Meanwhile, in Europe….(17). Price levels, wages.

from Merijn Knibbe

Eurostat has published new data on price levels in the EU:

1. Price levels in the EU vary between 51 in Bulgaria and 143 in Denmark (EU = 100). Life in Denmark is almost three times as expensive as in Bulgaria. In graph 1 these price levels are compared with wages per hour – a surprisingly tight relationship. (see below for technical information).

Graph 1. Wages and the price level, twenty European countries  Source: Eurostat

1. Interesting. Does this mean that higher wage increases necessarily mean inflation? That higher wages do lead to a higher price level! No. At least, not according to modern economic statisticians and Austrian economists (well, economists from Austria who later became Austrian economists).

a. Economic statisticians work with ‘hedonic’ prices, which take account of changes in quality and preferences of consumers. Only price changes not due to changes in quality and the like should be considered ‘real’ inflation or deflation.

b. Economists like Von Mises and Karl Menger already made this distinction in 1912, the difference between the ‘inner’ and the ‘outer’ value of money:  not every increase of the price level is inflationary. The ‘outer’ value was influenced by price changes due to changes in quality and preferences of consumers and changes the class structure of society. Only changes in the ‘inner’ value of money should be considered real inflation or deflation. To quote “Ludwig von”: “Mit welchen Einkommenstypen der Vergangheit sollte etwa die des modernen Proletariats verglichen warden? … Es ist leicht moglich, ja sogar hochstwahrscheinlich, das die subjektive Wertschatzung gleicher Realinkommensteile im Laufe der Zeiten gewechselt hat. Veranderungen des Geschmackes, der Ansichten uber den objektiven Gebrauchswert der einzelnen wirtschaftlichten Guter  trugen hier schon in kurzeren Perioden ganz ausserodentlich grosse Schwankungen hervor. Nimmt man bei der Beurteilung der Veranderung des Geldwertes dieser Einkommensteile daurauf keine Rucksicht, dann ergeben sich neue Fehlerquellen” (Theorie des Geldes und der Umlaufsmittel, Munchen, 1912, p. 2). Translation of the last sentence: “When you do not take these changes in income and the class structure of society in consideration when analysing/weighing in  changes in the exchange value of money, new sources of errors will appear”.

b. An example: when new houses become more expensive as they are larger and better insulated this should not be seen as an inflationary change in prices. When new houses however become more expensive because the government turns a blind eye to ever more reckless lending and Mickey Mouse Mortages, more money is chasing the same houses (sorry: land) and this might show up as either a unsustainable building boom or as an inflationary rise in prices. Note that it took about sixty years before new houses in the Netherlands were as large and well build again as in the twenties and thirties of last century: not all quality changes are improvements

2. Nice, but has this anything to do with wages? Surely. When increasing productivity or changes in the structure of demand lead to higher wages, this should not be seen as an inflationary increase of the price level. Remember: labor in a modern capitalist economy is, according to Marx, a market product, a ‘commodity’ – and one hour of labor in Sweden is a different commodity than one hour of labor in Bulgaria

3. So, wage inflation does not exist – higher wages should not be seen as inflationary as they reflect higher productivity, a change in quality! No, that’s too simple. Productivity driven wage increases should not be seen as an inflationary, even though they do increase the price level.

4. Interesting. But why is this important? It’s important because wage and price levels in the Euro area are quite different (graph 1) and an increasing amount of low wage countries have joined the Euro-club (Slovakia, Slovenia, Estonia, Cyprus, and Malta, totaling about 10 million inhabitants). And Poland and Romania with their fifty million inhabitants might. As productivity and wages in these countries rise much faster than in the Euro-core countries, this will mean that the average Euro-area price level will increase faster. I.e.: inflation as we measure it will increase. This is a new kind of problem for Central Banks, though comparable problems have to exist in the USA, India and China..

5. So, the ECB has increased its inflation target because these low wage countries joined the Euro-club? No, of course not. The ECB has a very limited grasp of the concept of inlfation.

6. But it should? What they really should do is to target another inflation rate, which is more indicative for the ‘inner’ value of money. A ‘hedonic’ GDP deflator, or something like that. Core inflation minus 0,6*(the increase of labor productivity) might do the trick, this 0,6 amounting to the share of labor in total income while core inflation excludes changes in the outer value of money due to changing energy prices and the like. At the moment, this indicator runs at about 1% in the EU – and is maybe even negative in Poland! In other times, it might be higher than headline inflation.

Technical addendum: as the Eurostat data on hourly wage rates are lacking for many countries post 2007 (and for some even in 2007), I compared 2010 price levels with 2007 wages – a bit messy, indeed. More recent data will probably show an even tighter relation. The price level information: http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-28062011-AP/EN/2-28062011-AP-EN.PDF