Wage Development in Denmark

Introduction

In recent years wage increases in Denmark have been at a historically low and stable level. From mid-1995 to the end of 1997 hourly wages for workers in manufacturing, which are the topic of this article, thus rose at a by and large unchanged rate of approximately 4 per cent per annum, cf. Chart 1. From the end of 1991 to 1995 the wage increases were even lower, ranging from 2 to 4 per cent per annum, a level otherwise not seen since 1950. This level of Danish wage increases to a great extent reflects an international trend following the general reduction in the inflation rates of many countries since the 1980s. In concrete terms, Danish prices have developed somewhat more slowly than wages in recent years, so that despite the low nominal wage increases real wages have risen. At the beginning of the 1990s the nominal wage development in Denmark was more subdued than for Denmark's most important trading partners. As from the start of 1995 this development reversed. The higher Danish wage increases coincide with stronger economic growth than in most trading-partner countries, and thereby a far more favourable development in unemployment than in other countries since 1993.

In a small open economy like Denmark's wage formation plays a central role in the ability of the economy to adapt to changes in external conditions, not least due to the great impact of wage formation on competitiveness. In the slightly longer term the effects of economic policy, including fiscal policy, are to a significant degree determined by the extent and speed that wages react to e.g. changes in output and employment. However, a number of other factors, including price formation in the commodities market, confidence and the development in interest rates, are also important in that context. The scope for manoeuvre of economic policy thus depends on other factors besides wage formation. This does not change the fact that it is important to have a clear idea of wage formation with regard to the compilation of Danish economic forecasts and when planning economic policy. The experience from the mid-1980s, when strong wage increases in 1987 made a decisive contribution to ending the economic upswing and to the onset of a long period of low growth, has had a strong impact. During 1997 unemployment fell to that same low level, with no indication of equivalent wage acceleration. These conditions in themselves call for a closer study of wage formation in Denmark. It should be noted that the wage relation so far used by Danmarks Nationalbank in modelling the economy has not shown any signs of being off course. An important issue in this connection is whether the reaction pattern today is nonetheless different from that of the 1980s, including whether wage formation has undergone a structural shift, or the wage reaction is merely delayed as the labour-market dispute in the spring of 1998 might indicate.

This article describes an empirical analysis of hourly wages in manufacturing which takes alternative wage-formation hypotheses as the starting point. The first section reviews the results of the econometric analysis. Then follows a discussion of the stability of the estimated relationship, in particular whether a structural shift in the wage formation may have taken place. This is followed by concluding remarks. The actual empirical analysis of wage formation is described in the Appendix.

A wage equation for Denmark

The econometric analysis supports that the rate of wage increases can be described as a relatively stable function of the unemployment rate and price increases, as in a more traditional Phillips curve¹⁾. Together with the

difference between producer- and consumer-price increases, the changes in the number of annual working hours and the replacement ratio of unemployment benefits these factors in overall terms give a satisfactory description of the wage development from the mid-1970s until today. The preferred equation, cf. Table 5 of the Appendix, can be written as follows:

w is the hourly wage rate for workers in manufacturing, p_C is the consumption deflator, p_Y is the deflator for GDP at factor prices for the nonagricultural private sector, h is the number of annual working hours, UR is the unemployment rate, and r is the replacement ratio on unemployment²⁾. Chart 2 shows the contribution to the wage development from each explanatory component in the wage relation.

The reaction of wages to economic cycles is captured primarily via the unemployment rate. In this connection it is noteworthy that in 1997 hourly wages increased considerably more slowly than in the second half of the 1980s, when unemployment fell to by and large the same level as today. According to the model the most significant explanation for this difference is the successive reductions of working hours which took place in the second half of the 1980s. These were partly the result of political decisions and were to a great extent granted with full wage compensation to wageearners.

