What if all wages went up by inflation?

Good morning from New Economy Brief.

Almost all Belgian workers have their wages automatically uprated by the rate of inflation, which ensures their standards of living are maintained and not eroded by rising prices.

Critics of the scheme argue that this should have produced a wage-price spiral…but it hasn’t. In fact, inflation in Belgium is dropping faster than many other economies. Why?

In the context of ongoing public sector strikes across the UK and slightly better than expected inflation figures last week, this week’s New Economy Brief looks at the system of wage indexation in Belgium and draws some lessons for the UK government.

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Belgian workers are insulated from the rising cost of living. Despite wages being eroded by inflation across the world, Belgian wages have been the most resilient across the OECD. Real wages have actually risen by 2.9% in the first quarter of 2023, where the OECD average was a 3.8% fall. This is due to Belgium’s unique system of wage indexation, which protects workers pay packets from any rise in inflation. Critics say this will lead to a wage-price spiral, but this is yet to materialise - in fact, CPI inflation in Belgium has been falling much faster than comparable economies this year; inflation peaked at 10.3% last year, and the European Commission forecasts it to fall to 3.4% in this year. What’s going on here?

How does indexation work? The Belgian system of wage indexation insulates households from inflationary shocks and shifts the burden of adjustment to firms and the government, as employers and the state are legally mandated to uprate public and private sector salaries. Since 1996, the Law on the Promotion of Employment and Maintaining Competitiveness obliges ‘social partners’ to negotiate salary increases over a two-year period within the bounds of an upper limit set by anticipated hourly wage developments in key export markets (France, Germany, the Netherlands) and a floor determined by expected inflation in Belgium. A good explainer on wage indexation systems by UNI Europa explains that nearly all Belgian workers have some form of automatic wage adjustment to account for inflation due to the almost 100% collective bargaining coverage rate and state-facilitated sectoral bargaining.
Inflation triggers automatic increases in wages. Wages are linked to inflation by a ‘health index’ - a calculation of the price of a basket of goods that excludes energy and unhealthy consumption items like tobacco and alcohol. Whenever a 4 month moving average of the health index increases by 2% or more, all public sector wages, most private sector wages, pensions and social security benefits are uprated by an equivalent amount.
Stronger purchasing power has bolstered Belgian growth. Wage indexation has led to a more resilient economy in Belgium, as it “cushions the blow of higher prices on the purchasing power of consumers to a considerable extent” in the words of a recent paper by the International Monetary Fund. The European Commission also reports that: “Economic growth in Belgium is expected to reach 1.2% in 2023 and 1.4% in 2024, on the back of resilient private consumption… The automatic indexation of wages and social benefits is set to continue to contribute to maintaining the purchasing power of households, especially as headline inflation is projected to substantially slow down”.

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Why hasn’t it led to a wage-price spiral? Critics warned that indexation would lead to wage-price spiral, where consumer prices and nominal wages rise simultaneously as firms are forced to put up their prices to maintain profitability, triggering a ‘second-round’ of inflation, further rounds of automatic wage indexation and thus spiralling prices. But analysts from Belgium’s central bank found that “Interestingly, markups appeared to play no role in driving up prices and in fact decreased or even offset the contribution of wages…To keep inflation under control, profits and/or wages should rise at a rate lower than overall price increases, and at least one side must be willing to accept a decline in purchasing power.” As the Belgian wage indexation system requires companies by law to increase wages, companies’ profits were forced to take the hit. “We however found that even in a country with automatic wage indexation, the profit-wage dynamics did not fuel prices increases in 2022.”

International competition prevented firms from hiking prices. The answer lies in the highly competitive nature of Belgium’s export-led economy - where exports account for one of the highest proportions of GDP in the world. Belgian economist Henri Bogaert explains that “companies exposed to competition, and in particular international competition, cannot pass on this double increase in production costs [wages and energy prices] in their selling price, since the latter is, by definition, constrained by the prices charged by international competitors”. Essentially, export-oriented firms had to keep prices stable to maintain their market share, which cut into profitability but limited the second round effects of inflation.
But profits are still high. However, this has not led to a large reduction in profits. 3.95% of the 8.2% inflation in 2022 was still due to ‘unnecessary price hikes’ to finance the profit margins of companies (between €35-40bn over 2021-22), costing the average Belgian €3,200 over the past two years. In fact, a group of Belgian economists wrote to the countries’ business press arguing that 60% of energy intensive firms with the ability to protect their margins (due to their inelastic products) by passing on the increase in costs to their customers should reduce their excess profits by increasing wages further. The Belgian central bank also argued last year that “the impact of energy was ten times greater than the impact of wages on business costs”.

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Takeaways for the UK economy. As governments, central banks and businesses in the UK and other countries continue to argue that increasing wages risks stoking inflation further, Belgium’s system of automatic wage indexation is an important lesson for the debate on the risks of wage-price or profit-price spirals. Since the UK already has some limited semi-indexation - of social security payments through benefit uprating, the minimum wage through the Low Pay Commission, and full indexation of the state pension via the ‘triple lock’ - is embedding wage indexation into collective bargaining agreements the logical next step for making households, workers and the economy more resilient to inflation?

