Posted by: Dirk | March 10, 2009

Declining nominal wages in Spain – “la crisis” 2009

In the European Union of the 1990s misalignments in international competitive inside the countries would trigger currency adjustments in order to reeestablish international competitiveness. Typically, a country that lagged Germany in productivity growth but experienced more inflation would then let its exchange rate slide. Therefore, the higher prices of products in deutschmark terms would diminish to a level where exports could stay competitive. With the introduction of the €uro, this kind of macroeconomic policy is not available anymore.

What channels are available then for adjustment? Adjusting the local price level is no option since the European common market does not allow it, so (nominal) wages are left to carry the burden of adjustment. These cannot be influenced by the government, in many countries that would be outlawed (Germany). A fall in nominal wages is a very unlikely thing, even during most recessions nominal wages are not falling. Adjustment occurs at the margin, so workers are laid off. Surprisingly, it seems that now a reduction of nominal wages is an acceptable thing to do. A friend of mine has told me that in her small consulting firm all wages were cut by 15%. That way, all employees are treated similarly while ensuring that the firm can stay competitive.

However, what is optimal for a firm might not be optimal for an economy. This is the fallacy of composition. When everybody earns less money, then demand will suffer. Prices have to fall to equate supply and demand again, increasing real wages along the way. However, this will harm all those that have to repay debt, which is a major problem in Spain since many household are deep in the red after they went on a debt-financed buying binge in the last years. If deflation seems to be coming up, the rational behavior of a household would be to reduce the debt level. That way, consumption would fall off a cliff, leaving domestic and also foreign firms struggling. These might be inclined to cut wages (again). Exports would fall, unemployment would rise, and all the while the GDP would move downwards.

If the problem of debt-deflation is the immediate cause of our economic problem, can the distribution of debt (in the financial sector as well as that of households) be influenced in order to increase the level of economic activity? And if so, how and with which (distributional) consequences? I think these are the questions that economists should try to answer. Otherwise policy makers like Tim Geithner are left alone to make important decisions without a clue about what´s going on.

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