Garett Jones  

Why Furloughs and Not Wage Cuts? A Test of the Slack Hypothesis

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"Low-Immigration, Pro-Immigran... "Locally Blonde"...
The Washington Post reports that if the sequester happens...

About 800,000 Defense Department civilians could face 22 unpaid leave days, spread out over as many weeks, amounting to a 20 percent pay cut over that period.

Because work requirements will not fall, [SecDef] Panetta said in a letter to the Senate, 'the workload on each employee . . . will be increased beyond what can reasonably be achieved.'

As a macroeconomist, my first question is simple: ???

Let me spell that out a bit: If the sequester kicks in, why are government executives deciding to give their workers unpaid vacations?  Wouldn't the sound response--especially in a weak job market, where job options are allegedly rare--be to cut back wages and tell everyone to show up ready to work on Monday? 

Note that your response to this question--if fact-based and not an ecstasy of mood affiliation--is a double-edged sword.  

If you say, "We can't cut wages, high quality government workers will quit to take private jobs," then you've just agreed that the labor market is tight for a sizable portion of the economy.  

If you say, "Workers will have low morale, and they won't work as hard; productivity of the workers will fall," then the obvious response is to fire the grumpy workers and hire new ones.  I'm repeatedly told by left and right that there's a reserve army of the unemployed out there, that the official unemployment rate understates the true desperation of workers. 

Sounds like a hiring opportunity to me.  

Let's return to the morale question.  I'm a fan of Truman Bewley's work of economic anthropology, Why Wages Don't Fall During a Recession, and he notes that private sector executives really do believe that worker productivity will fall if firms cut wages. But when it comes to wage cuts versus furloughs, the real question is: Which one hurts productivity more?  Can furloughs really be the better option?  Are unpaid vacations better for productivity than lower-paid workers?  I'm glad to hear of evidence to the contrary but count me among the skeptical. 

Perhaps wage cuts for federal workers aren't legal: Perhaps Congress would have to pass a law to permit wage cuts instead of furloughs. In that case, I'd expect the Senate or the President to block any attempt to convert furloughs to wage cuts.  Furloughs are a great way to hold the recipients of government services hostage (e.g., 90 minute TSA delays) and hence a great way to end the sequester.  But if legal barriers aren't an issue to pure and simple wage cuts, that should be the first line of response to the sequester. 

Coda: Same story applies to government contracts: Now's a great time to get a Joint Strike Fighter for 20% less!  And those who think that deal isn't on the table should wonder whether that means that there's less slack in the economy than they thought....

P.S. I didn't say "across the board wage cuts."  No reason not to be judicious....


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CATEGORIES: Fiscal Policy , Labor Market



COMMENTS (26 to date)
Perhaps wage cuts for federal workers aren't legal: Perhaps Congress would have to pass a law to permit wage cuts instead of furloughs.

Bingo. Even legislation probably offers no (short term) solution, as most of the workers are covered by union contracts.

Chuck Currie writes:

Typical government response - police, fire fighters and teachers are the usually hostages.

The funny thing is is government services are so poor now, who would actually notice if they got a little worse?

Life goes on, even in Detroit.

Cheers

jc writes:

Even in the absence of laws or unions...

If workers think wage cuts are worse than furloughs, might they react accordingly, i.e., would morale fall less when a bad thing happens to you (furlough) than when a worse thing happens (wage cut)?

Furloughs have this air of temporariness. And at least you get vacation time. (While many are angry, I know some who are ok getting furloughed; they value this time off.) Wage cuts, meanwhile, seem more permanent, w/ no newfound leisure to offset former monetary compensation.

Prospect theory/endowment effects suggest that we feel like those wages are ours; take them away and we react, perhaps more harshly than rational analysis suggests we should. Temporarily *trade* some of our wages for vacation time, though, and it feels like less of a straight up loss, and perhaps short-circuits extreme reactions?

So perhaps firms think the (even) lower morale from wage cuts is worse for productivity than the loss of worker input while folks are on furlough?

Garett Jones writes:

Patrick, can't those contracts by abrogated by law as well?

I'm no labor lawyer, but I'd suspect that in any case federal union law has some kind of vague "time of national necessity" language making the contract breakable whenever the federal government wants to break it even *without* a law.

Finally, let's add this to "questions I wish I knew the answer to": When does a collective bargaining contract create a legally enforceable quasi-property right, one that can't be revoked by statute?

Daniel Kuehn writes:

It's not about sound macroeconomics (we wouldn't be talking about sequester at all if that were the case) - it's about public choice theory. The sequester - once widely recognized as stupid policy - is now being embraced to attract a certain type of voter. You don't attract that type of voter by cost effective strategies - you attract that type of voter by taking a big indiscriminate swipe at government.

What frustrates me the most is that the things that are actually a problem in the budget - direct war spending and entitlements - aren't even covered by this.

david writes:

Someone once said: workers mostly build organizational capital, not final output.

Which implies that, at least when it comes to nailing that organizational capital to your organization, keeping turnover nailed to the floor is a priority.

