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 a

Publishing date
07 August 2013

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).

130625_Curve

130625_legend

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.

About the authors

  • Guntram B. Wolff

    Guntram Wolff is a Senior fellow at Bruegel. He is also a Professor of Public Policy and Economics at the Willy Brandt School of Public Policy. From 2022-2024, he was the Director and CEO of the German Council on Foreign Relations (DGAP) and from 2013-22 the director of Bruegel. Over his career, he has contributed to research on European political economy, climate policy, geoeconomics, macroeconomics and foreign affairs. His work was published in academic journals such as Nature, Science, Research Policy, Energy Policy, Climate Policy, Journal of European Public Policy, Journal of Banking and Finance. His co-authored book “The macroeconomics of decarbonization” is published in Cambridge University Press.

    An experienced public adviser, he has been testifying twice a year since 2013 to the informal European finance ministers’ and central bank governors’ ECOFIN Council meeting on a large variety of topics. He also regularly testifies to the European Parliament, the Bundestag and speaks to corporate boards. In 2020, Business Insider ranked him one of the 28 most influential “power players” in Europe. From 2012-16, he was a member of the French prime minister’s Conseil d’Analyse Economique. In 2018, then IMF managing director Christine Lagarde appointed him to the external advisory group on surveillance to review the Fund’s priorities. In 2021, he was appointed member and co-director to the G20 High level independent panel on pandemic prevention, preparedness and response under the co-chairs Tharman Shanmugaratnam, Lawrence H. Summers and Ngozi Okonjo-Iweala. From 2013-22, he was an advisor to the Mastercard Centre for Inclusive Growth. He is a member of the Bulgarian Council of Economic Analysis, the European Council on Foreign Affairs and  advisory board of Elcano.

    Guntram joined Bruegel from the European Commission, where he worked on the macroeconomics of the euro area and the reform of euro area governance. Prior to joining the Commission, he worked in the research department at the Bundesbank, which he joined after completing his PhD in economics at the University of Bonn. He also worked as an external adviser to the International Monetary Fund. He is fluent in German, English, and French. His work is regularly published and cited in leading media. 

Related content