Economics and politics - comment and analysis
5. May 2016 I Heiner Flassbeck I Countries and Regions, Economic Policy, Europe, General Politics

Wages and prices in Germany – or why Europe will not escape from deflation within the next twenty years. Part 3

In a discussion on wages and in wage negotiations productivity is almost always considered as given. This is very strange. Productivity falls, so to speak, out of the sky. It is seen as a result of technological innovation. As such, many assume that it has nothing to do with wage evolution or with macroeconomic dynamics. This point of view is more than questionable.

In a market economy, nothing falls out of the sky: everything is a result of economic dynamics. These dynamics are, in turn, heavily influenced by economic policies, including wage policies. In particular, investment activity, which is the most important driver of technological progress, depends almost completely upon the development of the economy as a whole as well as upon the competitive pressures on individual companies.

When we speak about productivity, we mean productivity of labour or labour productivity. Contrary to what neoclassical capital theory asserts, labour productivity is the crucial factor that determines the success or failure of economic development. This is because the remuneration of labour determines the degree of incentive that companies feel to replace labour by capital. Make no mistake about it, this is how mankind advances. It is the real motor of progress. The history of industrialisation is to be read as an evolution in which people tried to produce goods more efficiently and eventually with less hardship for those involved in the production process. If wages strongly grow and to the same extent for all companies, the central stimulus that drives companies is to streamline the production process and to save on labour costs. This process does not lead, as the neo-classicists suspect, to increasing unemployment at given incomes. It leads instead to rising incomes at a given rate of employment.

This process occurs at the microeconomic level: all companies are forced to adapt to a specific wage increase, no matter how high their individual productivity gains are. If the general wage increase depends upon average productivity growth and the inflation target, then companies must find compensation for the wages they are obliged to pay through productivity gains or, if this proves impossible, through price increases. Service companies and the public sector, which both have far less potential to increase productivity than industry, are constantly forced to adjust prices to rising costs. On the other hand, industries that are particularly productive are able to reduce prices. This is because their productivity growth is well above the average of the economy as a whole.

Any company that competes with other companies in the same industrial sector will always try to become more productive than any of its competitors because this leads to higher profits and a greater share of the market. This is the kind of constructive entrepreneurial competition that Joseph Schumpeter described a hundred years ago as a characteristic outcome of capitalism.

The problem is now that precisely this mechanism, which is absolutely essential for successful economic development, has in Germany to a large degree been eliminated since the beginning of this century through the implementation of ‘labour market flexibility’ policies. This is by far not only a German phenomenon. What the trade unions in Germany once called the ‘productivity whip’ has weakened everywhere in the developed world. The issue is that if a general wage increase in a national economy does not equal the sum of productivity growth and the inflation target, the incentive for companies to invest automatically lowers because in such a situation businesses consistently fail to utilise their capacities to the full extent.

Even worse than this was the decision to demolish precisely that instrument that proved to so especially functional for Germany’s successful economic development in the past, the ‘nationwide agreement.’  The nationwide agreement – this is a general wage increase (for all industry sectors and all services) – was for a long time the cornerstone of what distinguished Germany from other countries. It provided for a particularly good development of productivity. The decision by Red-Green government under Gerhard Schröder to no longer use nationwide agreements and to allow for the negotiation of custom-made agreements for ‘individual’ companies depending on their economic situation was an absurd and fatal breach of the rules that are necessary for a market economy to be successful. It destroyed proper competition.

Companies that failed to achieve the general productivity target and were unable to increase their prices (for example because the quality of their goods is too low), could from then on nonetheless remain ‘competitive’ because the government gave them the option of negotiating wage concessions with their workers. This is, in effect, the end of a normal market economy. The scheme means nothing else than the massive subsidization of such companies by its workers.

As I have shown in the series on automation from last January, the constellation of production costs and demand in the neoliberal world means that companies can make large profits without making substantial investments. How else should one interpret that investment ratios tend to decline almost throughout the whole of the Western world, although economic policies are trying everything imaginable (within a neoclassical framework) to make companies invest?

From this it follows that wage policy directly and indirectly influences the development of productivity. Everything Germany implemented in the last twenty years in terms of ‘wage flexibility’ did in fact lower its productivity growth. Those who understand this and want to do something about it, also see that wage formation and productivity are inherently related. Productivity growth does not fall out of the sky, it is not some exogenous given. The relationship between the two becomes abundantly clear when one considers the rate of productivity growth that prevailed when normal wage conditions still existed.

How would this work in practice nowadays? If one aligns wage formation with a 1.5 percent productivity growth plus the target inflation (the gray line in the Figure 2), the norm for wage increases in Germany comes to 3.4 percent (without the existence of a euro zone crisis).

Figure 1


Germany is of course well below this line. A lot of catching up has to be accomplished in order to prevent lasting European deflation and a collapse of the EMU. German nominal wages would have to rise for many years by at least 4.5 percent in order to eliminate the horror scenario (especially for German employment) of a collapse of the euro zone. By this standard, any proposal to stay within a two percent wage growth is irresponsible as well as any forecast that fails to reckon with the issue of the imbalances within Europe.

The fact that the German employers and the public services have apparently decided to set an example in the negotiations and the weakness of the trade unions (or, in some cases, their submissiveness) are not good signs. They show that Germany will continue its brutal mercantilist policies. It is prepared to take of risk of witnessing the collapse of the European Monetary Union.