Bryan Caplan  

Why Wage Cuts Are Good For Aggregate Demand

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Krugman's repeating his argument that wage cuts are individually rational, but collectively irrational:
[M]any workers are accepting pay cuts in order to save jobs. What's wrong with that?

The answer lies in one of those paradoxes that plague our economy right now. We're suffering from the paradox of thrift: saving is a virtue, but when everyone tries to sharply increase saving at the same time, the effect is a depressed economy...

And soon we may be facing the paradox of wages: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment.

If you're really anti-Krugman, you might think he's saying that, "Wage cuts reduce labor income, which reduces aggregate demand."  If this is his argument, it has two major problems:

1. Cutting wages increases the quantity of labor demanded.  If labor demand is elastic, total labor income rises as a result of wage cuts. 

2. Even if labor demand is inelastic, moreover, wage cuts reduce labor income by raising employers' income.  So unless employers are unusually likely to put cash under their matresses, wage cuts still boost aggregate demand.

But is Krugman even making an argument about aggregate demand?  At first glance, it doesn't look like it:

Here's how the paradox works. Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment -- which they do at the level of the individual employer.

But if everyone takes a pay cut, nobody gains a competitive advantage. So there's no benefit to the economy from lower wages.
Alas, this still leaves me saying, "No benefit?!  Huh?"  Won't consumers benefit when there's more cheap stuff?  In purely Keynesian terms, too, there's a real balance effect.  The most that Krugman could reasonably say is that wage cuts have underappreciated drawbacks.  What are these supposed to be?

1. "[F]alling wages, and hence falling incomes, worsen the problem of excessive debt."  Now Krugman really does seem to blithely assume that reducing wages reduces aggregate demand.  And I have to respond: "Do falling wages worsen the problem more than higher unemployment due to wage rigidity?"

2.  Krugman also warns that falling wages might lead consumers to expect further wage declines, effectively raising real interest rates - "And a rise in the effective interest rate is the last thing this economy needs."  I grant that this might happen if wage cuts continued for a long time, and could conceivably be bad if it happened.  But for now, this is paranoia. 

It's also worth pointing out that in a standard New Keynesian textbook model, higher inflationary expectations reduce aggregate supply and worsen the inflation-unemployment trade-off.  Corollary: The straightforward effect of lower inflationary expectations is to increase aggregate supply and improve the inflation-unemployment trade-off.

I'm far from a knee-jerk Krugman basher.  I gleefully assign The Accidental Theorist to my undergraduate labor students.  But when Krugman forgets that wage rigidity is the fundamental cause of involuntary unemployment, a sound bashing is in order.


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COMMENTS (34 to date)
spencer writes:

Great theory.

Now show me a single real world example where falling wages generated greater employment.

Theory is suppose to reflect reality and your theory completely fails that test.

Even in the US depressions wages and employment moved in the same direction virtually all the time.

gnat writes:

"Cutting wages increases the quantity of labor demanded. If labor demand is elastic, total labor income rises as a result of wage cuts."

Did you forget 'ceteris paribus'?

wintercow20 writes:

Spencer, I think you need to think about the forces that lead to falling wages.

An analogy in the goods market is perhaps instructive. If people find the health benefits of blueberries to be increasing and therefore reduce their demand for oranges, the price of oranges will fall, as will the quantity of oranges demanded. The falling price does not generate an increase in oranges sold ... but if prices of oranges had not fallen in response to the decrease in demand, the quantity supplied would far exceed the quantity demanded, and allowing the price to fall would have the quantity demanded increase and the quantity supplied decrease FROM WHERE IT WOULD BE IF PRICES WERE RIGID.

Nothing Bryan says is inconsistent with theory and reality. In fact, the "data" you point to neither refute nor confirm it. In recessions the demand for labor falls, and wages and employment would have to fall ... draw yourself the picture. Now ask yourself what would have happened (or what does happen) if wages were not free to adjust?

I just don't see what your point is.

spencer writes:

I know your theory and the simple supply demand curves you draw never work in labor markets.

