Wage Deflation Next for the Euro Zone

April 20th, 2013
in Op Ed, syndication

Written by

If you think you've already seen the worst effects of Europe's austerity policy, think again. The next phase is on the way, according to a new report by the French Economic Observatory (OFCE) here: a prolongation of the crisis by competitive wage deflation brought about by the obstinate blithereens of the European Commission.

As deflation will increase the real value of debt, all hope of reducing government debt will be vitiated.

"Our forecasts for 2013 and 2014 for the developed world can be summed up in these pessimistic terms: they will remain stuck in vicious circle of rising unemployment, a prolonged recession and growing doubts about the sustainability of public finances."

Follow up:

It's true that the contractive impulse from budget consolidation policies will be less strong in the euro zone this year at -1.1 % than it was in 2012, at 1.8 %, and will decline further to -0.6 % in 2014, but it will nevertheless remain strong in those countries with excessive debt and in France will rise to 1.8 % in 2013 and stick at -1.4 % in 2014.

The European Commission is not too worried by this because it believes that the multiplier effect of budget consolidation, after being, as it turned out, much stronger than expected in the first years of the crisis, will return to normal now.

"Everybody", meaning the Commission, the OECD and the IMF, assumed that multiplier effect (meaning the impact of economic growth of a given percentage reduction in domestic demand by budget consolidation) was 0.5 %, but it is now accepted that it was nearer 1 % and perhaps more.

The erroneous assumption made it relatively easy to justify austerity, but the outcome of "ill calibrated policy" was disastrous - 4.7m jobs destroyed since 2009, GDP in decline in 2012, and so on. When the EC says the multiplier effect will return to normal from now, it assumes that the economic situation has returned to normal.

That, says the OFCE, is not the case when there is massive unemployment. The OFCE argues that the multiplier effect is likely to remain high. And .......

"when pursuing short term budget consolidation when the multipliers are at an elevated level, the multipliers are reinforced. The period of unemployment and under-utilisation of (productive) capacity is prolonged. The dis-indebtment of the private sector, which was the origin of the whole crisis, is prevented, and the crisis continues."

The high level of unemployment increases the risk of deflation, especially as the rate of inflation corrected for tax increases is already very weak.

"In these conditions in the absence of a change of strategy in Europe, the euro zone may find itself faced with the conditions for prolonged deflation: in the course of 2012, the purchasing power of gross disposable income stagnated or fell in the euro zone."

The next phase may be wage deflation, not least because austerity policy imposed by the troika includes lowering the salaries of public sector employees, with effects that are seen in Greece, Ireland, Portugal, Italy and Spain.

Here is the starting line: Unit labour costs between 2009 and 2012 fell by 4.9% in Portugal, 11.2% in Spain, 5.8% in Greece and 9.5% in Ireland. In France and Germany, they increased by 0.8 and 0.9% and in Italy by 0.1%.

The persistence of the Europeans in insisting on austerity opens the way to contagious deflation in the whole of the euro zone through a generalisation of competitive (internal) devaluation.

This may bring gains in export markets for the first movers, but won't work in the longer term, for the one country's market gain in the euro zone is another's loss, leading those countries that did not impose to wage deflation initially to do so when they see what is happening.

This would set off a whole new chain of events - lower wages means lower consumption, means less investment, means less employment, means weakening government revenues and rising social welfare expenditure, means deficit targets are not met, means governments are persuaded to try another dose of austerity.

And we're not finished yet. The weakening of household incomes makes the deleveraging of the private sector ever more difficult. The banking system is exposed to an increase in bad loss risks .....and in the worst case we end up with new bank failures.

So cheer up everyone! Everything's going to be lousy!

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