In the current situation of high inflation and large budget deficits, salary increases for politicians and central bankers alike are rightly criticised. While, because of the poor economic situation, the wages of most citizens are falling in real terms due to inflation, these high-ranking civil servants are not feeling any of the pinch.
This fact is even more amusing since these are individuals whose job it is to avoid this and similar situations. And they are almost the only ones who do not feel the consequences of their botched job first-hand. The solution, most often proposed by the disgruntled population, is simply to cut politicians’ salaries (for some reason, the wrath of the mainstream does not extend to central bankers, who often bear the greater share of the blame), preferably to the minimum wage. While this move would bring some satisfaction, this reduction in costs would not save the state budget and would have no further effects. However, by applying ordinary economic analysis, we can arrive at an optimal and incentivising solution.
In this situation, there is only a different form of manifestation of negative externalities. Although externalities are used in textbooks as an example of market failure, here it is a clear failure of the state, or more precisely of the state bureaucracy. Politicians do not fully appreciate the social costs of their economic policies and so produce them in suboptimal quantities, resulting in a high state budget deficit. Their motivation is, of course, to buy voters through various attractive subsidies, social transfers or public goods. The state budget, in short, serves as a blank cheque.
The aim of every politician is therefore, in a standard situation, to buy as many voters as possible, regardless of the overall negative consequences for the economy, because these are 90% a matter for the next political cycle. Unfortunately, this behaviour will not be stopped by cutting their wages alone; this will probably only motivate politicians to become more corrupt, i.e. to otherwise procure the missing revenue. Wages need to reflect the real consequences of their economic policies, i.e. reward the good (and in its case grow) and punish the bad (and in its case decline). So, economically speaking, this negative externality needs to be internalized through wages.
The origin of this principle can be found in the work of economist Carl E. Walsh, who similarly considered the relationship between wages and the efficiency of the work of the aforementioned central bankers. The Wash contract, named after him, was intended to adjust the wages of central bankers in relation to the achievement of the inflation target.
According to Walsh, wages are negatively related to the difference between the actual and the target inflation rate. Thus, the closer the actual inflation rate is to the inflation target, the higher the central bankers’ wage. Central bankers are thus rewarded for the quality of their monetary policy management, and the information asymmetry between the central bank and the markets is reduced, since everyone knows that central bankers’ wages depend on how successfully they can achieve the inflation target.
In the case of politicians, several variables would then come into play. First, it would depend on whether the economy is in recession or growth. In the case of growth, a zero deficit might be the only acceptable outcome (however, in terms of the policy cycle and time inconsistency, the average of the last two years, with a 1% margin of error, should be considered). In times of crisis, the conditions could be set a little more benevolently, with a deficit threshold that could be derived from the form of budget brake that is used (though not adhered to) in most EU countries.
In the event of a breach of the rules, the wages of politicians in charge of economic policy would start to fall in direct proportion to 10% for every 1% of GDP by which the budget deficit rises. Conversely, if the rules were followed, there would be an automatic upward adjustment of 10% each year. Thus, the incentive to keep the government budget deficit low would enter into the classic incentive to be re-elected, which, combined with the Walsh Contract with central bankers, would surely mean the prospect of more price-stable times.
Written by Filip Blaha – analyst at CETA (Centre for Economic and Market Analysis).