David R. Henderson writes:

@Garett,
Excellent post. Also, don't miss jc's point above: one advantage to workers of furloughs is that they get time off. That's better for them than a comparable percentage wage cut any day. And, like Patrick R. Sullivan above, I'm virtually positive that they can't abrogate union contracts.

Thomas DeMeo writes:

This is about workers and organizations each bearing the proper risk for their roles.

Wage prices should be a reflection the value of that worker's efforts in the context of the overall labor market, not the individual firm.

If management comes to me and says our organization is having financial difficulty; we want to cut your wages, they are really trying to shift the overall financial risk of the organization to me, and in only one direction.

For the incentives to work properly, the organization should retain this risk, not the workers. If the organization is failing, it should purchase less of the work, but the wage should be based on the broader market.

Garett Jones writes:

david: Great point! Hence the need for discriminate cuts in wages.

David: Thanks! I think the wise push for wonks would be a legal change permitting wage cuts....if impossible this time, then change it now for next time. And the issue of whether furloughs are worse for *annual* output than wage cuts is still an open question....I suspect furloughs are better for *hourly* on the job output....

dk: true enough, but ex-ante it was likely prudent for government employees to rule out wage cuts ...makes a sequester less endurable....

david writes:

But then you can't easily fire grumpy workers en masse to replace them!

Chuck Currie writes:

david: Wrote

But then you can't easily fire grumpy workers en masse to replace them!

It wouldn't take many before the rest caught on and amended their attitude.

Cheers

Chuck Currie writes:

However, with regards to my last, the days of truly "at will" employment (at least from the employer's side) are long gone. You can quit, any day, any time, for any reason with out suffering any consequences. Firing an employee is an altogether different matter, unless they killed the CEO, and that doesn't necessarily apply to public employees (remember when we called them "civil servants" - those were the days), teachers are a good example. You have to have legitimate, business relative reasons. They have to have been on going and well documented, and the employee must have been counseled and confirmed the actions taken. This takes a long time and is not always sufficient to withstand challenge.

One tactic is to eliminate their position, but then you have to do without until a sufficient amount of time has passed and then you can create a similar, but slightly different, position.

Or, you can have a "reduction in force", but, once again, you have to do without.

So basically, you're stuck with the deadwood.

Cheers

Tom West writes:

But then you can't easily fire grumpy workers en masse to replace them!

It wouldn't take many before the rest caught on and amended their attitude.

The beatings will continue until morale improves!

More seriously, I know of no organization employing skilled labor that can survive its employees doing the absolute least they can get away with. If the large majority of employees aren't at least minimally onside with management (through their personal sense of professionalism and accomplishment if genuine enthusiasm is lacking), then that organization is, in my experience, doomed.

Chuck Currie writes:

Tom West: Robotics

Chuck Currie writes:

...and let's remember, we're talking about civil servants...not one of which is irreplaceable...think air traffic controllers circa 1981.

And what business wouldn't love fewer inspection and interferences from bureaucratic nabobs. Likely lead to an uptick in the economy.

Cheers

MingoV writes:
Wouldn't the sound response--especially in a weak job market, where job options are allegedly rare--be to cut back wages and tell everyone to show up ready to work on Monday?
That would be true if none of the employees were in a union or had contracts with guaranteed pay. In those situations, the only viable options may be forced reductions in work days for all employees or termination of some employees. (Given the staffing bloat of the federal government, I would prefer the latter. However, the management fights over who gets the ax would last for months.)
Steven Flaeck writes:

Government agencies often (always?) have predetermined contingency plans for natural disasters which specify the priority of workers in terms of essential operations. The simplest reason to issue furloughs is that it can be handled in the same manner, by the same process, and under the same scheme as a blizzard or facilities fire which would trigger the contingency plan.

It is the simplest thing to do. Wage cuts would make no sense unless you were certain that budget cuts would hold; doing so would require shifting resources to determining, negotiating, and implementing wage cuts. Best, then, to put that off until you are certain it is necessary, using furloughs to meet your budget in the meantime.

Jim Rose writes:

Alchian (1969) lists three ways to adjust to unanticipated demand fluctuations:
• output adjustments;
• wage and price adjustments; and
• Inventories and queues (including reservations).

Alchian (1969) suggests that there is no reason for wage and price changes to be used regardless of the relative cost of these other options:
• The cost of output adjustment stems from the fact that marginal costs rise with output;
• The cost of price adjustment arises because uncertain prices and wages induce costly search by buyers and sellers seeking the best offer; and
• The third method of adjustment has holding and queuing costs.

There is a tendency for unpredicted price and wage changes to induce costly additional search. Long-term contracts including implicit contracts arise to share risks and curb opportunism over relationship-specific capital.

These factors lead to queues, unemployment, spare capacity, layoffs, shortages, inventories and non-price rationing in conjunction with wage stability.

Alchian and Woodward’s 1987 'Reflections on a theory of the firm' says:

“… the notion of a quickly equilibrating market price is baffling save in a very few markets.

