Sunday, 27 September 2009

Hunting for woolly mammoths

Michael Taft: In a previous post, where I disputed the economic benefits of cutting wages, Professor Alan Mathews and Pavement Trauma questioned aspects of my analysis, raising important issues which deserve a considered response. For this goes beyond ‘what wage levels are best’; it is about defining what the critical issues behind our competitiveness and prospects for future employment really are. We we may put a lot of time, energy and resources going down one path only to discover that is dead-end, that we should have gone down an altogether different path. We may go hunting for woolly mammoths and may end up finding ourselves being the hunted.

Indeed, we have to be sure we are addressing the same issue. The argument that we should reduce wages to increase employment is not quite the same as the argument that we should reduce wages to increase competitiveness. The first assumes that wage ‘correction’ will facilitate new, more employment-friendly market conditions. The second assumes that wages are a structural part of the ‘loss of competitiveness’. So which are we addressing – or, if we cut wages, do we get a two-for-one?

Wage Share and Final Demand

Both Alan and Pavement Trauma suggested my use of wages was too restrictive, not taking into account the economy-wide benefits of a general wage reduction. I had argued that, taking one example, cutting wages in the computer services sector would have little effect since wages make up only 13 percent of total operating costs in that sector.

Alan stated that a more correct approach would be to look at the totality of wage cuts – for in a firm, wage cuts will not only affect its particular labour costs, but affect the labour costs of those companies sourcing it:

‘. . . think about those purchases of goods and services which the computer service firms have to make. Some of these goods and services will be imports, whose price is not affected by Irish wage levels. However, to provide the domestically-sourced goods and services bought by the computer services industry, other firms have to combine both imported and domestically-sourced raw materials and inputs with domestic labour and capital. So a reduction in wages in the industries supplying the computer services sector would also reduce the cost of its purchases of domestically-sourced inputs . . Thus the problem in your analysis is that you do not take into account the indirect as well as the direct effects of a general reduction in wages across the economy.’

Alan goes on to suggest using the CSO’s input-output tables to get a better assessment of the impact of a generalised wage cut:

‘ . . .the economy-wide ratio can be calculated as pay costs (€66.0bn) as a percentage of final expenditure (€232.6bn) or 28%. The other shares are imports (38% contribution to the final price) and gross operating surplus (33% contribution to the final price) with taxes not related to products playing a negligible role.’

In this construction, wages make up 28 percent of the final expenditure of all industries and services. Even so, cutting wages by 5 percent (the figure I used in the previous post) would still only reduce economy-wide final expenditure by 1.4 percent.

Therefore, the impact on direct and indirect inputs from a 5 percent general reduction is questionable. There are many inputs which would be unaffected by a wage reduction. As Alan pointed out, imports are one. 38 percent of final expenditure goes on imports but in many areas – notably, our modern export sectors – imports make up considerably more.

• Chemicals / Pharmaceuticals: 58.4 percent
• Office Machinery: 88 percent
• Recorded Media: 52.2 percent

In these sectors, dominated by import consumption, not only will reductions in direct wages have little effect, wage reductions among domestic suppliers will have little effect as well, since these, and the general multi-national sector, source so little from Ireland.

Moving to the enterprise level we would find inputs that would be little affected by the reduction in wages (that is, if we had more than just sketchy data). For instance, wages in Dublin retail enterprises are considerably lower than retail enterprises in Maastricht – considerably so. Yet, operating costs in Maastricht enterprises are lower. One reason is commercial rents which are six times less than in Dublin. Cutting wages will have no effect on this input.

We might even look to the energy sector, as these costs are high. But with the main supplier – the ESB – you could slash wages by a considerable amount with no effect on prices, since the Regulator sets ESB tariffs at a high non-market rate to facilitate private investment.

In conclusion, if wages were cut by 5 percent, the total amount of final demand would fall by 1.4 percent (and for key export sectors – even less). It is not unreasonable to ask whether this fall would result in enhanced competitiveness.

Comparative Wage Costs

In any event, to suppose that competitiveness will improve with a reduction in wages presupposes that wage increases are, themselves, an issue in competitiveness. How can we measure this? One way of doing this is by comparing labour costs. The latest figures come from the Destatis, the German Statistical Board – 2008 4th quarter:

Irish labour costs in the private sector are below – well below – labour costs (measured in per hour) than all other countries, bar one, in our peer group (that is, the top 10 EU economies).

