Monday, March 28, 2011

Yes, Wage Cuts Can Lower [High] Unemployment

Paul Krugman again tries to deny that wage cuts can solve the problem of high unemployment.

there would be no reason to expect a general fall in wages to raise employment.

Why? Don’t demand curves usually slope downward? Yes, but that’s because when you cut the price of something, it normally gets cheaper relative to other things, leading people to redistribute their spending toward the cheaper good.

But when you cut the price of everything — which is more or less what happens when wages fall across the board — there’s nothing else to substitute away from.

Yet as I pointed out in a previous post when Krugman made similar argument, there are two fallacies in Krugman's argument.

First of all, there is no need to assume that the fall in wages have to be the same in all sectors. For example, construction workers should see a big drop given their high level of unemployment, while the low unemployment for workers in the education and health sectors suggest that their pay may not need to be lowered at all.

And secondly, the price of goods and services consist of more than labor costs (you need capital to produce too), so a lower cost of labor would be a relative price cut. For this reason, it is also wrong to assume, as Krugman does, that lower wages would necessarily raise the nominal exchange rate by an equal amount, meaning that relative wages compared to foreign workers would also be reduced.