British reject “smart stimulus”: Should we?

I noticed that the British government rejected the idea of a “wage subsidy” that was put forward by unions (who would have guessed 😉 ). Now, whenever a government outright rejects an idea I usually ask myself the question “how could that idea have worked” followed by “would that idea have worked”. In this case there is definitely a how, and it might even work in the current situation.

Just before I began writing my ideas I saw this post on Econlog on a “smart stimulus”. In the post they support the idea that cutting the employers share of payroll tax would solely give money to employers (as wages are sticky). This money would both support employment by lowering the relative price of labour (which is too high given the shock to productivity), and it would incentivise “business activity” by increasing profits.

Ok, well I agree with the possibility of the idea that has been discussed at Econlog – but I need to look at it in more detail before I can say whether I would support it “in the current situation”. Lets try that:

For me the situation where you would subsidise labour, either through taxes or direct subsidies (its the same jazz) depends on your belief of what is going on in the labour market.

Say wages are sticky, and that we are experiencing a temporary shock to economic activity. Add to that a major (temporary) credit constraint on businesses. In this case, firms would like to temporarily lower wages in the face of lower demand – but they can’t. Furthermore, the existence of a credit constraint makes it impossible to “smooth” the wage bill overtime – implying that they need to cut it now. In this case, the firm will lay off staff, and cut back production more strongly than they would have if they could lower wages. Over the aggregate economy this is a pretty devastating thing.

Now, if the government roles in a temporarily subsidises wages they lower firms unit labour costs. As a result, even though wages are sticky this government intervention (if symmetric across the business cycle) is pro-cyclical. This would dampen volatility in employment and output over the business cycle.

Although I am not a big fan of government knowing when to improve relative prices – a situation with a huge shock to confidence in the economy, with incredibly sticky prices (possibly even deflation driving the real price in the wrong direction), and with massive (temporary) credit constraints could be improved by direct government involvement in the labour market.

This seems preferable to arbitrary government spending in the economy – and in the current extreme case it could even be good policy.