The Missing Third Leg of the Euro Architecture: National Wage Negotiations

Euro area policymakers have been focused in recent years on designing better banking and fiscal unions, two important legs of the euro architecture. But their discussions miss a third essential leg, namely major improvements to the macroeconomic adjustment mechanism, which can only be achieved through national wage negotiations.

The issue is not new. It dates back to at least the 1960s with Columbia University professor Robert Mundell's discussion of an optimum currency area. Mundell identified the conditions necessary for a common currency area to work well: Countries have to have similar shocks, or there has to be high labor mobility across countries, or, in the absence of these two conditions, countries need flexible prices and wages.

The first two conditions were not satisfied. Concerns that even the third condition would not be satisfied led many economists to worry about the functioning of the euro. And, to a large extent, the euro area banking crisis has proven these worries justified. The adjustment to country-specific shocks has proven to be painful, and, in some cases, perverse. It is unlikely that market-based adjustment can be improved very much. What is needed are better guidelines for wage and price evolutions, and such guidelines can only come from tripartite national discussions and negotiations.

The Argument against Market-Based Adjustments

There are two problems with market adjustment in common currency areas.

First, even if it worked well, the market adjustment is potentially perverse (a point that is poorly understood).

Euro member economies are subject to many shocks—supply or demand, domestic or foreign, permanent or transitory—each with their own actual and desirable dynamic effects on output, unemployment, and the current account. For the purposes of discussion, let me take up just one of these distinctions and focus on two types of demand shocks: shocks to domestic demand and shocks to foreign demand. (The point that different shocks require different adjustment mechanisms is more general, but this is not the place for a long catalog of cases).

The textbook market adjustment to a demand shock in a common currency area is well known and involves four steps: An adverse shock leads to lower output and higher unemployment. Higher unemployment leads to lower nominal wages. Lower nominal wages lead to lower prices. Lower prices improve competitiveness, leading to an improvement in the trade balance, an increase in demand, and a return to full employment. The same holds in reverse for favorable shocks: lower unemployment leads to a loss of competitiveness, a decrease in demand, and a decrease in output.

With respect to shocks to foreign demand (say, due to lower output and lower demand from the rest of the euro area, or a loss of competitiveness for any reason), the market adjustment described above is indeed the appropriate one. If it works, it undoes the initial decrease in foreign demand, and reestablishes both internal and external balance.

With respect to shocks to domestic demand (say, due to animal spirits, or a reassessment of future productivity growth), however, the market adjustment is the wrong one. It leads to solving a domestic demand shortfall by increasing foreign demand. Or, put another and more provocative way, the country solves its domestic demand problem by stealing demand from the other euro members. This is neither the right economic adjustment, nor the right geopolitical one, as it is likely to incur conflict.

Why does this matter? Because in most countries shocks to domestic demand are indeed a major source of fluctuations. In current empirical work, I find that the proportion of output fluctuations due to shocks to domestic as opposed to foreign demand is large, on the order of 80 percent in a number of euro countries. If so, in a large proportion of cases, the market adjustment is not the right one. The right one does not rely on wage adjustment, but rather on measures to increase domestic demand, from fiscal policy to measures to encourage private saving and investment.

Second, the market adjustment does not work well in any case.

This point is now well understood. Even leaving out the case of Greece (but why should we?), the long and painful adjustments of Portugal and Spain to their large current account deficits have made it clear that the adjustment process, and its many steps, works poorly. (The same is true, at the other end of the spectrum, of Germany, which has a current account surplus that is too large for its own good.)

Unemployment has had a limited effect on wages, partly due to the effective lower bound on negative nominal wage changes, partly due to a small Phillips curve coefficient in general. The passthrough of wages to prices has been surprisingly small, with lower unit labor costs leading to larger margins for exporters rather than a direct increase in competitiveness. Much of the improvement in current account positions has come from depressed output and lower imports, rather than from stronger exports.

