Wages and debt deflation

Alan made a comment in response to John Fitz that I think people need to think carefully about: wage cuts will be deflationary in that they will increase the real burden of debt. The Latvian piece Philip linked to talks about this, and Paul Krugman has been writing about this also.

I suppose that unlike in Latvia and other countries, most Irish household debt is owed to Irish financial institutions. As Krugman says, this implies that if we could adjust the real exchange rate by devaluation, that would be preferable to doing it through domestic deflation. However, devaluation is not an option for us. So, Alan is right: writing down the debt would seem like the best solution, assuming it were possible. Of course, you would like the banks rather than the taxpayer to take the consequent hit, and there is a fat chance of this with our current government.

If debts cannot be written down, then wage cuts will depress the economy still further through this mechanism. As will tax increases, and expenditure cuts, whether people like it or not. And thus the adjustment mechanism for our economy is most likely to be emigration. Which will of course further reduce economic activity, and asset prices, and increase the losses suffered in principle by banks, and in practice, one fears, by taxpayers. (And reduce GDP and the number of taxpayers, thus increasing the tax rates required to service a given level of debt.)

None of this is to disagree with John, but to point out how bad our options are right now.

Speaking personally, I would really appreciate a detailed debate in the next few weeks about two issues. First, what is the optimal timing of a return to 3% deficits? I am completely convinced by the argument that we are once again living in a Keynesian world, which on its own suggests doing this over a number of years, especially since we are starting with a low stock of government debt. (What else is a low stock of government debt for, one might ask.) The key questions then are: how rapidly will the stock of debt escalate to levels that are unacceptable? What are unacceptable levels of debt? How binding are the constraints which we will face due to increasing demands by governments for loans on world markets? How worried should we be about possible linkages between increments to and the stock of public debt, on the one hand, and the credibility of the government’s bank guarantee scheme on the other?

Second, what does the real exchange rate or labour market evidence suggest about the size of wage cuts required to get the real exchange rate back to some sort of sustainable non-bubble level? Can we do better than picking numbers out of the air?

A Path to Recovery

So far the bulk of the population have been insulated from the recession and, on present forecasts, this could continue through 2009. The latest ESRI QEC suggests that over the two years 2008 and 2009 output per head will fall by around 9% while real wage rates will actually increase. The insulation being provided for the bulk of the population comes from two sources: government borrowing, which will exceed 10% of GNP in 2009, and a dramatic collapse in the profitability of the company sector. A consequence of the loss of profitability, arising from the cumulative loss of competitiveness, will be that the rate of unemployment will exceed 10% before the end of next year. It is clearly unsustainable that the only people who will suffer a dramatic drop in their living standard will be those losing their jobs while those who continue in employment actually see an improvement in their living standards.

 Up to the summer the developing recession was a home-grown affair due to the mismanagement of domestic fiscal policy. The housing bubble was inflated by public policy and it crowded out the tradable sector of the economy by promoting a major slide in competitiveness. However, over the course of the Autumn the world financial crisis, and the particularly noxious form that it has taken in Ireland, has more than doubled the prospective fall in output.

 To get out of this mess a number of things need to happen. Firstly, the world economy needs to recover, including a restoration of order to the world financial system. Secondly, competitiveness needs to be restored. Thirdly, the imbalance in the public finances needs to be tackled. Fourthly the banking mess needs to be sorted out – properly.

Clearly the restoration of order to the world economy is outside the control of the Irish authorities. It remains unclear when the world economy will return to growth. Current hopes/expectations are for a turnaround by the end of 2009. The longer it is delayed the bigger the mountain that will have to be climbed in restoring the Irish economy to sustainable growth. However, when it does take place there is likely to be somewhat more rapid growth than normal in the world economy during a prolonged recovery phase.

If the world economy were to turn the corner before the end of 2009 it would have a very significant impact on the Irish economy because of its “gearing” through trade. It could be enough to undertake a significant part of the heavy lifting. It would probably eventually bring the rate of unemployment below 10% and the deficit in the public finances could fall substantially from its 2009 level. Nonetheless, the legacy effects of past policy mean that there is still likely to be a government deficit of well over 5 percentage points of GNP to be eliminated. It could well be larger than this if the world recovery is much delayed. Also, it would not address the competitiveness crisis so that unemployment would remain very high and it would not return the public finances to a sustainable path.