I still waiting for anyone to show a single real world example of the theory working in labor markets.

I've been looking for about 50 years and still have not found one.

Justin Ross writes:

Spencer:

I think you are confused about what supply and demand theory is. The quantity of labor demanded is inversely related to the wage, but the observed level of employment depends on its interaction with supply. If you have seen people both being employed and earning a wage for it, you have seen "simple" supply and demand work in labor markets. For your observation that aggregate employment and average wages move in the same direction...a decrease in demand for labor generates a decrease in BOTH wages and employment.

For research, Journal of Labor Economics and Journal of Labor Research are both credible places to start.

All the best.

spencer writes:

The problem is that labor is a derived demand.

If I am a manufacturer I do not demand labor for the sake of having labor. I hire labor because the labor produces the product I sell.

If my sales of widgets fall from 100 to 50, What I want is enough labor to manufacture 50 widgets. If each employee produces 10 widgets my demand for labor falls from 10 to 5 and even if you cut the price of the labor in half I still will only need enough labor to produce 50 widgets.

In your example consumers buys oranges or blueberries because they derives utility from consuming them. But as an employer I do not derive utility from consuming labor, so cutting the price does not increase my demand for labor.
The only thing that would increase my demand for labor is an increase in my sales of widgets.

Greg Ransom writes:

Why do you take it for granted that Krugman is making any sort of genuine argument here.

This is politics.

It meets the standards of politics.

Krugman doesn't do economics in his column.

Greg Ransom writes:

"The only thing that would increase my demand for labor is an increase in my sales of widgets."

Are we suppose to believe that "Spencer" knows any economics whatsoever?

Justin Ross writes:

You are quite right that there is no utility function for firms, but the price of labor still matters. Firms will hire anyone who's value of production is greater than their cost.

There are a number of ways to see this, extending from your example of widgets:
- There is usually more than one way to produce widgets, and the cheaper labor is the more likely you are to use it over the alternatives methods of production (think about the 1 person watching over 6 "u-scans" at the grocery store versus the individual cash registers)

- The choice of how many widgets you are willing to sell is not solely based on the demand (100 or 50), but also on what it costs to produce those widgets. I have to be able to sell enough to cover my costs. The more expensive labor is, the greater my costs, the more I have to be able to make in sales to cover those costs.

- Approach it from the other angle, suppose you have been producing 100, and realize there is enough consumer demand to sell 110, which I can hire another employee to make...should I do it? Well if the cost of employing another worker is less than what I could sell those extra 10 units for, then I should. The more costly it is to hire that extra employee, the less likely I am to be willing to make widgets 100 through 110.

Again, all the best.

Greg Ransom writes:

Spencer -- in Southern California labor is a consumer good. Gardeners, house painters, service staff, maids, subcontractor employees, and on and on. You see it everywhere.

dWj writes:

Spencer: United States, March 1933 - July 1933.

Also, as Greg Ransom notes, a majority of U.S. consumption at this point is service consumption. You can still account for labor as a derived demand, but it's very tightly coupled to the demand from which it's derived, and the classification has no real effect.

liberty writes:

Good arguments. I can't believe you assign Krugman.

Richard A. writes:

Total wages are something like 70% of GDP.

GPDn = 0.7 x W x Q

where
W = average wage
Q = quantity of labor

If GDPn declines by half, W will have to also decline by half in order to prevent a decline in Q. The above equation can also be written as

dGDPn/GDPn = dW/W + dQ/Q

spencer writes:

I've spent a lot of time in southern California.

People hire gardeners, pool boys, etc., because they want a nice garden and/or a clean pool, not because they want some poor laborer hanging around their home.

Show me a real world example of a Southern Californian hiring a gardener to hang around and do nothing.

spencer writes:

Greg Ransom--

how many people do you know who do not own a pool that hire a pool service to come hang around in their back yard for an hour every week?

John Bailey writes:

The most important thing that both Krugman and these comments ignore is that not all wages can or will fall. Companies whose workers take reduced wages become more cost-effective allowing them to stay in business.

