Relative Prices Matter At All Times

by Mario Rizzo

Paul Krugman has written a column stating that wage cuts at this time are a bad idea. Following Keynes he claims that nominal cuts will do no good – they will not stimulate employment (or prevent unemployment) – because aggregate demand will fall. Real wages will thus remain unchanged.  

In part, Keynes directed this argument at a straw man.  The economist Arthur C. Pigou is supposed to have advocated wage cuts as the main cure for recessionary unemployment. This is not true

In any event, Keynes focused on across the board nominal wage cuts. This is quite understandable from his aggregate or macroeconomic perspective. But, equally, it is wrong-headed. Krugman repeats all of this. 

However, the issue is not across the board wage cuts as if some central authority were issuing an edict. Furthermore, there is no empirical evidence that such a cut is occurring. From the perspective of resource allocation (something that Krugman seems to have suspended his concern for), relative wages need to be adjusted. Not primarily average wages relative to the price level, but wages in some sectors relative to others.  

Yes, the wages of autoworkers, financial sector workers, and construction works should fall relative to “average” wages. How else to ensure a reallocation of resources out of areas that were lately over- expanded by low interest rate and other policies?  

What Krugman appears to fear is deflation, that is, a decline in aggregate demand spiraling out of control. So he recommends more stimulus to, in effect, ratify the “high” wages. But how does any of this allow relative wages to change?  

Thus the immediately relevant issue is the likelihood of deflation. If we focus narrowly we see that food and energy prices have declined and this weighs down the consumer price index. However, as Allan Meltzer points out, during the first quarter of 2009 the “less volatile” gross domestic price deflator rose by almost 3 percent. This is not deflation by my arithmetic. 

Thus, if deflation is not a real threat then let relative wage adjustments take place. We should not suspend our belief in the price mechanism.

UPDATE: I am reminded by “Street-Wise Professor” of Sherwin Rosen’s colorful way of putting the issue.  HT: Peter Klein.

9 thoughts on “Relative Prices Matter At All Times

  1. He should look at Latvia (and other Baltic states where devaluing the currency is not an option and government deficits cannot be financed anymore). The government has cut wages to its employees by around 25%.

  2. Attempting to stimulate the economy with monetary and fiscal policy is hubris. Money enters the economy at a particular location; industries that receive money first will benefit disproportionately, that is, inflation will not stimulate the use of resources uniformly. However, the flow of additional resources to the stimulated industry is unsustainable. Once the distortions created by the stimulus are removed, prices will adjust and resources reallocated. Stimulating businesses to continue employing capital, which they should never have received, will not solve the underlying co-ordination problem. Instead, a stimulus will prolong a recession, since it will prevent the capital reformation necessary to put the economy back upon a sustainable development path.

    Although it is not mistaken to link recessions to a fall in aggregate demand, one has to consider why demand would fall in the first place. The simple answer is that resources have been squandered on goods and services which people do not want. In particular, many homes were built which buyers had no intention of ever living in or renting out. Before the bubble burst, that is, before the economy was exhausted of speculators, demand was sufficient to make such homes appear sensible investments, but only because the bubble created a temporary illusion of wealth. Once reality began to assert itself, many people realised that their spending was too loose. They bought stuff which they never would have if they understood the true value of their assets. Aggregate demand was too high–-artificially inflated from the last round of monetary and fiscal stimulus. The solution is not to stimulate aggregate demand more, but let it fall until prices reflect the real misallocation of resources that occurred during the bubble. Resources can then be redeployed to creating goods and services that people actually want to buy.

    Monetary and fiscal stimuli might increase spending, but at the expense of misallocating resources in the long run. One important function of prices is to prevent the reallocation of resources when the prevailing allocation is more valued, but inflation subverts this function and allows industries which receive the stimuli to draw resources from other uses toward themselves.

    When a recession begins, prices will begin to fall, but not all prices will fall proportionately. Some prices may fall a lot, others not at all, and others may even rise. There is not only a change in aggregate spending, but also in the composition of spending. It is foolish to believe that central bankers or politicians can competently weild monetary or fiscal policy. Which prices should go up, and by how much? What if the “idle resources” or “unemployed factors” are misallocated? Are not such actions in danger of setting up the next bubble, and subsequent collapse? Ultimately, stimuli amount to nothing more or less than trying to centrally plan the economy, albeit by different, and less direct, means than usual.

  3. [Addition to the above comment]

    The economy was exhausted of speculators far later than it otherwise would have been, because of the Federal Reserve’s monetary policy and Congress’s intervention in the housing market.

  4. I’m not a professional economist, but the idea of cutting the pay of employees of the federal government, starting with Congress, strikes me as a terrific idea. The last figures I read said that the AVERAGE annual pay and benefits of federal employees (not including the armed servides) was, fasten your seatbelts, $105,629. Besides being a ridiculous and indefensible figure, it’s just further proof, as if we needed any, that the GOP slumbered soundly for a dozen years and totally abdicated its oversight function.

  5. A while back, the Post Office delivery person on my route told me he was close to retirement and making a bit over $100k annually with benefits and overtime. Now if he could just deliver the mail properly.

  6. Is someone worried that the drop in energy prices signals deflation? It would seem that there was an asset bubble in the market that has deflated. Demand has not changed significantly relative to the change in oil prices. Similar effects were felt in the agriculture commodities markets in the the summer of 2008. From a consumer perspective, the drop in the price of land should eventually free up more money to stimulate demand for other products and services. Precisely what prices are dropping that aren’t simply a resetting of over priced asset bubbles?

  7. The late Fritz Machlup reminded us that there are many types of “inflation,” and thus deflation. They are being conflated in the current discussion. After a great run up (bubble), many asset prices have fallen. Also, commodity prices. There have been “pass through” effects on final goods prices and some measured “deflation.” Far from being a threat, the falling prices of some consumer goods have cushioned the effects of the recession. There certainly has been no deflation of the money stock. Quite the opposite.

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