Cutting wages is not the solution

Lars Syll

A couple of years ago I had a discussion with the chairman of the Swedish Royal Academy of Sciences (yes, the one that yearly presents the winners of The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel). What started the discussion was the allegation that the level of employment in the long run is a result of people’s own rational inter-temporal choices and that how much people work basically is a question of incentives.

Somehow the argument sounded familiar.

When being awarded the ‘Nobel prize’ for 2011, Thomas Sargent declared that workers ought to be prepared for having low compensation for unemployment in order to develop the right incentives to search for jobs. The Swedish right-wing finance minister at the time appreciated Sargent’s statement and declared it to be a “healthy warning” for those who wanted to increase compensation levels.

The view is symptomatic. As in the 1930s, more and more right-wing politicians – and some economists – now suggest that lowering wages is the right medicine to strengthen competitiveness within each faltering economy, to get the economy going, to increase employment and to create growth that will remove towering debts and create balance in state budgets.

But, intimating that one could solve economic problems by wage cuts and impairing unemployment compensation, in these dire times, should be taken as more as a sign of how low confidence in our economic system has sunk. Wage cuts and lower unemployment compensation saves neither competitiveness, nor jobs. What is needed more than anything else in these times is stimulus and economic policies that increase effective demand.

At a societal level, wage cuts will only increase the risk that more people will become unemployed. To think that this can solve an economic crisis amounts to turning the clock back to those faulty economic theories and policies that John Maynard Keynes conclusively showed to be wrong in the 1930s. It was such theories and policies that made millions of people all over the world unemployed.

It’s an atomistic fallacy to imagine that a policy of general wage cuts would result in a strengthening of the economy. On the contrary, the aggregate effects of wage cuts would – as shown by Keynes – be catastrophic. They would start a cumulative spiral of lower prices that would make the real debts of individuals and firms increase since the nominal debts wouldn’t be affected by the general price and wage decrease. In an economy that more and more has come to rest on increased debt and borrowing this would be the entrance gate to a debt deflation crisis with declining investment and higher unemployment. In short, depression would be knocking on the door.

The impending danger for national economies is that they won’t get consumption and investments going. Confidence and effective demand have to be re-established. The problem of our economies is not on the supply side. Overwhelming evidence indicates that the problem is on the demand side today. Demand is – to put it bluntly – simply not sufficient to keep the wheels of national economies turning. To suggest that the solution is lower wages and lower unemployment compensation is just to write out a prescription for an even worse catastrophe.

Source: Real World Econ Rev., 22 Feb 2017
https://rwer.wordpress.com/2017/02/22/cutting-wages-is-not-the-solution/#comment-117294