More on sticky wages

Karl Smith has a new post on sticky wages that makes the following claim:

So growing up in the New Keynesian paradigm I learned that sticky wages don’t make sense because the real wage is pro-cyclical. That is, in contrast to Keynes’s suggest labor is actually cheaper during recessions than during booms.

This moved the story to sticky-prices.

Not so fast.  It’s true that Keynes’s original model implied real wages should be countercyclical.  But that’s not the implication of the standard AS/AD model, with sticky wages.  Instead, the AS/AD model predicts that wages will be countercyclical when the economy is hit by demand shocks, and procyclical when the economy is hit by productivity shocks.  And a paper I wrote with Steve Silver (Journal of Political Economy, 1989) showed that this is the case.  Real wages are strongly countercyclical in the face of demand shocks, and strongly procyclical in the face of supply shocks.  I’d add that real wages rose especially sharply in some of the most easily identifiable adverse demand shocks (1920-21, 1929-32, 1937-38.)  Most researchers simply look for “the” cyclicality or real wages, just like they look for “the” fiscal multiplier, and lots of other unicorn-like parameters.

Since that time I’ve come to believe that “inflation” is pretty much a meaningless concept, just a number pulled out of the air by those who calculate price indices in Washington.  But I’m in the minority, most economists watch core inflation very closely, even though it is 39% housing, and even though the CPI showed housing prices rising during the greatest housing price crash in American history–even in relative terms.  To each their own.  In any case, I look at the ratio of the nominal hourly wage rate to per capita NGDP, which seems like a better indicator of how nominal shocks effect the labor market.

In the comment section to the previous post, many people don’t quite understand how strong the evidence is for nominal wage stickiness, and how big a problem it is for New Classical models.  Yes, one can explain some wage stickiness in a New Classical model.  And yes, one can explain why workers might be reluctant to accept real wage cuts.  But the real problem is the distribution of NOMINAL wage adjustments.  The sharp discontinuity at zero percent is extremely hard to explain.  The basic problem is that in New Classical models nominal variables shouldn’t matter, except perhaps to the extent that there might be menu costs to adjusting wages and prices.  But the problem is that given that wages are being adjusted, there is no difference between the menu cost of raising someone’s wage 1% and cutting someone’s wage by 1%.  The number zero doesn’t have magical, talisman-like qualities in New Classical models.  But in the real world it apparently does.

Could it be money illusion?



16 Responses to “More on sticky wages”

  1. Gravatar of dirk dirk
    15. August 2011 at 15:25

    Is belief that too little AD is our main problem contingent upon sticky wage theory?

  2. Gravatar of Scott Sumner Scott Sumner
    15. August 2011 at 15:55

    No. Sticky prices would do the trick. Some even argue that more AD would help on debt-deflation grounds.

  3. Gravatar of Bryan Willman Bryan Willman
    15. August 2011 at 16:06

    0% as a wage change rate might arise due to dynamic stability issues.

    Roubini made the claim (most agree) that the economy is sort of stalled, and must either go down (deflate) or up (grow) – but that “being stuck in place” isn’t actually possible for very long.

    Same is probably true of wages in most businesses. In particular, of the business is doing OK or well, it may offer some wage gains to attempt to offet inflation and see that it keeps doing well. People working on commission may see a kind of “free gain” just by surviving.

    Likewise, it’s easy to say how wages could fall a little bit in the current cirumstance, even with the forces of stickyness to contend with.

    So the 0 is probably like the “why is economic growth never exacly 0%? why do profits of a business never change exactly 0% from the year before?” etc.

    Also, “0” is a very exact point. Might be there are almost no changes at 3.84563% either. But we don’t notice that.

    Change the graph to 0.2% bands and see how the shape looks then.

  4. Gravatar of Full Employment Hawk Full Employment Hawk
    15. August 2011 at 18:03

    “But the problem is that given that wages are being adjusted, there is no difference between the menu cost of raising someone’s wage 1% and cutting someone’s wage by 1%.”

