Falling real wages

Tue, 08 Jul 2014  |  

This article first appeared in the Melbourne Review on 6 June 2014. https://www.melbournereview.com.au/commentary/article/falling-real-wages

It is rare in Australia to see falls in real wages but in the last six months the annual rate of inflation has been higher than the rate at which wages are increasing.

This loss of purchasing power for households, plus a hopelessly mismanaged and poorly framed budget, is driving consumer confidence sharply lower, towards levels not seen since the Global Financial Crisis was threatening to plunge the world economy into an economic depression.

Falling real wages are a sign of slack in the labour market. In other words, real wages are weak or actually fall when there is a sufficiently large pool of unemployed workers for potential employers to trim wage levels to entice people into a job. This wage moderation then filters through to those in employment and the path to real wage weakness in entrenched at least until the economy grows more rapidly and demand for labour increases with it.

While it would appear that Australia does not have a significant unemployment problem at the moment, several years of slightly below trend economic growth has seen the unemployment rate drift up from under five percent to now be around six per cent. At the same time, the workforce participation rate has been falling, suggesting a significant and increasing degree of slack in labour market conditions.

The fact that real wages are falling in response to these market pressures means that there is a high degree of flexibility in the setting of wages and the industrial relations structure more generally. Wages are adjusting, in real terms, to this period of softer economic growth and softening of growth in demand for labour and this low wages growth is, in turn, helping to keep inflation in check.

The Reserve Bank of Australia has identified this phenomenon. In the minutes to the May board meeting, the RBA noted, "the demand for labour remained subdued and was likely to remain so for some time. This had led to lower wage growth which in turn had seen inflation decline for non-tradable items whose prices were more sensitive to labour costs."

With low wages growth helping to dampen inflation pressures, the RBA has been able to keep monetary policy very stimulatory as it attempts to support the economy and lock in growth at an acceptable pace.

There is a problem if wage levels remains too low for too long. It holds back or even oppresses growth in consumer spending. The household sector needs steady real income growth if it is to maintain a solid growth rate in consumption spending. While borrowing and a run down in savings can temporarily underpin higher spending, more fundamentally sound and sustainable increases in spending rely heavily on household income growth.

Making matters more problematic at the moment are other negative influences on household incomes that result from the budget. The Medicare co-payment, the indexation of petrol excise and the two percent income tax increase on high-income earners will all dampen disposable incomes as money is taken from potential consumption and directed towards government revenue.

This suggests that household spending growth is vulnerable to some headwinds in the months ahead. Already consumer confidence is down and there is a solid correlation between consumer optimism and spending. While Australians are very wealthy with recent house price and stock market gains, these two drivers of wealth have recently stalled with house prices down and the stock market growth so far in 2014 underwhelming. The list of negative factors is slowly, but surely, growing.

About the only upside of low wages growth in the current flexible labour market climate is that the real cost of labour has fallen. When the economy does register stronger growth, employers will be inclined to increase their hiring due to these subdued labour costs. The low wages growth bodes well for further employment on the critical caveat that the economy can get to and then sustain above trend economic growth.

From a macroeconomic perspective, it is best if there is moderate but sustained growth in real wages. This generally underpins a solid rate of consumption spending and facilitates hiring as the economy grows.

At the moment, falls in real wages are threatening to undermine economic growth which could well be problematic if mining investment continues to fall and the recent stalling in the housing expansion turns into a downturn. What looked to be a strong start for the economy in 2014 is now faltering. The question is whether it is a temporary blip or something more sinister.

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