"Wages Must Fall!": What All Good Keynesians Should Say By Bryan Caplan

When Keynesians want to gloat, they often point to the overwhelming empirical evidence in favor of nominal wage rigidity. For the latest example, see Krugman on the Irish labor market. Their unemployment is 14.5%, but the nominal wage index has only fallen by about 2.5%. Krugman’s conclusion:

It is really, really hard to cut nominal wages, which is why reliance

on “internal devaluation” is a recipe for stagnation and disaster.

The gloating is easy to understand. After all, nominal wage rigidity is the driving assumption of the Keynesian model. Unemployment is just a labor surplus; since wages are the price of labor, the fundamental cause of unemployment has to be excessive wages. And as long as the wage rigidity is nominal, you can neutralize it by printing money or otherwise boosting demand.

What’s hard to understand, though, is Keynesian neglect of – if not outright hostility to – the logical implication of their argument: Wages must fall! If they’re right about nominal wage rigidity, it seems like “Wages must fall!” would be the mantra of all good Keynesians. But few words are less likely to escape their lips.

Why would this be so?

1. Keynesians could say that nominal wage rigidity is such an intractable problem there’s no point discussing it. That’s why Krugman emphasizes that “Ireland is supposed to have flexible markets — remember, before the

crisis it was hailed as an example of successful structural reform.” If wages won’t even fall in laissez-faire Ireland, what hope does the rest of the world have?

There are two big problems with this story. (a) Even if it’s true, Keynesians should still militantly oppose any government policy – like the employer health care mandate – that increases labor costs. (b) Government doesn’t face a binary choice between conventional labor market regulation and laissez-faire. There’s a third choice: Low-wage interventionism. If wages won’t adjust on their own, why don’t Keynesians ask government to actively push them down? If that sounds too brutal, see Singapore for clever ways to numb the blow.

2. Keynesians could say that monetary and fiscal policy are easier to promote than wage cuts. But Keynesians are the first to insist that fiscal policy is a valuable supplement to monetary policy. Why not hail wage cuts as a valuable supplement to both? At minimum, Keynesians should heatedly resist any government policy that pushes labor costs in the wrong direction – and remind us that “wrong” = up.

3. Keynesians could – and often do – retreat to the view that wage flexibility is a self-defeating solution to the problem of wage rigidity. The idea is that wage cuts reduce demand, which in turn exacerbates unemployment.

But this argument is full of holes. As I’ve pointed out before, there are strong reasons to think that wage cuts will increase aggregate demand, making this solution doubly attractive. Consider: Labor income equals wages multiplied by hours worked, so the effect on labor income is ambiguous; and as a matter of pure arithmetic, lower wages imply higher profit income. In any case, if nominal wage cuts really are as rare as a blue moon, what makes Keynesians so sure that wage cuts would backfire if tried? Without lots of empirical counter-examples, they have every reason to stick to the common sense position: “If wage rigidity is the cause of unemployment, wage flexibility is the cure.”

At this point, Keynesians could just bite the bullet: “Wages must fall!” But in my experience they don’t – and I don’t think they’re going to start now. The reason, I’m afraid, is politics. Keynesians lean left. They don’t want to say, “Wages must fall!” They don’t want to think it. “Wages must fall!” sounds reactionary – a thinly-veiled reproach to centuries of anti-capitalist intellectuals and militant unions. After all, doesn’t it mean that every “pro-labor” regulation and “victory for the workers” has an ugly downside – more workers unable to find any job at all?

Keynesians are right to ridicule people who deny the reality of nominal wage rigidity. But they’d be a lot more persuasive if they put leftist qualms aside and focused on the logic of their own model. Keynesians have every reason to rant against excessive wages. They have every reason to rant against regulation that increases labor costs. They have every reason to rant against unions. And there hasn’t been a better time to rant since the Great Depression. Oh my Keynesian brothers and sisters, let us rant together.

P.S. I’m doing a Stossel taping in NYC tonight (12/15). The show won’t air until January, but I’m hosting a meet-up after the show at 10 PM, at Becco – 355 West 46th Street. Hope to see you there.