Tuesday, 15 September 2009

The wooly mammoth conundrum

Michael Taft: How frustrating to read a generalised statement that has the hallmarks of authority but completely breaks down after a mere few minutes of looking up the facts. In the Irish Times this morning, Brian Devine – an economist with ‘stockbroking firm NCB’, is reported as making an authoritative statement:

‘The high cost of services used by business, ranging across accounting, law, waste disposal and energy, are seen as “non-pay” items, but Devine agrees wages in these are a big element of those costs, as pay accounts for 58 per cent of the overall economy.’

Now let’s look up some facts. First, that ‘pay’ accounts for 58 percent of the overall economy. The CSO’s National Accounts show that total ‘wages and salaries’ came to 47.6 percent in 2008. Now, this is a long ways off from 58 percent. Throw in employers’ social security contributions and it’s still a long ways (51 percent).

Of course, this ‘wages and salaries’ figures is not just about workers’ pay. It includes management and proprietary owners where they take income through wages, including their bonuses, benefit-in-kind, etc. The latest CSO data shows that management remuneration makes up over 36 percent of all labour costs in the manufacturing sector. I’ll go into more detail on this in a later post. Suffice it to say, when looking at gross wages and salaries in the economy – one has to remember this includes the pay, bonuses and benefit-in-kind of highly paid CEOs and senior management.

But let’s return to this alleged ’58 percent’ figure. It is cleverly used as an argument that wages are a big component of the high costs of services used by businesses. The equation works like this: Services are high cost, wages make up 58 percent of the overall economy; ergo, wages must make up a significant proportion of those high costs.

Neat. Except that those darned facts get in the way again. Let’s turn to the CSO’s Annual Services Inquiry. Unfortunately, the latest data we have is from 2006 – but these proportions don’t change much from year to year.

Under Business Services, there is helpful breakdown of the different services. These categories that I’ve selected make up nearly 90 percent of all non-real estate business services in the state.

What do they tell us about wages?

 Wages, including employers’ labour costs (PRSI, etc.) make up 22.6 percent of total operating costs. Less than a quarter. In some sub-sectors, wages make up a higher proportion – in the more labour intensive business. But even here, we are light-years from the alleged ’58 percent’.

I have constructed a ‘real devaluationist’ test. With Dr. John Fitzgerald and others going around saying we need to cut wages in the private sector to up our competitive game – let’s test this. What would be the effect of cutting wages by 5 percent on the operating costs in these sectors?

1.1 percent.

Let’s put this in perspective. If there are problems with high costs, lack of competition, sheltered sectors, etc. – is reducing total operating costs by 1 percent really going to set things right?

Of course, this doesn’t take into account the fact that a significant proportion of these wages are management and proprietary owners/directors pay, bonuses and benefit-in-kind (and as we’ve seen before, they don’t do cuts – at least, not for themselves).

And this doesn’t take into account the deflationary impact on domestic demand – which would drive down income to other businesses selling goods and services into the domestic economy.

And this doesn’t take into account the deteriorating impact of the Exchequer deficit – less income = less tax revenue (income tax, PRSI, VAT, etc.).

So all this – to reduce operating costs by 1 percent.

It’s like taking a pea-shooter to hunt a woolly mammoth.


Pavement Trauma said...

So if ~48% of the overall economy is wages and salaries, how are personnel costs only ~23% of the operating costs of the (labour intensive) business service sector? This must mean that either other sectors like manufacturing and agriculture have much higher proportion of wages than the 48% overall average (unlikely) or ... something else.

It doesn't take much thought to see it is something else. What is omitted from the above piece is any consideration of indirect wages costs - the wage costs component of all the goods and services supplied. Aggregating these
up you get a much higher figure than is quoted here.

Table 1 in the CSO National Income report shows ~€90 employee renumeration and self employed income in 2007. That was 48% of GDP or 56% of GNP.

By the bye, the ESRI Hermes model (oft quoted round these parts) predicted an increase of 1.4% in GDP and 2% increase in numbers employed from reducing nominal wages by 5%.

Michael Taft said...

The distinction, Pavement Trauma, is how one counts intermediate and final consumption of goods and services going into the process of producing goods and services.

I take the point that a cumulative series of wage costs at each stage of the varied inputs will show up some different numbers. But so will the same cumulative series of non-wage costs.

I would refer you to the excellent Forfas survey as an example (indeed, one of the few examples to tackle the issue of enterprise costs - we need one for each sector and spread throughout all our peer-group nations). Namely, their survey of retail enterprise costs. They show that, in comparison with Maastricht (the only Eurozone comparator), costs of running a retail enterprise are higher in Dublin. But, wage and labour costs are significantly lower here.

