Falling Wage Rates

November 12, 2009

by Jerry O’Driscoll  

In today’s Wall Street Journal, there is an article titled “Returning Workers Face Steep Pay Cuts.”  The article cites research by Kenneth Couch of the University of Connecticut that returning workers are taking on average a 40% pay cut from their old jobs.  This is first and foremost a personal tragedy for those affected.  The question we must ask as economists is why?  

Econometricians will still be picking over the data a decade from now. (And of course, they will be looking at revised data, rather than the data we are viewing today. But that is a subject for another post.)  One factor that must not be overlooked is that capital has been destroyed in the prior boom.  The so-called bust or crisis is the revelation of those losses.  Capital is heterogeneous.  The capital embodied in all those unoccupied homes in Las Vegas cannot be deployed to build goods and employ workers in the manufacturing sector. 

Many analysts, myself included, argue that economic recovery will involve a switch to a lower consumption path.  In the process, proportionately more resources will be devoted to production of goods for rest of the world.  New savings will be needed to finance that transition.  But much accumulated savings have been lost due to capital misallocation. In order to be competitive in the global economy, the U.S. must become a country of lower wages. And we are witnessing that painful adjustment in real time. 

The reflationists (whether monetary or fiscal) conflate cause and effect.  Falling wages rates are the consequence of prior bad policies and decisions.  They are not the cause of current problems.  Moreover, fiscal and monetary stimulus cannot restore the lost capital.  Printing money or redistributing income does not create real wealth.  

Falling real wages and declining living standards put flesh on the skeleton of macroeconomic policy debates.  They are the real-world consequences of bad macroeconomic policy: easy money, politically directed investment and regulatory capture.  All those bad policies are being continued or enhanced.  Only further misery will flow from them.

17 Responses to “Falling Wage Rates”

  1. Bob Murphy Says:

    Good post. How does your stat interact with the claim that “we need inflation because of sticky wages”? I could see it cutting either way. The pro-inflationists could say, “Businesses can’t easily lower everyone’s pay, so workers have to take pay cuts by getting laid off and then getting hired elsewhere. How terribly wasteful.”

    But is that right?

  2. chidemkurdas Says:

    One aspect of this adjustment process is that it is unequal– heavily unionized public sector jobs are mostly immune to wage cuts. What tends to happen is the unions protect their senior members & wages while junior and non-union workers bear the brunt of the layoffs. For instance, NYC laid off teachers’ aids in response to the revenue decline.


  3. Thanks. Quantity responses signal the need for adjustments in nominal prices and wages. Firms are price searchers both in their product markets and in factor markets. The duration of unemployment has been unusually long this recession. The amount of capital destruction is one, but not the only factor. We are also experiencing uncertainties brought on my policy regime change. Reflation addresses none of this.


  4. I agree with Chidem’s point. Protected labor markets impose even greater adjustment costs on the unprotected sectors. Much of the stimulus has been used to protect unionized public sector jobs. That is part of what I was referring to in my comment on income redistribution.

  5. Don Lloyd Says:

    Jerry,

    “…In order to be competitive in the global economy, the U.S. must become a country of lower wages….”

    I’m sure you know this, but competitiveness is not a simple function of wages, but must depend on the ratio of marginal productivity to marginal wage cost. Falling wages would be the result of a lower level of capital mixing with labor and a failure to withdraw from economic segments that are more productivity-critical on the margin.

    In a recession, the primary fact for the individual firm is that falling unit demand results in excess productive capacity. This inevitably results in layoffs and shorter workweeks. Simply lowering the wages of direct labor does nothing to deal with the excess capacity. Since layoffs must logically be ordered starting with high cost/low productivity direct workers, this does not, by itself, reduce the wages of remaining workers.

    Regards, Don


  6. Don Lloyd,

    Your comment presents a dilemma for me. I was trying to forestall the argument that, on competitive markets, there should be only price adjustments. You seem to be arguing that price adjustments cannot clear markets, no matter what.

    I stopped agreeing with you when you said: “lowering the wages of direct labor does nothing to deal with excess capacity.” Of course it does. If firms depreciate their capital sufficiently and reduce wage rates, they can retain or hire back their workers. (If the capital value has fallen to zero, then the firm, of course, must cease operations.) It’s about values, not physical stuff. Productive capacity is an engineering cocnept, not an economic one.

    George Stigler observed that the actual short-run theory of labor demand is a wages-fund theory, not MP analysis (the long-run theory). He was correct. Reduce the wages-fund, and either employment or wages must fall. As a practical matter, it is first the former (quantity response), then the latter (price response). Markets then clear: lower wages, full employment.

