Cutting wages is not the solution

20 February, 2017 at 19:01 | Posted in Economics | 7 Comments

axA couple of years ago yours truly had a discussion with the chairman of the Swedish Royal Academy of Sciences (yes, the one that yearly presents the winners of The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel). What started the discussion was the allegation that the level of employment in the long run is a result of people’s own rational intertemporal choices and that how much people work basically is a question of incentives.

Somehow the argument sounded familiar.

When being awarded the ‘Nobel prize’ for 2011, Thomas Sargent declared that workers ought to be prepared for having low unemployment compensations in order to get the right incentives to search for jobs. The Swedish right-wing finance minister at the time appreciated Sargent’s statement and declared it to be a “healthy warning” for those who wanted to increase compensation levels.

The view is symptomatic. As in the 1930s, more and more right-wing politicians – and some economists – now suggest that lowering wages is the right medicine to strengthen the competitiveness of their faltering economies, get the economy going, increase employment and create growth that will get rid of towering debts and create balance in the state budgets.

But, intimating that one could solve economic problems by wage cuts and impairing unemployment compensations, in these dire times, should really be taken more as a sign of how low the confidence in our economic system has sunk. Wage cuts and lower unemployment compensation levels do not save neither competitiveness, nor jobs.

What is needed more than anything else in these times is stimulus and economic policies that increase effective demand.

On a societal level wage cuts only increase the risk of more people getting unemployed. To think that that one can solve economic crisis in this way is a turning back to those faulty economic theories and policies that John Maynard Keynes conlusively showed to be wrong already in the 1930s. It was theories and policies that made millions of people all over the world unemployed.

It’s an atomistic fallacy to think that a policy of general wage cuts would strengthen the economy. On the contrary. The aggregate effects of wage cuts would, as shown by Keynes, be catastrophical. They would start a cumulative spiral of lower prices that would make the real debts of individuals and firms increase since the nominal debts wouldn’t be affected by the general price and wage decrease. In an economy that more and more has come to rest on increased debt and borrowing this would be the entrance-gate to a debt deflation crises with decreasing investments and higher unemployment. In short, it would make depression knock on the door.

The impending danger for today’s economies is that they won’t get consumption and investments going. Confidence and effective demand have to be reestablished. The problem of our economies is not on the supply side. Overwhelming evidence shows that the problem today is on the demand side. Demand is – to put it bluntly – simply not sufficient to keep the wheels of the economies turning. To suggest that the solution is lower wages and unemployment compensations is just to write out a prescription for even worse catastrophes.

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7 Comments »

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  1. Thanks for this post. From a Marxist perspective, which I am sure you have come across, there is potential for wage cuts or slowing wage growth to restore the rate of profit which then eventually fuels investment and growth. Having said that, I am still wrestling with the profit-led vs wage-led growth debate, and can understand how wage cuts can, by reducing consumption, reduce profits in wage-good industries, and from there reduce profits in capital-goods industries, which slows overall investment, growth and employment. But there is surely a tension between the production of surplus value or profit, and its realization via growth in demand. I wonder what your thoughts on this are. Many thanks.

  2. Its a circular system. When wages are cut and production is also reduced, then consumption is also down. The only people to benefit are the producers and that only until the lowered consumption catches up with lowered production. Wages should be made as high as the producers can reasonably afford, in order that the greatest amount of consumption can take place, thereby providing the highest standards of living. The dynamics of making more profit in the short-term has the opposite long-term result.

    • David. I am trying to work out if your tongue is in your cheek or not. And in case not – surely any businessperson would minimise wages as maximum short-term profits also mean maximum investment into the business for the best long-term result

      • I am quite serious. If you examine my paper in SSRN 2865571 on macroeconomics modelling and also in SSRN 2600103 on teaching with this model, you will better appreciate how the money circulates.

        Now as you should know, economics is a competitive thing. There are two sides, with the workers having to accept the least wages only if they have no skill and experience. With these assets well developed, they will seek a job where they are better paid than the minimum wages that their (your) businessperson (manager) begins to offer. Not every job employs its workers for short-term profits and some companies proudly emphasize how much skill and know-how they have managed to find and employ at considerable cost in order to provide long-term service and reliability.

        The other general side of wages I have already explained. When some desirable goods cannot be afforded due to low wages, the long term effect is less business, less employment and a few fat cats having to keep away from violent ex-employees.

        • But your example of paying high wages can be explained as avoiding all the costs associated with employee turnover such as recruitment and training and looking after customers when key employees move on. So I would say the employer is maximising his profits – maybe not over the very shortest term (months), but I would not say this is just a long-term strategy.

          And your example only applies to businesses which require high levels of skill and training. If your business is pushing a brush along the floor, the level of skill and remuneration will be much lower. And there may be some people who want that type of job either because they cannot acquire alternative skills or because they have non-employment reasons for wanting that type of work.

  3. We should be discussing the effect of wage cuts on business progress. I think Huw is off the point. For business to succeed the need is to support not screw the workers, is vital.Unless you think that child labor and no proper education is how a country can grow. Even in China they now know a bit better than that!

  4. This problem was presented by Henry Charles Carey in his book “Essay on rate of wages”. He said that capital grows when wages are high, asuming that worker also investing part of earnings ( in these days as Studies, but also in other areas) . His critic on Ricardo and the consequence slavishness to all humanity. Appears than all this speech is a continuation of Ricardo and “classic” economists until to day.


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