As to the ESRI HERMES programme - it just shows you that the output is dependent on the input. I don't accept the inevitable consequence of reducing wages will immediately result in employment increasing (as the ESRI model suggests). First, there has to be a demand for labour – yet firms are shedding workers because of a lack of demand for their products / services. Second, it assumes that firms won’t pocket the difference to help out cash-flow issues arising from the credit crunch – a rational thing to do (but there are better, less deflationary ways to solve that problem). Third, it assumes that management/owners won’t pocket the difference – note the CSO Earnings and Labour Costs survey I referred to: workers earnings down, management earnings up. Also, it doesn’t sufficiently take into account the loss of spending power in the economy. To wipe out five percent of people’s income must surely impact heavily through domestic demand.

At the end of the day, we are a relatively low-waged economy. According to Destatis (German Statistical Board) who have the latest comparisons from 2008 4th quarter, Irish labour costs are more than 13 percent below our peer group in the EU (the top 10 economies).

All I’m asking is that other, larger inputs be examined – with the same intensity as wages are examined (but with not the same blinders).

Forfas survey can be read here http://www.forfas.ie/media/forfas081222_retail_running_costs.pdf

Pavement Trauma said...

I take the point that a cumulative series of wage costs at each stage of the varied inputs will show up some different numbers. But so will the same cumulative series of non-wage costs.

The basic point of the piece, that a 5% cut in wages would only result in a 1.1% reduction in operating costs, is completely incorrect. The output of one firm becomes the input of another. If you take that point then you must accept that it is the aggregate proportion of the economy accounted for by wages that should be used to estimate the effect on costs or prices of a wage cut (the 48% or 56% or 58% figure, depending on your preference).

Alan Matthews said...


I had drafted this comment before reading Pavement Trauma's comment, but it is relevant to what both of your are saying. As my comment is too long to be accepted, I have broken it into two separate comments.

While your criticism of Brian Devine’s statement in this post is basically correct, the analysis you present of the importance of wage costs to prices in the economy is incomplete. It is worth trying to spell out the complete analysis here.

You answer the question “What would be the effect of cutting wages by 5 percent on the operating costs in these [service] sectors?”. Let’s take your example of computer services, where personnel costs are 13.3% of operating costs (or, more relevantly if we are interested in the effects of wages on final prices, 11.5% of turnover which is even more favourable to your argument). The remaining 88.5% of the firms’ turnover is spent on goods and services, taxes and, of course, gross operating surplus or (loosely) profit and depreciation.

Your point is that if wages were cut by 5%, then using your ‘real devaluationist’ test, prices in this industry would hardly be affected, falling by just 0.58% (i.e., 11.5 * 0.05). But this would be the case if only wages in the computer services sector were cut. The case being made for a generalised wage cut to improve competitiveness assumes that there would be an economy-wide cut in wages.

To see the difference this makes, 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.

So as well as the direct effect of the wage cuts on the wages bill in the computer services industry itself, there is a second-round effect on the cost of purchases. And because a reduction in wages would also reduce the costs of the inputs purchased by these supplying firms, there would be a third-round effect as these savings are passed on, and so on.

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. In order to do this, we have to resort to the methods of input-output analysis. An input-output table (more correctly, for the technically-minded, the Leontief inverse of the domestic flows of the input-output table) shows how every euro spent on buying some final good or service is broken down, ultimately, into one of the four basic components of costs. These are imports, employee compensation, taxes less subsidies, and operating surplus. What are called input multipliers show, after all the cycles of production are completed, how expenditure on an additional unit of final demand is spread over these input categories. Conversely, we can use these input multipliers in reverse to estimate the impact on the price of a unit of final demand of an increase in the cost of one of these inputs.

more on next comment.....

Alan Matthews said...

Continuation of previous comment....

Fortunately, the CSO calculates these input multipliers for us in the publication “Supply and Use and Input-Output Tables for Ireland 2005” which is the last year for which an input-output table is available. Unfortunately, the sectoral detail does not correspond to the sectoral breakdown you use in your post. However, for example, the direct plus indirect wage costs as a share of the price of final demand in computing services is 20% and for ‘other business services’ which includes most of the rest of your categories the share is 34% (these figures are from Table 5 in this publication).

Incidentally, for the economy as a whole, the relevant ratio is the ratio of ‘compensation of employees’ to the value of ‘final expenditure’ (this latter defined as the sum of gross domestic product at factor cost plus imports used for production). It is the need to factor in the cost of imports which means that just comparing the share of pay in national income is incorrect when trying to estimate the impact of a wage reduction on our cost competitiveness. From earlier tables in this publication, 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.

