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What Is the Risk of Wage Inflation in Europe?

With every new inflation reading in Europe, fears that price increases may become chronic and cause uncontrolled wage-price spirals grow. Joachim Nagel, the head of the German Bundesbank, recently tried to calm the public’s nerves by saying he could well understand trade unions were factoring the high rates of inflation into their demands, especially given the greater impact of inflation on lower incomes. 

However, he added, “wage bargainers have acted very responsibly over the past 25 years. I am confident that they will do so this time as well.” Is he justified in not showing greater concerns about the specter of possible wage inflation in Germany? And what does the German story tell about the wider EU context? 

A Shortage of Workers

Some evidence suggests that the Bundesbank’s demonstrative confidence in Germans’ innate wage restraint may not be entirely justified. Despite the rapidly cooling economy and rising unemployment, German corporations are desperately looking for more skilled employees — and not finding them. 

In Germany, two million jobs currently need to be filled, an increase of more than 60% compared to last year. According to research by IAB, a German labor market research institute, the main reason for the current shortage is structural, as baby boomers retire and employers struggle to replace them. Between 2020 and 2035, IAB expects the shortage to rise to a whopping seven million vacancies. Even allowing for the caveat that longer-term projections need to be taken with a grain of salt, this is a rather grim scenario for Europe’s economic powerhouse.

As part of a narrative of the increasing bargaining power of employees, the ousting of the CEO of Volkswagen AG, Herbert Diess in July made headlines in part because he had advocated slashing up to 30,000 jobs. Some observers interpreted his departure as a sign that unions are regaining the upper hand, after decades of declining power. 

However, the latest data still show unions struggling to retain membership. The downward trend continued in 2021, despite the economic uncertainties related to COVID. Only one in six workers in Germany are members of a union. And recent wage negotiations suggest that wage restraint may not yet be dead after all. 

The U.K. already provides a cautionary tale. There, the risk of inflation resisting all attempts to return it to the 2% level set by the Bank of England is even bigger than on the continent.

Wage Restraint Is Not Yet Dead

Various sectors, from banking to insurance, to textile, have agreed to limit wage increases to a range between 3 and 4.5%. The only outlier so far is the steel industry, which achieved a more substantial increase of 6.5%, still below the current rate of inflation. More wage negotiations for the manufacturing sector will take place in autumn with the union IG Metall asking for salary increases of 8%. 

With some exceptions, wage negotiations have followed a pattern that started during the first decade of the euro, with unit labor costs growing consistently below the common inflation target.

It is only since 2011, at the height of the euro crisis, that there has been sustained real wage growth in Germany, briefly interrupted by the COVID pandemic. Yet, even the sustained wage growth of the past decade has not absorbed all of the previous undervaluation vis-a-vis most of Germany’s most relevant euro-area partners. The fact that wage restraint became a common feature of most euro-area partners keen on reducing previous gaps in labor unit costs helped to reduce differences with Germany, but it was not sufficient to eliminate them. 

One notable feature of wage growth in Germany has been the variation between parts of the economy, with unit labor costs growing much faster in the manufacturing and financial sectors and much slower in construction, the public sector, and services such as hospitality and retail. 

Wage Bargaining Now More Likely at Company Level

Also, over the past decades, most sectoral negotiations have been replaced in importance by wage bargaining on an individual company level. One of the most well-known examples of this way of setting wages is, in fact, Volkswagen. It is a model tailored to the specificities of individual corporations and their employees. It is arguably what many workers at some U.S.-based companies are trying to emulate. 

However, the German model is not uniformly adopted across Europe, and wage-setting still differs from country to country. The longer it takes to tame price pressures, the higher the risk that sectoral wage-setting processes could result in greater inflation differentials across countries. 

In the eurozone, such an outcome would greatly complicate the ECB’s capacity to set monetary policies uniformly for the single currency. A higher interest rate in one country may well fail to address the needs of another. So far, this risk has not materialized. With some minor differences, the forces behind inflation in the biggest eurozone economies, such as France, Germany and Italy, are still driven by similar factors. 

Over Time, Wages Inflation Could Grow

However, the inability to control prices over a prolonged period of time risks changing the dynamic, as the credibility of policymakers and institutions such as central banks erodes and the chances for policy errors increase, making a wage-price spiral more likely.

A look across the channel to the U.K. already provides a cautionary tale. There, the risk of inflation resisting all attempts to return it to the 2% level set by the Bank of England is even bigger than on the continent, in large part because the country has to contend with an additional, structural, inflation-fueling factor, Brexit. The wave of summer strikes in the U.K. has dwarfed similar eruptions of discontent on the continent. 

Even the U.K.’s central bank’s independence has come under attack by some leading U.K. politicians. As purchasing power of British citizens erodes further, more politicians will inevitably be tempted to abandon sound policies and look for questionable, quick short-term fixes, thus creating more favorable conditions for wage-price inflation.

Alexander Privitera

Fellow at UniMarconi, Rome

Alexander Privitera teaches European Banking Integration at UniMarconi in Rome, and is senior geoeconomics fellow at AICGS Johns Hopkins University.

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