Tuesday, December 08, 2009

On the Consequences of Nominal Wage Flexibility

With the unemployment rate hovering above 10% and likely to stay in this range for some time, there has been a lot of discussion about what (if anything) the government should do to stimulate job creation. Following a link on Greg Mankiw's blog, I came across Gary Becker's view of the matter:
Keynes and many earlier economists emphasized that unemployment rises during recessions because nominal wage rates tend to be inflexible in the downward direction. The natural way that markets usually eliminate insufficient demand for a good or service, such as labor, is for the price of this good or service to fall. A fall in price stimulates demand and reduces supply until they are brought back to rough equality. Downward inflexible wages prevents that from happening quickly when there is insufficient demand for workers.
As one might expect given his diagnosis of the problem, Becker goes on to "fully endorse" a cut in the minimum wage, but does not see this as being politically feasible at present.

I found this post striking for three reasons. First, it expresses a view that is actually quite widely held among economists today, namely that if nominal wages were flexible in the downward direction, involuntary unemployment could not persist for very long. This view is held even by many who would strenuously object on fairness grounds to a cut in the minimum wage. Second, Becker attributes to Keynes an opinion that is precisely the opposite of that expressed in the General Theory.  And third, there has been very little serious analysis of the consequences of nominal wage flexibility in an economy with involuntary unemployment. A notable exception is a 1975 paper by James Tobin that has been largely (and unjustly) forgotten. For reasons discussed below, Tobin's analysis does not support Becker's position.

Keynes did indeed assume for the most part that nominal wages were inflexible, but also maintained that wage flexibility would make matters worse rather than better: "it would be much better that wages should be rigidly fixed and deemed incapable of of material changes, than that depressions should be accompanied by a gradual downward tendency of money wages" (p. 265). This is the starting point for Tobin's analysis:
Keynes tried to make a double argument about wage reduction and employment. One was that wage rates were very slow to decline in the face of excess supply. The other was that, even if they declined faster, employment would not - in depression circumstances - increase. As to the second point, he was well aware of the dynamic argument that declining money wage rates are unfavorable to aggregate demand. But perhaps he did not insist upon it strongly enough, for the subsequent theoretical argument focused on the statics of alternative stable wage levels.
To drive this point home, Tobin builds a simple model with three dynamic equations: output adjusts in response to excess demand in the goods market, inflation (relative to expectations) adjusts in response to deviations of output from its full employment level, and expectations of inflation adjust adaptively in response to the difference between actual and expected inflation. So prices (and nominal wages) are fully flexible and there is no limit to how low these can fall if output remains persistently below its full employment level.

An equilibrium of this model is characterized by full employment, steady inflation, and correct expectations. But Tobin is less interested in the equilibrium behavior of the economy than in the dynamic adjustment process from an initial state of disequilibrium. He establishes that even if the equilibrium is locally stable, it need not be globally stable: if, for whatever reason, output drops far enough below its full employment level, then (as in Axel Leijonhufvud's corridor hypothesis) cumulative declines in employment and prices can result.  Instead of improving matters, the downward flexibility of money wages can prolong and deepen an economic contraction.

Tobin's analysis here is methodologically old-fashioned in the sense that no attempt is made to provide microfoundations for the postulated adjustment processes.  But the logic is compelling, and I am certain that with sufficient ingenuity, the argument could be expressed in more modern terms. In any case, it is no less convincing than the partial equilibrium Walrasian analysis of the labor market that has led some to prescribe lower nominal wages as a solution to our current woes.


Update (12/9): Thanks to Mark Thoma for reposting this, to Paul Krugman for his comments and references, and The Economist for linking. I should note that aside from Keynes and Tobin, Fisher (1933) and DeLong and Summers (1986) have also explored mechanisms that can cause price flexibility to be destabilizing.

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