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Why Don't Wages Fall During a Recession?: Q&A With Me Channeling Truman Bewley

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Weekend Wall Street Journal... The Men and Women of the Moral...
I finally got around to reading Truman Bewley's Why Wages Don't Fall During a Recession cover-to-cover.  The book is a miracle - easily one of the five best empirical economics books I've ever read, and possibly the best of the best.  First published in 1999, the book builds on Bewley's interviews with over 300 employers, labor leaders, unemployment counselors, and business consultants during the mild recession of the early 1990s.  Everyone he interviewed had ample first-hand experience with real-world employment and compensation decisions.  The purpose of these conversations: To evaluate a wide range of labor economists' theories in light of practitioners' testimony.

What's so great about the book?

1. Bewley's empirical approach is vastly more convincing and probative than mere econometrics on conventional data.  Conventional data tell us that nominal wages rarely fall, especially for a single worker on a single job.  But if you want to know why, the best approach is to ask people with extensive wage-setting experience.  That's just what he does.

2. Bewley scrupulously avoids leading his witnesses.  He's a fantastic listener who goes out of his way to let his subjects describe their own behavior in their own words.  When he discovers that his working assumptions are wrong he cheerfully admits it.  This happens repeatedly; you can tell that the author intellectually grew as a direct consequence of his own research.

3. Bewley self-consciously tests a wide range of economic theories.  After his subjects have their say on a topic, he presents a series of economic theories for their consideration.  In each case, he strives to "translate" formal models into ordinary English, and records their reactions.

4. Bewley's organized and thorough.  He interviews on a wide range of topics.  Some, at first blush, are out of left field.  There's a whole chapter on severance pay, for example.  But if you give him half a chance, he elegantly motivates each topic.  Once you understand implicit contracts theory, for example, the low level of severance pay is suddenly a major puzzle in need of a solution.

5. Bewley maintains a consistently gentlemanly tone.  While his conclusions are clearly Keynesian, he treats skeptics with respect.  In fact, he unflinchingly grants the logic of the skeptics' doubts, and strives to methodically satisfy them doubt-by-doubt.

6. Most importantly, Bewley successfully answers not only the title question of his book, but scores of follow-up questions.  While I was sympathetic to his basic answer before I started the book, he made me appreciate several layers of complexity I'd previously missed.  In each case, he managed to elegantly resolve the very complexities he raised.

The best way to appreciate Bewley's answers is a Q&A format.  All the following words are mine, but I think he'd accept my write-up as a fair representation of his project.

Question: Don't wages fall all the time?

Answer:
Real wages fall all the time, and nominal wages often fall when workers change jobs.  But nominal wages hardly ever fall for a given worker at a given job - even when there's massive excess supply of qualified labor.

Question: OK, so why don't nominal wages fall for given workers at given jobs?

Answer:
Because almost all employers realize that nominal wage cuts are terrible for morale - and bad morale is bad for worker productivity. 

Question: Why don't they cut wages, then fire workers who slack off?

Answer:
Because labor productivity heavily depends on trust and reciprocity.  Firing can deter specific offenses, but can't make workers broadly promote their employers' interests.  Plus productivity is much easier to observe at the group level than the individual level.

Question: Why don't employers just cut wages for new hires, then?  Do new low-paid workers really have bad morale?  Do old workers really resent new low-paid co-workers?

Answer:
Initially, there's no morale problem at all.  New workers are thrilled to land a job, even if the pay is low.  Old workers only resent new workers if the newbies outearn them.  The problems start once the new workers realize they're paid less than their co-workers for doing the same job.  After 3-4 months, this leads to bad morale for new hires.  The new hires' resentment then poisons old workers' morale as well.

Question: So why not just fire all the old workers and replace them with new workers?  Wouldn't this neutralize the resentment?

Answer:
Yes, but it would be very expensive to retrain a whole workforce from scratch.  Plus employers worry this would give them a reputation as a bad employer and bad corporate citizen.

Question: So a few years worth of mild inflation would solve the problem?

Answer:
I'm afraid not.  Even during recessions, most employers keep giving their current workers nominal raises.

Question: Why?

Answer:
Failing to give raises hurts morale, too.  Not as drastically as a nominal pay cut would, of course.  But a firm that failed to give raises for three years in a row would spark resentment - and productivity would suffer.

Question: Can't firms at least create a two-tier wage system: Raises for existing employees, flat hiring pay for new employees?

