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Do Sticky Wages Weaken the Case for Markets?

Mises Daily: Monday, June 07, 2010 by

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When Rothbardian economists propose that the United States needs a Federal Reserve about as much as it needs a federal car company, it's not surprising that Keynesians ridicule the notion. What is surprising is that otherwise laissez-faire economists, particularly of the Chicago School variety, think that the market economy is good at producing goods and services except when it comes to money.

Specifically, these lukewarm free-marketeers think that, in a pure capitalist system, wages are "sticky." This observation supposedly proves the necessity of a central bank willing to inject whatever inflation is necessary to kick start the economy out of a deep recession.

As we'll see, this analysis is incorrect. Much of the alleged "stickiness" of wages is due to government policies, and the focus on macroeconomic aggregates overlooks the distortions among sectors that massive inflation causes. Economists who support the free market in other areas should bite the bullet and join the call to end the Fed.

The Alleged Problem of Sticky Wages

In his response to my earlier critique of his call for inflation, Greg Mankiw laid out the mainstream case. After quoting my argument that falling prices could restore equilibrium even if the economy needed "negative real interest rates," Mankiw wrote,

I think this analysis is correct, under the maintained assumption that prices (including wages) are completely and instantaneously flexible. But if prices are sticky, then the immediate deflation and concurrent increase in expected inflation won't occur painlessly. Instead, it would take a while for the price level to fall, and as we wait, the economy would suffer through a period of depressed economic activity.

According to conventional new Keynesian analysis, sticky prices are the ultimate market imperfection that makes aggregate demand matter. If you deny that prices are sticky and assume they can instantaneously jump downward to new equilibrium levels, many macroeconomic problems become much easier to solve. Indeed, you don't need to solve them at all, as the market would do it.

I wish we lived in the world that Mr Murphy describes, but my reading of the evidence is that we don't. (emphasis in original)

Mankiw is not alone in his view. For example, I recently debated a Fed economist who agreed with me on just about every major economic issue. But he thought that in periods when the demand to hold money increases sharply — such as in the early 1930s — that it is the job of the Federal Reserve to print new money to quench the thirst.

Because the Fed did not do so, it meant the exchange value of dollar bills had to rise, which is the same thing as saying that prices (quoted in dollars) had to fall. This led to massive unemployment, because workers' wages allegedly were much stickier than the prices of other products, meaning that businesses saw labor getting more and more expensive as the Depression intensified.

Finally, we have the case of Scott Sumner, a "right-wing" economist who is quite libertarian on most points. But Scott's claim to fame is that he thinks Bernanke was too timid during the crisis of 2008, and didn't create enough new money in the midst of the global financial panic. As a result, Scott thinks the United States suffered through an unnecessarily sharp recession, which a healthy dose of inflation could have greatly mitigated.

The Government Itself Makes Wages Sticky

As so often happens, the proponents of government intervention are pointing to a problem that is greatly exacerbated by the government itself. Recall that the trouble stems from workers not being willing to take pay cuts. When the demand from employers drops, at the old wage rate there is now surplus labor — a.k.a. unemployment. Only when market wages drop to a lower level, so that demand once again matches supply, will equilibrium be restored in the labor market.

Now we have to ask, why do workers hold out for so long without jobs, insisting on wages that no one is willing to pay? After all, the other goods and services in the economy see their prices fall in a speedy fashion even though the sellers of these items depend on them for their livelihood. So if a street vendor knows enough to slash his hot dog prices when demand collapses, why don't hairdressers accept pay cuts when the same happens to their industry?

"After the 1929 crash, Herbert Hoover gathered the nation's leading businessmen for a conference in Washington and urged them to allow profits and dividends to take the hit, but to spare workers' paychecks."

In the case of the Great Depression, the answer is simple enough: the federal government didn't allow wages to fall. After the 1929 crash, Herbert Hoover gathered the nation's leading businessmen for a conference in Washington and urged them to allow profits and dividends to take the hit, but to spare workers' paychecks. Rather than cut wages, businesses were supposed to implement spread-the-work schemes where workers would cut back their hours.

The rationale for Hoover's high-wage policy was that the worker supposedly needed to be paid "enough to buy back the product." Hoover had bought into the trendy new economic theory blaming depressions on underconsumption. The idea was that wage cuts would just cause workers to cut their spending, which would in turn lead to another round of wage cuts in a vicious downward spiral.

Because of the uncertainty and actual reduction in the stock of money (an accident of the fractional reserve banking system when people withdraw their cash from banks), prices in the economy fell drastically in the early years of the Depression. But because of pressure from the government, businesses allowed wage rates to fall very slowly. As a result, real wages (i.e., paychecks adjusted for price deflation) actually rose more quickly during the early years of the Depression than they had during the Roaring Twenties! Because labor got more and more expensive, unemployment surged to an unprecedented 25 percent by 1933.

