“Be bolder in tackling structural reforms”. It almost sounds like a line from the Star Trek television series but it is Commission President Barroso presenting the 2014 Annual Growth Survey (AGS) (see here).
This then is the key message coming from the new AGS: Reforms, reforms and more reforms. However, before continuing on this road, the Commission and member states would do well to consider what exactly it is that their structural reform policy is delivering, in particular in the domain of wages and collective bargaining systems.
The impact of structural reforms: Wages down
One key fact is that wage dynamics, in those member states that have been reforming the most, have simply collapsed. According to the Commission’s recently published autumn forecasts, workers in Spain have already been suffering a freeze in nominal pay for several years in a row, whereas nominal wages in Portugal and Ireland are expected to start falling and are already falling in Greece. Of course, this is exactly what economic policy-makers intended to achieve in the first place, to replace the missing instrument of a currency devaluation with a direct devaluation of wages.
However, under the pressure of the economic crisis, the pace of nominal wage increases has also seriously weakened in much of the rest of the Euro-area. In Italy, France, Belgium, Austria and the Netherlands, the Commission now puts wage increases at a mere (annual) increase of 1 to 1.5% in the 2013-2015 period.
Wage cuts and freezes in the periphery together with very moderate wage developments in much of the core combine to form a pattern by which average Euro-area nominal wage dynamics have come down to just 1.5% in 2013, with the Commission not expecting much of an acceleration of wage growth in 2014 and 2015 either. The ‘masters of structural deregulation’ will surely claim that such moderate wage developments across the majority of Euro-area countries are still a good thing for all member states involved because, by definition, such wage dynamics (or the absence of them) would create jobs and improve competitive positions. Leaving aside the question whether wages can indeed perform such tricks (they cannot because competitiveness is about relative positions!), there is another fundamental problem that overall Euro area wage depression raises. Indeed, policy makers should not ignore the fact that there’s a strong link running from nominal wages over productivity developments to inflation.
The graph below illustrates this link. It shows that, over time, inflation tends to move closely in line with unit labour costs, with the latter calculated by correcting nominal wage increases with developments in labour productivity. There are certainly time lags, with rising profit margins initially neutralising the moderation in unit labour costs. Over the medium term however, when profit margins have reached maximum levels, trends in unit labour costs do end up in similar trends in inflation.
The mechanism behind this is rather straightforward. If nominal wages increase by 1.5% and productivity by 0.7% (as would be the case for the Euro area over the years 2013 -2015), then firms can limit the increase in the price of their products to 0.8% while still enjoying the same profit margins. The implication is that, given current and expected wage and productivity trends, Euro-area inflation is set to move to a pace below 1%. In the coming period.
A panic room for the ECB
This brings us to the ECB. It will certainly not admit it openly, but the recent decision to cut interest rates indicates that many members of its governing council are getting pretty worried about the fact that inflation is too low and is starting to move to the threshold separating inflation from deflation.
Indeed, it’s not just the fact that inflation in October went down to a mere 0.7%. It is also the case that the fall in inflation rates we are now observing is broad based and is affecting all categories, not just energy prices but also the prices of food, services and industrial goods. This indicates that the October 0.7% inflation rate is not just a one- off phenomenon but part of a structural trend. This is also exactly what the analysis made above predicts what will happen when unit wage costs pushing inflation down below 1%
Here, the irony is that the ECB is now harvesting what it has been planting. Indeed, the ECB is one, if not THE ‘master of structural deregulation’ of wages. It is the ECB which, as part of the Troika, has imposed structural reforms to deregulate wage formation systems in Greece, Spain, Portugal, and Ireland in exchange for providing emergency credits. And while the ECB does not yield similar direct power over Italy, France or Belgium, it does try to push these countries and their governments into a similar deregulation of their bargaining systems as well.
So, if inflation is now uncomfortably low, the ECB only has itself to blame. By promoting and imposing the deregulation of wages and the weakening of collective bargaining institutions, the ECB has laid the foundation for this process of excessive disinflation to take hold.
Signs of change or signs of continuing denial?
In the AGS 2014, and more particularly in the alert mechanism report on macro-economic imbalances, there is one sign that may be pointing to the fact that at least the Commision is starting to understand this link between wage depression and low inflation bordering on the thresholds of deflation. Indeed, The Commission announces that a special, so called ‘in depth’, study will be made on Germany to see whether the huge surpluses on Germany’s current account (currently more than 6% of its BBP) represent an imbalance that may endanger the functioning of the single currency.
There is the hope that this would lead to the Commission insisting on Germany introducing a general minimum wage and boosting wage dynamics, in that way injecting new demand into its own and the Euro Area’s economy and reducing its own huge external surplus while pushing Euro Area average inflation away from zero.
However, a closer look at how the Commission has been commenting on Germany’s external surplus is not so reassuring. Indeed, what seems to be on the mind of the Commission is not to strengthen wage formation institutions in Germany but to push for more structural reforms of product markets (in particular opening up the construction sector) and for tax cuts on low wage earners. Whereas the latter implies that low wage earners will be getting a net pay increase from tax policy, not from their own employers, the former may actually even end up in downwards, not upwards pressure on wages in this sector. In the absence of a wide coverage rate for collective agreements, the removal of regulatory barriers in construction will trigger an additional influx of workers being offered a lower wage level than the collectively bargained one, thus actually putting some downwards pressure on overall wage developments in Germany.
This is, again, ironical. Indeed, with the exception of Estonia and Latvia, Germany is now the only Euro Area member state where nominal wage dynamics are somewhat stronger and real wages are increasing. With the Commission’s Autumn forecasts hoping that wage formation would accelerate from 1.9% in 2013 to close to 3% in coming years, it is actually wage formation in Germany that is helpful in keeping the Euro area average Euro a little bit up. What the Commission should be doing against such a background is to look for straightforward ways to strengthen wage dynamics in Germany. Instead, it threatens to get lost in a strange attempt to try and apply the failed concept of structural reforms on a member state that is in external surplus.
Conclusion: The same policies will produce the same results
One does not need rocket science to realise what will happen if member states follow the Commission’s indications to stay the course and stick to implementing structural reforms on wages and labour markets. The answer is straightforward: Nominal wage dynamics will get an additional negative shock. Instead of stabilising slightly above a growth rate of 1.5% (as expected in the autumn forecasts), wage dynamics will go down further still. This then will feed into the disinflation trend that is there already. Deflation for the Euro area will then be really just around the corner. Deflation, as we know from the days of Irving Fisher, will then produce an automatic and unavoidable increase in real interest rates, with the ECB unable to counteract this since nominal policy interest rate of the ECB have practically already reached the zero bound. For member states with high debt burdens, both in terms of public sector debt as in terms of household and corporate sector debt, this will be devastating. The ‘Masters of Structural Reforms’ should be careful in what they are wishing for.