Arnold Kling  

The Macro Doubtbook, Installment 4

Hayekian Moment Watch... Natural Libertarians?...

This installment, below the fold, discusses real wage rates and employment. The previous installment was here.

Real Wages and Employment

Perhaps the most widely-used theory of employment fluctuations is that they are caused by changes in real wage rates. In general, the thinking goes that if real wage rates rise, labor demand falls, and assuming that labor supply is highly elastic at the too-high real wage rate, this leads to unemployment.

Interestingly, there also are theories that employment declines because real wages are too low. One theory comes from the far left in Britain in the 1930's. That is that when real wages are low, the distribution of income favors profits. Capitalists have a higher propensity to save than workers, and excess saving leads to reduced output and higher unemployment.

The other theory comes from the far right in the United States in the 1980's. This theory says that labor supply is highly responsive to short-term changes in real wage rates. As a result, temporary adverse productivity shocks, which lower real wage rates, cause higher unemployment. This is perhaps the most common description of "real business cycle" theory, which focuses on shocks in the "real" or supply side of the economy rather than on shocks to the monetary or demand side of the economy.

Both of these theories of procyclical real wages have major empirical drawbacks. Profits are more procyclical than labor compensation, which is an inconvenient fact for the theory that recessions are caused by a redistribution toward profits. And the Great Depression, with its decade of high unemployment, is difficult to explain as a temporary reduction in labor supply.

Let us turn instead to the theory of countercyclical real wages. Often, this starts with a theory of sticky nominal wages. When the money supply rises sharply, prices rise faster than wages, causing the real wage to fall. As a result, the demand for labor rises. As long as the economy is below full employment, labor supply is highly elastic at this new real wage rate, so employment rises. For sharp decreases in the money supply, this entire process reverses.

The theory of countercyclical real wages is perhaps the most straightforward way to explain macroeconomic fluctuations. However, we will see that it suffers from both theoretical and empirical drawbacks. The theoretical problem is to explain why workers would be fooled into accepting low real wages when there is high inflation. The empirical problems include the fact that real wages have not been especially countercyclical in the United States since World War II as well as the fact that the sectors that bear the brunt of the business cycle--housing and durables goods production--are characterized more by inventory fluctuations than by real wage movements.

When there is high unemployment, it is almost certainly true that, all else equal, lower real wage rates would help to reduce unemployment. However, to concede that point is not to agree that the entire business cycle rests on countercyclical real wage rates. If a flood of refugees arrives, other things equal, the lower their wage rates the lower will be their unemployment rate. However, that is not an argument that high unemployment among a flood of refugees is entirely a problem of too-high real wage rates.

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COMMENTS (5 to date)
fundamenalist writes:

All of the competing theories make Hayek's Ricardo Effect even more appealing. What mainstream economists refuse to accept is that unemployment takes place primarily in capital goods industries. It's no different today than it was a century ago. The actual percentages for unemployment that Hayek provides in one of his essays are almost identical to today's numbers. The Ricardo Effect has good theory and data to support it, yet mainstream econ ignores it because it disaggregates data, which is a sin to them.

Lord writes:

Since nominal wages are fairly stable, the real in real wages is actually due to monetary fluctuations. Both workers and employers are fooled by the monetary illusion or at least find it easier to adapt, perhaps because their debt is nominal. All else fails to be equal under deflation.

Keith Eubanks writes:

I'm of the opinion that the focus on shifts in real wages is a red herring. The question is how many people can be employed by current income at current wages: both in nominal terms.

If for whatever reason an economy generates less nominal income one day than it did the day before, unemployment will be forced until wages adjust. Yes, this leads to a fall in real wages, but that is secondary. The issue is how much income an economy can generate, how much income is allocated toward wages, and what are wages.

A loss of income can occur from a shrinkage of the money supply or a real loss in the economy or a combination of the two. The cause probably doesn't matter for the generation of unemployment, but it probably matters a great deal for the speed of recovery.

A nominal loss can probably recover quickly with an adjustment in wages. A real loss will have to be supported with new investment to replace the lost production capacity in an economy. (note that utilization data is useless for this assessment; if the loss results from over-investment, excess capacity is of no value; if its not salvagable, it's junk.) That's my two cents.

fundamenalist writes:

Hayek had the best explanation of long term unemployment that I have seen - capital destruction. Few jobs today can be done without come kind of capital. Capital gets destroyed, at least in value, during the boom phase of the business cycle. In the most recent cycle, the capital that lost value was in the automobile and housing industries. No one wants the capital in those industries nor do the want to rebuild that capital because there was too much of it. That capital (equipment and buildings) can't be transferred to other industries, such as healthcare, because it's useless to those industries. Until other industries save and build the necessary capital that unemployed workers can use, those who depended upon automobile and housing capital will be without jobs. No amount of government stimuli will change that.

Lord writes:

A more accurate statement would be not enough capital was destroyed, and the loss is not that of capital but of capital opportunity. There exists a plentitude of capital but a lack of productive investment opportunities to put it to work, and it is the destruction of believable profitable projects that hinders recovery. Either less or no profits must be accepted, or even losses so cash looks better than any alternative.

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