Tuesday, 17 March 2009

Pay Cuts and Deflation

Paul Sweeney: Many economists and commentators are still arguing, very strongly and with great certainty, that pay cuts will be the major part of the solution to the economic crisis.

This post, my third on competitiveness and pay, will explore the belief that pay cuts will not have a deflationary impact on the economy. Thus, it is argued, pay cuts would not make things worse.

Pay in Ireland has been rising more rapidly than in competitor countries though Irish pay levels still remain lower than most, though not all, competitor economies and pay levels are not as important in our competitiveness as other issues, especially now.

Wage costs are just one aspect of competitiveness, as most economists agree. It is more important to look at unit labour costs or productivity (though that is far from the end of the complex issue). There has been much discussion of falling productivity in Ireland. Yet the data shows it has not been falling. It has been stagnant. It has not been rising. It would be better if it were rising, especially if it is rising in competitor countries and as the euro has risen.

Yet the latest OECD data shows that the level of productivity in Ireland was third highest after the US and Norway. The Irish Central Bank publishes a table which shows relative unit labour costs, in a common currency, for Ireland in 2009 was down at 67 (from 100 in 1995). It has been around this for the last four or five years years. A different Bank table, (on unit costs relative to the main trading partners), has also been stable at 99 for 5 years. With the growth in construction and in services, sectors with low productivity, during the domestic boom since 2001, productivity increases were difficult to achieve. With a deep recession, this may be even more difficult, due to labour hoarding.

With the chasm between public spending and plummeting revenue (thanks to the government’s obsession with tax cutting in the boom), the issue of pay reductions in the public sector, where it is the major cost, is generally accepted. The Transitional Agreement includes a pay deal signed by Government, employers and unions, only last September. The Government reneged on it and IBEC indicated that it would like not to pay it.

Yet many leading companies, where they can, are paying it. Some companies like CRH, which declared operating profits of €2bn, do not have a problem paying it. In other multinationals (MNCs), where pay is not significant in terms of total costs, they are paying it too. Many MNCs operate on intra-firm transfers and are not particularly price or even currency sensitive. The industrial relations newspaper, IRN, has listed around 70 leading firms which are adhering to the deal. Yet unions accept that in this deep recession, many firms, especially in services, will have difficulties. They are doing deals, as per the agreement, on inability to pay, on freezes, etc. If there is not negotiation at national level between the main players, based on fairness and shared understandings, actors may be forced to take hard positions.

Importantly, competitiveness is about much more than wages and even unit labour costs. I believe the major issue of Irish competitiveness is the lack of credit for firms, due to the collapse of the banking system, compounded by the Government’s decision to take a staggering €7bn out of the public purse (which is EMPTY) and give it to the collapsing Irish banks.

I think the second issue of competitiveness is Ireland’s appalling international reputation, ruined by a few of our enterprise leaders and by the Government's light regulation, light tax regime. There is also a domestic reputational issue too, where all Irish business leaders have been tarnished by the few, just as they are trying to impress their employees on the need for cooperation in facing really serious economic problems. Rebuilding Ireland’s reputation will be a key competitive challenge. But many political and enterprise leaders are still in denial on this vital issue.

There is a certain attraction to achieving a once-off reduction in total Irish consumer costs. These are a substantial 14% higher than the EU15 average for goods and over 23% above for consumer services. They are even higher against the average of the total of the 27 member states. But would it work by only cutting wages, even if this were possible?

What really exposes the class prejudice of these economists is that they only seek pay cuts for employees, and have no interest in demanding that the rest of the economy (which includes those who profited so greatly and who included those who caused the crisis) contribute. Is it simply that labour is the largest chunk of national income and is perceived as easiest to squeeze?

Or is it that Ireland would need a CAB-like Prices Commission to really police lawyers, solicitors, pharmacists, retailers, wholesalers etc. to force them to bring down prices and that this would be “state interference “ in the market? Some businesses will reduce prices because they have to, but others will not, especially when they can get away with it. A CAB-like Prices Commission is what is required in these exceptional times to ensure fairness in such a cost reduction mission. Or is it as simple as the fact the some economists would abhor state interference in the prices mechanism in these trying times, but that they have not such ideological qualms on the price of labour?

But what about the impact of this strategy for wage cuts only, if it were to be implemented? If workers concede major wage cuts, but the other sections of society do not, will it result in considerably reduced domestic prices? It is unclear that it will. The transmission machine if not working as any shopper will tell you. The fall in sterling was not passed though to consumers.

Some economists are predicting the prices will fall to minus 4 or minus 5% in 2009. Yet these are the same economists who predicted prices would fall, just as negotiations on the previous two national agreement were underway. They got it wrong each time. Much was made of the fall in consumer prices in February of -1.7%. But behind the figures was a decline in the rate of decrease from a substantial -1.7 in January to -0.4 in February. And the HICP (without mortgages) was still positive. Nonetheless, prices are likely to fall this year, but who knows by how much? Profiteering is part of the Irish business psyche. No economist has shown that wage cuts in profitable firms will not go straight to the bottom line - not to consumers.

Retail sales fell by 4.5% - the largest amount in 2008 since 1982 and excluding motors, it was the largest fall ever recorded. Retail sales had previously grown by plus 5/6% for years. Wages make up €80bn or over half per cent of national income, so would major cuts in wages depress domestic demand further? And tax revenue too. Many businesses will be forced to close down, leading to a deflationary spiral.

