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The economies of the Euro zone are on the verge of deflation. Prices are falling because demand is weak and the European Central Bank (ECB) is rightly worried about that. Deflation means that the real debt burden increases. Thus, households and firms with lots of debt will find it harder to service their debt because their current income is falling. If firms expect falling prices in the future, it makes sense to postpone investment, which dampens today’s aggregate demand. Once deflation gets hold, it may be difficult to reverse and Europe, like Japan, could be in for a decade or more of stagnation. But the fear of deflation also illustrates the futility of Europe’s strategy of structural reforms and competitiveness.

Indeed, what is the orthodox remedy to Europe’s crisis? Structural reforms! We are told we need a more flexible labour market, a lower minimum wage, and less job protection in order to gain competitiveness: a strategy of wage cuts. “If there is a crisis, it must have been because wages were too high! The answer to demand deficiency is foreign demand!” This is what Germany, the European Commission, and the ECB are telling the countries in crisis. This argument is absurd, its economic reasoning is flawed, and its consequences are potentially disastrous.

The absurdity of this argument is the following: the prescription to increase labour market flexibility is ultimately to increase competitiveness via wage suppression. If successful, i.e. if firms pass on lower wage costs, this implies falling prices. In other words: deflation. So if orthodox economics were correct, deflation would be a sign of success, not a problem. We are gaining competitiveness, finally! Worrying about deflation only makes sense if ultimately the economy needs domestic demand to ignite growth. It is an admission that orthodox economics are not working.

The remedy, however, is not working well before the point where prices are falling and the lesson to be learned is a more general one. Cutting wages has complicated effects on aggregate demand. It will reduce mass income and therefore consumption expenditures of wage earners. It may increase profits, which can stimulate investment. Finally, it will increase net exports because of improved competitiveness. The question really is how big these different effects are. Consumption is the largest component of aggregate demand and has a relatively close link to wage incomes. Investment is a small, but relatively volatile part of demand. In times of crisis, firms worry about being able to sell their products, not primarily about wage costs. Finally, the effect of wages on net exports depends on the degree of openness of the economy. A small open economy can export its way out of a crisis, while a large and relatively closed economy cannot. For the Euro area, the consumption effect is larger than the investment and net export effect. This effect is modest in size, but statistically significant. Most importantly, it goes the opposite direction from what orthodox theory would suggest. That is the case even before we enter deflation. Higher wages are good for growth in the Euro area.

A robust growth model requires solid growth of domestic demand. That is only possible if there is stable wage growth such that households can spend on consumption. Otherwise growth has to rely on foreign demand or on increasing debt. Healthy wage growth is part of the solution, not a problem.

“Healthy wage growth is part of the solution, not a problem.”