Some Thoughts on Wages and Competitiveness

There’s a lively debate going on about Philip’s earlier comments about competitiveness and recovery and I wanted to add to it but then wrote something so long I decided it would be best to exploit privilege and start a new post.

Let’s start with what I see as two correct points being made by those focusing on wage cuts.

1. Labour demand curves slope down. So an exogenous decline in wage rates will increase the demand for labour. And more people working will result in a higher level of output (in textbook microeconomics, this all happens at once, as the factor demand decisions of the firm simultaneously determine output.)

2. For an exporting producer, the wage that matters for their profits, and thus their labour demand, is the real product wage. So if a devaluation raises the real product wage, then this will raise labour demand and output. With this option gone, there is an increased focus on the first point.

That’s fine as far as it goes. However, consistent calls from economists for wage cuts to assist economic recovery should also be interpreted against the background of a few wider issues. I’ll focus here on four areas.

The Macroeconomics of Labour Markets

Despite what seems to me to be an exceptionally strong attitude in this country of calling on the government to solve every possible problem, we are largely a market economy and wage rates are set in a relatively decentralised fashion compared with other European countries. And despite the faith of many that unregulated labour markets should always clear to produce full employment, we have plenty of macroeconomic evidence that this is not the case.

The reality is that, in all economies, negative macroeconomic shocks tend to raise unemployment because wages never adjust quickly enough to get the labour market back to full employment. This has been a mainstream theme in macroeconomics since, at least, the General Theory.

In more recent decades, New Keynesian macroeconomic theorists have put forward a plethora of models to explain why the labour market does not operate in a simple market-clearing fashion (efficiency wages, implicit contract theory, bargaining models based on “holdups”). More recently, behavioural economists have documented the importance of “money illusion’’ which makes workers particularly resistant to cuts in nominal wages. The result is a significant amount of empirical evidence demonstrating the existence of nominal and real wage rigidity.

This is not to argue that wages are completely rigid or that the labour market does not have mechanisms to bring unemployment down after a negative shock. Macroeconomic data generally show good fits for Phillips Curve relationships such that wage growth is low when unemployment is high. But governments will generally not want to rely only on this mechanism to restore macroeconomic equilibrium because the pace of recovery will be too slow. Instead, they prefer, where possible, to use countercyclical fiscal and monetary policy.

In relation to Ireland today, these points suggest that, whatever the government does, wage cuts on their own are unlikely to deliver a fast economic recovery, though very high unemployment rates will restrain wage growth in the coming years.

But Aren’t Wages Far Too High?

One reaction to the points above is that we are in an exceptional situation that differs from that described by textbook macroeconomics. Whereas I have focused on the normal process of market-driven wage-setting, some would argue that what happened in recent years in Ireland represented some form of extreme departure from normal market practices and that we now need to come back to reality. And certainly, anyone who reads the newspapers or listens to the radio will regularly hear that “we’ve been paying ourselves far too much in recent years.”

But what’s the benchmark here? The various comparisons that one reads about nominal or real wage growth in recent years or wage levels relative to other countries still tell one little about what is a reasonable underlying level of wages. For instance, high real wages (W/P) can be justified by high levels of productivity (Y/L). A useful indicator that allows us to compare real wages with productivity is the labour share of income (WL/PY or real wages divided by labour productivity).

Data on the labour share of income from the European Commission (see page 94 of this PDF file) tell us that Ireland’s labour share of income declined throughout the 1980s and 1990s and bottomed out at 52.4 percent in 2002. So, throughout that period, productivity rose faster than real wages. This pattern reversed itself a bit in subsequent years, so that by 2007 the labour share had risen back to 58 percent. However, this is still a very low level by international standards. The EU-15 share for that year was 65.3 and has remained in a narrow 65-67 range over the current decade.

There are some measurement issues that affect this calculation—in particular the existence of some very high productivity, low employment plants in the Irish pharmaceutical sector—but I’m pretty confident that the conclusions about both the trends over time in Ireland and the level by international standards can hold up to appropriate adjustments.

By this reckoning, Irish wages could still have been judged as relatively low relative to justifiable productivity levels in 2007. Let me be clear, however, this is not the same as arguing that the housing bubble didn’t damage the economy. The remarkably skewed incentives that stemmed from the bubble meant that we ended up with a huge fraction of people employed in the construction sector and (since we were already at full employment) this squeezed out employment in the more cost-sensitive tradable sector. The next few years will see this process reversed, but only slowly and painfully.

What Can the Government Do?

Of course, our wages are not solely market-driven. The government can have an influence on wages through its influence as the state’s largest employer. By cutting wages for public sector employees, this can have an effect on economy-wide wages by influencing the various relativities. I’m not sure, however, exactly how strong this mechanism is. There is strong evidence that Irish public sector wages are above comparable prevailing market rates. Cutting public sector wages may end up reducing this premium without actually affecting private sector wages if public sector jobs are still seen as more attractive.

