Apart from the fiscal compact – on competitiveness, nominal wages and labour productivity

Marga Peeters, Ard den Reijer, 3 January 2012

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Eurozone members that face the consequences of severe asymmetric shocks can, in the absence of labour mobility, accommodate by means of fiscal transfers. In order to avoid becoming a one-way transfer union from the core to the periphery, the EU needs to address structural imbalances and persistent current-account deficits and surpluses that are due to real exchange-rate misalignment. For this reason, EU leaders started pushing for stronger economic policy integration focused on competitiveness and convergence of the Eurozone countries, and agreed earlier this year on a “competitiveness” pact (Euro-Plus Pact). As nominal exchange rates in a currency union are fixed, the price level is the only instrument for member states to correct real exchange-rate misalignment. Apart from the fiscal aspects that will be part of the fiscal compact to be enshrined in national law early next year, elements of the Euro-Plus Pact will also have to be part of it.

In order to increase product-price competitiveness in world markets, the growth in unit labour costs at national levels should be moderate. This implies that member states should align nominal-wage growth with labour-productivity growth, as the competitiveness pact prescribes. We explain what this means for the indebted periphery countries in comparison with Germany – a country that contained wages in recent years – by comparing recent developments and estimating wage elasticities across these countries at the macro level.

We share the view that aligning nominal-wage growth and productivity growth is a must for Eurozone member states in the absence of a fiscal union (see also Vanthoor 1996). We reason that the focus in the wage formation process should be on labour productivity and that there is no room for automatic indexation to prices. To steer the wage negotiation between employers and employees who are essentially private actors, we see the replacement rate as a policy instrument in the hands of the national governments.

Competitiveness

Earlier this year, Chancellor Angela Merkel and President Nicolas Sarkozy started pushing for stronger economic policy integration. As a result, fostering competitiveness is now a main objective. This should help member states in reducing their structural current-account deficits, pointing at the indebted periphery countries of Greece, Ireland, Portugal and Spain. A higher international competitiveness of their domestic products and services will lead to a better export position and, thus, increase their exports. The dire states of their governments’ public finances will, in due time, benefit from the better current-account positions, according to the line of reasoning (see also Wyplosz 2010 or Gartner and Merkl 2011).

In order to foster competitiveness, the Euro-Plus Pact and the November-drafted Six-Pack state that nominal-wage growth should evolve in line with labour-productivity growth in each of the member states. As Figure 1 illustrates for Germany, Greece, Ireland, Portugal and Spain for the years 2000-8, nominal-wage growth was mostly higher than productivity growth. Only German nominal-wage growth stayed close to the 45° line, where unit labour costs stabilise.

Figure 1. Nominal wage and productivity growth in 2000-8

Source: Peeters and Den Reijer (2011) based on OECD and EU.

Note: Unit labour costs equal gross nominal wages per hour divided by labour productivity per hour. Therefore, the growth in unit labour costs equals by approximation the growth in wages per hour (on the y-axis) minus the growth in labour productivity (on the x-axis). By consequence, in case wage growth equals labour productivity growth, the growth in unit labour costs is zero as indicated by the 45° degrees line.

What determines nominal wages?

Labour-productivity growth is not the only determinant of nominal wages. As many empirical studies show, in nominal wage-formation processes not only do inflation and the stance of the labour market play a role, but also taxes, social security aspects and replacement rates. Figure 2 shows the decomposition of the macro nominal wage growth into wage determinants, resulting from a non-linear wage-bargaining model. It incorporates interrelations between productivity and prices, unemployment and replacement rates, and models downward rigidities adequately.

Labour productivity explains most of the nominal wage growth in Germany and Ireland, prices contributed most in Greece and Portugal, and unemployment in Spain. While productivity mainly determined nominal wages in Germany in the period 2000-10, prices and unemployment also contributed to nominal wage growth, as did other factors. According to our calculations, productivity explains 40% of the German nominal wage growth, while prices and unemployment together explain 30%.

Figure 2. Contributions to nominal wage growth (in percentages)

Source: Peeters and Den Reijer (2011).

