Wednesday, 1 June 2011

Why are businesses going out of business?

Michael Taft: To listen to employers’ groups and Minister Bruton, you’d think that businesses are going out of business because the lowest paid workers in the economy are too highly paid. This argument has to ignore the EU Commission’s data showing that labour costs in the Irish hospitality and wholesale/retail sector are below the EU-15 average. This also ignores the fact that labour costs in these two sectors have already fallen by between 4 and 5 percent; if cutting labour costs will result in job retention and business survival why hasn’t it already?

So, if it’s not labour costs or high wages in the low-paid sectors, what is the problem? The answer is rather straight-forward: fewer customers spending less money.

We fail to appreciate the scale of the economic collapse in Ireland in comparison with other Eurozone countries: GDP, investment, etc. In particular, we fail to appreciate the collapse in consumer spending. In the three year period of our recession 2007-2010, Irish consumer spending has fallen in real terms by -10.2 percent. In the Eurozone, consumer spending has actually increased marginally by 0.1 percent.

In 2010, we spent €12 billion less than in 2007 – a fall in nominal terms of -13 percent. That is one heck of a hit for business reliant upon domestic demand to absorb – and many of them couldn’t.

The collapse in Irish consumer spending in unprecedented among the original Eurozone countries; there is nothing to compare to our experience – though Greece, a latecomer to the recession, looks set to see consumer spending fall by -13 percent in real terms up to 2011

The next couple of years aren’t going to provide much relief for domestic businesses. Up to 2012, the EU projects Irish consumer spending to fall a further -3 percent. The Eurozone, on the other hand, is expected to grow by 2 percent. Europe goes forward; Ireland lags further behind.

The demands for more pay cuts and Minister Bruton’s proposals are likely to exacerbate this situation. With more taxes coming down the line (the household/utilities charge) combined with rising interest rates and inflation are going to squeeze consumer spending even further. And then there is the precautionary saving arising out of concerns over pension funds, children’s education costs, nursing home costs and rising health insurance premium – a lot of social uncertainty compounding economic uncertainty.

Put simply, businesses are going out of business because there are fewer customers spending less money – whether that’s due to unemployment, emigration, falling disposable income (through tax increases), savings due to fear, etc. If you don’t fix that problem, that problem will persist.

But let’s not be seduced by the argument that if only we could ‘create’ certainty, then all those household savings could be unleashed into the market and growth would be restored. Consumer spending falls are as much a result of the economic collapse as a cause.

Sustainable recovery will occur when we drive up investment (whose collapse puts the fall in consumer spending in the shade). This will drive employment and productivity. More importantly, this will drive sustainable wage-led consumption, rather than credit-led consumption.

We need a different mind-set to the crisis than the one we’re being treated to. In short, when you deflate the economy and wages, you will crash consumption which will feed into further collapse.

In this context, if you believe cutting wages is a means to increase employment is not an exercise in economics. It is an exercise in alchemy.


Gerard O'Neill said...

A few things strike me about the issues you raise Michael. One is that consumer spending in 2007/8 'overshot' what was sustainable/appropriate for the economy because of a credit bubble.

Too many businesses (especially in retail) were established or expanded on the basis of a mis-reading of the underlying reality. They geared up through borrowings for 'more of the same', but instead have gotten a lot less. But the debts are still there of course. As I remind people from time-to-time: debt is a fact, wealth is an opinion.

That said, consumer spending this year will be back to where it was in 2005/6 in nominal terms, maybe a little higher in real terms (due to deflation). Enough for many businesses to survive on, but not for all of them.

So yes, the problem is a collapse in demand from the peak - but the peak was the problem: the subsequent collapse was an inevitable (and very painful) consequence.

As for sustainable recovery, investment is part of the story to be sure. But only part. A return to full employment will come through the services sector which is more labour intensive than capital intensive (with some obvious exceptions).

Wage-led consumption will help in this process - but you can only have a wage if you have a job. Which is why I continue to be perplexed by the view that lowering entry level wages (which is mostly what we are talking about in the case of the minimum wage) is somehow a bad thing.

