Should wages rise with inflation? Will this trigger a wage-price spiral?
Aussie opposition leader - Anthony Albanese - has suggested they should
Cost of living pressures have been increasing. This has been a global issue. US CPI increased 8.3%. Australia’s CPI increased 5.1% y/y. There have been worries of a wage-price spiral, in which wages push up inflation which pushes up wages in a vicious cycle. The Bank for International Settlements (BIS) has echoed such warnings, especially in the United States.
This inflation has caused some – including ALP leader Anthony Albanese – to suggest that wages should also increase 5.1%. Business groups have decried such a push. Similarly, the Reserve Bank of Australia (RBA) has warned against tying wages to inflation.
The situation is complex. Many employers have tried to underpay employees for an extended period. Many employers have routinely kept wage growth far below inflation, failed to increase wages with seniority, or have cut wages even in good times. This has triggered resentment, which bubbles over in high inflation periods. This is understandable and needs to be addressed.
This begs the question: Should wages be tied to inflation? And if not, why? What about living standards?
What is a wage price spiral and why is it bad?
A wage price spiral occurs when wage increases trigger inflation. And, then this inflation further triggers wage price increases. And, this occurs in a (hypothetically) never ending cycle.
This occurs for the following reason. Suppose a person’s income increases by $1. Let us think about the impacts:
1. The person now has another $1 they can spend on goods, invest, or save. At least some of that $1 will go to additional demand. Given that supply and demand largely determine prices, this increase in demand will shift prices up, holding supply constant.
2. The person’s employer must now pay them an additional $1. This increases the employer’s costs. Thus, the employer will pass on the costs to customers to the extent possible. Some companies can pass on the full amount. Some companies cannot. Former Prime Minister John Howard alluded to this when he asserted that policy should “make sure that wage rises that can be afforded by some companies and some firms aren't imposed on small businesses that can't afford them”. This will then put further upward price pressure on prices.
Now, suppose we are in a simple idealized world. In this simplistic world, people might say “What does it matter if bread increase 10% if my income has also increased 10%”. But, the world is not that simple.
To explore the negative impacts, we need to dig deeper. So far, we see grater inflation: People can pay more for goods, so demand increases. But, companies have higher input costs, so they charge more. The above two steps will continue for some time. This creates a cycle of inflation. But, eventually, this cycle will go off the rails, to mix metaphors. There are on-flow long term effects:
1. Imports will become more expensive and living standard will fall. They will do this because as the value of the $ declines, imports become more expensive, which reduces productivity and lowers’ peoples’ standard of living. Exports might increase, and in equilibrium could hypothetically off-set this over the long term. But, the possibility of a long run equilibrium hardly would solve the concern that imported food will become unaffordable now. This logic applies mutatis mutandis throughout the economy. Failing to reduce inflation, can trigger hyper-inflationary disasters.
2. Central banks will try to reduce inflation. But, if wages are now tied to inflation, the central bank will need to increase interest rates by even more: no longer could they count on wages stabilizing or falling to reduce inflation. Rather, the central bank will need demand destruction, operationalized by unemployment. Ultimately, this is not good for employees.
3. Some companies cannot pass on price increases. These companies become less profitable. They higher fewer people, or potentially go bankrupt. This hurts employees and increases unemployment. Ironically, this might, over the long term, reduce wage pressure and put downward pressure on wages if they are not mechanically tied to inflation.
4. As a result of some companies becoming failing, markets can become more concentrated. This would be a long term “tail event” type risk. However, if we are considering a situation of mechanically tying wages to inflation, as Anthony Albanese appears to want, then this is the ultimate outcome.
Thus, the overall outcome of tying wages to inflation is negative. But, this does not solve the problem: real earnings have fallen.
What then can we do?
There are several solutions that can help to mitigate the demands for, and need for, wages linked to inflation. Let us explore some of them.
Prevention is better than the cure: Employers can grapple seriously with employees’ wages. In periods of ‘stable’ inflation, wages would move roughly in line with inflation in equilibrium. It is important that employers do not impose a tax on loyal employees who stay with excessively low wage growth. Employers would also do well to invest in productivity gains, whether this is through mechanization, automation, or through upskilling their labor force. Such upskilling should not merely be adding hours to the employees job – as all too often is the case with workload plans – but should genuinely enable that employee to become more efficient.
Failing to invest in this way will simply cause employees to impose ‘shrinkflation’ on the company. Whereas a loyal or productive employee might have been willing to ‘go above and beyond’ before, in high inflation environments, they will just work to rule and engage in a side hustle. Thus, it is vital that employers do pay employees their market value. Otherwise, those employees will simply leave.
Employers should recognize cost of living pressures: Employers should explain to employees the issues with wage price spirals and whether price increases are affordable. Explaining these issues to employees and treating them like adults will likely reduce (albeit not eliminate) concerns.
Inflation must fall: Central banks should tackle inflation. The root cause of inflation-wage demands is high inflation. Reducing inflation, and inflation expectations, is essential. Employees are less likely to push for aggressive wage increases if they believe that inflation will subside. This involves credible signaling. Both the RBA and the Federal Reserve have signaled that future rate increase are on the table.
What can employees do now to mitigate issues? There is no one-size-fits all answer. The fact that wages can normalize over the next few years does not necessarily help cost of living pressures now.
Where possible, upskilling is the best approach. This creates more demand for your labor both in a strong labor market and a weak one. Warren Buffett has specifically advised to “be exceptionally good at something”. When people want to hire you, you can demand more money or change jobs.
As always, prevention is better than cure: It is always important to have a buffer ex ante. A side hustle might work for an efficient office employee who decides to work to rule. It might not be so viable for a manual laborer whose income is tied to hours earned. Nevertheless, focusing on efficient shift management (i.e., penalty rates, less desirable hours) can boost earnings with incrementally less pain.
Switching jobs is an important mechanism. Oft-times, employers impose a “loyalty tax” on employees that stay. At present, unemployment is 4% in Australia. It is below 4% in the US. There are myriad jobs for myriad different types of skills. If you are prepared to leave, you can often obtain a higher wage.
What does this mean for policy?
Where then does this leave us? Anthony Albanese has erred in suggesting that wages should increase merely because of inflation. Cost of living pressures are real. And, this is why central banks must control inflation so that over the long run living standards do not fall. Importantly, central banks have shown they are willing to do this.