The risks of cutting wages during this recession

Obviously, the jobs situation in New Zealand is deteriorating. On current trends, unemployment is now expected to reach 8 per cent before this recession is over. Not surprisingly at such a time, the hoary old issue of whether you should take a wage cut to save your job is also back on the table. Most of the time, there is no choice involved. Wage cuts are usually presented to staff as an offer they can’t refuse. Still, in today’s New York Times, economist Paul Krugman takes a hard look at the paradox of such wage cuts when they happen at the same time throughout an economy. The result, he says, tends to be higher unemployment.

How come? Well, Krugman explains :

Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.

But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.

What a fall in wages does is lessen demand – and remember this recession is characterized by the drying up of credit, spending declines and by attempts to pay off debt. All of which are exacerbated by falling wages. Krugman again :

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more than they have in a decade — but as wages fall, they’re chasing a moving target. And the rising burden of debt will put downward pressure on consumer spending, keeping the economy depressed.

Over the course of time, the net effect of those falling wages can readily offset any gains from a decline in interest rates. Dr Bollard can cut interest rates all he likes, but the chances of productive investment reaping returns (in the domestic economy in particular) will remain slim, if falling wages cancel out any savings on the home mortgage, thus leaving the retail sector still spinning its wheels. (Which it is doing. Over the past year, Statistics NZ figures have shown a decline of almost 6,000 jobs in hotels, motels, cafes and restaurants as a result of fewer tourists and reduced domestic spending.) In such circumstances, the temptation for further wage cuts is strong, and is likely to feed the spiral of decline.

The cautionary example, as Krugman says, is Japan – where private sector wages fell by more than one per cent a year from 1997 to 2003. This wage deflation, he argues, made a significant contribution to economic stagnation. Is this kind of scenario likely to play out in New Zealand ? The deterioration in the labour market was evident in yesterday’s Statistics NZ survey – during the March quarter, the figures for jobs filled, hours worked and full time employees all fell during the first three months of 2009.

Even so, any labour cost advantages that might be expected to flow from this growing pool of available labour, as NBR has pointed out, is not yet being reflected in wage surveys, because of the underlying skills shortage. To date, employers have been gritting their teeth and still paying top dollars to attract and retain prized staff – which is probably why, amidst a year long recession, private sector wages actually rose by five per cent in yesterday’s survey. Clearly, this will not be sustainable as the recession continues – and tomorrow’s Labour Cost Index figures should give a more accurate and telling snapshot of just how much the wage window has recently closed, even for skilled workers. On Thursday, further survey figures will show how steeply unemployment has risen from the 4.7 % rate recorded in December.

Up until now, it seems plain that public sector jobs have been helping to save the day. The big job declines have occurred in manufacturing – 19,000 fewer jobs than a year ago, and in building and construction, which is down by almost 10,000. While such closures as Lane Walker Rudkin justifiably gain headlines, there have been, as the Dom-Post has reported, offsetting job increases in the health sector and in education. Which merely goes to underline that if the government does carry out sweeping job restructuring in the public sector, it risks knocking out one of the few props remaining for the domestic economy. The urge to cut costs and reduce debt on one hand are in genuine conflict with the pressing need to keep stimulating the economy.

For these reasons, the Greens home insulation plan is looking more and more like a godsend. Besides the scheme’s intrinsic health and energy benefits, the home insulation programme also bids to create jobs in one of the key employment areas – construction – that is most in need of stimulation. How deeply ironic. As the government’s own flimsy ideas – the national cycle way, the equity scheme with banks – wither away on the vine, it is the Greens who, in opposition, have ended up providing one of the most practical solutions for our ailing economy.


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