    I think we’re 2 years away on full clearing. For reasons I’ve already explained.

  7. Keith E Says:

    Excellent post. Would not the quickest path to recovery have been to focus on savings so as to replace the lost capital as quickly as possible? Will stimulus spending and inflationary policies simply delay the replacement of lost capital needed for future production (and consumption) by 1)siphoning off future income for repayment and 2) by creating new misallocations and potentially new bubbles?


  8. Thanks, Keith. I have questioned the efficacy of stimulus (monetary and fiscal). Desired savings ratios have risen and these policies frustrate the transition. And I agree current policies are contributing to further misallocations. Larry Lindsay suggested a permanent 50% cut in the payroll tax as market-friendly stimulus. Somehere down the road, however, there would need to be either future new taxes or spending cuts.


  9. so, let me get this story straight. The lower consumption leads to higher savings that means that people want to consume more in ten future, a consequence of that is a build up of capital. the process takes time and in order to induce the changes needed for the reallocation from more consumption to less consumption, there has to be relative price changes. That is going on now in certain sectors of the economy and that leads to a fall of the marginal productivity of specific labor and capital. That would mean that if some workers are going to keep working on those sectors where the value of the marginal productivity is shrinking, then they must take a wage cut.

    am i right or should i just start reading my econ101 textbook again?

  10. Yophat Says:

    Great post! Time to pay the piper! Deflation will have the last laugh…

  11. Don Lloyd Says:

    Jerry,

    “…I stopped agreeing with you when you said: “lowering the wages of direct labor does nothing to deal with excess capacity.” Of course it does. If firms depreciate their capital sufficiently and reduce wage rates, they can retain or hire back their workers. (If the capital value has fallen to zero, then the firm, of course, must cease operations.) It’s about values, not physical stuff. Productive capacity is an engineering cocnept, not an economic one….”

    I don’t think that we would disagree if you would take my statement as it was intended, applying only in the time period before laid off workers get new jobs, at lower wage rates that reduce the statistical average wage level.

    The fact that productive capacity IS an engineering concept doesn’t make it any less true. The 10.2% unemployment rate has not been the result of only companies that go out of business entirely. I doubt very much if you believe that all of the companies that have reduced their workforces have been in error in doing so.

    If a company can produce 10 widgets with 10 units of direct labor, and now can sell only 5 widgets even after lowering prices, it will still have to lay off workers even after lowering wages if it is to serve its self-interest. Paying production workers to sit around uselessly makes no sense even if they are paid significantly less than before.

    Regards, Don


  12. Thanks to all for the comments. As I read Mauricio Flores comments, I think we agree.

    Why so many employers prefer layoffs to wage cuts — at least initially — is problematic. Certanly the existence of unemployment benefits makes layoffs less costly than would otherwise be the case.

    This issue gets to he points that Don Lyoyd raises. Unless the MP of labor has fallen to 0, why not offer workers a wage cut as an alternative to unemployment?

    Regards to all.

  13. Don Lloyd Says:

    Jerry,

    “…This issue gets to he points that Don Lyoyd raises. Unless the MP of labor has fallen to 0, why not offer workers a wage cut as an alternative to unemployment?”

    I don’t think it’s the best argument, but the effective net MP of labor can easily fall to 0. What counts is the marginal revenue product (MRP). This is not a constant at any time, but falls with every increase in produced output level for constant technology and constant demand curve. The last unit produced is the last one for which the marginal revenue exceeds the sum of the marginal costs of all the factors, including labor. Making the simplifying assumption that all factor costs other than labor are constant, it is not too hard to imagine that a recession may depress the demand curve so greatly that the pre-rec ession production level has a new marginal revenue that is smaller than the sum of all the non-labor factors, leaving nothing to pay labor unless the production level is reduced. Without an RIF of direct labor, there will be surplus labor not needed and wasted (even at a reduced wage) and any other factors used will also be wasted as the production is either not sold, or sold at a loss. This, I suspect, can be considered as a 0 or negative effective MP for labor.

    Regards, Don


  14. Don,

    Your last comment reinforces the main point I wanted to make: there are large relative price adjustments that must be made in the make of the bursting of an asset bubble. Reflation can’t avoid this. In any case, I appreciate your comments.

    Regards, Jerry

  15. Edward hake Says:

    It seems to me, and I am looking in this case at education, that the more the unions are involved the worst the product. Locally the non-union schools produce the highest rate of merit scholars, college ready students, and even the best sports team, at far less cost than the public schools. Why? The teachers are not paid more, even aas a rule less>

  16. Edward hake Says:

    The teachers are paid more, even as a rule less.


  17. Thank you google for finding me all this information, You are now top of my bookmark list


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: