In early 2020, the European Commission launched a comprehensive Economic Governance Review and consultation, with a view to designing a new strategy in the second half of the year. The Covid-19 pandemic pushed this process into the background, but decisions will soon need to be taken. Rather than focusing on fiscal rules, which tend to dominate the reform debate, we propose a greater orientation towards relative price and nominal wage developments, and thus to a balanced macroeconomic development in each member state. Macroeconomic imbalances, not fiscal profligacy, are the mortal danger for a monetary union.
The inability of central banks to hit their inflation target has caused increasing head-scratching amongst economists and policymakers alike (Cœuré 2019). In the euro area, since 2013 measures of core inflation have hovered around 1%, only around half the ECB target. This is despite QE, negative interest rates and forward guidance.
In the meantime, the ECB has adopted a new symmetric price stability target of 2% HICP inflation over the medium term, while continuing its extremely expansionary policy to reinvigorate real economic and price dynamics. But monetary policy can only work indirectly via monetary conditions.
Alongside repeated calls for support from fiscal policy, some have argued that collective wage bargaining should be deployed to break out of the ‘lowflationary’ trap. Two Bank of International Settlements economists have called on governments and social partners to agree “consensus packages” in which, coupled with fiscal expansion, “ad hoc nominal wage increases over several years” are implemented, “calibrated so that nominal unit labour costs increase at close to 2%, i.e. at the level necessary to sustain an inflation target near 2%” (Pereira da Silva and Mojon 2019: 1). They argue for nominal wage increases “across the whole monetary zone” bringing aggregate “inflation more in line with price stability” (p. 18).
Previously, former IMF Chief Economist Olivier Blanchard (2018) had identified national wage negotiations as a “missing third leg of the euro architecture”. His focus is on ensuring adjustment to asymmetric shocks and competitive imbalances within the monetary union, discussing how France, for example, could steer nominal wages in order to regain competitiveness without costly demand deflation.
Both contributions are welcome and timely, but unnecessarily limited in scope. Rather than being brought in to put out a deflationary fire or limit the cost of addressing a specific loss of national competitiveness, we have argued (e.g. Koll 2005, Koll 2013, Koll and Watt 2018, Watt 2005, 2017) that a stronger role for nominal wage-setting should be permanently institutionalised as an integral part of the economic governance of the euro area. This would have major advantages not just in terms of aggregate inflation performance – in both disinflationary and inflationary contexts – but also in addressing the Achilles’ heel of the common currency: the built-in tendency to divergences in internal demand dynamics and in competitiveness, both resulting in large current account imbalances between the member states.
If inflation is to be anchored at the central bank’s target rate, nominal wages need to increase in the medium run at the national trend rate of productivity growth plus that target rate. This rule holds in particular in the face of shocks to import prices or entrenched (dis)inflationary expectations.
This is the general logic behind the context-specific Pereira da Silva/Mojon proposal.
At the level of each EMU member state, any sustained deviation in unit labour costs and domestic inflation above (below) this target implies a real appreciation (depreciation), a loss (gain) of competitiveness against euro area trading partners, and pressure on the current account towards a deficit (surplus). It was implicitly believed by the architects of monetary union that this process would be self-correcting, the loss (gain) in competitiveness leading ,via higher (lower) unemployment, to a dampening (acceleration) of inflationary pressures. As the build-up to the Eurozone crisis demonstrated, however, this is not the case. Pro-cyclical forces – in particular differing and ‘perverse’ real interest rates, interacting with the fiscal rules, resulting in either booming or stagnant economies – more than offset the corrective effect working through the real exchange rate (Koll and Watt 2018: 6ff) Countries diverged persistently until tensions exploded in the crisis and imbalances were ‘corrected’ via hugely costly and one-sided deflationary policies.
This is the general logic behind the specific issue discussed by Blanchard.
