Monday, December 01, 2008

Krugman On Wage Cuts In A Depression

Paul Krugman has responded to the article by Amity Shlaes that I told you about in my previous post.

More specifically, he focuses his attack on the idea that a lower price of a certain thing will lower excess surpluses of it. Even more specifically, I refer to of course wage cuts as a way to reduce unemployment.

Krugman argues that if there were a general 20% of wages for all workers, then prices would go down by 20% too, which would leave real wages unchanged. There are several fallacies here. First of all, why assume a across the board cut equal for everyone? The point here is that first the Hoover administration and then the Roosevelt administration in various ways tried to prevent wage cuts. But with some sectors suffering greater job losses than others, there is every reason to believe that the needed wage cut was greater in some sectors relative to others, meaning that the interventions to stop that would disproportionably minimize wage cuts in sectors hit hardest by increased unemployment. This means in turn that without the Hoover-Roosevelt interventions, wage cuts would have been greater in some sectors compared to others. Krugman's "equal pay cut for all workers" assumption is completely unrealistic and unwarranted.

Secondly, there is no reason to assume that even a 20% across the board wage cut would leave real wages unchanged. Given the fact that corporate profitability turned negative, there is every reason to believe that businesses would use at least some of their cost reduction to restore the negative margins. Businessman in general really aren't stupid enough to think that "So what if I lose a dollar on every unit I sell-I'll make it up on volumes!" (The few that are will likely soon be bankrupted), so in a situation of negative profit margins lower nominal wages would likely result in ,lower real wages. That in turn means that more businesses could have survived which would have meant that fewer workers would have had to lose their jobs.

While most or at least a significant portion of wage cuts would have been used to restore badly damaged profit margins that we saw in, there is still reason to believe that it also would have resulted in lower prices. Which brings us to Krugman's third fallacy, namely when he first acknowledges that the lower prices will raise the real money supply, but that the usual way in which it will boost demand, through lower interest rates was closed because interest rates had hit zero. But this is not true, as the discount rate at its lowest was 1.5% during the Depression. Moreover, even had the nominal risk free interest rate been zero, a higher real money supply could have still affected the much higher actual lending rates, which due to risk premiums were much higher.

Finally, I should mention one objection that I know many Keynesians will be thinking about, even though Krugman didn't mention it, namely won't lower real wages lower the purchasing power of workers and so reduce demand? That lower real wages will lower worker's purchasing power is true more or less by definition, and it is certainly likely that workers whose only income is their wage/salary will reduce their demand. But since companies and their owners will experience reduced losses/higher profits, their demand will increase. Moreover, in a situation where pay cuts can boost employment, this is not simply a zero sum game, it is something which will boost total production and demand as new workers will get jobs and so will also receive an income.


Anonymous Fred said...

Wage cuts do not reduce debts of the wage earners. Mortgage payments won't change, for example.

I don't think Paul Krugman, with his tenure and fine house, is at all connected to the reality of his various proposals to real human beings. He certainly won't be affected by what he proposes for others' lives.

He has a model of a fungible economic man, the laborer, that would be a brutal herd life.

10:47 PM  
Blogger earth that was said...

The argument that wage cuts lead to lower demand and thus less employment has been part of "New Deal" folklore since the 1930s. Do you know of any attempts to empirically test the argument one way or the other?

10:46 AM  
Anonymous Ke said...

We are in dire need of wage cuts, but it's not going to happen. Who wants to get paid less? Certainly not me.

In fact, the opposite is happening. Even though California is bankrupt and businesses are failing, the minimum wage is getting raised again! And everyone's cheering! No wonder teen unemployment is getting close to 50%. Who business would want to pay kids 10 bucks an hour to stack clothes?

7:13 PM  
Blogger Celal Birader said...

Hi Stefan,

Thought i'd let you know i ordered that book on the Depression by Rothbard which you recommended HERE.

It will be my first foray into Austrian Economics. I look forward to learning more about this.


8:03 PM  
Anonymous Anonymous said...

I would point out also that lower wages would improve US competitiveness and demand from abroad for US products would increase. So probably prices would fall less than wages.

12:54 AM  

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