A new report from McKinsey Global Institute on how Europe can reform its economy to become competitive in the new world economy has a number of striking graphs. But this image in particular shows why the Eurozone experiment is so fraught.

It's a picture of "unit labor costs" for each country within the European Union. Unit labor cost measures, sensibly enough, the cost of labor. It is equal to compensation (workers' pay) divided by output (workers' work). High labor costs means more expensive labor, more expensive products, and less competitive industries.

Remember all the concerns from early this year about Spain, Greece, Italy and Ireland being constrained by their high costs, and unable to grow out of their debt crises? This is why:

Euro unit costs.png

This means the costs of production in Portugal, Ireland, Italy, Greece and Spain are as much as 25 percent higher than Germany. How can the "PIIGS" regain competitiveness?

Typically, when your products cost too much, you can devalue your currency to make workers and products cheaper. Cheaper products means more exports means more money for your country. But the PIIGS can't devalue against Germany or other European trading partners because they're all on the same currency, the Euro. That leaves wage reductions: forcing workers to accept smaller checks so that producers can charge less for their products. But that seems like a sure-fire way to start a riot.

McKinsey's solutions are wide-ranging. They include: delaying retirement benefits to encourage older folks to work (boosts output, saves government money); requiring people on unemployment insurance to participate in training programs;  deregulating service sector industries to promote competitiveness; and developing a "cluster" strategy to bring Silicon Valley-style creative density to Europe.

I don't know if those solutions will work. In the short term, the Eurozone is going to have to deal with its dramatic imbalances. That will likely mean short re-recessions for some PIIGS, leading to weak growth for continental export markets like Germany and broader doubts about the viability of the Eurozone contract.


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