In the private sector wage rates are generally set on the market rather than by the “partnership process”. In the past they have shown themselves to be flexible in an upward direction. At the time of the bursting of the dotcom bubble wage rates actually fell in a few exposed sectors that were particularly badly affected, as employers and employees worked to stay in business and protect jobs. With a likely very low rate of inflation in the Euro zone next year, and a consequential moderate increases in wage rates among our competitors, tackling the competitiveness problem will be difficult. If, for example, Ireland needed to improve its competitiveness by 5% relative to its partners this could be done in two ways. A pay freeze in Ireland with wage inflation in our partners of 1% to 2% a year would mean that the process could take 3 or 4 years. Alternatively, a 5% fall in nominal wages in 2009 would achieve it all in one year with major beneficial effects on unemployment and growth in the medium term. We don’t know yet how much ground we have to make up, only that the competitiveness hurdle is high. It does seem likely that the market will deliver at least a wage freeze in the private sector and, very possibly, a small fall in nominal wage rates. This would still leave a lot of work for future years, with a high cost in terms of prolonged unemployment.

Given the problems with the public finances and the prospect of at least a standstill in private sector wage rates, if not a much-needed fall, it will be essential that the public sector at the very least follows suit. Given that public sector workers are generally better remunerated than comparable workers in the private sector it would make sense for there to be a significant cut in nominal wage rates in the public sector in 2009.

Even with a world recovery and a major gain in competitiveness this will still not be enough to sort out the public finances. Over four or five budgets from 2010 governments will have to either raise taxes or cut expenditure to restore order to the accounts. Initially, by improving efficiency in public services, some savings on expenditure are possible. However, if the public continue to want at least the current level of public services then increases in taxation will be the order of the day. As Ireland today has one of the lowest tax burdens in the OECD a significant increase in tax rates over the years of economic recovery would be feasible. However, it will mean that government will have to pre-empt an unusually large share of the fruits of the recovery in its early years in the form of additional taxes, such as a carbon tax, a property tax, and higher excise taxes.

The area where the government faces the possibility of another important “surprise” in the forecast is with regard to the price level. If sterling were to remain where it is today it could result in a much more dramatic fall in the CPI than currently forecast. If, in turn, employees in the private sector bargained in terms of real after tax wage rates (as they have in the past), this could greatly help the process of cutting nominal wage rates to improve competitiveness. A fall in nominal wage rates of 5% would, in turn, cut the CPI by a further percentage point. Such a “surprise” fall in the price level could thus be very good for competitiveness. It could also be achieved without a major drop in real incomes for employees (due to the implied terms of trade gain). However, unless the government acts rapidly, it could also dramatically worsen the public finance problem.

To deal with a fall in the CPI of much more that 2% in 2009 the government would have to ensure that wage rates fell by a similar amount in the public sector. However, that would not be enough. With welfare rates scheduled to rise in nominal terms by 3% in 2009, real welfare rates could end up rising by the largest amount experienced since 1982. Such a dramatic increase, coming on top of an already very high replacement rate could have a major impact on the long-term unemployment rate well out into the next decade.

Very clever game theorists needed, or perhaps not

Was I the only one to find the following snippet from the Irish Times astonishing?

It has emerged that the Government increased the size of its planned investment in Anglo by half in the final hours of talks. Mr Lenihan was offering €1 billion up to lunchtime on Sunday but raised the offer to €1.5 billion in the face of tough negotiation by the bank.

Calmfors Driffill revisited

Everyone agrees that the Irish economy needs to restore competitiveness. Absent the possibility of devaluation, this either requires freezing nominal wages, and letting inflation erode their real value; or reducing nominal wages. The former course of action seems insufficient, since it will take too long, and we may even be heading for deflation.

So, the old Calmford Driffill literature from the 1980s may be relevant. (I couldn’t find their 1988 Economic Policy article online, but a survey article is here.)

Remember the basic point: if labour markets are very competitive, then wages will fall by themselves. If there are strong sectoral unions, on the other hand, then they may all play a game of ‘after you, my dear Alphonse’, and wages may not be cut. In that case, moving to central bargaining can help in coordinating wage cuts, in that no-one feels that they are falling behind in relative terms. Some would say that the introduction of social partnership in the late 1980s is a good illustration of that mechanism in practice. (OK, it involved wage restraint, not wage cuts, but that was useful in itself at the time, especially in the context of devaluation.)

The question for you all is: how flexible are private sector labour markets in Ireland today? We have all read about particular firms cutting wages, but how common is that? Are there studies on this? Will private sector wages fall sufficiently on their own, or is there a role for government coordination here?