Getting people (and let's be clear - we're talking mostly young males) into the labour market is vital. Employers will only hire unskilled workers when they believe that the marginal cost of doing so is a risk worth taking given the potential additional staff provides to deliver better or more services.

The same goes for entrepreneurs: in the current climate their main set up cost will be staff wages. So lowering the cost of setting up a service business in Ireland will make it easier to set up business.

The issue isn't aggregate demand - it is marginal demand. No employer cares about GDP and other abstractions like aggregate demand: they care about cost of hiring the next employee and serving the next customer.

Economic recovery will be 'a game of inches' - we'll get their one job at a time, one customer at a time, one start up at a time. Alchemy has nothing to do with it.

Rory O'Farrell said...

@ Gerard O'Neill

There are many studies of the minimum wage and employment. The most anti-min wage survey I can think of is by Neumark and Wascher. However, even with their study the elasticity is almost always less than 1. In plain English, a 1% wage cut leads to less than a 1% increase in employment. (Remember, this is probably the most anti-min wage study. There are plenty that give a more positive assessment.) So any increase in employment or working hours is not enough to compensate workers for the pay lost.

The problem with any such study is that a lot of the effect depends on the general economic environment. I agree that demand for retail in '07 was excessive. However, the economic problem is still due to the decrease in demand. In a demand crisis the effects of reducing demand further are magnified, as there is nothing to 'soak up' the reduction in demand by cutting wages. This effect is stronger the lower the income group.

So we have two competing effects in a closed economy. 1) The direct effect of reducing wages reducing demand. 2) The lower prices due to lower wages increasing demand. The first effect is dominating. This is as wages are less than 100% of the cost of production. So in real terms incomes are falling. (Eg in the hospitality sector wages are less than 25% of output, so a 10% wage cut only cuts prices by 2.5% in the most optimistic scenario where all the pay cut is passed onto customers.) This is clearly the case at the moment. The net effect is shifting income from the low paid to the owners of restaurants etc.

Of course we are not a closed economy. However Irish labour costs for the low paid are inline with the EU-15. For hotels property is the major cost. In Waterford you can stay in a hotel for under €60 a night. In January (off-peak post Christmas) I stayed in a 3* hotel in Sibiu in Romania for €60 a night. This example just illustrates that Ireland's modest wage rates, hotels can still allow price competition with Romania. (Food was a lot cheaper there though)

So overall, cutting the wages of the low paid will probably increase unemployment.

You also make the point of the cost of serving the next customer. There is some spare capacity in the low paid sectors due to the recession, so there will have to be a decent increase in demand before employment increases.

I agree with you about 1 step at a time. I'm not so sure about wages being the biggest cost for establishing a business. I reckon rent/property is (and thankfully thats coming down, in spite of NAMA). I suppose it depends on the sector. In Waterford I see new service businesses opening, that just employ a few people. Your basic family business. I think people are using their redundancy money to open a café, bake cakes etc. They are just using their own labour, giving themselves and wives/husbands a job. I think these are the little acorns from which great oaks will grow.

Michael Taft said...

Gerard - there is much in your comment; a few blogs worth. I'll just address three points.

First, you refer to driving down wages for new, young entrants in the lower-skill sectors. They are already ultra-low. For a general sales assistant the JLC rates for those under 18 is €6.64 an hour. For a first year entrant (over 18) - €7.58; in the second year - €8.54. New workers don't reach the basic rate until the third year.

Similarly in hospitality: under 18 - €6.52 per hour for general floor staff; first 8 months - €6.99; second 8 months - €7.45 per hour; third 8 months - €8.38.

Given the churn in individual firms in these sectors, at any one time a significant proportion of workers are on below minimum wage rates (which puts employers claims in the JLC debate into perspective). So new entrants are already paid the ultra-low wages you are seeking. Surely, you’re not suggesting cutting them even further?

