<p>So let me repeat a point I made a number of times back when the usual suspects were declaring that FDR prolonged the Depression by raising wages: the belief that lower wages would raise overall employment rests on a fallacy of composition.<br /> In reality, reducing wages would at best do nothing for employment; more likely it would actually be contractionary.<br /><br />Here’s how the fallacy works: if some subset of the work force accepts lower wages, it can gain jobs. If workers in the widget industry take a pay cut, this will lead to lower prices of widgets relative to other things, so people will buy more widgets, hence more employment. But if everyone takes a pay cut, that logic no longer applies. The only way a general cut in wages can increase employment is if it leads people to buy more across the board. <br /><br />And why should it do that?<br />Well, the textbook argument — illustrated in this little writeup — runs like this: lower wages lead to a lower overall price level. This increases the real money supply, and therefore liquidity. As people try to make use of their excess liquidity, interest rates go down, leading to an overall rise in demand.<br /><br />Even in this case, it’s hard to see the point of cutting wages: you could achieve the same effect, much more easily, simply by having the Fed increase the money supply. <br />But what if we are in a liquidity trap, with short-run interest rates at zero? <br />Then the Fed can’t achieve anything by increasing the money supply; but by the same token, wage cuts do nothing to increase demand. Wait, it gets worse. <br /><br />A falling price level raises the real value of debt. To the extent that debtors are more likely to cut spending in such a case than creditors are to increase it — which seems likely — the effect of the wage cuts will actually be a fall in demand.<br />And one more thing: to the extent that people expect further declines in wages and prices, this raises real interest rates, which is even more contractionary. <br />So proposing wage cuts as a solution to unemployment is a totally counterproductive idea. Not that I expect any of this discussion to make any impact on those proposing it.<br /><br />Somebody is going to ask, what about the real balance effect? Doesn’t a falling price level make people wealthy, by raising the real value of the money they hold. The answer is, consider the magnitudes. Before the crisis, the monetary base — the system’s ‘outside money’ — was around US$800 billion. This means that even a 10 per cent fall in the price level, which is very hard to achieve, would raise real wealth by only US$80 billion. Compare this with the effects of the decline in housing and stock prices, which reduced household wealth by US$13 trillion in 2008. The real balance effect is totally trivial.</p>
<p>So let me repeat a point I made a number of times back when the usual suspects were declaring that FDR prolonged the Depression by raising wages: the belief that lower wages would raise overall employment rests on a fallacy of composition.<br /> In reality, reducing wages would at best do nothing for employment; more likely it would actually be contractionary.<br /><br />Here’s how the fallacy works: if some subset of the work force accepts lower wages, it can gain jobs. If workers in the widget industry take a pay cut, this will lead to lower prices of widgets relative to other things, so people will buy more widgets, hence more employment. But if everyone takes a pay cut, that logic no longer applies. The only way a general cut in wages can increase employment is if it leads people to buy more across the board. <br /><br />And why should it do that?<br />Well, the textbook argument — illustrated in this little writeup — runs like this: lower wages lead to a lower overall price level. This increases the real money supply, and therefore liquidity. As people try to make use of their excess liquidity, interest rates go down, leading to an overall rise in demand.<br /><br />Even in this case, it’s hard to see the point of cutting wages: you could achieve the same effect, much more easily, simply by having the Fed increase the money supply. <br />But what if we are in a liquidity trap, with short-run interest rates at zero? <br />Then the Fed can’t achieve anything by increasing the money supply; but by the same token, wage cuts do nothing to increase demand. Wait, it gets worse. <br /><br />A falling price level raises the real value of debt. To the extent that debtors are more likely to cut spending in such a case than creditors are to increase it — which seems likely — the effect of the wage cuts will actually be a fall in demand.<br />And one more thing: to the extent that people expect further declines in wages and prices, this raises real interest rates, which is even more contractionary. <br />So proposing wage cuts as a solution to unemployment is a totally counterproductive idea. Not that I expect any of this discussion to make any impact on those proposing it.<br /><br />Somebody is going to ask, what about the real balance effect? Doesn’t a falling price level make people wealthy, by raising the real value of the money they hold. The answer is, consider the magnitudes. Before the crisis, the monetary base — the system’s ‘outside money’ — was around US$800 billion. This means that even a 10 per cent fall in the price level, which is very hard to achieve, would raise real wealth by only US$80 billion. Compare this with the effects of the decline in housing and stock prices, which reduced household wealth by US$13 trillion in 2008. The real balance effect is totally trivial.</p>
