Paul Krugman looks at the evidence on nominal wage rigidities here and sees additional reason to believe the primary economic challenge is a demand shortfall. He concludes with this point:
Oh, and someone is sure to chime in and say that this proves that the solution to unemployment is to make wages more flexible. No, it isn’t: in a liquidity trapped, deleveraging economy lower wages would actually worsen the situation.
It is important to emphasize this point, and Japan provides a good example. Via the Financial Times:
..Bonuses have been coming under heavy pressure in Japan for years as part of a wider effort to restrain incomes.
And while workers around the developed world have been complaining of a squeeze on incomes over the past two decades, in Japan thinner pay packets fuel wider deflation. That makes it even harder for the government to rein in its runaway debt and for the central bank to use monetary policy to boost growth...
...While policymakers bemoan the salary squeeze, political pressure is growing for heavy cuts to public sector pay as a quid pro quo for a proposed doubling of Japan’s 5 per cent consumption tax. Shortly after becoming prime minister last year, Yoshihiko Noda – already Japan’s poorest premier on record – gave himself a 30 per cent pay cut.
I think the role of role of bonuses in driving Japan's deflation is underappreciated. The bonus system allows for more flexible wages, thus allowing for the real possibility of negative nominal wage growth and thus deflation. In contrast, downward nominal wage rigidities in the US reduce the likelihood of deflation, but lessen the resolve of monetary policymakers to stimulate activity - for example, see the efforts by St. Louis Federal Reserve President James Bullard to argue that existence of low rates of inflation is evidence that the economy is operating at potential rather than see the flattening of the relationship between unemployment and inflation as a straightforward outcome of downward nominal wage rigidities.
