Ten years after the Global Financial Crisis, the recovery is underway and output levels have surpassed pre-crisis levels in most advanced economies. But how are labour markets performing?
At a high level, they have (almost) never been better. Figure 1 shows that the Organisation for Economic Co-operation and Development ("OECD") harmonised unemployment rate is at its lowest ever recorded rate of 5.4%. But despite tightening labour markets, wages have not yet picked up as economic theory would predict. This has been a key feature in large economies like the US and the UK—we looked at the latter in more detail in our UK Economic Outlook report last July.
In this edition, we look closely at the relationship between unemployment and wage growth— traditionally described as the ‘Phillips Curve’ — for the Eurozone. Looking at the high-level statistics, the Eurozone unemployment rate currently stands at the 8.5% mark– but this doesn’t reveal the wide variation across member states from around 3.5% in Germany to over 20% in Greece.
Our analysis highlights some of the potential reasons for the decoupling of wage inflation from unemployment rates, including:
On a broader note, we continue to monitor economic developments in the Eurozone, which continues to grow at robust rates– the latest flash estimate shows the bloc grew by 0.4% quarter-on- quarter in the first three months of the year.
However, our analysis of the latest set of detailed national accounts data shows that the Eurozone is increasingly reliant on external demand as a key source of GDP growth. This could make the bloc more susceptible to uncertainties in the international trade arena and could explain some of the softening of the survey data which came out last month.
By comparison, the US economy grew by 0.6% quarter-on-quarter for the first three months of the year, whereas the UK just by 0.1% quarter-on-quarter. We will be monitoring these for any revisions in the coming weeks.
Eurozone GDP is growing at robust rates…
Ten years on from the global financial crisis of 2008, the Eurozone is exhibiting signs of broad-based growth. Last year, for example, the bloc grew at an estimated rate of 2.3% —the fastest rate of growth recorded since the financial crisis.The latest breakdown of the national accounts shows a more detailed picture of the sources of growth Our analysis of the data in Figure 2 shows that:
…with net exports the bloc’s strong and weak point
However, the most impressive turnaround recorded is that of net exports, which swung from a negative contribution of almost one percentage point in the second quarter of 2016 to a positive contribution of 1.3 percentage points in the fourth quarter of 2017 (see Figure 2). Geographically, most of this was driven by the peripheral economies (particularly in the tourism sector where most experienced a recorded breaking year).
Looking to the future, net exports highlight both the Eurozone’s key strength and vulnerability. On the one hand, strong growth in the Eurozone’s key exports markets is expected to continue. But at the same time, reliance on external demand as a key source of economic growth means the Eurozone is more susceptible to uncertainty and potential disruption in the global trading system.
Global institutions have supported merchandise trade growth
Since the foundation of the World Trade Organization (“WTO”) in 1995, global merchandise trade has increased by over 200%, facilitated by a reduction in average tariffs. More importantly, this has been accompanied by the establishment of a rules-based framework making trade practices stable and predictable. But how has trade performance differed between larger and smaller businesses?
The data suggest that larger businesses are more likely to export
Our analysis of data (see Figure 3) for a selection of OECD and other European countries shows that larger businesses do indeed tend to be more active in the export market compared to small and medium sized enterprises (SMEs). This makes sense as large multi-national businesses—particularly those in the manufacturing sector—tend to have widely spread production processes with components crossing various international borders as part of the growing prevalence of global value chains (“GVC”).
There are also other reasons why larger businesses are naturally more inclined to export, which include:
Easier access to international capital markets, which is important for funding working capital and capital expenditure, making them more cost-efficient and competitive in international markets; and
Economies of scale (possibly because of a patented product or production technique) which allow them to spread their fixed costs over a large volume of output.
