Economics and politics - comment and analysis
2. August 2020 I Heiner Flassbeck I Economic Policy, Economic Theory, General Politics

 How to Create Unemployment and Deflation

Wage cuts and underspending are a direct route to another Great Depression. The US and Germany seem to be headed that way.

Cross-posted from Makroskop and Brave New Europe

Translated and edited by BRAVE NEW EUROPE

In the US at the moment pretty much everything that can be done wrong is being done wrong. If wage cuts are now being implemented across the board, a scenario like that of the Great Depression of 1929 can no longer be ruled out. But even in Germany the importance of stable wages is not understood.

A lesson in the wrong economic policy choices can currently be learned in the US. Once again, companies are doing what they can’t help doing: They cut wages. As is graphically reported here (in German), not only are many millions of workers being laid off in the US as a result of this crisis directly caused by the state, but many more millions are having their wages cut because unemployment is high.

That is fatal, as the report rightly points out. Because the American economy is more dependent on consumption than any other, the reduction in wages leads directly to a fall in consumption, which in turn directly harms companies as a whole. Is the reduction in wages becoming a mass phenomenon (and who wanted to prevent this in the case of companies free to make their own decisions?) the wage cuts are a direct route to deflation and a crisis that is really almost impossible to control.

Just as in the Great Depression

This corporate behaviour is exactly what dramatically exacerbated the crisis in many countries, including Germany, during the Great Depression of the 1930s. Because of mass unemployment, companies cut wages at that time, which exacerbated the unemployment and drove up deflation. It is more than tragic that more than a hundred years later the relevant context is still not understood.

Friederike Spiecker and I already pointed out last week (in German) that even in Germany, and deep inside trade unions themselves, there is a tendency to forego wage increases because of the difficult economic situation. This is exactly the same mistake as the US is making, only the dimension is different. If, as you can hear these days all over the country, companies step on the cost brakes hard, they will trigger nothing less than a dangerous deflationary mechanism.

Dismissals, however harsh they may be for those affected, are in fact better than wage cuts in macroeconomic terms. In this case, a suffering shared is not a suffering halved, but rather, actually, doubled. A company that cuts wages for the entire workforce by ten percent does more damage to the economy than a company that cuts its payroll by ten percent by laying off ten percent of its workforce. The complete loss of wages for the ten per cent made redundant is offset by 60 per cent state support, whereas no one is compensated if wages are cut for the entire workforce. If the affected employees do not draw on their savings, the wage reduction will have a full impact on demand and thus a negative effect on jobs. Wage cuts immediately destroy jobs and, in a second step, force companies to adjust prices downwards, thus deflation following unemployment.

Companies as a whole cannot reduce costs…

The principle behind this is actually easy to understand, but has still not found its way into the generally accepted canon of economics, although it is of paramount importance. Companies that reduce their costs always immediately and directly reduce the profits of other companies. As the companies concerned tend to do the same, because they too fear losses, a downward spiral occurs which knows no limit. The companies dig their own grave with the reduction of costs, unless at least one powerful actor counters it and even then does not cut (but better still increases) its expenditures, even if it itself is affected by cuts by the other actors. It is apparently only the state that may be able to understand the programmed failure of entrepreneurial endeavours and can oppose them vigorously.

… and never spend their resources

Conversely, however, it is also true that companies that spend money with their hands full always only fill the hands of other companies. The corporate sector as a whole is a cash cow whose reserves never run out. If companies take on debt to invest, they can trigger a boom, which likewise only comes to an end when it leads to inflation via rising wages and calls on the state, this time in the form of the central bank, which chokes off the boom with interest rate hikes.

What can an enlightened state do?

An enlightened state can, of course, intervene long before the catastrophe occurs and try to stop companies from their senseless actions. Especially in today’s deflationary situation, where the state no longer has the simple means of stimulating low interest rates and further interest rate cuts, other interventions must not be seen as taboo from the outset. The state could easily impose a wage target that would prohibit companies from adjusting wages downwards in any way during the crisis. However, it cannot at the same time prevent a company operating in a market from reducing its staff if the company is in a state of crisis.

On the one hand, it follows from this that the state can improve the situation for all companies through direct state demand. But there are limits to government demand. The state cannot really serve all areas of the economy, but is usually extremely heavy on construction because it focuses on public infrastructure. On the other hand, the state is often not fast enough to absorb a deep slump in time. But there is a simple way out of this dilemma: the state can pay an extremely generous wage replacement benefit, i.e. unemployment benefit, to all those who become unemployed in such a crisis.

Generous unemployment insurance as a solution

If the state were to pay all unemployed people 70 to 80 per cent of their last earnings for two years, it would on the one hand facilitate wage negotiations and on the other hand support demand better than any other measure without completely calling into question the existing production structures.

This is often overlooked: it is not possible to replace the existing production structures with new ones without friction – not only the “machinery” but also the workforce with its know-how. The restructuring process takes time and is accompanied by unemployment. Particularly in times of already high unemployment this is a massive additional burden for the employees. They are expected to be highly mobile and flexible in terms of their adaptability in terms of qualifications and line of work at a time when the chance of finding a job is low.

This solution can easily be implemented in all large, relatively closed economic areas. In the US in particular, the export share of less than 15 percent is so small that domestic demand plays a decisive role (Figure 1). But even for the euro zone as a whole, where exports account for around twenty percent of GDP, only such a measure can prevent massive labour market problems.

Figure 1Share of exports as a percentage of GDP

With its huge current account surplus and its extreme dependence on exports, Germany is in a much worse starting position than the rest of the euro zone or the US (Figure 2). No one can replace the loss of export demand, neither domestic private households nor the state.

Figure 2Nominal exports as a percentage of GDP

This structure is simply not sustainable, unless a miracle happens to enable importers around the world to buy the goods that Germany offered before the Corona crisis, again and very soon. But this miracle will not happen because it is already clear that the shock has caused and will continue to cause massive distortions in income and profits in practically all countries. In Germany, more than in any other comparable country, even with major macroeconomic countermeasures, millions of jobs are no longer viable because of its export-heavy structure.

It is high time that German policymakers drew conclusions from this and actively pushed ahead with restructuring towards a greater role for domestic demand. Political support for a wage policy that is not influenced by the current crisis is the most important measure.