In recessions, wages and salaries do not behave like other prices. Wages do not adjust to the drop in demand in recessionsit 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 economys collapse into true deflationif employment does not fall too much. But the recession staring us in the face this time is far too deep. 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. 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.
In the current circumstance, firms need to recognise that 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.The basic idea is the well understood concept of employees sharing in the ups and downs of a firms performance.
It is not only that such a wage mechanism will increase employees incentives and productivity. More significant is the fact that now firms would always choose to expand employment at the going wage if they could. This is because now 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 during a recession, as the marginal cost of labour drops to the fixed component of wage. Adjustments will take place through prices rather than quantities.
The author is reader in economics at the Judge Business School, University of Cambridge, and fellow of Corpus Christi College