    A major reason for wage stickiness when the economy is adjusting downward because of a demand shock is because wages are changed sequentially, rather than simultaneously. Therefore when economic conditions call for wages to be cut, there is a “who goes first?” problem. The first employer who cuts nominal wages, while others have not yet done so, is cutting the real wages of his workers. Therefore he will face the problem that his best workers, who are most able to find alternate employers, will leave. And the remaining workers will perceive to be treated unfairly and therefore put forth less work effort as a result. So the first employer and employers to reduce wages subject themselves to a major cost in this respect. Therefore employers will be reluctant to be the first to cut and each wait for the other to go first, so cuts are slow to take place. This is why sticky wages are intrinsically more important than sticky prices during such a downward adjustment. The first firm to cut its prices will put itself at an advantage. When it cuts a price, with other prices still unchanged, its relative price has been reduced. Therefore its sales increase and, with monopolistic competition, it may be able to keep some of the customers it gains before others have cut prices. Therefore the inhibition against going first does not exist. Rather, there is an incentive to do so. I would conjecture that sticky wages are one of the main reasons for prices also being sticky during the downward adjustment.

    The situation is reversed during an upward adjustment due to a demand shock. In that case the firm that raises prices first puts itself at a disadvantage because its relative prices have increased. On the other hand, the first firm to raise nominal wages puts itself at an advantage.

    This implies that the reasons for stickiness in wages and prices differs for downward and upward adjustments due to demand shocks. And the reasons for stickiness during a supply shock are still different. Therefore there is no one explanation for sticky wages and prices that fits all situations. But a lot more emphasis should be put on sticky wages than the New Keynesians are doing.

  5. Gravatar of Morgan Warstler Morgan Warstler
    15. August 2011 at 18:09

    Reading Bill Gross, I think I have had a breakthrough, something I’ll repeat ad nauseum and no one will respond to.

    He says this:

    “The debt crisis as it crests ultimately gives way to these growth-inhibiting, spending-contractionary secular forces. Having run up our credit card to keep on spending, we have reached market-enforced limits that force deleveraging. It is not the debt, however, but the lack of global aggregate demand that is at the heart of the crisis. As the entire world strives to put its own people to work before other nations do, policymakers constructively lower interest rates and delay sovereign, corporate and household defaults to provide breathing room. Fiscally, however, an anti-Keynesian, budget-balancing immediacy imparts a constrictive noose around whatever demand remains alive and kicking. Washington hassles over debt ceilings instead of job creation in the mistaken belief that a balanced budget will produce a balanced economy. It will not.”

    And I think it finally dawned on me what I think is true:

    We CANNOT increase AD in real term.

    Gross states clearly that we have not not increased AD in DECADES, and it all has been papered over in debt:

    “We and our global market competitors are and have been experiencing a lack of aggregate demand for several decades.”

    Ok, so it is impossible. Why try?

    The choice is not between something that I LIKE (liquidation) and something I don’t like.

    The choice is between something I like and… there is no other choice.

    Raising real AD without more debt is impossible. Bill Gross admits it.

  6. Gravatar of Benjamin Cole Benjamin Cole
    15. August 2011 at 19:15

    I find Scott Sumner’s commentary about inflation to be fascinating. I sense that at low rates–such as those of toady–the CPI almost disappears into the smog. Are we having deflation or inflation? If you buy a house today, and drop some telephone land lines for a cell phone, or are a heavy consumer of electronic goods, then you are living in deflation.

    If you buy a lot of health insurance, are stuck renting, drive a big car, and eat a lot of corn chips, you are experiencing inflation.

    Amazingly, the CPI-U (headline) in June is up only 2.6 percent from three years earlier. So while the Chicken Inflation Little crowd is in hysterics over inflation, at least as measured we are experiencing minute amounts, well below targets (if we have targets).

    This is the story that the Obama Administration has failed to tell, and that the Fed has failed to explain and act upon.

    Somehow what passes for public discourse has been swamped by the gold fetishists and people showing off shiny boots and jodhpurs (the Austrians).

    Really, can we preserve the value of a Ben Franklin in monetary formaldehyde? We can, perhaps, and kill the economy too. That is the reality we need to bring to the American public.

  7. Gravatar of Lorenzo from Oz Lorenzo from Oz
    15. August 2011 at 23:37

    If you want a nice piece on problems with the CPI (at least in the Australian version) try this.

