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.

Author: pithom

An atheist with an interest in the history of the ancient Near East. Author of the Against Jebel al-Lawz Wordpress blog.

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