Thursday, 11 December 2008

Wage reductions in a downturn

Robert Peston raises the old chestnut about wage reductions. According to neoclassical theory, wages should reduce in a downturn as workers realise there is less demand for their services and cut the price accordingly. In the case of Corus and JCB, two British manufacturers, this is exactly what is happening - the unions have proposed a 10% wage cut in order to prevent plants from closing altogether.

However, adjustment rarely happens this way and there are some competing explanations for this - game theory and anchoring being the top two.

Here is an article from the Economist giving some of the alternative viewpoints.

But I would add two things:
  1. Despite what Robert Peston says, the MPC was probably right not to assume this would happen. It would never have taken place if the union and workers were not immersed in the conversation about the savage recession we are expecting.
  2. Wage stickiness has a positive economic effect - both to combat deflation and also to maintain gross demand. It helps to force employers to reduce their saving, acting as an automatic stabiliser in a downturn. Therefore this cut is not necessarily a good thing (I realise that there are positive aspects to it too - it is not clear to me where the balance lies).
Update: Corus is now asking the government to consider subsidising its wage costs in the short term - based on a Dutch scheme which aims to avoid the destruction of valuable company-specific skills through layoffs. My feeling is that this is a role for an equity investor rather than government. At most, perhaps government might be persuaded to share some of the benefits of continuing to get income tax revenue, or avoiding unemployment benefit. It feels like a slippery slope.

2 comments:

halbhh said...

We can't presume what held true in the past applies in all cases to the present, as the current situation has some new pieces.

For instance, information spreads very rapidly now. Even average workers can now be aware of general economic dynamics, like consumer demand reductions forcing either layoffs or wage reductions, so that the *idea* of wage reductions will be met with a different attitude than in the past.

Since we know that consumer demand was unsustainably high via unsustainable credit/debt creation, we know the downward adjustment in consumer demand isn't reversible, and that prices will adjust downward. In *this* context (different from other recessions), wage reductions have a different meaning -- buying power may stay the same or even increase for many workers due to the deflation.

paulm said...

The BBC liars have different economics depending on the propaganda requirements. Marginalism in a slump-how real wages clear labour markets but only in a downwards direction-"workers take pay cuts to keep their jobs". But of course in a boom the BBC liars know nothing about real wages clearing labour markets in an upward direction. Have you ever heard a BBC story that tells you how real wages need to rise over time in line with rising marginal productivity ? Or a BBC story that the "shortage" of labour is not a real shortage a result of the real wage below marginal productivity. Of course not. Instead in a boom the BBC liars will magically forget all about marginalism and we will now hear that a rise in money wages will always appear as a rise in the price level and curiously never as a rise in the real wage. Marginalism for a slump and Keynesian "wage inflation" garbage for a boom.