Why wages fell and profits surged

To those who actually buy stuff this may not seem like a groundbreaking insight, and yet for the past nine months, the European Central Bank (ECB), responsible for keeping prices level, has increased interest rates, making it even harder for people to buy things, while letting corporate profits — the main driver of current inflation — off the hook.

Higher borrowing and mortgage costs put further pressure on disposable income, which despite massive government support schemes — estimated at €800bn in 2022 alone — fell by 2.9 percent in the EU last year; 6.9 percent in Greece and 3.1 percent in Germany, where it fell for the third year in a row.

The question is, why? Why do we suppress wages while letting let profits rip? To put it in historical perspective: in the 1970s, nearly 70 percent of economic output in Europe went to employees, with just over 20 percent going to profits. Now, labour's share stands at 56 percent with a third going to profits.

To discuss this, EUobserver sat down with Mark Blyth, author of the book Austerity: The History of a Dangerous Idea and professor of international economics and international affairs at Brown University. He is also one of the most lucid (and fun) deconstructors of economic thought out there.

EUobserver: It seems that whenever something goes wrong in the economy, wage earners have to pay the difference. In the austerity years of the 2010s, wage suppression was meant to fix government deficits. Fast forward to today and its central banks that are restraining wage growth out of fear, it would drive up inflation even further. How come?

Mark Blyth: It's a fantastically interesting topic. Wage restraint is kind of hard-wired into EU policymakers. One bump in the road, and it becomes the reflex. So the present question is, why? Let's be clear: there is zero evidence of a wage-price spiral. But we have seen some, by conventional standards, hefty pay increases.

Now, here's the thing: the European business model relies on real wage restraint for competitiveness. So what the ECB is worried about is that people expecting further inflation will start to demand even more pay raises, which would knock inflation expectations forward and become self-fulfilling.

Makes sense?

The expectations story is bollocks. Ordinary people don't pay any attention to the inflation outlook of central banks. If you give a person on the street a list of names and ask who runs the US Federal Reserve, most people will probably name Nancy Pelosi. So the notion that we're all just sitting around waiting for signals from the central bank is bloody ridiculous.

'The EU is a disinflation machine designed to drive exports'

The real wage growth rate in the EU has been lower than in the US for over a decade. Why is that?

We spent 40 years building the EU architecture. Inflation comes right to the heart of the European model. The EU is a disinflation machine designed to drive exports. That's the beast. That's what it is. If you're going to be competitive in this way, your inflation tolerance is much lower than in a large consumption-driven economy like the US.

How so?

Wages are not a driver of the EU economy. External demand is. Northern countries in the EU are importing demand from abroad. The last thing Germans want is demand growing at home because if demand goes up at home, wages will go up, costs will go up, and suddenly their BMWs are more expensive. The Dutch are the same: a giant financial parasite in the north of Europe. Their external surplus shows up as internal deficits on Italian, French and Spanish budgets who buy all their stuff.

Europeans are worried about the US outcompeting them on clean technology with the Inflation Reduction Act—which includes a large green spending package. The US barely gave the effects on the EU a second thought. What does that tell us about the difference between the US and the EU?

The EU talked itself into a situation where cost competitiveness is the only thing that really matters, and debt is always a problem because it drives up domestic demand.

The paradox is the EU is serious about decarbonisation in a way the US isn't. The planning is deeper. The institutions that are needed actually exist. The problem is the EU itself. It is a monetary union, not a fiscal union. The EU doesn't have the allocative authority the US has. It has the same amount of money available, but it's terrified of spending it.

How does that work its way into the politics?

You see the usual constraints popping up: northern countries want to monitor everything. They don't just want to give it to the Greeks out of fear they'll just end up making Retsina. Meanwhile, the IRA is a bottomless margarita with an infinite amount of tax credits. That is why the US state of Georgia alone is opening nine battery factories.

So basically, we lost?

The entire EU framework was settled in the 1990s, which is based on cost competitiveness, where everybody should be "a bit more German". It's like being Tony Blair in the 2020s. Nobody cares. It's just an outdated model.

Low wage growth was one of the reasons the European economy lagged following the financial crisis, right?

Absolutely.

What would happen if we did allow wages to rise?

