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.