Cutting wages — the wrong medicine

6 Jan, 2019 at 16:20 | Posted in Economics | 1 Comment

'Sure, your salaries are low but think of all the apples you're getting.'A 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’ in 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 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 is stimuli 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 crises in this way is a turning back to those faulty economic theories and policies that John Maynard Keynes conclusively 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 catastrophic . 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 in 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.

1 Comment

  1. “Demand is — to put it bluntly — simply not sufficient to keep the wheels of the economies turning.”
    There is something very dogmatic about the assumption that economies must grow GDP. GDP is over half made up as Jacob Assa and others (Diane Coyle) have documented recently.
    Why do statisticians drop standard error from their imputed GDP statistics? Standard error should be calculated for each summary statistic included in GDP. The errors multiply when using GDP to scale some other figure with its own standard error. The result would be error bars of plus-or-minus 100%, I bet. Any story you wanted to tell could then be justified as plausible within the 95% confidence interval of any GDP or GDP-scaled figure.
    I personally want to reduce my demand as I learn more. How do I fit into economic models of growth capitalism?
    Do economists simply ban me from their inboxes, thereby ignoring my microfoundation because it doesn’t fit their story that growth is good, mmkay?

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