Paul Krugman: Falling Wage Syndrome

Are we doing enough to reduce the risk that we’ll face a sustained period of deflation and stagnation?:

Falling Wage Syndrome, by Paul Krugman, Commentary, NY Times: Wages are falling all across America. Some of the wage cuts, like the givebacks by Chrysler workers, are the price of federal aid. Others, like the tentative agreement on a salary cut here at The Times, are the result of discussions between employers and their union employees. Still others reflect the brute fact of a weak labor market: workers don’t dare protest when their wages are cut, because they don’t think they can find other jobs.

Whatever the specifics, however, falling wages are a symptom of a sick economy. And they’re a symptom that can make the economy even sicker.

First things first: anecdotes about falling wages are proliferating, but how broad is the phenomenon? The answer is, very.

It’s true that many workers are still getting pay increases. But there are enough pay cuts out there that, according to the Bureau of Labor Statistics, the average cost of employing workers … rose only two-tenths of a percent in the first quarter of this year — the lowest increase on record. Since the job market is still getting worse, it wouldn’t be at all surprising if overall wages started falling later this year.

But why is that a bad thing? After all, many workers are accepting pay cuts in order to save jobs. What’s wrong with that?

The answer lies in one of those paradoxes…: 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. … So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.

In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more … but as wages fall, they’re chasing a moving target. … Things get even worse if businesses and consumers expect wages to fall further in the future. …

Concern about falling wages isn’t just theory. Japan … is an object lesson in how wage deflation can contribute to economic stagnation.

So what should we conclude from the growing evidence of sagging wages in America? Mainly that stabilizing the economy isn’t enough: we need a real recovery.

There has been a lot of talk lately about green shoots and all that, and there are indeed indications that the economic plunge that began last fall may be leveling off. The National Bureau of Economic Research might even declare the recession over later this year.

But the unemployment rate is almost certainly still rising. And all signs point to a terrible job market for many months if not years to come — which is a recipe for continuing wage cuts, which will in turn keep the economy weak.

To break that vicious circle, we basically need more: more stimulus, more decisive action on the banks, more job creation.

Credit where credit is due: President Obama and his economic advisers seem to have steered the economy away from the abyss. But the risk that America will turn into Japan — that we’ll face years of deflation and stagnation — seems, if anything, to be rising.

Here’s a graph of the Phillips curve over the last two and a half years (2006:Q3 – 2008Q4) as measured by the year over year percentage change in the employment cost index (total compensation) versus the civilian unemployment rate:

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Artificially restraining wages from falling is not the correct response, the key is to drive the unemployment rate down so that the labor market tightens and wages rise in response. That is why it’s essential that stimulus programs provide a boost to employment, and I’ve wondered from the start if the stimulus programs we enacted have focused enough on providing employment opportunities. Building new infrastructure does provide long-term benefits, and that gives political cover to the large government expenditure and tax cuts that were enacted, but infrastructure projects alone do not give the maximum possible boost to employment. Providing jobs – some of which may not directly boost long-run productivity – is an essential component of short-run stabilization policy, and there is more that we could do to give unemployed workers opportunities for employment until jobs begin to reappear in the private sector.


Originally published at Economist’s View and reproduced here with the author’s permission.

One Response to "Paul Krugman: Falling Wage Syndrome"

  1. Guest   May 5, 2009 at 11:26 am

    This is an odd analysis coming from Krugman who has advocated Keynesian stimulus as a corrective policy in this recession. Keynes’s logic is predicated in part on “sticky wages” (http://www.econlib.org/library/Enc/NewKeynesianEconomics.html), and now Krugman offers evidence that wages, in the U.S. at least, might not be very sticky. In fact, the neo-classical critique of Keynes rests on the view that wages will adjust within a reasonable period, clearing the labor market. In his essay on the heuristic value of the IS-LM model, Krugman appears to acknowledge this point (see http://web.mit.edu/krugman/www/islm.html ): “To make the transition [to Keynes’s analysis] we must introduce some kind of price-stickiness, so that incipient deflation is at least partly translated into output decline . . . I regard the evidence for such stickiness as overwhelming . . .” We ought to celebrate evidence to the contrary, that in our contemporary economy, stickiness is overrated and the classicists may now be right, even if in the 30s they were wrong. But of course, if one regards Keynesian stimulus as an artifice to drum up support for a disguised desire to expand government command over society’s resources, than acknowledging this implication must be avoided. Krugman’s latest column shows that he believes the best defense against this obvious flaw in the Keynesian argument is an offense, turning healthy market adjustment into yet another imagined symptom of dysfunction.