Europe's Low Wage Policies Are Counter-Productive and Lead To Stagnating Economies

The European Commission has set on a course to make the economy of the 27-nation union one of the most competitive in the world by 2020. Underpinning the grandiose strategy it has recommended ever more deregulated labour markets and policies that keep wages low.

Although we are already half way through the decade-long Europe 2020 strategy, research carried out at the University of Greenwich with my colleague Thomas Obst for the Foundation of European Progressive Studies shows that these labour market policies over the last three decades have delivered poor economic growth, a declining share of wages in national income and rising inequality.

Our work shows that policies of wage moderation are counter-productive and lead to stagnation of economic growth. Keeping wages low also increases the risk of deflation and, in some countries, destabilises the economy by stimulating debt while in others it creates excessive reliance on exports.

Because our work treats wages as drivers of demand in the economy and not simply as a cost for employers, the more those wages are squeezed, the weaker eventual growth. Our simulations showed that a 1 percentage point fall in the share of wages in the economy leads to a 0.3% fall in gross domestic product across 15* EU countries. The effect of this race to the bottom on growth was as high as 1.03% in Greece.

IN MOST OF THE 15 EU ECONOMIES INDIVIDUALLY AND THE IN EU AS A WHOLE THE ECONOMY IS DRIVEN BY WAGESLower wages affect many parts of the economy, not just domestic consumption. Private investment, domestic and export prices and the amount of exports and imports are also affected.

In all the countries we looked at, a fall in wages leads to lower consumption because workers spend more as a proportion of their income compared to those who earn income from profit. It also shows that private investment is not very responsive to an increase in profits, but it responds strongly to demand – which is driven by wages. So, when the wage share is reduced, investment falls in most countries including the UK, Germany and Spain. Even where profits do drive investment in countries such as France, the Netherlands and Italy they still don’t make up for the negative effects of weaker consumption.

It is also misleading to look at EU member states in isolation given that the same wage moderation policies have been implemented in all countries more or less simultaneously. The EU is a rather closed economy with a high degree of trade between member states and only limited trade with other parts of the world. It is for this reason that a fall in wages in Europe as a whole has only moderate positive effect on trade, but it has a substantial negative effect on domestic demand. This flies in the face of much conventional wisdom on the subject.

When wages change simultaneously in all the EU15 countries, export prices of each country relative to the other countries change little leading to “beggar thy neighbour” policies of wage suppression. As stated already, these lead to strong negative effects on domestic demand, which are not offset by the any gains in international competitiveness.

As a result, most of the countries we studied contract as a result of wage restraint policies. Again it’s Greece, albeit a small open economy, that is affected more than the rest: domestic consumption falls strongly; private investment does not respond to higher profits; exports are not very sensitive to labour costs; and imports do not react to the fall in labour costs at all.

These findings turn the beliefs of traditional neoclassical economics on their head. This is particularly important because such beliefs form the theoretical basis of the wage restraint policies of the EC, which assumes that all economies in Europe grow by increasing profits. This is empirically not true.

In short, in most of the 15 EU economies individually and the in EU as a whole the economy is driven by wages. Understanding this is fundamental because it means that more egalitarian policies would deliver stronger economic growth. This is almost exactly the opposite of what is both preached and practiced.

Our work simulated what economic growth might look like across all 15 countries if wages were to increase at a faster rate than productivity. The results are significant and growth would be slightly more than 1.5% stronger in the 15 countries by 2020, assuming a 5 percentage point cumulative increase in the wage share in the big wage-led countries, less so in others. The Greek economy would be over 5% bigger, Spain’s 2.7 % and Germany’s 2.2% bigger.

The idea that we have to choose between having decent wages and a strong economy is based on an outdated economic orthodoxy that doesn’t stand up to scrutinyThis wage-led recovery would lead to a modest 1.2 percentage point increase in inflation in the EU15 which, in light of the current deflationary risks threatening the Eurozone, might be helpful.

Further, wage policy coordination among the EU member states would not only improve economic performance but would also help tackle unsustainable growth that is either driven by debt or overly reliant exports. And while a higher wage policy can be implemented in a single country, the impact would be stronger if coordinated. It would also do away with the temptation for countries to engage in wage competition with one another.

The benefits from a wage-led recovery on economic growth and employment are modest, but they are positive. That is very different from the existing consensus that stresses that the only way Europe can compete in the so-called global race is by driving down wages.

In most of the big EU economies, wages drive consumption and consumption drives growth. Policies to help wages grow more quickly would also help reduce widening levels of inequality.

The idea that we have to choose between having decent wages and a strong economy is based on an outdated economic orthodoxy that doesn’t stand up to scrutiny. It’s time that leaders in Brussels and Europe’s capitals put higher wages back on the agenda.

* Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain, Sweden and the UK

Özlem Onaran is Professor of Workforce and Economic Development Policy, University of Greenwich in London.

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