Thursday, 23 July 2009

Why wage cuts are not a good thing

This post was written by Professor Terrence McDonough of the Department of Economics in NUIG in May. Given the current debate on pay levels (whether in the public sector or for those on the minimum wage), it seems appropriate to bring it to the top again.
Terry McDonough: When Ronald Reagan wanted to send a message to unionized workers across the American economy, he picked a group of public employees, the air traffic controllers, and broke their union. Ironically, this union was one of the few that had endorsed his candidacy for president. Margaret Thatcher followed a similar strategy with the miners. When the current coalition government decided that their only strategy for recovery was repairing Ireland’s competitiveness through across the board wage cuts, there was only one way to announce their intentions. They picked on public sector workers and announced a wage cut.

Brian Lenihan has bragged that we Irish have an amazing capacity to take pain and that if such a cut had been announced in France there would have been riots. How did he get away with this in Ireland?

First, a carefully orchestrated campaign in the media stirred up begrudgery about public sector pensions. The pay cut was labelled a pension levy and the impression was given that it would go to help pay for these ‘Rolls Royce’ public sector pensions. Public sector unions felt exposed by the lack of support from fellow citizens in the private sector and accepted the cut. Support for the pension levy by private sector workers ignored the fact that they were next in the crosshairs. Irish private sector employers had got the message. It was now open season on wages.

Just as an ESRI report had earlier announced the start of the Irish recession, their latest report predicting a 17 percent unemployment rate amounts to official notice of an Irish depression. The ESRI’s solution? They joined a chorus of other economists and commentators calling for a fall in wages. Garret Fitzgerald’s recent column in the Irish Times was headlined “reduced pay could be silver lining of crisis.” Despite this apparent consensus there are sound economic reasons why wage cutting in the Irish economy is far from a good thing.

First, stable wage rates provide an anchor in the economy. All other prices are tied to them. Falling wages can cause falling prices which can trigger further falls in wages and prices. This is called deflation by economists. What’s wrong with falling prices? Would you buy a product now if you expected it to be cheaper in the future? Would you pay today’s prices to invest now if you could only eventually sell your product at tomorrow’s lower prices? Deflation has the potential to seize up an economy.

Secondly, falling wages directly damage demand, cutting sales and creating further unemployment. An environment of wage cutting creates insecurity and reduced spending.

Thirdly, falling wages will compound the problem of our high levels of indebtedness. Falling incomes means that debt payments will take an ever larger percentage of income.

Fourthly, inequality is at the root of the international crisis. Across the board wage cutting will make the problems worse. Stagnant wages led to low levels of demand for consumer goods, leading investors to put their money into financial markets instead of productive investment. This led to a flood of lending to cash strapped consumers and fuelled the housing bubble. When this bubble burst a credit crisis combined with stagnant wages to create a demand crisis. This demand crisis will still be with us even if the banks are repaired.

Fifth and finally, falling wages will not recreate the Celtic Tiger. It is true that lower Irish wages initially contributed to attracting foreign investment. But it is not possible to wind the clock back to 1987. Much has changed. There are even lower wages available elsewhere and, with the enlargement of the EU, available not so far away. In the age of globalization, transnational corporations locate different parts of the production and distribution process in different kinds of places. Where they will find attractive for a particular function in the future is very hard to predict.

There are two lessons here. The first is that Ireland must be more self-reliant in the future. The second is that, against all the conventional wisdom, we should stop worrying about competitiveness. Rather we should set about building the society we want. We should be seeking high levels of equality and well-being (recent scientific studies show the two are closely connected), high levels of health, high levels of education, high levels of culture and self-expression. If we have a well functioning society, not just an economy, we will find that we have no trouble participating in the international economy and even attracting foreign investment if that is one of the things we want. Now that social partnership is in trouble, there is no reason unions and other social organizations can’t still do their bit for recovery. They can contribute a great deal by doing their day job – defending working people’s living standards and fighting for greater levels of social justice.


Tomaltach said...

I would agree completely about the way in which the public sector has become the bashing boy of right wing media. I would also agree about the dangers of a deflationary spiral.

