Wage Indexation

Twentyfive years ago Ezio Tarantelli – a professor of Labour Economics in the University of Rome La Sapienza – was assassinated by the Red Brigades shortly after giving a lecture. A distinguished economist, he was a follower of Franco Modigliani with whom he had studied and taught at MIT, and an economic advisor to CISL (the Italian Confederation of Trade Unions). He was a strong supporter of an incomes policy negotiated within a Social Pact, not just for Italy but throughout Europe as a pre-condition of the single currency, which he also strongly supported long before it materialised. But his main interest was the advocacy of curtailing Italian wage indexation (the scala mobile) which he regarded as responsible for perpetuating and accelerating the wage-price spiral that follows any inflationary shock. He successfully advocated the adoption of a pre-determined inflation target, to be agreed among social partners and the government, in place of actual recorded inflation.

Ezio Tarantelli’s proposal for cooling inflation by indexing wages to a negotiated target instead of actual inflation faced two difficulties:

First, the alternative is never whether a given nominal wage level should or should not be indexed. For a given relative negotiating strength of Trades Unions and Employers' Unions, if wages are indexed there is less need to take into account subsequent expected inflation in wage-fixing. Indeed if indexation is full (i.e. of 100% of the nominal wage with unit elasticity of the wage with respect to prices and with a short enough lag) there is no need and no case for taking into account subsequent expected inflation at all. In times of rapid inflation, especially of accelerating inflation, wage indexation defuses inflationary expectations and allows the negotiation of a lower nominal wage than would have to be fixed if there was no protection from future inflation. This is precisely why, when wage indexation was first introduced in Italy in 1947, the President of Confindustria (the Confederation of Italian Industrialists) shipowner Angelo Costa actually greeted it as a major anti-inflationary measure. Wage indexation thus has an ambivalent impact: it prolongs an inflationary process but starting from a lower wage and price level than is achievable without indexation.

Second, nominal wages are not fixed forever but are normally re-negotiated periodically. Inflation-proofing through indexation, if triggered by a shock after negotiation, will exhaust its effects completely at the next wage settlement. The new nominal wage will be determined by the relative negotiating strength of employees and employers and other fundamentals prevailing at that later time, regardless of how much the nominal wage might have risen in the intervening period thanks to wage indexation. On average, with rounds of nominal wage negotiations taking place, say, at two-year intervals, the impact of wage indexation will last for only one year, for the new nominal wage will be fixed starting from scratch, from a tabula rasa. To be more precise, it will last for one year (half the period between negotiations) minus the lag between price and wage rises (say at least three months), since the last indexed wage rise during that year will coincide with and will be taken into account at the next round of wage re-negotiation.

In conclusion, wage indexation is neither a shield against inflation nor an inflation engine, it has a positive and a negative impact on inflation, respectively defusing inflationary expectations and prolonging the impact of a shock; but both effects - partially reduced though not eliminated by Tarantelli's proposal - are operational only for a very, very short time. In all, we are talking at best of nine months partial wage protection, though on balance the impact of wage indexation on inflation may actually be beneficial. (A paper of mine in Italian developing these points, Indicizzazione e scala mobile (1994), is available on my website).