Don't blame the workers By Scott Sumner

A popular Keynesian theory of recessions is that nominal wages are sticky, and hence reductions in aggregate demand lead to high unemployment. They often go on to advocate more government spending to put people back to work. Free market economists often get frustrated by this argument. Sometimes they blame unions. Sometimes minimum wage laws. Often there’s a suggestion that uneducated workers suffer from some sort of “money illusion” and hence are too dense to understand that they need to accept lower wages to save their jobs during a recession.

I’m a free market economist, and yet I don’t think much of this tendency to blame workers. Indeed I see not one but three fallacies involved here:

1. It’s not just labor markets: Fluctuations in nominal GDP growth cause two big problems, labor market instability and credit market instability. We all know about nominal wage stickiness, but it turns out that debt contracts exhibit even more nominal stickiness than wages. Suppose GE issues a corporate bond, which is purchased by institutions such as pension funds and insurance companies. What can we say about this transaction?

First, it’s a relatively free market. There are no labor unions involved, nor minimum wage laws. There are no uneducated people; the GE finance people and the institutional bond buyers have all taken economics in college. And yet the bonds are almost never indexed to NGDP, they are nominal bonds. This practice leads to financial crises when NGDP growth is highly unstable.

2. It’s also companies: It takes two sides to negotiate wage contracts. And wages are not just sticky in the downward direction. In the late 1960s, NGDP growth accelerated to a very high rate. If wages were perfectly flexible they would have risen even faster than they did. Instead wages were sticky due to long term wage contracts, and the faster NGDP growth led to extremely low unemployment by the end of the 1960s, about 3.5%. I doubt it was the workers who objected to breaking the contracts and offering even higher wages.

3. It’s an externality problem: A system of complete wage flexibility offers huge external benefits, by making the business cycle milder. But that is mostly an external benefit; it’s very rare for workers at individual firms to be able to save their jobs with wage cuts.

Consider a sudden 8% decline in NGDP growth per capita, relative to trend. One example occurred between mid-2008 and mid-2009, when the growth rate plunged from the normal 4% to negative 4%. Now suppose you are a group of nurses. Would you be anxious to accept an 8% wage cut relative to your previous expectation? I don’t see why, nurses aren’t likely to lose jobs in a recession, nor are lots of other people, such as tenured teachers. But if they don’t accept wage cuts then just imagine how big the wage cuts must be in other sectors to reduce the aggregate nominal wage rate by 8% below trend. Even worse, if you are a worker in a windshield wiper plant, good luck saving your job with wage cuts when the automakers you supply stop making cars.

The macroeconomy is a very complex system. Macro problems cannot be understood by thinking in terms of workers at a “representative firm,” because very few workers are at such firms. This means there are huge externalities to wage (and price) flexibility, which makes it even less likely that society will reach an equilibrium with sufficient wage flexibility.

Engineers don’t bemoan the existence of gravity when they design airplanes. Nor do they blame gravity for air crashes. Free market economists should not blame workers for money illusion, they should design monetary regimes where the existence of money illusion by workers, firms, lenders and borrowers does not lead to business cycles and financial crises. That way the Keynesians won’t be able to ask for more government spending.