Wage-Price Deflationary Spiral

I don’t usually read (or cite) Sherry Cooper, chief economist for BMO Capital Markets, but in a recent article she was on the money:

Layoffs and reductions in hours worked have been accelerating in recent months and cover firms in virtually every sector of the U.S. economy. The same has been true in Canada, but to a much lesser degree as our jobless rate is below the U.S. This, in itself, is contractionary, but now it has taken on an even more troubling aspect. For the first time since the Depression, workers have been willing to take pay cuts in the hopes of keeping their jobs….

Not since the 1930s have we seen this phenomenon. The last time salary freezes were popular was when we attempted to reduce government budgetary red ink. Lower personal income means lower personal consumption, which in turn leads to reduced production, sales, and revenue for business. In consequence, capital spending plans are shelved and prices fall. This wage-price deflationary spiral is very difficult to stop and it points to continued weak economic activity.

Cooper is suggesting that workers are electing to do this of their own free will, but it is usually being forced on them by people like federal industry minister Tony Clement and others, compounded by all the economic policies that have undermined the power of workers.

I’m not incredibly concerned about the price side of the deflationary spiral: we’ve had ongoing declines in the price of many capital goods for some time, housing will become more affordable as it falls further in price, and the Bank is continuing to print money.  But a downward slide of wages should be a major concern.  In a recent reaction to Clement’s move:

”This is a destructive strategy,’‘ says Ken Georgetti, President of the Canadian Labour Congress. ‘’If the Great Depression of the 1930s taught us anything, it is that lowering wages creates a downward spiral without bottom. Workers who lose their purchasing power can no longer support their local businesses and communities.

Sounds similar.  

Chief bank economists and the president of the labour congress on the same page.  Are Clement and Flaherty listening?


  • Toby: I think we should be equally, maybe more concerned, with price deflation. Expected price deflation raises real interest rates, which causes firms to reduce investment demand and households to postpone consumption demand. That’s my spiral-fear.

    Firms buy capital goods to produce consumer goods. If consumer goods prices are expected to fall, it reduces the profitability of that investment, and is equivalent to a rise in the rate of interest.

    You are right to point out that falling capital goods prices is not new. But was the recent fall mostly due to the exchange rate appreciation? If so, and firms expected it to be temporary, firms would not have postponed investment waiting for prices to fall further, (until now).

    Falling nominal wages, for given prices, change the distribution of income, and not the level of income. You might care about that in its own right, but the effect on aggregate demand is muted, since it is proportional to the difference between the marginal propensities to consume out of wage income and non-wage income.

    For example, if the mpc out of wage-income is 0.8, and the mpc out of non-wage income is 0.6, then the first round effect of a $100 cut in wages, holding prices constant, is $20, not $80.

    (There may also be effects of changes in real wages, and expected wage deflation, on investment demand, but I can’t think right now which direction they would go.)

  • “Are Clement and Flaherty listening?”

    [chuckle] can’t be helped,
    i got this image just now of two little boys sulking in the corner…and others like them; ‘but, but…’

  • Those are all very good points, Nick, and a good summary of the theory. However, I don’t think sustained price deflation across all goods and services is as much a possibility or threat today in our more globalized world with much more international trade in goods and services than it was during the 1930s. Much of the variation in the CPI in recent years has been the result of swings in oil, energy, food, and housing prices, while the core rate has been more stable. Core inflation is a better measure of the movement of the general price level and I’m not sure if anyone is forecasting deflation for that.

    What’s important for the firms doing the investment is the expected price and profits in the markets for their goods in relation to their costs, and not necessarily measures of aggregate price levels. For those producing for domestic consumption, I think that expectations of demand, which is certainly affected by wage levels, would be more of a concern than expectations of general price levels. In terms of generalized price inflation in Canada, the 2% target seems to be pretty well entrenched over the long-term; although we may hear more from Carney about this on Tuesday.

    Our economies are also more dynamic, with prices for many consumer goods and capital goods having been driven down by productivity improvements and globalized production moving to lower wage countries for a number of years. For instance, the cost of clothing on average is now 15% lower than it was in 2002; home entertainment equipment 20% lower; the price index for consumer computers is down by 80% from 2002. The costs and prices for these goods are more set by factors (and exchange rates as you note). Ongoing steep cost-cutting for certain commodities from moving production to these areas may be slowing: there’s only so low that some wages can go to subsistence levels, especially with still high prices for food.

    (I also suspect that there is a greater spread between the MPCs for wage and non-wage income in the current circumstances.)

  • Thanks Toby. You may be right on the deflation. I hope so!

  • The art of explaining these economic bulwarks is quite a fascinating task.

    For me, once the consumption bubble burst, combined with a high dollar at the beginning of this whole transformation, has been brutally efficient in destroying productive assets.

    Each market shrinks with astounding speed, then the shock of the wall street crash, scared the beans out what was left in credit consumption and speculative earnings.

    We now enter a period of declining markets, the pie shrinks. Competitors, start doing whatever it takes to secure its piece of this shrinking pie. Even within the less competitive sectors, collusionary rules start getting tossed out the window.

    LAyoffs and wages are the first victim to try and adjust to these declines and increased competitive pressures.
    Oddly enough even when forced by government policy aka, the government driven auto sector cuts. From forestry , manufacturing and now the public sector, these wages pressures are what will accelerate our downward fall.

    Somehow we need to ensure this message starts catching fire within the policy circles of both the public and private sector. The question is, what can mitigate these forces.

    Stimulus will help put on the breaks, but it is going to take some very very intelligent stimulus with some quite focused granularity within specific sectors on supply side.

    And this will need to be countered with some stay at home spending on the demand side. i.e. infratructure, greening of the productive assets, energy efficiency of housing stock etc.

    For us Canadians, we can hope that the Obama led stimulus will leak north.

    I cannot imagine trusting the tories with such a grandiose interventionist strategy. For one thing we will need a leader with two hands, and we all know Harper will be holding his nose with one hand ever step of the way of this interventionist strategy.

    Flaherty will have to be replaced as the only instrument that fits in his hand is an axe.

    I would hope that the coalition gets a chance but I will lay a lot of money on the Tories hanging around for the next couple years. I just don’t see Iggy jeopardizing his chance at full control in the next election by going into the coalition which I am sure he perceives as a real negative for his chances at a win . It will not happen and I think the tories know that.

    The budget Tuesday could be quite important on the future of this deflation.

    There is hope but it needs some quite difficult policy intervention to get us there.


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