Even the one exception – the UK: it’s not that Irish wages are rising faster but that Sterling is deteriorating. Destatis states that UK private sector wages fell by 10 percent in the year up to 2008 4th quarter but this didn’t happen in the UK – it happened in the currency markets. In the UK, wages actually increased by 4.4 percent (compare that to Irish wage increases of 3 percent according to Destatis).

The important point here is that if Irish labour costs are already substantially below those of other countries, how can reducing our overall labour costs even further contribute to an increase in our ‘competitiveness’? It’s interesting to note that a spokesperson for Failte Ireland which commissioned a study on costs in restaurant (where wages do make up a significant proportion of costs), was somewhat blasé about the role of wages.

‘“While the recent economic slowdown has moderated cost pressures and, in some cases, led to cost reductions, concerted action will nevertheless still be required on the part of restaurants to contain costs.”

Asked if wages should be reduced, Mr Pender said wages were not all that high to start with. Of the restaurants surveyed, the average hourly rate was €11.67 for chefs, €9.49 for kitchen porters and €9.78 for waiting staff. Ireland’s current minimum wage is €8.65 per hour.’

Understandable. It’s not like anyone could argue that an annualised wage of less than €25,000 per year for trained chefs could be considered ‘too high’.

Will What is Happening Continue to Happen?

Another argument is that reducing wages will contribute to employment creation, thus cancelling out any deflationary effects (e.g. lower consumption, less tax revenue per head). But this contains a number of assumptions that may not play out in the economy – never mind, the Irish economy – in the way that it is intended. Let’s take one small look at what is happening with earnings and employment in the manufacturing sector – always remembering that is just a snapshot which might not reflect longer-term trends.

• In the first quarter of this year, the hourly earnings of production workers fell by nearly 1 percent. The number employed fell by 7,000, or by 5.8 percent.

• In that same quarter, the hourly earnings of management rose by 6.5 percent and experienced no job losses.

Interesting that the sector that saw their hourly earnings fall was also the sector that saw job numbers fall. I wouldn’t push this too far – we’ll have the opportunity to review a longer time span when the new quarterly earnings survey comes out in a few weeks.

The point here is that we shouldn’t automatically assume that a wage decline will, of its own, create the conditions for increased employment. From this snapshot, we see that wage decreases and job losses among production workers have helped the management sector to increase their earnings and maintain their job numbers.

In other words, going forward in our analysis we will have to be careful to distinguish a labour market that is the totality of inputs that readjusts on the basis of changes in the supply-demand curve, and a labour market where outcomes are dependent on relative power-relations between certain, sometimes competing groups.

* * *

None of this is to dismiss the role that wages can play in economic recovery. But what it may require is a more forensic approach, combined with complementary social and industrial policies, rather than the mere fiat of wage reductionism. I will be addressing this issue shortly, for clearly in a relatively low-waged economy (relative to our EU peer group) with a high level of wage and income inequality and a very limited ‘social’ wage – action will need to be taken. If, however, we assume the ability of the market to ‘correct’ itself to the benefit of lower unemployment, we had better be on strong ground. Otherwise, we might end up making matters worse without addressing the real issues behind ‘competitiveness’ and unemployment.

We could get stampeded by a horde of woolly mammoths. And not a lot of good ever comes from that.


Proposition Joe said...

The problem with concentrating on the average wage costs across the entire private sector (cf. your bar chart above) is that our huge cadre of low-wage workers mask out considerable variation in the mid-tier. Do we expect that a recovery, and even the next wave of prosperity, could possibly come from the retail and services side? (Now that the credit binge fueling the last consumer boom is well and truly consigned to history)

Would it not be more instructive to concentrate the competitiveness analysis on those smaller strategic sectors that have some chance of pulling us out of this situation? No disrespect to shop-workers in Maastricht, but what we really need to know is how much Dutch software engineers earn compared to their Irish equivalents.

Paul Hunt said...

Michael, your zeal in defending wage levels and social welfare rates is understandable and commendable. Perhaps, however, you might wish to link your analysis to the subsequent perceptive comments by An Saoi on the impact of NAMA on property prices and rents. Stripping out excessive and unjustified costs is the best way to regain competitiveness. Even if wage and SW rates fall somewhat as well, they might well end up higher in real terms.

Michael Taft said...

