Arnold Kling  

The Best Policy for the Sovereign Debt Crisis

Time for Cryptonomicon... European Monetary and Fiscal C...

Megan McArdle is rationally pessimistic (apologies to Matt Ridley). But get this:

Jürgen Stark, executive board member of the European Central Bank, said on Wednesday that restoring sustainability to the public finances was "even harder for the UK, the US and Japan".

As Tyler Cowen says, the key point is to recognize that we are not as rich as we thought we were. I think what is needed is for every deficit-plagued government to lower public sector salaries by ten percent until the crisis blows over.

The worst thing that could happen is that cutting wages could reduce aggregate demand through Keynesian channels. But gosh, look at some of the alternatives: sovereign defaults, bank runs, cuts in public sector jobs? A cut in public sector pay is probably the least unpalatable option.

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CATEGORIES: Fiscal Policy

COMMENTS (10 to date)
Doc Merlin writes:

"The worst thing that could happen is that cutting wages could reduce aggregate demand through Keynesian channels"

I thought Keynesians believed that the reason recessions happened was wages were too sticky on the down side. Wouldn't cutting wages then boost aggregate demand according to a Keynesian?

mulp writes:

Have economists of your thinking called for their wage to be cut?

Or is this a case of "do what I say, not what I do"?

We've seen way too many leaders demand and act to cut wages of workers and then double their own wages, claiming collectively they have done great things by cutting the incomes of their customers.

But hey, I guess public sector workers should find innovative ways to increase their incomes, like the police and government agents in places like Mexico, Columbia, Iraq, Afghanistan, etc. Turning government into piece work with the worker collecting the payments based on the job he personally done is very entrepreneurial.

mulp writes:

I thought Keynesians believed that the reason recessions happened was wages were too sticky on the down side. Wouldn't cutting wages then boost aggregate demand according to a Keynesian?

You don't understand the Eccles solution that Keynes tried to explain: the problem is debt that does decrease as prices and wages fall. If you buy a house like everyone else for $100,000 when you are making $50,000 like everyone else, and buying the things you need to live for $36,000 and paying $14,000 to service the debt, having your wages go down to $25,000 and the prices for the goods you buy go down to $18,000, while you and businesses you buy from remain stuck with debt service of $14,000 creates a personal and economy wide crisis.

Friedman suggested indexed debt, so if all debt were indexed, that $100,000 debt would drop to $50,000 and the debt service would drop to $7,000. Of course, if your wages go up along with everything else, your debt would also need to go up with your payment. But who figures out how much? If my wage goes up by 20% and yours goes up by 10% with some economist declaring the rate of inflation is 12%, are you going to accept your debt and debt service going up 12% willingly?

Friedman concluded that a bit of inflation was a good thing absent indexing everything, because if you under perform on wages for reasons if your own or not, you are rewarded will relatively less debt over time. But you can only benefit if you own assets, with or without debt. Thus the "ownership society" Bush pushed is based in Friedman's reasoning, as a means of helping everyone. But Friedman advocated a bit of inflation.

The problem is as Eccles first put it, sometimes creating the required inflation with monetary policy is like pushing on a string.

Ted writes:

Uh, you can't seriously think that is a solution.

A reduction in public sector pay by 10% would accomplish almost nothing. Yes, it permanently puts it on a lower trajectory, but that is completely dwarfed by other future liabilities already in place. Why in the world would you cash in so much political capital to fight for something that would be little more than symbolic? You should be using your political capital for serious fiscal reforms, not jokes like public sector wage cuts. A painless ways to save a good deal of money would be the selling of unused federal property. Nobody should use political capital for something like a 10% wage cut. I guess you can argue it sends a signal to the market you are "serious," but I would probably believe it was more of a gimmick than anything.

Note that I wouldn't really mind if public sector wages were cut (although maybe I should be given efficiency wage models - maybe they would shirk even more than they already do!). They are clearly paid more than they should be, but I don't want a President or whoever to cash in that much political capital on an issue when he should be using it for more meaningful fiscal measures.

@Doc Merlin: I think you are mixing up sticky wages and sticky prices. The idea of a "coordination problem" generating sticky prices can result in a recession. Sticky wages have more to do with why labor markets don't clear, and hence why unemployment doesn't correct itself more quickly. So, while a recession is more about sticky prices - unemployment is more about sticky wages (although obviously there are interactions going on here, an economy isn't really compartmentalized). Wage reductions reduce aggregate demand because, well, think about it - you have less money to spend now! On a related note, an economy-wide wage reduction would actually turn inflation expectations downward - which would obviously be bad. Ideally, a central bank would then offset that negative inflationary pressure though interest rate cuts. However, at a zero-lower bound environment it's a bit trickier and requires more unconventional policy. However, a curious feature of New Keynesian models though is that if some government policy (raising minimum wage, making it easier to unionize, or maybe just saying all wages are 20% higher now) pushes up economy-wide wage this will be actually expansionary when the nominal interest rate is zero because it pushes up inflationary expectations since it inhibits prices and wages from falling. I think this is probably a by product of a while successful, imperfect and stylized model. I don't think those policies could really be expansionary.

William writes:

[comment deleted for ad hominem remarks]

infopractical writes:

"Have economists of your thinking called for their wage to be cut?"

Economists aren't making a 30% premium to market wages. And unlike public sector salaries, they are the 498713rd highest line on the government budget as opposed to the 1st.

Tracy W writes:

Why public sector wages? Why not just eliminate every public subsidy and tax preference for private sector activity? (I want to distinguish between things like providing subsidies for growing crops, versus running public schools entirely even though there are private schools, but I hacan't work out the exact wording).

I can't see how it would be any more politically difficult, you'd eliminate a lot of distortions, and of course once you've done the cuts you could cut the wages of the public sector employees who administered those programmes by 100%.

John writes:

[sarcasm]Oh, but I thought that Krugman definitively proved that government salaries were negligible expenses compared to distributions? [/sarcasm] (See

rpl writes:

mulp, What, exactly, in Arnold's post gave you the impression that economists in the public sector (which includes Arnold himself) would be exempt from the across-the-board wage cuts? I don't see anything in the post that even hints at that. I think you made that part up yourself.

I'm also skeptical of your claim that corruption in a country's civil service is due to civil servants being underpaid. I think it's more likely a function of a society's tolerance for that sort of behavior.

Justin P writes:

Well just looking domestically, if California were to cut their public salaries by 10%, they'd be doing a heck of a lot better, but they'd be having riots too.
But that's only a small fraction of the problem. The real problem is the unfunded Pension liabilities.

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