The inflation rate has fallen considerably during the period considered and has been lower in the 1990s than in the 1980s. This dampens inflation expectations and therefore the rate of increase in consumer prices contributes to explaining the change in the level of the rate of wage increases. The same applies to the average replacement ratio on unemployment, which today is lower than in the mid-1970s.

Moreover, wage increases are determined by the growth in producer prices since the offered wage will depend on the price development from the producer's viewpoint. In concrete terms the wage equation comprises the difference between the rates of increase in respectively producer and consumer prices. This element does not affect the trend of the wage development since in the longer term the two price series will move in parallel. However, in the short term the influence of this factor may be significant.

In general, the estimated relationship gives a good description of the wage development. The overall wage movements within the estimation period are captured, whereas major fluctuations from one quarter to the next are not always reflected, cf. Chart 3. Outside the estimation period the wage increases of recent years are likewise predicted with reasonable accuracy. It is noteworthy that during the most recent upswing the model-determined rate of wage increases is hardly affected, even if the estimation period stops in 1992 instead of 1995. This shows that the wage development in recent

years does not give problems for the estimated relation and thus that the development can be explained without recourse to the hypothesis of a structural shift in wage formation.

Structural shift in wage formation?

The current debate on "new economics"³⁾, i.e. the idea that output and employment can rise without an upturn in the inflation rate, due to such factors as intensified competition and globalization, may imply that the Phillips curve has become flatter, i.e. a reduction of the marginal reaction of the rate of wage increases on changes in unemployment.

An obvious explanation for this structural shift might be a growing awareness that high wage increases have a tendency to be absorbed by equivalent price increases and a decrease in employment. Experience from the most recent decades shows that real wages have increased particularly in periods of low wage increases, cf. Chart 1.

The coincidence of low wage increases and a significant drop in unemployment might also be explained by a less tight labour market than the change in the unemployment figures might indicate. It could be the case that the labour-market policy pursued in recent years has reduced the level of unemployment at which wages normally begin to accelerate. This corresponds to a sidewards shift to the left of the Phillips curve. The most remarkable results have been achieved in combatting youth unemployment, which has fallen considerably. The decline in unemployment has furthermore been distributed broadly across different sectors, and bottleneck problems on the same scale as during the upswing of the 1980s have not yet been seen.

A further possible explanation might be that the decline in unemployment to a significant degree is due to the transfer of the unemployed to leave schemes, transitional allowance and early-retirement benefit. In so far as this concerns unemployed with relatively loose ties to the labour market, who therefore have not made any significant contribution to keeping wages down, unemployment may have declined without leading to greater pressure on wages. This also corresponds to a shift of the Phillips curve to the left.

Overall, the estimated relation shows a stable relationship between the rate of wage increases and its explanatory factors, cf. the analysis of the stability properties in the Appendix, hence implying the absence of a structural shift in wage formation. However, the slope of the Phillips curve, i.e. the coefficient of unemployment, has evened out a little after 1993.

In an empirical analysis it is generally difficult to distinguish between the different explanations for the lower wage increases in recent years than during the upswing in the 1980s. However, there is no doubt that changes in annual working hours play a significant role. In formal terms all reductions of working hours have been accompanied by immediate wage compensation, although it is possible that this effect might be reduced subsequently. The most significant individual wage increases from one quarter to the next, i.e. in 1975, 1979 and 1987, thus took place in quarters with significant reductions of working hours, cf. the comparison of Charts 2 and 3.

Conclusion

It is shown that a limited number of factors can describe the wage development since the mid-1970s. There appear to be no significant problems in using the wage equation to explain the historically modest wage increases up to end-1997. However, as always, the results of the econometric analysis must be interpreted with caution and it cannot be denied that a more accelerated wage development is "waiting around the corner", in step with the increasingly tighter labour market in the present economic upswing. However, at the same time wage increases of around 4 per cent per annum must be assessed to be problematic in view of the latest collective wage agreements in Germany and the generally low wage increases abroad.

"to be continued"

Footnotes