We Know Wages Are Extremely Sticky, We Just Don't Know Why

by: Scott Sumner

Here’s a story on found on Tyler Cowen’s blog:

They are a cornerstone of Chrysler’s unlikely comeback: 900 employees turning out a Jeep Grand Cherokee sport utility vehicle every 48 seconds of the working day at an assembly plant here.

Nothing distinguishes them from other workers at the Jefferson North plant, except their paychecks. The newest workers earn about $14 an hour; longtime employees earn double that.

…the advent of a two-tier wage system in Detroit is spiking employment for one of the country’s most important manufacturing industries.

Here’s what we know for certain about the US business cycle:

  1. If nominal wages are highly sticky, then NGDP slowdowns will raise unemployment.
  2. Nominal wages are highly sticky for at least some workers.
  3. The period after mid-2008 saw the largest NGDP growth collapse since the Great Depression.
  4. The period after mid-2008 saw a huge rise in unemployment.

Here’s what we don’t know:

  • Why didn’t Chrysler cut all wages to $14? Fear of strikes? Efficiency wages?

BTW, I do realize that long time employees are more skilled on average. But that sort of huge pay gap didn’t exist in the 1960s or 1970s, and thus I think we can assume at least a big part of it is “artificial” in some sense.

Marxists would argue that further pay cuts for infra-marginal workers would merely raise profits. I believe some of the money would go to extra employees. And as Nick Rowe showed, in the public sector all of it could go to additional jobs. I’d also note that health care is practically the public sector.

In an earlier post Tyler Cowen asks this question:

For how long — in today’s America — can an AD-driven recession last? At what point do even the Keynesians toss in the towel and say “By now it is a growth and structural problem, not mainly AD”? After all, the private sector had a chance to create more M2 and it failed. How sharp is the distinction between the short run and long run?

Great question. If I were forced to argue against my theory of the recession in an Oxford debate, my top three arguments would be:

  1. Natural rate hypothesis.
  2. Natural rate hypothesis.
  3. Natural rate hypothesis.

It’s a great model, I believe in it, and it suggests nominal shocks shouldn’t last for more than a few years. I’ve already argued for the “entanglement theory” of this recession (between structural and AD factors), but let me provide three reasons why I think that monetary stimulus would help three years after the 2008 crash, but would not have helped (much) three years after the mid-1981 collapse in NGDP growth:

  1. The problem of 99 week extended UI benefits. Powerful monetary stimulus would lead to a quick repeal.
  2. The problem of money illusion. It’s much easier to slow the rate of increase in nominal wages, than to cut wages outright. In 1982 we needed to slow the rate of increase in wages. Now we need to actually cut many wages, which is far harder even if the consequences for real wages are exactly the same. After I made this comment in a previous post lots of commenters wrote in trying to provide a rational explanation for worker reluctance to accept nominal wage cuts. I thought all their arguments were bogus, and it just confirmed my view that money illusion exists. My commenters are really smart. If even they have money illusion I think it’s safe to assume the broader public does as well.
  3. The problem of reallocation out of fields like housing. More NGDP would reduce the debt burden and raise real housing prices. This would reduce unemployment caused by construction workers having a hard time finding other jobs. Of course I’ve argued that housing is not the main problem with the recession, but it is a problem.

None of these applied to the 1983-84 recovery, which was the best example of the natural rate in action. The UI wasn’t raised from 26 to 99 weeks, there was higher trend inflation, and hence less need to cut nominal wages, and there was no big housing/debt crisis. Even the minimum wage situation was slightly different.

I would take Tyler Cowen’s challenge, and direct it at Keynesian fiscal policy advocates. Originally fiscal policy was justified on the basis that NGDP was growing slower than Ben wanted, but Ben would not fix the problem on his own. On the other hand, he wouldn’t stop fiscal stimulus from fixing it. I never quite bought the argument, although I find it defensible. But for how long? After all, it is a fairly convoluted way of looking at monetary policy, isn’t it? Is it still true? Is monetary policy still not reacting at all to NGDP growth trends?

PS. I don’t follow Tyler’s M2 comment. I think he means NGDP. But the private sector can’t create NGDP, only the Fed can. And they haven’t created enough to support many jobs without massive wage cuts. And it’s hard to cut wages, as we’ve seen at Chrysler.

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