Wages, Recessions, Productivity

To understand why wages do not fall during the vast majority of recessions is to understand the difference between micro- and macro- economics.*

Charted on a Micro 101-style Price & Quantity (most of the time, filled only with supply and demand curves) graph, the labor market in recessions looks like this:
Screenshot (10)
Basically, labor supply shocks. Now, we know recessions are not labor supply shocks (this is because job openings fall during recessions, BTW). The Great Recession was not the Great Vacation. Workers didn’t just walk off their jobs, causing their employers to bid their wages upwards. We know involuntary unemployment is real. Alright, maybe the U.S. is always in a Brazilian-style hyperinflation. How about real wages?
Screenshot (9)
The 1991 recession is the circle in the middle. The Great Recession and 2001 recession still look mostly like giant vacations. So what’s going on?

If you model the labor market as something that could be explained by micro principles, you would get something like this during a recession (assuming the labor supply curve is fairly price-insensitive, which, in real terms, in strongly inflationary recessions, it generally is):


Indeed, the post-Soviet depression did look something like this, though there was still substantial disequilibrium in the labor market, though much less than during the U.S. Great Depression, especially when one accounts for job openings.

The key to understanding this is the difference between physical (per-worker, per hour) and economy-wide (per labor force participant) productivity.

Physical productivity (how much physical output a worker can produce per hour) does not change significantly in most firms during a recession.

Economy-wide productivity is something quite different. A taxi driver of the same physical productivity would receive a much higher real wage in the United States than in Bangalore for doing physically the same work. Why is this? It is because the productivity of a few key industries often matters far more than the productivity of many small ones in determining everyone’s real wages. Examples of this include the oil industry in Russia and Qatar, the finance industry in New York City and the diamond-mining industry in Botswana.

If the physical productivity of only a few key firms and sectors is affected in recessions, then, if the recessions are not the result of tight money, the recessions should mostly show up not in falling employment (though that may happen), but in a rising price level. Indeed, in Russia, unemployment growth since August has only been by a percentage point, while real wages have plummeted. Due to the resource-disallocating effect of a downward economy-wide productivity shock, unemployment may, of course, still rise during a highly inflationary recession. But, while real output fell in early 1990s Russia as much as it did in the United States during the Great Depression, unemployment in early 1990s Russia never breached 15%. In the United States, unemployment breached 20%. This, despite the fact that there were far more and far more labor-intensive malinvestments to be liquidated in Russia than in the United States. This was because real wages collapsed in early 1990s Russia due to the hyperinflation there, while the Great Depression was largely a demand-side, deflationary depression caused by money hoarding and bank failures.

Why do firms almost never cut nominal wages during a recession? It is because, while economy-wide productivity may be falling, the physical productivity of the vast majority of firms may be rising. Indeed, it is quite possible for the physical productivity of all firms to be rising and for economy-wide productivity (per labor force participant) to be falling at the same time. Output per labor force participant may be falling while output per worker may be rising. This is what happened in the U.S. economy in general in the Great Recession, though not for all firms or industries.

As the Lord Keynes points out, when nominal wages are cut by an employer, employees cut their physical productivity. But why do workers cut physical productivity when changes in economy-wide productivity are adjusted not by rising prices, but by falling nominal wages? After all, is not money neutral?

This is where Irving Fisher’s “money illusion“, of which Scott Sumner talks about, comes into play. It was crucial during the Great Depression (and important during the Great Recession), but was unimportant in the 1973-5 recession and the Russian experiences (except in 2008 Q4-2009 Q1, when unemployment rose sharply due to wage stickiness resulting from this illusion). When workers see a nominal wage cut coming from their employer, they take it as meaning that their employer wants them to work less physically productively, as there is nothing about these wage cuts that necessarily apply to the world outside their employer. However, when the same real wage cut comes from rising prices outside their employer, the employees see that there is nothing special about their employer or their predicament, as prices have risen for everyone, no matter where they might be employed. For an individual firm, labor supply curves are fairly horizontal. Even a small reduction in the price of labor caused solely by a decrease in labor demand causes a much smaller quantity of labor to be supplied in a typical firm. However, a much less price-sensitive (more vertical) labor supply curve applies for the entire labor market. For the broader economy, this results in nominal GDP cuts exacerbating the labor market disequilibrium (unemployment) caused by disallocation of resources during the recession, and, thereby, exacerbating real GDP cuts due to employers not being so self-disrespectful as to cut their workers’ physical productivity. Thus, the appearance of “great vacations”.

