Do Nominal Wage Cuts really stabilize Demand-driven Recessions?

Effects of a wage increase

Effects of a wage increase (Photo credit: Wikipedia)

Robert Lucas suggests that most unemployment in times of crisis is actually voluntary. He substantiates his assertion by pointing to a model of the labour market where wages adjust to take into account both the supply of, and the demand for, labour. Lucas’s model helps to illustrate his view of what happened to the labour market during the Great Recession. The shortfall in the demand for labour causes a disequilibrium between demand and supply which creates a downward pressure on the wage rate. Employers face falling revenues, so they need to cut wage costs by an equivalent level to stabilize the production and profit base of the firms in the macro-economy. Therefore, they need to cut the nominal wages of their workers to re-equilibrate the labour market.

This theory provides a ready source of attacks against all sorts of employment security, as well as against collective bargaining, including the usual conservative bug-bears such as labour unions and labour market rigidities(of course, pesky regulations). Abolish these luxuries, say the New Classicals, and we return to growth in employment, through the magic of flexible wages. Essentially, the opportunity cost of hiring for firms decreases, and they have more incentive to employ workers.

Or, to put it more simply, when the cost of a “commodity” decreases, the quantity demanded of that commodity increases.

However, (and obviously), the reality does not bear this out. Nominal Wage Cuts do not stabilize a deflating economy. Consider a two-sector economy with no foreign or government sector. This “model economy” is staffed by workers, businesses, and crucially, a Circuitist financial sector.

(1) Imagine that this economy is hit by a massive negative leverage shock, which results in a widespread decrease in asset prices. This decreases the monetary wealth of households, and overleveraging places a liquidity constraint on them. This results in a massive decrease in consumer spending.

(2) A Keynesian Aggregate Expenditure Model would indicate that this leads to lower Business revenues as well, and therefore, businesses need to cut costs to stay afloat. The first thing businesses would reduce is business investment, as they would like to keep the focus on the reduction of existing inventories. The second thing that they would have to do, given the magnitude of the negative revenue shock, is to reduce the wage rate of currently hired workers.

(3) Now, and this is the important bit, businesses take advantage of the luxuries of the idealized economy, and manage to decrease the wages of workers they hire. This happens en masse across the macroeconomy. At this point, the labour market has adjusted to this shock, and (according to the Neo Classicals), Macroeconomic equilibrium returns as product markets equilibrate.

(4) However, there is an important intertemporal point to be made here. In scenario (1), the consumers already caused a negative demand shock with their reduced consumption(say by a factor of x), and if their wages would be cut, their consumption would likely be cut further than the original, which already caused  a severe reduction in demand, after their wages were cut. This does even take into account the disequilibrating factors of debt deflation, and of a massive decline in asset values, both of which would affect the labour market , leaving aside the original Demand shocks.

The point that I am trying to make here is that a demand-side spiral cannot be contained by a decrease in nominal wage. In fact, it is likely to make things worse, by pushing down labour demand still further, due to the loss in consumption demand. The Neoclassical picture would be more suited to a temporary reduction in the demand for labour in an individual market, such as the advent of ATM’s in the labour market for bank cashiers. However, a reduction in effective demand is neither temporary, nor in an individual market. Neoclassicals  also commit a fallacy of composition. An individual person and business might stay profitable by reducing costs to the minimum, but all businesses and consumers doing so in the aggregateThe outcome is not good for the neoclassical theory.

An example of the Keynesian phenomenon can be seen during the Great Depression. In many ways, this is a perfect natural experiment. During the Great Depression, employers did not have to rely on as many labour market rigidities as they do today. Therefore, this situation is as close as we can get to a perfectly flexible macroeconomy attacked by a major financial crisis.  If we take a look at Nominal Wage data, combined with indicators of personal consumption and investment, we can see clearly the disequilibrating impact of a demand-side debt-deflation spiral. Nominal Wages decrease, as Effective Demand decreases. This then has knock-on effects on consumption and investment, both of which experience major declines.

FRED Graph

The decline in macroeconomic variables moderates in 1932, but the correlation between nominal wage cuts and declining Aggregate Demand is plain to see. Note also that, in this analysis, I have not taken into account the factors of debt and declining wealth. A Debt Overhang or a plunge in Asset prices can set off the initial and fatal decline in demand, mentioned in step (1). However, the point stands.

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4 thoughts on “Do Nominal Wage Cuts really stabilize Demand-driven Recessions?

  1. Great stuff. It reminds me of a section in Lawrence Klein’s “Keynesian Revolution” as he hits on many of the points you make about nominal wage cuts. Interestingly enough, the Classical Economists were making the same exact argument as Lucas during the Great Depression, and they were pretty much debunked by Keynes. This really makes me wonder why Lucas was making this argument? And people who make the tired argument that Keynes assumed sticky prices and fixed nominal wages in the GT are just plain wrong.

    http://keynestoday.blogspot.com/2005/10/myth-of-keynes-and-sticky-wages.html

    People need to study their Economic history!

    • “Keynes was more savvy than this. The General Theory has at least two places where Keynes explicitly assumes flexible nominal wages. He uses flexibility of wages to show that a fall in wages may NOT lead to greater output and employment, if investment demand simultaneously drops. In the standard IS-LM and AS-AD model of modern macroeconomics what Keynes meant was that a fall in wages would no doubt lead to increased AS, but that the AD curve might fall if entrepeneurs felt that wages would continue to fall in the future.”

      I’m not even sure about this, though. as I’ve outlined above, decreasing nominal wages would just lead to less consumer demand, as the original consumer demand shock is repeated by the loss of business revenue.

  2. The possibility that nominal wage and price deflation would stabilise a demand-driven recession, and that Keynesian intervention was therefore unnecessary, was discussed at length in the 1940′s and 1950′s – the key text was Patinkin ‘Money Interest and Prices’. Patinkin argued that balanced deflation would raise demand through what was called a real-balance effect – holders of outside money (gold?) would become better off as wages and prices fell, and the increase in their demand would be enough to stabilise the economy. But in the end most economists agreed that (quite apart from the undesirability of redistributing on such a massive scale from debtors to creditors) such a process would not work in practice – since real-world firms enter into debt contracts written in nominal terms ‘the path to full employment would be paved with bankruptcies’.

    • This is very interesting. But the principle that I find will be followed is that
      “Debts that cant be paid, won’t be paid”. You are completely right to suggest that the road to full employment would be littered by bankruptcies. The mass of private debt that would be increased by wage and price deflation is far greater than the demand created by the gold-holders. It is even unlikely that these people would stimulate the economy. This is for three reasons.

      (1) The expectations of prices falling further would induce savings.

      (2) Factor(1) is exacerbated by the lack of confidence generated by a weak economy.

      (3) The overhang of private debt is such that the economic impact of debtors is larger than the economic impact of creditos.

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