While the economics are straightforward, the crucial insight that nominal wage-setting in member states within a monetary union is a key macroeconomic variable is not widely appreciated. Orienting it towards a benchmark of national trend productivity growth plus the price stability target (‘golden wage rule’) and ensuring – if needed flanked by strong competition policies – a parallel development of domestic prices has huge economic benefits. Then, with a unique nominal (short-term) interest rate set by the central bank, real interest rates are equalised across the currency area. Real exchange rates between the partner countries remain broadly constant. It avoids destabilising shifts in the functional distribution of income, helps avoid and correct imbalances in both internal demand and competitiveness and hugely facilitates the task of monetary policy, meaning it can focus – as required by its subsidiary mandate – to provide favourable conditions for investment and employment, without needing to resort to unconventional measures. A stable and dynamic economic development is also favourable for government finances, reducing the likelihood of having to impose corrective fiscal rules.
Institutionalising a role for wage setting
Nominal wages are, of course, not an instrumental variable that can simply be set in accordance with what is macroeconomically desirable. They are driven as well as drivers. National wage-setting systems differ in institutional terms, but they contain functional equivalents such as statutory minimum wages, sector and economy-wide agreements or guidelines (Watt 2017: 82ff). The goal must be to make the best possible use of existing capacity in each case and to take steps – which could usefully be coordinated within the European Semester – to enhance it (Koll and Watt 2019: 122f).
Medium-run domestic price developments are primarily influenced by the interaction of nominal unit labour cost developments and the fiscal stance. Wage policy can certainly not offset a wrong fiscal stance – e.g. maintaining price stability and competitiveness if the national fiscal authorities are shovelling coal on an already hot fire; the social partners responsible for wage setting and the fiscal authorities need to be on the same page. Where collective bargaining institutions are only weakly developed, collective bargaining and social dialogue should be encouraged, as called for in Principle 8 of the European Pillar of Social Rights. Where steering capacity remains weak, the fiscal authorities, working through the Phillips curve, will need to shoulder a larger role; the fiscal stance must be resolutely countercyclical. Additionally, macroprudential regulation can also play a role in steering demand, for example addressing asset price bubbles without deflating the whole economy.
These insights indicate the sort of institutionalisation that is required. Cooperative policymaking institutions are needed both at national and at euro area level; the latter should seek coherence between national trajectories, not least avoiding beggar-thy-neighbour temptations. They need to bring together government, social partners and monetary authorities at national level, the ECB, all finance ministers and representatives of the Commission and of the social partners at euro area level. As successful national corporatist models have shown, this is usefully supported by technocratic expert bodies that can establish a commonly agreed ‘knowledge base’ – for example, projections and simulations – on which political choices can be made.
Institution-building, especially in the EU, with its notorious veto points, must pay attention to matters beyond economic first principles. Fortunately, an institutionalisation that largely makes use of existing bodies offers itself (Koll and Watt 2018: 21ff).
With the Productivity Boards established in each member state, and the European Fiscal Board at EU level, expert bodies have been set up that, if their remit and composition were adapted, could provide the necessary expertise. They should be combined and reformed under the suggested title of Advisory Boards for Macroeconomic Convergence. Long-term supply-side drivers of productivity should be dealt with in other fora.
In terms of policymaking, there already exists a body – the Macroeconomic Dialogue of the EU (MED) – that brings together the key actors: European Commission, Council representatives, social partners, and monetary authorities (Koll 2005). However, it suffers from a lack of articulation with the national level. Establishing MEDs at the level of both the euro area (EUROMED), including all finance ministers, as proposed also by the Five Presidents’ Report, and of each member state (MEDNATs) would provide the necessary fora for the key economic policy actors to exchange views and produce ‘consensus packages’, not just as an ad hoc lowflation or competitiveness fix but as an ongoing process.
Support for this proposal comes from a recent opinion passed by the European Parliament (2021: §62) with a large majority.
