Neoclassical Wage Restraint Madness

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It had to hap­pen: neo­clas­si­cal econ­o­mists are now advis­ing that the antic­i­pat­ed reces­sion will be much milder if only work­ers would accept wage cuts.

When I saw this cri­sis was immi­nent in Decem­ber 2005, one major fac­tor that moti­vat­ed me to go pub­lic with my analy­sis was the cer­tain­ty that, when the cri­sis hit, neo­clas­si­cal econ­o­mists would either blame it on wages being too high (”the abo­li­tion of Work Choic­es caused the Depres­sion!”), or would sug­gest that wages should be cut to reduce the imbal­ance between the sup­ply of and demand for labour.

The cri­sis hit too ear­ly, and was far too glob­al, for the abo­li­tion of Work Choic­es to “cop it sweet”. But yes­ter­day, in an OpEd in the Syd­ney Morn­ing Her­ald, Mark Davis report­ed that “Eco­nom­ic mod­ellers” had con­clud­ed that 1% cut in the rate of growth of wages will boost employ­ment growth by half a per­cent:

Eco­nom­ic mod­ellers reck­on cut­ting aggre­gate wages growth by a per­cent­age point boosts employ­ment growth by half a per­cent­age point. Some think it boosts employ­ment more. In the cur­rent envi­ron­ment that could save more than 50,000 jobs.

Let’s extrap­o­late a bit here: giv­en the stan­dard increas­es in pro­duc­tiv­i­ty and pop­u­la­tion, employ­ment growth of about 2.5 per­cent is need­ed to keep the unem­ploy­ment rate con­stant. So “eco­nom­ic mod­ellers” (i.e. neo­clas­si­cal econ­o­mists) reck­on that a 5 per­cent cut in the rate of wages growth would trans­late into a 2.5 per­cent boost to the rate of growth of employ­ment.

Since those same mod­ellers are also antic­i­pat­ing growth slow­ing to about zero (but not neg­a­tive of course–that would mean a reces­sion, and as we all know, Aus­tralia is spe­cial and won’t suf­fer one), all we need to do to make sure Aus­tralia lucks out with both no reces­sion AND no rise in unem­ploy­ment is to … cut wages by one per­cent (since the cur­rent rate of growth of wages is close to 4 per­cent).

Non­sense. This is stan­dard neo­clas­si­cal eco­nom­ic think­ing that if one low­ers the price for a prod­uct (in this case, labour), more of it will be demand­ed. This think­ing has some rel­e­vance when the mar­ket in ques­tion is that for, say, apples (though the basic “sup­ply and demand” math­e­mat­ics is false). But when the mar­ket you are talk­ing about is Labour, even in the absence of debt, the think­ing is only half baked.

In an indi­rect way, the income that apple pro­duc­ers earn from sell­ing apples is a com­po­nent of the demand for apples–but the scale of that demand is triv­ial. Equal­ly, in an indi­rect way, the income that work­ers earn from sell­ing their labour is a com­po­nent of the demand for labour–and here the scale of that demand is no longer triv­ial.

Reduc­ing real wages–and thus reduc­ing the capac­i­ty of work­ers to pur­chase out­put–may boost prof­its in real terms by skew­ing the dis­tri­b­u­tion of real income fur­ther in favour of cap­i­tal. But it will undoubt­ed­ly impact on some cap­i­tal­ists badly–not mak­ers of sports cars per­haps, but cer­tain­ly those who run super­mar­ket chains–and the aggre­gate effect is a toss-up.

But as Keynes argued in the Gen­er­al The­o­ry, a cut in mon­ey wages is high­ly unlike­ly to affect real wages in the same direc­tion. Since labour is an input to the pro­duc­tion of lit­er­al­ly every­thing, a gen­er­al cut in mon­ey wages is like­ly to lead to a gen­er­al fall in prices as well. Again, whether wages will fall more or less than prices becomes a toss-up.

Here Keynes made one of the few acknowl­edge­ments of what I regard as the real cause of the Great Depression–the unwind­ing of the debt bub­ble built up dur­ing the spec­u­la­tive mania of the 1920s (an issue that Irv­ing Fish­er was far bet­ter on with his Debt Defla­tion The­o­ry of Great Depres­sions). Since Keynes accept­ed the neo­clas­si­cal notion about real wages and the demand for labour, he agreed with his con­ser­v­a­tive oppo­nents that real wages had to be cut to increase employ­ment. But he said there were two ways to attempt achieve this–directly by cut­ting mon­ey wages, or indi­rect­ly by caus­ing infla­tion.

The for­mer, he argued, would large­ly lead to fur­ther defla­tion, which “increas­es pro­por­tion­ate­ly the bur­den of debt; where­as the method of pro­duc­ing the same result by increas­ing the quan­ti­ty of mon­ey … has the oppo­site effect. Hav­ing regard to the exces­sive bur­den of many types of debt, it can only be an inex­pe­ri­enced per­son who would pre­fer the for­mer.”

An “inex­pe­ri­enced per­son” indeed. Keynes used sev­er­al epi­thets to refer to his intel­lec­tu­al oppo­nents in this sec­tion of the Gen­er­al The­o­ry: “unjust per­son”, “fool­ish per­son”, “inex­pe­ri­enced per­son”. In every case, he meant the neo­clas­si­cal econ­o­mists of his day. Now their great-grand­chil­dren are repeat­ing the same fool­ish, inex­pe­ri­enced and unjust mantras today.

My let­ter cri­tiquing this neo­clas­si­cal non­sense was pub­lished in today’s Syd­ney Morn­ing Her­ald (Jan­u­ary 3rd 2009):

Giv­ing our pay pack­ets a shave would cost jobs

Jan­u­ary 3, 2009

Mark Davis’s sug­ges­tion that wage restraint would reduce the rise in unem­ploy­ment this year is non­sense (“Give your pay pack­et a shave and help save jobs”, Jan­u­ary 2).

Unem­ploy­ment will rise in 2009 not because work­ers were paid too much in 2008 (or ear­li­er), but because house­holds and busi­ness­es took on too much debt dur­ing a spec­u­la­tive bub­ble that has now burst. In the after­math, sane peo­ple attempt to reduce their debt but that means a reduc­tion in spend­ing, which caus­es unem­ploy­ment to rise.

To reduce that rise in unem­ploy­ment, you have to tack­le the root cause by mak­ing it eas­i­er to repay debt. Reduc­ing wages — even cut­ting the rate of growth of wages — will make that hard­er, not eas­i­er, espe­cial­ly since many of those who are trapped by debt are work­ers.

That Davis’s argu­ment is sup­port­ed by eco­nom­ic mod­ellers con­firms that the case is poor­ly thought out. These mod­ellers com­plete­ly failed to antic­i­pate the glob­al finan­cial cri­sis because their neo­clas­si­cal mod­els ignored the role of debt.

John May­nard Keynes dis­cussed sim­i­lar­ly naive think­ing dur­ing the Great Depres­sion. Though he agreed that real wages should fall, he said there were two avenues to achiev­ing it: caus­ing infla­tion, or reduc­ing wages.

Keynes argued that a fall in mon­ey wages would sim­ply cause prices to fall fur­ther, adding to the defla­tion that made the Depres­sion so intractable.

He con­clud­ed that giv­en the exces­sive bur­den of debt and the fact that falling prices would make debt even hard­er to repay, “it can only be a fool­ish per­son who would pre­fer a flex­i­ble wage pol­i­cy to a flex­i­ble mon­ey pol­i­cy”.


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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.