But in most situations, productivity is the better path to prosperity
Competitiveness, Michael Porter remarked in The Competitive Advantage of Nations, his 1990 best-selling book, means different things to different people. As a member of US President Ronald Reagan’s competitiveness commission in the 1980s, the American economist met business leaders who believed it was about a global strategy to compete in world markets and members of Congress who thought it meant having a positive balance of trade. Today this commonly used term continues to defy definition and to divide opinion.
If increasing competitiveness means boosting productivity, economists would agree that this is almost always and everywhere a worthy goal. But they would also note that more productivity raises a country’s welfare regardless of its effects on exports and even if the country doesn’t trade at all with other countries.
Competitiveness, however, implies that relativity matters—that policymakers are less concerned about their country’s absolute level of productivity than about how it compares with that of other countries. If another country’s productivity is on the rise, it must be bad news, because their own country is becoming less competitive. Does this reasoning stand up?
Worrying about a competitor’s productivity makes sense in a zero-sum competition like soccer. If another soccer team in the league gets better, it means that my team has a worse chance of winning the championship. However, a key insight from economics is that world trade is not a zero-sum game. By allowing each country to specialize in the goods and services it can produce most efficiently, global trade increases productivity worldwide, and everyone is better off.
Terms of trade
So is it good or bad for my country if a foreign country increases its productivity? As is usually the case in economics, the answer is, It depends.
When a foreign country produces a certain good more efficiently, it typically raises the global supply of this good, reducing its price. If your country is mainly an exporter of this good, the lower world price for your exports will typically make your country worse off. But if your country is mainly an importer of this good, the lower world price means your country will likely be better off because it will now pay less for imports.
In other words, the effect of a foreign country’s higher productivity depends on how it affects your country’s terms of trade—the price of your country’s exports relative to the price of its imports.
For small countries (or regions) that specialize in the production of a few goods, these effects can be large. Suppose a small country specializes mainly in the production and export of a particular type of robot that becomes obsolete when foreign competitors invent a superior robot. The economic effects on the small country could be devastating.
Economists such as Paul Krugman, however, have shown that terms-of-trade effects from changes in productivity in foreign countries are typically small for large, diversified economies such as the United States, China, and the European Union. This is because large economies tend to rely less on foreign trade. Also, the trade that does occur tends to be spread across a range of products. Consequently, productivity improvements in other countries tend to affect both import and export prices, so the net effect is modest relative to the large gains from improvements in a country’s own productivity.
Moreover, it’s also typically easier for a country to affect its own productivity than that of another. This is why the focus of economic reforms in most countries should be increased productivity rather than increased competitiveness.
Export prices
A second strategy for raising a country’s competitiveness is to reduce the price of its exports, which raises export sales volume. In countries with widespread collective bargaining, this can be done by keeping wage growth in check—provided businesses use the savings to hold output prices down.
Sometimes countries try to achieve a similar effect by attempting to weaken their currency—that is, changing its exchange rate so that each unit of foreign currency buys more units of domestic currency. Exchange rate depreciation is another way countries can try to reduce export prices (and wages) when measured in foreign currency, which gives their exports a competitive advantage in foreign markets.
But if a country is already near full employment, more demand for its exports will exceed its capacity to produce them. This excess demand will push up prices and wages, and the improvement in competitiveness will vanish.
To avoid this result, the government could combine currency depreciation with measures to reduce aggregate demand, such as raising taxes or cutting spending. Currency depreciation would then increase demand for exports, while fiscal tightening would reduce demand for domestically consumed goods. Together, such policies would shift employment and production toward export sectors and away from sectors that produce for domestic consumption and investment. National income would be unchanged, but national savings would be higher because the government would run larger fiscal surpluses (or smaller deficits), and domestic consumption would be lower.
Savings and investment
This example highlights a central fact of international economics: As a matter of accounting, a country’s trade balance (exports minus imports) must equal the difference between its savings and investment. This is because investment is funded by savings—and if a country’s savings exceed its domestic investment, the remainder must be invested in other countries. And a country will have the excess cash flow to be a net investor in other countries only if it runs a trade surplus. Conversely, countries can run trade deficits only if other countries loan them money (are net investors in them) to allow them to purchase more in imports than they sell in exports. (For simplicity, this discussion excludes capital income flows, which does not affect the key conclusions).