In our times, the extension of unemployment benefits is the most obvious example of a government intervention that prolongs job searches. Rather than accepting a job for lower pay than they are accustomed to, laid-off workers can continue their quest for much longer than would be the case in a free market. (Incidentally, Chicago School economists agree, and so does Mankiw.)

To see that wages can adjust on a relatively free market, even in the face of massive shocks to the economy, consider the 1920–1921 depression. From its peak in June 1920, the Consumer Price Index fell 15.8 percent over the next 12 months — a one-year price deflation that was half again more severe than any one-year drop during the Great Depression.

Even so, the economy quickly bounced back and entered the prosperous 1920s. The answer wasn't a massive injection of Fed money, either; in fact the Fed had jacked rates up to record high levels.

On the contrary, the reason the US economy quickly adjusted in the face of massive price deflation was that wages fell quickly too, dropping about 20 percent in a single year.

There's More to an Economy than Aggregate Price Levels

In the above section we saw that the argument that a free market has "sticky wages" and therefore requires massive doses of inflation simply doesn't hold up empirically. Ever since the 1930s, there have been systematic government (and labor union) efforts to prop up wages during economic downturns. In the relatively laissez-faire year 1920, wages fell quite rapidly to eliminate unemployment in the face of a collapse in prices.

But let's put all that aside, and tackle the issue head-on: Suppose that even on a relatively free market for some reason the demand to hold cash suddenly spikes. If the central bank stands by and does nothing, the increased demand for cash balances (with a constant stock of money) would lead to a general fall in the prices of goods and services. As businesses saw the demand for their products plummet, they would lay off workers. In principle, it could take years for wage rates to fall as much as other prices, meaning the economy would be operating below capacity for a long time.

"By dumping gobs of new money into a few access points of the economy, the central bank overlays the market's nuanced signals with a huge amount of interference."

In our hypothetical scenario, couldn't the central bank alleviate the misery by printing up wads of new cash early on? That way, the demand to hold more money would be satisfied by an increase in the number of dollar bills rather than by a wrenching fall in prices.[1]

To see why this suggested remedy is quite dangerous, let's forget about the sudden demand to hold more cash. Suppose we had an economy with a stable demand for cash, and all of a sudden the central bank doubled the money supply. What would happen?

Of course, in the long run, prices in general would rise, perhaps doubling. But in the interim, there would be other effects. In practice, when the central bank increases the money supply, it doesn't magically augment every single person's cash balance by the same percentage. No, some lucky recipients get the new money first. These people then have the ability to spend the newly created dollars at the old prices. They would therefore become relatively richer.

On the other hand, the people who were last in line to receive (or spend) the new money, would see prices rising at the store while their incomes were stuck at the old levels. These latecomers to the party would become relatively poorer.

Beyond the one-shot redistributive effects, there is also the damage caused by the existence of an inflationary central bank in the first place. Knowing that the bank had the ability to inject massive doses of new money into the market, investors and businesspeople would have less faith in the long-run purchasing power of the money unit. They would spend time and devote resources to hedging themselves against erratic central banking decisions, rather than focusing exclusively on the "fundamentals."

All of these problems hold true in a scenario starting with a sudden demand to hold more cash. In reality, it's not the case that every single person suddenly wants to increase his cash holdings by x percent, or that the central bank can instantly endow every person in the economy with the exact amount of new cash that he wishes to accumulate. (And even if it could, who wouldn't then say, "In that case, I'd like some more hundred dollar bills, please"?)

When people become fearful of the future in times of economic uncertainty, they naturally aim to bolster their liquid assets, especially their holding of money. But each person will cut back on his "normal spending" in a unique way. One person might cut out his weekly visit to his favorite restaurant, while another will sell some of his old baseball cards. In order for these subtle differences to be communicated through the economy, entrepreneurs need to see the changes in relative prices. In our example, workers need to leave the restaurant industry, while speculators may want to attend baseball card shows looking for bargains.

Mises Academy

By dumping gobs of new money into a few access points of the economy, the central bank overlays these nuanced signals with a huge amount of interference. Only in simplistic macro models, which contain a few variables like M and P, does the "shock" of the increase in demand for money become perfectly offset by the increase in M. In reality, these two different disturbances don't cancel each other out. The economy is in fact left to deal with the real events that fueled the panic in the first place — people don't suddenly decide to hold a bunch of cash for no good reason — as well as the huge injection of money into the hands of politically connected bankers.

Conclusion

The argument of sticky wages does not justify the existence of a central bank. Market prices, including wages, are flexible enough to smooth out macroeconomic disturbances. To the extent that workers hold out for a better job, rather than take a pay cut, this too reflects a legitimate outcome on a free market. Only in a simplistic macro model, with ad hoc assumptions about wages and prices, can the central bank improve the economy.

Notes

[1] Notice that if someone wants to, say, double the amount of purchasing power in his wallet, he has two options: (A) He can get twice as many dollar bills, with prices staying constant, or (B) he can keep the same amount of dollar bills in his wallet, with prices falling by half.