Wages and Inflation: Let Workers Alone

[Note: this is a slightly edited ChatGPT translation of an article for the Italian daily Domani]

Last week’s piece of news is the gap that opened between the US central bank, the Fed, and the European and British central banks. Apparently, the three institutions have adopted the same strategy, deciding to leave interest rates unchanged, in the face of falling inflation and a slowdown in the economy. But, for central banks, what you say is just as important as what you do; and while the Fed has announced that in the coming months (barring surprises, of course) it will begin to loosen the reins, reducing its interest rate, the Bank of England and the ECB have refused to announce cuts anytime soon.

To understand why the ECB remains hawkish, one can read  the interview with  the Financial Times  of the governor of the Central Bank of Belgium, Pierre Wunsch, one of the hardliners within the ECB Council. Wunsch argues that, while inflation data is good (it is also worth noting that, as many have been saying for months, inflation continues to fall faster than forecasters expect), wage dynamics are a cause for concern. In the Eurozone, in fact, these rose by 5.3% in the third quarter of 2023, the highest pace in the last ten years. The Belgian Governor mentions the risk that this increase in wages will weigh on the costs of companies, inducing them to raise prices and triggering further wage demands; As long as wage growth is not under control, Wunsch concludes, the brakes must be kept on. Once again, the restrictive stance is justified by the risk of a price-wage spiral, that so far never materialized, despite having been evoked by the partisans of rate increases since 2021. Those who, like Wunsch, fear the wage-price spiral, cite the experience of the 1970s, when the wage surge had effectively fueled progressively out-of-control inflation. The comparison seems apt at first glance, given that in both cases it was an external shock (energy) that triggered the price increase. But, in fact, it was not necessary to wait for inflation to fall to understand that the risk of a wage-price spiral was overestimated and used by many as an instrument. Compared to the 1970s, in fact, many things have changed. I talk about this in detail  in Oltre le Banche Centrali, recently published by Luiss University Press (in Italian): Automatic indexation mechanisms have been abolished, the bargaining power of trade unions has greatly diminished and, in general, the precarization of work has reduced the ability of workers to carry out their demands. For these and other reasons, the correlation between prices and wages has been greatly reduced over three decades.

But the 1970s are actually the exception, not the norm. A recent study by researchers at the International Monetary Fund looks at historical experience and shows that, in the past, inflationary flare-ups have generally been followed with a delay by wages. These tend to change more slowly than prices, so that an increase in inflation is not followed by an immediate adjustment in wages and initially there is a reduction in the real wage (the wage adjusted for the cost of living). When, in the medium term, wages finally catch up with prices, the real wage returns to the equilibrium level, aligned with productivity growth. If the same thing were to happen at this juncture, the IMF researchers believe, we should not only expect, but actually hope for nominal wage growth to continue to be strong for some time in the future, now that inflation has returned to reasonable levels: looking at the data published by Eurostat, we observe that for the eurozone, prices increased by 18.5% from the third quarter of 2020 to the third quarter of 2023,  while wage growth stopped at 10.5%. Real wages, therefore, the measure of purchasing power, fell by 8.2%. Italy stands out: it has seen a similar evolution of prices (+18.9%), but an almost stagnation of wages (+5.8%), with the result that purchasing power has collapsed by 13%.

Things are worse than these numbers show. First, for convergence to be considered accomplished, real wages will have to increase beyond the 2021 levels. In countries where productivity has grown in recent years, the new equilibrium level of real wages will be higher. Second, even when wages have realigned with productivity growth, there will remain a gap to fill. During the current transition period, when real wages are below the equilibrium level, workers are enduring a loss of income that will not be compensated for (unless the real wage grows more than productivity for some time). From this point of view, therefore, it is important not only that the gap between prices and wages is closed, but that this happens as quickly as possible.

In short, contrary to what many (more or less in good faith) claim, the fact that at the moment wages are growing more than prices is not the beginning of a dangerous wage-price spiral and the indicator of a return of inflation; rather, it is the foreseeable second phase of a process of rebalancing that, as the IMF researchers point out, is not only normal but also necessary.

