Another follow-up to Tim's post gleaned from a post by Karl Whelan at The Irish Economy:
Some Thoughts on Wages and Competitiveness, by Karl Whelan: There’s a lively debate going on about ... competitiveness and recovery...
Despite what seems to me to be an exceptionally strong attitude in this country [Ireland] of calling on the government to solve every possible problem, we are largely a market economy and wage rates are set in a relatively decentralised fashion compared with other European countries. And despite the faith of many that unregulated labour markets should always clear to produce full employment, we have plenty of macroeconomic evidence that this is not the case.
The reality is that, in all economies, negative macroeconomic shocks tend to raise unemployment because wages never adjust quickly enough to get the labour market back to full employment. This has been a mainstream theme in macroeconomics since, at least, the General Theory.
In more recent decades, New Keynesian macroeconomic theorists have put forward a plethora of models to explain why the labour market does not operate according to the simple market-clearing fashion (efficiency wages, implicit contract theory, bargaining models based on “holdups”). More recently, behavioural economists have documented the importance of “money illusion’’ which makes workers particularly resistant to cuts in nominal wages. The result is a significant amount of empirical evidence demonstrating the existence of nominal and real wage rigidity.
This is not to argue that wages are completely rigid or that the labour market does not have mechanisms to bring unemployment down after a negative shock. Macroeconomic data generally show good fits for Phillips Curve relationships such that wage growth is low when unemployment is high. But governments will generally not want to rely only on this mechanism to restore macroeconomic equilibrium because the pace of recovery will be too slow. Instead, they prefer, where possible, to use countercyclical fiscal and monetary policy. ...
[W]e may be facing the paradox of wages: workers at any one company can help save their jobs by accepting lower wages, but when employers across the economy cut wages at the same time, the result is higher unemployment.
Here’s how the paradox works. Suppose that workers at the XYZ Corporation accept a pay cut. That lets XYZ management cut prices, making its products more competitive. Sales rise, and more workers can keep their jobs. So you might think that wage cuts raise employment — which they do at the level of the individual employer.
But if everyone takes a pay cut, nobody gains a competitive advantage. So there’s no benefit to the economy from lower wages. Meanwhile, the fall in wages can worsen the economy’s problems on other fronts.
In particular, falling wages, and hence falling incomes, worsen the problem of excessive debt: your monthly mortgage payments don’t go down with your paycheck. America came into this crisis with household debt as a percentage of income at its highest level since the 1930s. Families are trying to work that debt down by saving more than they have in a decade — but as wages fall, they’re chasing a moving target. And the rising burden of debt will put downward pressure on consumer spending, keeping the economy depressed.
Things get even worse if businesses and consumers expect wages to fall further in the future. John Maynard Keynes put it clearly, more than 70 years ago: “The effect of an expectation that wages are going to sag by, say, 2 percent in the coming year will be roughly equivalent to the effect of a rise of 2 percent in the amount of interest payable for the same period.” And a rise in the effective interest rate is the last thing this economy needs.
Concern about falling wages isn’t just theory. Japan — where private-sector wages fell an average of more than 1 percent a year from 1997 to 2003 — is an object lesson in how wage deflation can contribute to economic stagnation.