Real wage growth in the euro area has moderated since the 1970s, particularly over the past decade. Such wage moderation helps to contain production costs and support firms’ profitability and can thus lead to reduced unemployment and increased output. But unemployment in the euro area has declined only slightly since the mid-1990s, and per capita GDP growth has fallen—a puzzling development that raises questions about the benefits of wage moderation. In a recent IMF Working Paper, Marcello Estevão examines the relationship among wages, unemployment, and output growth. He finds that wage moderation does spur output and lower unemployment but that the magnitude of these effects depends on the degree to which countries’ product markets are regulated.
The annual growth of real hourly employee compensation in the euro area’s business sector has declined from about 6 percent at the beginning of the 1970s to 1 percent recently. Unemployment rates began to recede in the mid-1990s, bottomed out at about 8 percent in 2001, but have since climbed to about 9 percent. And annual growth in per capita business GDP has declined from an average of 3 percent in the 1970s to about 1.9 percent in the past 10 years. Why has the apparent moderation of wages in the euro area not made firms more profitable and led to faster production growth?
The wage-growth puzzle
Simple correlations from cross-country data for the euro area from 1983 to 2003 suggest that real wage changes have a weak relationship with unemployment and are positively related to output. They suggest that, if real wages decline, both the unemployment rate and GDP per capita growth also decline. However, Estevão says, such raw correlations between real wage changes and economic performance may capture forces other than those associated with structural changes in wage-setting behavior. For example, changes in wages can affect economic activity by influencing workers’ income and, thus, their consumption, which would cause wages and output to be positively correlated in the short run. In addition, the costs of being unemployed diminish during good times because those who lose jobs in one business have a high probability of being hired by another business. In this situation, workers would demand higher wages, which could again lead to a positive correlation between output growth and real wage growth.
To unravel the relationship between shifts in wage-setting behavior and unemployment, Estevão looked at 20 industrial countries using a standard bargaining model—according to which workers and firms negotiate wages, and the goal of firms is to maximize profits—to isolate structural changes in the relationship between wages and unemployment rates—a “wage curve”—and the effects of the changes on production costs. In this theoretical framework, the wage curve may shift for several reasons, including when labor market reforms increase incentives to work (see diagram).
According to the model, downward shifts in the wage curve, representing increases in wage moderation, are associated with higher employment rates and higher per capita GDP growth. Wage moderation generates higher profits, encouraging new firms to enter the market and existing firms to invest more, thereby resulting in higher output. What might cause increased wage moderation? Possible factors include reductions in unemployment benefits; declines in workers’ bargaining power, which might occur because of the expansion of the labor pool through globalization; changes in unions’ preferences away from wages toward employment; and lower labor-income taxes, which would allow firms to offer lower wages while workers’ net take-home pay would rise.
How regulations affect product markets
The model also suggests that regulations that curb competition will tend to dampen the positive effects of wage moderation on economic performance. Regulations can operate through a short-term competition effect on firms’ pricing power, for example, from direct government intervention in pricing; and through a long-run market contestability effect, such as barriers to entry, that curbs potential new entrants and affects competition among existing firms. Moreover, a large concentration of state-owned companies and other state interventions could distort market signals and slow output responses to cost shocks. Thus, an improvement in wage-setting conditions in less regulated product markets may generate fiercer competition for market share. In the process, output and employment increase more in these markets. In more regulated product markets, though, softer competition pressures may lead existing firms to expropriate a larger share of the cost reduction in the form of higher profits.
Labor market reforms and work incentives
Stronger product market competition amplifies the effects of wage moderation.
Citation: 35, 6; 10.5089/9781451967951.023.A011
Estevão’s econometric evidence supports the finding that restrictions on product market competition dampen the effects of wage moderation, which is consistent with a link between product market regulation and firms’ rent-seeking behavior. Such restrictions vary over time and from country to country, causing large disparities in the effects of wage moderation. Over the past 20 years, wage moderation has indeed varied considerably among the 20 countries and, in particular, within the euro area. It has also had different effects on countries’ economic performance, depending on the extent of product market regulation.
Overall, Estevão found that wage-setting conditions had improved at least since the 1990s, except in Greece, Japan, and Switzerland. Ireland stands out because its wage-setting conditions have improved dramatically and continuously since the 1970s. In the euro area, wage setting has improved significantly in the Netherlands since the early 1980s and in Finland since the early 1990s. Wage moderation has occurred in France and Italy since the 1980s and in Belgium, Germany, and Spain since the mid-1990s. Outside the euro area, wage setting deteriorated through the early 1980s in Australia, Canada, the United Kingdom, and the United States but has since improved steadily.
As for regulatory developments in product markets, they became more flexible between 1975 and 1998, increasing the pass-through from wage moderation to growth and employment. Different data for economy-wide product market regulation for only two years (1998 and 2003) suggest that impediments to product-market competition have declined further (see chart). And, in particular, the extent of government involvement in product markets and barriers to international flows of capital and trade have fallen considerably since 1998.
Product market regulations have declined, making economies more competitive.
Citation: 35, 6; 10.5089/9781451967951.023.A011
Note: The indicator of economy-wide regulation is measured on a scale from 0 (most liberal) to 6 (most restrictive) and is described in Paul Conway, Véronique Janod, and Giuseppe Nicoletti, “Product Market Regulations in OECD Countries: 1998 to 2003,” Economics Department Working Paper 419 (Paris: OECD, 2005).
Data: Organization for Economic Cooperation and Development.
Euro area should liberalize more
Still, important cross-country differences persist, and further product market liberalization within the euro area would increase the benefits of labor market reforms. According to Estevão’s data, 8 euro area countries were among the 10 most heavily regulated industrial economies in 1998. Thus, wage moderation in the region was, on average, less effective in raising GDP growth and lowering unemployment.
Estevão presents empirical evidence that product market reforms increase the economic benefits of labor market reforms, thus making them more politically acceptable. These findings are consistent with previous work on the complementarity between reforms of the two kinds of markets. Some studies suggest that product market reforms should come first because, by lowering barriers to entry and fostering competition, they tend to increase real wages and reduce unemployment. Higher real wages would buy goodwill from unions and ease implementation of labor market reforms, which sometimes have a negative wage effect in the short run.
Overall, heavily regulated product markets are undermining the effectiveness of labor market reform in the euro area. Although product markets in virtually all industrial countries have become more market friendly over the past 30 years, policy approaches and results continue to differ, including within the euro area. Without additional liberalization in this area, wide segments of society may continue to resist calls for more labor market reforms to lower unemployment and increase production.
Copies of IMF Working Paper No. 05/191, “Product Market Regulation and the Benefits of Wage Moderation,” by Marcello M. Estevão, are available for $15.00 each from IMF Publication Services. Please see page 96 for ordering details. The full text is also available on the IMF’s website (www.imf.org).