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The Greek Plague: Sticky Wages

June 24, 2010

Tags Booms and BustsPolitical TheoryPricesProduction Theory

After the deaths of three bank employees, Greek president Karolos Papoulias lamented that the debt-ridden country had finally "reached the edge of the abyss." It should be so lucky. Abysses allow for falls into the deep unknown. If real wages would make the plunge, Greek workers would have a future with more options than striking and senseless destruction.

Many input prices — commodities for example — adjust instantly and painlessly on well-organized exchanges. Wages, however, are often fixed in advance, and comprise a large portion of input costs, making them the typical example of the sticky price.

Nobody likes taking a wage cut — present company included — but the deeper question is "why not?" Inflationary environments, with purchasing power constantly and inauspiciously confiscated from workers, create an intense dislike for nominal wage reductions. If prices are continually climbing for consumers' goods, a reduction in a nominal wage will result in significant cuts to one's purchasing power. The result of an inflationary environment is an engrained mindset — suspicious and, at times, intolerant of any wage cut.

Central banks — those institutions created to combat the reductions in output caused by downward sticky prices — paradoxically are the reason some prices exhibit this stickiness to begin with. As the money supply is increased, price inflation follows. As price inflation sets in, wage fixity becomes the norm; workers cry out against reductions in their purchasing power through nominal wage cuts (or even for a lack of wage increases paced with price inflation).

During periods of price deflation (or price constancy), nominal wage cuts need not necessarily translate into purchasing power losses. If, for example, prices of consumers' goods declined by 3 percent last year, and a waitress forwent any nominal pay raise, her real wage (in terms of purchasing power) would increase by the 3 percent in question.

Decades of central banks increasing the money supply have resulted in a sustained period of rising prices. Within the eurozone, this has been especially pronounced for many of the southern countries.

Greece has proven to be an extreme example. After its ascension to the European Union, Greece witnessed a period of increased demand for its government bonds. The decline in the perceived risk of default resulted in lowered interest rates. This seeming good fortune allowed for an orgy of spending, driving prices upward in a frenzied spiral.

A prime enabler of this inflationary boom was the European Central Bank (ECB), which was willing to accept the government bonds of any EU member state as collateral on its lending programs. Greek debt was effectively monetized, driving inflationary pressures higher.

The country's recent fiscal mess has done nothing to alleviate this precarious situation. The ECB will continue accepting Greek government bonds — now rated as junk — further monetizing the Hellenic republic's debts and prolonging the inflationary trap.

"Refusing to accept wage reductions, workers must accept unemployment."

The trap strengthens, because the longer the inflationary forces reign, the stronger will be the workers' aversion to pay cuts. Refusing to accept wage reductions, workers must accept unemployment (which, thanks to relatively generous unemployment insurance, is already an attractive option for many). Without a productive workforce, exit from the current recession will be unlikely.

The Greek economy thus suffers from its abnormally high cost rigidity.

This problem is state-instigated. It is, for example, more expensive to transport a bag of potatoes from the mountainous north of the country to Athens than it is to transport the same bag from Athens to Germany. Freight, like many sectors of the Greek economy, is comprised of impenetrable cartels unwilling to adjust prices to the new reality.

Employees are by-and-large unwilling to accept wage cuts, for fear that continued price increases will destroy their purchasing power. A heavily unionized labor force complicates the process further, because any calls for austerity are met by aggressive protests at the spurring of union bosses. Current price levels make existing salaries unattractive for many. Thanos Petrou, an Athens University student, lamented that "If I get a job as a trainee lawyer, I'll only earn €300 a month. How can anyone survive on that?"

The plot thickens, unfortunately, when we look at further measures that will serve to reinforce the Greek loathing toward pay cuts. A true reckoning of wages can only be done on an after-tax basis. One does not go golfing, after all, and score only the strokes after the ball hits the green. With teams of IMF and eurozone bureaucrats pushing for austerity packages for Greek public-sector employees, tax adherence will come to the fore.

Few enjoy paying taxes, especially in Greece. Discrepancies between what people earn or the taxable assets possessed, and what is declared to the taxing authority are wide and widely acknowledged.

One wealthy suburb of northern Athens, where summer temperatures regularly reach 90 °F, had just 324 residents declaring pools on their tax returns last year. Tax investigators scrutinized satellite photos of the neighborhood and found the true number a little different — 16,974 pools were tucked away in backyards to provide refreshment during the steamy summers.

Similarly, a survey of 150 doctors in the trendy neighborhood of Kolonaki — with offices nestled between Prada shops and Chanel boutiques — found that half of all residents declared income of less than $40,000. Thirty-four claimed an income less than $13,300, the maximum level exempting them from all tax charges.

One study by the Federation of Greek Industries estimated that tax evasion could have amounted to upward of $30 billion last year. This money would go a long ways toward easing the ailing government's credit woes, and is sure to be found by the prying eyes of Greece's cautious saviors — sympathetic European Union countries and the International Monetary Fund. With the current bailout placing $146 billion (€110 billion) on the line, these creditors would be hard-pressed to allow such levels of blatant tax evasion to persist for long, lest their repayment be jeopardized.

Such behavior may prove more difficult to change in deed than word. Tax evasion is high in Greece for a myriad of reasons. Some reckon its long history of Turkish occupation makes Greeks skeptical of their government, and weary of funding it. Indeed, hiding wealth in a culture where the widespread belief is that money is an evil — the productive are thought to have plundered the unproductive and to be obligated to pay their retribution — is a rational response to preserve wealth. More likely, Greeks fundamentally disagree with the way that their tax euros are directed — one would be much less inclined to refuse remitting taxes if the cause at least matched their preferences.

Asking Greek workers to take a wage cut and start paying all their taxes will be a difficult sell — provided that prices do not swiftly decline.

Since the government will probably use the increased tax income to increase its own spending programs, pressures on price inflation will see little relief. Nor will inflation be tamed so long as the ECB continues to monetize Greek debt. With no respite from inflation, workers will not accept wage cuts (or even wage stability). With no fall in input costs — which are led by wage rates — output will decline. This output decline is "fixed" in the short term by increased taxation and more ECB-induced inflation completing the deadly cycle.

Greeks have little idea that deflation could be a healthy alternative, nor that taking wage cuts is an essential element of recovery. An oppressive tax regime has transformed them into a people reliant on dodging taxes to maintain their lifestyles.

The actions of the eurozone, and especially the ECB, over the past weeks have signaled that the mindset skewed toward expecting prolonged inflation will not change yet. Scores of eurozone bureaucrats will soon force the payment of taxes, so long avoided by the Greek populace. Neither outcome will usher the country to sustainable recovery.

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