Friday, December 18, 2009

Why Wage Cuts Will Increase Employment

A basic truth of economics is that whenever supply exceeds demand, a lower price will reduce that excess and increase the number of actual transactions. On this issue, no disagreement exists between Austrians and neoclassicals.

Yet a surprising number of leading leftist economists deny this fundamental truth in the case of the labor market. Debating this issue with Tyler Cowen and Bryan Caplan, particularly Paul Krugman and Rajiv Sethi tries to deny this. Needless to say, I agree with the Cowen-Caplan view and not the Krugman-Sethi. That a lower price will increase demand is so self-evident at least under normal circumstances that I won't bother to elaborate upon it. So I will instead directly adress Krugman's and Sethi's argument for why it does not apply under the current circumstances. I'll start with Krugman. Here are his first argument:

"Here’s how the fallacy works: if some subset of the work force accepts lower wages, it can gain jobs. If workers in the widget industry take a pay cut, this will lead to lower prices of widgets relative to other things, so people will buy more widgets, hence more employment.

But if everyone takes a pay cut, that logic no longer applies. The only way a general cut in wages can increase employment is if it leads people to buy more across the board. And why should it do that?"

First of all, there is no need to assume that all wages will be cut. Some sectors suffer from higher unemployment than others so wages will likely be lowered there more than others, causing a relative shift of employment from sectors with a relative shortage of labor to those with a relatively high unemployment rate.

Secondly, even if all wages were cut by an equal amount there are good reasons to assume it would increase the demand for labor (at least given the currently high level of unemployment). The reason for that is that while wage cuts would create a negative income effect for workers who would have been employed anyway, it would create a positive income effect for their employers (the capitalists) Assuming employment won't be affected, wage bargaining is a zero sum game between employers and employees.

And since income in other countries won't be affected, lower wages would through the substitution effect increase demand for American labor by foreigners (or in other words increase net exports). And that same substitution effect would increase demand for products made by American workers by American capitalists.

And given the above factors, there are good reasons that aggregate income would rise as the losses of workers who would have been employed anyway is more than compensated by the gains of the capitalists and the workers who are employed because of the substitution effect.

Contrary to Krugman there is thus no need to assume that real interest rates would be lowered to realize that lower wages would increase employment.

As for Krugman's bisarre arguments in later posts that nominal wage cuts can't cut the real wage, it overlooks of course that the cost of products consists of more than just labor costs, and that demand for products doesn't just come from domestic workers, but also capitalists and foreigners.

Turning now to Rajiv Sethi, he quotes Bryan Caplan's post which makes similar arguments about the substitution effect and employer's income and then responds with these arguments:

"Let's take this step by step. First, consider the claim that cutting wages increases the quantity of labor demanded. Through what mechanism does this occur? Consider a firm (McDonald's, say) that can now pay its workers less. It will certainly do so. But will it increase the size of its workforce? Not unless it can sell more burgers and fries. Otherwise its newly expanded workforce will produce a surplus of happy meals that will (unhappily) remain unsold. And this will not only waste the expense of hiring and training new workers, it will also waste significant quantities of meat, potatoes and cooking oil. So the firm will make do with its existing workforce until it sees an uptick in demand. And no cut in the minimum wage will automatically provide such an increase in demand. As a result, the immediate effect of a cut in the minimum wage will be a decline in total labor income."

This of course ignores that a lower cost of labor will likely induce McDonald's to lower its price of happy meals and other items as the semi-fixed cost that labor costs constitute declines, something which given the above mentioned fact that wage negotiations are a zero sum games between employers and employees and will thus not affect demand, will increase demand for labor.

After having assumed that employer's income would not rise in his analysis of the substitution effect, Sethi misleadingly jumps to an analysis of the income effect where the substitution effect is completely ignored

"Employer income, of course, will rise. Some of this will be spent on consumption, but less than would have been spent if the same income had been received by low wage earners. The net effect here is lower aggregate demand. But wait, what will happen to the remainder of the increase in employer income? It will not be placed under mattresses, on this point I agree with Caplan. It will be used to accumulate assets. If these are bonds, then long rates will decline, and this might induce increases in private investment. Then again, it might not, unless firms believe that additions to productive capacity will be utilized. And right now they do not: private investment is not being held down by high rates of interest on long-term debt.

Finally, what if employers use the unspent portion of their augmented income to buy shares? We would have a run up in stock prices not unlike that we have seen in recent months. Note that this would not be a speculative bubble: the higher prices would be warranted given that firms have lower labor costs. But would this asset price appreciation stimulate private investment in capital goods? Again, not unless the additional capacity is expected to be utilized."

First of all, his assertion that lower long-term interest rates won't affect investment demand is an assertion completely without any empirical or theoretical assertion. He simply asserts it. If long-term rates had been zero, he would have been able to point to the zero bound barrier, but since long-term rates are way above that, this defense won't hold

And secondly, because the increase in employer's income will come through higher margins, this will induce employers to hire more, and invest more in capital goods.

Moreover, the "wealth effect" of higher stock prices would increase aggregate demand further.