Why Paychecks Could Shrink

High unemployment and low inflation may lead to a decline in pay—and that could slow the recovery

Will employers take advantage of the abundance of available labor to cut workers' paychecks? It would be rare for wages to fall economywide, and it's not in most economists' forecasts. Nevertheless, outright declines in average pay are a genuine possibility—and if they were to occur would be a major threat to the nascent recovery.

For now, pay is still rising—a little less than 2% for the year through June 2009, according to the government's employment cost index. But the weak job market is creating the perfect conditions for a decline in pay: low inflation and high unemployment (9.7% in August). With a huge reserve army of unemployed—more than 2 million of them college-educated—it would be easy for many employers to demand concessions.

One of Wall Street's more bearish forecasters, Goldman Sachs (GS) chief U.S. economist Jan Hatzius, predicts that average hourly earnings will fall about half a percent from the fourth quarter of 2009 through the fourth quarter of 2010. Hatzius says his prediction accounts for workers' strong aversion to wage cuts. Without that adjustment, the projection would be negative 2%.

Some economists argue that falling pay would help cure unemployment: Companies would hire more people if they didn't have to pay so much for them. But others warn that wage cuts would make it harder for workers to repay their debts.

The risk is a downward debt-deflation spiral like those of the U.S. in the 1930s and Japan in the 1990s. In such a trend, debt-burdened workers cut back on spending to make their interest payments, which drags the economy down even more. "Imagine a person who got laid off six months ago," says Paul Ashworth, senior U.S. economist for consultants Capital Economics. "They're going to get more and more desperate to get a job and more and more willing to take lower wages as time goes on." While wage deflation isn't Ashworth's "central scenario," he says it's dangerous enough to bear watching.

In the short run, workers could come out O.K. if prices fall even faster than their salaries. Late last year, for example, Americans got a big boost to inflation-adjusted pay because of the huge drop in gasoline prices. But since the start of 2009, inflation-adjusted wages have been roughly flat. Average hourly earnings for production and nonsupervisory workers, or 80% of the workforce, have fallen fractionally after adjusting for inflation.

PAY RECOVERY IN 2010?

Slightly better was the seasonally adjusted employment cost index of wages and salaries, which covers all civilian workers. It was up about 1% from the end of 2008 after adjusting for inflation. The index for professionals and managers was up a little less. In any case, falling prices are no cure-all in the long run. Deflation caused by excess capacity is destructive and hard to stop, as the Japanese have discovered.

The conventional wisdom is that 2010 will be a year of recovery for pay. Benefits consultants Towers Perrin and Watson Wyatt Worldwide (WW) conducted employer surveys earlier this year showing a median forecast of 3% increases in base pay next year. Next year "will certainly be improved," says Laura Sejen, Watson Wyatt's global practice director for strategic rewards.

Will wages really recover, though? Federal Reserve rate setters on Sept. 23 pointed to "substantial resource slack" in the economy. Labor is the economy's single most important resource. As unemployment keeps rising, downward pressure on wages will get stronger—and that could mean tough times all around.

Coy is BusinessWeek's Economics editor.