1. The International Wage Flexibility Project Presentation at ECB Watchers Conference, Frankfurt June 3, 2005

2. What is the IWFP? 13 Country study of wage inflation supported by the ECB and directed by Erica Groshen (NY Fed.) and me using micro data on individual and occupational wages analyzed by teams in each country familiar with the data broader than analyzing wage rigidity (sand and grease), but that is the part that I’m going to talk about today

3. Country Teams Austria Belgium Denmark Finland France Germany Italy Norway Portugal Sweden Switzerland United Kingdom United States

4. Disclaimers Preliminary results! Mainly based on European Community Household Panel data which is quite noisy. My views only (not the views of the ECB, Brookings, or any other members of the IWFP project team).

5. Point of Departure In 1994 growing interest in targeting “price stability” (zero inflation) as the sole goal of central bank policy. Akerlof, Dickens and Perry (1996) showed that the combination of dispersion of wage changes and resistance to nominal wage cuts (DNWR) produces a long-run trade-off between inflation and unemployment at low rates of inflation. According to that model, targeting too low a rate of inflation could increase unemployment by a full percentage point or more.

6. Questions Could DNWR be an explanation for Europe’s persistent unemployment problems? While ADP model fits very well for US and Canadian data it fits very poorly and gives nonsensical results when applied to European data. Is the model appropriate for Europe? Some studies done in Europe (notably UK) show much less Downward Nominal Wage Rigidity than US and Canadian data, so is DNWR a problem in Europe? Alternatively, do more centralized wage setting institutions lead to more real and less nominal rigidity in Europe?

7. How Could We Answer Questions? Initially we were unsure about how to get at presence of different types of rigidity. At first meeting some very interesting results emerged examining wage change histograms.

9. Belgium

11. UK

12. Can we use wage change histograms to diagnose nature and extent of wage rigidity?

14. Big Problem is Measurement Error If people make mistakes reporting their wages then we see wage changes where there are none. If we compute wage=income/hours we see “wage” changes due to overtime, bonuses, or mistakes in reporting hours. If we use social security data we have similar problems since almost no country has data that allow us to accurately identify base wage. All evidence suggests that for most data sets frequency and extent of errors make this a very serious problem (evidence suggests that in many data sets most reported wage cuts are actually errors of these sorts).

15. Validating New Error Correction Method We have developed new method for correcting for errors in wage change distributions. Results applying new method to US largely fit with those of other studies (a very high degree or downward nominal rigidity). Finnish data has virtually no errors and correction procedure leaves it virtually unchanged. Portuguese have good and bad data and (as we will see) the correction doesn’t change the good data, but makes the bad data look like the good data.

16. US PSID Error Correction Model

17. Finland Service Sector

18. Portugese Data

19. Some Preliminary Results Caution is warranted. These are preliminary results from the ECHP and US PSID and (if I have time) summaries of those presented at our conference last June. Method used to determine expected inflation for estimates at conference didn’t do a good job so rigidity estimates are noisy (problem fixed in new analysis coming in now). ECHP data very noisy compared to other data we are using in this project. Requires lots of correction. Rigidity estimates derived from estimating parametric model of wage change process using estimated true wage change distributions as data. Good news is that where we have both country results and ECHP results, rigidity measures are similar.

20. From ECHP and PSID

22. (ECHP)

23. (Full Sample)

26. (Tentative) Conclusions For US, new method confirms results of previous studies – significant resistance to nominal wage cuts (DNWR). New finding is that there is little evidence of resistance to real wage cuts -- particularly after 1982. In contrast, there is substantial evidence of resistance to real wage cuts (DRWR) in many European countries. Countries that have considerable DNWR show less evidence of DRWR (some suggestion that more centralized wage setting produces DRWR and reduces DNWR). EMU has both types of countries in it. Nearly all countries show some evidence of some sort of wage rigidity.

27. (Tentative) Implications While U.S. and Canadian central banks can reduce equilibrium unemployment by maintaining moderate rates of inflation, ECB may not be able to have same effect in countries without substantial nominal rigidity (including France, Belgium and, Germany). However, should ECB allow inflation rates to fall much lower, countries with substantial nominal rigidity could begin to experience significant increases in equilibrium unemployment.

28. More (Tentative) Implications Further, theoretical models of the effects of both downward nominal and downward real wage rigidity suggest that employers’ ability to circumvent wage rigidity through manipulating benefits, freedom to pay for performance (rather than giving across the board wage increases), and to hire and fire at will, are important for minimizing unemployment effects of rigidity when present. Combination of these procedural rigidities with downward wage rigidity could require higher rates of inflation to obtain lowest sustainable rates of unemployment in countries with nominal rigidity and high rates of productivity growth in countries with downward real rigidity.