The point? Don’t be afraid of high inflation/NGDP growth. Russia (and Belarus) managed just fine until the recent oil price shock with years of it after the Great Recession. Greece could have done so, too, had the European Central Bank let it.

*Yes, exaggeration, I know. But that’s about half of it.


Definitions of Factor Intensity

Land: Anything not of human origin and not capital.
Land-intensive: Requiring much land per worker or per unit of capital.
Example: Primary industry in Argentina, 18th century.
Labor-intensive: Requiring much labor per unit of land or capital.
Example: Agriculture in China and Japan, 18th century.
Example: Manufacturing in Belarus, Mauritius, Ukraine, and Malaysia is believed to be this.
Capital: Anything not directly consumed, but increasing the productive abilities of labor and land.
Capital-intensive: Requiring much capital per unit of labor.
Example: U.S. manufacturing, c. 2008.
Capital: Accumulated unconsumed portion of expenditure minus depreciation.
Capital-intensive: Requiring much capital per unit of labor or TFP.
Example: Manufacturing in North Korea and Russia, c. 1980.
TFP: Anything that isn’t differences in employment as a percentage of the population and differences in accumulated unconsumed portion of expenditure minus depreciation. It could be land, for all anyone cares. It’s not counted as unconsumed portion of expenditure, right?

To encourage clear thinking.

WaPo Admits the Truth (for the wrong reasons)!

Never thought I’d see this from the U.S. mainstream media. BTW, though leaving Iraq in 2011 had nothing to do with the rise of the Islamic State, nor did leaving Maliki behind, and neither did not backing the rebels, not threatening to kick Turkey out of NATO had everything. WaPo has long had a track record of subverting establishment narratives, and, while it is this time 100% correct in its conclusions, it is totally wrong on the causes. It’s right on climate change and national security this time around.

For How Long Was the U.S. the World’s Largest Economy?

A solid century. According to conventional wisdom (i.e., Maddison, whose estimates should always be taken with a pinch of salt), British and American per capita GDPs (PPP) were rather similar, with Britain’s being slightly higher, until Britain fell clearly behind during the years immediately after the two World Wars, thanks, presumably, to its socialist and laborist policies of the time. Bob Allen confirms U.S. real wages were slightly higher than British throughout the 19th century (at least, by his method of measurement), however, Allen presumes the British profit share of income was higher. The population of China, the largest economy in the world in the early 1850s, was around 430 million, standard error 50 million (a contemporary source lists 396 million; trust these statistics only as much as you trust contemporary Chinese statistics) at the time, and only fell the following decade and a half thanks to the Taiping Rebellion. The population did not significantly change throughout the rest of the 19th century. According to Robert Allen, real wages in London in the 1900s were some four and a half times higher than those in Beijing. Assuming this reflects a GDP per capita (PPP) difference, and that the per capita situation was roughly the same as in the U.S. (which is fairly reasonable), the U.S. economy surpassed the Chinese sometime (see U.S. population figures) in the early 20th century, probably by 1908. The significance of labor force participation, population pyramids, and the rent share of income is probably sizable here, but is rather difficult to ascertain. The assumption that they all even out in the end is a somewhat dubious, though not completely unreasonable one. However, the general pattern-that the U.S. economy surpassed China’s in the early 20th century, very likely by 1910-remains very sound. In the case of the U.K., for which population figures are readily available, the case is much clearer. The U.S. surpassed the British economy sometime in the early 1850s, certainly by 1855, and almost certainly by 1854, even if it did have a lower GDP per capita (PPP) at the time.

Edit: a study confirms British GDP per capita was higher than American until 1880, when it reached approximate parity, and that the divergence became larger in America’s favor 1899-1906 and 1920-1926.