Blog Post

Much pain for small gain: difficulty of cost adjustment in the euro area

IMF’s latest World Economic Outlook discussed reasons for relatively stable inflation following the Great Recession. It noted that large output gaps and high unemployment have resulted in surprisingly little disinflation in advanced countries. This was attributed to more firmly anchored long-term inflation expectations as well as the reluctance of workers to accept nominal wage cuts. The positive implication is that efforts to stimulate the economy should not result in rapidly rising inflation even if output gaps are overestimated provided that long-term expectations remain anchored. However, the finding also means that intra-euro area price adjustment is more challenging, which is the focus of this blog entry.

By: and Date: August 7, 2013 Topic: European Macroeconomics & Governance

IMF’s latest World Economic Outlook discussed reasons for relatively stable inflation following the Great Recession. It noted that large output gaps and high unemployment have resulted in surprisingly little disinflation in advanced countries. This was attributed to more firmly anchored long-term inflation expectations as well as the reluctance of workers to accept nominal wage cuts. The positive implication is that efforts to stimulate the economy should not result in rapidly rising inflation even if output gaps are overestimated provided that long-term expectations remain anchored. However, the finding also means that intra-euro area price adjustment is more challenging, which is the focus of this blog entry.

Amid weak domestic demand, growth in Southern Europe is heavily reliant on increasing net exports to regain growth. We have already documented a significant improvement in the external balance of southern economies. This has been mostly export-driven in Ireland, Spain and Portugal while Greece has adjusted exclusively through import compression. Slower wage growth in the south than in Germany since the start of the crisis is part of the story but it has coincided with very high unemployment. 

Can the moderation in wage growth in the south and the simultaneous pick-up in Germany be explained by the unemployment levels? Is the intra-euro cost adjustment working as expected through changes in unemployment levels? What does the Philips curve relation imply for adjustment?

In Figure 1, we plot the Philips curve based on wage inflation for two periods: pre- and post-EMU. A number of findings stand out. First, the Phillips curve generally became flatter since 1999. Second, wage developments in the most recent period are relatively well explained by the estimated Phillips curve. In particular, German wage developments since 2008 are consistent with its Phillips curve for 1999–2007. Also the estimate of German wage inflation of 2.8 % this year (Lichtenberg 2013) is in line with the pre-crisis curve.

Figure 1: Phillips curves based on unemployment and growth in compensation per employee (1992–2012).

In Spain we can detect excessive wage increases in 2008 and 2009 when unemployment was already rising considerably. However, wage growth since 2010 has been consistent with the pre-2008 relationship between compensation and unemployment.

In Greece the Phillips curve for the period 1999­–2007 is influenced by the very high (11.4 %) wage growth in 2002. Nevertheless, the very steep curve of the 1990s has been replaced by a more gently sloped relationship since the crisis. Since 2010 Greek unemployment has increased dramatically with three continuous years of nominal wage cuts.

Recent wage developments in France, Italy and Portugal are also broadly compatible with the pre-crisis Phillips curve with high Portuguese unemployment coinciding with two successive years of reductions in compensation.

The flat curve has important implications for adjustment in the EMU. If we use past wage inflation divergence as a simple measure of how much wages may have to correct, significant relative wage adjustments are still ahead.  Table 1 represents the cumulated differences in hourly wage inflation relative to Germany pre- and post-crisis.

Table 1: Difference in cumulated hourly wage growth relative to Germany.

Period

Spain

France

Greece

Italy

Portugal

2000-2007

20.1

16.3

42.1

12.6

18.0

2007-2012

-2.5

0.2

-15.5

-2.3

-8.0

2000-2012

19.4

18.5

23.8

11.4

9.9

Note: As an example the 2000–2007 figure for Spain is calculated as the difference in cumulated wage growth in Spain in 2000–2007 (29.5 %) and Germany (9.4 %), i.e. 29.5 %-9.4 %=20.1 %.

Source: Bruegel based on ECB.

Wages grew considerable faster in all of the highlighted countries than in Germany pre-crisis. Although all except France have undercut German wage growth since 2007, German wage costs have still increased by considerable less than in other countries over the whole period of 2000–2012.

Greece and Portugal have roughly halved the pre-crisis excess wage growth relative to Germany since 2007. This has coincided with an increase in unemployment by 16 %-points in Greece and 7.7 %-points in Portugal, a tripling and doubling of the pre-crisis levels respectively. Therefore, only a very severe recession led to the price adjustment.

In turn, in Germany, unemployment had to fall to really low levels before wages started to pick up. The flat German Philips curve also means that it is unlikely that wages will increase very significantly in the future. This again renders adjustment of relative prices in the euro area more difficult.