So you are right to criticise the idea that wage costs are the largest contributor to the selling price of goods and services, but this only goes to show how fiendishly difficult it will be to restore competitiveness. In my view, a reduction in wage levels is vitally important if we are to succeed in this.

You worry about the deflationary impact, without taking into account that what counts for businesses is total spending power in the economy, not spending power per head. In the public services, for example, the gross pay bill would be maintained, but total employment would increase. Similarly in the private sector. Without a cut in wage levels to restore competitiveness, the deflationary impact simply appears as rising unemployment and rising emigration, it does not magically disappear. In my view (as someone teaching young graduates who are now coming on to the labour market), that is not an equitable way of sharing the burden of adjustment to our current economic crisis.

Michael Taft said...

Unfortunately, Pavement Trauma and Alan, I am away from my desk and can`t give the reply both your comments deserve. However, on my retun I will adress these issues zhich; Alan, you provided considerable clarity:

Pavement Trauma said...

It is the need to factor in the cost of imports which means that just comparing the share of pay in national income is incorrect when trying to estimate the impact of a wage reduction on our cost competitiveness.

Alan, thanks for your genuinely illuminating comments. You are entirely correct - I was not considering imports in my response. I guess it be more correct to say that 48% (or whatever) of the costs that we have control over are wage costs.

Can one make the assumption that the foreign economies we compete with pay, on aggregate, the same price for imports that we do (if not, necessarily the same % of imports)?

paul sweeney said...

Alan, PT and Michael, I take Alan's point on the emphasis on a generalised economy wide-cut in wages, but I disagree on teh need for such a cut (in the basic rates, especially). Competitiveness is much more complex than total costs, labour costs or even actual pay rates, as I have argued in several blogs on this site. Irish pay levels (to workers) are still behind those of most of our competitors, but more importantly, Ireland'd total labour costs are 18th down in the list of 30 OECD members. So we are still competitive even though wages have been rising rapidly here for some years. Several economists have recently asserted that our wages costs/rates are higher than in EU, but no evidence has been produced...because they have are unavailable. Further, consumer prices faced by workers here are much higher than in the EU15 and higher again compared to the 27 (part of our problem). Maybe if a wage deflation worked here prices would fall. I am not sure at all.

I have been beating the high costs drum for 5 years or more... mainly focusing on the deliberate shift to consumption taxes on pushing up prices and the simultaneous reducton in income and profit taxes... to no avail. We missed that opportunity to reverse that fiscal shift.

Martin O'Dea said...

This is a very interesting debate. Two opposing and strong arguements for the economic impact of wage cuts, plus their associated real-life impacts are on display; and both seem viable. While this is clearly a debate prompted by a discussion of wage-cut implication if I could beg patience to broaden the grounds a little.

Ireland explored with some success a liberal economic perspective with undoubted leanings towards certain interest groups and weak service provision being by-the-way ressults of this economic "tide lifting all boats" and relatvie low governemnt involvement policies.

The negative impact of indebtetdness resulting from a short-termist and capital-centric paradigm has come into focus sharply in the initial housing slump and then international credit crisis' searchlight on the Irish economy.

The government (give-or-take-a-few) that held the reins during this process is still in power and attempting to redirect the national approach while being required to defend the general tenet of their stated earlier policies; in light of this, then at best this will lead to a return to the status quo as outlined regarding the groups who retain a prioritised position in power making and another inevitable boom and bust (making the same mistake and awating different outcomes) or at worst a complete absence of the boom.

Polticially then this is a clear opportunity for a political and societal reallignment of values and priorities

What is needed, perhaps, at this juncture and in this conutry then is an alternative political perspective to the current offering. A perspective with policies that empower further, rather than burden with a negative earning debt, the many. Issues that people in the round express as their priorities; healthcare, education, policing, concern for the young and elderly and protection for the disadvantaged should supersede appeasement of the cheque signers.

Concurrently in arenas such as nanotechnology, genetics and robotics the world economy as always driven by innovation is arguably at a point of readiness to embrace progress at a rate surpassing anything previously seen when the financial economy can be recovered to the point of facilitating this progress.

There should now be a major investment in education; as to be a leading economy in the next technological surge will require vast numbers of graduates in disciplines that those graduates could not currently even identify. The drive up the value chain and the leading position in R&D and innovation should be pursued relentlessly.