Answer:
Some have tried, especially during the 1980s.  But bad morale keeps raising its ugly head.  New workers are happy at first, but resentment of pay inequity kicks in after a few months. 

Question: Hold on.  Workers don't seem to deeply resent earning less than their CEO, do they?

Answer:
Not really.  Most resentment comes from lack of "internal horizontal pay equity."  If two people in the same firm do the same job, people expect their pay to be roughly equal.  Other pay inequalities are tolerable unless they're extreme or change quickly.

Question: Can the job market really be that monolithic?

Answer:
There is a major exception: the "secondary" labor market.  Part-time work, seasonal work, consulting, that sort of thing.

Question: How does the secondary labor market differ from the rest of the labor market?

Answer:
In the secondary labor labor market, workers don't know each other well enough to compare their pay.  Furthermore, workers in this market rarely base their self-esteem on their careers, so they don't fret much about pay inequities if they discover them.

Question: So nominal wages do fall in the secondary market?

Answer:
Not for the same worker for the same job.  But in the secondary labor market, employers often cut nominal wages for new hires.  In fact, some employers in the secondary market deliberately prod their longer-time, higher-paid workers to quit so they can replace them with new, low-paid workers.  They freely confessed it.

Question: Workers seem to prefer a small risk of unemployment to a large chance of a nominal wage cut.  Who are you to second-guess their utility function?

Answer:
Everyone with first-hand experience said that lay-offs are devastating for workers - financially and otherwise.  Pay cuts, in contrast, mostly just wound workers' pride.  That's why workers react so much more negatively to nominal pay cuts than real pay cuts.

Question: You're still being pretty paternalistic, aren't you?

Answer:
Employers often openly compared their workers to children.  I suspect they're on to something. [Disclaimer: Bewley is probably too gentlemanly to actually say this, but it's very consistent with his findings.]

Question: OK, what happens when employers go ahead and cut nominal wages despite the expected morale problems?

Answer:
It's hard to say with much confidence because nominal wage cuts are very rare.  I deliberately sought out firms that cut nominal pay, and found two very different patterns.

Question: Namely?

Answer:
Firms in blatant financial distress found that pay cuts worked as long as they clearly explained the situation to their workers.  Otherwise, pay cuts failed from employers' own point of view.

Question: Do pay cuts cause any additional problems besides bad morale?

Answer:
Yes.  Employers expect their best workers to leave first.  With lay-offs, in contrast, employers make their worst workers leave first.  (Exception: Unionized firms usually lay-off on the basis of seniority, not productivity).

Question: Doesn't this suggest that the better-paid employees were underpaid?

Answer:
Absolutely.  Internal horizontal pay equity norms depress pay for good workers and inflate pay for bad workers.

Question: I'm confused.  Don't lay-offs hurt morale, too?

Answer:
Yes, but the damage is relatively short-lived.  Wage cuts keep misery close to home. Lay-offs "get misery out the door." 

Question: Is that the whole story?

Answer:
No.  Lay-offs are bad for morale if they drag on, or if workers see no light at the end of the tunnel.  But a big quick wave of lay-offs, followed by reassurances of job security for everyone remaining, only hurts morale for a few weeks or months.  Many employers sweeten the deal by using the cost savings of lay-offs to fund raises for remaining workers!

Question: So human psychology, not government intervention, is the sole cause of unemployment?

Answer:
That's too strong.  Employers of low-skilled workers often cite the minimum wage and transfer payments as important factors.  For skilled workers, though, government policy isn't very relevant.

Question:
Bottom line: All we need to do to end the scourge of involuntary unemployment is replace human workers with Vulcans?

Answer:
Maybe.  I deliberately bypass this high-level macroeconomic question to focus on easier-to-answer micro questions.  But none of my evidence contradicts the view that involuntary unemployment would disappear if the workers of the world had a more mature attitude. 



COMMENTS (21 to date)
edarniw writes:

Neat post. Does Bewley address the suggestion that our unwillingness to take nominal wage cuts might be tied to an environment of steady, albeit low, inflation?

I have trouble imagining that attitudes would be the same in a world where the price level doesn't change over the course of 100 years. I suppose someone has looked into nominal wage cuts during the 19th century?

Jim Rose writes:

salary and conditions cuts are common in recessions in the labour markets where I work! Three countries in all. intensification of work in recessions is even more common!

another round of salary and conditions cuts is about to happen in canberra after the merger of government departments.

Jim Rose writes:

reducing wages for new hires is common too.