It is not the employers who get the benefit of the reduced wages, it is the companies customers, suppliers, et.al.

spencer writes:

Why am I not surprised that the way Greg Ransom tries to settle a dispute is to insult the person he disagrees with rather than trying to marshal any facts to make his case.

floccina writes:

spencer wrote:
I've been looking for about 50 years and still have not found one.

I think that if you look at historical data of Singapore that you might find some data. Also one cold consider the wage controls in the USA in WWII as a data point (unless you rule it out because it was only a fall in real wages not nominal).

Joshua Lyle writes:

spencer,

How many people do you know that have a pool and have it cleaned at exactly the same frequency regardless of how much that costs?

cputter writes:

Bryan:

Reminds me of a discussion between Robert Murphy and Greg Mankiw a few week back:

http://blog.mises.org/archives/009861.asp


Do Keynesians think prices are too sticky and we need the gov to step in and fix that, or do they think deflation will 'gut' the economy? It seems to me they like making both arguments at the same time... which is slightly inconsistent.


What's so bad about moderate deflation in any case? Didn't we have deflation during the 19th century and a growing economy at the same time? I'd think moderate deflation is much better then moderate inflation. What do Keynesians have against allowing poor people to afford stuff?

ragards

johnleemk writes:

liberty:

If you haven't read The Accidental Theorist, you should. Most of it is available online anyway. It really is some of the best economics around, and every time I see something Krugman writes today, I grimace knowing how much potential has been lost. I still hope one day Krugman will come to his senses and write the stirring defenses of markets and trade which he once so readily penned.

cputter writes:

Has anyone read any research on labour price rigidity? Specifically whether it's stickier going up then going down.

My first thought would be that labour prices are more rigid going up then coming down. This is because both employer and employee have large incentives for agreeing on a lower wage rate when business is bad. The employer would like to stay in business and the employee would like to keep his job (especially with over supply in the labour market). Not doing so would harm both, if the business goes broke said employee loses his job in any case.

Whereas only the employee has large incentives for wanting a wage increase. Clearly an employer can hold out on increasing wages longer then he could hold out on decreasing them. Of course the labour market eventually takes care of this and employers paying the best wages end up with the most skilled workers.

Add the whole health insurance mess to this and you have some pretty good reasons for people to willingly take wage cuts, while at the same time wait longer for a wage increase.


Maybe my analysis is too superficial so I'd appreciate it if someone could educate me, or point me to some pretty graphs.


regards

Bill Woolsey writes:

If the real demand to hold money rises 10%, and the nominal quantity of money is assumed to be fixed, then the market process that raises the real supply of money to match the demand is a 10% drop in the price level. In this context, it is really all prices that need to drop, including resources prices--including labor.

If no prices drop, then the excess demand for money is matched by an excess supply of goods. Nominal and real aggregate demand falls below productive capacity. Firms produce less, and hire less labor. Real wages are roughly at the correct level, but total employment and production is below equilibrium.

If we imagine that final goods prices do fall, but wages don't, then real wages rise as prices fall. Firms will suffer losses and go bankrupt if they tried to hire the quantity of labor supplied at these extra high real wages. Regardless, they will cut their losses by producing less and hiring less labor. This is the scenario wage there is unemployment and real wages are too high. Lower demand, prices of products fall, and wages don't.

So, there is the situation. Lower wages result in a less than proportional decrease in prices (keep in mind that prices already fell to get to the "stuck wage" disequilibrium. Profits expand. But most imporantly, the real supply of money rises. Once it rises to meet the demand, the economy is back to equilibrium. Real aggregate demand equals productive capacity, the real supply of money equals the real demand for money, and real wages and real profits are at the level are back at equilibrium.

What are the problems with the market process that adjusts the real supply of money to the real demand for money? Nominal contracts only adjust through bankrupcty. There is a transfer from debtors to creditors, though if it results in insolvency, bankrupcy (a costly process) adjusts the nominal contract in various ways. The debt to equity swap makes the contract flexible, but that isn't the only approach.

