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Wages and Unemployment

The April data on Italian unemployment are out, and they look no good. Not at all. The overall rate (10.2%)  is at its maximum since the beginning of monthly data series (2004), and youth unemployment is  above 35%. The rest of Europe is not doing any better, with more than 17 millions people looking for a job in the eurozone alone.

We already knew. The latest data just add to the bleak picture. We also know (I discussed it) what the consensus diagnosis is: Too many rigidities, excessively high labour costs, both because of wages and of  taxes on labour (the so-called tax wedge). Therefore, let’s have lower wages, and all will be well! Unemployment will disappear, growth will resume. Mario Draghi said it rather nicely:

Policies aimed at enhancing competition in product markets and increasing the wage and employment adjustment capacity of firms will foster innovation, promote job creation and boost longer-term growth prospects. Reforms in these areas are particularly important for countries which have suffered significant losses in cost competitiveness and need to stimulate productivity and improve trade performance.

Unfortunately, things are not that simple. What about looking at a few data? It is simple to download them  from the website of Eurostat.

The consensus would claim that countries with a higher wage will have higher unemployment. Let’s look at that (each dot is an EU country, and all variables are nominal):

Mmhh, no good for the consensus. The correlation, if any, seems to go in the other direction. Countries with higher wages have lower unemployment. Furthermore, the crisis does not seem to have played any role, as the negative correlation existed in 2008 (blue) like in 2011 (red). The trend line is actually steeper after than before the crisis.

Hold on, would say a consensus follower. It is not just wages, it is wages and taxes that keep unemployment high. Good, because we have a name for that thing, which is labour costs, defined as wages plus the tax wedge (social contributions, essentially). And here is the figure:

Still no good; there is no major difference with the figure on wages… There is one last line of defense, though. The consensus could argue that it is not absolute values (levels) that count, but their variation. Countries with more flexible labour markets reacted better to the crisis. Or did they? Let’s look at changes from 2008 to 2011

Here the blue dots are labour cost changes and the red dots wages and salaries changes, all against changes in unemployment. And guess what? Unemployment increased more in countries were wages and/or labour cost increased less. Here as well, little  comfort for the consensus

Is this a puzzle? Yes if we stick to a simplistic “its all a problem of structural reforms” view of the world. But not at all if  we take a broader view; then one would  realize that the flip side of wages is demand, and the problem for European firms was not and is not (only) labour costs, but demand for their goods. And countries that pay more their workers, or that tax firms to finance stimulus plans, may see demand and activity increase with positive effects on unemployment. It is after all the idea defended by Keynes in chapter XIX of his General Theory. In other words, in a general equilibrium perspective, demand and supply need to be considered jointly to have an accurate view of problems and solutions (I have written a very obscure paper on this, in another geological era).

All this is not meant to say that rigidities play no role;  everything is not well in Europe (and most notably in European labour markets). Nor I believe that a few figures and correlations constitute scientific evidence. They do not.
But a few figures may suffice as counter examples. They may be useful to warn against easy diagnoses leading to easy recipes that more often than not are simply false. An healthy economy emerges from a mix of supply and demand factors, that need to be kept balanced; sometimes through government intervention, sometimes by leaving market forces deploy freely. Pretending that all is white or black is the best way to head towards disaster. The fact that I feel obliged to write such a triviality is probably the best indicator of how dire the state of public debate is today. We are in the hands of a bunch of amateurs…

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