Other institutional avenues – such as strengthening the link between the Eurogroup where ECB is present, and the social partners – could also be explored. Whatever path is taken, it needs to be embedded within a reform of Europe’s economic governance rules. Here, alongside fiscal reform, it is key that the Macroeconomic Imbalance Procedure (MIP), introduced in 2011, is reformed. Its impact has been limited (Bricongne and Turrini 2017). It must be made symmetrical with regard to the upper and lower limits of its scoreboard and streamlined to focus on key imbalances (Efstathiou and Wolff 2019, Bénassy-Quéré and Wolff 2020). With the ECB inflation target as the main benchmark, current wage and price inflation rates and their cumulative deviations, along with (relative) current account positions, should be the crucial indicators of whether the policy stance is appropriate. Legally, MIP reform is relatively simple and could be initiated as a first step in economic governance reform.
Along lines proposed by the European Fiscal Board (2019), countries for which the (reformed) MIP has identified imbalances should be set appropriate fiscal adjustment paths under the fiscal rules. These should also be more symmetrical and focused on stabilisation and sustained public investment (e.g. Dullien et al. 2020). The more member states target polices to avoiding macroeconomic imbalances, orienting unit labour and price developments in a symmetrical way to the inflation target of the ECB, the less excessive deficits will occur and fiscal rules – current or new ones – will need to be imposed.
Bénassy-Quéré A and G Wolff (2020), “How has the macro-economic imbalances procedure worked in practice to improve the resilience of the euro area?” Study for the European Parliament.
Blanchard, Olivier (2018), “The missing third leg of the euro architecture: national wage negotiations”, PIIE Realtime Economic Issues Watch, February 28.
Bricongne, J C and A Turrini (2017), “The EU Macroeconomic Imbalance Procedure: Some impact and no sanctions”, VoxEU.org, 22 June.
Cœuré, B (2019), “Monetary policy: lifting the veil of effectiveness”, Speech at the ECB colloquium, 18 December.
Dullien, S, C Paetz, A Watt and S Watzka (2020), “Proposals for a Reform of the EU´s Fiscal Rules and Economic Governance”, IMK Report 159e, Macroeconomic Policy Institute, Dusseldorf.
Efstathiou, K and G Wolff (2019), “EU policy recommendations: A stronger legal framework is not enough to foster national compliance”, VoxEU.org, 17 July.
European Commission (2020), Communication from the Commission, Economic governance review, COM(2020) no. 55 final.
European Fiscal Board (2019), “Assessment of EU fiscal rules with a focus on the six and two-pack legislation”, August.
European Parliament (2021), “Review of the macroeconomic legislative framework”, European Parliament resolution of 8 July 2021 on the review of the macroeconomic legislative framework for a better impact on Europe’s real economy and improved transparency of decision-making and democratic accountability (2020/2075(INI)).
Koll, W (2005), “The Macroeconomic Dialogue – development and intentions”, in E. Hein, T. Niechoj, T. Schulten and A. Truger (eds) Macroeconomic policy coordination in Europe and the role of the trade unions, ETUI: Brussels.
Koll, W (2013), “The new economic governance arrangements and autonomous collective bargaining in the European Union”, IMK Studies 30e.
Koll, W and A Watt (2018), “Convergence and stability in the Euro area through effective macroeconomic policy coordination”, IMK Studies 61e.
Periera da Silva, L and B Mojon (2019) “Exiting low inflation traps by “consensus”: nominal wages and price stability”, Speech, based on the keynote speech at the Eighth High-level Policy Dialogue between the Eurosystem and Latin American Central Banks, Cartagena de Indias, Colombia, 28-29 November.
Watt, A (2005), “Can reform of the Macroeconomic Dialogue improve economic policy-making in Europe?”, in E. Hein, T. Niechoj, T. Schulten and A. Truger (eds) Macroeconomic policy coordination in Europe and the role of the trade unions, ETUI: Brussels: 237-259.
Watt, A (2017), “Explaining unemployment developments in Europe: The role of wage-setting institutions and macroeconomic policies”, IMK Studies, Nr. 57.