The real reasons to worry about wage settlements in the euro area...

By: Eurointelligence ECB Watch

To which extent should we worry about a wage-induced rise in euro area inflation? We already argued in our latest ECB Watch Update not to worry about strong wage acceleration in Germany (the argument is repeated below). But this does not settle the issue. On the contrary, the euro area still faces wage inflation, but most of this is coming from outside Germany.

 

Bundesbank president Axel Weber warned last week of a net inflationary impact from this year’s wage round since wage acceleration in Germany would not be offset by wage moderation in member countries with less productivity growth. We are not as pessimistic as Weber about Germany, since we expect above-productivity wage settlements in some sectors to be neutralized by below-productivity settlements in others. We are expecting an economy-wide settlement of about 2.5%-3%, which is less than the sum of inflation and labour productivity in 2006. But what to expect from member countries with low productivity growth?

 

Productivity increases are disappointingly low despite a cyclical upturn in all euro area countries, as the latest Conference Board research has shown. (Bart van Ark and Gail Fosler (2007): The Conference Board Executive action series No 224). Spanish productivity growth was -0.5% in 2006, in Portugal it was -0.3%, and in Italy it was 0.1%. It may not be correct to compare the three countries in this manner. Spain, for example, is a country with a significant trade-off between employment and productivity growth. The strongly growing sectors in Spain are construction and tourism, sectors with naturally little productivity growth. And Spain is also subject to large immigration. There are a number of authors who dispute the validity of the Spanish doom and gloom story (see for example Angel Ubide in the Spanish section on this site).

 

Table:  Productivity and employment in the euro area

 

	Productivity level (GDP/hour US$) 2006	Productivity growth   2005             2006*		Employment growth  total working hours        2005          2006
Luxembourg	65.1	2.2	3.1	1.8	2
Belgium	53.1	-0.5	1.9	1.8	1.1
France	53.1	1.4	1.4	-0.3	0.7
Ireland	53	1.2	0.9	4.2	4.3
Netherlands	51.4	0.8	2.1	0.8	0.9
Austria	50.2	-0.1	2.4	0.7	1.4
Germany	46.4	1.3	2.0	-0.4	0.6
Italy	45.7	0.4	0.1	-0.5	1.7
Finland	45.3	2.1	3.7	0.8	1.3
Spain	35.6	-0.6	-0.5	4.2	4.2
Greece	32.8	2.8	2.5	0.5	1.5
Slovenia	30.3	3.8	3.9	0.2	0.8
Portugal	26.9	0.9	-0.3	-0.5	1
USA	50.3	1.8	1.4	1.4	1.8
* estimated. Source: The Conference Board Executive action series No 224, Jan 2007

 

The above table is interesting a few respects. We can safely forget Luxembourg. The high productivity of Belgium is a small-country effect. Belgium, especially Flanders, has many process industries, such as oil refineries and large chemical plants. Interesting is the high productivity level of France – higher in fact than the US. But France is about to loose its productivity advantage as productivity growth rates had been below those of the US in recent years. A second noteworthy feature is that productivity levels of Germany and Italy are broadly in line, through productivity growth is significantly better in Germany. With those productivity data you would expect a relatively robust wage round in countries such as Germany, Finland and Slovenia, and very little in terms of wage pressures from countries such Italy, Spain and Portugal.

 

But this is not the case. Whichever explanations you may have for temporary factors depressing labour productivity growth, nationwide wage increases should correspond to nationwide labour productivity of longer periods of time. The problem of southern European countries, including Spain, is a wage-setting mechanism that generates above-productivity wage settlements – not necessarily in each sector – but for the economy at large. That is not a sustainable position.

 

This is the outlook for the 2007 wage demands: Again we believe that Germany will average about 3%, perhaps slightly less (see below for further details). In order to regain some competitiveness, Spain, Italy and Portugal should all strike wage agreements significantly below the level of Germany. But we believe that they will all match or exceed Germany’s 2007 pay rises, and that the competitiveness gap could therefore widen again this year.

 

In Spain, during Q3 2006 labour costs rose by 4.1% year-on-year. The average private sector pay rise negotiated under collective pay agreements in agriculture, industry, construction and services was 3.23% (this affects about 8.5m workers). With persistently high inflation, workers expect further increases from collective pay agreements this year. Public sector wages are de-facto, though not de jure, inflation-linked, a practice that has drawn the scorn of the ECB. In September, the Spanish government agreed a 2007 basic pay increase of 3% for the public sector. Spain’s largest union Comisiones Obreras wants to extend inflation indexation to all collective wage bargaining deals this year covering 9 million workers.

 

 

In Italy, we have no indication yet of the outcome of the 2007 pay round, but we would expect a relatively robust pay increase, given the recent upsurge in cyclical economic growth, and the Prodi government’s continued failure to modernize the public sector, and to reform collective wage bargaining mechanisms. Even though the Italian economy remains one of the weakest in the eurozone, this weakness is structurally not reflected in the wage bargaining system.

