Pur Autre Vie

I'm not wrong, I'm just an asshole

Thursday, September 04, 2014

Another Way to Substitute Capital and Labor

Had a random thought, may flesh it out more, but here are the bare bones.  (Inspired by this post on "pent-up wage deflation.")

Let's say you are an employer, and you want to retain flexibility in terms of lowering wages if business goes poorly.  Of course you can just write a contract that allows you to lower salaries at will, or on a yearly basis or whatever.  But it turns out that employers are reluctant to lower wages (in nominal terms) even if they have the legal right to do so.  (This inspired my crazy idea of a few years ago - that the government should be able to lower all wages simultaneously so as to coordinate a massive wage deflation equally distributed across society.  Then wages would have nowhere to go but up.  Please bear in mind the idea is meant to be used by a country that does not control its own currency.)

However, I think employers are much more willing to reduce or eliminate bonuses than base salaries.  So if you want to maintain flexibility, you simply pay a substantial bonus (in good times) and then cut it down (in bad times).

But then it occurred to me that base salary is, in a sense, more "valuable" to the employee than a bonus, precisely because it is reliable.  Two workers with identical compensation might have very different capacity to, say, get a mortgage, or make long-term plans, because one of them receives substantially more of his compensation in the form of a bonus.  A guaranteed salary can be a hugely valuable thing because it enables long-term financial arrangements.  Someone exposed to fluctuating wages has to compensate by "over-saving" or otherwise maintaining extra liquidity.  This is a real cost, and it may go some way to explaining why government workers are paid less than private-sector workers.

Another way of thinking about this is that when you pay bonuses, you effectively expose your workers to the risks of an equity holder in the business.  And you reap the same rewards that you reap when you raise equity capital (as opposed to debt):  you have flexibility to adjust your costs to meet business conditions.  Lowering bonuses during hard times is much like lowering dividends.  Whereas lowering salaries is like lowering your debt payments, in that it is more painful (in the case of salaries, painful because of the effect on morale; in the case of debt payments, painful because it requires renegotiating your debt or entering bankruptcy).

So to the extent your compensation policy is a substitute for a capital structure, you can imagine a company choosing whichever is cheaper.  A company with generous, steady compensation policies may require more equity financing.  A company that imposes risks on its employees may be able to impose less risk on its investors (that is, get more of its financing from debt as opposed to equity).  And across the world, you can imagine some societies in which workers are expected to bear more risks, and other societies in which investors are expected to bear more risks.  And so again you would want to account for this in cross-country comparisons of wages - just as you have to think about risk-adjusted rates of return on investments, you want to think about risk-adjusted compensation for labor.

And one final thought.  As workers are increasingly exposed to equity-like risks, it might affect their optimal asset allocation when it comes to their investments.  If you have limited capacity to bear equity risks, and those costs are increasingly imposed on you through your wages, then you may need to shift your investments toward other (safer) asset classes.  (I realize I am repeating my earlier point - no, no, I am emphasizing and elaborating on my earlier point!)  This probably bears on how much retirement income people should get from Social Security, since for a lot of workers that is probably the main determinant of retirement income besides the stock market (and in fact, for a lot of workers it is probably the main source of retirement income, period).


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