Imagine an employer and an employee. Will they renegotiate price every hour, or with every perceived change in circumstances?

If the employee is a waiter in a restaurant, would the waiter’s wage be renegotiated with every new customer? Would it be renegotiated to zero when no customers are present, and then back to a high level that would extract the entire customer value when a queue appears?

… But what is the right interval for renegotiation or change in price? The usual answer ‘as soon as demand or supply changes’ is uninformative.”

Alchian and Woodward then go on to a long discussion of the role of protecting composite quasi-rents from dependent resources as the decider of the timing of wage and price revisions.

Alchian and Woodward explain unemployment as a side-effect of the purpose of wage and price rigidity, which is the prevention of hold-ups over dependent assets.

They note that unemployment cannot be understood until an adequate theory of the firm explains the type of contracts the members of a firm make with one another.

Benjamin Klein’s theory of rigid wages in American Economic Review in 1984 is one of the few that explored rigid wages as an industrial organisation issue.

Klein treated rigid wages as a response to opportunism and hold-up problems over specialised assets and are forms of exclusive dealership or take-or-pay contracts.

Gayle writes:

"For the incentives to work properly, the organization should retain this [overall financial] risk, not the workers. If the organization is failing, it should purchase less of the work, but the wage should be based on the broader market."

The overall financial risk to the organization applies to the workers as well. First, because one of the highest costs, if not the highest cost, of business is wages. Second, because if the organization fails, the workers become unemployed.

Thomas DeMeo writes:

Gayle- "The overall financial risk to the organization applies to the workers as well. First, because one of the highest costs, if not the highest cost, of business is wages. Second, because if the organization fails, the workers become unemployed."

If wages are in equilibrium with the broader market, and an organization still fails, who is really responsible? Who is making the relevant decisions? In the case of the government, do you really want to make it even easier for Congress to screw up?

Hal Anderson writes:

Another reason the workers may prefer this is money illusion. Study after study has shown that workers think in terms of nominal wages. Firms, on the other hand, think in term of real wages.

So, let's say there's a pay cut now and in a year the crisis is somehow deemed to be "over." Will the employer restore wages to keep them on the previous nominal trend or to keep them on the real wage trend? I bet it would be the latter.

If the workers accept the pay-cut model, they run the risk of a later loss of nominal wages. If they accept the furlough, on the other hand, they ensure that their nominal wages are still on trend, much to the chagrin of their real wages.

Just a thought-

Jim Rose writes:

Hal Anderson, Alchian and Kessel in the early 1960s tested the hypothesis that workers suffered from money illusion by comparing the rates of return to firms in capital intensive industries with those of labour intensive industries.

In Canadian industries in the 1960s and 1970s, wage indexation ranged from zero to nearly 100%.

Under your Keynesian model, industries with little indexation should show substantial responses of real wage rates, employment and output to nominal shocks. Industries with lots of indexation would be affected little by nominal disturbances.

Monetary shocks had positive effects but an industry’s response to these shocks bore no relation to the amount of indexation in the industry. Those with lots of indexation were as likely as those with little indexation to respond to shocks.

If the signing of new wage contracts was important to wage rigidity, there should be unusual behaviour of employment and real wage rates just after these signings, but the results are mixed.

Olivei and Tenreyro used the tendency of contracts to be signed at the start of years to show that monetary policy had significant effects in January but little effect in December because the effects were quickly undone.

HT: Robert Barro

Working for the government and in government contracting, I am not sure budget cuts would transfer to discounts in contracts. Certainly not cut contracts where the money is already obligated.

Also, the government uses unpaid leave precisely because once a budget is passed, they like to pay back all those workers for all that time not worked as if the workers worked the entire time. Free vacation. That is how the government works.

Tee Toe writes:

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Peter writes:

@Steven Flaeck:

A man after my own heart but the problem with that is you would be amazed how many people are defined as essential. I know within the Weather Service for example, because they didn't want to fight with the union, the last government shutdown designated EVERYBODY INCLUDING THE SECRETARY AND JANITOR as emergency essential once you got out of the beltway (they had to furlough some beltway management types to keep up appearances). And if you to hold people to their COOP planning as written you would be amazed how fast the government could move to re-write them all to include those same secretaries and janitors.

Politics is the real reason here and I think we all understand it. This is captured well here:

http://boardingarea.com/blogs/viewfromthewing/2013/02/22/is-the-faa-talking-themselves-into-inconveniencing-travelers-as-part-of-the-budget-showdown/

Though you could substitute FAA for any agency.

PS: I also agree that the practical, but real difference, between a furlough and a pay cut is the temporary nature, key partial federal pay freeze (congress and military exempt) the last couple years. It's much easier politically to back pay people for a furlough once the budget passes (like in the 90's) than give retroactive pay increase of 20%.

Charlie Weesner writes:

There's a question of training, I would think. I don't think I can substititute for the TSA worker until I at least learn to interpret the X-Ray images.

I don't know how long this delay feeds into the labor market, but there must be a lag in exchanging workers, not to mention the idea that we pay people while they are being trained.

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