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Real wages and Employment

This week, the British Labour Party has launched a new attack on the government on falling living standards. Real wages have been falling consistently since the coalition took power; OBR figures project that the median worker will be £6,660 worse off in real terms in 2015 than in 2010.

Labour is right to point out that it is morally wrong that workers should bear the cost for the sins of bankers and the failure of regulators. But in economic terms the position is less clear-cut. As the Financial Times editorial of 7 August put it, “voters have grudgingly accepted that their living standards had to drop for the economy to recover”.

The FT comment assumes the existence of an inverse short-period relationship between real wages and employment. As real wages fall, more workers can be profitably employed.

The argument is that, with a fixed capital stock, the marginal product of labour falls as extra workers are hired. More and more workers have to share the same capital, and an extra worker can add less and less to total output. Hence firms will demand a higher quantity of labour only if the real wage falls to compensate for the reduction in the marginal product of the last worker when more workers are employed.

In his General Theory, Keynes accepted this piece of neoclassical nonsense, but argued that ‘there may exist no expedient by which labour as a whole can reduce its real wage to a given figure by making money bargains with the entrepreneurs’. (13) This was because cuts in money wages would reduce prices in ‘almost the same proportion, leaving the real wage and the level of employment practically the same as before’. (12) It would be far more sensible, he said, to expand the quantity of money so as to cause prices to rise faster than money wages. (267-8)

This, it seems to me, is the mechanism for recovery that western governments have stumbled on, in the absence of any other positive ideas. They have gone for inflation to reduce the real cost of debts, private and public, and to lower unemployment through cuts in real wages. Hence the current enthusiasm for quantitative easing as the way out of the crisis. However, two questions arise:

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(a) How much inflation will QE actually produce? The consensus seems to be that it will produce enough to overcome the deflationary impact of fiscal consolidation. Indeed, the massive injections of money into the economy since 2009 must partly explain the decline in the real earnings of labour and the relatively modest rise in unemployment since then.

(b)How robust is the inverse relationship between real wages and employment? There is a lot of data showing that real wages move pro-cyclically, not counter-cyclically. A correlation isn't a cause, but it is reasonable to believe that employment improves when wages improve, for workers' greater spending is employers' expected greater income. On this view, the FT is way off the mark in suggesting that recovery requires a drop in living standards.

The gamble of western governments seems to be that the asset boom created by QE will be sufficient to overcome the depressive effects on consumption and investment of the decline in average real earnings.

I doubt this. It may be able to offset the decline in real spending for a time (and in some sectors) but failure to restore a broad-based market for consumption is bound to abort the recovery before long. The fact is that QE creates far more losers than winners. So we should not be too keen to revise our growth forecasts upwards.