In any case, it should be kept in mind that the government has already taken some action here—the public sector “pension” levy reduced net take-home pay for public sector workers by about 7 percent. This is a large wage cut by international standards. It is likely that there are more public sector pay cuts to come but the impetus will largely be the state of the public finances and the evidence for public sector pay premia, rather than their impact on economy-wide wages.

Beyond public sector pay, the Irish government could perhaps encourage lower wages by deregulating the labour market. It is well known that average levels of unemployment across countries tend to correlate positively with labour market rigidities, so reducing these rigidities may help to limit the increase in unemployment.

Three points can be made on this. First, even highly deregulated labour markets such as the US are suffering from high levels of unemployment during the current recession, so deregulation is not a panacea for recession. Second, Ireland does not have a highly regulated labour market: The World Bank’s Doing Business survey ranks Ireland 38th in the world in terms of the freedom of its labour markets, compared with 142nd for Germany and 148th for France. Third, social protection measures are popular with the electorate and, to some extent, many citizens may be willing to accept higher unemployment rates in exchange for labour protection laws and generous welfare benefits.

Within the set of available options and against the background of deflation, I think the comments from various government ministers that a cut in the minimum wage needs to be considered, and the Snip recommendations of reduced welfare rates, are reasonable. However, I think the overall effects on employment of these measures would be limited.

The Loss of the Devaluation Tool

Finally, there has been a lot of hand-wringing about the loss of the devaluation tool. I think this loss is being overstated. Yes, devaluation can have a positive short-term effect but its competitive effects tend to get offset fairly quickly by inflation. And remember that EMU monetary policy has contributed to counteracting our current recession by giving us historically low interest rates of 0.5%. The cost of the existence of the devaluation tool is the high interest rates that come from the threat that we use it occasionally. The current period is a reminder that the long-term gains that come from the commitment to EMU can come at the expense of occasionally substantial short-term losses.

Of course, being in a currency union influences how macroeconomic policy should be formulated. However, while many influential commentators have focused on allowing wages to get out of hand as the key mistake made during our period in EMU, I would argue that the mistakes relating to our decidedly pro-cyclical fiscal policy and shrinking tax base were an order of magnitude more important. It is these mistakes that have left us without a macroeconomic tool to soften the effects of the recession.

None of these points are meant to criticise those who argue for cutting public sector pay rates, minimum wages and social welfare rates, all of which can be justified in the current situation. However, without a useful context and reference to actual policies that the government could undertake, generalised grumbling about wage levels isn’t very useful.

16 thoughts on “Some Thoughts on Wages and Competitiveness”

  1. Karl:
    Very helpful survey of the issues.
    But your claim “remember that EMU monetary policy has contributed to counteracting our current recession by giving us historically low interest rates of 0.5%” ignores the effect of (expected) deflation on the real interest rate. Firms borrowing in Ireland face nominal interest rates of over 4% (assuming they can persuade their bank to lend) and they should factor in expected inflation of minus 2% (on the HICP measure), so they face real interest rates of over 6%. It takes a lot of courage to shoulder these costs of borrowing in the face of (at best) flat aggregate demand.
    You believe the loss of the devaluation instrument is exaggerated because its “competitive effects tend to get offset fairly quickly by inflation”. This may have been true in the past – although it depends what you mean by “quickly” – but things might be different this time – Iceland’s experience will be relevant. But whatever about its effects on wage/price competitiveness, a devaluation would be more likely to reduce real interest rates to where they should be in the depths of a recession than will be possible through the deflationary route.

  2. Nominal rigidities for experienced workers, particularly in the public sector, arise partly of course because of contracts and partly because of social customs. Money illusion, as Karl mentioned, is also a potential reason. Also, in some of the papers, rigidities work both ways. I don’t know whether this concords with the experience of employers reading this blog, but a lot of the interviews done with wage setters in US suggested that they preferred to let people go rather than push wages downwards due to the potentially bad morale effects downward wage adjustments have on staff that remain. See Bewleys “Why Dont Wages Fall During a Recession” for this type of thinking.

    http://cowles.econ.yale.edu/books/bewley/tfb_wages.htm

  3. How much of Irish workers higher productivity can be attributed to transfer pricing and/or shifting profits through Ireland subsidiaries to take advantage of low corporation tax?

  4. Karl

    It is certainly true that the gains from devaluation may be offset by an increase in inflation. This is relevant under several scenarios. First, if all wages and prices are flexible, clearly a nominal exchange rate shift will have no real effect and all wages/prices will adjust to ensure a zero real impact. Second, if there is full employment, adding stimulus via devaluation will be mostly absorbed via an increase in demand-driven inflation (Ireland during 1999-2001 when the euro fell a lot against the dollar). Third, if devaluation is accompanied by a loss of monetary control, then the same regime that devalues may also deliver a higher inflation rate.

