Tuesday, September 1, 2009

Real Wages, Depression, and Unemployment

David Ohanian has a new paper that argues that Hoover's efforts to keep firms from cutting wages led to the high unemployment during the Great Depression.

While excessively high real wages might cause a surplus of labor and unemployment, focusing on high real wages is a mistake when describing the consequences of a shortage of money and a general glut of goods. While a careful reading of Ohanian's paper shows that he understands the central role of monetary disequilibrium, less careful readers may be confused.

Unemployment looks like a surplus of labor. Basic supply and demand analysis implies that a surplus of any good exists when its price is above equilibrium. A lower price of the good raises quantity demanded, reduces quantity supplied, and clears up the surplus. And so, a lower price is the solution to a surplus.

In the labor market, the wage is the price. Unemployment looks to be the result of wages above equilibrium. A lower wage rate should increase the quantity of labor demanded, decrease the quantity of labor supplied, and clear up the surplus. Isn't it obvious that lower wages are the solution to unemployment?

Basic supply and demand analysis is based up relative prices, the ratios of the money prices of different goods. A surplus exists for a good when its relative price is above equilibrium, and a lower relative price clears it up. In labor markets, the parallel concept is the real wage--the money wage relative to the money prices of goods and services. A surplus of labor (and apparently, unemployment,) would be due to real wages being above equilibrium. Wages are high relative to the prices of products. Real wages need to fall, clearing up the unemployment.

However, if the quantity of money is less than the demand to hold money, the result will be a net surplus of other goods, including currently-produced goods. Since firms will not produce goods they cannot sell, output declines. And with less output to be produced, firms demand less labor. A surplus of labor can exist without there being any change in real wages.

The problem, however, is money prices of all sorts, including resource prices like labor, are too high. A drop in all money prices, including money wages, will result in a higher real quantity of money. As the real quantity of money rises to meet the demand to hold money, the shrinking shortage of money is matched by a reduced surplus of goods. The growing demand for goods and services should result in firms producing more and hiring more labor. While both money prices and money wages need to fall, they need to fall at least roughly in proportion. Real wages are not too high and do not need to fall.

There is, however, a realistic disequilibrium process where excessively high real wages develop and appear to be the cause of unemployment. When there is a surplus of a good, each firm is motivated to lower money prices. And while firms are also motivated to cut wages when there is a surplus of labor, goods prices may adjust more rapidly than wages. If this occurs, then surpluses of products and labor will result in money prices falling more than money wages, so real wages rise.

The sticky adjustment of money wages slows the decrease in the prices of goods and services. From the point of view of each firm, it cannot continue to lower prices if costs do not fall as well. Production must be reduced. It is possible to conceive of an "equilibrium" where the firms are maximizing profit (or minimizing loss,) output matches sales (at a depressed level) and there is a surplus of labor, with continuing downward pressure on money wages.

In this "equilibrium," as the surplus of labor continues to result in falling wages, cost fall, and supply rises. The profit maximizing (or loss minimizing) level of output is higher. Firms lower prices less than in proportion to the decrease in costs, and real wages fall.

However, the key element of the process is that the lower prices are increasing the real quantity of money and clearing up the underlying shortage of money. This is what increases the demand for goods and services, and so increases the demand for labor as well.

The emphasis on the changes in real wages is just a red herring. The problem is that sticky prices are hindering the adjustment of the real quantity of money to the demand for money. Some prices can be more sticky than others, and the adjustment process involves increases in the relative prices of goods whose money prices are more sticky and decreases in the relative prices of the goods whose prices are more flexible.

Because unexpected changes in the price level (including wages,) involve shifts between debtors and creditors, and because deflation of prices increases the real rate of return on zero interest currency, there are advantages to some monetary institution that corrects for a shortage of money some other way. From that perspective, complaining about excessively high real wages during recession is counterproductive. Still, it is important to recognize that the market process that corrects for a shortage of money is a generalized deflation of all prices, including the prices of resources like labor. If some prices fail to adjust, that adds to the disruption.

1 comment:

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