So if by raising “competitiveness,” policymakers mean they want to increase their country’s trade balance, this outcome is possible only with policies that raise national savings or reduce national investment. But is this a good idea? It depends on whether national savings and investment are where they should be, or far from it—because of policy distortions or market failures.
Legitimate concern
Sometimes weak competitiveness and savings-investment imbalances reflect major economic problems. For example, suppose lax financial sector oversight has allowed an influx of foreign capital to drive an unsustainable credit-fueled boom in consumption and speculative investment. Excessive demand for domestic consumption and investment would drive up domestic wages and prices, undermining the competitiveness of the country’s exports and boosting import demand. The result? A hefty trade deficit.
In this situation, the country’s lack of competitiveness (its large trade deficit) would be a source of legitimate concern: the flip side of an unsustainable credit-fueled bubble, destined to burst and inflict considerable damage.
Sometimes, though, national savings are too high, investment is too low, or both, which implies that a country is too competitive. For example, a country may be investing too little in public infrastructure. Spending more (and thus incurring a higher fiscal deficit) could boost the economy’s productive capacity. Higher demand for domestic investment would likely increase domestic wages and prices relative to other countries and thus reduce the competitiveness of exports. But this adjustment would be part of the necessary process of shifting production capacity away from the export sector and toward the domestic investment sector. And if returns to domestic investment are higher than in the export sector, as is assumed in this case, this shift would increase the productive capacity of the economy as a whole.
To sum up, boosting competitiveness is a popular objective among policymakers. But a focus on economy-wide productivity, regardless of the effect on international trade, is often a more appropriate goal. Situations can arise in which a country’s price level relative to its competitors is an economic problem leading to trade imbalances. But these situations are less common than most policymakers realize and can be difficult to identify, even with the aid of indicators economists use for this purpose.
How is competitiveness measured?
A common way to examine a country’s competitiveness is to look at trends in its share of world exports. A rising trend is seen as evidence of rising competitiveness; a declining trend denotes the opposite. Trends in export shares can be informative, but they have limitations.
First, looking only at exports misses the import side of the trade equation. Domestic firms compete with foreign firms not only when they export, but also when they compete in the domestic market with imports from other countries. In addition, many of the components of exports are imported, so the value added from a country’s exports may be much lower than their gross value. To adjust for these effects, one could look at a country’s ex-ports net of imports—its trade balance.
Second, a country’s exports as a share of world exports may be falling simply because its economy is declining as a share of the world economy for reasons unrelated to competitiveness, such as slow population growth. One way to adjust for this is to look at the trade balance as a percentage of a country’s GDP.
Third, the trade balance as a share of GDP can be affected by the cyclical state of the economy in ways that are unrelated to competitiveness. In particular, when countries are in recession, consumer demand and hence imports are unusually low. To adjust for this effect, economists sometimes calculate a “cyclically adjusted trade balance” that adjusts the trade balance and the denominator (GDP) to estimates of what they would be if both the country and its trading partners were in a neutral phase of the business cycle.
Fourth, the trade balance is simply the flip side of a country’s savings-investment balance, and there may be good reasons why a country’s savings exceed its investment (for example, high saving to prepare for future population aging), leading to appropriately large trade surpluses. Or there may be good reasons why investment significantly exceeds savings (for example, a poor country needing foreign investment to grow), resulting in large trade deficits.
In assessing whether there is a competitiveness problem, a further refinement is thus to adjust the cyclically adjusted trade balance for factors that justify large surpluses or deficits and to focus on the residual—remaining imbalances that appear to be attributable to policy distortions or that are unexplained. This is the approach taken by the IMF’s External Balance Assessment.
A complement to this approach is to examine how a country’s price level has evolved over time when measured in the trade-weighted average currency of its trading partners. This statistic is known as a country’s real effective exchange rate (REER). If the REER has risen substantially or seems high for a country’s level of income, this may also indicate a lack of export price competitiveness.
KEVIN FLETCHER is an assistant director in the IMF’s European Department.
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.