Wage elasticities of prices and the reservation wage

Empirical evidence shows that wage elasticities of productivity for Greece were small – a 1% drop in labour productivity led in the long run to a drop of -0.15% in nominal wages at the macro level in the period 1985-2010 (see Table 1). Apart from labour productivity, inflation and other factors impact nominal-wage developments. For instance, a 1% decrease in prices reduced nominal wages in this same period from 0.45% to 0.56%. Similar magnitudes follow for Ireland, Portugal, and Spain, but also for Germany. Important in this respect is the reservation wage also. Below the level of the reservation wage, a person rather stays unemployed or in the informal sector. High reservation wages drive up wages, as potential employees will be inclined to negotiate a higher wage. Employers are willing to pay this nominal wage when labour markets are tight or the preference for working in the informal sector is high. Conversely, low reservation wages moderate the nominal wage growth. The reservation wage is an unobserved variable that is determined by, among other factors, the replacement rate. This reflects the gap between unemployment benefits and the average nominal wage.

Portugal and Spain, and also Ireland, record the highest replacement rates of this group of economies, at 41.1%, 36.1% and 33% (Table 1). In Portugal and Ireland, the reservation wage has even increased by 5 percentage points in comparison with a decade ago. A decrease of 5 percentage points in the replacement rate for Portugal, for example from 41% to 36%, which would bring the country back to its 1990s level according to Table 1, could have led to a fall in the Portuguese nominal wage in the long run ranging from 0.33% to 0.84% (see Table 1). In Spain, a 5% decrease in the replacement rate could have affected nominal wages much more than a 1% decrease in productivity, a 1% decrease in prices, and a 1%-point increase in unemployment. The replacement rate is therefore a powerful instrument.

Table 1. Nominal wages, reservation wages and long-term wage elasticities 1988-2010

Source: Peeters and Den Reijer (2011).

Although we do not discuss here the implementation of wage coordination as proposed in the Euro-Plus Pact, we see the replacement rate as a valuable instrument for national governments. Other than the wage growth, which is mainly determined as a negotiation result between private actors in the national labour markets without interference of the governments, the determination of the developments of unemployment benefits is at the discretion of the national ministries of social affairs, economics or finance. Indexing the unemployment benefit to the wage rate in the government and market sectors will keep the replacement rate constant.

Conclusion

Although increasing competitiveness is essential to keep up the pace of growth, securing the euro requires further fiscal and economic integration, and wage coordination within the Eurozone is an ambitious aim. Aligning nominal-wage growth with labour-productivity growth seems hard in Greece, Ireland, Portugal, and Spain, but also in Germany. There is no guarantee that price inflation or tighter labour-market conditions will not push up wages in times of low productivity. Labour unions and other stakeholders in the wage negotiation processes should obtain a completely different mindset, away from price indexation and the like in order to focus mainly (and eventually only) on productivity. To steer wage growth, the replacement rate is a powerful policy instrument in the hands of the national governments.

Authors' reply to comment (added 21 February 2012)

Nominal unit labor cost (ULC) is a better proxy for competitiveness than real ULC as the nominal ULC captures both cost - and price - competitiveness. The distinction between nominal and real doesn’t actually matter much for a closed economy or for an open economy with a flexible exchange rate regime. In a closed economy, producers would translate higher nominal wages into higher prices so the price mechanism restores equilibrium between real wages and productivity. In an open economy with a flexible exchange rate regime, the higher prices would moreover move the nominal exchange rate to restore competitiveness abroad. However, in an open economy that is part of a currency union, the one-size fits all nominal value of the exchange rate is exogenous. The one-size fits all value of the euro implies an overvalued exchange rate for Spain, you say. The peseta would have been at a more depreciated level. The only way to regain (price) competitiveness at the world markets for Spain within the strait-jacket of the euro then is through the “internal devaluation” of lowering the price level. Say, Spain would manage to lower wages and prices simultaneously, then real wages remain unchanged, as do real unit labor costs and real productivity. However, Spain would regain price competitiveness at world makets. So, the key issue is that you need real wages to steer cost- competitiveness measured by ULC and nominal wages to also steer price competitiveness at world markets as measured by the real exchange rate.

