Wage cuts and profits

This comment from Duncan has created some controversy:

Whilst it may be logical for one business to focus on ‘cutting costs’ to safe guard profit margins, it is illogical for all businesses to do the same.  It would be even more illogical if the State joined them.

This is one area where a little basic maths might help.
Let’s start with the basic identity that national income is the sum of consumer spending (C), capital spending and inventory accumulation (I), government consumption (G) and net trade (X - M):
Y = C + I + G + (X - M).
Incomes are also equal to the sum of profits, wages and taxes upon production:
Y = P + W + T.
We can re-arrange this to get an identity for profits:
P = (C - W) + I + (G - T) + (X - M)
We can use this to focus on the question: how can a cut in wage income - be it a wage cut or job losses, in the public or private sector - raise aggregate profits? There are several possibilities:
1. Consumer spending falls by less than wages, so C - W rises. This would happen if workers dip into their savings, or increase borrowing, to tide themselves over bad times.
2. Wage cuts reduce interest rates, which boost I.
3. Wage cuts make tradeable goods cheaper, which raises X and/or reduces M.
We can, however, be sceptical about all these mechanisms. The reluctance of banks to lend means it is more than usually unlikely that consumer borrowing will rise to offset lower wage incomes. Indeed, it’s possible that consumer spending would fall faster than wage incomes, if workers increase their savings in anticipation of losing their job. That would reduce profits.
Similarly, the interest elasticity of investment is low - were it not, we’d have a capital spending boom now! And if firms fear that consumer spending will fall, they might even cut investment. Again, this would cut profits.
And the price-elasticity of demand for tradeable goods is also low, at least in the short run and certainly with respect to public sector wages: the government doesn’t export much.
The best we can say here is that wage cuts - in the public or private sector - don’t obviously raise profits. It takes considerable elasticity optimism - about the response of net exports to costs or investment to interest rates - to argue that this is the case.
My prior, instead, is with Duncan - that wage cuts are downright dangerous.  But then, I’m an old-fashioned Kaleckian: “workers spend what they get; capitalists get what they spend.”

Comments

[Duncan]

Thanks for that Chris. I'm basically a Kaleckian myself.

I'd be curious to hear your views on the IS-LM, investment/saving debate I'm having with Tim today.

[Duncan]

Also - I'd argue that scenario (1) explains a good deal of both the growth and debt build up of recent years.

[Luis Enrique]

Some questions: When does cost cutting amount to an increase in productivity? (and, how would you use national income accounting to illustrate an increase in productivity?) and how can you talk about the relationship between costs and profit margins, without talking about prices and competitive behaviour? Does the nature of competition change during a recession?

[chris]

Ta, Duncan.
I've regarded the IS/LM as utter cods ever since my Masters days back in 1986-87, when I read Fitoussi's Modern Macroeconomic Theory.
(Two clues - stocks vs flows, treatment of expectations)

[Laura]

What about opportunity costs? If a country is using all its workers to make food, it doesn't have any left to do other things like build houses and provide medical care. If food production becomes more efficient and sheds a few jobs, then there are workers available to go into other things (or you can continue to employ those workers and trade the excess products produced with another country for other goods or services). This obviously is not a an argument in favour of increasing GDP through lower wages, simply a suggestion that making efficiency savings through job losses might not be a zero sum game and that one industry's job losses might not always result in permanent unemployment for those workers, but may in fact be another industry's gain. Specifically, I assume that it is beneficial to a country's GDP when it ceases to be purely agricultural and has capacity in its labour force for doctors, software developers, hairdressers and in fact pretty well any profession where the average wage is higher than the average agricultural wage lost - or the average wage lost in any other industry creating job losses due to efficiency measures. (Not that that makes being one of the workers who loses their job in an efficiency cut any less difficult on a human level.)

[Sam]

Wage cuts don't obviously have much of a net effect, but surely the elimination of wasteful jobs frees up people to do something else? If someone moves from a pointless job to a useful one, does this not conserve C and W, but increase I?

Or looking at it another way (and perhaps from the point of view of the State), if my taxes are going to employ a bunch of people anyway, I'd rather they did something useful (clean the filthy streets, maybe?) than sat around on their arses.

[reason]

Money wage cuts are the same as fall in the value of the domestic currency (so ceterus parabus) they should push up net exports. Whether that offsets falls in domestic consumption and investment in the short term (Laura) is another question.

P.S. Laura, I think we are talking about short term disequilibrium effects here, not long term equilibrium effects.

[Spango]

I know it's not what Cameron has in mind, but couldn't you effectively maintain equilibrem by cutting wages/costs and using that to fund an increase in government spending (i.e. raise the JSA, or buy new tech for Hospitals.)? Bolstering (G - T) to offset the falls in (C - W).

Again, not what the Tories are liekly to think, but could it not be argued that, in fact, doing so without attacking the frontlines nessecarily implies bidding down the cost of managerial workers, as the state would fire a load and increase employee supply. Which would probably result in reduced costs and inequality, long run.

Bit speculative, but possible?

[Spango]

And, equally, that cutting the states wage bill, without reducing taxtion, nessecarily implies a fall in (G - T).

Which even further makes a mockery of the claim that it will in anyway help.

[Chris G]

A civil servant friend of mine (half)-joked at the time of the VAT cut last year that the best thing the government could do would be to increase civil servants' wages, as they were most likely to spend any increase given their high level of job security. I think he was advocating a strong version of Duncan's argument.

Surely the economic impact of public sector wage cuts depends on what the government does with any money it saves. If it uses it to cut total government spending, then sure, the effect will be to reduce total spending in the economy. But if the government used the savings to employ more people (for example, some of the soon-to-be 3 million unemployed), the impact would be expansionary if you make some reasonable assumptions about relative propensities to consume.

I can't think of any good policy reason why we should want wages in the public sector to increase relative to private sector wages in a recession. Rather, it's in the opposite direction the government should try to push.

[Laura]

@reason, such a short term model seems rather unfortunate for making decisions about an economy. Who'd do R&D if only the profit you were able to make from it within three months or a year counted? Who'd fund start up companies? Or were you suggesting that new industries take decades or even centuries to evolve? This doesn't seem to be borne out by the last 100 years or so.

Sure, if everyone made job cuts on efficiency grounds on Tuesday next that would be bad for the country, but if everyone made them some time this decade, the issue would be rather different, as new jobs would be more likely to arise at a similar rate to the job losses. I agree that it would be bad for the economy if everyone made job cuts to gain efficiency on Tuesday next. The chances of that actually happening rather than many companies making job cuts to increase efficiency spread over the next ten years seems quite low though. How theoretical is this model?

[Clara James]

Let me Present the above formula in some different manner if we particularly view it from the business point of view. . .

Total Income = Total Customer

Now the formula is shown customer relevant form

Total Customer = Existing Customer + New Customer - Lost Customer

[ad]

I'm a bit puzzled.

It seems to me that the argument regards Y = National Income, as a constant.

And then shows that if you hold National Income constant, nothing can change National Income.

[reason]

Laura,
I don't won't to disagree with your point (I don't think anybody does), I just think it is not very relevant to this particular discussion.

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