The conclusion deserves to be emphasized as clearly as possible: if the ECB or national governments tried to limit wage growth with restrictive policies, they would not only act against the interests of those who paid the highest price for the inflationary shock. But, in a self-defeating way, they would prevent the adjustment from being completed and delay putting once and for all the inflationary shock behind us.

A Piketty Moment

Update (10/27): Comments rightly pointed to different deflators for the two series. I added a figure to account for this (thanks!)

Via Mark Thoma I read an interesting Atalanta Fed Comment about their wage tracker, asking whether the recent pickup of wages in the US is robust or not.

The first thing that came to my mind is that we’d need a robust and sustained increase, in order to make up for lost ground, so I looked for longer time series in Fred, and here is what I got

This yet another (and hardly original) proof of the regime change that occurred in the 1970s, well documented by Piketty. Before then, US productivity (output per hour) and compensation per hour  roughly grew together. Since the 1970s, the picture is brutally different, and widely discussed by people who are orders of magnitude more competent than me.

[Part added 10/27: Following comments to the original post, I added real compensation defled with the GDP deflator.  While this does not account for purchasing power changes, it is more directly comparable with real output. Here is the result:

The commentators were right, the divergence starts somewhat later, in the early 1980s. This makes it less of a Piketty moment, while leaving the broad picture unchanged.]

Next, I tried to ask whether it is better for wage earners, in this generally gloomy picture, to be in a recession or in a boom. I computed the difference between productivity (output per hour) and wages (compensation per hour), and averaged it for NBER recession and expansion periods (subperiods are totally arbitrary. i wanted the last boom and bust to be in a single row). Here is the table:

Yearly Average Difference Between Changes in Productivity and in Wages
	In Recessions	In Expansions	Overall	% of Quarters in Recession
1947-2016	1.51%	0.40%	0.57%	15%
1947-1970	1.62%	-0.14%	0.19%	19%
1970-2016	1.42%	0.67%	0.76%	13%
1980-1992	0.64%	0.84%	0.81%	17%
1993-2000	N/A	0.68%	0.68%	0%
2001-2008Q1	4.07%	1.10%	1.41%	10%
2008Q2-2016Q2	2.17%	0.12%	0.49%	18%
Source: Fred (my calculations)
Compensation: Nonfarm Business Sector, Real Compensation Per Hour
Productivity: Nonfarm Business Sector, Real Output Per Hour

No surprise, once again, and nothing that was not said before. The economy grows, wage earners gain less than others; the economy slumps, wage earners lose more than others.  As I said a while ago, regardless of the weather stones keep raining. And it rained particularly hard in the 2000s. No surprise that inequality became an issue at the outset of the crisis…

There is nevertheless a difference between recessions and expansions, as the spread with productivity growth seems larger in the former. So in some sense, the tide lifts all boats. It is just that some are lifted more than others.

Ah, of course Real Compensation Per Hour embeds all wages, including bonuses and stuff. Here is a comparison between median wage,compensation per hour, and productivity, going as far back as data allow.

I don’t think this needs any comment.

Praising the Bundesbank

I am puzzled by Wolfgang Münchau’s latest piece in the Financial Times. Let me start by quoting the end:

[…] The ECB should have started large-scale asset purchase a year ago. It certainly should do so now. The EU should allow governments to overshoot their deficit targets this year, and suspend the fiscal compact, which will result in further fiscal pain from 2016.

