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The road to Europe: can wage-setting save the monetary union?

The periphery and core countries of the EU have been locked for many years prior to the crisis into opposing ‘virtuous’ and ‘vicious’ circles. How do we buck the trend?
Andrew Watt
1 November 2011

The urgency of the European crisis has stimulated debate on the ‘The road to Europe’ in the Italian daily Il Manifesto and on a website committed to economic alternatives, Sbilanciamoci. openDemocracy joins this debate, beginning with three opening contributions this week from Rossana RossandaMario Pianta and  Donatella della Porta. We invite your responses both in comments and article submissions:

Analysis of economic developments over the course of European Monetary Union, both in the run-up to the crisis and during it, allows us to draw four main conclusions regarding the role of wage policy in monetary union:

  1. Appropriate wage-setting is key for the effective functioning of monetary union.
  2. Wage-setting is not, though, the solution to all the euro area’s problems.
  3. The greatest possible degree of decentralisation of wage-setting is not the way forward for Europe.
  4. Europe needs a cooperative policy mix with well-developed, effective and coordinated demand-management and collective bargaining institutions if it is to enjoy sustained, balanced and inclusive growth.

EMU, macroeconomic imbalances and wage setting

Wage policy has been a key part of the debate about the performance of economic and monetary union (EMU), before and particularly during the crisis. There is a clear discourse coming from policymakers and most mainstream commentators.

Supposedly ‘excessive’ wage growth in countries now particularly badly affected by the euro area crisis – I will for the sake of convenience refer to the GIIPS, Greece, Ireland, Italy, Portugal and Spain – is identified as a fundamental cause of these countries’ current economic problems. Too fast wage growth, so the argument runs[1], has ruined their competitiveness, making it impossible for them to recover from the crisis and service their public debt. This in turn calls for bail-outs by countries that have followed ‘prudent’ wage policies. The solution, widely considered self-evident, is to cut wages in the GIIPS countries. And the appropriate way to do that is to decentralise wage bargaining in order for wages to be set at a level closer to ‘the market’ and thus in a way that is sensitive to competitiveness considerations.

If you compare the development of unit labour costs (ULC[2]) in the euro area since 1999 with the development of current account imbalances, the strong correlation is immediately apparent.[3] Countries with above-average ULC growth have seen their current accounts move (further) into deficit. Countries with below-average ULC growth have seen their current accounts move (further) into surplus. Current account imbalances, if large and sustained, have been shown by the crisis to be highly destabilising in a monetary union.

This is suggestive evidence for my first conclusion (Appropriate wage-setting is key for the effective functioning of monetary union). However, it in no way validates the standard policy recommendation to cut wages in the periphery. And it certainly says nothing about the relative merits of collective bargaining systems of various types. Regarding the former – I will return briefly to the issue of effective collective bargaining systems below – two key points are in order.

First, EMU member countries have diverged symmetrically from the 2% annual ULC target which should be considered the baseline. (See the reference in the previous footnote for an explanation.) This in turn implies that sustained ULC growth below the 2% benchmark is just as undesirable as that above it. The latter causes inflation. The former deflation. The latter goes hand in hand with current account deficits. The former, i.e. below-productivity wage increases, raises competitiveness and increases net exports. Intuitively this is a ‘good thing’, and most commentators and policymakers see it this way. But within the confines of a monetary union it simply cannot be a strategy that all can follow. It is logically impossible. One country’s net exports are the other’s net imports[4]. The obvious policy implication is that adjustment should not come about just from one side, i.e. the deficit countries, but rather from convergence between countries on both sides of the distribution.

