Democracy in America
AT THE conference of the European Economic Association (EEA) in Malaga (see here for an earlier post on this) the president of the EEA, Jordi Gali, used his presidential address to discuss the merits of “wage flexibility” over the business cycle. The implications of his presentation for Europe are worrying, to say the least.
In New Keynesian models, the dominant work horse of macro analysis in academia and central banks alike, more wage flexibility can neither magically fix an unemployment problem in a recession, as is often, if only implicitly, argued; nor does it lead to a downward spiral into an economic abyss. The crucial element, as Mr Gali showed, is the response of monetary policy. Under optimal monetary policy, the economy does gain from more wage flexibility.
Critics of New Keynesian economics will argue that these models ignore important aspects of the economy, like a high demand for safe assets that downward adjusting wages cannot fix, and may even make worse. Or the belief of consumers about their future wealth, that dropping wages may worsen, too. But here is the worrying bit: you don't even need to go there in order to come to a worrying conclusion for Europe.
The reason is that Mr Gali also added two important caveats to the argument that wage flexibility can help. First, if monetary policy cannot react appropriately for some reason, deflationary pressures through lower wages lead to higher real interest rates, hurting the economy. Germany in the early 2000s is a case in point: because of its wage adjustment, it had low inflation and consequently one of the highest real interest rates in the developed world. Second, if you have households that cannot easily borrow to bridge a period of low income—because of high debt, say—downward adjusting wages hurt consumption, and thereby the economy. Both aspects are similar to those raised in a paper by Gauti Eggertson and Paul Krugman last year.
One country with both problems is Mr Gali's home country: Spain. There is no monetary policy that can be tailored to Spain's needs, and there are many highly indebted households and firms. In the short run, downward adjusting wages will hurt the Spanish economy because there is no countervailing increase in aggregate demand—unless exports can pick up the slack, which in current circumstances is unlikely to happen. What makes it even worse, in my view, is that Spain is not in a liquidity trap, that sufficient monetary (plus fiscal?) stimulus could potentially solve. It is trapped in monetary union with a 2% inflation target that makes Spanish wage adjustment almost inevitable. Spain is truly stuck between a rock and a hard place.
All this shows how wrong it was in the 1990s to argue that “flexible labour markets” will be a stabilising force in the macroeconomy of a future euro area. The opposite is more likely to be true, in the short run. Second, it is one more, and important, reason why austerity in the current circumstances is such a bad idea: apart from exports, fiscal policy is the only source of aggregate demand that could cushion the wage adjustment. A third lesson, as Stephanie Schmitt-Grohe and Martin Uribe show in a recent paper, is that temporarily higher inflation in the euro area would go a long way to help countries adjust their wages without hurting their economies. Alas, inflation expectations in Europe remain well-anchored—at 1.3%. Some good advice for Europe's next boom economies: don't let wages rise on the back of a consumption/credit/construction boom. The way down is a nightmare.