Jim Rose writes:

see What can wages and employment tell us about the UK's productivity puzzle? by Richard Blundell, Claire Crawford and Wenchao Jin at http://www.ifs.org.uk/publications/6749 showing that in the Uk recession 12% of employees in the same job as 12 months ago experienced wage freezes and 21% of workers in the same job as 12 months ago experienced wage cuts. Their data covered 80% of all workers in the New Earnings Survey Panel Dataset.

Larger firms tended to lay off workers while smaller firms have tended to reduce wages

Tom West writes:

My brother alerted me to an interesting phenomena. Companies that look for troubled companies and deliberately poach the employees left after severe layoffs.

The idea is that only the best are left after severe lay-offs, and they're the ones most worth hiring. As well, just after severe lay-offs, morale is usually low and questions about the company's future are foremost in employee's minds.

Of course, the employees being poached are also usually critical for the company, so it's not at all unusual for the poaching to collapse the troubled company.

Talk about circling vultures...

Glen Smith writes:

@Jim Rose

I suspect much of the reducing of new employee wages is indirect. For example, hiring a new employee for a less demanding role and then asking him/her to do much more than originally agreed upon. I also see this happening to old employees via layoffs where the workforce is reduced but the work requirements aren't.

I know that most of my fixed obligations are paid at a nominal rate and won't change based on inflation (alternatives to reduce those obligations may disappear). Given that the employee's profit is basically what he/she earns AFTER those obligations are met, decreasing nominal wages actually would damage the employee's real profit by more than a fall in his/her real wage.

Floccina writes:
Question: Doesn't this suggest that the better-paid employees were underpaid?

Answer: Absolutely. Internal horizontal pay equity norms depress pay for good workers and inflate pay for bad workers.

Back when I was a manager in restaurants I noticed that for example some dish washers would do 2 or 3 times as much work as others but they were never paid much more rather, they might be promoted to cook or in one case given management duty over the other dish washers with higher pay. That puzzled me. It seems inefficient, it is one of the reasons that I think a higher minimum wage would not help all workers but cause some shuffling around as better workers would take some jobs and the worse workers loosing their jobs quicker. So the wage goes up but for different better workers.

Eli writes:

Would a smart lay-reader find the book valuable?

Philippe writes:

Some Further Comments on Nominal Wage Flexibility:

"Tyler Cowan thinks that we should cut the minimum wage, and links to Bryan Caplan for an explanation. And Caplan thinks that it's all quite elementary:

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

Let's take this step by step. First, consider the claim that cutting wages increases the quantity of labor demanded. Through what mechanism does this occur? Consider a firm (McDonald's, say) that can now pay its workers less. It will certainly do so. But will it increase the size of its workforce? Not unless it can sell more burgers and fries. Otherwise its newly expanded workforce will produce a surplus of happy meals that will (unhappily) remain unsold. And this will not only waste the expense of hiring and training new workers, it will also waste significant quantities of meat, potatoes and cooking oil. So the firm will make do with its existing workforce until it sees an uptick in demand. And no cut in the minimum wage will automatically provide such an increase in demand. As a result, the immediate effect of a cut in the minimum wage will be a decline in total labor income.
Employer income, of course, will rise. Some of this will be spent on consumption, but less than would have been spent if the same income had been received by low wage earners. The net effect here is lower aggregate demand. But wait, what will happen to the remainder of the increase in employer income? It will not be placed under mattresses, on this point I agree with Caplan. It will be used to accumulate assets. If these are bonds, then long rates will decline, and this might induce increases in private investment. Then again, it might not, unless firms believe that additions to productive capacity will be utilized. And right now they do not: private investment is not being held down by high rates of interest on long-term debt.
Finally, what if employers use the unspent portion of their augmented income to buy shares? We would have a run up in stock prices not unlike that we have seen in recent months. Note that this would not be a speculative bubble: the higher prices would be warranted given that firms have lower labor costs. But would this asset price appreciation stimulate private investment in capital goods? Again, not unless the additional capacity is expected to be utilized.
Mark Thoma has more on this, as does Paul Krugman. I discussed the opposing views of Becker and Tobin in an earlier post. What I cannot understand is why people of considerable intelligence persist in conducting a partial equilibrium Walrasian analysis of the labor market, as if we were dealing with the market for oranges. Please stop it."

http://rajivsethi.blogspot.co.uk/2009/12/some-further-comments-on-nominal-wage.html

Mike Rulle writes:

This is a very interesting post. Having worked in large corporate and small business environments at all levels, Bewley's Q&As are synchronous with my own experience. Its great this study was done---but the answers are almost obvious if one has worked in business.

