Monday, August 15, 2011

Will Lower Wages Cure Unemployment?

In my view, the reason for the Great Recession is simple--the Federal Reserve allowed an excess demand for money to develop, so GDP fell 14% below its growth path from the Great Moderation.   

In my view, the solution is simple as well.   The Fed needs to increase GDP, moving it to a higher and stable growth path, and keep it there.

The key symptoms of the Great Recession are that real GDP has fallen 12% below its trend growth path and employment has fallen 10% below its trend growth path.   The unemployment rate has more than doubled, from 4.5% to 9.1%.    

But surely, unemployment is like a surplus of labor.   Shouldn't the unemployed workers just accept lower wages?   If wages drop, then quantity demanded will rise and quantity supplied will fall, so that there will be no more unemployed workers.   

It is simple.   If wages fall, then the cost of hiring additional workers will be lower.   Firms will expand production, hire the workers, produce more, and sell the extra output by lowering their prices.   


Suppose the Fed fails to expand GDP and it remains constant.

Obviously, there is no need for the employed to accept lower wages.   They have jobs.   

How much must the wages of the unemployed fall so that they can be employed?

Suppose the workers accepted 1/2 pay.    And let's not expect a miracle.   Suppose that employment increases only by 5%.   In other words, it returns only halfway to the growth path of the Great Moderation.

Presumably, firms will only hire the additional workers to produce more goods and services, and suppose that they can expand output by 5%.    In other words, suppose real GDP recovers about half of the shortfall from the Great Moderation.   

With GDP constant, the only way this 5% additional production can be sold is at 5% lower prices.   If firms sell 5% more for 5% less, their total revenue remains constant.    Surely, selling 5% more for 5% less will be profitable if the wage cost of producing that extra output is 50% lower?

But no.   What happened to wage costs?   The cost of producing the initial level of output is unchanged.  Using 5% more labor at 50% of the previous labor cost per unit will result in an increase in labor cost of 2.5%.    

Revenues remain constant and wage costs rise 2.5%.  Why would firms do this?

Well, perhaps the wages cuts weren't enough and a 50% recovery of the shortfall of employment would be too much to expect.

Let's instead suppose that wages are cut 90%, and employment is increased by 1%.  

How does that work out?

The increase in employment generates a 1% increase in output.  This requires a 1% decrease in prices to keep GDP constant.   Revenues are unchanged.   Since wages of additional works are only 10% of those of those already employed, they are very low cost.   Surely employing additional workers that cost only 10% as much will be profitable if prices only drop by only 1%.    

Look again.   Revenues are the same.   Wage cost of the currently employed is the same too, and while the added workers increase wage cost by a minuscule .9%, that still means more costs and the same revenue.   What is the benefit?

So, the answer is simple.   What wage rate must the unemployed accept?   Zero.  They must work for free.   And then all of them can be employed.   For example, 10% more workers can be employed, producing 10% more output.   With GDP constant, it can be sold for 10% less.   Revenue is constant.   Wage cost for the employed workers is the same.   The new workers cost nothing.    While it isn't clear there is much benefit for the firms, it isn't a losing proposition.

Does this mean that the only way to increase employment is to raise GDP? 


The way lower wages for the unemployed results in increased employment is that the competition of the unemployed workers results in lower wages for currently employed workers.   Those workers who have jobs must be paid less.

The simplest approach is for greedy and selfish employers to take advantage of their employees and tell them that their pay is to be cut because there are plenty of unemployed workers out there who would like their job.   And further, if the worker doesn't like it, he or she can quit, and become one of the unemployed workers.

Now, if the result of this is that the prices of the goods and services remain unchanged and wage costs fall, then given constant GDP, employment will remain little changed.   At current prices, firms will sell the same amount of output.   Firms will produce only what they can sell.   And firms will employ only what they need to maintain current levels of production.   Lower wages and constant prices (and that means lower real wages for all workers) will leave employment unchanged.

