Why Wage Cuts Are Good For Aggregate Demand By Bryan Caplan

Krugman’s repeating his argument that wage cuts are individually rational, but collectively irrational:

[M]any workers are accepting pay cuts in order to save jobs. What’s wrong with that? The

answer lies in one of those paradoxes that plague our economy right

now. We’re suffering from the paradox of thrift: saving is a virtue,

but when everyone tries to sharply increase saving at the same time,

the effect is a depressed economy… And soon we may be facing

the paradox of wages: workers at any one company can help save their

jobs by accepting lower wages, but when employers across the economy

cut wages at the same time, the result is higher unemployment.

If you’re really anti-Krugman, you might think he’s saying that, “Wage cuts reduce labor income, which reduces aggregate demand.” If this is his argument, it has two major problems:

1. Cutting wages increases the quantity of labor demanded. If labor demand is elastic, total labor income rises as a result of wage cuts.

2. Even if labor demand is inelastic, moreover, wage cuts reduce labor income by raising employers’ income. So unless employers are unusually likely to put cash under their matresses, wage cuts still boost aggregate demand.

But is Krugman even making an argument about aggregate demand? At first glance, it doesn’t look like it:

Here’s

how the paradox works. Suppose that workers at the XYZ Corporation

accept a pay cut. That lets XYZ management cut prices, making its

products more competitive. Sales rise, and more workers can keep their

jobs. So you might think that wage cuts raise employment — which they

do at the level of the individual employer. But if everyone takes

a pay cut, nobody gains a competitive advantage. So there’s no benefit

to the economy from lower wages.

Alas, this still leaves me saying, “No benefit?! Huh?” Won’t consumers benefit when there’s more cheap stuff? In purely Keynesian terms, too, there’s a real balance effect. The most that Krugman could reasonably say is that wage cuts have underappreciated drawbacks. What are these supposed to be?

1. “[F]alling wages, and hence falling incomes, worsen the problem of

excessive debt.” Now Krugman really does seem to blithely assume that reducing wages reduces aggregate demand. And I have to respond: “Do falling wages worsen the problem more than higher unemployment due to wage rigidity?”

2. Krugman also warns that falling wages might lead consumers to expect further wage declines, effectively raising real interest rates – “And a

rise in the effective interest rate is the last thing this economy

needs.” I grant that this might happen if wage cuts continued for a long time, and could conceivably be bad if it happened. But for now, this is paranoia.

It’s also worth pointing out that in a standard New Keynesian textbook model, higher inflationary expectations reduce aggregate supply and worsen the inflation-unemployment trade-off. Corollary: The straightforward effect of lower inflationary expectations is to increase aggregate supply and improve the inflation-unemployment trade-off.

I’m far from a knee-jerk Krugman basher. I gleefully assign The Accidental Theorist to my undergraduate labor students. But when Krugman forgets that wage rigidity is the fundamental cause of involuntary unemployment, a sound bashing is in order.