But I think other parts of your analysis are more problematic. For instance, you cite thirdly on your list of problems that "falling incomes mean that deby payments will take an even larger percentage of income". The problem for working households now is not their burden of debt, which, if they had substantial mortgages, has reduced considerably. Take my own case. I was unfortunate enough to take out my first mortgage a few years before the property market peaked (some stooge eh!). Yet between the interest rates reaching peak and now my repayments have fallen almost 30 per cent. No, debt is not my main worry, it is the risk to my job. I know exactly how real that risk is because last September my company had a sudden round of layoffs and I found myself back in the welfare office. Very fortunately I found a job again just after Christmas. But since then my new company has also had layoffs. True, I cannot extrapolate from my case to create a picture of the economy as a whole, but of all the people I have spoken to about the economic crisis not one cited debt as their main concern - but nearly all feared for their jobs.

You then go on to say that inequality is at the root of the international crisis. By which I take it you mean a cause of the crisis. I have not seen this demonstrated in any meaningful way. True inequality is a major concern, but is it a cause of the current crisis? I would say that poor regulation, deep flaws in the short-term shareholder value model, bad politics, and the dogma of market efficiency were the main culprits. Yes, many of these give rise to inequality, but as a consequence not a cause.

You make the point that "when [the] bubble burst a credit crisis combined with stagnant wages to create a demand crisis". In Ireland at least, wages (until now) were not stagnant. Wage growth in Ireland during the Celtic Tiger was fairly impressive. True we came from a low base, but the growth was there nonetheless. The demand crisis is surely exacerbated now by falling wages. But I would argue that the key drag on demand is not smaller wages -- though it is curely a component -- but a shrinking workforce and a pathological fear of the future which has gripped the nation. Those with secure and still well paid jobs are not spending. This illustrates how largely sentiment bulks in the demand equation. People also see the queues at welfare offices and have heard that unemployment will keep rising until it hits 17%. So they fear that their financial security will worsen before it improves. That is what is driving people out of the market.

Michael Taft said...

The most frustrating aspect of the debate over wages is the failure of the real devaluationists to produce any supportive data for their contention that wages are somehow 'uncompetitive'. Assertion is taken as fact, regardless of the data available from the EU, OECD, US Labor Bureau and our own CSO. When the Government tore up the wage deal it was an open invitation to IBEC to do the same - which they did in quicktime. They claimed their members couldn't afford wage increases. Despite the fact that the Irish Industrial Relation News has catalogued a range of companies - in the manufacturing and service sector - who have recently paid up (even the company of which IBEC's President is CEO paid up). Both the Government and IBEC are facilitating the deflationary slide.

We should not only counter this fact-less argument. We should go further. As you say, Terrence, wages are the anchor. We should show that supporting and enhancing the incomes of those in the lower deciles - the low-paid, social welfare recipients - has a beneficial effect during declining output. Rather than cut, we should increase wages and welfare rates. The Obama Adminstration's multiplier outputs show that increased social protection measures for those recently made unemployed and those on food stamps is the most beneficial.

Greater wage equality is the key to recovery. No better time to start than now.

Tim said...

Is anyone looking into the merit of a cap on income based on a certain multiple of the average industrial wage? And does anyone know the name of the article in which this measure was sugested by George Orwell?

James Wrynn said...

The CSO publication on earnings for Q3 of 2008 (the latest data available) shows that only 2% of employees are on the minimum wage. If wage costs were a key issue, it would not be unreasonable to assume that a much higher percentage of employees would be on the minimum wage, driven down by so called competitive requirements. Furthermore the percentage on the minimum wage in Q3 2008 was actually slightly lower than in Q3 2007.

Tomaltach said...

A figure from the tail of the bell curve hides more than it reveals. So the bulk of workers are not on the minimum wage. Ok, but let's suppose this is true in all countries. But that in Ireland the middle part of the bell is not as high in the middle as in other countries. Then overall, we have a lower cost base than other countries. Competing forces, where they are at play, are only going to force costs down below the equivalent elsewhere. Basically it depends on the shape of the overall distribution and how this maps into exporting sectors.

paul sweeney said...