Second, it is important to emphasise that correlation does not necessarily imply causation from ULC growth to the current account. It could conceivably be the other way around; this is implausible, though. But what is eminently plausible is that ‘third factors’ have simultaneously driven ULC and current account developments in the corresponding directions, producing the correlation. And this is exactly what happened, with the periphery and core countries locked for many years prior to the crisis into opposing ‘virtuous’ and ‘vicious’ circles.[5] On joining EMU, previously high-inflation countries which had had high interest rates benefited from a sharp fall in borrowing costs, setting off a – seemingly – virtuous circle: these fast-growing, high-inflation economies enjoyed relatively low real interest rates (the common ECB-rate minus their high inflation rates), while slow-growing, low-inflation countries were in a vicious circle (suffering from relatively high real interest rates). Asset (especially house) prices rose rapidly in the peripheral countries, thanks to low interest rates, creating wealth and confidence effects that stimulated spending and borrowing. Employment growth was strong and unemployment fell significantly. By contrast Germany’s labour market performance was extremely weak during the pre-crisis EMU period. This situation led to a situation of sustained nominal wage/price ‘spirals’ – wages and prices chasing themselves upwards –  that spun faster in some countries than in others. The combination of faster-rising prices and a stronger dynamic of domestic demand in deficit countries restrained their exports while fuelling import demand; the reverse happened in surplus countries. In Germany domestic demand was essentially stagnant – as were real wages – and such economic growth as it achieved was driven solely by higher net exports.

The conclusion is that wage policy was one factor behind the imbalances, but that given the economic developments and the other failings of the economic governance regime, it could not, and in future also will not be able to resolve the competiveness issues and current account imbalances on its own. 

Implications for wage policy

The previous analysis suggests that wage policy can make a contribution to avoiding and rectifying imbalances, but it can do so only within a conducive framework. (This was my second main conclusion: Wage-setting is not the answer to all the euro area’s problems.) Such a framework has two main components. First an economic governance architecture that is conducive to more balanced aggregate demand growth in the monetary union. Most importantly, national fiscal policy and also regulatory policies, notably in the financial sphere, must be deployed symmetrically to keep member state economies close to their respective rates of non-inflationary potential output growth; ‘symmetrically’ means here dampening demand in booming but also stimulating it in stagnant economies. And that requires sensible rules to encourage and where necessary enforce such behaviour. A second area is to promote structures of collective bargaining conducive to outcomes that meet these macroeconomic requirements. But first it will be useful to make explicit what those outcome requirements for wage policy are.

We can formulate a simple ‘Golden Wage Rule’ for wage developments at the macroeconomic level in European monetary union as follows (see Watt 2010, for a fuller exposition Watt 2007): starting from a position where member states are in ‘equilibrium’, nominal wage growth in each country should grow at a rate equal to national medium-run productivity growth plus the central bank’s inflation target.

At this rate real wages grow in line with productivity. The wage share remains constant. Core domestic inflation will remain close to the definition of price stability. Given this condition the central bank is obliged by its subsidiary mandate to support sustainable economic and employment growth. To that extent the wage rule can also be seen as a condition for achieving and maintaining full-employment.

Starting from a position of ‘disequilibrium’ – such as at the present time – there should be a wage ‘bonus’ in current account surplus or ‘over-competitive’ countries, and a wage ‘malus’ in current account deficit or ‘uncompetitive’ countries.

We can now briefly address a final issue: what sort of collective bargaining structures are appropriate for achieving the desired outcomes. Collective bargaining systems are highly complex and do not lend themselves to simplistic classifications. It is not my intention here to review the voluminous literature[6], merely to point to the very one-sided approach favoured by the European institutions which, precisely does not seem to have taken this research into account in any systematic way, but bases its recommendations on, if anything, simple prejudices and wrong-headed conceptions about the way wage setting is supposed to work, even in a traditional neo-classical framework.

One key point that does need to be made here is that if wage-setting is to take macroeconomic conditions, and specifically macroeconomic imbalances, into account, then there must be at least a minimal degree of wage centralisation/coordination, for appeals to wage-setters to make any sense whatsoever. A country with completely decentralised wage bargaining can only rely on national fiscal policy to steer national aggregate demand in such a way that the ‘right’ wage outcome is generated by the Philip’s curve, i.e. it creates the ‘right’ amount of unemployment to ensure this. Yet we know that national fiscal policy is not up to this task.

For the reasons given above I reach my third conclusion: the greatest possible degree of decentralisation of wage-setting is not the way forward for Europe. 

Conclusion – what Europe needs

If the preceding analysis is correct, my fourth conclusion follows quasi-automatically: Europe needs a cooperative policy mix with well-developed, effective and coordinated demand-management and collective bargaining institutions if it is to enjoy sustained, balanced and inclusive growth.

