Recessions are a result of changes in the dynamic of supply and demand and inflexibility in prices. If supply begins to exceed demand, the seemingly natural outcome would be that prices would quickly fall to the point where supply and demand would be rebalanced. But this doesn’t appear to happen with the alacrity one might expect, and we thus face extended periods of downturn and the resulting unemployment. What’s wrong?
There are certainly bureaucratic reasons for the failure of prices to fall with the speed one might, in theory, expect. It is not outlandish to anticipate that business managers will resist a reduction in prices in the face of all evidence of the need to do so. But what I want to focus on here is the resistance that arises from the contradiction in interests that is endemic to capitalism: the contradiction in interests that arise from the employer-employee relationship.
The severity and length of a recession is determined by the flexibility of price adjustments. It behooves us, then, to take a look at whatever might be interfering with price flexibility if we want to lessen the severity and length of recessions. And one price that is particularly resistant to downward pressure is wages and salaries.
I do not mean to suggest that the persistent downward pressure on employee compensation due to the endemic shortage of job openings isn’t operative. On the contrary, that condition persists in good weather and bad, requiring a legislative response at all times. But when I refer to the lack of downward flexibility of wages and salaries I mean the wages and salaries of those already employed and receiving their compensation.
When supply begins to exceed demand and sales drop, output needs to decrease in order to adjust. Less output means that firms are faced with a choice between the reduction of employee compensation and a reduction in the number of employees. The choice made is usually to reduce the number of employees: layoffs. This, in turn, can adversely impact the overall health of the economy, as the overall purchasing power of the public is reduced proportionately.
But why are layoffs usually chosen rather than the reduction of employee compensation? A 2000 article  from The Economist tells us this:
Explanations for why wages are sticky abound, but they are often unconvincing. Neoclassical economists, who have a starry-eyed faith in the efficiency of markets, think wage rigidity is an illusion. In their view, workers quit their jobs when pay starts to fall in a downturn. This stops wages falling much and makes them appear inflexible. But their theory implies that unemployment in a recession is voluntary—a view at which reasonable people might rightly scoff.
While scoffing does indeed seem an appropriate response to such a notion, scoffing isn’t even half the battle. Far better would be finding the answer. Alas, economists can’t seem to agree on what causes it. The article goes on:
Keynesians, who accept that markets are often imperfect, think wages are sticky, but cannot agree why. Some blame unions or established employees (‘insiders’) for blocking pay cuts. Keynes himself thought that workers were so concerned about their wages relative to those at other firms that no company dared to cut pay. Others argue that firms pay high ‘efficiency wages’ in order to make the threat of job loss more costly for workers and so spur them to work harder. (Wages might still fall in a recession, though, since workers are more afraid of not finding another job when unemployment rises.) Still others claim that firms implicitly insure workers against a fall in income in exchange for lower long-term average wages. And so on.
The article itself is about the theory of Yale University economist, Truman Bewley, and his book, Why Wages Don’t Fall During a Recession, published by Harvard University Press. Mr. Bewley reached his conclusion, based on “interviews with over 300 businessmen, union leaders, job recruiters and unemployment counsellors in the north-eastern United States during the early 1990s recession.” The Economist explains Mr. Bewley’s theory this way:
Mr Bewley concludes that employers resist pay cuts largely because the savings from lower wages are usually outweighed by the cost of denting workers’ morale: pay cuts hit workers’ standard of living and lower their self-esteem. Falling morale raises staff turnover and reduces productivity. Cheerier workers are more productive workers, not only because they work better, but also because they identify more closely with the company’s interests. This last point is crucial. Mr Bewley argues that monitoring workers’ performance is usually so tricky that firms rarely rely on coercion and financial carrots alone as motivators. In particular, high morale fosters teamwork and information-sharing, which are otherwise difficult to encourage.
Firms typically prefer layoffs to pay cuts because they harm morale less, says Mr Bewley. Pay cuts hurt everybody and can cause festering resentment; layoffs hit morale only for a while, since the aggrieved have, after all, left. And whereas a generalised pay cut might make the best workers leave, and a selective one damage morale because it is seen as unfair, firms can often lay off their least competent staff.
Setting aside the scoff-worthy argument of the neo-classical economists, it seems that most economists grasp that the reason wages and salaries don’t fall during recessions is that employees don’t want them to fall, and that making them fall anyway would have adverse effects on firms that would outweigh any benefits. So the only answer is to resort to layoffs, whereby any aggrieved parties will be removed to where their displeasure can have no impact on the firm.
The fact that wages and salaries are sticky impacts the ability of firms to lower their prices, since, notwithstanding the state of the economy, companies can’t set prices at a level insufficient to pay employee compensation. This will have a preventative effect on the ability of prices to fall to an equilibrium level unless labor costs are reduced another way, and the only alternative is to lay off employees. Peoples’ jobs, therefore, become the inevitable casualty of economic downturns.
Considering all of this, one might be tempted to chide employees who behave in such a self-interested manner. Don’t they understand that the refusal to agree to a reduction in compensation hurts the company they work for? Aren’t they biting the hand the feeds them? And don’t they care about their fellow employees who will lose their jobs?
But the adversarial relationship that employees have with their employers, and even their fellow employees, is systemic. To the employer, the employee represents a cost, and all incentives are directed toward keeping costs as low as possible. The employee on the other hand rationally seeks to keep that cost, insofar as it pertains to him, as high as possible. Moreover, an employee knows that his interests are adverse to those of his employer. He thus has no reasonable confidence that his compensation will rise to previous levels after a recession, since the interest of an employer is always to keep costs as low as possible, in both good times and bad.
The adversarial relationship that the employee has with his fellow employees arises out of the fact that those other employees also represent costs to the employer, costs that place limits on the compensation that can be afforded for any individual employee. Thus we see that the efforts of labor unions must be directed, first and foremost, to unifying the interests of all employees, removing the competition amongst themselves so as to more efficiently deal with the adverse interests of the employer and the employees generally. And thus we often see employees rejecting unions, not trusting that a union will adequately deal with the effects of inter-employee competition.
It is evident that a measure of commonality needs to be introduced. For there to be a unification of employee and employer interests, the employees should become owners in any firm they work for in order for all concerned to be equally interested in the firm’s success. By the same token, the firm will have an interest in the success of the employees, they being the firm’s owners. This, of course, would be distributism in operation.
A distributist company wouldn’t be immune to business cycles, but it would be able to adapt to recessions more easily than a capitalist firm. The employee-owners would be much more willing to temporarily lower compensation in a recession, not only out of a kind of firm patriotism or sense of duty to self-sacrifice, but because it would be in their direct interest to do so. Moreover, being the owners of the company, they would have no concern that compensation wouldn’t rise back to previous levels when it was prudent for that to happen. This dynamic, available only in a distributist society, would go far toward lessening the length and severity of recessions.