Monday, July 14, 2008

Inflation may lead to wage increase but there is no evidence the other way around

What was Mr Tharman talking about?

My layman brain is throbbing with a big, fat headache. Are there any economists out there that can explain?

Our Finance Minister says that wage increases will fuel a second round of inflation. I have been trying to work out the dynamics in my mind as rationally as I can. I have tried speaking to people to see if anyone can shed light on the relationship between wages and inflation. Looks like it can be argued both ways (for and against the Minister’s proposition). After doing a bit of google-searching, I have discovered this excellent policy discussion paper:

“Does Wage Inflation Cause Price Inflation?” by Gregory D. Hess and Mark E. Schweltzer (Policy Discussion Paper, Number 10, April 2000), Federal Reserve Bank of Cleveland

Gregory D. Hess is the Danforth-Lewis Professor of Economics at Oberlin College and an academic consultant to the Federal Reserve Bank of Cleveland.

Mark E. Schweitzer is an economist at the Federal Reserve Bank of Cleveland.

The Abstract of the discussion paper says it all:
“Recent attention has turned from unemployment levels to wage growth as an indicator of imminent inflation. But, is there any evidence to support the assumption that increased wages cause inflation? This study updates and expands earlier research into this question and finds little support for the view that higher wages cause higher prices. On the contrary, the authors find more evidence that higher prices lead to wage growth”

The conclusion that they reach at the end is:
“There is little systematic evidence that wages (either conventionally measured by compensation or adjusted through productivity and converted to unit labour costs) are helpful for predicting inflation. In fact, there is more evidence that inflation helps predict wages. The current emphasis on using changes in wage rates to forecast short-term inflation pressure would therefore appear to be unwarranted. The policy conclusion to be drawn is that inflation can appear regardless of recent wage trends.”

The policy paper can be accessed online:

On a related note, the European Central Bank recently warned against wage increases and alleged that wage increases would lead to another round of inflation. But, the European Trade Union Confederation has rebutted that. The following is an extract from a Reuters article dated 1 July 2008:

BRUSSELS, July 1 (Reuters) - Trade unions in the European Union chided the European Central Bank on Tuesday for urging caps on wage growth and reiterated their opposition to any interest rate increase.
The European Trade Union Confederation said ongoing wage bargaining or expected wage trends would trigger no second-round inflationary effects -- the feed-through of high energy and food prices into the wider economy -- as feared by the ECB.
"The ECB's concerns on wages are unfounded and dangerous. The ETUC calls upon the ECB to stop using wages as an alibi to hike interest rates," ETUC General Secretary John Monks said in a statement.

So, how did our trade unions respond? In fact, our Finance Minister was speaking directly to one of our trade unions. He was at a dinner organised by the Singapore Industrial and Services Employees’ Union. Mr Philip Lee, the Deputy President of the Union is reported to have said that his union would not push for higher wages. Incidentally, Mr Tharman is the Chairman of the Union’s Council of Advisors. Looks like the Union would be taking the Chairman’s suggestion to heart.


Anonymous said...

well. here's a simplistic argument.

increased wages
increased cost of production for firms
to offset (to maintain same level of profits), 2 things can happen, firms absorb, or pass on to consumers
firms are more likely to pass on increased costs to consumers by increasing price of goods to point where profit level will remain the same as before the wage increase (assuming no exploitation of the situation)


Subra said...

Yes, as I was trying to logically analyse it, at stage 3 it becomes evident that it is unpredictable as to what producers would do.
They may absorb the wage increase or they may increase the price of their goods or services. The latter would set off a second round of inflation.
Having spoken to some chaps who have a better understanding of economics, I realise that this process spelled out by you could lead to a spiral of ever-increasing wages and never ending inflation. Some economists call that the wage-price spiral. But, it seems that this relationship between wage increase and inflation is not without dispute and the policy paper that I am refering to makes a clear case based on data that the relationship is in fact a false assumption. Let me just quote the following part of the paper:

"The intuition behind this view (refering to the wage-price spiral) is that since labour costs are a large fraction of a firm's total costs of production, rising wages and compensation should put prssure on firms to pass these higher costs on as higher prices. We have several reasons to doubt the accuracy of this view. First, if a wage incrase is brought about by increased labour productivity, it will not create inflationary pressure. (This would explain Mr Tharman's suggestion that workers should retrain and then command higher pay). Second, a wage increase will not create inflationary pressure if it leads to a squeeze in profits because a firm cannot pass along cost increases. No firm inherits the right to simply 'mark-up' the pricesof its output as a constant proportion above its costs; competitive market pressures strongly influence the pricing decisions of firms. Finally, causation could work in the opposite direction. An increase in aggregate demand may permit firms to raise the price of their products, and the resulting increase in profits would lead workers to demand higher wages in future negotiations. It turns out that the vast majority of the published evidence suggests that there is little reason to believe that wage inflation causes price inflation.

Anonymous said...

Looking at it *very* simplistically...

Increased wages = increased money supply/circulation...

which can lead to inflation, no?

but i think it's the wrong question to ask anyway. Increased wages may lead to inflation but it's only a small factor. There are other bigger factors out there influencing inflation.

While increasing wages may perhaps cause inflation, the miniscule degree it does so (and thus its corresponding harm) is probably lesser than the benefit it brings to the lower/middle class workers.

Anonymous said...

Singapore is an open economy which imports virtually everything.

Main causes of inflation like energy and food prices have little relation to wages in singapore.

Other causes are housing rents(ask MBT), medical (ask Khaw). Maybe transport (RL?)

complain no use. Join the gahmen.