What is going on with wages?

In the last issue of its Economic Bulletin, the European Central Bank confronts us with an uncomfortable reality:

Wage growth in the euro area is at its historical minimum despite the decline of unemployment rates.

Following a classic economic logic, lower unemployment should lead to higher wages. It’s the old story of supply and demand. Though, for some reason this time it is different. Something has changed…

In fact, the European Central Bank itself admits in its report both its surprise and its inability to accurately forecast the evolution of compensation per employee and unemployment indicators in the last years:

Why is that?

The world has changed, the labor market too

The ECB might be missing its forecasts on wage growth because they underestimate the combined effect of several concurring trends in the labor market:

1. A larger amount of slack (beyond unemployment)

The economy is doing better, and unemployment rates are declining. However, unemployment is still too high in many countries, which means that from the perspective of labor supply, there are still large numbers of people looking for a job, many of them for a long time, and ready to work for very low wages.

In addition, we should keep in mind that during the years of the economic recession, some governments encouraged part time employment as a means to legalize informal work and fight unemployment. Similarly, many companies that had to restructure their workforces agreed in their social plans to split full-time into part-time employment to preserve jobs.

Also, many young people decided to resume their studies, and way too many women returned to work as housewives after having lost their jobs…

Therefore, although unemployment is now declining, there are still many unemployed people, many people working on a part-time basis who would like to work more hours if they could, and there is also a significant number of discouraged workers who are not even looking for a job, and don’t count as unemployed in the official statistics.

Blanchflower and Levin explain this in their paper “Labor market slack and monetary policy” (2015):

"In the wake of a severe recession and a sluggish recovery, labor market slack cannot be gauged solely in terms of the conventional measure of the unemployment rate (that is, the number of individuals who are not working at all and actively searching for a job). Rather, assessments of the employment gap should reflect the incidence of underemployment (that is, people working part time who want a full-time job) and the extent of hidden unemployment (that is, people who are not actively searching but who would rejoin the workforce if the job market were stronger)."

2. Job polarization

As a consequence of automation and offshoring, the number of well-paid middle-skill jobs in manufacturing and clerical occupations has decreased in the past decades, exerting downward pressure on the wages of this category of employees, and increasing the supply of people ready to perform lower level jobs.

3. Low productivity employment

Reduced wage growth is also related to the kind of employment that is being created in Europe. Unemployment rates are declining, but since 2013 the bulk of employment creation in the euro area is concentrated not in high value added (and higher wages) industries, but in lower productivity (and lower wages) services.

4. Low inflation rates

The low inflation environment is another factor that contributes to the deceleration of wage growth in Europe. Indexation mechanisms, introduced in collective bargaining agreements and other norms to preserve the purchasing power of wages and salaries, are keeping wages flat, while individual workers do not have a strong incentive to push for higher wages as in a higher inflation scenario.

5. Impact of structural reforms

The European Central Bank might have also underestimated the impact of the structural reforms some member countries have introduced in the labor market to weakening downward wage rigidities, and making wages more responsive to market conditions. For instance, salary cuts, and the transformation of full time into part-time jobs, are now common practice in companies in difficulties, while in many organizations new hires are being paid significantly less than employees with longer years of service.

6. De-unionization

Finally, as union membership declines in many countries, the number of jobs with union wage and benefit premiums goes down. This phenomenon also weakens the power of unskilled workers to bargain for higher wages, more comprehensive benefits, and better working conditions; and reduces the “spillover effect” wherein non-unionized firms raise wages and benefits to compete with unionized firms for the best professionals.

Considering all the above I wonder if officers of the European Central are overoptimistic once again when they predict:

“Compensation per employee is expected to grow moderately in 2016, picking up to 2.1% in 2018, following the gradual recovery in euro area real GDP.”

Link to Spanish version.