One confidence fairy dies….
In its latest report on the Spanish economy, the IMF takes a major step back from its usual practice of recommending tough fiscal consolidation policy. Alarmed by the devastating consequences fiscal austerity is having on growth (and perhaps also inspired by all the papers its own research department has been publishing on the fact that fiscal multipliers are much bigger than had been assumed), the IMF is now of the opinion that “consolidation should continue but be as gradual and growth friendly as possible”. The IMF therefore supports the new strategy of the Spanish government of looking at structural fiscal balances instead of actual deficits. The IMF also approves of Spain spreading out fiscal adjustment over the next five years, up until 2018, in that way limiting the annual fiscal cuts to be delivered to 0.7% of GDP.
In fact, the IMF takes an even stronger position stating that, in case growth disappoints, structural deficit targets should also be made flexible on top of nominal ones.
The idea that fiscal cuts, by restoring confidence in the sustainability of public finances), would actually make economic agents spend more and lead to an overall recovery of the economy is clearly off the table. Paul Krugman, in his blogs, has systematically been denouncing this idea of fiscal cuts having an expansionary impact on the economy as believing in a ‘confidence fairy’.
… While a new one is born
At the same time, the IMF opens up a new line of attack. With unemployment projected to remain above 25% by 2018 (!), the IMF is calling for additional labour market reforms, targeting those rigidities that force the adjustment onto employment rather than wages. At the top of the IMF’s wish list are a fully decentralised system of collective bargaining, further liberalisation of opt-outs, elimination of indexation and ending the validity of collective agreements after they expire.
However, even with such reforms implemented, the IMF fears that wages and hiring would still adjust only gradually. It is at this point that the IMF report comes up with the surprising proposal for a “compact on wages and prices’. The IMF invites trade unions and employers to come to an agreement, a sort of ‘grand bargain’ by which employers commit to significant employment increases in return for trade unions to agree to wage cuts. In this way, the process of wage adjustment would be accelerated. This proposal is further explored by the IMF by undertaking an econometric simulation using a reduction in nominal wages by 10% over two years (the 10% is, as the IMF calls it, ‘for illustrative purposes’). According to this simulation, GDP would end up 5% above baseline, employment 7% above baseline, unemployment is to be reduced by 6-7 percentage points by 2016 and price levels would be 4-5% lower after two years.
The IMF report (partly) explains these results by pointing out that that workers, when facing a substantial fall in their monthly pay checks, will at the same time discount the possibility that they are in less danger of losing their jobs or, alternatively, are enjoying a better chance in finding a new job (see page 12 of the IMF report). The effect of improved worker and household confidence would then (more than) cancel out the effect of reduced wage checks. And so the net result would be more, not less, private consumption. Business in turn would react by restarting investment. A domestic demand driven (not just an export) driven recovery would be put into motion in this way.
So, basically, what we have here is another story about ‘confidence’ with striking resemblance to the other fairy of tale of ‘expansionary fiscal austerity’. In both cases, it is suggested that improved credibility will increase (not decrease!) household spending, even with social benefits, public services or wages being cut.
‘Balance sheet deflation’ versus ‘Confidence’
Why didn’t the fairy tale of ‘expansionary fiscal austerity’ work? The reason is that other factors and mechanisms that play a key role are being ignored. Households, even if they acted as rational economic agents by anticipating a reduction in tax pressure somewhere in the future, will still not bring consumer spending forward if they are cash constrained, are saddled up with an overload of debt, and if banks are imposing a credit squeeze. Confidence effects in these circumstances exist only on paper and in the minds of the IMF and the EU Commission, not in economic reality. In fact, as we have seen in recent years, things then turn out the opposite way: instead of restoring confidence, fiscal austerity has shocked it further by increasing workers’ fear about their income, social benefits and jobs, thereby depressing the economy further instead of reviving it.
With this call for wage cuts, the IMF is making a similar mistake. ‘Confidence’ effects’ are being invoked but the wider context of and exact situation Spain finds itself in is simply overlooked.