The IMF concludes that a flatter Philips curve signifies that monetary policy has more leeway to operate. This is true for the euro area as a whole. However, it does not help with achieving relative wage adjustment. The flat Philips curve instead suggests that in order to avoid sustained and prolonged high unemployment rates, other instruments are needed to shift the curve. One option could be the more deliberate use of fiscal devaluation strategies.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read article More on this topic More by this author

Blog Post

Raising the inflation target: a question of robustness

In an unexpected move, the Federal Reserve Chair Janet Yellet has recently brought up the issue of raising the inflation target. This blog argues that an increase in inflation targets may prove to be beneficial in achieving price stability in the long run. This would increase the credibility of central banks in achieving inflation goals and stave off the distortionary effects of deflation.

By: Maria Demertzis Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article More on this topic

Blog Post

Can EU actors keep using common law after Brexit?

English common law is the choice of law for financial contracts, even for parties in EU members with civil law systems. This creates a lucrative legal sector in the UK, but Brexit could make UK court decisions difficult to enforce in the EU. Parties will be able to continue using English common law after Brexit, but how will these contracts be enforced? Some continental courts are preparing to make judicial decisions on common law cases in the English language.

By: Uuriintuya Batsaikhan and Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article More on this topic More by this author

Blog Post

The size and location of Europe’s defence industry

There is growing debate about a common European military policy and defence spending. Such moves would have major economic implications. We look at the supply side and summarise some key facts about the European defence sector: its size, structure, and ability to meet a possibly increased demand from EU member states.

By: Alexander Roth Topic: European Macroeconomics & Governance Date: June 22, 2017
Read article More by this author

Parliamentary Testimony

House of Commons

Exiting the European Union Committee

On 19 April 2017 Zsolt Darvas appeared as a witness at the Exiting the European Union Committee, the House of Commons, United Kingdom.

By: Zsolt Darvas Topic: European Macroeconomics & Governance, House of Commons, Testimonies Date: June 20, 2017
Read article More on this topic More by this author

Blog Post

Brexit and the future of the Irish border

The future of the Irish land border has been thrown into uncertainty by Brexit. The UK's confirmation that it will leave the EU's single market and customs union implies that customs checks will be needed. However, there is little desire for hard controls from any of the parties involved. This is especially true for Theresa May's potential partner, the DUP. Creative solutions are needed to reach a solution.

By: Filippo Biondi Topic: European Macroeconomics & Governance Date: June 19, 2017
Read about event

Upcoming Event

Jul
6
12:30

Is there a way out of non-performing loans in Europe?

At this event we will look at the issue of non-performing loans in Europe. The event will also see the launch of the latest issue of "European Economy – Banks, Regulation and the Real Sector."

Speakers: Emilios Avgouleas, Giorgio Barba Navaretti, Giacomo Calzolari, Maria Demertzis, Martin Hellwig, Helen Louri and Laura von Daniels Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

Jul
12
12:30

Perspectives on Universal Basic Income

At this event, we will discuss the possible benefits but also the possible disadvantages of Universal Basic Income.

Speakers: Grégory Claeys, Olli Kangas, Professor Philippe Van Parijs and Prof. Dr. Hilmar Schneider Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic More by this author

Blog Post

Is Greece’s labour market bouncing back?

After rapid increases in unemployment and large wage reductions, Greece’s labour market is showing signs of recovery. Certain sectors of the economy are showing strong employment growth, which could hint at a broader economic recovery.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: June 14, 2017
Read about event More on this topic

Past Event

Past Event

Lessons for the future governance of financial assistance in the EU

On 14th June, Randall Henning will present his latest book on the Euro crisis and we will discuss how financial assistance should be governed in the euro area in the future.

Speakers: Servaas Deroose, C. Randall Henning, Rolf Strauch and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 14, 2017
Read article More by this author

Blog Post

The Universal Basic Income discussion

What’s at stake: the concept of a Universal Basic Income (UBI), an unconditional transfer paid to each individual, was prominent earlier this year when Finland announced a pilot project. It’s now back in the discussion as the OECD published a report illustrating costs and distributional implications for selected countries. We review the most recent contributions on this topic.

By: Silvia Merler Topic: European Macroeconomics & Governance, Global Economics & Governance Date: June 12, 2017
Read about event More on this topic

Past Event

Past Event

CANCELLED - What should be Greece's next growth model?

Due to unforeseen circumstances, we will have to cancel this event.

Speakers: Kuriakos Mitsotakis and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: June 8, 2017
Read article Download PDF More by this author

Policy Contribution

German Bundestag

Charting the next steps for the EU financial supervisory architecture

The combination of banking union and Brexit justifies a reform of the European Banking Authority (EBA) and the European Securities and Markets Authority (ESMA) in the near term, in line with the subsidiarity principle and the accountability of EBA and ESMA and their scrutiny by the European Parliament should be enhanced as a key element of their governance reform.

By: Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation, German Bundestag Date: June 7, 2017
Load more posts