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Recently I've seen some statistics about wage growth in the European Union in the last 30 years and surprisingly, Italy is the only country with a negative value. So, what is the root of this problem? And how should Italy try to solve the issue?

Some economists argue that since inside the Eurozone the country can't devalue its currency like it was done with the Italian Lira, to regain competitiveness the only remaining tool is to cut wages, as reducing taxes is impossible due to the government budget deficit rules imposed by the EU and the high public debt. Others say that employees are too few skilled. What is true about these statements?

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Source of the plot: https://europa.today.it/lavoro/italiani-stipendi-inferiori-1990.html

Edit: the data on the plot probably come from OECD https://data.oecd.org/chart/6wIK

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There are several reasons for this.

Stagnant Labor Productivity

First, the wages are typically highly correlated with labor productivity (Strauss and Wohar, 2004). This should make intuitive sense, since marginal labor productivity ultimately should determine the wage in competitive markets. If an employee produces 1000 euro worth of product every month profit maximizing employer would not want to employ that person for wage larger than 1000 euro.

Now, real world markets are often imperfect, so as Strauss and Wohar (2004) show in their cross-country empirical estimation relationship between wages and productivity, typically productivity grows faster than wages. Nonetheless, the fact remains that wages are highly correlated with labor productivity, even though the increases in labor productivity are associated with less than unity increase in real wages.

Below, you can see that labor productivity growth in the Italy was very almost non existent. Except for a jump up and down in 2020-2021, which is a statistical artefact likely caused by the covid lockdowns, you see the Italy's labor productivity growth is often low and often also negative.

Consequently, one would not even expect real wages to increase in the Italy over last 30 years.

enter image description here

Stagnant Productivity in General

Next, wage increases are also often highly correlated with total factor productivity (i.e. productivity of both labor, capital etc), as there is some evidence employees can capture some rewards even from increases in productivity of other factors (e.g. see Hornbeck and Moretti 2019). This is because capital has to often be combined with workers in production, so even increase in capital productivity only might increase demand for workers. So it is also worth while to examine total factor productivity.

However, in Italy total factor productivity actually declined between 1990s and now. Given this it is actually not a puzzle that the wages in Italy are stagnant (it would be more surprising if they were increasing).

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Adoption of Euro

Italy has a competitiveness problems (as demonstrated above). When a country is unproductive it can only stay competitive by either offering lower wages, or pursuing more loose monetary policy that let's exchange rate depreciate.

Now both of these strategies reduce purchasing power of the worker, but typically the second strategy is not as punishing as the first one.

However, once Italy adopted euro, it essentially locked itself into fixed exchange rate regime with all other Euro-zone members. Given that many other Euro-zone counties like Germany, are getting more and more productive over time, without flexible exchange rate the only thing that Italy can do is to suppress its wages.

Too Much Austerity

Italy's fiscal policy is very restrained. This on one hand is not surprising given the enormous level of debt that Italy has (which reduces its fiscal space). Italy still has the largest debt in the euro-zone even though covid-19 made some Euro-zone countries to almost catch up with the Italy. In addition, due to euro, Italy cannot easily just monetize this debt (at a cost of inflation) because they do not anymore control the monetary policy.

However, fiscal restraints tends to suppress economic activity which further supresses wages. As you can see from OECD data Italy's spending as % of GDP contracted.

Now to be clear, I am not making here any judgements. One can debate whether this restraint was necessary because Italy's public finances are unsustainable and government was spending already too much or that it was self-inflicted unnecessary wound because maybe Italy's economy has primarily aggregate demand problems not supply ones. However, from macroeconomic perspective a fiscal contraction will shift aggregate demand to the left and put downward pressure on prices (as well as increase unemployment) in the short run.

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I believe the 4 points above should be able to explain most of the real wage decline in Italy.

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  • $\begingroup$ Hi I check the FED data of your first labor productivity argument and it is weird. This measure shows the similar pattern for other countries like US, Japan, German when selecting index. Maybe it's better to show the growth rate of this indicator which has Italy lower than US for most time? Or maybe a yearly data of the OECD databse is a better choice? $\endgroup$ Nov 18 at 0:39
  • $\begingroup$ @Alalalalaki hi, yea you are right now that I am looking at it there is something weird about it. Well I will replace it with productivity growth. Looking at the data I think maybe selecting index in that dataset just made index for growth not for the actual numbers $\endgroup$
    – 1muflon1
    Nov 18 at 0:53
  • $\begingroup$ @Alalalalaki I just put the growth of productivity there, thanks for suggestion $\endgroup$
    – 1muflon1
    Nov 18 at 0:58
  • $\begingroup$ Also some other European countries follow the same productivity trend, but Italy seems the only nation to have such a pressure on wages. shorturl.at/xFPZ5 $\endgroup$
    – Claudio
    Nov 18 at 13:27
  • $\begingroup$ @Claudio but those countries are Greece Portugal Czech Republic etc. there wages already are very low to begin with. Wages in Czech Republic are less than half of that in Italy. If both Czech Republic and Italy have the same productivity level, suppose that average worker produces 1000 EUR worth of G&S per month and in CZ wages were 500 EUR and Italy 1500 EUR you would expect Italy’s wages to drop to 1000 and Czech wages to increase by 500. $\endgroup$
    – 1muflon1
    Nov 18 at 13:33

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