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How wage agreements eroded competitiveness

30/08/2008 | Stephen Kinsella | UL | Economy of the Republic of Ireland, European Monetary System, Fiscal policy, Inflation, Ireland, Irish Times

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Not entirely sure how I missed this, but my colleague Dr Tony Leddin has a piece called How wage agreements eroded competitiveness in the Irish Times describing the recent history of Ireland's attempts to get to grips with the spiral of wage increases following inflation following wage agreements. It seems clear from the article that what Tony feels we need is quite severe wage moderation, to reduce inflation and make us more competitive relative to our export partners. We are told right away that

THE MOST comprehensive indicator of price competitiveness - the real effective exchange rate index - indicates that the Irish economy is now at its most uncompetitive since the early 1970s.

This is serious stuff, and the mechanism to get us out of this position of ever-increasing wage demands coupled to inflation is not entirely clear, because right now, I can't see any government calling for further wage restraint following the collapse of the pay talks earlier this summer. No other actor in the system has an incentive to change the status quo either.

What is clear is that we did achieve a deflationary, policy driven inflation moderation for a few years, so this has happened before---when Ireland wanted to gain entry to the European Monetary System, the precursor of the Euro system. Tony shows we did actually achieve inflation and wage moderation targets for a few years.

As Tony rightly points out, now we're in the Euro system, we can't devalue our currency and get out of the inflationary spiral that way. The only way to slow things down is to use fiscal policy---the government budget---and this will be unpleasant, because it means cutbacks.

On whether such an action is politically feasible, I'm not sure. On whether it is economically necessary, I am sure.

Check out the article itself for more information on this topic.

Update: the Irish Time server seems to be down. I've copied the text from my RSS reader below, just click on the 'read more' link to get access to the article.

How wage agreements eroded competitiveness

Between 1997 and 2004 national pay deals helped transform Ireland into a high-cost, high-price economy, writes Anthony Leddin
THE MOST comprehensive indicator of price competitiveness - the real effective exchange rate index - indicates that the Irish economy is now at its most uncompetitive since the early 1970s.
The country's immune system has been suspended, leaving the economy vulnerable to a whole variety of adverse shocks, giving rise to the possibility of a prolonged economic slowdown.
To what extent has the wage process, in the form of national wage agreements, contributed to this loss of competitiveness?
Since wage agreements were reintroduced in January 1988, there have been seven to date. Each agreement contains its own set of pay awards. So, using these pay awards, it is possible to construct a wage agreement 'pay award index' for both the private and public sectors over the past 20 years.
This index indicates how a worker would have fared if his or her wages were wholly determined by the pay awards. This is a 'pure' indicator of wage developments as it is not influenced by workers being promoted, incremental salary increases and the like. But it does not capture the extent to which the national wage agreement awards were observed or exceeded.
What matters, of course, to workers is not nominal earnings but real, inflation-adjusted earnings. Hence, the pay award index has to be adjusted for price inflation to obtain the real wage outcome.
This index shows that over a period of nine-and-a-half years (1988-97), the cumulative real pay award was 4.3 per cent for the public sector and 6.8 per cent for the private sector. This calculation does not take tax developments into account. A central part of the wage agreement philosophy was that pay moderation could be bought through income tax cuts. Income tax rates were reduced from three bands of 35 per cent, 48 per cent and 58 per cent in 1987 to two bands of 20 per cent and 41 per cent in 2008.
The real pay index indicates that workers in both the private and public sectors, whose earnings were constrained by the pay awards, received a relatively small share of the prosperity associated with the booming Irish economy. Other data sources confirm that from 1988-1997, wages' share of the 'national cake' fell over 25 per cent.
Not surprisingly, given the dramatic fall in unemployment and the booming economy, the trade unions attempted to redress this imbalance in the next round of negotiations. Under Partnership 2000, pay awards of approximately 10 per cent were conceded to both public and private sector workers over a two-year period.
However, after years of relatively subdued inflation, the annual rate of inflation suddenly increased from 1.5 per cent in October 1999 to 7 per cent in November 2000. This upsurge in inflation was unanticipated by the trade unions, as even the Central Bank underestimated inflation by 2.8 per cent in its forecast for 2000.
By Autumn 2000, real earnings growth was back in negative territory as inflation outstripped pay awards. Between January 1988 and September 2000, the cumulative real wage agreement pay award was a mere 5.2 per cent for the public sector and 8.3 per cent for the private sector. Clearly, Partnership 2000 did not deliver to workers a sizable share of the continual economic prosperity.
In the next round of wage agreement negotiations, the Programme for Prosperity and Fairness, pay awards of 24 per cent and 18 per cent were conceded to public and private sector workers respectively over two-and-a-half years. The seeds of Ireland's competitiveness destruction sown.
This process is very similar to the 'Phillips Curve' theory, named after the New Zealand economist Bill Phillips. As unemployment falls, wage demands and the failure of trade unions to forecast inflation accurately precipitate a wage-inflation spiral.
The acceleration in inflation in 1999-2000 was not entirely due to compensating wage demands. The falling euro exchange rate and negative real interest rates played a critical role.
Charlie McCreevy's supply-side-enhancing fiscal policy - the 'if we have it, we spend it' approach to government expenditure - undoubtedly fuelled the inflationary flames and had a long-term, detrimental impact on competitiveness. The notion that government expenditure, intended to expand the supply side of the economy, could offset demand-side pressures and keep a lid on inflation, can be confidently filed away under the heading 'recent Irish economic fallacies'.
Contrary to the Phillips prediction of a spiralling wage-price process, Irish inflation instead stalled and then, over a three-year period, gradually decreased to the ECB's upper inflation target of 2 per cent. However, the damage had been done. Between 1997 and 2004, Ireland was transformed into a high-cost, high-price economy. From 2001 onwards, the appreciation of the dollar-euro exchange rate accentuated the loss of price competitiveness.
This interpretation of the pay award process illustrates that even for a small, open economy like Ireland, inflation is not entirely externally driven but is instead strongly influenced by domestic developments.
Unfortunately, a key assumption underlying Ireland's EMU entry (that adopting the single currency would deliver low inflation) has proved to be unfounded. Since 1999, Irish inflation, however measured, has consistently exceeded the EMU average.
The 'do nothing, say nothing' approach to inflation that characterised Brian Cowen's tenure as minister for finance can no longer prevail. The old wage agreement model of wages chasing inflation is redundant. What is required is a proactive approach, based on social partnership, where the Government and Ibec offer guarantees as to future inflation and pursue active policies to deliver on that commitment.
An inflation objective was, after all, delivered, albeit for a short period, during the run-up to Ireland's qualification for EMU entry in 1997.
Given that devaluation is now no longer an option, there are no easy solutions to our deteriorating competitiveness. It is going to take years of wage and price inflation below that of our trading partners to unravel the inflationary damage of the last decade.
Dr Anthony Leddin is head of the Department of Economics at the University of Limerick

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Stephen Kinsella

Economist at the University of Limerick