Revision: Wage Cuts in a Recession

What connects professional rugby players at Gloucester RFC, staff at Swindon’s Honda car plant, employees of the successful Game retail store and thousands of people working for the Royal Mail? The answer is that all of them have been asked either to take a pay cut for the year ahead, or at the least endure a wage freeze until economic conditions improve. They are part of a growing trend.

Pay is under pressure. According to news reports this week, the average wage in Britain, including bonuses, fell by 0.4 per cent in the three months to March – knocking about £95 off annual salaries to £24,000. People working in the private sector are at highest risk of a wage freeze or actual wage cut, whereas average earnings in public sector jobs continue to rise at or just below the rate of inflation.

The accompanying chart from the Bank of England shows the changing distribution of pay settlements across the private sector of the UK economy. There is a clear shift to the left with 20 per cent of wage agreements made in the first five months of this year ending in a pay freeze. Wage cuts are thin on the ground, but we will see a burgeoning number of case studies in the months ahead.

To some economists pay cuts in a recession are what one might expect and hope from a flexible labour market. Wages and bonuses can rise during an upturn, so why should they not dip during a downswing in the business cycle? Indeed without some pay cuts, the brunt of the recession will be seen through large-scale job losses and a higher risk of business failures.

But as is always the case in economics, the reality is far from straightforward.

Yes a pay cut can reduce a firm’s costs and improve their cash flow and profitability. And for many workers, faced with the prospect of a short run dip in the pay packet set against the chance of a job lost for good, the decision to take a wage cut might seem straightforward - but it is not:

1/ Wage cuts and deflation: If wage cuts become widespread across the economy the negative effect on real disposable income might cause a further drop in consumer demand, a deeper recession and a significant chance of deflation. In which case, the real value of debt will rise just at a time when people have less money to spare to start paying it back.

2/ Productivity: Pay cuts might seem an attractive option for a business but the medium term consequences for employee productivity and worker retention must be considered carefully. If productivity slips after a wage cut, the unit labour cost of production might actually rise.

3/ Pensions: For workers on final salary pension schemes, pay reductions can have a serious effect on their standard of living once retired.

According to the British Chamber of Commerce,

58% of UK firms plan to freeze salaries this year, with 12% planning to cut wages.
and
50% of companies are either considering or certain to make redundancies during the next 6 months.

Pay in a recession becomes a very difficult issue and it will be interesting to see how management and trade unions respond to the challenge. I suspect much depends on how much further the Retail Price Index falls into negative territory. For the moment, inflationarty expectations remain positive (people have not forgotten the pain of high food, fuel and energy prices in 2008) and this makes agreeing to a pay cut much more difficult to swallow.