Sticky Trajectory for Wage Inflation

Simple microeconomics suggests that price falls in response to a surplus.   In labor markets, the price of labor, the wage, should drop in response to a surplus of labor.  

The Market Monetarist explanation of the Great Recession is that nominal GDP fell to a much lower growth path while the price level fell to only a slightly lower growth path.   This resulted in a large down shift in real expenditure on output, to which firms responded by shifting their production to a much lower growth path.   Since this lower growth path of production required less labor, they reduced employment as well.

Market Monetarists don't deny that "supply-side" factors might have reduced potential output a bit, or that workers may have decided they don't want to work quite so much.   But as a matter of fact, we think these were not very significant.   And so, it would seem that on a micro level, the typical market should be in surplus.    

Of course, spending on output began to grow in 2009, as did production and employment.   These factors would tend to reduce the surpluses, but a growing eligible population and rising productivity are tending to increase the surpluses.   In fact, the typical Market Monetarist interpretation is that the growth in production and employment is at best just keeping up with growing capacity.   The underlying surplus remains little changed.

But how is that consistent with basic microeconomics?   If that is true, prices and wages should have both decreased enough so that real expenditure would rise enough to match the productive capacity of the economy.   The surpluses should close through lower prices.  Lower product prices for product markets and lower wages for labor markets.     If nominal GDP is actually kept along the new lower growth path (rather than allowed to drop further,) the decrease in output prices raises real expenditures and so real sales.   The lower wages allow costs to fall enough so that this doesn't generate losses for the firms.     The firms expand production and employment to match the increase in real sales.

Now, let's suppose that firms refuse to actually cut wages.   Wages are sticky, or even rigid, in a downward direction.   Then, the surpluses of labor should result in wages remaining constant.   Prices might fall a bit, but since wages won't fall, firms cut production and employment along with the rising real wages.   Once spending begins to rise, prices should rise along with production and employment.  

Of course, what happened since 2008 is that wages have continued to rise though the rate of increase has decreased.    And while there was one quarter's worth of actual deflation in output prices, generally prices have continued to rise, again, at a slightly lower rate.   Both price and wages are on slightly lower growth paths.  

And so, if the Market Monetarist approach is correct, prices and wages have both continued to increase despite surpluses of output and labor.    Market Monetarists (or most of them) realize that we need to do more than explain that wages won't fall, but rather why the trajectory of wages and prices is sticky.   Why do prices and wages continue to increase in the face of surpluses of output and labor?

In my view, the problem is fundamentally one of "insiders" and "outsiders."    Long run success for a firm depends on having a reputation for being a good employer.   Such a reputation requires that current workers be protected whenever possible.    Managers should be servant leaders, promoting the good of their team.

No existing firm, however, need take responsibility for new entrants into the labor force.  And so, problems develop.

Suppose that population is increasing one percent a year, and the typical career lasts 50 years.   In equilibrium, each year 2 percent of the labor force retires and new hires are 3 percent of the labor force.    Spending on output is growing 5 percent, with employment growing one percent, productivity growing 2 percent, and inflation is 2 percent.      Employers provide compensation plans that provide a cost of living raise and rewards for productivity, so wages increase 4 percent per year.

Spending on output drops to a 15 percent lower growth path.   Employers, seeking to protect their reputations, keep their compensation program unchanged, raising wages 4 percent.   To keep up with rising costs, they continue to raise prices 2 percent.   With productivity rising 2 percent, they can pay 4 percent more and have unit costs rise 2 percent.    

With the significant drop in spending on output and continued price and wage increases, the real volume of sales drop significantly.   The firms don't lay off their employees, since that would hurt their reputation as well.   But they quit hiring new workers.    As workers retire, total employment shrinks by attrition, 2 percent a year.   After 4 years, this would cause employment to fall approximately 8 percent.   The gap between employment and the trend of employment would be approximately 12 percent.

Of course, not all firms can protect all of their employees.    With a severe and rapid drop in sales, some firms may have to restrict or even stop pay increases or layoff employees.   A sharp increase in separations should be expected when spending on output is absolutely dropping.   And perhaps some prices might fall and the rate of increase in prices and wages might slow a bit.   But after biting that bullet, the firms will want to stop laying off employees and return to raising the pay of existing employees according to compensation programs aimed at maintaining their long run reputation as a good employer.

