Scott Sumner  

Sticky wage model test: The results are in

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In October 2009, the US unemployment rate peaked at 10%. By January 2012, it was down to 8.3%. But in January 2013 it was still 8.0%. (And "austerity" was about to be implemented.) It was during this period that a lot of doubts were raised about the sticky-wage model (perhaps with some justification.) Other factors such as sharply higher minimum wage rates and 99 week unemployment insurance probably also played a role.

I saw one persistent line of criticism, and two alternative hypotheses. The persistent criticism (especially from the right) was that it didn't seem plausible that wages would be sticky for so long. You'd think that by the time 3 or 4 years had gone by, wages would have adjusted. I responded by pointing to the zero lower bound problem on nominal wage growth (money illusion) and also that NGDP growth was unusually low in the recovery, so the US was continually being hit by (modest) negative demand shocks. We were seeing 4% NGDP growth, not the 11% of the first 6 quarters of the Reagan recovery. Money was effectively "tight".

The two alternative hypotheses were as follows:

1. We are moving toward a permanent condition of higher unemployment, as technology makes many low-skilled workers unemployable. Especially low skilled men who (culturally) aren't suited for office work.

2. The Obama administration was creating all sorts of disincentives to employment, such as Obamacare.

In contrast, I claimed that sticky wages were still the main problem (while guesstimating that perhaps 0.5 percentage points of unemployment was due to extended UI benefits.) I suggested that there was a lot of ruin in a nation, and that employment soared under LBJ's highly interventionist big government "Great Society" programs (although arguably their long run effects were more negative.)

Over business cycle frequencies, I still think it's NGDP growth and sticky wages that drives the unemployment rate. (I call this the "musical chairs model"). What can we say today about the sticky wage model debate of 2012-13? Here's what we can say:

Fed's estimate of natural rate of unemployment = 5.0% to 5.2%

Actual (U3) unemployment rate in August, 2015 = 5.1%

Objections?

1. No, you cannot point to hidden unemployment or part timers, or U6, as the sticky wage skeptics were specifically claiming that U3 was high due to factors other that sticky wages.

2. Yes, unemployment could have fallen for other reasons--I believe Casey Mulligan has looked at some real factors that might explain movements in unemployment.

But suppose unemployment was still at 8%, despite 3 more years of 4% NGDP growth. Even I would have had to throw in the towel. After all, I consistently predicted that unemployment would continue falling if we had even halfway decent NGDP growth. And we know from Europe (post-1970s) that it's quite possible for unemployment to rise sharply and then get stuck at 8% or 10%. So here is one point I'd insist on:

Suppose both sides of the debate over theory A believe that outcome B would tend to discredit that theory. And suppose opponents of theory A think outcome B is quite plausible (but not certain.) Then if outcome B does not occur, that provides one significant data point in favor of theory A.

Here's an analogy. I've predicted 6% Chinese growth. If it comes in at 0%, then I'm wrong. Full stop. If it comes in at 6.2% or 5.9%, I still might be wrong, as the Chinese government might be faking the data. But it's beyond dispute that 6.2% is better for my prediction than 0%.

The sticky wage model successfully dodged a bullet:

Nothing in life is so exhilarating as to be shot at without result.

Winston Churchill


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COMMENTS (12 to date)
Philip George writes:

"We were seeing 4% NGDP growth, not the 11% of the first 6 quarters of the Reagan recovery."

There's a very simple explanation for this. The Reagan recovery did not follow an asset market crash. In contrast, the average US family lost more than a decade of accumulated saving (or net worth) in the asset market crashes of 2008. To recover that decade of lost saving they would have to double (or substantially raise) their saving rate for a decade. The result is of course a reduction in aggregate demand, but the cause is not, as Keynes thought, a reduction in investment demand.

It is for this reason that recoveries following asset market crashes are long-drawn-out.

Assume I have a factory employing ten workers operating ten lathes and producing 100 units of output. If demand falls to 90 units (as a result of the compression in aggregate demand) I have two options. I can sack one worker (probably the least productive) and pay the remaining their old wages. Or I can reduce the length of the working day and pay each of the 10 workers nine-tenths of his old wage. It seems to me that the first option is more efficient. So where do sticky wages come in? My profits remain the same in either option.

Glen W Smith writes:

Not sure what you mean by low-skilled. Do you mean something like an average software engineer as opposed to a top 5% one or something else? I know automation actually hurts the mid-level and even the highly skilled worker. Much of the low-skilled work is hard to automate but high-skilled work is often relatively easy to automate.

Scott Sumner writes:

Philip, No, the recovery was slower because monetary policy was tighter in 2008-15. The financial crisis was partly caused by the tight money. For instance, the recovery after March 1933 was quite rapid, despite a severe financial crisis.

Your example with the worker uses real GDP, whereas AD is a nominal concept. If nominal spending falls by 10%, you get lots of unemployment with sticky wages, but much less if hourly wages also fall by 10%.

Glen, No I don't mean software engineers, I mean men who didn't go to college, and didn't learn a specific trade like plumbing or electrical work.

baconbacon writes:
No, you cannot point to hidden unemployment or part timers, or U6, as the sticky wage skeptics were specifically claiming that U3 was high due to factors other that sticky wages.

