Spanish economists: lower wages lead to higher consumption!

What happens when, at the same time, the decline of Spanish construction is finally bottoming out, which causes a lower rate of job losses, while at the same time real wages take a small hit and four mainstream Spanish economist run a kind of regression on these data? Right. They not only conclude that the -0,4% decline of real wages causes a lower rate of job losses but Miguel Cardoso, Rafael Doménech, Juan Ramón García and Camilo A. Ulloa in in their article also state:

An example of the impact that a more flexible wage-setting mechanism could have going forward is that, according to our estimations, if the reduction in real wages observed in 2012 [-0,4% according to them, M.K.] had happened in 2008 and 2009 (when real wages went up), the loss of around one million jobs could have been prevented (around one-third of total job destruction between 2008 and 2012).

So, Spanish employment would have been about 8% higher than it is today. Are they wrong? Yes. Their style of reasoning is an example of the tendency of classical economists, mentioned by Lars Syll, to state that as long as wages are equal to the marginal productivity of workers there will be no unemployment:

if the real wage somehow deviates from its “equilibrium value,” the representative agent adjusts her labour supply, so that when the real wage is higher than its “equilibrium value,”  labour supply is increased, and when the real wage is below its “equilibrium value,”  labour supply is decreased.

Notice that the demand for labour is not problematic, in these basically non-monetary models. The real wage is something like the amount of cherries one can pick in an hour and once the amount of cherries dwindles or one has enough cherries labour supply is decreased. In these representative consumer models supply of labour is the demand for labour.

Such ideas were of course refuted by the Great Depression. Wages went down – but unemployment didn’t.  Keynes tried to make theoretical sense of this, as Lars argues. Classical economists don´t, anymore: read how Cole and Ohanian define unemployment during the Great Depression away  by calculating the of course declining average number of hours worked per adult and presenting this variable as the aggregate consequence of personal choices about numbers of hours worked, ideas which are echoed by the four Spanish economists.

And this is so wrong.

* these ideas are based upon a world without investments and  without a circular flow of money where wages are only costs and not a component of monetary income and as such a mayor determinant of monetary spending. The cherries are your income…

* also and contrary to their statements, real wages did go down in Spain (though they didn’t). Ehm… yes. The purchasing power of wages did decrease (wage as income) but the real cost price of labour didn’t (wages as a cost) as consumer prices increased faster than producer prices (partly due to an increase in indirect taxes)

Investments and the circular flow of money are crucial to an understanding of such situations, as was shown by the Great Depression. Investment imploded which meant that unemployment went way up. During the preceding decades investment had increased from 5 to 8% of GDP to about 25% of GDP. Almost overnight, it went back to 5 to 8% of GDP.  To compensate this almost 20% of GDP decrease in demand either government expenditure had to double or household expenditure, at the time about 70% of total expenditure, had to increase with about thirty percent!

However:

* Households were constrained because unemployment had gone up while, as a consequence of this, consumption went down, too. Deflation added to this as debts weighed ever heavier.
* And government spending was constrained because tax receipts were falling.

Investments didn’t go up, either, as even very low interest rate did not convince companies to invest because there was a lot of unused capacity while productivity continued to increase, exacerbating the problem.The circular flow of money stalled at a low level. It’s somewhat comparable to rainfall in a tropical forest, which permanently diminishes when the forest is cut down.

This of course resembles the present situation in Spain. About half the job losses between 2009 and 2012 in Spain were concentrated in construction (investment). When we add job losses in activities directly and indirectly connected to construction this share easily rises to 80%. There is no way that wage decreases in construction or low interest rates would have prevented this.

According to the four economists, however, lower real wages would have saved a million jobs. But somebody has to pay this million. Which means that, as Spanish government expenditure is constrained while there is no way that Spanish investments would have gone up, lower real wages should have led to a ´back of the envelope´ level of household consumption which is about 16% higher than the present level, despite lower purchasing power of wages. 

Dream on. Lower real wages work during the upturn, when demand for whatever reasons increases. Not during the downturn.

Technical detail: as far as I can figure out (they are rather fuzzy about this, also in a  background paper) the authors deflated nominal wages with the GDP-deflator, which was basically flat in this period. Consumer prices however increased with 7%.