Can we afford real wage cuts and skyrocketing rate hikes as households struggle to balance their budgets?

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You would think that we will become better at predicting the future.

Consider all these sophisticated business models, the amount of gray matter used – not to mention the huge pool of data and experience – that we can tap into.

But our success rates in anticipating problems seem to be declining. When it comes to solving them, the situation is even worse.

Perhaps the reason is not so mysterious. Just like religion, theories about economics can be interpreted in any way that suits you best. And, at a time when rational debate and the desire for consensus have been replaced by a polarizing race to the extremes, the economy has become a turbulent battleground.

Take the salary debate right now.

If you believe most corporate and banking economists, we are on the brink. Just as in the 1970s, they argue, we are at the start of a debilitating cycle of rising wages and prices that threatens our future and without firm action to eradicate it immediately, we will be doomed.

This is an argument widely adopted by the Reserve Bank of Australia, as well as by all other central banks. In a rare show of unity, they are all in a panic, pushing lightning-fast interest rate hikes to plunge a knife into the heart of what they fear most, inflation.

There is just one minor detail they seem to have overlooked. Things have changed a lot since the 1970s.

Salaries are not soaring. And they are unlikely to do so. They could rise to the fastest clip in seven years. But they’ve come out of the slowest growth in history and, in real terms, they’re sinking.

Extreme shortages, modest price increases

A shortage of building materials has led to soaring prices for home renovations and slowed construction.(ABC Midwest and Wheatbelt: Samille Mitchell)

Adam Smith would be turning in his grave. The Scottish lawyer and philosopher, who wrote the first modern work on economics in 1776, is still considered the standard-bearer of free market thinking.

And yet here we are, 250 years later, unable to find a logical explanation for a few very simple questions.

Why has wage growth been so slow? And, given that we now have the lowest unemployment rate in half a century with more jobs available than workers to fill them, why are wages still only rising modestly?

At first sight, this is a phenomenon that defies all economic theory. Hey, we know why we pay through the nose for fuel. There are global shortages following Russia’s invasion of Ukraine.

The same goes for building materials. Prices for some jumped more than 30% because shipping delays and blockages in China created massive shortages. Used car prices are skyrocketing as there is a shortage of new cars.

This is a trend that runs through the entire economy.

A photo shows three workers in front of their computers, seated alongside a shared desk
Only 14% of private sector workers received a pay rise in the June quarter.(Unsplash: Arlington Research)

But when it comes to the cost of labor – paying a human being to perform a service – the normal rules of economics don’t seem to apply.

Wages, on an annual basis, increase only 2.6 percent. This is well below inflation at 6.1%. And this comes at a time when we supposedly have – yes, you guessed it – a chronic labor shortage.

A little digging into last week’s payroll data reveals some fascinating insights. Private sector workers, who got a pay rise in the June quarter, saw – on average – a 3.8% pay increase, which seems pretty tidy.

But only 14% of private sector workers received a raise. And many of them received a one-time bonus, rather than a permanent pay raise.

Just for a bit of perspective, remember that for most of the Howard administration, salaries were growing at a much higher rate, between 3 and 4 percent a year.

So what gives?

A black and white photograph outside the George Hotel near the corner of Gray and Fitzroy streets in St Kilda.
Australia in the 1970s was often dogged by industrial action and runaway inflation.

(State Library of Victoria Archives: Maggie Diaz)

Perhaps the biggest problem is that labor does not operate in a free market, so prices – wages – do not react as easily to changes in supply and demand.

This is especially the case today because, when it comes to the balance of power, the pendulum over the past half century has shifted from workers to corporations.

For much of the 1970s, Australia was plagued by industrial chaos. Inflation has plagued the developed world and our highly organized workforce has demanded, and in many cases received, compensation. This further entrenched inflation and fueled a vicious circle of price hikes.

Not anymore. The changes began with the Hawke-era agreements, where workers agreed to moderate wage demands and forego industrial action in exchange for a pension plan.

This continued through the Howard government era with WorkChoices and the Rudd/Gillard years with the introduction of Fair Work Australia. You now need court approval to strike.

Imagine saying that to a union boss in the 1970s.

A chart showing industrial disputes in Australia

Source: Australian Bureau of Statistics

The results were astounding. In fact, the changes have been far more dramatic than even the graph above shows. In the 1970s, the average number of days lost was more than double that of the 1980s.

However you measure it, industrial action has fallen to the point where it is now rare.

There are also other factors. Collective bargaining, designed to level the balance of power between workers and companies, has weakened over the years. Then there are company bargaining agreements that lock in wages for years.

Add to that restraint in raising the minimum wage and a system that has allowed widespread wage theft, and you begin to paint a picture of why real wages are dragging the chain.

The productivity problem

How do you fix this? Ask any reputable economist what should be done and you’ll get a complicated dissertation on productivity.

What they will tell you is that wages can only increase if we get an increase in productivity. Essentially, if everyone is working harder and producing more, wages can rise to compensate for the extra effort, because companies would have made bigger profits and could afford to pass on some of the revenue.

It’s great in theory.

The only problem is that productivity has been rising sharply for years. It’s just that workers have missed out on many of the gains as soaring profits have increased revenue share.

A graph showing Australian productivity versus real wages over the past 20 years

Source: Saul Eslake

Productivity gains, while always welcome, are clearly not the remedy. At least not in isolation.

Your workers are also your customers

You don’t have to be a genius to figure out that as a boss, if you limit wages, your profits will increase.

If this is your business, you end up with the product. If you run a large public company, you will be generously rewarded by shareholders.

But too much of a good thing can be bad for you and everyone around you. Low wage growth – especially when it is well below inflation – provides less money in the pockets of workers, which means they spend less. Ultimately, this results in lower profits and a weaker economy.

Household spending accounts for around 60% of gross domestic product (GDP). So when households limit their spending, it can have a big impact on the economy and hit profits hard.

Over the past six years, the dramatic decline in wage growth has been a concern, albeit bubbling in the background. As long as inflation was extremely low, there was no real urgency to remedy it.

The sudden spike in global inflation changed all that, suddenly eroding the purchasing power of Australian consumers. As the impact of rapid rate hikes begins to be felt later this year, wage growth may well be needed to ease the pressure.

The problem is that we spent half a century creating a system specifically designed to limit wages.

Bringing this up, even a touch, won’t be easy, but it might be necessary.

Soaring Inflation, Skyrocketing Rate Hikes and Sluggish Wage Growth: What Could Go Wrong?

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