Anti-inflation Policy
The advantages of corporatism

Movements in exchange rates and import prices have largely determined the recent behaviour of inflation in the industrial countries, Research Fellow Michael Bruno told a CEPR lunchtime meeting on 17 March. He argued that anti-inflationary policies which rely on creating wage restraint only with higher unemployment will have limited success. If contractionary policies do succeed in reducing inflation, this will largely be through their effect on the exchange rate. The labour market does, however, influence the trade-off between inflation and unemployment, according to Bruno. Real-wage resistance and the degree of centralization in the bargaining process ('corporatism') are crucial to this trade-off. The United Kingdom has fared badly in recent years because it combines high real-wage resistance with a low degree of corporatism, Bruno concluded.

Michael Bruno is Professor of Economics at the Hebrew University, Jerusalem, a Research Fellow of CEPR, and currently President of the Econometric Society. He has published extensively on a wide range of macroeconomic policy issues. Professor Bruno is the author of Economics of Worldwide Stagflation (with Jeffrey Sachs) and of 'Sharp Disinflation Strategy: Israel 1985', in the April 1986 issue of Economic Policy.

Between 1980 and 1985 inflation rates in most industrial countries fell to their lowest levels in over 15 years. Bruno called attention to the marked differences between countries in the rate of this deceleration. Although they were at approximately the same level in 1980, US inflation fell considerably faster than the average for the EEC countries (11% compared with 8%). The differences in unemployment between the US and Europe are even more striking. The US unemployment rate has now returned to its 1980 level and is close to the levels of the early 1970s. European unemployment continues to be high (5% above 1980, 8% above the early 1970s). Within Europe there are also marked differences in inflation and unemployment, with countries such as the UK, France, and Belgium apparently suffering more costly trade-offs than Scandinavia. Bruno's research attempted to explain these different patterns between countries and over time and to assess the influence of external factors on the trade-off in any given country. These cross- country comparisons, Bruno argued, suggested ways to reduce the costs of the trade-off between unemployment and inflation in the UK as well as elsewhere.

Bruno and Sachs in their joint research have pointed to the importance of supply-side factors (oil- and commodity-price shocks, real-wage gaps) in accounting for the sharp rise in unemployment in the 1970s. They also emphasized the need to integrate this supply-side story with the more conventional aggregate demand factors. Bruno discussed his own recent work, in which he had estimated how much of the increase in unemployment since 1965-69 was due to what was termed the 'wage gap': that is, the difference between employers' actual wage costs and the level of wages which would clear the labour market. The remaining unemployment was attributed to domestic and foreign demand fluctuations. His estimates suggested that the wage gap played virtually no role in unemployment in the US and Canada, and a considerable but diminishing role in France and Germany. It played a relatively important role in the case of the UK, however, and accounts for about 50% of the rise in unemployment since 1965-69.

Bruno claimed that international comparisons also demonstrate the overriding influence of import prices on inflation over the last 15 years. Commodity prices have been by far the most important factor in the acceleration and deceleration of the general level of world inflation during this period, while differences among countries can be explained by the movements of their exchange rates. For example, the rise in the value of the dollar relative to European currencies has been the most important factor explaining the difference in US and European inflation during 1980-85. Although monetary and fiscal policies were important, they operated primarily through their effects on exchange rate movements, Bruno argued.

There is still a trade-off between inflation and unemployment, Bruno stressed, despite the dominant influence of exchange rates and import prices on inflation. At a global level the trade-off is clearly illustrated by the recent fall in commodity prices, brought about by high real interest rates and low world demand. For an individual country the trade-off is constrained, however, by the size of its economy and by the economic environment it faces. Domestic inflation in small- or medium-size economies may be affected by demand conditions, unemployment and even wage behaviour elsewhere. The principal effect of a contractionary domestic policy stance on inflation is indirect, through the balance of payments and the dampening effect of exchange rate appreciation. Unemployment, through its effect on wage restraint, has only a small direct influence on the rate of inflation, unless contractionary policies are coupled with supply-side measures such as an explicit incomes policy.

The labour market nevertheless plays an important role in the inflation-unemployment trade-off. Cross-country comparisons of inflation and unemployment by Bruno and Sachs show the overriding importance of two distinct labour market characteristics, real- wage resistance ('nominal wage responsiveness') and the degree of centralization in the bargaining process ('corporatism'). Bruno had classified the major industrial countries by these two characteristics and then assessed the inflation-unemployment trade-off in each (see table). The US and Japan have done well because of relative wage flexibility. Among those countries with less flexible wages, more corporatist economies such as Austria, Finland, Sweden and Norway have performed relatively well since the second oil shock. The UK has fared much less well: it combines high wage resistance and low corporatism.

Bruno referred to his analysis of the recent Israeli stabilization programme in the second issue of Economic Policy. The Israeli experience, he argued, demonstrates that a favourable trade-off between inflation and unemployment can be obtained in a corporatist economy, in which there is close cooperation between the trade unions, employers and the government. Monthly inflation has been reduced very quickly from 15% to 1%, while overall unemployment rose by only 2 percentage points (from 5% to 7%). This was achieved by using the exchange rate and an agreed wage- price freeze as nominal anchors, while sharply reducing the fiscal deficit.

Bruno noted that the policy lessons that can be drawn from these studies must be tailored to the particular circumstances and institutions in each country, but he argued that two general conclusions could be drawn. First, the exchange rate, coupled with explicit wage restraint, may be a more effective means of controlling inflation than the money supply. Such policies would be consistent with recent proposals to return to a system of closely managed exchange rates, one example of which is the Exchange Rate Mechanism of the European Monetary System. Second, only a sustained expansion of demand can achieve a substantial reduction in unemployment. The best means of carrying out such an expansion is through improved macroeconomic policy coordination among the industrial countries. But even if full coordination cannot be achieved, an individual economy such as the United Kingdom should embark on a more expansionary path. If this were combined with clear and credible supply-side policies, unemployment could be reduced with only minor inflation costs, Bruno concluded.

Source: Table 11.10 in M. Bruno and J. Sachs, Economics of Worldwide Stagflation, Blackwell, 1985.