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The perils of a Living Wage

The perils of a Living Wage

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The discussion surrounding a Living Wage, prompted by falling real wages over the Great Recession, continues apace in the press. Yet what concerns me about these efforts is not the aim, which is highly laudable, but the potential trade-off between unemployment and underemployment.

Let me first define my terms. Unemployment, as measured by the unemployment rate, is a measure of the proportion of the economically active population who are unemployed. Underemployment, however, is a measure of the number of the employed who want more work than is currently available to them.

Falling real wages, especially for those at the lower end of the income spectrum, is likely to lead to an increase of the latter to the marginal benefit of the former. That is, if the cost of workers is falling companies may be more inclined to maintain higher staffing levels than they otherwise might but those workers seeing their incomes fall could then want to do more work to make up the difference. This could go some way to explaining the unusual character of the UK`s labour market over the crisis, which has experienced a much less severe rise in the unemployment rate than would be expected given the scale of the economic shock.

Yet this was not a costless gain. Real wages continue to fall because prices continued to rise despite stagnant (nominal) wage growth. Another way of looking at it is that what people have gained in maintaining their jobs they have paid for through sacrificing purchasing power. Not quite the jolly Christmas message people will have been hoping for.

The question is, do we think it is better for more people to keep their jobs than it is for those who have jobs to have their real incomes protected?

It might seem obvious at first glance – the unemployed suffer significantly more hardship than those simply seeing their purchasing power gradually eroded – but overall suffering is difficult to measure. Moreover, if we were to allow wages to be completely flexible it is possible that this could encourage firms to slash wage bills as a first recourse when facing a downturn, dramatically worsening the underemployment problem.

So some wage stickiness, particularly nominal wage stickiness, might be considered to be an economic benefit helping to maintain aggregate demand in a downturn and prevent a spiral of falling demand feeding further wage cuts. Moreover, according to Efficiency Wage Theory, employers themselves should be reluctant to lower wages because (net) productivity is a function of the wage paid.

As such, we have good reason to expect a degree of downwards wage rigidity during a recession. In previous recessions this nominal rigidity combined with falling prices actually meant that purchasing power increased for the employed over the downturn:

But as mentioned above, this came at the cost of significantly higher unemployment:

The above chart shows the performance of the UK over the Great Recession is something of an anomaly compared with previous downturns. This time really is different. Wages have fallen persistently, unemployment rose less than expected but has remained well above its pre-crisis level and inflation has also been stuck above target. As discussed earlier, the lower unemployment rate could in fact be a function of falling real wages. Yet we haven`t had low unemployment, it has been and remains stubbornly high despite the hit to workers` purchasing power.

One way of looking at this problem is that globalisation has replaced the problem of wage rigidity with price rigidity. In a closed economy depressed demand would cause prices to fall until the two reached a new equilibrium from which to base a recovery. In a globalised world dominated by large multinational corporations prices are not determined at a local level, but by global demand. If prices cannot adjust to a level consistent with full employment then wages must carry the burden.

What do wage rigidities do in this situation? Look again at the unemployment rate chart and we may be seeing one consequence of them. The unemployment rate has remained largely constant since the middle of 2009. One explanation for this could be that firms were unable to sufficiently adjust their input costs, including labour costs, meaning there has been more slack in the labour market than there otherwise would have been.

Yes, under a flexible wage scenario wages would have fallen more sharply. But if more people had been employed it is possible that the recovery would have set in earlier too. With the labour market tightening wages would have been pushed up and productivity improved.

Of course, there are significant potential downsides to completely flexible wages. As Miles Kimball explained in a recent Quartz article:

“The only way a bottom-of-the-heap, dead-end job will ever be worth something to a worker is if there is a something worse than a bottom-of-the-heap, dead-end job. In Efficiency Wage Theory, that something worse is being unemployed. To make workers care about bottom-of-the-heap, dead-end jobs, employers have to keep raising their wages above what other firms are offering until workers are expensive enough that there is substantial unemployment—enough unemployment that being unemployed is worse than having one of those bottom-of-the-heap, dead-end jobs. For the worker, Efficiency Wage Theory is bittersweet.”

Wage falls could make relying on state benefits preferable to working in these “bottom-of-the-heap, dead-end jobs”. As such in order to provide an equilibrium state consistent with full employment benefits would have to be withdrawn and unemployment made even less tolerable that it already is. We can see some of this thinking behind the Coalition`s workfare scheme, for example.

From a moral standpoint making unemployed life utterly intolerable is difficult to defend, especially if you believe that luck plays important roles in people`s career outcomes. A Living Wage, or much higher minimum wage, presents one solution by setting wage levels high enough to maintain incentives for the unemployed to seek work but if it comes at the cost of higher unemployment in a downturn it may be of scant comfort to those forced out of their jobs.

I think the problem here is being misdiagnosed. Low paid, “bottom-of-the-heap, dead-end jobs” are a function of the lack of low-skilled workers` bargaining power. If we could empower both the employed and the unemployed, say through a basic income model, those jobs that are necessary would have to adjust their wage offers to compensate people for the nature of the work. A basic income would also allow for a much greater degree of wage flexibility, as workers would be less resistant to accepting pay cuts in a downturn and more forceful in demanding compensation during a boom, even as it provides a backstop to aggregate demand (preventing a downwards wage/demand spiral).

Ultimately there will always be trade-offs. But we should not as a society become blinded to human suffering in the name of economic efficiency.

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