Paradox in Europe: Wages, Productivity and Inflation Are Disconnected

Paradox in Europe: Wages, Productivity and Inflation Are Disconnected

Economic theory says that wages are linked to productivity, that is, that productivity improvements will be reflected in workers’ salary improvements and that wage pressures impact on high inflation rates.

But the truth is that in Europe it has been showing an interesting paradox to analyze in relation to wages, to the progress of productivity and inflation levels in recent years.

Salaries have increased faster than productivity in many European countries, but the signs of underlying pressures on consumer prices remain limited.

To shed light on this puzzle, we are going to look specifically at the link between wage growth and inflation in Europe and the factors that influence the strength of the transfer of labor costs to consumer prices.

As we see in the following graph, historically, wage growth leads to higher inflation, but this premise has weakened since 2009. The transfer is significantly lower in periods of moderate inflation expectations, greater competitive pressures.

Nominal wage prices and labor market conditions linked to productivity have been improving in Europe since 2013, with strong employment growth and falling unemployment at levels below those of the crisis in most economies.

In Europe, the difference between wage growth adjusted for productivity and inflation is smaller, around 0.4 percentage points, but it is still considerable compared to 2000-16.

In several EU countries, the annual growth of real wages has exceeded the increase in productivity by more than one percentage point since the beginning of 2017.

The apparent disconnect between the evolution of wages and prices in Europe in recent years is disconcerting. In principle, if real wage growth exceeds productivity gains, those higher labor costs faced by companies should eventually raise the prices of the products and services they provide. But this is not what is happening.

Labor costs constitute a large part of business expenses in Europe, 53% in EU countries. However, inflation has remained stubbornly below the target in many countries, despite the fact that production gaps have been closed in the last three years, and there have been rapid increases in wages adjusted for productivity.

A variety of factors can explain this puzzle. How wages, at the European level, advance in the absence of inflationary pressures that are weakening.

Competition factor

A problem that arises for companies (not for the consumer) is competition. The pricing strategies of companies depend heavily on their exposure to competition, whether national or foreign.

Translating, in a more competitive environment, companies may be reluctant to transfer cost increases to consumers for fear of losing market share to competitors or being expelled from the market.

We have to keep in mind that Europe is one of the world’s most open regions to international trade and more deeply integrated into global supply chains. The most significant fact is that between 1999 and 2010, EU foreign trade doubled and now represents more than 30% of its GDP.

In fact, the surveys of the Wage Dynamics Network of the European Central Bank indicate the preferences on the part of EU companies are more aimed at reducing other costs rather than increasing prices in response to wage disturbances when operating in an environment more competitive

Inflation expectation factor

In Europe, inflationary expectations are on the ground. The latest revisions on the expectation of infringement within the European Union have been constantly revised downwards. Today, the inflation measured by the IAPC will be, on average, at 1.2% in 2019, will fall to 1% in 2020.

When we find a scenario in which companies expect low inflation, it is likely that they will consequently perceive cost increases as temporary or temporary.

As a result of this interpretation, they may be reluctant to pass higher labor costs on consumers, since they expect their competitors to raise their prices only moderately.

And, linking with the first factor cited, if these costs impacted, they would face the risk of losing market share.

Thus, it is likely that price stability, for example, due to the improvement in the anchoring of inflation expectations, reduces the sensitivity of inflation to wage growth.

On the contrary, cost increases are likely to be perceived as more persistent in countries with relatively high inflation and higher inflation expectations. In that context, companies are more likely to pass on these costs to the consumer, obtaining more inflation.

Business profit factor

The recent increase in adjusted wages based on productivity was accompanied by a decrease in the share of corporate profits. Since the beginning of 2017, corporate profits have declined every year.

This pattern suggests that companies are using their reserves to absorb the fastest wage growth we have seen, rather than passing higher labor costs to their customers.

In countries and periods in which the share of the benefits of the business sector throughout the economy is relatively high, a significantly lower proportion of wage growth is reflected in the inflation of consumer prices. In Europe, although the progress in business results is poor, the percentage of benefits over Gross Value Added is relatively high, 40 %.

We find that an increase of 1 percentage point in labor costs leads to a cumulative increase in inflation of only 0.7 percentage points during the three-year period when evaluated in the 75th percentile of the distribution of profitability business.

If we focus on those companies that have greater problems of business profitability, with scarce benefits (25th percentile of the distribution of corporate profitability), the impact of wage growth on inflation is 2.5 times greater, with a somewhat greater impact.

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