Euro area needs to ease product market regulations to stimulate growth

• Pages: 92-93

Page 92

Real wage growth in the euro area has moderated since the 1970s, particularly over the past decade. Such wage moderation helps to contain production costs and support firms' profitability and can thus lead to reduced unemployment and increased output. But unemployment in the euro area has declined only slightly since the mid-1990s, and per capita GDP growth has fallen-a puzzling development that raises questions about the benefits of wage moderation.

In a recent IMF Working Paper, Marcello Estevão examines the relationship among wages, unemployment, and output growth. He finds that wage moderation does spur output and lower unemployment but that the magnitude of these effects depends on the degree to which countries' product markets are regulated.

The annual growth of real hourly employee compensation in the euro area's business sector has declined from about 6 percent at the beginning of the 1970s to 1 percent recently.

Unemployment rates began to recede in the mid-1990s, bottomed out at about 8 percent in 2001, but have since climbed to about 9 percent. And annual growth in per capita business GDP has declined from an average of 3 percent in the 1970s to about 1.9 percent in the past 10 years. Why has the apparent moderation of wages in the euro area not made firms more profitable and led to faster production growth?

The wage-growth puzzle

Simple correlations from cross-country data for the euro area from 1983 to 2003 suggest that real wage changes have a weak relationship with unemployment and are positively related to output. They suggest that, if real wages decline, both the unemployment rate and GDP per capita growth also decline.

However, Estevão says, such raw correlations between real wage changes and economic performance may capture forces other than those associated with structural changes in wagesetting behavior. For example, changes in wages can affect economic activity by influencing workers' income and, thus, their consumption, which would cause wages and output to be positively correlated in the short run. In addition, the costs of being unemployed diminish during good times because those who lose jobs in one business have a high probability of being hired by another business. In this situation, workers would demand higher wages, which could again lead to a positive correlation between output growth and...