Krugman on Wage Cuts

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A reader drew my attention to the following quote from Paul Krugman’s New York Times Blog: “Wage cuts are the last thing America needs right now: We sell most of what we produce to ourselves, and wage cuts would hurt domestic sales by reducing purchasing power and increasing the burden of private-sector debt. Lower wages probably wouldn’t even help the fraction of the U.S. economy that competes internationally, since they would normally lead to a stronger dollar, negating any competitive advantage. The point, however, is that these feedback effects from wage cuts aren’t the sort of things even very smart business leaders need to take into account to run their companies. Businesses sell stuff to other people; they don’t need to worry about the effect of their cost-cutting measures on demand for their products. Managing national economic policy, on the other hand, is all about the feedback.”

The reader noted that many good macro theorists, dating at least back at least to Keynes, have extended Krugman’s obviously correct conclusion by arguing that meaningful wage rigidity (MWR) is not necessary in the construction of coherent, stabilization-relevant macroeconomics. That is, of course, much different from arguing whether wage cuts are what “America needs right now”. The broader conclusion is both wrong and, more problematically, has done great damage to the stabilization-relevance of macro theory. It must be, once and for all, rejected.

Stiglitz & Greenwald

The most cited marginalization of MWR in macroeconomics is the 1993 Journal of Economic Perspectives article (“New and Old Keynesians”) from Bruce Greenwald and Joseph Stiglitz. G&S defined two NK camps: “…these two new Keynesian approaches have different implications for how the economy works. The first holds that the classical dichotomy breaks down, allowing monetary policy to have effects other than on the price level, because nominal prices are at least somewhat rigid throughout the economy. The second approach, however, holds that monetary policy has real effects even when wages and prices are flexible.”

G&S summarize their message: “The new Keynesian view that emphasizes price flexibility suggests an alternate and more complex perspective: first, that natural economic forces can magnify economic shocks that may seem small, and second, that existing price rigidities may reduce the magnitude of the fluctuations, as Keynes argued. Since even with perfectly flexible wages and prices, the economy could experience substantial variations in employment, they believe the single-minded focus on price and wage rigidities is misguided. And since small disturbances can give rise to large effects, there is less concern about identifying the source of the disturbance: in one case, it may be a supply shock (the oil price shocks of 1973 and 1979), in another case it may be a monetary shock (the Volcker recession).” G&S identify “incomplete contracts, and, in particular, imperfect indexing as central market failures”, as well as imperfect competition and coordination failures, as important sources of macro-shock propagation.

GEM Project

Two interrelated propositions, featured in the GEM Project, are relevant to the MWR debate. In the first, a particular class of nominal wage rigidities is identified to be both a necessary condition for the existence of involuntary job loss and inherently nonexistent in coherent market-centric general-equilibrium theory. The second asserts that macroeconomics must accommodate involuntary job loss in order to be useful to stabilization policymakers.

First proposition. In the textbook market-centric general-equilibrium narrative, employees respond to wage reductions from their market opportunity costs by quitting, voluntarily moving to the alternative, now better-paying positions. Involuntary job loss plays no role. Moreover, if workers find themselves receiving wage rents (for example, as a result of an adverse shift in aggregate nominal demand), they must rationally accept any pay cut, in lieu of job loss, that does not violate their opportunity costs. Forced job separation continues to play no role.

The introduction of involuntary job loss into coherent macro modeling requires the textbook labor-pricing story to be altered in two fundamental ways. First, for whatever reason, at least some employees rationally receive wage rents. Second, firms’ capacity to impose wages that reduce or eliminate those rents in lieu of job loss must be rationally suppressed, implying circumstances in which excess labor supply cannot induce labor-price cuts. The two-part wage rigidity is named “meaningful”. The first proposition is: Forced job separation implies the existence of meaningful wage rigidity.

The G&S reworking of coherent macroeconomics to exclude wage rigidities does not, and can never, accommodate involuntary job loss and recognizable involuntary joblessness. Meanwhile, G&S surely know that forced job loss always plays the dominate role in rising unemployment during recessions. The perilous 2007-09 Great Recession is illustrative. Its six-million increase in involuntarily lost jobs accounted for more than three-quarters of the increase in total unemployment. Whatever G&S are describing in their NK modeling, it has little to do with what actually happens in U.S. recessions. They are playing games and do not seem to care that they badly mislead.

Perhaps  more telling, G&S also must ignore that the rational suppression of wage recontracting by MWR uniquely provides the channel through which adverse nominal demand disturbances induce involuntary job and income loss. At least since Keynes, macro theorists have understood that nominal-real linkage to occupy a central place in stabilization-relevant monetary theory. The channel is critically associated with a crucial meta-externality. Meta-class externality exists when the overall costs of a continuous-equilibrium macro arrangement differ significantly from constituent micro-decisionmaker costs, making a set of aggregate-market outcomes inefficient and invoking Pigou’s famous justification for public intervention.

Second proposition.  Policymakers understand that mass involuntary job loss, partly because of the reduced income resulting from the characteristic absence of alternative employment paying comparable wages, is a socioeconomic problem that is central to business-cycle pathology. In the second proposition, axiomatic policymaker preferences cause them to reject, emphatically, the absence of endogenous forced job loss from models used to support their decision-making.

Despite the assumption of mainstream economists  that job separation is always voluntary, government and business leaders generally refuse to ignore welfare-relevant facts. G&S and many other macro theorists  have been forced to choose between familiar, coherent market-centric thinking and policy usefulness. It is a tough choice that frequently produces odd behavior.


Keynesians today disagree on the significance of MWR.  A basic confusion is between the role of MWR in the effective modeling of instability in highly specialized economies and its role in the design of effective policies to reverse weakening aggregate demand in order to ameliorate the costs of economic instability. Krugman’s correct policy advice quoted above in no way contradicts the GEM Project’s equally correct demonstration of MWR’s centrality in the nature and consequences of recognizable business cycles.

Blog Type: Wonkish Saint Joseph, Michigan

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