Theory: Central banks and inflation
The standard neoclassical model stipulates that the rate of inflation is determined primarily by the growth rate of the money supply, which is controlled by the central bank, while the rate of unemployment is affected by the level of real wages, and unanticipated changes in government policy (banks are conspicuous by their absence).
The core policy recommendation therefore is an independent central bank, competitive labour markets and stable government.
Making the central bank independent of political control increases the credibility that monetary policy will remain tight (overcoming time-inconsistency problems), thereby allowing wage-bargainers to lower their nominal wage demands, in the assurance that real wage gains are not lost to inflation.
The importance of this theory, although it is rarely stated as such, is that central bank independence matters because of its signaling, credibility and coordination effects.
Under these conditions, rationality alone leads actors to coordinate their behavior on an optimal equilibrium. From a political economy point of view, this assumption creates two obvious problems:
- It assumes unrealistically high levels of information
- It neglects collective action problems on how to coordinate behaviour
Institutions: the labour market
From a political economy perspective achieving coordination will depend upon an appropriate set of institutional arrangements; institutions that allow for credible commitments. Central banks are embedded in a much wider ecology of institutions and therefore independence alone is insufficient to improve employment outcomes.
Primarily, the institutions of wage bargaining can have large effects on economic performance. The coordination of wage bargaining refers to the agree to which unions and employer organizations actively coordinate the determination of wage settlements across the economy in response to monetary signals.
Wage bargaining is nested in 5 sets of interactions, or dyads:
- Between confederal organizations representing employers and employees
- Within these organizations between leaders and rank and file members
- Between organizations/firms across the economy
- Between organizations and economic policymakers
- Between monetary policymakers and fiscal policymakers
Free for all or coordination?
Imagine a scenario where wage bargaining is not coordinated (most countries today, particularly the USA), but conducted by many unionized units/firms acting separately. Each union will be tempted to seek an inflation increment (teacher unions).
Each unit does not think about the effects on the economy overall. They are not responsive to monetary threats.
Imagine a scenario where wage bargaining is highly coordinated (in decline in most European countries, but generally exists in core Eurozone countries). The lead bargaining unit knows that its settlement is likely to be followed by the whole economy, and therefore it internalizes concerns about inflation and unemployment.
It is highly responsive to monetary threats.
One important hypothesis emerges from the second scenario: countries with coordinated labour markets will have lower rates of inflation regardless of central bank independence. The impact of central bank independence is positive when wage bargaining is highly coordinated, and negative when it is not.
In the EU, most policymakers assume that the effectiveness of the high employment and low inflation scenario in Germany is the outcome of central bank independence. This is only one institutional feature, the other feature is it’s coordinated wage-setting regime.
The Confederation of German Trade Unions (Deutscher Gewerkschaftsbund, DGB) comprised eight unions with a total membership of 6,155,899 in 2011.
The two biggest unions under the DGB’s umbrella are the German Metalworkers’ Union (Industriegewerkschaft Metall, IG Metall) with some 2,245,760 members in 2011 and the United Services Union (Vereinte Dienstleistungsgewerkschaft, ver.di) with some 2,070,990 members.
Think about that for a moment, IG Metall organizes 2.3 million manufacturing workers in Germany, more people than the entire Irish workforce. Their power resources are central to the German “growth model”.
German employers and unions exert significant control over their membership via the resources that they provide to that membership: skill certification, vocational training schemes, and social insurance. For most of the post-war period the economy wide pay settlement is led by IG Metall, the metal workers union.
In the build up to EMU, non-coordinated market economies also had an incentive to coordinate their wage settlements. This gave birth to social pacts in Ireland and southern Europe, as a strategy to meet the Maastricht criteria.
Independent central banks are not a free lunch
The data tends to suggest that the more independent the central bank, the lower the inflation rate. The unemployment effects of increasing the level of central bank independence varies according to the degree to which wage bargaining is coordinated.
Or to put in another way: full employment does not lead to inflation unless trade unions are strong, and bargain for economy wide wage increases.
Hence – contrary to the assumptions underpinning the policy response to the Euro crisis – the unemployment costs of increasing central bank independence are not zero.
It depends on the degree of labour market coordination. Competitive market mechanisms are not sufficient to coordinate monetary, fiscal and wage outcomes, in the interest of employment performance.
Institutions such as collective bargaining, sectoral composition, trade unions, employer associations, the minimum wage, employment protection and various other issues pertaining to labour market governance should not be seen as factors that interfere with the market. They are the market. They constitute the market.
Central bank independence is only a “free lunch” in the European Monetary Union when combined with effective coordinated wage setting. This is very difficult to secure, and cannot be engineered from outside.
The broader implication is that monetary union has clear winners and losers, and a large part of this is related to the extent to which the labour market is coordinated.
Winners and losers
This institutional asymmetry and the distributive effects of the monetary union can be observed both between, and within, the core and peripheral member-states of the Eurozone. Those at the margins of the labour market bear the greatest cost.
Real exchange rate
Why did d the real exchange rate diverge in the first ten years of the Euro?
Höpner & Lutter (2014) provides a useful synopsis of the general causal mechanism: cheap credit = economic growth = NULC inflation = general price inflation = competitive disadvantage = current account deficit = sovereign debt crisis.
But what explains the heterogeneity in NULC inflation? The short answer is heterogeneity of European labour and wage bargaining regimes.
The Euro area, by definition, demands that countries develop an export-led growth model. Absent:
- Interest rate adjustment
- Exchange rate adjustment
- Independent fiscal polices
The only mechanism to stimulate and grow the economy is through the export channel.
In countries with low to medium tech manufacturing (Germany) this implies that countries must compete on the basis of wage-labour costs. CME’s in this regard have an in-built structural advantage.
Table 1 in Höpner (2014) is very revealing.
It confirms the argument that it was not the exposed sectors but the sheltered (public and construction) sectors were most nominal wage pressure occurred.
Germany also stands out as the one country where significant wage repression/compression occurred, fuelling wage competition.
The conclusion is that regime-type variables (i.e. not just economic and credit growth) have an independent effect on differences in NULC increases, and subsequently price increases, even after controlling for a battery of other explanatory factors.
Why does this matter?
Discuss: The interventions by the European Commission and the Troika push Southern European countries in the opposite direction to what makes Northern European countries successful.