New Statesman fails macroeconomics 101

27th September 2012

In the piece, which carried the headline "Pegging benefits to wage inflation fails Macroeconomics 101", he wrote:

"If benefits were to be pegged to wages, rather than inflation then some of that counter-cyclicality would be scrapped. The benefits bill would shrink in recessions and increase in boom times, compared to where it would be without the change. That would mean prolonged depressions, and a magnification of the boom-and-bust cycle. Macroeconomically, its one of the worst things you could do."

To demonstrate his claims he includes a chart showing that over the last decade wages have risen at a faster rate than inflation before the pattern switched with the onset of the financial crisis. So it is certainly the case that during the recent recession benefit payments linked to inflation have risen more than they would have done under a wage link.

Moreover Hern is correct to point out the counter-cyclical benefits of the welfare system. Without these automatic stabilisers the economic downturn would have been harder and persisted for longer than it did.

Where I depart from him is in the claim that a wage-link would provide less counter-cyclical government spending during a recession than an inflation link. Indeed the history of recessions suggests the precise opposite is true.

Renato Faccini and Christopher Hackworth of the Bank of England's Structural Economic Analysis Division produced an interesting paper in 2010 looking at how output, employment and wages behave in recessions. They conclude that the manner in which businesses have responded to the falls in output during this recession looks rather different [than previous recessions]. Real wage per hour growth has been weaker than in the early 1990s".

In previous recessions wages have remained stickier than inflation. This is due to a combination of those on low salaries losing their jobs, which pushes up the average, and the difficulty employers face in reducing the wages of their employees.

As can be seen from the chart below, however, the rate of inflation falls much faster during a downturn. This is to be expected – a recession causes aggregate demand to fall and this forces commodity prices down under normal circumstances.

"I think the performance of commodity prices has been weaker in previous recessions," says Simon Ward, chief economist at Henderson. "My suspicion is that quite often inflation falls more than average wages."

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