Then those who think wage cuts alone will reduce our cost base so much that exports will then “take off” and replace the now collapsing domestic demand. But do they not know that international trade is now in decline? Trade, which grew at a multiple of economic growth for decades, is now actually declining.

Germany, Europe’s biggest economy and the world’s biggest exporter, is seeing its exports plummet. “German manufacturing is in freefall” says the Financial Times. Domestic demand is stagnant and growth is falling. Overseas orders for capital goods were down as massive 48.2% in the year to January.

So who is going to snap up the now bargain Irish exports, brought down so much in price, (it is fervently hoped) by cuts in wages? Few, I fear. International demand is flat or mainly declining. Even if the fine economic models are tweaked and squeezed to show a happy outcome, in the real world, there a danger that this strategy of wage cutting could make things worse.

It is hoped that the real solution, a big stimulus package, will be made in London on 2nd April. But it is not looking as if the stimulus to be agreed by the G20 will be anywhere near adequate. In the meantime, Ireland’s international reputation is in tatters.

Only the workers can save the Irish economy by agreeing to massive wage cuts! Or so some economists appear to believe.


Aaron McDaid said...

The big issue I think, that you have left out, is debt levels. Even if uniform price cuts and income cuts across all of society could be implemented overnight, the only effect would be to make debts such as mortgages even more expensive in real terms. Then, a higher proportion of incomes would end up being hoarded in banks instead of being spent.

It would effectively be identical to the government waving a magic wand which increase all debts by 10% overnight; even in good times this wouldn't be healthy. Today, I presume we owe more to the outside world than we are owed by the outside world, so we certainly don't want increasing real levels of debt.

But I don't see how the government can prop up wages even if it wanted to. The 7bn you mention isn't staggering compared to all the other liabilities and risks out there.

If the government did borrow heavily to prop up incomes (private and public incomes) most of that money would be wasted by the feckless Irish in importing more rubbish. The domestic part of the multiplier would be quite low.

I never thought I'd say this, but the only way to make borrowing by Ireland work now is by implementing import restrictions. This wasn't necessary when we devalued the punt, but we can't devalue the euro.

So there we have it: the EU must agree massive coordinated fiscal stimulus and give Ireland soft loans or else watch trade barriers go up in Europe again.

Gerard O'Neill said...

A thought-provoking post Paul. Some thoughts in response:

I doubt if many serious economists think that cutting wages in the traded-sector of the economy is the primary or even key path to improving competitiveness. If you are an exporter and your Irish labour costs have put you at a serious competitive disadvantage then you are either going out of business and/or planning to relocate somewhere cheaper (outside the eurozone). A 10%/20%/30% pay cut won’t change your mind. As you point out yourself, those MNCs for whom pay is not a significant element in total costs are not really affected by the ‘Irish competitiveness’ issue.

You are right about productivity: in the long run it is the primary driver of economic growth (either because more people are working, or people are working harder, or – hopefully – people are working smarter). I wouldn’t worry about labour hoarding holding down productivity levels: the deeper the recession gets the faster hoarding looks like a silly strategy. As it does right now.

As for the chasm between public spending and plummeting revenues, you blame the government’s obsession with tax cutting during the boom: I blame their obsession with increasing spending faster than the underlying economic growth trend. Both get us to the same chasm’s edge of course.

I’m not quite as convinced as you are that the issue of pay reductions in the public sector is generally accepted. Perhaps around the social partnership table, but most of the public sector workers I have spoken to see the private sector as deserving to take most of the pain since they (apparently) took most of the gain in the good times. Makes you wonder what benchmarking was all about?

It seems to me we are already in a deflationary spiral. Thus the government’s budget target is a moving one – and any assumptions about the underlying size of the taxable cake are likely to be proven optimistic. You worry about the deflationary impact of wage cuts (as do I – not least because I reckon the marginal propensity to spend of public sector workers is higher than their private counterparts due to job security and low pension contributions). But I worry about the deflationary impact of higher taxes – especially on those previously outside the net.

Personally, I think we’re going to have to plan for a ‘new normal’ after the recession whereby our standard of living has ratcheted back down to a level somewhere last seen in the late 1990s (or early 2000s if we are lucky). With implications for taxes, borrowing, spending and employment that won’t be pretty ...

paul sweeney said...

Paul S writes: Aaron, imports are falling so one does not have to worry about people spending on frivilous items! The €7bn is an actual payment or series of payments to be made soon to recapatilise the banks and so it will eat into our Pension and other reserves.

Gerard, I do think that the issue of tax cutting and also switching from direct taxes on incomes and profits to the construction(some call them property taxes) taxes combined with the huge property tax breaks gave the economy a major economic stimulus, which was the last thing it needed in 2001-07. I agree that increased public spending has a similar impact, but we were and still are (past tense will still hold for some time, I guess) catching up with Europe.

My essential point is around fairness. I think that you may have a point on many public servants not being in accepting mode of the pay cuts/levy, even though the economy is spiralling downwards, precisely because they do not see other sectors/strata sharing the burden of adjustment. In tough times, people compare themselves much more againt others and can get mightly resentful.