following year and rose 3.3 per cent in 1995. In Italy they rose 2.6 per cent in 1993 but then fell 2.7 per cent and 4.3 per cent. Germany and Japan, both strong-currency countries, have suffered a deterioration in this measure since 1990.

The growth in unit labour costs is equal to wage inflation less productivity growth. It increases when pay rises are not matched by improvements in productivity. As wage inflation has been low by historical standards in Britain, productivity performance must be the key.

This detour through trade as a way of measuring national competitiveness has returned to the point at which economic theory would have begun to monitor a country's prosperity. Looking at export performance or Britain's declining share of world trade in manufactures is a diversion. The lesson of history is that in the long run living standards rise in line with productivity growth.

Economists tend to describe anything that boosts productivity - anything that produces more output per unit of input - as "technical change". But it is more complicated than this makes it sound. As well as innovations in technology this also includes new efficiencies. One example was the organisation of production in assembly lines earlier this century.

Another more recent - and more contentious - example would be the shake- up of labour market institutions by Britain's Conservative governments. Reducing union power and introducing more flexibility have, arguably, raised productivity and potential growth.

The institutional framework in which businesses operate is one aspect of the economy a government can try to change to enhance productivity. Another is education. Here Britain trails most other industrial coutries in both quality and numbers in further education.

The Organisation for Economic Co-operation and Development - a big fan of the flexible labour market - recently pinpointed upgrading the skill levels of the workforce as the main challenge facing Britain. "Relatively low levels of human capital probably were, and continue to be, one of the main factors explaining the low level of per capita GDP in the United Kingdom," compared with other industrial countries.

Government measures had cut the number of unqualified 16-19-year-olds entering the jobs market, the OECD noted. But it concluded that attainment levels lagged well behind those in our main competitors. Not surprisingly, the Government's skills audit published yesterday reached the same conclusion.

No doubt today's White Paper will contain another list of pledges on education and training. It needs to. Britain's competitiveness and prosperity can be improved either by reducing the number of badly educated people employed - the pattern in recent years - or by educating the workforce better.

Labour costs compared

Total hourly labour costs in manufacturing, 1995

Index, Germany = 100

Germany 100

Japan 75

France 61

US 55

UK 45

Hungary 10

Czech Republic 7

Singapore 23

Korea 19

Malaysia 6

Source: BIS