The Examiner

The Economics of the Growth Agreement

Roger Kerr

EXECUTIVE DIRECTOR 25 OCTOBER 1990

NEW ZEALAND BUSINESS ROUNDTABLE

THE ECONOMICS OF THE GROWTH AGREEMENT

Last month the government announced an Agreement on Growth with the trade union movement. This involved a commitment to restrain wage increases to 2 percent in the current award round, with any additional amount being dependent on productivity gains.

How should we think about the agreement as a component of an economic strategy?

The wage accord can be seen as part of a family of initiatives over the years in New Zealand to regulate wages by central decree. These took forms such as general wage orders, remuneration tribunals, wage guidelines, wage/tax trade-offs and the wage freeze implemented at the end of the previous government's term of office.

Wage (and price) controls were employed by a number of OECD governments during the 1970s to try to combat inflation and the effects of oil price increases, but have largely fallen into disuse. Australia is the only OECD country currently operating an institutionalised wage accord.

The basic lesson from OECD experience with incomes policies is that while they can have some favourable short term effects they generate increasing pressures and distortions the longer they remain in place. For this reason they harm long term economic growth.

Governments have also tended to employ incomes policies when other economic policy settings have been inadequate. Typically, such accords are unable to compensate for the effects of bad policies. They usually make it more difficult to effect the necessary changes and other policies tend to become compromised over time.

Australian and New Zealand experience bears out these observations.

There has been a significant reduction in real wages since the mid-1980s in Australia, and an impressive growth in employment, especially in part time and female employment. There is some dispute as to whether this has been due to the Accord or to underlying economic conditions and the lessons learned from the 1981 wage blow-out, which resulted in unemployment rising from 7 percent to 10 percent of the workforce in just over 3 months.

In any event there is now widespread agreement in Australia about the relationship between real wages and employment - both the negative effects of excessive real wages growth and the employment-creating effects of real wage reductions. The debate about this relationship which was fiercely contested in the 1970s has now been largely resolved.

However, the counterpart to central wage fixation has been the perpetuation of the micro-level rigidities in the Australian labour market, with the result that productivity growth since 1983 has been effectively zero. Labour deepening has occurred, as theory would predict, but the environment has not been conducive to innovation and industrial flexibility. New variations of the Accord have not prevented Australia from sliding into its current economic predicament, and unemployment, which is at similar levels to New Zealand, is on the rise again.

Moreover, economic policy initiatives which are widely recognised as necessary in Australia have become hostage to the Accord. The Australian Council of Trade Unions vetoed the introduction of a goods and service tax, and only recently has the Hawke government managed to take the first tentative steps towards privatisation.

Experience with the Muldoon government's wage freeze was not dissimilar. Initially employers welcomed the reduction of wage pressures. As the benefits of real wage reductions came through, employment grew by over 40,000 during 1984 and 1985, the only significant period of job growth in the 1980s.

The difficulties came further down the track, when the distortions that had built up during the 20 month freeze had to be unwound. The unions did not accept the further cut in living standards necessitated by the 1984 devaluation, and demanded a catch-up for losses in the 1985-86 wage round. The result was a significant increase in real wages through 1986-87, a steep rise in unemployment and a loss of competitiveness from which the economy has still not recovered.

It is certainly a positive feature of the growth agreement that the link between wages and employment and the economy's weak competitive position appears at last to be recognised. Only a couple of years ago the Council of Trade Unions was arguing for wage increases on the basis of old-fashioned Keynesian notions of 'maintaining purchasing power'.

There may be a growing understanding about the demand side of a small economy, namely that tapping the enormous potential of international demand is dependent on being competitive in all respects and that effective domestic demand is assured by a stable monetary policy that facilitates real output increases, not inflation.

The reality of our weak competitive position is that across both the tradeables and non-tradeables sectors of the economy, our wage structure is generally too high relative to productivity. The problem is particularly acute at the low-skilled end of the market.

