Job cuts increase unemployment but lowering wages encourages companies to hire

According to new research, cuts in public sector hiring increases unemployment. Also, public sector wage cuts can reduce unemployment by triggering a reduction in private wages, which encourages private firms to open up new job positions.

Researchers Guilherme Bandeira (Bank of Spain), Evi Pappa (European University Institute), Rana Sajedi (Bank of England), and Eugenia Vella (University of Sheffield) recently studied these effects in European countries such as Greece, Italy, Spain, Ireland and Portugal, with the aim to reduce the public deficit.

In normal times, cutting jobs or lowering wages in public sector occupations pushes jobseekers to look for employment in the private sector. The result is an increase in available workers which can boost private economic activity.

But, these cuts have recently occurred in a special economic environment which has seen interest rates close to zero. Low inflation and low interest rates have resulted from suppressed demand after the recent financial crisis. This suggests that the private sector is not able to employ the amount of workers that are no longer interested in working within the public sector.

A crucial factor that the research has highlighted, is the degree of movement from workers between the public and the private sector. If jobseekers cannot easily switch their job search towards the private sector, the outcome is more adverse for the economy. As these unemployed jobseekers are not hired into private sector jobs, the unemployment rate rises.

Another important factor to note is the amount of public goods and services that public employees produce. If public goods and services contribute to the private sector’s economic activity (such as public infrastructure), then public sector downsizing can be self-defeating. By contrast, when goods and services provided by the public sector are ‘a waste’ to the economy, then public-sector downsizing can improve economic performance.

Further details can be found at:

Guilherme Bandeira & Evi Pappa & Rana Sajedi & Eugenia Vella, 2017. Fiscal Consolidation in a Low Inflation Environment: Pay Cuts versus Lost Jobs, Working Papers 2017012, The University of Sheffield, Department of Economics.

If you’re interested in contacting the authors of this research then please contact them using econ@sheffield.ac.uk or +44 114 222 5151