Wages: Real debt, relative prices, and the labour market

In a recent column by Paul Krugman, he bemoans the fact that wages appear to be falling (ht Economist’s View). His primary justification for this comes from the following section:

And soon we may be facing the paradox of wages: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment.

Here’s how the paradox works. Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.

But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck.

Let’s think about this a little.

Primarily he is saying that he is concerned that a weak labour market will lead to wage deflation – and that this deflation will increase the real debt burden of households. Given that the US is overindebted – this high real debt burden will actually act like a negative income shock to households, which is no good.

However, I’m not really fully comfortable with this characterisation. If the marginal product of labour has genuinely fallen in the US economy then we need a reduction in aggregate wages to prevent a “surplus in the labour market” – or unemployment. People keep employed as firms sell products for a lower price – again leading to a drop in wages in aggregate (but not deflation – as it is a price level shift), but still potentially helping the unemployment situation.

As a result, outside of the “real debt burden” impact it isn’t clear at all that lower wages will lead to higher unemployment – as Krugman is stating. If there has been a shock to the economy then relative wages and prices need to adjust.

In order to actually understand the situation we have to ask where a market failure comes into the picture – and how that failure can then be propagated through the macroeconomy. Often people say that wages are sticky – and as a result we end up with excessive unemployment. If wages refuse to fall, but the price of products can respond, then the allocation of resources will be suboptimal – now this isn’t what he is saying as he fears wages will fall.

Ok, then say that product prices are sticky and wages are flexible – this could also lead to excessive unemployment as the whole reaction to a shock to the firm has to come through production. But this just doesn’t make sense to me – all the evidence I’ve seen, and all the common sense I can muster suggests that it is harder to change wages than product prices.

As a result, I don’t see a “paradox of lower wages” here.

What about the real debt burden

Now this is a concern of course. As we are essentially saying that we have deflation and a zero bound on interest rates – implying that real interest rates are rising.

So if this is the only real concern – we need to get inflation expectations up. As a result, print money, buy government debt, charge penalty interest, and maybe lift some types of government expenditure – but do these things with the aim of lifting inflation expectations. That way we keep real interest rates down – and we don’t need to concern ourselves with a lift in real debt burdens.

Conclusion

The fact that wages and prices are moving is not the problem – the problem may be that they are moving because of expectations of deflation, not because of a change in relative economic fundamentals.

We don’t want the first type of shift – but we desperately want the second type of shift.