Tuesday, 28 April 2015

Wage devaluation: Why Brussels insists on this mistake

The Brussels consensus keeps insisting that to solve the external adjustment problems in the peripheral countries they need a major wage devaluation. They ignore both theory and experience showing that wage and currency devaluations are substantially different and that even the later has limited success in balance of payments adjustment. Moreover, they also ignore the macroeconomic debate and experience on money illusion concerning the differences between real and nominal wage declines.

They persist in their recommendation despite a failure of the current adjustment programmes to show the benefits of such policy. And, unfortunately, some of the countries are eager to accept them unquestionably. For instance, some supporters of the Irish Fine Gael – Labour coalition are calling for a €2 an hour cut (25%) in the minimum wage fixed since 2007 and which is paid to less than 5% of the labour force. Slovenia, has in place measures aimed at cutting the public sector wage bill. Likewise, in Portugal both the government and the main opposition party are disputing the next general election with a proposal to cut the taxes on wages (the so-called TSU).

Regardless of whether nominal wage costs are reduced through cuts in the minimum wage, public servants pay cuts or labour tax reductions, the relevant assessment is how wage cuts impact on take home pay and employer total labour costs, as well as in the government budget.

The following charts drawn from OECD data illustrate some of the misconceptions about nominal wages.



The chart above depicts the evolution of manufacturing hourly wages in Germany and the peripheral countries. It shows that, as expected, they have risen in all countries, except in Portugal.

Now, with rising wages, the so-called labour unit costs (the measure often used to assess competitiveness) will also rise unless productivity gains outpace such rise. The following chart shows that, except in Germany for the period before the 2008 crisis, none of the countries achieved the necessary rise in productivity.



The case of Portugal is especially noteworthy. Since it did not experience a rise in hourly wages, the rise in unit labour costs means that it had a serious decline in productivity. However, the link between hourly wages and unit labour costs does not work only through productivity. Two other factors – employment and nominal wages - also play an important role. Let me illustrate it through a numerical example for Germany and Portugal.

Imagine that the high wage sectors employ 30% and 40% in Portugal and Germany, respectively. Moreover, assume that wages and productivity are 50% higher in the high wage sectors and two times higher in Germany than in Portugal, so that both countries would have the same unit labour costs. What would happen under three different scenarios?

First, imagine that nothing changed in Portugal but in Germany wages continued to rise at 1% and 2% in the low and high wage sectors, respectively. In this case the unit labour costs would rise 1.5% in Germany but remained constant in Portugal.

Next consider the case where additionally 10% of the labour force in the Portuguese low wage sector migrates to Germany increasing the low wage labour market there by 3% without affecting the sector’s average wage and productivity. In this case unit labour costs would remain constant in Portugal and rise slightly less in Germany (1.49% against the 1.50% of the first scenario).

Finally, ponder the case where nominal wages and productivity are cut by 5% in the Portuguese high wage sector. In this case the result would be exactly the same as in scenario two. Only if productivity had not declined as much as wages would we have a reduction in unit labour costs. For instance, if productivity had declined by just half of the nominal wage cut the unit labour costs would be reduced by 1.05% continuing to assume that the labour force in the low wage sector had been reduced or just 0.99% if there was no change in its labour force.

This relationship between employment, wages and productivity depends on how much workers take home out of their salary and whether retained earnings are used to pay taxes or fund pensions. The following chart highlights once more the striking difference between Portugal and Germany in the aftermath of the 2008 crisis.



It can be observed that, on average, the Portuguese took home almost less than 10 percentage points while the Germans took home more than before (1 percentage point). Such a drastic reduction had a dramatic effect on nominal contracts (in particular mortgage loans) and on private consumption. If continued, this could degenerate in a vicious circle of reduced productivity, higher unemployment, higher public debt, higher taxes, lower take home pay and lower productivity, without achieving any significant reductions in relative unit labour costs.

Now, contrast this policy with a policy without nominal wage cuts. Using the numerical example given above and assuming that productivity declined by merely half a percentage, then the rise of unit labour costs would be barely noticeable (0.2%) and the negative impact on unemployment and fiscal consolidation would be much smaller.

In conclusion, the small gains in relative labour unit costs achieved through wage devaluation are too small to justify the large costs in terms of employment and fiscal consolidation.

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