In the face of slow adjustments in wages and prices, policymakers have argued for structural reforms to increase productivity and potentially reestablish competitiveness. But productivity growth increases do not come at will and cannot be relied on every time a country gets into trouble. And there has been no productivity boom.

What a National Wage Negotiation Process Would Look Like

How can macroeconomic adjustments be improved?

Conceptually, macroeconomic adjustments can be improved in two ways: by differentiating between the shocks and identifying the relevant ones, and, for each one, by assessing the desirable adjustment of wages and prices—one size does not fit all.

Practically, improvement can occur through a process of analysis, discussion, and negotiation at the national level, which comes as close as possible to characterizing and helping achieve the proper adjustments. In other words, what is needed is a tripartite process of wage negotiations, involving representatives of workers and businesses as well as the state, based on a clear view of what the country needs to achieve.

The wage negotiation process must involve the state for at least two reasons: first, because the state, through its fiscal and budget policies, setting of the minimum wage, and role in determining public sector wages, has a central role to play in achieving the desired outcome; and second, because any such exercise implies a careful analysis of the situation and of the needed adjustments, given by an expert and hopefully neutral party.

The process must be part of an architecture of negotiations. It needs to start with assumptions about the evolution of prices at the euro level, as determined by the European Central Bank's monetary policy: What matters for competitiveness is the evolution of domestic inflation relative to euro area inflation. The process also needs to be complemented by negotiations at the sectoral and the firm level. The exact articulation of negotiations at the national, sectoral, and firm levels is a subject of much rethinking and goes beyond the scope of this blog post. What is important is that lower-level negotiations have a clear sense of desirable national evolutions and position themselves in this context.

Applying this Logic to France Today

Let me take a rough pass at the specific problems national wage negotiations would address, were they to take place in France today.

First, France still suffers from a substantial unemployment gap. Put another way, it can accommodate a substantial increase in demand without running into labor market constraints. (It is difficult to assess where exactly the natural unemployment rate is today. I believe, based on the evidence from other countries such as the United States and Germany, that it is lower than it was, and that there is substantial room for a sustained decrease in unemployment.) The adjustment for this unemployment gap does not require a particular adjustment of either nominal wages or prices, just stronger demand. Stronger demand, in turn, may come naturally or may require more active fiscal policy to make it happen faster.

Second, France needs to improve its competitiveness. The country is running a trade deficit, which is likely to increase as output recovers and imports increase. Given that there is no obvious justification for France to run a sustained trade deficit, this suggests that France needs to improve its competitiveness and implies price inflation should run below the euro area average for some time. In the absence of a productivity boom, this implies in turn that nominal wage inflation should run below its euro area average as well.

Third, France may need to decrease real wage growth below productivity growth for a while. The reason for this lies in the evolution of productivity and real wages since the start of the crisis. While productivity decreased substantially during the crisis and remains below its old trend, real wages have not reflected this relative decline. If productivity does not return to its old trend line, real wages will have to adjust. Put another way, nominal wages will have to rise by less than price inflation minus productivity growth for some time.

Only quantitative work and an econometric model can integrate these three dimensions and characterize the desirable path of wages and prices. But such an exercise can clearly serve as a starting point for a useful discussion between social partners and deliver a better outcome than a market adjustment that relies on the pain inflicted by unemployment.

Is my proposal utterly unrealistic? I believe it is not, even if it may not be in the "air du temps." Indeed, such a structure was in place in France when it still had indicative planning, and it was widely seen as useful. Such a structure is even more useful under the tighter constraints imposed by the currency union. Will social partners agree on a diagnosis and the implied adjustments? Probably not fully. Will workers and firms stick to agreed guidelines? Again, probably not fully. Nevertheless, national wage negotiations would be an improvement over the laissez-faire market adjustment. The stakes are high. Slow and perverse adjustments have fed anger and populism. Better macroeconomic adjustments can reduce the pain and the risk.

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