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Tyler Cowen (Marginal Revolution: What's the actual problem in the labor market?):

Yet I have seen not one such post to the unemployed: "Hey guys, lower your wage demands! It's good for you! You'll get a job and avoid the soul-sucking ravages of idleness. It's good for the country! It's good for Bernanke, you'll get those regional Fed presidents off his back! Why not? The best you can hope for is to get tricked by money illusion anyway! Show up those elites and get to that equilibrium on your own! Take control!" and so on. If such posts would seem patently absurd, we should ask what that implies for our underlying theory of current unemployment...

Such posts are not "patently absurd," but they are almost surely wrong, and very dangerous as well.

Is the problem with the U.S. economy that the real wage is too high for it to be profitable for employers to re-employ the unemployed even at normal levels of demand--that we are in a situation of classical unemployment? I would say no. Is the problem with the U.S. economy that workers think that the real wage is lower than it is and so are unwilling to accept the jobs offered--that we are in a situation of Lucas price level-misperception unemployment? I would say no. is the problem that demand is too low--that we are in a situation of Keynesian unemployment? I would say yes.

So what happens in a situation of Keynesian unemployment if you have wage deflation?

What happens is that as wages fall more working households find that they can no longer make their mortgage and their credit card payments, and defaults rise. Rising defaults increase the flight to safety and quality in financial markets and push down aggregate demand further. If you could have what Jacob Viner called a "balanced deflation"--wages and debts--that would be fine. That is why devaluation works so well to cure Keynesian unemployment in an economy that does not have large net foreign-currency liabilities: devaluation is a way of attaining balanced deflation--and it works.

So in my view, Tyler's thought experiment tells us nothing about our underlying theory of current unemployment. Indeed, Keynes dealt with this 74 years ago: Chapter 19 (here):

A reduction in money-wages is quite capable in certain circumstances of affording a stimulus to output.... The argument simply is that a reduction in money-wages will cet. par. stimulate demand by diminishing the price of the finished product, and will therefore increase output and employment.... In its crudest form, this is tantamount to assuming that the reduction in money-wages will leave demand unaffected... aggregate demand depends on the quantity of money multiplied by the income-velocity of money and that there is no obvious reason why a reduction in money-wages would reduce either the quantity of money or its income-velocity....

Let us... apply our own method of analysis.... [E]ffective demand, being the sum of the expected consumption and the expected investment, cannot change if the propensity to consume, the schedule of marginal efficiency of capital and the rate of interest are all unchanged.... Thus the reduction in money-wages will have no lasting tendency to increase employment except by virtue of its repercussions either on the propensity to consume for the community as a whole, or on the schedule of marginal efficiencies of capital, or on the rate of interest.... The most important repercussions on these factors are likely, in practice, to be the following:

A reduction of money-wages will somewhat reduce prices. It will, therefore, involve some redistribution of real income (a) from wage-earners to other factors entering into marginal prime cost whose remuneration has not been reduced, and (b) from entrepreneurs to rentiers to whom a certain income fixed in terms of money has been guaranteed.... What the net result will be on a balance of considerations, we can only guess. Probably it is more likely to be adverse than favourable....

If we are dealing with an unclosed system, and the reduction of money-wages is a reduction relatively to money-wages abroad when both are reduced to a common unit, it is evident that the change will be favourable to investment, since it will tend to increase the balance of trade. This assumes, of course, that the advantage is not offset by a change in tariffs, quotas, etc. The greater strength of the traditional belief in the efficacy of a reduction in money-wages as a means of increasing employment in Great Britain, as compared with the United States, is probably attributable to the latter being, comparatively with ourselves, a closed system....

If the reduction of money-wages is expected to be a reduction relatively to money-wages in the future, the change will be favourable to investment, because... it will increase the marginal efficiency of capital; whilst for the same reason it may be favourable to consumption. If, on the other hand, the reduction leads to the expectation, or even to the serious possibility, of a further wage-reduction in prospect, it will have precisely the opposite effect....

