Cutting Wages Won't Help

Conservatives are using the recession to revive their long-standing opposition to the minimum wage. The argument they are making this time is that cutting the minimum wage will add substantially to employment, and this is starting to get some attention in the press. But a cut in the minimum wage would likely make things worse, not better.

Why? There's a more sophisticated story below, and I may be oversimplifying too much, but basically when things are bad -- when firms cannot sell all that they are (or could be) producing -- a cut in the wage does not generate any new employment, it simply reduces income. Why hire more people when you aren't selling anywhere near to existing capacity (in the story below, even if interest rates did fall as a result of the wage cut, I don't think it would generate much investment due to the excess capacity that firms have)? In fact, the reduction in income from the fall in wages makes it even harder to sell the goods that are (or could be) produced, and that will cause firms to lay off even more workers, which lowers income even more, and a downward spiral ensues.

The point is that in a severe recession, a cut in the wage rate may not generate any new employment, instead it simply lowers income and demand, and that makes things even worse.

Here's a more detailed version of the story:

Would cutting the minimum wage raise employment?, by Paul Krugman: It seems that more and more Serious People (and Fox News) are rallying around the idea that if Obama really wants to create jobs, he should cut the minimum wage.

So let me repeat a point I made a number of times back when the usual suspects were declaring that FDR prolonged the Depression by raising wages: the belief that lower wages would raise overall employment rests on a fallacy of composition. In reality, reducing wages would at best do nothing for employment; more likely it would actually be contractionary.

Here’s how the fallacy works: if some subset of the work force accepts lower wages, it can gain jobs. If workers in the widget industry take a pay cut, this will lead to lower prices of widgets relative to other things, so people will buy more widgets, hence more employment.

But if everyone takes a pay cut, that logic no longer applies. The only way a general cut in wages can increase employment is if it leads people to buy more across the board. And why should it do that?

Well, the textbook argument — illustrated in this little writeup — runs like this: lower wages lead to a lower overall price level. This increases the real money supply, and therefore liquidity. As people try to make use of their excess liquidity, interest rates go down, leading to an overall rise in demand.

Even in this case, it’s hard to see the point of cutting wages: you could achieve the same effect, much more easily, simply by having the Fed increase the money supply.

But what if we’re in a liquidity trap, with short-run interest rates at zero? Then the Fed can’t achieve anything by increasing the money supply; but by the same token, wage cuts do nothing to increase demand.*

Wait, it gets worse. A falling price level raises the real value of debt. To the extent that debtors are more likely to cut spending in such a case than creditors are to increase it — which seems likely — the effect of the wage cuts will actually be a fall in demand.

And one more thing: to the extent that people expect further declines in wages and prices, this raises real interest rates, which is even more contractionary.

So proposing wage cuts as a solution to unemployment is a totally counterproductive idea. Not that I expect any of this discussion to make any impact on those proposing it.

* Somebody is going to ask, what about the real balance effect? Doesn’t a falling price level make people wealthy, by raising the real value of the money they hold. The answer is, consider the magnitudes. Before the crisis, the monetary base — the system’s “outside money” — was around $800 billion. (It’s a much more confusing situation now, so I won’t try to parse the current numbers here). This means that even a 10 percent fall in the price level, which is very hard to achieve, would raise real wealth by only $80 billion. Compare this with the effects of the decline in housing and stock prices, which reduced household wealth by $13 trillion in 2008. The real balance effect is totally trivial.