Pay Cuts Are A Double-Edged Sword for The Economy

This recession is introducing many Americans to a novel experience -- the pay cut.

Fifteen percent of employers surveyed by the Society of Human Resource Management reduced pay in the past six months -- a threefold increase from earlier this year.

Companies like Hewlett-Packard , Caterpillar and the New York Times have taken the pruning shears to wages. Real pay cuts — when wages fail to keep pace with inflation — are commonplace in recessions, but you would have to look back to the 1930s for the last example of widespread cuts in nominal wages in the United States.

Since Keynes, many economists have treated nominal wage cuts as a virtual impossibility. In 1999, Yale economist Truman Bewley wrote the optimistically titled "Why Wages Don't Fall During a Recession."

Wage cuts cause huge resentment, damage morale and raise the risk of losing star employees. Bewley found American firms prefer to lay people off to "get the misery out the door."

The notion that pay is rigid on the downside has been a cornerstone of much post-war economics. This assumption is now proving about as true for wages as it was for houses.

Pay cuts are threatening to make the leap from anecdote to generalization. The Employment Cost Index is already showing wages growing more sluggishly than at any time since 1983.

Downward pressure on salaries is intensifying. While job losses slowed in May, the unemployment rate jumped to 9.4 percent — the highest since July 1983.

Even this may not fully capture the current oversupply of labor. The U6 unemployment rate — which includes people working part time because they can't find permanent positions — climbed to 16.4 percent.

With so many workers waiting in the wings, wages nationwide may start to fall over the next couple of years.

The United States would be following the path of Japan in the 1990s — the most recent example of absolute pay cuts in a modern economy. The impact on consumers could be worse than focused layoffs — spreading the pessimism over a broader base.

The Conference Board's measure of consumers' income expectations has dipped to the lowest level in its 21-year history.

Alpine levels of household debt — which has doubled to 134 percent of disposable income since 1985 — put consumers in a particularly vulnerable position. Lower wages make it harder to service loans and increase the incentive to defer spending.

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As demand ebbs, companies cut headcounts and remuneration further. If companies use the money saved to grab market share by reducing prices the final piece of the deflationary jigsaw slots into place.

Pay cuts, far from averting layoffs, could increase them.

If the trend toward pay cuts increases, the economic consequences will be profound. The damage may be deeper than merely the erosion of spending power. Breaking the taboo on wage cuts greatly heightens the threat of a deflation mentality.

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