Full Wage Indexation (FWI), indexing wages to the full Consumer Price Index (CPI), that is, increasing money wages at regular intervals by the same proportion as the rate of price increases during those intervals, is intended to maintain living standards by maintaining real wages. This is kindergarten economics.
The idea is that if prices go up by say, 10 percent over three months, through whatever cause, then if you increase money wages by 10 percent at the end of the three months, purchasing power, real wages, will be restored to what they were at the start of the three months.
In fact real wages are not the same as money wages; purchasing power is not a simple function of money wages. It is a function of throughput, population, and the distribution of money income.
In turn, one determinant of throughput is, as already stated, the relative proportions of money flowing through the different channels in the economy.
The rate of change of prices is erroneously called inflation. It includes inflation but it is not the same thing. It is the resultant of several rates of change (each of which have one or more different determinants, including each other). These are:
(i) value inflation (defined earlier);
and rates of change of
(ii) taxes,
(iii) wages,
(iv) interest rates, and
(v) currency exchange rates;
(vi) the rate of improvement of technology and
(vii), obviously, the rate of change of money value, this being determined by the difference between the rates of change of the money supply and of the level of economic activity.
The more cumbersome but more precise term “rate of change” is used throughout the previous paragraph rather than “increase” because although the rates of change are usually upward, this does not have to be so and has not always been so.
The expectations and business decisions, rational or otherwise, of those responsible for setting prices affect the variables listed above, and in turn are affected by them.
The combined effect of the variables fluctuates over time. The relevant point for the stagflationary situation is that for a couple of decades, prices rose faster than throughput.
Indexing wages to the full CPI, forcing them to rise as fast as prices, causes wages to rise faster than throughput. This causes a steadily worsening ratio distortion.
This affects all the rates of change listed earlier in the direction of increasing the upward rate of change of prices that in turn increases the upward rate of change of money wages.
The rate of devaluation of money will rise. Interest rates will rise because of this and because borrowing demand would rise for three reasons:
(i) governments would borrow more to pay escalating public sector wages and more and higher welfare transfers,
(ii) consumers would borrow more because of the greater confidence engendered by regular money wage increases, and
(iii) many companies would buy time in the face of insufficient profits by borrowing more.
The currency of the country with a Full Wage Indexation policy tends to fall in value relative to currencies of countries without Full Wage Indexation.
The effect of improving technology on retarding the rate of increase of prices of goods and services is lessened because the rate of improvement of technology, determined in part by the availability of investment and development finance, is slowed by insufficient profits and higher interest rates. As a counter to this, insufficient profits and ever-rising money wages provide a greater incentive than before to improve technology to achieve higher productivity, that is to reduce the work force needed for a particular rate of structuring of goods and services.
All these effects apply to the stagflationary context in which the end result of a policy of Full Wage Indexation is not to maintain real wages, but actually to reduce them. That is, the net result of each upward adjustment in money wages is to reduce real wages, not only relative to what they were before the adjustment, but relative to what they would have been had no upward adjustment taken place.
So the effect of a policy of Full Wage Indexation is quite opposite to the intention.
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