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In a recent blog post we showed that the upturn of the German economy between 2000 and 2009 was primarily due to a restrictive wage policy. In this article we answer the question whether this strategy could work for the crisis-ridden southern European countries.


How does wage-setting affect economic development?


Starting point of the following line of argumentation is a wage policy, which keeps the wage increase in line with inflation and productivity gains (reference scenario). If we assume that there will be no inflation, growth rate of wage equals growth rate of productivity. In two alternative scenarios we work with different wage-setting strategies:


  • Wage moderation strategy: The increase of wage is lower than the increase in productivity.
  • Wage promotion strategy: The increase of wage is higher than the increase in productivity.


The most important effects of a wage promotion strategy within the Eurozone are the following economic consequences:


  • A wage increase which is larger than the increase in labour productivity results in a rise in costs of production. Hence prices go up. As the increase in prices affects all goods and services of the entire economy, inflation rate rises, too.
  • Exports go down as, due to higher prices, the country loses international competiveness.
  • The European Central Bank (ECB) responds to rising prices with a restrictive monetary policy. Thus the interest rate grows. Higher interest rates have a negative impact on investment.
  • A strong wage growth increases purchasing power of working people. This leads to an increase in private consumption.
  • Companies are faced with a growing consumer demand. Therefore they increase their production capacities and hence increase investment.


All in all, an increase in wages which is higher than the increase in productivity has positive as well as negative impacts on the aggregate demand of an economy. Furthermore it is necessary to take into account economic effects for other countries and their potential reactions on a certain wage-setting strategy. In order to analyse such interdependencies and feedback loops our project partner, Prognos AG, carried out some simulation calculations.


Our set up:


In our simulations we divide the Eurozone in two groups. Group A includes countries with a relatively high level of utilization of production capacities in 2014. The countries are Latvia, Estonia, Lithuania, Ireland, Germany, Austria and Belgium. Countries of group B had a relatively low level of utilization: Greece, Spain, Portugal, Italy, Netherlands, Slovakia, Slovenia, Finland and France.


For each country group two wage-setting strategies are possible: the increase of wages can be 25 percent larger than the increase in productivity (25-percent wage promotion) or 25 percent lower (25-percent wage moderation). The deviation of wage development from the development of productivity lasts from 2015 to 2020. Afterwards growth rate of wages equals growth rate of productivity. We calculate four different scenarios (25-percent wage promotion in both groups, 25-percent wage promotion in both groups, 25-percent promotion in A plus 25-percent moderation in B and vice versa) and their impact on economic development. The economic development is compare to a situation in which there is no deviation of wage growth from productivity growth. The calculation extend to the year 2030.


The logical solution might not be the best one


At first glance, the scenario with wage moderation in both groups provides the best long-terms results for the entire Eurozone in terms of growth rate of growth domestic product (GDP). Unfortunately, this scenario carries many risks. Hence, we think that this strategy does not work for the Eurozone:


  • The model calculations leave out possible wage policy reactions from other countries. What happens if they react to wage moderation in the Eurozone with the same strategy? The danger of a race to the bottom or revival of the beggar-thy-neighbor policy of the 1930s should at least be taken into account.
  • Furthermore, the advantage of a collective wage moderation strategy is limited if it leads to an increase in the current account, at least in some Eurozone countries compared with the rest of the world. Current account imbalances represent a huge stability risk for the global economy. Another threat is the risk that foreign assets must be written off in the case of national bankruptcy.
  • Another prerequisite for the success of this strategy is for countries outside the Eurozone to experience a higher growth in the future and generate sufficient internal demand. Potential exchange rate reactions, revaluation of the euro, are also possible, which would compensate for the advantages of the strategy.
  • Finally, the political component should be taken into account, namely, that to people in countries in Group B a strategy would be recommended that would worsen their situation in the next few years again before gains were seen much later.


The intuitively best strategy to improve the competitiveness of crisis countries (economically strong countries have wage strategies beyond productivity measures, and economically weak countries have no wage reserves) is the most unfavorable solution from the point of view of crisis countries. There are two reasons for this. Wage reserves reduce internal demand in crisis countries and weaken growth in terms of demand. In economically strong countries, the price-increasing effect of wage promotion leads to a rise in interest rates in the Eurozone, which reduces investments in all Eurozone countries.


To quickly improve the international competitiveness of crisis countries, this strategy is only possible when extensive economic measures are put in place:


  • Moderate wage promotion in economically strong countries increases internal demand and growth there. Economically weak countries benefit from this because demand for imports also rises in the economically strong countries. Higher demand leads to a price rise, to which the ECB reacts with interest rate rises, which negatively affect investments in the entire Eurozone. To counter a decline in investments, the ECB must accept a higher inflation target (which prevents otherwise necessary interest rate rises). Economically strong countries, including Germany, would therefore have to accept a decline in exports.
  • Moderate wage reservation in economically weak countries increases their international competitiveness but weakens internal demand. To compensate for this, investments must be increased. To finance these investments it would be possible for the EU to launch in economically weak countries an investment program to promote private and public investments. Productivity would therefore be increased and international competitiveness further enhanced. Accompanying measures must also be taken to increase non-price competitiveness (infrastructure, R&D, training systems, etc.). EU transfer payments must be part of this.


So what should we do?


In conclusion, the following may be asserted. Temporary wage reservation in economically weak countries is only then an element in restoring competitiveness when it is accompanied by economic policies. Accompanying measures include in particular wage promotion in economically strong countries, transfer payments to promote investments, and at least temporary acceptance of higher inflation rates in the Eurozone.



Reference: This blog post builds on the new GED Study “Wage-setting strategies for the Eurozone