Neoclassical Wage Restraint Madness
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”.