Peter Lyons: Wage reductions will cost everyone in the long run

Labour market flexibilities are rarely applied to professional occupations such as doctors. Photo / Getty Images

Jean-Baptiste Say was a French philosopher and economist in the late 18th century. He is buried in a Paris Cemetery near Jim Morrison, lead singer of the Doors. Jim Morrison gets more visitors.

Say's main contribution to economic thinking was that a free market economy always tends to full employment. If markets are left to weave their magic then the incomes created by production will ensure sufficient demand to buy the total output. Say did not deny that there could be temporary excesses of supply in particular markets but overall the economy would always tend to full employment.

Say's law underpins free market ideology. Its modern translation is that large scale unemployment is the result of rigidities in the labour market. These take the form of minimum wages, worker rights, unemployment benefits and union power. Unemployment is due to the unwillingness of workers to accept the wages that a truly competitive labour market would offer.

In the 1930s Depression, John Maynard Keynes attacked Say's law. The lengthy mass unemployment of this period suggested that free markets do not always ensure full employment. Keynes' insight was that an economy could spend a significant period with mass unemployment. There was a need for activist government policy to break this stalemate.

Say's law rests on the premise that net incomes are either spent or saved. Income that is saved is then used for investment in new factories, machinery, houses and other productive investments which create employment, output and incomes. Keynes suggested that during a severe recession, the incomes that are saved may not be reinjected into the economy to create more production and employment. The reason is that businesses lose confidence. They are unwilling to borrow and spend on new production because the demand is not there. Savings just pile up or are used for speculative none-productive investments such as existing housing or shares.

Since the global financial crisis central banks in most Western economies have slashed interest rates to virtually nil. Yet this accelerator is not engaging the economic engine. In the United States the near zero interest rates have resulted in a huge pile up of bank reserves because the punters aren't borrowing. In New Zealand, record low interest rates have served to re-stimulate the housing market. Using borrowed money to bid up prices for existing houses creates no new jobs or output.

The other recovery strategy being touted is to increase labour market flexibility and worker productivity. This is invoking Say's law. Greater flexibility means driving down wage rates and ensuring a supply of workers needing to work at these rates. Policies to achieve this include benefit reforms, reducing union power and allowing inflation to eat away at the minimum wage rates and benefits.

However, wage rate flexibility tends to apply mainly at the lower end of the labour market. This is a reason for the rise in income inequalities in recent decades. Wage rate flexibility at the board room level tends to work in one direction only.

Policies aimed at labour market flexibility are seldom applied to professional occupations. If the Government moved to make it easier for overseas doctors, lawyers, dentists or accountants to practice in New Zealand this would cause an outcry from professional associations. The argument would be about the need to maintain standards but there is also a large amount of gatekeeping involved. Unions are bad because they demand better pay and conditions for their members. Professional bodies are good because they maintain standards.

Keynes pointed out a further problem of reducing wages to reduce unemployment. Reductions in wages further reduce demand in the economy unless the prices of goods and services drop correspondingly. This increases unemployment rather than reducing it. Also if wages fall but debt levels remain, the debt becomes much harder to service.

Real wages for many New Zealanders are falling. It is becoming very hard to make ends meet for those at the bottom of the ladder who operate in the most competitive labour markets. The divide in our society continues to grow and in a small society, this eventually costs us all.

Peter Lyons teaches economics at St Peters College in Epsom and has authored several economics texts.