2009 podcast kattuman distributing the downturn

Distributing the downturn

3 February 2009

The article at a glance

The International Labour Organisation has forecast a rise in unemployment by 20 million worldwide by the end of 2009. The Organisation for …

Distributing the downturn The International Labour Organisation has forecast a rise in unemployment by 20 million worldwide by the end of 2009. The Organisation for Economic Co-operation and Development (OECD) has forecast a loss of up to 10 million jobs within the OECD group of countries, and up to 25 million jobs worldwide between 2008 and 2010. However, would a strategy of cutting wages as opposed to cutting jobs in the face of this recession create the conditions for economic recovery? Dr Paul Kattuman, Reader in Economics at Cambridge Judge Business School, believes it would.

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In recessions, wages and salaries do not behave like other prices. Wages do not adjust to the drop in demand in recessions – it is employment that falls. One explanation for sticky wages is that, individually, groups of employees resist wage cuts supposing that other groups of employees would also resist. The acquiescing group alone would suffer a decline in real wages, and so no one agrees to wage cuts. Secondly, managements believe that reducing wages would encourage workers to leave, the most productive workers first. Employees who remain will be less productive, and unhappy about their lower wages.

In a “normal” recession, sticky wages may actually help to moderate its harmful effects: wages that adjust down too quickly could entrain the economy onto a downward wage-price spiral. Friction in wage adjustment can help prevent the economy’s collapse into true deflation – if employment does not fall too much. But the recession staring us in the face this time is far too deep and pervasive. As demand continues to fall, firms will get squeezed beyond their bottom lines. Lay-offs next year will be severe as the decline in consumer spending and production cut-backs spiral down together.

As companies are shaping their strategy of cutbacks in the face of recession, it is useful to recall the example of FedEx among other companies, who have taken the route of cutting emoluments of executive and salaried employees, rather than cutting jobs. In economic conditions such as we are facing now, reducing wages will not raise the risk of departure of employees. Large-scale layoffs are just as demoralising and would cause shirking at least as much as wage cuts might. Conditions are in fact such that it would be a good signal for an employer to be seen to be preserving employment by cutting wages. Managements should be able to convince employees about the calculations that underlie proposed reductions in wages and salaries, and the virtue of this, vis-a-vis, job cuts. It will of course help if the process started with the CEO taking a significant cut.

There are strong grounds for government policy that would influence firms in making their choice between laying off employees on the one hand, and cutting wages across the board, but with discretion. If unemployment can be kept to a minimum, the negative effect on consumption will be lower. There will be fewer defaults from people who have no reasonable prospects of paying their bills. From a macroeconomic point of view wage cuts will be less disruptive and less expensive than unemployment increases. Reducing employment related costs will also create the conditions for economic recovery.

The current circumstance, when almost all firms face the need to formulate, almost simultaneously, their cut-back strategies for the recession offer an opportunity for re-engineering the wage setting system for the future. The current time offers us an opportunity to move in a co-ordinated way towards the “share economy”, proposed by Martin Weitzman in the mid 1980s. There are benefits that follow if the majority of the organised corporate sector adopted a wage system where all employees shared in the ups and downs of firm performance. In such a system, rather than being fixed in nominal terms, wages would have a fixed component, and a share of profits or revenues, which would automatically go down in the recessions.

It is not merely that such a wage mechanism will increase employees’ incentives and productivity. More significant, firms would then always choose to expand employment at the going wage if they could. This is because under this system the marginal cost of labour is always below average cost, unlike the case with standard wage contracts where the average cost of labour to the firm is equal to the marginal cost.

The share economy will allow firms to retain workers (and keep motivation sharp) during a recession. Adjustments will take place through prices rather than quantities. If a significant number of firms share profits with their employees, the result will lower natural unemployment rates, and lower vulnerability of employment to macroeconomic variations.

This opinion piece by Dr Paul Kattuman was first printed in The Financial Express, India, 30 December 2008.