Draghi Is Right to Hold Out for Wage Growth
Call it the mystery of missing wage growth. The euro zone recovery is gathering pace, but there are no signs this spurt of activity is giving workers the pay rise they have been waiting for. Wages rose by a mere 1.6 percent at the end of last year. This is well below the historical average of 2.1 percent.
This puzzle also matters for rate setters at the European Central Bank. The ECB on Thursday upgraded its growth forecasts for the euro zone, but cut its predictions for inflation. The reason is that energy prices have fallen again. Meanwhile, underlying inflation remains low and flat. Until wage growth picks up, it will be hard for the ECB to hit its target of just below 2 percent.
There are several forces that help explain why employers in the euro zone remain stingy, as ECB President Mario Draghi noted on Thursday. Distinguishing between them is critical for monetary policy. One says that if wage growth is set accelerate as the recovery continues, the ECB need only keep its foot on the gas and wait until wages and inflation picks up. Conversely, if there is something more structural at play, wages will be of little guidance for the future direction of monetary policy. The first explanation appears more convincing.
The most obvious reason why wage growth is so slow in the euro zone is because the recovery still has a long way to go. Unemployment, while falling, remains 9.3 per cent on average in the euro zone, well above the pre-crisis level. The ECB has also suggested this indicator may be underestimating the true plight of joblessness: an alternative measure of "slack" in the labor market shows that between 15 and 18 per cent of the workforce are either unemployed or would like to work more hours. Why should employers give generous pay rises if they know they have a large pool they can draw from?
The impact of unemployment on wages matters however deep you think the impact of the crisis really was. The recession may have driven workers out of the labor market altogether -- an effect economists call hysteresis. Yet, even if there were fewer workers competing for a given number of jobs, you would still expect wages to react, if only a little earlier. Furthermore, there is little evidence that hysteresis has taken place in the euro zone. In a speech last month, Benoit Coeure, a member of the ECB’s executive board, showed that participation is growing within all age groups. “Workers have on the whole remained attached to the labor market,” Coeure said.
A second explanation for why changes in salaries may be lagging behind growth relates to the nature of wage bargaining. Workers seek pay rises that at the very least compensate them for inflation. Prices in the euro zone have grown very slowly over the past two years: any deal negotiated during that time is unlikely to have led to substantial wage increases. Once again, as the recovery continues, workers will be able to push for higher settlements, which will help inflation accelerate.
It is also possible that the slowdown in wage growth is down to a combination of cyclical and structural factors. Take for example the labor market reforms that have been passed in several countries, including Spain and Italy, since the crisis. Relaxing hiring and firing rules, as both countries did to some extent, are bound to depress wages initially. However, this effect is not permanent: As the recovery gathers pace, greater labor market flexibility should in theory trigger more investment. Productivity growth -- which has been lackluster in the euro zone -- can then accelerate, enabling workers to reap higher wages.
Could wage growth be permanently slower? That would require some fundamental changes in the way the European economy works. Technological development or globalization would have to result in a permanent reduction in the bargaining power of workers and entail a fundamental shift in the share of income going to capital. Alternatively, productivity growth would need to be stuck at the rates we have seen over the past two decades. The quality of jobs created in Europe -- which ECB research has shown to be rather low in recent years – would have to be stagnant.
It is easy to be a pessimist after the prolonged crisis the euro zone has just been through. The conspicuous absence of sustained wage growth from much of the rich world would also suggest there is something deeper at play in the global economy.
However, if there is a region where cyclical explanations are hard to discount, it's Europe. After all, Europe is at a much earlier stage of the cycle than the U.S. Unemployment remains much higher than it is in Japan. Wages will take a while to pick up, but they eventually will. The ECB should continue to watch wages closely -- but there's no point in acting before they finally climb again.
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