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Why lowering wages may not help the economy

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Paul Krugman published an op-ed today explaining why wage cuts won’t help the economy if done across the board:

And soon we may be facing the paradox of wages: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment.

Here’s how the paradox works. Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.

But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more than they have in a decade — but as wages fall, they’re chasing a moving target. And the rising burden of debt will put downward pressure on consumer spending, keeping the economy depressed.

The key point to note is that since everyone is doing it, no one will stand to benefit from it since no competitive advantage is gained.  Of course this doesn’t mean to say we can’t derive a greater benefit if one cuts wages severely enough such that no other follows suit.  But the most immediate impact on wage cuts is that the company gets to cut costs; and very little of that benefit is passed down to workers.  The notion that wage cuts save jobs relies on a crucial assumption that the company is able to quickly restructure its organisational capability to make up for the lost productivity of that fired worker if workers are retrenched instead.

Written by defennder

May 5, 2009 at 1:06 AM

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