Lowering wages is not the solution

3 April, 2017 at 17:34 | Posted in Economics | 4 Comments

In connection with being awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel a couple of years ago, Thomas Sargent, in an interview with Swedish Television, declared that workers ought to be prepared for having low unemployment compensations in order to get the right incentives to search for jobs.

This old mercantilist idea has very little support in research, since it has turned out to be exceedingly difficult to really get clear cut results of causality on the issue.

workers-wages-vsMany well-known and influential economists have for decades been writing out the same prescription — lower wages — for solving no matter what problem facing our economies.

As in the 1920s, more and more right-wing politicians — and economists — 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 the towering debts and create balance in the state budgets.

But, intimating that one could solve economic problems by impairing unemployment compensations and wage cuts, in 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 – of course – 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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4 Comments

  1. Wage cuts would actually reduce unemployment via the so called “Pigou effect”. That goes as follows. In a recession and given a totally free market (e.g. no trade unions) wages and prices would fall, which would raise the real value of money (base money in particular). Plus it would raise the real value of government bonds. But government bonds amount to the same thing as base money, as pointed out by Martin Wolf and Warren Mosler. That all equals a rise in the real value of private sector liquid assets, which would encourage spending, which would cure the recession.

    Of course the latter is a very unrealistic and theoretical point, and a deficit, which increases the number of dollars making up the latter assets rather than value of each dollar comes to the same thing and is clearly a better option.

    I’m pretty sure Keynes made the above points in his General Theory, but don’t remember where. Lars: can you put me right on that one?

    • Keynes has a discussion in GT (ch 19) where he argues that the (possible) Pigou effect would be counteracted (or even overwhelmed) by debt effects (in line with Fisher’s debt-deflation theory) operating on households, private enterprises and the government (lower prices => increased liability).

      • There had been many fine names, like Pigou and men,after and him ,that actually say the same mantra. In Germany ,for exampel,they talk about the 1923 Inflation ,”so long gone, so fare a way “(as old B.Dylan wrote!)But this is not what we dealing with.A Inflation is not the big trouble.(in Germany it even blow away their war war liabilities,in some years.Lars P Syll,who is not not onlya Economic Doctor,but even a Economic Historian,could ,maybee clear things out, for you! Great wishes, in studies. Jan Milch

  2. I just sent this note to my history of economic thought class to accompany this perspicacious piece by Lars:

    Some ideas never seem to die an honorable death! The wage cuts argument suffers from a classic fallacy of composition: any one firm can make more profit per unit if its workers accept a lower money wage. The reason for this conclusion is that nothing will happen to the MPN curve so long as producers are assured of selling all the goods that its workers produces. Any who not? After all, workers at a firm don’t tend to purchase the goods they produce; I don’t take my paycheck and rush over to the registrar’s office to sign up for classes. If that were the case, however, then lowering my wages (I think I get a ‘salary’ – the College is picky about that nomenclature) might prevent me from signing up for as many courses at Skidmore [where I work — RJR] as I would were my wages not lowered. But that’s NOT the case; obviously. And that logic is true for every firms in the economy, ceteris paribus. What’s true for each and every firm taken in isolation of all other firms, is not the same when thinking about all firms. For in that case all the workers do purchase all of those firms’ products (excluding imports in this example). If there were across the board wage cuts (does that include compensation for top execs?) then the lower purchasing power of all the workers would translate into lower sales of all firms’ products. The assumption underlying the MPN curve, that everything produced is sold, no longer holds. Even though the profit margin per unit of output would be higher, total profits would be lower as sales revenue would fall with the reduced demand for all products in the country. As Adam Smith might have put it, the fall in ‘effectual’ demand would result in lower sales, lower profits, and lower employment for the economy as a whole.

    Then there is the argument that artificially higher wages imposed on firms by union contracts (unions? What are they?), minimum wage laws, etc., are de facto taxes on those firms causing a lower rate of profit per unit of output and therefore lower employment (again, for a given MPN function where it is assumed that everything produced is sold – see the Say’s law connection?). Proponents of right to work laws, the abolition of minimum wages, etc., are resting their case on the Ricardian-like argument (not for the cost of foodstuff, however, as was Ricardo’s argument) that higher wage costs would lead to lower profits and therefore fewer dollars left over to be ploughed back to increase capital investment and therefore employment. The view from this top, so to speak, the top that trickles down, argues that it is those firms who make the most profits who are the greatest employers. Everything should be done, therefore, to pursue policies that would allow them to make the most profits without artificial impediments and barriers to that end. Do you see how this argument is based on what we learned when reading J.B. Say, that anyone who produces something is at the same time demanding some other good of equivalent value? Or what we read in Marx when he says that the argument of Say, et al., rests on the assumption that every supplier brings her/his own demanders to market? Such an argument, assumes what it wants to prove: that more people will be employed if there were to accept lower compensation because everything produced will be sold, so there is no reason for any producer not to increase her/his capital stock and workforce if s/he makes greater profit per unit. Dropping the tautological assumption that every producer brings demanders to the market when s/he sells her good, then we’re back to the same criticism that I raised above – the only way that firms will have the incentive to hire more workers is if they’re selling the goods they’re now producing. When thinking in this latter fashion, we are compelled to approach the discourse from a different (or should I say more open) angle: it is not only producers who hire workers by the validation of their sales and the expectation that those sales will persist, but it is also workers who ‘hire themselves’ by virtue of the fact that it is they who are the ones buying those goods that validate their hiring. This argument has been made elegantly and clearly for years by Robert Reich.

    At the end of the day, the argument for cutting worker (notice it’s never executive) compensation, boils down not to economics – because the economic logic is fallacious – but to outright class politics. The irony of ruling class consciousness dominating the playing field, is that such actions that would deprive workers of a suitable (living?) compensation package results in firms trotting out onto the playing field and summarily shooting themselves in their feet: a situation where no one winds up with a job! Except, perhaps, orthopedic surgeons.


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