Second, the equilibriating process is for the price level (including wages) to be low. Falling prices and wages doesn't help. And, it might hurt. It makes holding money more attractive. (This is more or less the same thing as Krugman's claim that it raises real interest rates.)

My view is that the quantity of money should be increased to meet any increased demand for money. If errors are made, it is desirable to had "level" targeting, I think of nominal income. If nominal income is expected to return to its targetting level after a time, the lower the price level now, the higher the expected inflation rate because it is expected to return to normal.

In such a policy environment, an increase in the demand to hold money will elicit an increase in the quantity of money. To the degree that a remaining short fall of money results in lower prices and wages, this will raise the real supply of money, reinforcing the increase in the nominal quantity of money. With nominal income expected to return to normal, lower current prices imply an incease in the expected price level and so motivate increased spending as well.

So, there is nothing "collectively irrational" about cutting wages in response to a surplus of labor. It is both individually and collectively "rational." It is adjusting the real supply of money to meet the real demand for money.

I do think there are better ways to go about it.


cputter writes:

@Spencer:

Let's assume the price for pool services falls due to greater supply of unskilled labour, and you own a pool cleaning company employing 10 people that maintain 100 pools in the area. If you would like to stay in business you need to insure that the factors that go into producing that service cost less than the new lower price.

It's been mentioned earlier that labour can be substituted. In this case we'll assume that you can substitute 1 pool boy using pool chemicals with 2 pool boys not using pool chemicals.

Prior to the drop in prices for your service you were using pool chemicals. Even though the chemicals are expensive labour costs at the time were even more so.

So as an entrepreneur you need to decide how to combine your factors of production to make a profit. To maintain 100 pools you can either use 10 employees using chemicals, or 20 employees without.

Here's the numbers before and after the increase in the supply of labour:

Before (per pool):
Chemicals 35
Pool boy 40
Income 90

After (per pool):
Chemicals 35
Pool boy 30
Income 70

Do the math and let me know whether you employ more people after a drop in wages.

There are many substitutes for unskilled labour, mostly machinery requiring skilled labour. If labour costs are low employers use more of it, if costs are too high labour gets substituted for something cheaper.


As an aside, this might inform you why labour unions are always lobbying for increases in the minimum wage, even though most unions consist of skilled workers earning far above minimum wage.

Matt Nolan writes:

"But when Krugman forgets that wage rigidity is the fundamental cause of involuntary unemployment, a sound bashing is in order."

Good call :)

mulp writes:

Let's see, I'm paid $4000 a month that I use to pay
$1000 for my mortgage
$200 for property taxes
$1000 for health insurance
$500 for car payments
$100 for car insurance
$100 for gas to work
$100 to savings
$1000 for food and such

So, I agree to a 10% wage cut and now spend:
$1000 for my mortgage
$200 for property taxes
$1000 for health insurance
$500 for car payments
$100 for car insurance
$100 for gas to work
and then either:
$900 for food and such assuming they fell 10%
plus draw $200 from savings
or
$700 for food and essentials spending over 20% less

Either investment spending will be reduced, meaning someone's income will fall, or my spend will be reduced meaning someone's income is going to fall more than their 10% wage cuts to lower prices.

If the government were to index debt, as Milton Friedman suggested, to the CPI then a 10% pay cut would also translate into a 10% fall in prices, a 10% reduction in debt, and a 10% reduction in saving account balances.

Scott writes:

Mulp,

Where do you think the $400 that your employer retains goes? It doesn't vanish into thin air.

You may have $400 less investment and/or spending, but your employer now has $400 more to invest or spend.

Kevin Donoghue writes:

"But when Krugman forgets that wage rigidity is the fundamental cause of involuntary unemployment, a sound bashing is in order."

Given that Krugman was invited to write an introduction to a new edition of Keynes's General Theory of Employment, Interest and Money, it is really quite unlikely that Krugman has "forgotten" this pre-Keynesian claim regarding the causes of unemployment.

Most likely he just thinks Keynes was right: the cause of involuntary unemployment is a deficiency of effective demand.

Perry writes:

Hey spencer,

Here's a real world example for you - the firm that I work for had to lay off three people. They also cut all of the remaining staff salaries by 5%. Without that cut, they would have let go of another employee.

