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 about event More on this topic

Past Event

Past Event

Europe's trust deficit

This event seeks to discuss the rise of populism in Europe and the economic, security, and identity concerns behind the movement.

Speakers: Maria Demertzis, Giuseppe Porcaro, André Sapir and Guido Tabellini Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: September 21, 2017
Read article Download PDF More by this author

Policy Contribution

Dutch Senate

Europe’s fourfold union: Updating the 2012 vision

The depiction of the euro area/European Union (EU) as a ‘fourfold union’ emerged in the first half of 2012 at the height of the euro-area crisis. In the past half-decade, Europe’s financial union has been significantly strengthened but remains incomplete and is challenged by Brexit. No consensus has been found on fiscal union and economic union has not made material progress, but political union might have advanced further than many observers realize.

By: Nicolas Véron Topic: Dutch Senate, European Macroeconomics & Governance, Finance & Financial Regulation, Testimonies Date: September 21, 2017
Read about event

Upcoming Event

Sep
28
12:30

Unfinished business: The unexplored causes of the financial crisis and the lessons yet to be learned

At this event Tamim Bayoumi will present his upcoming book on the financial crisis, showing how the Euro crisis and U.S. housing crash were, in fact, parasitically intertwined.

Speakers: Tamim Bayoumi, Maria Demertzis and Aerdt Houben Topic: European Macroeconomics & Governance, Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article

Blog Post

How has banking union changed mergers and acquistions?

The aim of the banking union was to break the toxic link between banks and states. One way of achieving this is by increasing cross border banking through mergers and acquisitions. This blog shows that little has changed in M&A activity since the banking union was launched. In fact, we seem to be witnessing a slight re-nationalisiation of banking consolidation.

By: Inês Goncalves Raposo and Guntram B. Wolff Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: September 13, 2017
Read article More on this topic More by this author

Blog Post

Speech by Peter Kažimír at Bruegel Annual Dinner 2017

Peter Kažimír, Slovakia Finance Minister, delivered the keynote speech at Bruegel's Annual Dinner 2017, held on 7 September 2017.

By: Peter Kažimír Topic: European Macroeconomics & Governance Date: September 7, 2017
Read about event

Past Event

Past Event

Bruegel Annual Meetings 2017

The Annual Meetings are Bruegel’s flagship event. They offer a mixture of large public debates and small private sessions about key issues in European and global economics. In a series of high-level discussions, Bruegel’s scholars, members and stakeholders will address the economic policy challenges facing Europe.

Speakers: Carlos Sallé Alonso, José Antonio Álvarez Álvarez, Agnès Bénassy-Quéré, Pervenche Béres, Matthias Buck, Grégory Claeys, Zsolt Darvas, Jean Luc Demarty, Maria Demertzis, Anna Ekström, Lowri Evans, Ferdinando Giugliano, Sandro Gozi, Peter Grünenfelder, Reiner Hoffmann, Levin Holle, Kate Kalutkiewicz, Steffen Kampeter, Peter Kažimír, Emmanuel Lagarrigue, Matti Maasikas, Steven Maijoor, Reza Moghadam, Nathalie Moll, James Murray, Johan Van Overtveldt, Julia Reinaud, André Sapir, Dirk Schoenmaker, Mateusz Szczurek, Marianne Thyssen, Jean-Claude Trichet, Reinhilde Veugelers, Nicolas Véron, Ida Wolden Bache, Liviu Voinea, Guntram B. Wolff and Georg Zachmann Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Location: Square - Brussels Meeting Centre Date: September 7, 2017
Read article More on this topic More by this author

Blog Post

EU posted workers: separating fact and fiction

After President Macron’s recent tour of Central and Eastern European countries, EU posted workers are getting a lot of attention. However, a major reform of the system is already underway and we should not confuse posted workers with long-term labour migrants. Posted workers are a small part of the labour force, and their labour market impact is likely to be minor.

By: Uuriintuya Batsaikhan Topic: European Macroeconomics & Governance Date: August 31, 2017
Read article Download PDF More by this author

Parliamentary Testimony

European Parliament

Could revising the posted workers directive improve social conditions?

This presentation was delivered in Brussels on 31 January 2017 at a hearing of think-tanks, to advise the European Parliament on the revision of the Posting of Workers Directive.

By: Zsolt Darvas Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: August 29, 2017
Read article More on this topic

Opinion

Europe must seize this moment of opportunity

As the EU enjoys a period of growth and relative stability, there is finally room to undertake long-needed reforms. But it is vital to act soon, and priorities must be set. There are three pillars of reform for the coming months: completing a robust euro area; building a coherent EU foreign policy; and harnessing the single market’s potential to deliver strong and inclusive growth.

By: Agnès Bénassy-Quéré, Michael Hüther, Philippe Martin and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: August 12, 2017
Read article More on this topic More by this author

Blog Post

Italian economic growth and the Euro

While the Euro has frequently been blamed for the poor growth performance of Italy over the years, a long-term analysis shows deteriorating growth before the introduction of the Euro. Additionally, Italy has shown worse performance than other euro-periphery countries, such as Spain, implying deeper structural reasons for Italy’s economic malaise.

By: Francesco Papadia Topic: European Macroeconomics & Governance Date: July 26, 2017
Read article More on this topic More by this author

Blog Post

The international effects of ECB’s monetary policy

What’s at stake: the literature on monetary policy spillovers is abundant of studies investigating the impact of the US Federal Reserve’s monetary policy announcements and actions on emerging market economies. More recently, economists have been investigating the effect of the ECB’s credit easing as well.

By: Silvia Merler Topic: European Macroeconomics & Governance Date: July 24, 2017
Read about event More on this topic

Past Event

Past Event

Perspectives on Universal Basic Income

At this event, we discussed 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 Date: July 12, 2017
Load more posts