The Australian’s economics editor Adam Creighton is today advocating for public sector wage cuts by Australian governments, a policy which may be morally virtuous but would be economically damaging in this time of economic contraction, in my view (see Coronavirus pay cuts: This may make you very, very angry). Creighton writes:
Perhaps a temporary higher rate of income tax cutting [public service wages] is the cleanest solution.
During the Depression, the Scullin government cut public sector pay by 20 per cent.
Regular readers will know I’m in favour of public sector wage restraint, but what Creighton is advocating makes no sense in an economic contraction, where it would make things worse. Indeed, policies such as the Scullin government’s public sector wages cut are widely regarded by economic historians as having exacerbated the Great Depression.
In recessions and depressions, the Paradox of Thrift identified by John Maynard Keynes applies. This Paradox is generally described with reference to households but the logic applies to government spending, too. What may be beneficial for households acting alone is not beneficial for the whole economy, as the impact of everyone saving and reducing spending is to reduce output and income across the economy. It is a fallacy of composition to suppose that what is beneficial at the household level is beneficial at the economy-wide level. This is a first-year economics lesson we need to remember in this time of economic contraction.
Adam Creighton is recommending a perverse fiscal policy. Cutting public service wages during this time of contraction would reduce household incomes and aggregate spending and inflict further pain across the economy.