    Models where money does not matter make my head hurt. Why do we have money? If it is just a irrelevant/completely transparent epiphenomenon, why do we bother? Why do people keep using money even in amazing hyperinflation conditions? If money performs genuine functions, then surely it can have “real” effects?

    Money simplifies: trying to keep track of relative prices without some unit of account would be an enormous cognitive burden, which would get worse as the range of goods and services multiplies. By being the “measure” of prices, it becomes the way we accrue obligations: they are specified in the medium of account. Which means we care about how much of the medium of account we receive across time: hence nominal wage stickiness. A lot of alleged “money illusion” strikes me as either consequence of cognitive simplification or ignoring money’s use to specify obligations.

    If people stopped using that weird statistical artefact “real prices” and started using “barter prices” (prices in terms of goods and services), these points would perhaps be more obvious.

  8. Gravatar of Scott Sumner Scott Sumner
    16. August 2011 at 06:08

    Bryan, You misunderstood the graph, There are lots of times when wages don’t change, this graph only shows actual wage changes.

    FEH, But your argument applies to real wages. For nominal wages one must assume money illusion.

    Morgan, I prefer to talk about AD in nominal terms. I’m not quit sure what real AD means.

    Thanks Ben.

    Lorenzo, I agree.

  9. Gravatar of James in London James in London
    16. August 2011 at 07:02

    I thought you’d lost the argument in the earlier post and comments. There were plenty of good micro reasons, non-money illusion ones, for the chart. Are you so blind to good micro?

  10. Gravatar of James in London James in London
    16. August 2011 at 07:57

    Ditching CPI is good. Why not ditch unemployment too and just talk about workforce participation? (A low number being good or bad.) Then you could ditch National Income next, another pretty meaningless concept. Then AD. Then macro. And then would you re-train as a micro-economist or a different profession entirely.

  11. Gravatar of Full Employment Hawk Full Employment Hawk
    16. August 2011 at 12:21

    “FEH, But your argument applies to real wages. For nominal wages one must assume money illusion.”

    But my point is that when nominal wages are set sequentially, one cannot initially cut nominal wages without cutting the real wages of the workers who are the first to receive the wage cuts. The same is true for all workers who are the early recipients of the wage cuts. Only after the adjustments of wages and prices have been fully completed can there be a cut in nominal wages without it requiring a cut in real wages. It is the inablility to begin cutting nominal wages without initially cutting real wages that explains the stickiness of nominal wages.

  12. Gravatar of Scott Sumner Scott Sumner
    16. August 2011 at 19:28

    James, Reading those comment sections just made me realize how big a problem money illusion really is. Almost no one sees what that graph shows. They think there’s some rational explanation. It just shows how almost everyone confuses nominal and real variables.

    FEH, Whether a nominal wage cut is also a real wage cut depends entirely on the rate of inflation. Workers should care about real wages, not nominal wages. They should not want to get real wage cuts. They shouldn’t care at all about nominal wage cuts.

  13. Gravatar of James in London James in London
    17. August 2011 at 01:30

    Money illusion is a rational explanation, just not the right or best one. It’s rational to say workers confuse real and nominal wages, people confuse things all the while. But is the right explanation, or are there better explanations that more closely fit the facts in your chart. Or say the chart isn’t the whole story. Those comments saying it is employers competing with each other for workers, not workers who drive the outcome is a good start, for instance. Do employers get confused? I think not.

  14. Gravatar of ssumner ssumner
    17. August 2011 at 14:40

    James, It is certainly not employers, as they’d have no objection to paying lower wage rates.

  15. Gravatar of James in London James in London
    18. August 2011 at 05:19

    I think you don’t get micro. “Employers” as a macro grouping may have no objection, but then “employers” as a macro grouping don’t exist. There are millions of individual employers who care very much about beating the one or two empoyers down the road, and if they aren’t paying their staff less she can’t either.

    Employers generally prefer to cut jobs rather than reduce wages because of this very real problem, for them on a micro level. Sometimes all the staff can agree to take a wage cut, or work less, but that takes a lot of organisation and effort – but does occur occasionally as your chart shows.

    Not money illusion but micro-reality.

  16. Gravatar of ssumner ssumner
    18. August 2011 at 17:50

    James, All I an do is repeat that you are confusing real and nominal variables. Your argument applies to real wages, unless there is money illusion.

Leave a Reply