Wednesday, 16 May 2012

Wage Stickiness and Greece

Imagine that you've been working for the same employer for a decade.  Over that time you've met all expectations, and have been rewarded for your loyal efforts with regular raises and several promotions.  You've built friendships, brought your family to corporate outings, and the like.  Then something changes.  A recession hits, and your formerly faithful employer offers you a regrettable lesson in Economics 101, from the chapter on supply and demand.
When a retailer orders more shirts, chocolate bars or cars than customers want, they must clear them by lowering prices, putting supply and demand back in balance.  Economic turmoil has left many people without work, leading to an excess supply of labor.  The unemployed are willing to lower their wage demands, reasoning that a lower paying job is better than none at all.  You're offered a choice: accept a wage cut of 35% or forfeit your job to someone who will.  How do you react?
If you're like nearly all workers, you're hurt, confused, indignant.  It's simply not fair.  After all, why should you be punished for economic forces beyond your control?  In fact, the responses to such demands are so strongly, so instinctively negative that employers rarely make them.  They know - or at least fear - that employees who feel betrayed have great power to harm their employer: spurned workers can be unmotivated, unproductive - or worse.  Since workers are the face of their employer's business, and are responsible for producing safe/reliable/quality goods and services, morale must be maintained.
On the surface, this may seem like an unnecessary dose of common sense, but it's actually known officially as Keynesian wage stickiness, a rare and powerful exception to the usual rules of supply and demand.  This is why there are few "clearance sales" in the labor market, and part of the reason unemployment exists.  It's all about fairness.  Indeed, careful analysis has shown that wages are often set above the rate that employers could get away with paying, and that workers understand that they are lucky to have a job during times of high unemployment (1).  This is not some stale detail from economic theory; it very much applies to real-world economics, including the current troubles in Greece. 
Workers in Greece lucky enough to have a job feel exactly as expected: they're not responsible for the over-borrowing of past governments, the corruption of society or the plight of their employers.  This is partly why Europe's current policy for restoring Greek competitiveness has failed.  Slow, grinding deflation has created a depression in the labor market - unemployment is above 20%, and over 50% for youth - but wages have hardly fallen.  (Even if wage cuts could easily be enacted, it would worsen the near-term economic problems, given the Greek government's inability to offset a fall in private demand by increasing public spending).  Many economists believe wages must fall by at least 20% to restore the Greek economy's competitiveness.  This would take years, but Greece's social and political fabric is already fraying.
There are two viable options for restoring Greek competitiveness.  The "in-the-Euro Zone" option is to promote significant inflation in the richer northern European countries - notably Germany - which reduces relative prices in the struggling southern nations.  This can be accomplished by monetary policy, or increased fiscal spending in the north.  Given the ECB's mandate to keep inflation at just below 2%, and Germany's unyielding resistance to elevated inflation or quantitative easing, fiscal measures hold more promise.  German wage growth has been deliberately kept below inflation for the past decade, leaving room for an increase, which would increase the price of their exports.  Thankfully, there’s been progress recently, as one of the country's largest unions won a pay increase of up to 6.5% by the end of 2013.  In addition, finance minister Wolfgang Schaeuble defended other unions trying to bargain for significant pay hikes (2).
The second, scarier option would see Greece exit the Euro Zone and reintroduce the drachma.  Though there would be turmoil following such a move, the new currency would immediately fall sharply against the Euro, restoring competitiveness and renewing growth.  Perhaps because Greece has no equivalent to Germany's ultra-competitive mittlestand, there is a view that Greece exports nothing, and thus stands to gain little growth via currency depreciation.  But Greece does "export" a lot of services, especially in shipping and tourism.  In fact, exports of goods and services are nearly 25% of GDP. 
Judging from the recent flight of deposits from Grecian banks, this option is becoming increasingly likely.  We may know for sure after June's elections.  What we know already, though, is that the demand for fairness ensures that the current policy of deflation will not work.  Yet another time-tested lesson from John Maynard Keynes that we've had to relearn the hard way.
(1) Akerlof, George A. and Schiller, Robert. Animal Spirits: How Human Psychology Drives the Economy, and Why it Matters for Global Capitalism. Princeton: Princeton University Press, 2009, (pp 97-106).
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