cyclic compensation structures
Economics is a discipline that is replete with examples of situations where individually rationalistic decisions lead to systematic breakdowns. It may make sense for each firm to lay off some of its employees to weather the recession, but when every firm engages in a similar behavior the downturn simply becomes worse. Another example is related to compensation structure of employees. Linking part of the compensation to performance can be beneficial for the company if there are easily verifiable performance metrics. (An employee is in general more motivated to work for his company when he is given the chance to share a slice of the profits.) However a widespread replacement of the traditional fixed salary structure by a performance based variable compensation scheme can be macro economically destabilizing.
In a closed economy where personal consumption constitutes a greater chunk of GDP than government spending and corporate investments, cyclic wages will exacerbate the magnitude of economic expansions and contractions. The current recession in US was triggered by a credit crunch which led to a sudden withdrawal of domestic purchasing power. If wages decrease along with the diminishing profits of companies and there is no increase in government spending and corporate investments, the overall personal consumption will be lower and recession will deepen. On the other hand if wages stay fixed, deflation will increase the real purchasing power of consumers and eventually the economy will once again gather expansionary momentum.
Provision of unemployment benefits will also contribute to stabilization during a downturn. However the way government chooses to finance these benefits is extremely important. Borrowing and taxation may crowd out corporate investments if corporations and government fight for same pool of money. In that case printing money will be a better choice, especially if there is a supply side slack which allows corporations to respond to higher demand by increasing production levels. (If there is no supply side slack, production will not be able to adjust accordingly and higher demand will cause inflation.)
In a closed economy where personal consumption constitutes a greater chunk of GDP than government spending and corporate investments, cyclic wages will exacerbate the magnitude of economic expansions and contractions. The current recession in US was triggered by a credit crunch which led to a sudden withdrawal of domestic purchasing power. If wages decrease along with the diminishing profits of companies and there is no increase in government spending and corporate investments, the overall personal consumption will be lower and recession will deepen. On the other hand if wages stay fixed, deflation will increase the real purchasing power of consumers and eventually the economy will once again gather expansionary momentum.
Provision of unemployment benefits will also contribute to stabilization during a downturn. However the way government chooses to finance these benefits is extremely important. Borrowing and taxation may crowd out corporate investments if corporations and government fight for same pool of money. In that case printing money will be a better choice, especially if there is a supply side slack which allows corporations to respond to higher demand by increasing production levels. (If there is no supply side slack, production will not be able to adjust accordingly and higher demand will cause inflation.)
