An inflation-adjusted social contract for Europe by Daniel Gros

During the global economic crisis of 2008, a recurring criticism of the eurozone framework was that it meant the European Central Bank was “the only game in town”. Today, by providing household income support, governments are helping to prevent a 1970s-style price-wage spiral – and making the ECB’s job much easier.

DUBROVNIK — With high and rising energy prices and soaring inflation, it’s starting to look like the late 1970s again. But looks can be deceiving.

The similarities are obvious. In 2022, as in the 1970s, an energy price shock led to a sustained rise in the prices of many other goods. The so-called core inflation rate, which excludes the volatility of energy and food prices, is now approaching 6% in the United States and 4% in the euro zone. And fears are growing that, as in the 1970s, this trend will continue.

But we are hardly living a repeat of the 1970s. One of the main differences is in labor markets. At the time, the widespread indexation of wages meant that rising energy and other prices automatically led to an equivalent increase in wages. Where wage indexation was less important, unions achieved the same result, refusing to accept any deterioration in the standard of living of their members.

This is not the case today, at least in the euro zone. According to the European Central Bank’s new wage tracking system, eurozone wages have risen only 3% so far, well below the 8.6% inflation recorded in June. In other words, there is no sign of the wage-price spiral of the 1970s.

Another difference today is that European producers have been able to increase their prices enough to offset a significant portion of the rising energy costs. Based on June 2022 prices, the euro area energy import bill is expected to rise by more than 4% of GDP this year. Over the past year, soaring energy prices have led to a 24% increase in EU import prices, after more than a decade of stability.

But prices charged by EU exporters have also risen, by more than 12% – and the EU exports more than it imports. European producers have thus been able to offset a little more than half of the loss of income due to the rise in energy prices, keeping it at just under 2% of GDP. It’s a high price to pay, but it’s also manageable.

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The challenge will be to distribute the revenue losses between economic sectors. With real wages falling by around 5%, European workers have so far borne all the costs of inflation. Given that the share of wages amounts to around 62% of GDP in the euro area, a 5% fall in real wages would make available to other sectors around 3.1% of GDP, more than the loss of income 2%, allowing profits to increase. This is more than enough to offset the terms-of-trade losses suffered so far.

The situation is very different in the United States. As the world’s largest producer of oil and natural gas, it exports as much energy as it imports. US terms of trade therefore did not suffer at all, with both import and export prices increasing by the same amount. But wages have risen more than 6%, according to the Federal Reserve Bank of Atlanta’s wage tracker, meaning the United States is much closer to a wage-price spiral than the United States. Europe.

How reliable is wage moderation in Europe? As things stand, the EU is experiencing more profit inflation than wages, despite the overall loss of revenue. And the fall in real wages is particularly difficult to accept when profits soar. In fact, wage demands are already on the rise in the euro zone. Germany’s influential IG Metall union, for example, is demanding an 8% wage hike for workers in the metal industry, which is currently recording high profits. To maintain social peace, several countries, including Germany, have introduced double-digit increases in the minimum wage.

Nevertheless, negotiated wage increases have so far remained modest, around 4%, according to the ECB. Real wages could rise further as employers in sectors experiencing shortages decide it is worth paying workers a premium. Yet there is no sign that wages are expected to catch up with inflation anytime soon.

The main reason for this is that governments across Europe pay direct transfers to households, to offset higher energy costs. For example, the German government has unveiled an aid package that includes a lump sum payment for employees and a heating cost subsidy for households on housing benefit.

The Spanish government, for its part, subsidizes the cost of natural gas for electricity producers. This approach to containing electricity prices is flawed, as it encourages the use of gas at a time when Russian President Vladimir Putin is threatening to cut supplies. But such schemes reflect a new social contract emerging in Europe: governments protect workers from the bulk of higher energy costs, in exchange for workers moderating their wage demands.

In the aftermath of the 2008 global financial crisis, a recurring criticism of the eurozone framework was that the lack of fiscal authority meant the ECB was “the only game in town”. This time looks different. By stepping in to provide income support, governments are helping to prevent a 1970s-style price-wage spiral – and making the ECB’s job much easier.