Ireland's consumer cost base is second highest in EU only to Denmark. That is why the min wage needs to be the second highest, but in practice, it is the third highest as Denmark does not have a minimum wage but the general pay rate there is c€15ph, compared to our €8.65. But wages are only a small part of competitiveness and indeed of total costs. What depresses me is that some Irish economists' comment has reverted back to the early 1980s when the Three Wise Men (at the beshest of Government) produced a simplist and crude view of Competitiveness which was based only on wage movements. Today's economists like Mike Casey and the "comrades" over on Irish Economy are forgetting unit labour costs and productivity. They are very ideological but anyone who even reads the National Competitiveness Councils reports, even superficially, will see the many, many factors which make up national competitiveness. Why are so many excellent economists apparently debasing themselves so, by indulging in such crude politial economy in a time of national crisis?

Tomaltach said...

Good point about the non-wage factors in competitiveness. There may be one possible explanation for why wage dominates the discussion. That it is seen as the easiest of these factors to alter. You mention for example productivity. That is notriously difficult to prod in the right direction and certainly, in theory at least, would be quite difficult to get it to move while wages could be adjusted more quickly and by a more significant amount. I'm not arguing for a moment that the focus on wage is right or that the other factors should be overlooked. I'm merely stating another reason, apart from the ideological one, as to why wages may be seen as the more attractive target.

paul sweeney said...

Tomaltacht, I think you are right. Economists focus on wage movements because of the ease of measurement. But for many years, Ireland has had had a comparative policy advantage over many other countries, I would argue, precisely because we have, officially, a much clearer and deeper understanding of the complexity of the issue of competitiveness. And it is official ie through a tripartite body, the NCC, government, employers (who sought its establishment) and unions probe, review and debate the many issues (I am on the NCC Council) constantly. Sadly, academic economists are stuck back in the 1980s. They are either, a) unaware of how policy has evolved and left them behind, or b) deliberating being ideological to take the focus off the many other issues which inform competitiveness (with the exception of the access to credit /banking - which they are beating to death!)

Michael Taft said...

The German Statistical Office (Destatis) has compiled the most recent European comparison of labour costs - relating to 4th quarter 2008. In the EU-15, overall Irish private setor and manufacturing wages came in 10th place. And when compared with our peer group (excluding the poorer Meditarranean countries), Irish private sector wages would need to increase by 14 percent just to reach the average wage levels pertaining to the top-10 economies. In terms of 'competitiveness' - the reason why some are calling for wages to be cut - clearly its not our wage level that is the problem.

Proposition Joe said...


Although interesting to note that we're so far down the league table, I don't think the average private sector wage is that useful a metric in our situation.

First there's the issue of these wages not really driving the problematic costs. Those costs in our economy that are high and still rising are inflated by high wage rates in public sector dominated areas (energy, transport, health, education) and hefty professional fees. Of course the fact that ESB workers enjoy a large wage premium doesn't show up in the private sector average, but does have a large impact on our competitiveness.

Secondly, there's a low signal-to-noise ration in such aggregate data. We're betting our future growth prospects not on manufacturing, retail or the service industry, but instead that much bandied-about knowledge economy. So we really need to know how wage rates in relatively small strategic knowledge-based industries fare against the EU-15, without the drag of a huge cadre of low-skill workers pulling down the average. Google for example don't care how much retail assistants earn here, but they will think twice about investing more in Ireland if the cost of highly qualified software engineer is way above the European norm.

Donagh said...

Proposition Joe, what the heck has Ireland's attraction for a corporation like Google got to do with wage levels?

Pavement Trauma said...

I would suggest that when it comes to comparing competitiveness with other countries, the overall average absolute wage level isn't really the salient statistic.

We are competing for FDI, generally from large American MNCs, who want to locate some operations in the EU. We have advantages over other EU countries in language and corp tax rates but an obvious infrastructural disadvantage. The relative cost of the specific type of labour required (be it factory workers, software engineers, PhDs or whatever) and their productivity is one factor taken into account (as indeed are the cost of services, electricity etc.)