The reduction in the wages-bill, accompanied by some reduction in prices and in money-incomes generally, will diminish the need for cash for income and business purposes; and it will therefore reduce pro tanto the schedule of liquidity-preference for the community as a whole. Cet. par. this will reduce the rate of interest and thus prove favourable to investment. In this case, however, the effect of expectation concerning the future will be of an opposite tendency to those just considered....

Since a special reduction of money-wages is always advantageous to an individual entrepreneur or industry, a general reduction (though its actual effects are different) may also produce an optimistic tone in the minds of entrepreneurs, which may break through a vicious circle of unduly pessimistic estimates of the marginal efficiency of capital and set things moving again on a more normal basis....

On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partly offset any cheerful reactions from the reduction of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency....

This is not a complete catalogue of all the possible reactions of wage reductions in the complex real world. But the above cover, I think, those which are usually the most important.

If, therefore, we restrict our argument to the case of a closed system... we must base any hopes of favourable results to employment... to an increased marginal efficiency of capital... or a decreased rate of interest....

The contingency, which is favourable to an increase in the marginal efficiency of capital, is that in which money-wages are believed to have touched bottom, so that further changes are expected to be in the upward direction. The most unfavourable contingency is that in which money-wages are slowly sagging downwards and each reduction in wages serves to diminish confidence in the prospective maintenance of wages. When we enter on a period of weakening effective demand, a sudden large reduction of money-wages to a level so low that no one believes in its indefinite continuance would be the event most favourable to a strengthening of effective demand. But this could only be accomplished by administrative decree....

On the other hand, it would be much better that wages should be rigidly fixed and deemed incapable of material changes, than that depressions should be accompanied by a gradual downward tendency of money-wages, a further moderate wage reduction being expected to signalise each increase of, say, 1 per cent. in the amount of unemployment. For example, the effect of an expectation that wages are going to sag by, say, 2 per cent. in the coming year will be roughly equivalent to the effect of a rise of 2 per cent. in the amount of interest payable for the same period. The same observations apply mutatis mutandis to the case of a boom.

It follows that with the actual practices and institutions of the contemporary world it is more expedient to aim at a rigid money-wage policy than at a flexible policy responding by easy stages to changes in the amount of unemployment; — so far, that is to say, as the marginal efficiency of capital is concerned. But is this conclusion upset when we turn to the rate of interest?

It is, therefore, on the effect of a falling wage- and price-level on the demand for money that those who believe in the self-adjusting quality of the economic system must rest the weight of their argument; though I am not aware that they have done so.... We can, therefore, theoretically at least, produce precisely the same effects on the rate of interest by reducing wages, whilst leaving the quantity of money unchanged, that we can produce by increasing the quantity of money whilst leaving the level of wages unchanged. It follows that wage reductions, as a method of securing full employment, are also subject to the same limitations as the method of increasing the quantity of money. The same reasons as those mentioned above, which limit the efficacy of increases in the quantity of money as a means of increasing investment to the optimum figure, apply mutatis mutandis to wage reductions....

There is, therefore, no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment; — any more than for the belief than an open-market monetary policy is capable, unaided, of achieving this result. The economic system cannot be made self-adjusting along these lines.

If, indeed, labour were always in a position to take action (and were to do so), whenever there was less than full employment, to reduce its money demands by concerted action to whatever point was required to make money so abundant relatively to the wage-unit that the rate of interest would fall to a level compatible with full employment, we should, in effect, have monetary management by the Trade Unions, aimed at full employment, instead of by the banking system.

Nevertheless while a flexible wage policy and a flexible money policy come, analytically, to the same thing, inasmuch as they are alternative means of changing the quantity of money in terms of wage-units, in other respects there is, of course, a world of difference between them...

Source: Tyler Cowen Calls, I Think Wrongly, For Deflation