So between disability rolls, lower lfpr and lower net immigration the US has 8-12 million fewer jobs than would have been expected from a (simplistic) view of the country in 2006/2007- these trends aren't worth discussing? Or the fact that people leaving the workforce is the exact opposite result that you would expect from a sticky wage scenario being resolved, is that why you don't want to discuss it?

Daublin writes:

I don't see how the new employer mandate for health care could do anything but lower employment. I'd be very interested in any serious economist who can string together a plausible scenario to the contrary.

Unless the mandate is so weak that it doesn't really affect anyone, it's going to drop a rung or two from the bottom of the job ladder. That's what it's designed to do: it's a large increase in minimum compensation. I don't see how such a change could leave employment untouched, at least if we choose labor force participation as the employment metric.

There are people who had jobs in 2005 that do not have the skills to pull a 40k+ kind of job that is required by the employer mandate. Those people either don't have jobs now or have switched to part time.

Scott Sumner writes:

bacon, You said:

"So between disability rolls, lower lfpr and lower net immigration the US has 8-12 million fewer jobs than would have been expected from a (simplistic) view of the country in 2006/2007- these trends aren't worth discussing?"

Yes they are! I recommend reading Kevin Erdmann, who's done some great research on that topic. But it has nothing to do with the topic being discussed here, which was predictions about how U3 would evolve over time.

The sticky wage model is about the effect of demand shocks, and those are supply shocks.

It's not enough for someone to say "I predicted some bad stuff would happen, and some bad stuff happened." Precisely what bad stuff?

Daublin, You said:

"I don't see how the new employer mandate for health care could do anything but lower employment. I'd be very interested in any serious economist who can string together a plausible scenario to the contrary."

I completely agree.

John Hayes writes:

Daublin,

The mandate as implemented probably won't cause too big a drop because employers will convert employees to part time to avoid it or otherwise deflate effective wages. However, the phase-out of subsidy on the mandatory health insurance is a large marginal tax.

Looking at the MAGI incoming range 20-75k, which represents about 50% of tax returns, it's an additional 15% tax on marginal income. This doesn't count the transition from Medicaid to a silver plan, which is expected to cover 70% of expenses.


Income (MAGI) Subsidy/Year Marginal Tax Rate
$20,000.00 $6,432.00
$25,000.00 $6,324.00 2%
$30,000.00 $5,604.00 14%
$35,000.00 $4,980.00 12%
$40,000.00 $4,260.00 14%
$45,000.00 $3,540.00 14%
$50,000.00 $2,736.00 16%
$55,000.00 $1,920.00 16%
$60,000.00 $1,092.00 17%
$65,000.00 $612.00 10%
$70,000.00 $132.00 10%
$75,000.00 $- 3%


If you add other programs like EITC, the marginal tax in the middle quintiles of income levels is getting steeper. Should the theory really be sticky take home pay instead of sticky wages?

Sina Motamedi writes:

Scott, are you suggesting that price stickiness can also be caused by things other than money illusion?

baconbacon writes:

Scott-

I'm already a follow/commenter of idiosyncraticwhisk.blogspot.com.

The sticky wages story makes specific predictions about LFPR because LFPR is defined by those who want jobs and think that the prevailing wage is acceptable. Any SW model must either have an increase in the LFPR or an explanation as to why those outside of the labor force aren't subject to the money illusion.

What you have to reconcile in the current situation is that LFPR has been falling for 6 years. This is not a demographic problem as LFPR for 25-54 year olds is also still falling as of the most recent data.

Textbook macro says that those outside of the labor force have a reservation wage higher than the market wage- sticky wages supposes that nominal wage increases fool workers into thinking their reservation wages have been met. It would require extremely strong evidence to suppose that those not just already outside of the labor force, but those that were in the labor force in 2008-2014, would not respond to nominal wage increases but those in the labor force would.

And to clarify about hidden UE- the LFPR for 25-54 year olds has dropped more than 2.5 percentage points and disability applications have been on average ~ 600,000 per year higher from 2009-2014 than they were from 2004-2008 (total of 3.6 million more than expected- on a lower baseline LFPR!). Just taking extra accepted disability claims + the decline in LFPR for 25-54 year olds could constitute well over 50% of the decline in U3 since its peak.

Dustin writes:

Is the gist of this post that the sticky wage model is consistent the path unemployment since the recession? More generally, that the effects of sticky wages can take several years to be resolved in an environment of low NGDP growth and tight money?

LK Beland writes:

One quick point about wage and price stickiness lasting more than a few years.

Debt contracts are typically set in nominal terms and often last more than a few years. In my opinion, it is obvious that this has a sizable effect on prices and employment when NGDP is hit. From what I gather, these effects are relatively well documented, both theoretically and empirically.

baconbacon writes:
Debt contracts are typically set in nominal terms and often last more than a few years. In my opinion, it is obvious that this has a sizable effect on prices and employment when NGDP is hit. From what I gather, these effects are relatively well documented, both theoretically and empirically.

This doesn't explain why wages would be sticky though. In fact it suggests the opposite, that firms will never bend first in raising wages. There will be fewer instances of companies paying more and less support for workers looking for higher wages.

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