In this context then, wage cuts may not be seen as the right move, as they are momentum gatherers in a certain direction and embody a nation trying to hide its mistakes and save itself; when what is needed is an admission of those mustakes, a political reallignment, and an embracing of future possibilites. Retraining and upskilling should be a further priority and surely to think of charging for education in an ever more informed and empowered society where information comes faster and cheaper is a most counter-egalitarian and counter-productive move.
Perhaps, one might also argue that to pursue this strong governance what is required is not just an election but an explanation of the countries financial plan.

Instead of defending investment in property mid-property crash perhaps a plan of investment would be outlined for the money we are directly/indirectly borrowing. Perhaps the money would be better spent educating the future employee than protecting the existing power brokers.

In this context temporary nationalisation of banks, open borrowing from the ECB, investment in health, education, research, and infrastructure, as well as the always necessary propper management of public spending should be pursued

Slí Eile said...

@Martin Excellent comment. I couldn't agree more with you. Everything you wrote, I think, rings true and loud. And 'Polticially then this is a clear opportunity for a political and societal reallignment of values and priorities'. Absolutely!

Martin O'Dea said...

Thanks Sli Eile. I believe only a Labour led Government under Eamon Gilmmore could begin to offer such a proposition. I feel Fine Gael suffer the same weakness as their more successful counterparts, i.e. that they have resulted/evolved from a scramble for influence after historic events - rather than representing any ideologies and emerging from the wishes of the people.

I sincerely hope that Fianna Fail will be a spent force after the next election; their past success being rigthly attributed to their greater hunger for power and desire to win a game; and anethema to the concept of politics as a service! So for someone like me the hope is for a renewed Labour led government emerging from a selection of hopeful (and hardworking on others behalf) successfully elected new Dail candidates.

Perhaps FF and FG would blend together in the long-term to give us the standard Centre/Left - Centre/Right balance found in so many countries.

However, where I come from this will need the same breakthrough factor as an African-American U.S. President. Clearly, in Dublin FF are going to hurt but in other areas if they survive to 2012 and can resist the then tiring anger of the population (and find any sort of positivity at all for presentation) they could still top the poll!!
And the political and societal realligment we so justifiably seek could be stalled for a very long time

Paul Hunt said...

"open borrowing from the ECB"?!?
The ECB is explicitly prohibited by its own rules from lending directly to governments. It is currently providing large voluems of short term liqudity which it has allowed some of the weaker Eurozone members to convert into indirect government funding. These liquidity advances will have to be repaid.

There is no Fairy Godmother out there prepared to throw good money after bad. Quite simply, some existing state equity will have to be realised to generate the leverage for additional external financing.

Slí Eile said...

@Paul You may have seen John McManus' article in today's Irish Times

as well as last Saturday. The scale of 'indirect' lending via bond collateral is considerable.

Martin O'Dea said...

Paul I agree that the ECB and the Irish government are clearly bound to each other in complex ways currently, involving budgetary conservatism required from the government and clearly the point John MacManus makes regarding the importance of the euro in this and indeed a whole array of other elements would tie them in that manner.

However, there may be errors in just accepting the current boundaries as a fait acompli. Firstly, this may be the best deal that the current government can make. However, it may be percisely for this reason that we would benefit from an immediate change in government. The economist decision makers in the ECB are surely aware of the limitations of having a government that can call on such low popularity in an arena such as a volatile economic dynamic that places such emphasis on trust. It is less likely that any economic plan arrived at by this government would work due to this inescapable weakness.

We might well speculate that with a new government and a mandate from the general population offering at least a period of trust the ECB's willingness behind the scenes or in the relative open to give greater rein to that government. We could further postulate that this new government would be much less in a weakened bargaining position with the ECB and would rightly set about a progressive road to recovery with an assured support from the ECB rather than the clandestine arrangement that currently operates with a government that will hang on regardless.

The above may seem like political bias Paul, but there is I feel a large dollop of truth in the fact that the four and a half million final adjudicators in matters of the state have bayed for the blood of banks and others and are being denied the opportunity of the cleansing process of an election.

In the end, I feel, we must also be careful to not unnecessarily dampen our future position and drive by becoming overly focused on knee jerk harsh measures and dampening over caution as opposed to measured confident purpose; but again this changed outlook necessitates a changed government

Paul Hunt said...

@Sli Eile,

I (and many others) have been pointing out the ECB's role for some time. It provides little satisfaction that the journos have finally cottoned on. But the ECB wants to wind down this excessive support and this is the key issue in the Lisbon vote. A No vote could encourage a more rapid winding down of this support.

I don't disagree with the thrust of your response, but my focus is on the mix of economic policies required when this government is gone. It is focused on politcial survival irrespective of the damage done.