Despite all the hysteria about the current inflationary pressures and the reversion of central bank policy committees to the New Keynesian norm – interest rates have to rise to kill off inflation otherwise it becomes a self-fulfilling process where wage demands are made in ‘expectation’ of more inflation and firms (passively in their view) have to pass on the higher unit costs, I remain of the view that this period is transitory. That doesn’t win me any friends (other than my true friends). It also leads to another hysterical line of Twitter-type statements that the Modern Monetary Theory (MMT) have gone silent because they were wrong about fiscal deficits not causing inflation and are too ashamed to admit it. I haven’t gone silent. I have been continuous in my advocacy both privately and publicly. The rise in fiscal deficits during the pandemic and the central bank bond purchases have had little to do with this inflationary episode. Covid, sickness of workers, War, natural disasters (floods, fires) and noncompetitive cartels and energy markets are the reason for the inflation (variously in different countries) and interest rate increases won’t do much at all to target changes in those driving factors. New ECB research (released August 3, 2022) in their Economic Bulletin (Issue 5, 2022) – Wage share dynamics and second-round effects on inflation after energy price surges in the 1970s and today – reinforces my assessment of the situation.
The ECB research appeared as a ‘box’ in the latest Economic Bulletin and aimed at reviewing:
… wage share dynamics and potential second-round effects on inflation at times of energy price increases.
So, they want to explore what is going on with wage movements after a major imported raw material price shock has occurred.
In the 1970s, of course, a major energy price shock occurred when the OPEC cartel pushed up oil prices (massively) starting in October 1973 as the US provided military support to continue the illegal Israeli occupation of the Sinai Peninsula and the Golan Heights.
That set off the 1970s inflation as oil-dependent nations struggled to deal with the distributional dilemma as to who would bear the real income loss initiated by the imported raw material cost rise (which diverted national incomes to the foreign oil companies and producers).
At that time, trade unions were much stronger and had more ‘price-setting’ power – that is, they had the ability to impose major costs on firms who refused nominal wage demands that were designed to protect real wages.
Firms also had (and have more now) ‘price-setting’ power – that is, they had market power which enabled them to protect their real profit margins by passing on the rising unit costs from the wages growth onto final consumers.
Both sides of the conflict – labour and capital – were intent on protecting their real incomes and forcing the other side to take the loss embodied in the imported raw material rise.
And as a result, the initial price shocks triggered what I call a ‘propagating mechanism’ – the wage-price or price-wage spiral – which then ensured the inflationary pressures would continue and escalate into a full blown distributional battle of ‘mark-ups’.
It was also complicated by the second oil embargo in 1979 in relation to the Iran-Iraq war, which pushed another energy shock into the global economy.
But by this time, major substitutions were underway around the world that meant this shock was less damaging than the first.
Oil heating had been abandoned in many countries in favour of the cheaper gas and the big, gas-guzzling 6- and 8-cylinder cars were being replaced with better and more efficient, 4-cylinder cars that used less fuel per km.
If the distributional propagating mechanism had have been absent, then the 1970s inflation would have petered out fairly quickly.
The initial price rises in 1973 really only lasted for a few years, and were then resumed by the 1979 shock (the ‘second oil shock’).
But, by the early 1980s, oil prices were falling pretty quickly as OPEC increased supply and cheaper oil supplies from Mexico (for example) became available.
The current situation
The lack of the distributional propagating mechanism is why I consider the current situation is not akin to the 1970s.
And the ECB researchers agree with me.
The situation now is a little different because the energy shock to Europe is driven not only by the OPEC cartel but also by the impact of gas supply restrictions as a result of Europe’s (Germany) dependence on imported gas from Russia.
The euro area is a “net energy importing region” and at present it is facing a massive:
… deterioration in the terms of trade (the ratio of export prices to import prices), thereby eroding the income used to remunerate domestic factors of production.
So that much is similar to the 1970s.
Nations are facing significant reductions in the real income they produce that can be distributed to their workers because an increasing share of that real income has to be paid to foreigners who want higher prices for the goods and services that they supply to the nations.
The ECB chooses to focus on the:
… wage share and inflation dynamics in the euro area after the energy price increase observed since the second quarter of 2021
1. To see what the parallels and differences are between the 1970s inflation episode, which lasted into the early 1990s as a result of the wage-price propagation.
2. To see whether the euro area dynamics are similar to those in the US, which is experiencing the same imported raw material price rises (though tempered compared to Europe).
What is the wage share?
Please read this blog post – The Weekend Quiz – May 21-22, 2022 – answers and discussion (May 21, 2022) – and go to the answer for Question 2, for a full derivation of the wage share and its link to real wages, productivity and unit costs.
By way of summary:
1. The wage bill is a flow and is the product of total employment (L) and the average wage (W) prevailing at any point in time = W.L
2. The wage share is just the total labour costs expressed as a proportion of $GDP – (W.L)/$GDP in nominal terms, usually expressed as a percentage
3. Labour productivity (LP) is the units of real GDP produced per person employed per period = GDP/L.
4. The real wage is the nominal wage (W) deflated by the average price level (P) to express the purchasing power of the nominal wage – W/P.