The point is five or more years ago the labour cost differential to other EU countries was larger and we were very competitive based on all the complete package of factors MNCs weigh up when choosing an FDI destination. We won a disproportionate amount of investment. Between then and now our labour costs have risen considerably compared to other EU countries - as indeed have other costs. Consequently we are not winning as much inward investment as before.

It is the 'package' of factors that should be the comparator across countries. We have improved our infrastructure somewhat, but the rise in labour and other costs have made us less competitive than before. It is just not true to say 'But our workers are cheaper than those in EU15 and hence we could raise wages X% and still be competitive!' as we would not be competitive on the package basis.

Proposition Joe said...


Is that a rhetorical question?

Google needs employees. These employees have an availability and a price function. Google may have more flexibility on the latter when making investment decisions, but certainly not infinite flexibility.

The point though wasn't "what is Google going to do?". Rather that over-blown wages in certain key growth sectors may have a disproportionate impact on our prospects for recovery, even when such localized wage inflation is masked by wage stagnation in the wider private sector.

In other words, I don't think is a slam-dunk to infer that all is well on the wage competitiveness front solely on the basis of average wages throughout the entire private sector.

Donagh said...

My point was that Google has set up here perhaps for a number of reasons, but the primary one is that we have low corporation tax. Wage competitiveness is not a factor, if you are suggesting that the competition would be with other countries in the EU because Google, like other MNC employs people from all over Europe. Wages maybe an issue for a MNC that is at risk or is resisting a takeover, as in the case of Lucent recently enough. There is also the fact that within MNCs there is competition in different European regional bases to drive wages down. That is, if Corporation X in the Prague office can get the same type of people for less than those in the Barcelona office for example, then those who run the Barcelona office are under pressure to reduce wages for those jobs, to avoid losing those jobs to Prague. As Sheila Killian said in the Irish Left Review piece I tried to link to, governments are powerless in the face of pressure that can be applied by MNCs. Moderating wages in the hope of 'attracting' jobs from MNCs is futile. It's another myth of 'competitiveness'.

Pavement Trauma said...


"Wages maybe an issue for a MNC that is at risk or is resisting a takeover"

So for those MNCs not at risk (and *maybe* even some that are), wage levels are not an issue? Really? I can almost picture the scene:

"Costs? Pfft! We don't care about costs! We're an MNC, happy to pay whatever you guys think you're worth. We're good like that. Have a cigar. Really. Take two."

Donagh said...

I did not say that they were not an issue, only that it is being exaggerated as an issue which might impact upon whether or not a MNC would invest here. High tech companies often have to attract employees from all over Europe. There are lots of factors that they have to take into account when accessing the pay levels and they are very methodical about it, but I would suggest that is not a significant factor (not even close) when deciding whether to invest here or not.

Proposition Joe said...


On the point about low corpo tax being the main draw, I think you're assuming a severe lack of creativity on the part of Goolge's accountants :)

Engineering activities are often viewed as a pure cost centre, especially forward-looking R&D that can't be directly tied to current customer revenue.

So what would be the down-side to booking all the advertizing revenue in Ireland, while running a loss-making engineering outpost in Prague? Or where-ever there's a supply of suitably qualified engineers available at a reasonable price.

You still get all the benefits of the low corpo tax as all profit-making activity is still based in Ireland. OK, maybe you incur some extra organizational complexity, but the upside is the supply of local reasonably-priced talent that you can tap into directly. If Google or whomever have to go to Prague anyway to recruit (because of the diminishing supply of quality grads here) its only a short mental step to going the whole hog and setting up an outpost there. Especially when a growing tax wedge, high cost of living and relatively poor public services may make it all the more difficult to incentivize people to relocate here.

I agree that wages are not the *main* concern of an outfit like Google, but you can be sure *all* costs feed into investment decisions in some way. So while there's a fair amount of elasticity on wage levels, this elasticity is certainly finite.