Increasing UK public sector pay won’t fuel inflation. A timely report from IPPR finds that “Contrary to claims made by the government and others, a real-terms pay rise for public sector workers would not meaningfully increase inflation”. Authors Joseph Evans, Carsten Jung, Henry Parkes and Pranesh Narayanan explain that public sector wages do not feed into pricing decisions of public services, and therefore can’t ‘pass on’ inflation into the rest of the economy by ‘second-round’ effects, and that there is no evidence that public sector pay growth puts upward pressure on private sector wages either, pointing to the Treasury’s own analysis. They calculated that an additional stimulus of £7.2bn in 2023/24 to increase public sector pay by 10.5% would not stoke inflation, especially if funded through taxation, but even if it was financed via borrowing.
But it could solve many problems in the economy. Even if public sector workers receive a 6% pay rise on average, they will still be £1,400 worse off this year in real terms than before the pandemic. But “a stronger pay settlement would help to address four problems facing the public sector: declining living standards, a workforce crisis, the decreasing quality of services and the reality that pay for the UK’s public sector workers lags behind our international peers” argue the authors. Increasing public sector pay in the NHS in particular is likely to help ease labour shortages there but also in the private sector due to the rise in long-term sickness.‍
Labour market architecture. Finally, it is worth pointing out that implementing large-scale wage indexation outside of the public sector in the UK would require the creation of new labour market institutions. The UK lacks the tripartite labour market structures that exist in Belgium and many other European countries and which bring government, unions, and employers together. The calls for sectoral collective bargaining from unions, some of which have been adopted in Labour’s New Deal for Working People, would be a step to recreating these institutions and bringing more workers under the umbrella of collective wage agreements.

Weekly Updates

Inflation and climate change

Climateflation. The UK is “particularly vulnerable” to the inflationary effects of climate change, argues the New Economics Foundation’s Chaitanya Kumar, highlighting that we roughly import 50% of our food including 84% of fresh fruit. Kumar argues that current policies of freezing foreign aid and central bank interest rate hikes “fail to address the bigger picture” and instead calls for “domestic resilience to food price volatility” and “greater international solidarity”.

Regulation

The disaster of deregulation. ‘Tory deregulation’ explains a lot of the country’s woes and why things in Britain are now “a bit shabbier” and why “nothing works”, argues Progressive Britain’s Tom Collinge. A new paper from Progressive Britain finds that one in four regulatory impact assessments are rated “not fit for purpose” by their own watchdog and puts forward proposals for regulatory reform.

Tax

Wealth taxes to combat inflation. Raising taxes for wealthier people is a better method to curb inflation than raising interest rates “which ultimately hurts workers”, argue top economists. Dame Kate Barker, who has previously been a member of the Bank of England’s monetary policy committee, called for “better coordination between monetary and fiscal policy” and argued that raising taxes would allow “the pain that we have to take” to be “more evenly spread amongst different groups of people.”

Labour and inheritance tax. With scrapping inheritance tax “back on the Tory agenda”, Labour should defend the policy and “not be timid” in the face of the country’s “regressive tax system”, argues author and academic Stewart Lansley. “Labour should take the lead and make the case that taxes on wealth need to be raised”, Lansley also said.

Inequality

Should Labour embrace social mobility? A new paper published by the Social Market Foundation think tank explores the political and rhetorical issues with the “relatively innocuous concept” of social mobility. Critics argue that social mobility does little to tackle inequality. SMF’s Aveek Bhattacharya argues that “rather than returning to social mobility as a goal, an alternative way forward is to embrace a conception of equality of opportunity as valuable for self-realisation, emphasising the value of every individual having a better chance to realise their potential, whether or not that moves them up the social hierarchy”.

Paradigm shift

Economic security. Economic security is a “foundation for dignity, opportunity and hope in an age of uncertainty”, argues the Joseph Rowntree Foundation’s Graeme Cooke in a new report which explains how the frame of economic security speaks to “an age of uncertainty” and appeals “across the ideological spectrum”. A policy programme focused on economic security would entail “far-reaching social reform”, “with the aim of increasing people’s control over key aspects of their lives” and would “respond to immediate, everyday concerns, while also confronting longer-range shifts that have undermined the foundations of security for many households”.

Public services and social security

Early years education “pays for itself”. “High-quality, universal early years education is likely the highest-returning investment a government can make:”, argues the New Economics Foundation’s Jeevun Sandher and Thomas Stephens. The new analysis finds that “universal, high-quality early years education will lead to greater growth and tax revenues in the short and long run. In the short run, early years education raises maternal employment and wages, and so tax revenues. In the longer run, an increase in child skills, productivity and wages will lead to growth.”

‍The impact of Universal Credit sanctions. A new report by Citizens Advice’s Kate Harrison finds that the sanctions rate for those on Universal Credit has doubled since before the pandemic, with young people and men the most likely to be sanctioned. It also finds that “94% of people sanctioned in the last six months have had to cut back, borrow money, seek crisis support and/or go without essentials”.