Economics and politics - comment and analysis
15. September 2023 I Heiner Flassbeck I Economic Policy, Economic Theory, Europe

Flexible wages or flexible profits – how does a market economy work?

When a high-ranking European policymaker like Christine Lagarde gives a keynote speech on “policymaking in an age of shifts and breaks” at a meeting of the world’s most important central bankers, one should listen carefully. Because that is indeed what matters in this world: how to manage the inevitable structural change without making serious macroeconomic mistakes.

The ECB President’s answer sounds plausible at first glance:

“Large-scale reallocations can also lead to rising prices in growing sectors that cannot be fully offset by falling prices in shrinking ones, owing to downwardly sticky nominal wages. So the task of central banks will be to keep inflation expectations firmly anchored at our target while these relative price changes play out.”

However, the addition of “sticky nominal wages” raises eyebrows. Apparently, Lagarde assumes that wages rise in one sector where sales are booming and wages fall in another that is shrinking. Is this true? In the kind of market economy we know, do wages adjust flexibly downwards and upwards respectively to sectoral developments or to those of the sectors or even of the companies? And if they do not, should we want a market economy in which wages are flexible in the Lagardean sense?

Anyone who assumes at this point that this is probably about a theoretical dispute of principle is wrong. It is about a central functional principle of the market economy and anyone who misunderstands such a principle can never make proper policy. Imagine, from the point of view of the workers in different industries, how structural change takes place when wages are flexible.

Flexible wages?

The engineers in the favoured industries, say those who work for the manufacturers of climate-related products, get higher pay because their industries are booming. The engineers in the disadvantaged sectors, let’s say in the automotive industry, have to cope with falling wages because the automotive industry is on the decline. How long will that last? When will the engineers in the car industry say, how come we have falling wages when we can easily do the same work as the engineers in the booming industries? So let’s go where higher wages are paid.

If workers are able to compare the wages paid by different companies in different industries for a given comparable skill, they will migrate. They will apply to the companies from which the highest wages are offered. In this way, wages for a particular qualification are aligned across industries and companies at any time and quickly, and no company can escape this because otherwise it would simply not get certain skilled workers. In Lagarde’s diction, however, wages are then inflexible because the prices of the products of the differently developing sectors may no longer be able to react differently: those that are threatening to fall cannot stop or even prevent this by lowering their prices; and the sectors that are on the upswing do not have to pass on cost increases in their product prices that are solely and specifically wage-related.

However, the high mobility of labour that is assumed in this consideration does not exist for the most part in modern labour markets. Outside the US, at any rate, workers have become quite sedentary and cannot and do not want to move every few months to look for a new job. Companies are also keen to retain well-trained skilled workers because search costs can be very high on their side as well. Consequently, in the 1950s and 1960s, the collective bargaining partners in some countries moved towards collective agreements that regulated salary structures and wage increases in a similar way across entire sectors or – through cooperation between different trade unions – even across the economy as a whole.

These sectoral collective agreements are nothing more than a functional equivalent to labour mobility in a world where the labour force is no longer so mobile. The regional collective agreement establishes conditions that would prevail in a market with high labour mobility and is precisely for this reason not a social and trade union policy instrument imposed on the market system from the outside, but the perfect substitute for labour mobility, which is far from perfect for many institutional reasons, and which would not be desirable at all, but would represent an anti-family nomadic life.

Flexible profits

The regional collective agreement seems to have created an instrument perfectly adapted to Schumpeter’s ideas of a market economy dynamic driven by individual companies. The system is driven by the temporary profits of those who have managed to rationalise a production process or successfully market a new product. As productivity rises but wages remain the same as those of competitors, their unit labour costs fall, bringing temporary business success to the innovative firms. Those that cannot compete have to declare bankruptcy and exit the market because they cannot fall back on the option of lowering wages.

Such a system is controlled by flexible profits because input prices are rigid. The more inflexible the prices of intermediate inputs, including labour, are for the individual firm trading in the market, the more flexible and efficient in managing the system is the profit of that firm. Conversely, systems of flexible input prices (including wages) create inflexible profits and therefore require different control mechanisms. The more flexible intermediate input prices, including labour, are, the more rigid, and thus inefficient as a control mechanism, is profit.

It is more than astonishing that at the beginning of this century in Germany it was precisely the employers who tended to move from a system of flexible profits to a system of inflexible profits and that politics supported them in this (keyword: wage agreement opening clauses). Why does it make sense from the employers’ point of view to set up a system in which every productivity advantage that a company acquires is to a considerable extent steered away by price increases for its specific inputs, including labour? Who decides in this system whether a company can remain in the market that survives despite permanently weak productivity development because it has to pay far less than its competitors for its inputs including labour?

But also from the trade unions’ point of view one has to ask whether it makes sense to endorse a system in which the productivity advantage of a company only or predominantly benefits the workers of that company? Who then decides which workers are allowed to work in good and which in bad factories and thus earn high or low wages? In any case, the reaction of the labour force with migration is likely to set limits to a system of wage differentiation according to earnings, since the costs of immobility for the individual worker – the comparatively lower wage – will eventually remove the mobility barrier.

Monetary policy and flexible prices

The repeatedly called for “flexibility in the labour market”, in the sense of different prices (i.e. wages) for the same work, has nothing to do with price flexibility in a functioning market economy. The latter does not mean that every supplier or consumer in a particular market can agree on an individual price, but that a uniform price is set for all participants in a market. This price can then change over time, i.e. it can be “flexibly” adapted to the most diverse influences. But then it changes for all market participants in the same way and not for a few in this way and for some others differently and for the rest not at all.

The flexibility of prices that is really important for the functioning of the system is greatest when the visible differences in the prices of similar products and services are close to zero. To put it graphically: If in all bakeries in a city a bread roll of the same size and quality costs 40 cents in a given month, no one would think of talking about encrusted structures or a supplier cartel. If the price of a bread roll were to rise to, say, 44 cents in all bakeries the following month due to devastating crop damage and a corresponding increase in the price of flour, the necessary market-economy flexibility, i.e. the ability to react quickly to changing conditions, would obviously be given.

It is fundamental for monetary policy to understand that in a functioning market economy there is no mechanism that could ensure that price increases in booming industries are offset by price reductions in the less favoured ones. The idea that it is due to inflexible (sticky) wages if this does not happen is dangerous. With such a view, monetary policy tends to generally blame workers for “too little price flexibility” and to react with interest rate hikes. However, if shortages occur temporarily in structural change and certain sectors are able to impose such high price increases that the price level also temporarily rises overall, interest rate hikes are the exact opposite of what the economy and business need.

This is because interest rate hikes hinder the process of competing away pioneer gains through imitative investment and thus the removal of bottlenecks indicated by price increases. Especially in times when rapid structural change is particularly necessary to counter climate change, stronger price surges in individual sectors are almost pre-programmed. To suppress these by making investment more difficult is to rob the market economy of its ability to adapt flexibly.

The fact that the ECB raised interest rates again yesterday, although there is no longer any inflationary pressure in Europe and the leading indicators such as producer prices are already well into deflationary territory (as shown here most recently), is the result of such fatal misunderstandings about how our economic system works. The fact that the ECB directly justifies the renewed increase with a higher path of energy prices (here in the press release) shows that it has not understood that there can be no market mechanism that can compensate for such an exogenous effect, which again will be temporary.