More specifically the euro area needs broad-based economic governance reform to bring about the following.

  • Integrated monetary-fiscal policy mix to ensure stable, balanced growth of nominal GDP in aggregate and at national level.
  • Context-sensitive and symmetrical surveillance of macroeconomic imbalances
  • Sensible product market reforms to limit firms’ pricing power.
  • Support for collective bargaining institutions delivering nominal wage growth in accordance with Golden Wage Rule, while respecting historically developed national institutions, along with evidence-based adjustment of mal-performing systems.
  • Support for trade unions’ wage coordination efforts at the European level and an active commitment by European trade unions to step up their efforts in this area.
  • A major reinforcement of the existing Macroeconomic Dialogue at European level and its establishment at national level to help monitor and coordinate both demand side and wage policies, also in the face of shocks (Koll 2011).

This is what Europe needs. It does not need an all-out attack on wage-setting and wage-setters, such is now being made on, in particular deficit countries, combined with hugely damaging austerity policies. This approach is visibly failing. Policy should move in the direction of the cooperative policy mix sketched out here.

 

Literature

Allsopp, C. and A. Watt (2003) 'Trouble with EMU: Fiscal policy and its implications for inter-country adjustment and the wage-bargaining process', Transfer, European Review of Labour and Research, 10 (4), Winter 2003

De Grauwe (2011) The Governance of a Fragile Eurozone, CEPS Working Document, No. 346, May 2011, www.ceps.eu/ceps/download/5523/

Koll, W. and V. Hallwirth (2009) ‘Strengthening the Macroeconomic Dialogue to tackle economic imbalances within Europe’, A. Watt and A. Botsch (eds.) After the crisis: towards a sustainable growth model, ETUI, http://www.etui.org/content/download/2193/24269/file/FINAL-ETU032_LivretCrise_Int_BAT-31.pdf/

Theodoropoulou, S. and A. Watt (2011) ‘Macroeconomic developments and policy issues, ETUI (ed) Benchmarking Working Europe 2011, ETUI: Brussels 6-19, http://www.etui.org/content/download/2114/23501/file/Chap+1.pdf/

Traxler, F., S. Blaschke, and B. Kittel (2001) National labour relations in internationalized markets. A comparative study of institutions, change and performance, Oxford University Press

Watt, A (2007) 'The role of wage-setting in a growth strategy for Europe', P. Arestis, M. Baddeley and J. McCombie (eds.) Economic growth. New directions in theory and policy, Edward Elgar: 178-199

Watt, A (2010) ‘From End-of-Pipe Solutions towards a Golden Wage Rule to Prevent and Cure Imbalances in the Euro Area’, December 2010, http://www.social-europe.eu/2010/12/from-end-of-pipe-solutions-towards-a-golden-wage-rule-to-prevent-and-cure-imbalances-in-the-euro-area/ 

Watt, A. (2011) ‘Economic governance in Europe in the wake of the crisis: reform proposals and their alternatives’ Transfer Review of Research and Labour, 17(2): 255-261

 


[1] For a recent clear exposition see Alan Greenspan in the Financial Times of 7 October 2011. http://blogs.ft.com/the-a-list/2011/10/06/europe%E2%80%99s-crisis-is-all-about-the-north-south-split/

[2] Unit labour costs are the total labour costs of producing one unit of output. The rate of change in ULC is the pace of wage growth minus the rate of productivity growth (both expressed either per employee or per working hour).

[3] To do so look at page 10 here: http://www.etui.org/content/download/2114/23501/file/Chap+1.pdf/

[4] Note that this does not mean that countries should become ‘less good’ at exporting, reduce their productivity or ‘work less hard’ or other such calumnies. It means that countries’ incomes (and thus their imports) should grow broadly in line with their productive capacity, and, specifically, their wages in line with their productivity growth.

[5] For an early statement see Allsopp and Watt 2003, for a recent assessment Theodoropoulou and Watt 2011.

[6] A good starting point is Traxler, Blaschke and Kittel (2001).

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