Smaller businesses tend to be more focused on services which are less tradeable
But this does not give the complete picture. According to a policy brief by the OECD* , smaller businesses tend to be more active in the services sector which, in turn, tend to be less tradeable. This, however, is not an iron-clad rule. For example, in Cyprus and in Malta, most small businesses are focused in the tourism, travel and accommodation sectors, which are much more export-oriented. Similarly, the Mittlestand in Germany and Austria or the highly skilled engineering businesses in the North of Italy are highly export oriented businesses despite their relatively small size.
But technological changes are supporting growth in cross-border services activity
Despite the absence of a globally agreed set of standards for trade in services, rapid and sustained technological advancements have boosted services trade. The International Monetary Fund ("IMF"), for example, estimates that cross-border trade in services has grown steadily in the past forty years and now accounts for about one fifth of global exports.
The key sector that has led growth in cross-border activity here is the “modern services” sector, which covers activities that can be delivered at a distance including telecommunications, financial intermediation and professional services. The export outlook for these sectors continues to remain bright.
In conclusion, larger corporations are expected to be more active in the international trade space because of factors inherent in their size. SMEs, which tend to be more active in the services sectors, tend to trade less internationally (with the exception of some industries mentioned above), partly because international services standards do not yet exist here to the same degree as in manufacturing. However, technological change is making the selling of cross-border services easier over time, which should help more SMEs to export in these sectors.
*Small and Medium-Sized enterprises: Local strength, Global Reach, OECD (2000)
Personnel costs make up a significant component of business costs, while wages and salaries also make up a key source of consumer demand in the economy, so it is important to be able to predict wage inflation . Traditional economic theory suggests that as the unemployment rate decreases and the labour market tightens, wage inflation should pick up. This relationship is generally described as the ‘Phillips Curve’ after the economist (A.W. Phillips) who first documented this empirical regularity.
Higher wage inflation tends to feed through into higher consumer price inflation through both a demand effect (higher purchasing power for households) and a supply effect (higher cost base for businesses). In anticipation of this, central banks may start to raise interest rates in response to signs that unemployment is falling because they expect this will feed through into higher wage and eventually price growth.
Lately, however, economists have been puzzled by the state of the labour market in the UK and US, which seems to defy the above logic. In the UK, for example, the unemployment rate has fallen to just over 4%, the lowest level since the mid-1970s, but wage growth remains relatively modest. Is the Eurozone in a similar position?
Eurozone Phillips curve has gone lower and flatter
To answer this question, we have modelled the Phillips Curve for the Eurozone as a whole since the mid-1980s (see Figure 4). We find that the relationship between the unemployment rate and a proxy for wages in the Eurozone can be characterised by three distinct periods:
As can be seen from Figure 4, the relationship between the unemployment rate and wage growth has become much flatter in the 1999-2008 and 2009-2017 periods than it was in 1986-1998, when a downward-sloping, higher Phillips curve did seem to be in operation (albeit with significant variation around the line of best fit). As well as the flattening of the curve, we have also seen the Phillips curve shift downwards over time as wage growth rates have declined.
Structural factors help explain some of the movement…
A number of structural factors help to explain the downward shift of the Phillips Curve, some of which are common to most advanced economies. These include the gradual decline of unionisation over the period, partly driven by shifts in the structure of the economy and partly by policy changes (including privatisation). These changes reduce labour’s bargaining power and could contribute to flattening the Phillips curve. Similarly, the digitalisation of work through rapid technological change could be another contributor to the flattening of the curve, as a wider variety of work can now be carried out remotely, so making labour supply potentially more elastic.
…but the creation of the European Central Bank has also had an effect
However, what our analysis also shows is that the transfer of authority to set monetary policy from the national central banks to the European Central Bank (“ECB”) in 1999 has also had a material impact on the relationship between compensation and the unemployment rate. Specifically, our analysis suggests (see Figure 5) that two key events affected the Phillips Curve through the following channels:
What does this mean for the future? Assuming no further structural change, the above analysis suggests that labour market slack is unlikely to be the key driver of wage growth in the future. This makes other factors like structural changes to boost labour productivity growth rates more important in the future to improve wage growth prospects in the Eurozone.
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Economist, PwC United Kingdom
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