5. Nominal GDP is $GDP and is real GDP valued at the price level = GDP.P
6. So the wage share is (W.L)/(GDP.P) which if you do some algebra that I don’t expect everyone to follow means that we can get an alternative expression for the wage share:
(W/P) divided by (GDP/L)
Don’t worry about the symbols – this just means that the wage share can also be expressed as the ratio of the real wage and labour productivity.
In other words, if the real wage grows faster or declines more slowly than labour productivity then the wage share rises and vice versa.
So we have a close link between the wage share, productivity and wage and price movements, which is the focus of the ECB research paper.
What is going on in Europe?
The ECB express it this way:
… the wage share rises when there is an increase in real consumer wages (measured by nominal wages per employed person divided by the private consumption deflator), a decline in labour productivity or a deterioration in the terms of trade (proxied by the GDP deflator-to-private consumption deflator ratio).
They note that if imported energy prices rise, the real wage is squeezed and:
… the impact of energy price hikes on the wage share crucially depends on the response of labour income. In turn, all other things being equal, the response of labour income to energy price hikes will affect unit labour costs and the GDP deflator.
That is the same dynamic I summarised in the early part of this post.
The ECB conclusion:
The recent deterioration in the terms of trade has had limited implications for labour income and the GDP deflator relative to the experience in the 1970s.
First, the initial income loss this time “was only about a third of the drop triggered by the OPEC oil embargo between the fourth quarter of 1973 and the third quarter of 1974.”
Second, “real consumer wages declined after the recent rise in energy inflation, while they strongly increased in the 1970s.”
The result – “a slight decline in the wage share, in contrast to a sizeable increase after the OPEC oil embargo”.
The same dynamic is playing out in Australia and I have produced these wage share and profit share graphs before (when I last analysed the national accounts release in June).
The declining share of wages historically is a product of neoliberalism.
But the point is that Australian workers are seeing further wage share falls in the recent energy crisis (motivated by different factors to some extent than the European situation) as opposed to what happened in the 1970s when unions could defend the real wage and extract a greater share of productivity growth.
And look at the profit share – rising!
In Australia, we have a major gas crisis with shortfalls in domestic gas supply and huge increases in the local price.
How can that be given we produce more gas than we can ever consume?
Foreign-owned gas companies (90 per cent control over domestic gas) with huge tax breaks from the government have sent all their uncontracted gas off to the rest of the world, exploiting the massive price rises as a result of a shortage of Russian gas supply.
Huge increase in their profit margins and profits and a shortage of local gas supply leading to a hike in local gas prices.
The circumstances are a little different to Europe but the dynamic is the same.
Workers are paying the price of this inflationary episode and business profits are booming.
That should be a wake-up call for our governments to really regulate the capitalists.
Sadly, it hasn’t led to much policy action.
And the central banks are taking the running in that area and worsening the plight of workers while transferring billions into bank profits.
If you were buying shares – banks and energy companies!
The ECB research notes that while the wage share has declined in Europe, profits margins (over unit costs) are rising:
These dynamics reverberated in the profile of the GDP deflator, which grew moderately and through different channels in the recent period (mainly through unit profits and taxes, rather than unit labour costs) compared with the 1970s.
This excellent graph (produced by the ECB in their Bulletin Box) takes some study but captures the essence of their research.
Is the US any different at present?
The ECB show that:
Wage share dynamics in the United States are similar to those in the euro area today, but these differed markedly in the 1970s.
In other words, similar story with some differences.
1. Smaller real income loss now relative to the 1970s.
2. Wage share declined in the US in the 1970s.
3. Profit margin push played “a significant role in both episodes” (1970s and now) in the US.
Overall, the US experience shows that the GDP deflator may increase considerably as a result of energy price shocks, despite limited wage indexation mechanisms and, especially today, low net energy dependency and strong monetary policy credibility.
Which means that the US corporations were able to continue pushing prices up after the initial shock as a strategy to gain more real income for themselves rather than as a retaliation response for major wage push from workers.
Which means that the US product market is relatively uncompetitive and corporations have excessive market power and abuse it when they can.
This is a similar story to Australia now.
The ECB verify their results using statistical modelling which shows that:
Second-round effects played a major role in the transmission of oil supply shocks to inflation in the 1970s and 1980s, but these have been largely absent on average in the period since the euro was launched.
That is, there has been no propagating mechanisms to drive any imported raw material price shocks into an extended inflationary episode.
Unlike the 1970s, where the focus became ‘excessive trade union power’ and was used as a justification for hammering unions through a variety of anti-union regulations and laws, the current episode is highlighting the destructive market power that corporations have and their profit greed at a time when workers are suffering real income losses and worsening standards of living.
The response of central banks to exacerbate that suffering is criminal in my view.
Unless society comes to terms with this and demands from our governments that they take action against corporations and restrict their market power the situation will continue.
That is enough for today!
(c) Copyright 2022 William Mitchell. All Rights Reserved.