Sunday , July 5 2020

Wage cuts

Summary:
A decision by the Fed to cut its interest rate target is usually expansionary.Falling market interest rates are usually a bad sign, an indication that money is too tight, and getting tighter.A decision by a firm to cut wages is usually expansionary for employment.Falling aggregate wage rates are usually a bearish indicator, a sign that money is too tight.Most people have trouble wrapping their mind around these seeming contradictions.The recent surge in unemployment has caused massive distortions in the labor market. Due to “composition effects” we don’t have good data on aggregate wage changes for a given skill level. (Average hourly wages are rising, but only because it’s mostly the lowest skilled workers who are losing jobs.) Nonetheless, Bloomberg suggests there is

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A decision by the Fed to cut its interest rate target is usually expansionary.

Falling market interest rates are usually a bad sign, an indication that money is too tight, and getting tighter.

A decision by a firm to cut wages is usually expansionary for employment.

Falling aggregate wage rates are usually a bearish indicator, a sign that money is too tight.

Most people have trouble wrapping their mind around these seeming contradictions.

The recent surge in unemployment has caused massive distortions in the labor market. Due to “composition effects” we don’t have good data on aggregate wage changes for a given skill level. (Average hourly wages are rising, but only because it’s mostly the lowest skilled workers who are losing jobs.) Nonetheless, Bloomberg suggests there is strong anecdotal evidence of falling wage rates in a number of firms:

Companies across the U.S. are cutting salaries as they fight to survive the coronavirus, upending a key assumption in modern economics and raising another hurdle to rapid recovery.

The hard numbers won’t be in for months, but anecdotal evidence is piling up. On earnings calls, big businesses including The Container Store Group and Lyft have cited what they say are temporary salary reductions. Federal Reserve officials also have found plenty of supporting evidence.

As is often the case with wage cuts, people wrongly assume that this phenomenon contradicts sticky wage models:

That’s not supposed to happen, according to ideas that have dominated economics for the better part of a century, since John Maynard Keynes unveiled his famous “General Theory” during the Great Depression.

The phenomenon is known as “sticky wages.” Employers may be able to cut inflation-adjusted pay by raising wages less than prices, the argument goes. But it’s harder to cut pay in nominal terms — in other words, by putting a smaller number on people’s paychecks.

That’s why supply and demand get out of balance in a slump, according to the so-called New Keynesian model that Fed officials and other policy makers lean on.

There may be some economists who are so ignorant of history that they don’t know about nominal wage cuts, but most of us are aware of the phenomenon.

Sticky wage models predict that hourly nominal wage rates will fall much less sharply than NGDP during a slump. And that’s exactly what’s happening right now.

As an aside, I don’t believe the sticky wage model is particularly helpful in explaining the recent slump in the economy (which is primarily due to a real shock), but I do fear that the model will be useful next year, at least if NGDP is still depressed.

To find declines in NGDP comparable to the second quarter of 2020 you need to go back to the early 1920s or the 1930s. And nominal wages also fell on those occasions. There’s nothing new under the sun.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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