Increasing wages sustainably

Improved productivity, coupled with tight macroeconomic policies which limit companies from passing on higher costs to consumers, are essential if economies are to afford much higher wages without fanning inflation.

With the Budget speech still fresh in most people’s minds, it is difficult not to pay attention to the business lobby and its various organisations complaining about higher wages. 

Joseph Farrugia, director general of the Malta Employers’ Association (MEA), claims that Malta “might be experiencing a wage-price spiral” and that MEA members says that wage inflation in their businesses over the past two years has been greater than inflation in Malta’s economy.  Not to be outdone, Silvan Mifsud, a council member of The Malta Chamber, has written about wages “feeding the inflation monster”.

For the uninitiated, a wage-price spiral is a situation in which the higher cost of living leads to workers demanding higher wages which, in turn, forces businesses to up their prices to keep up with costs. This would mean that inflation in Malta would not only be caused by external factors – such as increased shipping and importation costs – but also by the internal dynamics of the labour market.

Now, it is true that, empirically, tight labour market conditions are closely associated with higher wage growth.  There is no doubt that the labour market has been tight and that employers have had a challenge finding workers, especially for certain skilled and professional occupations.  It is only to be expected with an economy still growing at above-Eurozone average.  One also has to admit that the situation has been made worse by the effects of an ageing population, though this has been mitigated considerably by the increased labour force participation rate induced by the incredibly-successful Making Work Pay scheme.

Whether real wages will continue to adjust through lower inflation or through faster wage growth hinges on the underlying conditions in the labour market and their prospects. Short-term wage pressures could well combine with a continuing longer-term tightness in the labour market to stoke inflationary pressures.  But is it fair to blame it all on workers?

The wider, European picture

The backdrop in Europe is instructive.  After two years of falling purchasing power, it is not surprising that Europe’s workers have been pushing for more pay. Nominal wages rose by 4.5% in the euro area and more than 10% in other parts of Europe in the first half of 2023. Higher wages help alleviate cost-of-living pressures and support economic expansion.  There is no doubt that Europe’s economic recovery has been getting a much-needed boost from rising wages and higher incomes.

Wage growth has differed across countries. Across much of Europe’s advanced economies, wages have further to rise before they catch up with prices, meaning that pressure for pay rises is likely to persist. In Central, Eastern, and South-eastern Europe, wage growth has been more rapid and kept up with prices.  The catching-up process was particularly needed in the lowest-pay categories, which have seen their incomes severely dented.  The box figure shows how the ratio between minimum and average wages in five EU Member States has declined between 2015 and 2019 and 2023.  Malta had the second highest decline, with some 6%.

Pressure for higher wages unlikely to ease

Wage pressures are unlikely to subside any time soon.  As a chart from the IMF shows, longer-term trends are already squeezing labour supply (total hours worked).  Demographics and shorter working weeks mean employers face fierce competition to find qualified workers and must pay more to retain them.  Malta will be no exception.

Over the past decade, Europe’s labour force participation grew relatively rapidly. Even if this trend continues, the labour supply could decline by 0.1% annually over the next five years as the population ages, population growth slows, and the shortening of working weeks continues.  Again, we can expect this in Malta.

How labour cost has evolved

But back to whether what has been happening in Malta is exceptional: the following chart shows how labour cost (compensation of employees plus taxes minus subsidies) has evolved in Malta since 2008 compared to overall inflation.  While inflation in Malta has followed more or less the same trajectory as in the rest of the EU – though somewhat higher during most of the period – nominal labour costs have differed considerably.

Based on an index with 2008 as the base year, nominal labour costs in the EU have risen by 40% while those in Malta have gone up by just half the EU rate.  One other distinctive feature was the constant rising trend, though with an occasional slow-down, in the EU.  Compare this to stagnation in Malta’s rate between 2008 and 2012, a steep rise between 2012 and 2016, then an almost equally steep decline up to 2021 followed by an uptick to 2022, which still leaves labour costs below their 2016 level.