If you think rising wages is a good thing—and I do believe raising wages is a good thing—the outcome depends on where you do it. If you're in France, a relatively closed economy where domestic consumption is a key driver, you can get away with it. In Spain, you can get away with it. Italy hasn't grown in 25 years because of the obsession with running a budget surplus: they desperately need higher wages. But it is the last thing you need if you are in the north.

I've always believed high-surplus countries like the Netherlands should raise wages, which would be a good thing for the economy.

If you're willing to change the business model. If you're willing to say: why are we just doing all these exports, this is obscene? A handful of companies and a very small part of the country are getting very rich, and the rest of us are getting screwed, right? If we relied more on domestic consumption, that would be more equalitarian, and we could grow differently. So I would agree with you.

What's obstructing it?

Take Germany: they outsourced high-skilled labour to Romania, which over the past 20 years, had the fastest real-wage growth in the EU because it came from a very low baseline. German businesses could afford to increase wages there because the return on capital was still huge. Well, what does that mean for the guy that's running an IT chain in Germany? They are not gonna get 10-percent wage increase because your company's costs would go up.

So a political shift is needed.

You have to look at this electorally. There is an electoral constraint on changing these boundaries as well. What would also happen is inflation hawks would warn of a wage-price spiral and stoke fear, which feeds on older people who have assets that generate fixed returns. When they start getting hit with inflation, they're the ones that come out and go: let's not do this.

And a lot of experimental evidence shows austerity is surprisingly popular. Most people work. Most of them want to pay less tax, so they like the idea of the government spending less even if they want more social welfare. They recognise cutting social programmes leads to lower deficits, right? But the outcome of tax cuts on such programmes isn't immediately obvious to voters. So the right has an inbuilt advantage with austerity.

'We know that 42 percent of all foreign direct investment is tax dodges'

Profits last year were exceptionally high. Profit margins of US companies in 2022 surpassed a level not seen since 1947. EU corporations registered a 25 percent profit jump compared to 2019. What's your perspective on this?

We have a world in which we have high profits and low wages. That's a feature, not a bug. It's by design. One of the myths feeding this is that profits automatically get turned into investments. But from a Dutch study in 2019, we know that 42 percent of all foreign direct investment is tax dodges. So the relationship between profits and investment is sketchy at best. And when you take profits and ship them off to a tax haven and buy a series of luxury hotels in the Bahamas, it's not exactly benefiting the local community either.

If real wages are falling, who is paying for those profits?

Corporations can make super profits even though wages have fallen if the economy has lots of rent assets—invariants that people need like homes or the internet or whatever —then profits can be very high, and you can keep squeezing because people don't have an alternative.

So we have high profits and low wages, which are by design but have resulted in a loss of living standards in recent years and real wage stagnations over a longer period. What would you say is a smart way forward?

The ECB has some hard problems to think through. Everybody has student loans, and mortgages, meaning private balance sheets are incredibly large and heavily-stressed, right? They risk rupturing household balance sheets if they keep pushing up interest rates. What you get then is basically another financial crisis. If wages are allowed to rise because of inflation, that has a feel-good factor to it. But then all the northerners will scream bloody murder about losing competitiveness.

Most likely, they will keep pursuing a Goldilocks strategy: not too hot, not too cold. In other words, they hope this stuff works itself out because there are no obvious alternatives.

Why has it taken so long for mainstream economics and ECB policymakers to accept that rising prices are driven by corporate profiteering and not wages?

This is where the long shadow of the 1970s matters. Then the experience of inflation was a profit squeeze. It wasn't a profit boost like it is now. One of the simple ways to think about inflation is as a tax on profits. If you are in a tight labour market, and you're trying to source skilled labour while there is inflation, you'll have to pay more than you can make up for with productivity gains. That's what happened to a lot of firms in the 1970s. What's happening now is profit-gouging. In the short run, companies can do this. In the long run, there's a constraint, and it becomes dangerous for capital itself. But profits are sacred. Profits are like the pure expression of economic virtue. So they don't go after that.

There's this move to try and make the ECB more transparent and hold it accountable for the effects its monetary policies have on household income and inequality. Do you see anything in that?

Who's listening? Who cares? The constituency of the central bank is the financial sector. They listen to every word. The rest of us get to play in that world once they decide what to do with the information.