Balance sheet deflation of the corporate sector
Let’s start with the fact that corporate debt in Spain is extremely high, close to 200% of GDP. Companies, especially SME’s, are now facing a terrible credit crunch, so the number one priority of management is to find the money to get rid of these high debt loads as quickly as possible. This implies that the first thing management will do with the proceeds of a general nominal wage cut of 10% is not to reduce rice price levels or finance new investment projects but to use this sizeable and structural windfall to pay back debt. This immediately blows apart the IMF simulation which is based on the assumption that business would cut prices by 5%. Workers, when giving up 10% of their nominal wages, would not be facing a 5% real wage cut as the IMF is suggesting but a cut in the purchasing power of their wages close to 10%. Correspondingly, the negative impact on consumer demand directly coming from the cut in wage income will also be almost twice as high as the IMF is assuming in its simulation. As said, real hourly wages will be falling by close to 10%, not 5%, making it extremely unlikely that any ‘confidence’ effect (if such effect would arise in the first place) would be powerful enough to compensate for it.
The net negative effect on household consumption will then have knock-on effects on investment: business, reacting to depressed consumption demand, will adjust investment spending downwards and this despite increased profit margins.
In fact, this type of strategy of business seizing the efforts from wage moderation to boost profits has actually been ongoing for a number of years in Spain. Since 2009-2010, falling nominal unit labour costs have systematically been translated into exploding profit margins (see graph below, the black dotted line for Spain is showing an enormous profit boom in Spain), not into lower prices or higher investment. Given the continuing credit squeeze, there is no reason to expect Spanish business would suddenly react otherwise, even if, for the sake of putting on a more ‘social face’, employers would formally commit to press prices down and raise employment in addition.
Households’ balance sheet
There is, however, more. Just as the corporate sector, Spanish households are also heavily indebted, facing a debt ratio close to 140% of disposable income. So even if Spanish workers would initially become more confident in keeping their jobs, they will at the same time start to wonder how to service existing debt obligations from wages that are being reduced by 10%.
The thing is that the IMF and others are always ranting on about labour market rigidities while ignoring the rigidity that is represented by nominal debt. Nominal debt does not go down when nominal wages go down.
The outcome of this is twofold: either households try to meet nominal debt payments from a reduced wage by consuming even less. In this case, the recession deepens. Alternatively, households start defaulting on their loans, thereby delivering an additional blow to banks’ balance sheets. In this case, the recession deepens as well because banks react to the deterioration of their balance sheet by restricting access to credit even more.
Watch out for Spain over the next couple of months
It is all very nice for the IMF to launch seemingly novel proposals on a ‘social pact’ and support these by model simulations promising substantially more jobs. A serious analysis, however, shows that the IMF simulation, just as was the case with the fairy tale of ‘expansionary fiscal contraction’, is based on invoking wild and unlikely stories of restoring confidence while at the same time ignoring the factors and mechanisms that really matter (indebtedness and deleveraging).
At the same time, one should not overlook the fact that the real policy agenda of the IMF and others is to continue with labour market deregulation and internal devaluation of wages. The IMF and others basically want to do in Spain what they have already managed to do in Greece: deep across the board cuts in nominal wages so that nominal unit labour costs fall sharply. The graph below (based on the Commission spring forecast) shows that Greek workers are now beating German workers in their efforts to push wage costs down (!). The increase in unit labour costs from 1999 to 2014 is now lower in Greece compared to Germany. The zealots of wage cost competition should now be recognising that that Greece, not Germany, is to be considered ‘über-competitive”.
While Spain has seen its wage cost curve turn the corner as well, its fall in unit labour costs has not been as dramatic as in Greece. If the IMF is insisting on more structural reforms and, on top of that, a pact to voluntarily accelerate the fall in wages, it is to achieve the same type of wage cost collapse as has been the case in Greece.
Things may very well come to a showdown in the coming months if DG ECOFIN decides to use the new power it has been granted by the new procedure on excessive macroeconomic imbalances to impose an agenda of deregulatory reforms on Spain. Indeed, Spain, together with Slovenia, has recently been declared by the ECOFIN council to be in a state of ‘excessive imbalance’. Member states in such a position are forced to implement the Commission recommendations unless a qualified majority within the ECOFIN council decides otherwise.
Evolution of Labour Unit Costs since 1999 (in %)