 

Portugal just approved the largest increase in mimimum wages in 15 years and promised a 5.3% annual wage increase through 2011. In his analysis of growing competitive tensions in the euro area,  Olivier Blanchard estimates that Portuguese nominal wages will grow at close to 2.9% this year with productivity growth of 0.4%. Unit labour costs will rise by 1.8% relative to the euro. In 2008, the gap will still continue to widen, albeit it at the more moderate rate of 0.7%. He also made the important point that Portugal\’s current deficit is now almost 10% of GDP, and is associated with a large and persistent fiscal deficit. Blanchard predicts for both Portugal and Italy a slow and painful adjustment. He said the best policy reaction would be aggressive wage adjustments, which may be difficult if impossible to achieve politically. He said Spain was next on his hit list. 

 

In others words: The story about increasing tensions in the euro area due to rising competitiveness of Germany and falling competitiveness of southern Europe continues even this year, as Germany has traversed past the top of its economic cycle. Germany has many unresolved economic problems, but excessive wage growth is not one of them.

 

 

Why their are no reason to worry about the German payround

(A reprint from our ECB Watch update of January 24, 2007)

It sounds like one those economic horror stories from the 1990s. Germany’s IG Metall is asking for a 6-7% pay rise. If they got what they asked for, and if this pay round were to be replicated in other sectors, Germany would loose a large extent of the competitiveness it had gained since the beginning of EMU in 1999.

 

But this is not going to happen. In fact, we believe that Germany will continue to improve its relative competitiveness versus other euro area countries even in 2007. Last year, German wages fell in real terms, while this year they will rise again economy-wide, but hardly by more than 2.5%-3% in nominal terms, which would translate into a real rise of under 1%.

 

One important thing to notice is that IG Metall, the metalworkers union that grabs most of the newspaper headlines, is no longer the economy-wide trendsetter that it once was. One of the big stories in the German labour market has been the decoupling of economy-wide wages from those controlled by the dominant labour market institutions, as unions and employers organisations have been losing members.

 

Now, this is what we are expecting for 2007: IG Metall, which represents the country’s engineering sector, will settle for a deal with a nominal headline figure of 4% plus. But this deal may consist of many components, such as one-off payments, opt-outs, etc, which in their combination will mitigate its inflationary impact. There will probably be strikes in support of this deal. The IG Metall has the money in support of some selected strikes, and the employers in the engineering sector currently do not have the nerve to withstand a long drawn-out conflict. They have full order books, and would rather pay a little more in wages than risk a sectoral downturn. This wage round will go to IG Metall, but it will not be a dramatic victory.

 

Given the buoyancy in the chemical sector, we would also expect a similar outcome there, except that the moderate chemical union IG BCE will reach this deal without strike action.

 

But many of the other trade unions are in a weaker position than IG Metall or IG BCE. This is true especially of the public sector where we do not expect wage settlements of more than 2%, the same goes for the still weak retail sector and the construction industry. If you add all this up, and include estimates for the non-organised part of the labour force, you arrive at an economy-wide earnings increase of about 2.5%, but no higher than 3% for 2007.

 

This is a modest settlement even by the standards of 2006 data, let alone what we expect this year. In 2006, labour productivity (income per hour) grew by 1.9%, while German headline inflation was 1.4%. This year, inflation will go up due to the 3-point VAT increase. The most common estimate is that inflation will temporarily increase by 1 percentage point. Even if labour productivity were to grow at rates slightly below those of 2006, our estimated wage increase during 2007 will be well below the sum of productivity and headline inflation. Given Germany’s current position in the economic cycle, an economy-wide average settlement in the range of 2.5%-3% would therefore be unusually modest. This is not a return to the 1990s, far from it.

 

What are the implications of a 2.5%-3% wage increase? On monetary policy, the effect is neutral. The ECB would start to be concerned with wage settlements at above 3%, but this is going to be below the ECB’s pain threshold. So we are sticking with our call of ECB policy rates to rise to an economically neutral level of about 4% by the summer.

 

On unemployment, the effect is also broadly neutral. Unemployment may not fall as fast as it has done so far during this economic upswing – but this slightly negative effect will only come through once pay settlements come into force later in the year. In the meantime we would expect employment growth to continue.

 

An interesting question is how this would affect Germany’s relative competitiveness in the euro area. It will probably strengthen Germany’s relative competitiveness further albeit at a smaller rate of change. At worst it will be neutral. This means Germany’s strategy to improve its relative competitiveness at the expense of its neighbours in the euro area will probably continue even in 2007, as real wages in other European countries will in all likelihood grow faster.

 

If this pay round is alarming, then only in the sense that it points towards future tensions within the euro area. Until these tensions boil over, it is a fairly safe bet to make that Germany will remain the most attractive industrial country in the euro area for some time to come. While we do not believe that an economic strategy based on cost-cutting is viable in the long run, it may be viable for an uncomfortably long time.

 

Susanne Mundschenk and Wolfgang Munchau

 

Email:

mundschenk(at)eurointelligence.com

munchau(at)eurointelligence.com

 

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