    For a country with lots of unemployment and that is a member of a monetary union (so that the monetary regime is externally secured), the risk that devaluation will be quickly eliminated via inflation is not too high. This is the European experience in 1993: inflation did not budge for those countries that devalued. It is also the experience of countries such as Argentina that undertook devaluation when unemployment was high (sure inflation rose in Argentina but it was much lower than the scale of the peso devaluation).

    Regarding Liam’s point, I discussed this type of evidence in my recent ESR article. It indeed seems to be fairly robust that nominal wage reductions are rarely used to address firm-specific problems. But that is not the current scenario, whereby there is a big macroeconomic problem and the standard prescription is devaluation. The support of the union movement in explaining why wage cuts are helpful would be valuable in convincing workers to overcome resistance to nominal wage reductions.

  5. @Karl, I don’t wholly understand your position that cutting the minimum wage needs to be looked at given our current options and level of deflation.

    Firstly, only around 3% earn the minimum wage though it is obviously a yardstick for setting wages in other areas.

    Secondly reducing the minimum wage might be expected to help deliver a recovery, reduce unemployment and reduce distortions in the labour market.

    However in this post you state that wage cuts are unlikely to deliver a recovery, that Ireland already has what is considered a free labour market and cutting the minimum wage will have a limited effect on overall employment.

    I may be entirely wrong so feel free to correct any misinterpretations.

  6. Karl

    It’s hard to disagree with your point that nominal wages are often sticky (although we’re still waiting for good private sector data here), or that there is an urgent and important political and economic reform agenda beyond the labour market.

    But the question remains: to what extent can wage cuts contribute to the recovery process, and over what time period?

    There must be good empirical evidence internationally regarding the slope of the demand curve for labour in the short-, medium, and long-terms, adjusting for different labour market structure and institutions.

    It would be very useful if this evidence could be brought to bear on the upcoming debate.

    It seems to be that comparing wage and unit costs levels between Ireland and other countries is interesting, but ultimately misses the point. We have a huge surplus of labour, which will likely only be reabsorbed back into employment through an improvement in external competitiveness.

    Andrew

  7. What is a cynic? A man who knows the price of everything and the value of nothing.

    Oscar Wilde

    Do economists understand the value of production? It seems not. These heated and one-sided discussions of wages and competitiveness are symptomatic of a beancounting exercise, rather than an example of constructive debate on the economy. It is not the price of labour nor the cost of business which determines profitability and, consequently, the creation of added value in society, i.e. economic growth. It is the organic composition of how products and services are produced. Efficiency is not dictated by price, it dictates the cost of production. Infrastructure (transport, energy, etc), regulation, innovation and investment are far more prescient issues to determine productivity.

    Economies are not driven by the price of everything, they are driven by our willingness to invest in the hard slog of structural reform and our hunger for broad economic growth. Neither are evident in these discussions of wage cuts or competitveness. There is nothing inspiring in the mantra of cuts, but more importantly there is nothing positive either. The Irish economy and our living standards will only languish longer if we allow economic discussions to be dominated by the cynical imperative of price adjustment.

    Imagination, innovation and ambition are missing from the vocabulary of economics. More practically, the Irish economy needs more hard-nosed discussions about the lop-sided structure of the Irish private sector (retail and tourism meh!) and our business elite’s continuing aversion to long-term risk and productive investment. As for the public sector, there is a need for a public discussion to thrash out what role the state should play in the economy. Getting the prices right may suit those with economic minds, but please leave that to sales departments

  8. @ Andrew
    “There must be good empirical evidence internationally regarding the slope of the demand curve for labour in the short-, medium, and long-terms, adjusting for different labour market structure and institutions.”

    But how relevent is that empirical evidence?

    We are in unchartered waters. This downturn is unprecidented in size and scope since the Great depression (possibly since the industrial revolution) and the economic controls and leavers (Quantitive easing stimulous packages etc) we are using were not around then. So any evidence from previous times must keep this in mind.

  9. Both employers and employees dislike wage cuts, namely the effects they have on the relative status of workers in their firm and industry. Philip suggests that the firm-level processes outlined by Bewley are less important in Ireland given the centralised nature of the wage bargain, and that a coordinated wage cut can get round this and solve one potential coordination problem.

    However, the public sector contract makes this difficult and reading comments on any blog (not a representative sample admittedly) shows a strong potential for “money-burning” in that people will take enhanced risk of unemployment rather than take a perceived disproportionate pay cut. This, despite all evidence, that unemployment has such a massive effect on welfare independent of income.