Proposition Joe - I used the Forfas study only because it is one of the few studies we have comparing operating costs of enterprises across borders (Forfas has another study - an excellent analysis of the Print and Publishing sectors that runs over 150 pages; in that study Irish wages in the sector are considerably below EU averages but unfortunately the data comes from 2003/2004). So you are correct that international competitiveness won't come from the retailing sector though, given that it is an input, it will have an indirect impact on general costs in society.

Here's the breakdown of one particular sector - manufacturing wages, a sector I'm sure you would agree is important to our cost competitiveness. Again, the percentages represent the relation Irish labour costs with other countries:

Denmark -20.1
Luxembourg -12.0
Belgium -22.3
Sweden -19.9
France -16.8
Netherlands -12
Germany -18
Austria -12.6
Finland -11.9
UK 11.6
Average -16.5

Manufacturing labour costs in Ireland are even lower than in the private sector as a whole.

Just another small statistic - in Germany finance workers earn a wage of €59,400 in 2008; in Ireland the average wage is €56,200 - another key economic sector.

Paul, thanks for the comment. My interest in the wage issue is from the perspective of 'competitiveness'; that is, if wages are already comparatively low, then there may be other inputs we should prioritise to determine competitiveness. It may well be that wages could fall - given the fall in prices - and still, some people might be better off (though I suspect that is altogether a more complicated and grey-area argument) - but that's a separate issue to competitiveness and inputs.

As to social welfare, I would have thought that with falling rents, etc. (though by no means do all social welfare recipients rent in private sector - some rent in the public while a large segment, especially pensioners, own their houses outright), we have an opportunity to right a great inequity. Namely, we have some of the lowest social welfare rates in Europe and one of the highest levels of relative poverty. Using falling prices to repair this would require less investment - but even that investment would be stimulus to business, especially businesses which sell goods and service to low-income earners or which operate in low-income areas.

Paul Hunt said...

Michael, we're not a 100 miles apart. You say "if wages are comparatively low, then there may be other inputs we should prioritise to detremine competitiveness". My focus is on these inputs. Let's leave energy, water and waste water, telecomms, transport utilities and infrastructure on one side for the moment. I think we both agree that there is huge potential for investment in these areas to generate economic activity, to increase efficiency and to lift future growth and economic performance (all contributing to competitiveness), but I doubt we'll agree on the mechanisms required to finance this investment.

(continues in next post)

Paul hunt said...

This leaves us with the whole area of professional, financial and insurance services and the prices and rents of land and property. Major changes in competition law and its enforcement and collective consumer action are required to address the former. NAMA, as currently proposed, is the major hindrance that will prevent land and property prices and rents reaching levels that will boost internal economic activity and international competitiveness. Even while the legislation is ambling through the Dail the Government could cut a deal with the bondholders in Anglo and Nationwide and start the process of winding them up. This would more than halve the famous €54b. Prices and rents would fall and the Government would have to inject more equity in the remaining banks, but they would recover more quickly and the increased equity investment could be disposed of at a profit.

The fall in prices and rents would impact throughout the economy and sensible development projects would be completed - boosting construction employment. I also think some state equity should be used to write down (on a tapered basis) some of the value of the mortgages taken out at the height of the madness.

This is part of my recipe to maintain and grow employment and prosperity. We will have failed (again) as a nation if we allow another generation of young people to depart.

An Saoi said...

Paul, Thank you for the comment to my piece. I have added a further comment, which might be of interest to you. On your point regarding the reduction of wages, there has been pressure on wages already, but as has been pointed out elsewhere, this has been very much among the lower paid and not senior management. This is a problem in both the private and public sector. Roddy Molloy is one example, but perhaps a more worrying one was Frank Daly. Here is a man on a pension of approx. €160,000 per annum, who already has a couple of other part-time jobs, then draws over €120,000 for another part-time gig. At least the Minister's first cousin Feargal O'Rourke took nothing.... I was speaking during the week with a very senior current Revenue official during the week who was appalled by Mr. Daly's behaviour, repeating what he actually would get me barred!!

Paul Hunt said...

An Saoi,

Thank you. I am pleased to see more attention being paid to the surplus profit gouging and inefficiencies that have increased the cost of doing business in Ireland beyond that in our main trading partners - and have, of course, penalised all consumers. And, of course, the knee-jerk reaction is to cut pay and wages rather than to tackle the unnecessary additional costs that justify pay and wage levels. However, I don't think it's wise or useful to personalise the issue.