One question would be if it was possible to check their subjective opinions of what they were doing versus what they actually did. But I suspect he captured reality.

I do find the "more mature attitude" comment either naïve or unrealistic. Not quite sure what it means. It suggests, as you say, a "Vulcan" attitude would be more mature. Except, of course, Vulcans were imagined creatures portrayed with great contradictions in a 3 year old 60s TV show.

Vulcans do not exist. :-)

Keith K. writes:

What about historically?

It seems to me rather narrow to focus only on one period of recession to really get an idea of how this works.

Did this happen the same way (for example) during the 1920-21 depression?

I feel like the notion that wages are self-stabilizing with the employment level is much more correct when nothing else is out of the ordinary. But we live in an era of basically central planning of the money supply and all those resultant effects.

If we were to go back to a gold standard (where we'd have long-term deflation instead of inflation), would we not expect the idea of wage decreases to be much more common and palatable? What were worker attitudes during pay cuts back when we actually had sound money?

Pete T writes:

I'd be interested to know what result, if any, there would be on employee morale after a pay cut if management made it public that they were taking a bigger haircut than the employees. Seems to me that a lot of employees would be OK with getting paid less as long as it was obvious everyone in the company was sharing the pain. Instead, we see lots of instances where employees are laid off while management gets raises. This isn't addressed in your questions. Is it addressed in the book?

Andrew writes:
Employers often openly compared their workers to children. I suspect they're on to something. [Disclaimer: Bewley is probably too gentlemanly to actually say this, but it's very consistent with his findings.

To be fair, many employees treat their employers as parents. Always there to tell them what not to do and supposed to bail them out.

Philippe writes:

"none of my evidence contradicts the view that involuntary unemployment would disappear if the workers of the world had a more mature attitude."

What Bryan Caplan is basically saying here is that incentives shouldn't matter.

He's saying that people should work just as hard for lower wages. Their behaviour should not change in response to changed incentives. Morale shouldn't change. Incentives shouldn't matter.

This position completely contradicts his other arguments.

This obvious inconsistency should help to illuminate the fact that Caplan's views on this subject are fundamentally biased and ideological in nature.

MingoV writes:

I have a hard time understanding why a non-Keynsian economist would consider this book to be one of the best in the field. I can like a book's style, presentation, format, and tone; but if the book supports a viewpoint that scads of evidence has shown to be wrong, then I won't praise it.

Mr. Econotarian writes:

Not mentioned was what you tell your wife when you wage gets cut.

This may play a role in the "married men earn more" phenomenon....

Jim Rose writes:
Question: Can't firms at least create a two-tier wage system: Raises for existing employees, flat hiring pay for new employees?

Answer: Some have tried, especially during the 1980s. But bad morale keeps raising its ugly head. New workers are happy at first, but resentment of pay inequity kicks in after a few months.

I have been on several individual and collective agreements that grandfathered pay and conditions for existing workers and paid recruits less.

I have lost count of the number of retirement pension scheme closed to new employees since I first encountered this cost saving practice in 1981. closing workplace retirement pension schemes to new members is common in Australia.

Craig Brown writes:

What are the four other empirical economics books you'd recommend?

Jim Rose writes:
Question: OK, so why don't nominal wages fall for given workers at given jobs?

Answer: Because almost all employers realize that nominal wage cuts are terrible for morale - and bad morale is bad for worker productivity.


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 to the 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 a theory of the firm explains the type of contracts the members of a firm contract with one another.

martin spencer writes:

Interesting that the final sentence is a whine about human nature "workers should be more mature". Shouldn't we deal with the world as it is? Shouldn't the system work on the assumption that workers will be immature.

Why wouldn't employers give the workers a vote. Either we can sack X workers or we can give everyone a Y% wage cut. I suspect that they will often vote for wage cuts and morale will be fine.

Of course, collective employee ownership would solve the problem once and for all.

Jim Rose writes:
Question: How does the secondary labor market differ from the rest of the labor market?

Answer: In the secondary labor labor market, workers don't know each other well enough to compare their pay. Furthermore, workers in this market rarely base their self-esteem on their careers, so they don't fret much about pay inequities if they discover them.

bewley has never been to a union meeting, a living wage rally or the pub on payday

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