Pay Cuts and Deflation

Paul Sweeney: Many economists and commentators are still arguing, very strongly and with great certainty, that pay cuts will be the major part of the solution to the economic crisis.

This post, my third on competitiveness and pay, will explore the belief that pay cuts will not have a deflationary impact on the economy. Thus, it is argued, pay cuts would not make things worse.

Pay in Ireland has been rising more rapidly than in competitor countries though Irish pay levels still remain lower than most, though not all, competitor economies and pay levels are not as important in our competitiveness as other issues, especially now.

Wage costs are just one aspect of competitiveness, as most economists agree. It is more important to look at unit labour costs or productivity (though that is far from the end of the complex issue). There has been much discussion of falling productivity in Ireland. Yet the data shows it has not been falling. It has been stagnant. It has not been rising. It would be better if it were rising, especially if it is rising in competitor countries and as the euro has risen.

Yet the latest OECD data shows that the level of productivity in Ireland was third highest after the US and Norway. The Irish Central Bank publishes a table which shows relative unit labour costs, in a common currency, for Ireland in 2009 was down at 67 (from 100 in 1995). It has been around this for the last four or five years years. A different Bank table, (on unit costs relative to the main trading partners), has also been stable at 99 for 5 years. With the growth in construction and in services, sectors with low productivity, during the domestic boom since 2001, productivity increases were difficult to achieve. With a deep recession, this may be even more difficult, due to labour hoarding.

With the chasm between public spending and plummeting revenue (thanks to the government’s obsession with tax cutting in the boom), the issue of pay reductions in the public sector, where it is the major cost, is generally accepted. The Transitional Agreement includes a pay deal signed by Government, employers and unions, only last September. The Government reneged on it and IBEC indicated that it would like not to pay it.

Yet many leading companies, where they can, are paying it. Some companies like CRH, which declared operating profits of €2bn, do not have a problem paying it. In other multinationals (MNCs), where pay is not significant in terms of total costs, they are paying it too. Many MNCs operate on intra-firm transfers and are not particularly price or even currency sensitive. The industrial relations newspaper, IRN, has listed around 70 leading firms which are adhering to the deal. Yet unions accept that in this deep recession, many firms, especially in services, will have difficulties. They are doing deals, as per the agreement, on inability to pay, on freezes, etc. If there is not negotiation at national level between the main players, based on fairness and shared understandings, actors may be forced to take hard positions.

Importantly, competitiveness is about much more than wages and even unit labour costs. I believe the major issue of Irish competitiveness is the lack of credit for firms, due to the collapse of the banking system, compounded by the Government’s decision to take a staggering €7bn out of the public purse (which is EMPTY) and give it to the collapsing Irish banks.

I think the second issue of competitiveness is Ireland’s appalling international reputation, ruined by a few of our enterprise leaders and by the Government's light regulation, light tax regime. There is also a domestic reputational issue too, where all Irish business leaders have been tarnished by the few, just as they are trying to impress their employees on the need for cooperation in facing really serious economic problems. Rebuilding Ireland’s reputation will be a key competitive challenge. But many political and enterprise leaders are still in denial on this vital issue.

There is a certain attraction to achieving a once-off reduction in total Irish consumer costs. These are a substantial 14% higher than the EU15 average for goods and over 23% above for consumer services. They are even higher against the average of the total of the 27 member states. But would it work by only cutting wages, even if this were possible?

What really exposes the class prejudice of these economists is that they only seek pay cuts for employees, and have no interest in demanding that the rest of the economy (which includes those who profited so greatly and who included those who caused the crisis) contribute. Is it simply that labour is the largest chunk of national income and is perceived as easiest to squeeze?

Or is it that Ireland would need a CAB-like Prices Commission to really police lawyers, solicitors, pharmacists, retailers, wholesalers etc. to force them to bring down prices and that this would be “state interference “ in the market? Some businesses will reduce prices because they have to, but others will not, especially when they can get away with it. A CAB-like Prices Commission is what is required in these exceptional times to ensure fairness in such a cost reduction mission. Or is it as simple as the fact the some economists would abhor state interference in the prices mechanism in these trying times, but that they have not such ideological qualms on the price of labour?

But what about the impact of this strategy for wage cuts only, if it were to be implemented? If workers concede major wage cuts, but the other sections of society do not, will it result in considerably reduced domestic prices? It is unclear that it will. The transmission machine if not working as any shopper will tell you. The fall in sterling was not passed though to consumers.

Some economists are predicting the prices will fall to minus 4 or minus 5% in 2009. Yet these are the same economists who predicted prices would fall, just as negotiations on the previous two national agreement were underway. They got it wrong each time. Much was made of the fall in consumer prices in February of -1.7%. But behind the figures was a decline in the rate of decrease from a substantial -1.7 in January to -0.4 in February. And the HICP (without mortgages) was still positive. Nonetheless, prices are likely to fall this year, but who knows by how much? Profiteering is part of the Irish business psyche. No economist has shown that wage cuts in profitable firms will not go straight to the bottom line - not to consumers.

Retail sales fell by 4.5% - the largest amount in 2008 since 1982 and excluding motors, it was the largest fall ever recorded. Retail sales had previously grown by plus 5/6% for years. Wages make up €80bn or over half per cent of national income, so would major cuts in wages depress domestic demand further? And tax revenue too. Many businesses will be forced to close down, leading to a deflationary spiral.

Then those who think wage cuts alone will reduce our cost base so much that exports will then “take off” and replace the now collapsing domestic demand. But do they not know that international trade is now in decline? Trade, which grew at a multiple of economic growth for decades, is now actually declining.

Germany, Europe’s biggest economy and the world’s biggest exporter, is seeing its exports plummet. “German manufacturing is in freefall” says the Financial Times. Domestic demand is stagnant and growth is falling. Overseas orders for capital goods were down as massive 48.2% in the year to January.

So who is going to snap up the now bargain Irish exports, brought down so much in price, (it is fervently hoped) by cuts in wages? Few, I fear. International demand is flat or mainly declining. Even if the fine economic models are tweaked and squeezed to show a happy outcome, in the real world, there a danger that this strategy of wage cutting could make things worse.

It is hoped that the real solution, a big stimulus package, will be made in London on 2nd April. But it is not looking as if the stimulus to be agreed by the G20 will be anywhere near adequate. In the meantime, Ireland’s international reputation is in tatters.

Only the workers can save the Irish economy by agreeing to massive wage cuts! Or so some economists appear to believe.