    Philip talks about the role unions may play in selling a devaluation to their members. Firstly, they would need to accept Philip’s analysis that this is an effective method of recovering the economy and thus accept the idea that the long-run expected value of accepting the cuts was positive. Secondly and as importantly, they would need to convince their members that this is a fairly applied pay cut. Countless studies show that people will reject potentially financially beneficial offers if they perceive unfairness. The clear debate in this literature is how people actually process different offers as being fair or unfair (in experiments its pretty easy as the fair solution is usually to share an amount like 100 euro evenly).

    Related to fairness is trust. If people trusted the centralised bargaining decision processes then achieving a high employment, lower nominal wage equilibrium would be easier. Once again, the unrepresentative sample of blog commentators suggests that both trust in the process and perceptions of its fairness will make it difficult for the wage bargaining process to deliver a coordinated nominal wage reduction in current set-up.

    http://ideas.repec.org/p/ucb/calbwp/92-199.html (Rabin on fairness)

    http://ideas.repec.org/e/pfe29.html (Ernst Fehr’s work covers inequity aversion, bargaining, trust and related topics including the potential causal effect of trust on improving economic outcomes)

  10. These last two threads have been very interesting.

    An important issue appears to be whether or not an economy wide wage cut would be equivalent to a devaluation.

    For instance, would David Begg or Micheal Taft oppose a devaluation if we were not members of the euro? Or is there opposition to wage cuts based on a belief that wage cuts would not have the same or at least very similar effects to a devaluation?

    It appears to me there are two arguments taking place

    1) If we could, should we devalue? and,

    2) Will economy wide wage cuts deliver an effective devaluation?

    Would it be useful to not conflate the two questions?

    Andrew raised the question of potentially different distributional effects between the two on the previous thread. Is there a reading on that?

  11. @Liam

    How can there be “trust in the process” when:

    1) most of the “brain trust” (such as it is) of the government proposing “the process” is made up of the very same people who got us into this mess as a matter of explicit policy;

    2) their cronies in the banking sector have been protected throughout this debacle;

    3) “the process” has been characterised by a concerted effort–no doubt hatched by that very same brain trust and their allies in IBEC–to demonise the public sector (largely through their mouthpiece, the Independent Newspapers)?

    Economists here can lament that the political situation is not propitious for the stern medicine that, they say, we all need. But they might have more credibility on this if more of them publicly made note of and denounced the three factors above (and not only NAMA) rather than constantly trying to ingratiate themselves to the government and the media. Twenty of you signed a letter about NAMA that got quite an echo. Where’s the collective letter denouncing the demonisation of the public service and the cronyism of the current government?

  12. If we reduced all our wages/salaries AND all our costs to East Asian levels would we ‘recover’? No! Think about this. The explanation lies outside your boxes.

    The principal current economic problem is a significant surplus of labour (world-wide), but there is either a falling or stagnant demand for labour (depends where you live). This is a long-term emerging problem which was disguised for many years – now its out in the open.

    We live in an economy which has both extensive and high ‘costs’ – all sorts of things. Our wage and salary levels are necessary to ensure that we can pay for things – not just consumer goods, but mandatory services. Reducing wages and salaries will – with a short lag phase – impact on our ability to pay our mandatory service costs. This is a deflation spiral. Once it starts it is quite difficult to halt. The end result is long-term economic misery.

    There are two ways out of this mess. 1. Default the debts (all categories) – and start again. 2. Inflate the money supply. Both of these options bring their own set of special problems, but continue on with the current ‘soft-shoe-shuffle’ and you risk increasing, systemic, social unrest as the young have nowhere to ‘escape’ to this time.

    Brian P

  13. To return to this topic belatedly, here’s a relevant comment on the Polish economy from RGE Monitor:

    Poland
    Amid the general Eastern European malaise, Poland’s economy has been a br ight spot. In the first quarter, the economy posted positive real growth of 0.8% y/y, outperforming all other EU economies with the exception of Cyprus.

    Why is Poland a stand-out? For starters, Poland’s economy did not boom to the same extent as its regional peers in the Baltics and Balkans, and therefore did not build up the same level of accompanying external imbalances, which helps explain its milder downturn. Second, as Eastern Europe’s biggest economy, Poland has a large domestic market, making it relatively less dependent on exports to ailing Western Europe. Third, the country’s flexible exchange rate and record-low interest rates have helped cushion the slowdown. Finally, Poland proactively distinguished itself from others in the region and boosted investor confidence in May by securing a US$20.5 billion Flexible Credit Line from the IMF – a special facility reserved for emerging markets with strong fundamentals. While Poland’s economy has weathered the global turmoil better than its regional peers, a rapid recovery is unlikely and the outlook is not without risks. In particular, Poland’s fiscal situation is deteriorating, which will likely push back the country’s planned euro adopt ion in 2012.

Comments are closed.