Of course, under normal conditions, many firms fail and lay off employees.   Existing firms that are doing well and new firms expand employment.   For the economy as a whole, if there are few new firms and the relatively successful firms are not doing very well, and so don't expand employment, the drop off in total employment can be very rapid.   Some firms just have a pause in new hiring.   Other firms that would have been successful and hiring, just replace the employees that leave.   And some firms are only replacing some of the employees that leave, and still others are cutting back total employment as fast as possible without actually laying off employees.     With the sort of massive turnover normal in the U.S. economy, rapid decreases in total employment are possible by just limiting new hires.

With the drop off in new hires, there are plenty of workers who would like to have jobs.    Many economists emphasize that it may take some time for these workers to recognize that they cannot find jobs with wages consistent with the previous trend in wages.   Only gradually will they reduce their reservation wages.    But after many years, surely they will accept lower wages.

Of course, labor markets hardly ever involve employees posting offer prices, and then firms choosing to take them.   It is rather that employers offer employment.    And while successful economists may focus on the negotiating process they have experienced, for many new entrants to the labor force, employment is more of a take or leave it "bid" by the employer.     This would surely be true in a buyers' market where total employment is contracting, or at least, growing much more slowly that the number of new entrants into the labor force.

No, what is supposed to happen is that the entrepreneurs in charge of the firms will  change their compensation programs, paying new employees less.   The firms are supposed to recognize that there is a buyers' market and that the unemployed workers have a lower reservation wage.   While this only slightly lowers average wage statistics and average costs, it does reduce marginal costs.   The firms should expand production and employment.

And, sure enough, wages and prices are rising a bit more slowly, and production and employment are growing.    Suppose that spending on output begins growing 5 percent (remaining on a 15 percent lower growth path.)    Firms adjust their compensation packages and start new employees at lower wages, and so inflation is only  1.5 percent.   Real output grows 3.5 percent rather than 3 percent.   How long does it take to recover from a 13 percent shortfall in real GDP?   Decades?

What is wrong?   It is the next step.    Suppose unemployed workers and employees all provided offer prices for their labor, and employers just took it.   The unemployed workers reduce their offer prices, and the employers take them, and some of the existing employees become the unemployed workers unless they also lower their offer prices.    Of course, labor markets work nothing like this.

Now, suppose instead that when employers realize that they can hire new employees at a lower wage, they go to existing employees and explain that they can be replaced at a lower wage.   They also point out to the employees that if they quit, it is difficult to find new jobs, and so they really have no choice but to just take the pay cut.   By taking advantage of their workers, they cut wages and costs rapidly.    Rather than small decreases in marginal costs, there are large decreases in marginal costs.   If firms are competitive, output prices fall.   If nominal GDP is kept on the new (lower) growth path rather than drops further, then real expenditures rise.   Firms expand production and employment.   Both wages and prices fall to the new, much lower growth path that is necessary for real expenditure to rise back to potential output.

So, why don't firms "take advantage" of their existing employees?   Why don't they force pay cuts on them?   There is a surplus of labor.    Their workers have no choice but t0 accept the pay cuts.   Why?  It is because they don't want to have a reputation of taking advantage of their employees.    

Now, if this situation was expected to be permanent, then perhaps the absolute pay cuts would occur.   But even in this scenario, where it is only new hires that take the pay cuts, a firm can maintain its reputation for protecting all existing employees and eventually the economy returns to full employment.   The situation is not permanent.

Even more so, if there is an expectation that spending on output will grow more quickly, generating a recovery more quickly, then any firm that took advantage of existing employees would have a difficult time recruiting good workers, or would have to pay workers more during "normal" times, and suffer a competitive disadvantage.  

More interestingly, if enough firms cut wages and lowered prices, then the other firms could explain to their employees that they have no choice but to do the same.   If all firms cut wages and prices when nominal GDP was low, then no firm suffers a competitive disadvantage during normal times.   (Perhaps all employers would be considered greedy and wicked.)   But if a few firms follow the policy of taking advantage of their employees, they might have fleetingly lower costs and increased profits during the recession, but they would suffer during "normal" times.

For Market Monetarists, the answer is easy.   Don't allow nominal GDP to fall to a lower growth path, and if it does, get it back up to the target growth path as soon as possible.  Allow firms to develop their compensation programs based upon an expectation that spending on output will grow at a slow, steady rate and then fulfill the expectation.