References

De Grauwe, Paul,( 2011), The governance of a fragile eurozone, Centre for Economic Policy Studies.
Gartner, Hermann and Christian Merkl (2011), "The roots of the German miracle", VoxEU.org 9 March
Giordano, Raffaela, Domenico Depalo, Manuel Countinho Pereira, Bruno Eugène, Evangelia Papapetrou, Javier J. Perez, Lukas Reiss and Mojca Roter (2011), "The public sector pay gap in a selection of euro area countrie"s, European Central Bank Working Paper no 1406.
Peeters, Marga and Ard den Reijer (2011), "On wage productivity, wage flexibility and wage co-ordination – A focus on the wage impact of productivity in Germany, Greece, Ireland, Portugal, Spain and the United States", MPRA Paper No. 31102.
Peeters, Marga and Ard den Reijer (2008) "On wage formation, wage development and flexibility: A comparison between the European countries and the United States", Applied Econometrics and International Development 8.
Wyplosz, Charles (2010), "Germany, current accounts and competitiveness", VoxEU.org 31 March
Vanthoor, Wim FV (1996), European Monetary Union since 1848 – A political and historical analysis, Edgar Elgar.

Topics: EU policies, Productivity and Innovation
Tags: eurozone, productivity, wages

Comments

Real productivity and Nominal Salaries?

I am in Spain and cannot avoid feeling that the politicians (Germans and Spanish) as well as establishment paid economists are pushing the idea that Nominal Labour Unit Cost is a good proxy for Competitiveness (whatever that term means). In Spain base 2000=100 Nominal Labour Unit Cost index on Q3 2011 is over 20% higher than in Germany. 
My contention is that Real Labour Unit Cost may be a better proxy of competitiviness.
Real Labour Unit Cost in Spain base 2000=100  is on Q3 2011  5% lower than in Germany
We should not mix Nominal Salaries with Real Productivity. We should use Real Salaries with Real Productivity, Real Labour Unit cost = Real Salaries / Real Productivity.
Are you aware the GDP (ppp) per employed person is higher in Spain than in Germany?
Politicians and many economists keep pushing to the public in Spain the story that salaries have to go down to gain competitiviness. But, Spain has a positive trade balance with Europe and growing, as well as a positive and growing Current Account balance.
Spain has problems with non European countries with whom we run a big trade deficit. This problem is caused by the Euro, it is not caused by the Spanish Salaries. there is no way that reducing salaries in Spain can do what 30% currency devaluation would do.
 
 
 

Nominal unit labor cost (ULC)

Nominal unit labor cost (ULC) is a better proxy for competitiveness than real ULC as the nominal ULC captures both cost - and price - competitiveness. The distinction between nominal and real doesn’t actually matter much for a closed economy or for an open economy with a flexible exchange rate regime. In a closed economy, producers would translate higher nominal wages into higher prices so the price mechanism restores equilibrium between real wages and productivity. In an open economy with a flexible exchange rate regime, the higher prices would moreover move the nominal exchange rate to restore competitiveness abroad. However, in an open economy that is part of a currency union, the one-size fits all nominal value of the exchange rate is exogenous. The one-size fits all value of the euro implies an overvalued exchange rate for Spain, you say. The Peseto would have been at a more depreciated level. The only way to regain (price) competitiveness at the world markets for Spain within the strait-jacket of the euro then is through the “internal devaluation” of lowering the price level. Say, Spain would manage to lower wages and prices simultaneously, then real wages remain unchanged, as do real unit labor costs and real productivity. However, Spain would regain price competitiveness at world makets. So, the key issue is that you need real wages to steer cost- competitiveness measured by ULC and nominal wages to also steer price- competitiveness at world markets as measured by the real exchange rate.

Ard den Reijer

Economist, Modeling Unit, Monetary Policy Department Sveriges Riksbank

Marga Peeters

Research Fellow, Netherlands Institute for Advanced Study, Royal Netherlands Academy of Arts and Sciences

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