For this to work out, each firm must be so greedy for what would be remarkably high profits, that they undercut the prices of other firms, seeking to expand market share, and hire more and produce more.   If any one firm does this, it will earn even more profit at the expense of those firms that left their prices high.   

But as those firms respond, the price level falls, and given GDP, the volume of real expenditures expand and the total amount all firms can sell expands as well.    As the total amount firms can sell expand, they expand total production, and they employ more workers.   Once the price level falls roughly 10%, then real GDP expands about 10%, and employment expands about 10%.   And how much do wages need to fall?  About 10% too.

And so, if GDP is given, then the way to expand employment is to expand real GDP.   And the way to expand real GDP is to expand real expenditures.   And the way to expand real expenditures is to lower the price level.   And firms can only afford to lower the price level if wages fall roughly in proportion.  And, sure enough, if wages fall, competition among firms should bring down the price level.    If unemployment of labor causes wages to fall among the employed, then there is a market process that will result in increased employment.

Of course, it could be that employers are too kind to take advantage of their employees by telling to them that they can be replaced and if they don't like it, they will have trouble finding a new job.   However, even kind-hearted and progressive-minded employers can be forced into imposing wage cuts.   

 A new entrant can purchase the assets of some failed firm, and hire unemployed workers at lower wages and undercut the prices of existing firms.   That firm can expand employment and production, but at the expense of existing firms who will lose sales and contract production and employment.    Now, rather than telling their workers that they want to take advantage of them, the existing firms must explain that pay cuts are the only way to face competition.   It is, of course, possible that some firms will seek to keep prices and wages up despite the competition, but every time a firm fails and its assets are redeployed, more of the economy shifts to the new price and cost structure.   Notice, however, that the wages of current employees end up getting cut.

With GDP 14% below the trend of the Great Moderation, and firms complaining that their key problem is lack of sales, and there being high levels of unemployment, why isn't this process occurring now?    

I don't have an answer to that question.    It could be that the productive capacity of the economy has fallen by 12% and the natural unemployment rate has doubled.    If could be that that claims by firms that their problem is low sales is just an illusion of some sort, and that lower prices and wages might result in more real expenditure, but firms couldn't produce more in response because they are already pressing against capacity constraints. 

But I doubt it.

And I am certain that focusing on the wages that the unemployed workers are willing to accept is really beside the point.


  1. "The way lower wages for the unemployed results in increased employment is that the competition of the unemployed workers results in lower wages for currently employed workers. Those workers who have jobs must be paid less."

    Why doesn't this lead to a fall in GDP as consumption falls? This fall in GDP offsets the rise in output you describe as prices fall.

  2. Nominal consumption (dollar value) per worker falls 10%, but with total employment increasing 10%, total nominal consumption remains unchanged. Real consumption per worker stays the same because the prices of consumer goods are 10% lower, but total real consumption expands 10% with nominal consumption expenditure the same and prices 10% lower.

  3. "It could be that that claims by firms that their problem is low sales is just an illusion of some sort, and that lower prices and wages might result in more real expenditure, but firms couldn't produce more in response because they are already pressing against capacity constraints."

    That sounds a bit like the Austrian argument that mis-allocations of resources during the housing boom has broken the structure of production and what we need is just time (without government intervention) for things to fix themselves.

    It would be interesting to know what data points would be needed to validate this theory.

    More likely however the fears about potential sales are another way of expressing low confidence and leading businesses (and individuals) to maintain a high demand for money. This is what makes monetary solution's to the recession very tempting but (because of the inflation and structure of production concerns) very risky.

  4. No, I don’t think it can really do that but I don’t really know. I mostly try to focus on what’s happening instead of thinking in this way. I never have to do too much hard work on it because of OctaFX broker which have all the tools in the box to help me out. I can always get updates daily with their daily market update feature and then there is also Economic Calendar that I can keep eye on + monitoring system on their web site to know about top traders doing, it’s all easy to work with.