Why?  Apart from the effects of the Covid pandemic, there is absolutely no doubt that the main reason has been the importation of cheap labour as the foreign component of the population increased from 3.4% in 2008, up marginally to 4.8% in 2012, then through 10.4% to 20.0%-20.6% between 2020-2022.  In looking at these figures, it is necessary to keep in mind that wage growth lags behind other economic changes, so it is no surprise that the decline in labour costs between 2016 and 2021 followed the sharp increase in the foreign population component by four years. 

What’s in store?

In view of the recent high inflationary pressures, as well as continuing tight labour market conditions, nominal wage growth is projected to be relatively strong from a historical perspective. According to the Central Bank of Malta, compensation per employee is set to grow by 5.5% in 2023, 5.7% in 2024, and 3.9% in 2025. Indeed, this will outpace consumer price inflation during the last two years of the projection horizon as consumer price pass-through to wages is projected to occur with a lag.

Moreover, a persistently negative employment gap implies that labour market tightness will remain a factor that could limit economic growth going forward, albeit less than before. This easing of labour market tightness should also dampen upward pressure on wages by 2025.

Mind the gap

Rather than the rise in wages themselves, what I personally am worried about is the gap between wages and productivity.  In the past, rising wages in south-eastern Europe, including Malta, had been mitigated by high productivity growth.  Today, it is weak. That means further high pay rises would chip away at competitiveness.  However, improved productivity, coupled with tight macroeconomic policies which limit companies from passing on higher costs to consumers, are essential if economies are to afford much higher wages without fanning inflation.

The scope to offset these labour market trends is limited.  Both the Government and the Opposition, that agree about nothing, are opposed to a further increase in retirement age – just like they oppose any increase in social security contributions, even though pension system sustainability might indicate otherwise. There is also little scope to increase average working hours because shorter work weeks are gaining popularity.  Some are even mentioning a four-day week.

What can policymakers do? There is a fine line between aiding economic recovery and banishing stubbornly high inflation.  The European Central Bank must watch for upside risks to inflation and closely monitor wage settlements and their consistency with productivity trends. A marked divergence would be worrisome. The mix of monetary and fiscal policy should remain appropriately tight to bring inflation back to target.

At the same time, structural reforms to increase productivity are becoming critical. Doing so would both lower inflationary labour-market pressures and raise longer-term economic growth potential. Boosting the labour supply by allowing workers to work more hours, making it simpler to transition between jobs, equipping new generations for future jobs, reskilling workers, and facilitating the integration of migrant workers all have an important role to play.

The Government has introduced various incentives to encourage pensioners to remain in the labour force or to entice them back to it.  But they are not enough.  Similarly, some enlightened employers have extended greatly enhanced flexibility in working hours to their employees, but overall much remains to be done.

Structural policies should play a complementary, but increasingly important role, especially where long-term trends indicate a risk that real wages risk will drift above productivity.  Here, emphasis should be placed on policies to enhance labour productivity and labour supply. Policies could include upskilling the existing labour force to facilitate worker transition from declining to growing sectors.

Rather than reducing foreign workers, like the Opposition would have us do suicidally, we need better integration of immigrants through language training while job search support would help labour supply. The recent Government initiative on a skills card is welcome, though some employers again incredibly objected to it because it costs them something!

Eliminating disincentives for full-time employment, including by further reductions in tax burdens that discourage individuals from working full time as second earners, would increase the effective labour force participation rate and thereby raise labour supply. The labour supply could be further expanded by promoting higher participation among female workers by securing for them increased flexibility in work arrangements and equal opportunities for career advancement.

Finally, policies that can help engineer the reversal in the secular decline in productivity growth are needed, which would also help accommodate higher wages without undue pressure on prices.  Here, the Government is failing and needs to grab the bull by the horn, together with the social partners.

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