Wage increases would fuel inflation

The degree of success or otherwise of the strike last week and its motives and political agenda will be discussed by many from several different standpoints. It is to a parallel discussion on the economics of the wage demands that we must turn here. As is often the case, the financial aspects and economic consequences of the demands tend to be the least understood and discussed. There is also often a divergence between equity and financial feasibility and economic consequences. The plain truth is that however much the demand for higher wages may be reasonable, its financial consequences could be detrimental to the economy. We therefore discuss here the merits or otherwise of the wage demands and the financial and economic consequences of granting them.

Everyone is aware of the sharp increases in prices in the last year. The people’s perception of the price increases are not based on the statistical calculations of experts, but the day-to-day experiences of people managing their own affairs. It is because of this that people are sceptical about the rate of inflation that is trotted out by the Department of Census and Statistics. It is generally agreed that the measurement of the cost of living by the official indices is an underestimate. There are technical and non-technical reasons to think so. The sentiment that the cost of living has been much higher than even the almost 30 percent that was estimated by the cost of living indices is not difficult to understand.

This is especially so in the case of the poor and middle class families, who find the increases in prices of essential commodities for their basic living far higher than the officially calculated inflation rate. The price increases of basic items such as kerosene, gas, transport, rice, bread, wheat flour, sugar, dhal, vegetables, coconuts, oil and all other items have made the wages of workers quite insufficient for their basic needs to be fulfilled satisfactorily. In fact even the official statistics disclose an enormous increase in prices.

The official statistics of price changes show that in the past year (June 2007-June 2008), the cost of the average Colombo household’s expenditure increased by a staggering 28.2 percent. That is indeed a huge amount for fixed income wage earners to absorb. What it means is that if a household spent Rs. 20,000 a year ago, it required about Rs. 24,600 to buy the same basket of goods and services in June this year. To put it in another way, today they have to spend an extra Rs. 4,600 to obtain what they were able to buy a year ago. Those who earn much less and therefore spend less are in an even more perilous situation of being unable to access even their insufficient below nutrition requirement of food that they consumed before the latest bout of inflation.

Therefore, viewed from the point of view of wage earners, the demand may be considered justified. The extent of that wage increase is another matter. An objective assessment would no doubt justify a salary increase although the wage demand of Rs 5000 coud be regarded as too high and a more modest demand considered acceptable. This is more so, as there have been wage increases during this period. In the case of public servants they were given a salary increase of Rs.3280. In addition to this the President agreed to give a further salary increase of Rs. 1000, in response to the recent wage demand of Rs. 5000. Therefore the wage demand of Rs. 5000 plus Rs.2.50 for every point increase in the cost of living index is in addition to this.

However much the wage increase is reasonable owing to the increased cost of living, one arrives at a different conclusion from the perspective of the economy as a whole. The granting of such a demand would release enormous inflationary pressures and may turn the current inflation into a galloping one. This is owing to the enormous amount of government expenditure that the wage demand would entail. The cost to the government of this wage increase is staggering. On the one hand, the amount of the salary increase is high at Rs. 60,000 per employee per year. On the other hand, the number of public servants is excessive. In fact the government increased the number significantly in the last two years. Since the number of public employees is estimated at 1.2 million, the wage demand of Rs 5000 per month would result in an increase in the wage bill by Rs. 72 billion a year. This would be an enormous strain on the public finances that are already bursting in the seams. It will increase the fiscal deficit that is already higher than the budget estimate to above 10 percent of the GDP and set in motion fresh inflationary pressures.

If the wage demand of public servants is given there would be justification for similar increases in the wages of private sector employees. In fact the wage demand had this component as well, as they asked for a wage increase for plantation workers as well, of Rs. 500 per day. An all round increase in wages will increase inflationary pressures and in the case of many private sector enterprises diminish their profits or even make them unprofitable. A very serious threat to the economy arises from the fact that increases in the costs of production arising out of wage increases could render industrial exports unprofitable. This is especially so as the exchange rate is being kept fairly stable through foreign borrowing. Besides this, the costs of production of our export competitors are not rising as fast, as the rates of inflation of these economies are much lower.

Salary increases would set in motion what economists call a wage-cost spiral with increasing prices providing a further justification for another wave of wage increase that would continue to feed the inflationary pressures with no sign of declining. It is important to remember that the increases in prices generated by the wage increases would also affect those who are not recipients of the wage increases. This is the reason why, while on the basis of equity and the livelihoods of wage earners, there is a strong justification for a substantial wage increase, economic consequences of such an increase would be disastrous. The increase in money supply to accommodate this huge salary increase would speed up inflation further setting in motion an uncontrollable wage cost inflationary spiral. A higher rate of inflation than the current soaring inflation would damage the economy in many ways and create serious consequences that may be difficult to resolve. Therefore in spite of a wage increase of perhaps a more modest amount being reasonable, even such an increase would aggravate the high inflationary conditions in the economy.