Second, I’m not sure the point you are making re: aggregate and marginal demand. I would have thought (and this is what I get from local businesses that I shop in), the issue is reduced custom. I think you may be under-estimating business people; they are quite capable of totting up the total demand in their premises – and it is falling for all the obvious reasons: unemployment, falling wages and income (including social welfare / family benefit cuts along with regressive taxation), emigration, and precautionary savings. Spend per capita is an important metric.

Third, if growth doesn’t come from investment, where will it come from? We won’t/can’t/shouldn’t spend (private consumption) our way to growth – this is as much a consequence of growth as a feed-in. Ramping up government consumption was tried by FF in the late 1970s to spur indigenous enterprise – a misguided policy with no macro-economic context; indigenous enterprise didn’t respond and we know what followed. Export growth will add some but as long as it remains rooted in multi-nationals, the input into the domestic economy will be limited (the IMF’s description of MNCs being an ‘enclave’ is apt).

Investment is the key – driving productivity, enterprise start-up and developments, employment and wages. And we have gone beyond ‘inches’ (though I appreciate the manner in which you put it, much of which I would agree with). With some forecasters estimating that employment levels will remain below peak level for the next 20 years – we need kilometres of investment, not inches.

paul sweeney said...

While I agree with Gerald’s point that the peak of consumption was an artificial peak, the fall has been stunning. Of course, we did not know that at the time that we were in a massive bubble. Some of us thought that there was a bubble (mainly in property) but we certainly did not know how big it was. Nor how hard the fall would be. Those who were beginning to warn of it were told to go and commit suicide, by the then Taoiseach.

Michael takes consumption, but if you take all domestic demand, the fall has been from €43bn in Q1 2008 to €32.9bn in Q4 2010, the last available National Income data. This is a fall of a staggering 24% in less than three years in Domestic Demand.

In normal times businesses can expect a small rise in this of around 2 or 3 per cent a years, but to suffer a fall of one quarter is staggering. Deflationary policies, of the magnitude we have endured for 3.5 years, do not assist.

On the point of wage cutting leading to more jobs, the Duffy-Walsh report undertook a literature review which does not point to wage or premia cuts generating more jobs (to sell coffee to whom, when demand is eviscerated?), but their “regression results do not provide evidence that there are positive wage premiums for JLC workers.” Their “analysis fails to provide any large wage premiums.”

Ireland has a major economic crisis, caused in the main by de- or un-regulated banks. We are swamped by socialised private banks debt. This, our major economic problem has generated unemployment, insecurity, etc.. It is not a labour market reform issue. Nearly all studies show Ireland has a very flexible labour market. We should focus on the real problem –the banks and financial system.

But I suspect crass opportunism by the employers and conservatives. It is a case of “never let a good crisis go to waste.” The downside is that it detracts from much more serious issues which needs intellectual work.

Paul Hunt said...

"The downside is that it detracts from much more serious issues which needs intellectual work."

Intellectual work? What intellectual work? There is real work to be done. The process of public policy formulation, scrutiny, amendment, enactment, implementation and review is broken. It's time for backbench TDs to get off their backsides and get this working in the public interest. Let the intellectual effort be applied here to thrash out the best policy options in an open and adversarial manner.

The process of economic regulation is in an even bigger mess. It needs major reform, but the principal requirement is to establish statutory, robust, adversarial advocacy of consumers' interests on a collective basis. Why not apply some intellectual effort to ensure there is an equitable balance between the interests of consumers and citizens and the interests of the providers of finance, the management and staff of the regulated businesses?

The EU/IMF MOU sets out a number of time-bound actions that are very much in Ireland's interests. Time to get cracking on these and informing citizens about what is involved and required and why. (My only regret is that the IMF did not give itself/have enough time to dig into more of the serious policy, regulatory and competition law dysfunction than it did.) It's a good start, but it gives the government quite an amount of discretion to avoid tackling areas that are crying out for reform, to water down implementation and to kick things into the long grass.

Still it's considerably better than anything they would come up with by themselves.