The downturn in key export prices and the new round of oil price increases has heightened the need for wage and productivity adjustments. Some employers appear to view the 2 percent benchmark as a welcome response. Given the coming economic crunch, however, it is arguable that no such floor should be put under wages and that market conditions would dictate lower outcomes in many circumstances. Colin Clark of the PSA has stated that several unions supported the agreement because "they doubted whether even a 2 percent increase could be achieved in some awards in the coming round".

The productivity leg of the agreement is also troublesome. Productivity improvements by themselves are not a basis for higher wages. Wages should basically be determined by the prevailing conditions of labour supply and demand in the particular job, industry and location. Productivity improvements should not lead to wage increases if there is an ample supply of workers with relevant skills seeking jobs. To do otherwise merely lengthens the unemployment queue for such workers.

Instead higher productivity and profits should be a signal to existing firms to expand and for new firms to enter the industry. Such firms would hire the available labour at prevailing wage rates until supplies become scarce and it becomes necessary to bid up wages to attract additional workers. That is the only way unemployment can be reduced.

Current labour market conditions in many industries do not justify wage increases. A new meat plant in Dunedin recently received 5 times as many job applications as the number of positions it was seeking to fill.

Productivity bargaining is in any case greatly hampered by the present award system. As a general rule, sensible deals are only possible at the level of specific enterprises, not on an industry or occupational basis. For example, the agreement in the recent metal trades negotiations to allow working beyond standard hours at ordinary time rates and to permit two rest periods in the day instead of three will be meaningful for some firms but irrelevant for others. It is economically damaging to incorporate a general productivity element in wages in these situations.

More generally, a regrettable feature of the wage accord is that it sees the government intruding anew into wage fixing after a period of disengagement which brought new attitudes and realities into employment relations. It will reduce the impetus which the government has been encouraging towards a wider, more market-related dispersion in wage settlements and towards new bargaining arrangements. It also reintroduces a form of two-tier bargaining, contrary to the intentions of the Labour Relations Act. Because no parties are bound by the accord, and employers are not even involved, there is every possibility of breakdowns. In that event there will be pressure for greater coercion or for the government to retreat from other economic policies.

Assuming that it remains in place, past experience with incomes policies indicates that a full evaluation of the effects of the agreement will not be possible for some time, perhaps 2-3 years. Because of this uncertainty, long term interest rates are unlikely to be reduced in the near future.

One acid test of the agreement would be the response to an exchange rate depreciation which, to be effective, would necessitate a further reduction in real wages. Another will be the response to the commitment to substantially reduce the projected budget deficit, a key commitment which has not yet been backed up with detailed plans. Unless this is to be achieved through tax increases, it will necessitate spending cuts in areas that are sometimes regarded as the 'social wage'.

One thing that is certain from all past experience is that over the long run central planning, including in the labour market, does not work. Economic growth depends on allocating all our resources to their best uses and using them productively. The labour market is a crucial allocation mechanism; labour accounts for some two thirds of the value of productive resources used in the economy every year. In a market economy, wage rates, along with interest rates, exchange rates and prices in general, are the signaling devices on which efficient economic activity depends. Suppressing by central decree the role of wages in adjusting supply and demand in the labour market, and in providing incentives for skill and effort, can only impair economic performance.

It is for these reasons that even advocates of incomes policies such as Professor Bryan Philpott see them as short term measures which need to be backed up by basic micro reforms in the labour market. This has been a key missing ingredient in the government's economic strategy and there are no indications of plans to implement significant reforms.

Even before the intervention of the accord, Rob Campbell had observed that "Over the full range of issues, we now have a more regulated labour market than in 1984". The fundamental gains from deregulation arise from the ability of employers and workers to continuously strive for more productive working methods in ways that are blocked by a centralised system. Whatever else the 'growth agreement' may achieve, it will not achieve growth until comprehensive labour market reform is moved to the top of the policy agenda.