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The European Commission today publishes its “Recommendation for a Council recommendation” on national reform programmes. Such recommendations are in principle published for all EU countries in the framework of the European Semester (see my colleague Benedicta on this). Arguably, the recommendations are particularly important for countries that have been identified as potentially facing particularly large challenges in the context of the Macroeconomic Imbalances Procedure (MIP). Italy is among those. So what is the Commission’s assessment of how adjustment in Italy and Germany is addressed?

I would argue that the problem of competitiveness adjustment and what it implies for growth and wage developments is central to Italy, Germany and to the euro area as a whole. The following table shows the simple numbers of compensation per employee in Italy and Germany measured in euros.

These numbers are extraordinary. In fact, in 1999, an Italian worker earned 2723 euros less than a German worker. In 2007, he or she earned 1801 euros more and in 2011 even 2688. Assume for a moment that labour productivity growth has been equal in the two countries, then the relative adjustment need amounts to 20%. Unit labour cost developments support this picture with the gap between Italy and Germany raising by 25%. Interestingly, nominal unit labour cost developments in Germany increased only slightly by 6% whereas Italian’s increased by 32% compared to the euro area’s average 20,7% increase.

The numbers suggest that the Italian wage setting processes has allowed wages in Italy to grow far above productivity developments whereas German wages have been somewhat below productivity. Correspondingly, employment developments have been very different, in particular during the last 4 years when the re-adjustment processes started. Since 2007, German employment increased by 1.7 million whereas Italian employment dropped by 0.25 million.

The adjustment challenge is thus daunting and in a recent policy contribution I have shown that also the forecast is worrying. To close the competitiveness gap and get employment increased in Italy, the eurozone would need a 5 percentage point gap between Italy and Germany during 5 years if we assume that 1999 prices were adequate. There are good arguments that in 1999, Germany was slightly overvalued whereas Italy was slightly undervalued so my guess is that the actual gap is smaller. Probably, 4-5 years of 4% differences would do the job. If we assume 0.7% productivity growth in both countries, German wages would need to settle at around 4.7% whereas Italian wages would settle at 0.7%. This would imply 0% inflation in Italy and 4% inflation in Germany with average euro area inflation somewhere in between and close to the ECB target.

The European Commission forecast on inflation does not provide such numbers. In fact, the Commission predicts Italian inflation to remain far above the euro area average. For Germany, recent wage settlements show some developments towards the numbers outlined above with recent wage agreements of 4.3 and 4.5% for the metal and chemical industry. So adjustment in Germany appears to happen. The Commission should monitor that no measures are taken that would counter this wage adjustment in Germany. The Commission’s working document on Germany is disappointing in this regard as wage developments do not figure in the executive summary. Certainly the MIP procedure is not sufficiently symmetric and the Commission therefore misses the adjustment process in Germany.

So what are the policy descriptions to Italy in the Commission document? The Commission assesses progress since last year’s recommendations and finds that the 28 June 2011 reforms of the wage bargaining process in Italy have been important. However, the Commission underlines that implementation is central for reforms to succeed. Indeed, according to the Commission, “social partners will have to effectively apply” the new rules and “There is also scope to further improving the wage setting framework with a view to quickly regaining external competitiveness.” Given the numbers I show above, I could not agree more. Adjusting wages and prices is absolutely central to restoring growth and competitiveness. It is for the Commission to judge and evaluate carefully progress made on the labour and product market reforms. The leaked document that circulated the last days suggests that the assessment of labour market reforms is quite complicated and highly disputed. It is important to get the assessment right as the euro area cannot sustain such permanent divergences.

In , Guntram Wolff discusses the findings of the policy contribution "Arithmetic is absolute: euro area adjustment" and presents his assessment of price adjustment in the euro area and the forecast of consumer price inflation for the years to come.