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It’s time for strong medicine
Sunday, January 18, 2009 By Philip Lane
It is difficult to exaggerate the dire state of the public finances. The government’s projections for the next five years were published on January 9 in the catchily titled ‘The Addendum to the Irish Stability Programme Update’.

If reforms are not introduced, the budget deficit is set to exceed 10 per cent of GDP for each year during the 2009-2013 period. In fact, there is an element of optimism about these projections, since the forecast assumes a return to decent output growth from 2011 onwards.

Accordingly, the government must consider radical adjustments in public spending and taxation. The scale of the projected deficits means that few areas can be protected from fiscal retrenchment: we can confidently expect a substantial increase in taxation and revisions to the level of public investment and public services.

Of course, the public finance problem is not the only difficulty facing the government. The large-scale recession is driving up unemployment in the private sector, and it is generally accepted that the economy needs to rebalance, with an expansion of the productivity-enhancing export sector to fill the gap left by the collapse of the construction sector.

For the export sector to prosper, the relative cost of doing business in Ireland has to fall. While this must include efforts to reduce the cost of domestic inputs (energy, business services), the central component in cost reduction inevitably requires a reduction in the level of domestic wages across the economy.

It is against this backdrop that the debate on public sector pay must be considered.

A reduction in the level of public sector pay helps to protect the public services (the alternative is a larger cut in the volume of public services) while also facilitating wage adjustment in the private sector.

The case for a generalised reduction in public sector pay levels is reinforced by several factors. The evidence indicates that there is a considerable premium in public sector pay, as was most recently documented in a careful study by ESRI researchers. This found a substantial premium even before account is taken of the better pension arrangements in the public sector, or the superior level of job security.

The typical arguments against nominal wage reductions do not carry much weight in the current environment. The most commonly cited reason not to cut wages is the negative impact on morale.

However, much of the morale effect relates to the relative status of workers: if there is a general wage reduction across the public sector, the relative positions of different groups of workers would be unchanged.

Since public sector pay reductions would take place against a back drop of tough private-sector labour market conditions, and a recent history of very strong growth in public-sector incomes, the status of public sector workers relative to private sector counterparts would also not be unduly affected (beyond the potential elimination of the public sector pay premium).

Moreover, a major problem in achieving nominal wage reductions in the private sector relates to the difficulties encountered by workers in assessing the true financial state of their employers, such that private-sector pay cuts are often delayed until a firm is close to collapse.

However, the state of the public finances is common knowledge and the scale of the financing gap is clearly evident to public sector workers and their representatives.

A core strength of the social partnership infrastructure is that it is broader than a pay agreement. Accordingly, in negotiating with a union movement that cares about the quality and level of public services, in addition to the pay and conditions of its members, the government

should be able to negotiate public sector pay reductions (plus efficiency-enhancing reforms of public sector service provision) in exchange for the preservation of a given level of public service provision. This would not be feasible if the individual trade unions cared only about the wages of their own members and did not take into account the impact on the overall public sector in making pay claims.

Importantly, a cut in public sector wages will be helpful in promoting wage adjustment in the private sector, both through the direct competition for labour and via a demonstration effect. Even for those private-sector industries that do not formally abide by the national pay agreements, the level of public sector pay is a natural benchmark in determining wages across the economy.

Accordingly, by setting a lower pay norm, the social partnership agreement could facilitate a smoother form of adjustment in the private sector. It will also make it easier to make the political case for higher taxation, if it is shown that everything is being done to align public sector pay with conditions in the private sector.

Also, contrary to what some union leaders are arguing, nominal wage reductions may also actually be helpful in boosting aggregate demand in the economy.

While a decline in public sector incomes maybe thought to directly lead to a reduction in consumption, this does not take into account the impact on savings related behaviour. If pay cuts help to stabilise the public finances, a major deterrent to spending plans is removed, in that decision-makers can better forecast the future tax burden. The improvement in external competitiveness will give confidence that economic recovery will be based on a sustainable foundation of expansion in the tradables sector.

The boost to aggregate demand will be strongest if the nominal wage reduction is front-loaded. A sufficiently large initial wage reduction should enable the government to gradually raise the inflation adjusted value of wages in subsequent years. Expectations that future incomes will be above current incomes provide a support for current consumption, since the saving imperative is lower in that case.

Wage cuts will not lead to Japanese style deflation. While Irish inflation in the next few years may fall below the area wide average (and may well be negative for a sustained period), this is a purely temporary phenomenon, and is just a byproduct of engineering a depreciation in the real effective exchange rate. Rather, long-term inflation expectations for Ireland will be driven by ECB monetary policy, which is committed to delivering a long-term annual average positive inflation rate of 2 per cent.

The design of the pay deal could also provide some upside potential to workers by specifying the possibility of faster wage growth if economic recovery takes hold more quickly than is currently expected.

This can be achieved by agreeing a formula by which wage growth (after the initial cut) is expressed as a function of macroeconomic indicators, such as the rate of (appropriately-measured) productivity growth.

For these reasons, public sector pay cuts should be welcomed as an important part of the joint solution to the twin crises of poor economic performance and instability in the public finances.

Philip Lane is Professor of International Macroeconomics at Trinity College Dublin and the founder of the www.irisheconomy.ie website

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