So for the same total wages, they can have one more employee on staff so that if and when demand picks up again, they have the immediate capacity to take on that work.

And with the costs of training and hiring people, especially on a macroeconomic scale, I don't see how having 'extra' labor capacity available is less preferential to a firm than maximum utilization of its staff especially if the assumption is that the economy will recover..

D. Watson writes:

Spencer:

Let's go back to your earlier example. Demand was for 100 and fell to 50 AT THE ORIGINAL PRICE LEVEL, where P=MC. If prices and wages stay the same, the employer lets go of 5 people and maybe does something clever with some extra capital. If a wage cut can be negotiated (say 10%) for the same costs, we can hire 5 full time workers and a half-time worker at the same wage bill, produce 55 units, and (all assuming the right elasticities) sell them all for a slightly lower price. Employment is higher than it would have been, but there's still a clear drop.

Adam P writes:

Bryan Caplan is just wrong. Here is what he said in the post:

Caplan: "1. Cutting wages increases the quantity of labor demanded. If labor demand is elastic, total labor income rises as a result of wage cuts."

Krugman made quite clear he was talking about wages and prices falling in tandem. I'm pretty sure Krugman has in mind an unchanged real wage. If the real wage is unchanged then so is the quantity of labor demanded. Econ101 stuff here.

Caplan: "2. Even if labor demand is inelastic, moreover, wage cuts reduce labor income by raising employers' income. So unless employers are unusually likely to put cash under their matresses, wage cuts still boost aggregate demand."

The same critique applies here as well, no change in the real wage means no change in anyone's real income.

But suppose we do think that it's just a wealth redistribution, if employers and labor have the same marginal propensity to consume then it's a wash, it doesn't raise aggregate demand. If Caplan is claiming that employers marginal propensity to consume is higher than labor's he should say so and try to back it up because that seems like a tough case to make.

Richard A. writes:

GPDn = 0.7 x W x Q
The above equation is in error.

It should be
0.7 x GPDn = W x Q

WQ/GPDn is not an exact constant. It tends to increase with rising unemployment and decrease with a booming economy.

El Presidente writes:

Bryan,

Your assumptions are inaccurate, so your conclusion cannot be affirmed.

1. Cutting wages increases the quantity of labor demanded. If labor demand is elastic, total labor income rises as a result of wage cuts.

Labor demand is NOT elastic with respect to production technology. Changes in production technology (MRTS with respect to factors of production) are part of long-run analysis, not short-run. So, Spencer's explanation that labor demand is derived is actually quite accurate and to the point since production technology is rigid and employers won't stop using their existing labor saving capital simply because labor is now cheaper. They will just produce less and capital will be idle.

2. Even if labor demand is inelastic, moreover, wage cuts reduce labor income by raising employers' income. So unless employers are unusually likely to put cash under their matresses, wage cuts still boost aggregate demand.

Employers ARE unusually likely to put cash under their mattresses, but employers don't have very much cash of their own. The question is more one of what financing they can find. If you meet your payroll with credit rather than cash, your sales determine your credit-worthiness and your ability to hire. Depressed sales directly effect your labor budget. This is why they are contemplating wage cuts in the first place. That doesn't seem difficult to comprehend. Uncertainty still abounds so liquidity preference remains high, and remarkably low inflation encourages people to keep money rather than spending it. It's pretty simple.

El Presidente writes:

Bryan,

Perhaps I was too harsh. There is one way in which data confirms you are partially correct. In the end of 2007 and beginning of 2008 we saw an uptick in service sector employment (leisure and hospitality) in my region while incomes were declining. This was due to people washing out of the real estate business and taking lower-paying jobs, which continued to drive wages for those jobs down. The correlation existed, but the causation was opposite from what you propose for the reasons I previously stated. Some forecasters, colleagues of mine, were hopeful that this signaled revitalization, since an increase in service sector employment CAN be a leading indicator of economic recovery and expansion. They were wrong about the causation because they were using the same framework as you.

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