Even a casual reader of this blog will quickly realize that it would be hard for me to agree more with these statements. The macroeconomic stance at the EMU level has been seriously inappropriate since 2010, with fiscal policy globally restrictive (thank you austerity), and monetary policy way too timid.
So, what is the problem? The problem is the first part of Münchau’s editorial, in which he attacks the Bundesbank for its plea in favour of faster wage growth in Germany (the Buba asked for an average wage increase of 3%).
This is frankly hard to understand. The eurozone problems, and it’s flirting with deflation, stem from the victory of the Berlin View, that laid the burden of adjustment on the shoulders of peripheral countries alone.
The call for wage increases in Germany signals, and it was about time, that even conservative German institutions are beginning to realize the obvious: there will be no rebalancing, and therefore no robust recovery, unless German domestic demand recovers. This means a fiscal expansion, as well as private expenditure recovery. Unsurprisingly, the Buba rules out the former, but it is nice to see that at least the latter has become an objective. Faster wage growth may not make a huge difference in quantitative terms, but it still marks an important change of attitude. This is a huge step away from the low-wage-high-productivity-export-led model that the Bundesbank and the German government have been preaching (and imposing to their partners).
Münchau is right in calling for a different policy mix in the EMU. But this is complementary, not alternative, to a change in the German growth model. I would have expected him to applaud a small but potentially important change in attitude. Instead I have read a virulent attack. Puzzled, puzzled…

Overheat to Raise Potential Growth?

Update, March 20th: Speaking of ideological biases concerning inflation, Paul Krugman nails it, as usual.

On today’s Financial Times, Phillip Hildebrand gives yet another proof of unwarranted inflation terror. His argument is not new: In spite of the consensus on a weak recovery, the US economy may be close to its potential , so that further monetary stimulus would eventually be inflationary.

He then deflects (?) the objection that decreasing unemployment reflects decreasing labour force participation rather than new employment, by suggesting that it is hard to know how many of the 13 millions jobs missing are structural, i.e.not linked to the crisis. I think it is worth quoting him, because otherwise it would be hard to believe:

However, an increasingly vocal group of observers, including within the Fed, posits that more of the fall in the participation rate appears to have been structural than cyclical, and it was even predictable – the result of factors such as an ageing workforce and the effect of technology on jobs.

(the emphasis is mine). Now look at this figure, quickly produced from FRED data:

Supporting Aggregate Demand in Fiscally Constrained Economies

In the past weeks I have argued at length that  the eurozone is in recession because of a strong contraction of aggregate demand; and that in spite of this fact the overall fiscal stance is restrictive.

I also argued that in the current situation the best that can be hoped for peripheral countries is a more gradual consolidation (ideally a neutral stance, but this is too much to ask). I do believe that a fiscal expansion, even in the periphery, would be sustainable and growth-enhancing. But at this stage this is just daydreaming. It won’t happen.

The fiscal stance of the eurozone will not become expansionary (as is sorely needed), if the core (and in particular Germany) does not implement robustly expansionary fiscal policies.

If their fiscal space is limited or non-existent, what can peripheral countries do, besides waiting for an improbable fiscal stimulus in Germany? A lot, actually. If public demand cannot be significantly increased (and will actually be further compressed, albeit at a slower pace), it is all the more important that the governments of Italy, Greece, Spain and so on, find ways to restart private demand.

There is a lot of discussion about structural reforms. They are not the answer. First, because they have an impact mostly on supply (and the problem, let me repeat it, is demand); second, because their benefits, if any, won’t materialize before a few years. And there is no time. The cumulate effect of five years of crisis is now threatening social cohesion in most peripheral countries.

A more straightforward policy, that could be implemented in the next few months with immediate effects, is a strong redistribution of the tax burden towards higher incomes. The increasing inequality of income of the past three decades is in my opinion one of the deep causes of the crisis;  inequality has further increased since 2008. The squeeze of revenues for low incomes, coming from the combination of high unemployment and fiscal adjustment, is depressing both the capacity to spend and the morale of households. Increased inequality contributed to global imbalances in the past, and  is recessionary in the current crisis.

In September, when the season of budget laws begins, governments in the periphery should propose to their parliaments revenue-neutral tax adjustments, lowering taxes on low income households and increasing them on the rich and very rich. This would be fair, and more importantly, effective to boost morale and consumption. I am talking about a substantial shift of the burden, large enough for its macroeconomic impact to be significant. This is all the more necessary if standard Keynesian deficit spending can not be implemented.

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.