How Sticky Are Wages?

Over at EconLog Bryan Caplan has posted a review of Truman Bewley’s Why Wages Don’t Fall During A Recession. Based on the glowing review it seems that it should be well worth the read. In his post, Bryan summarizes a number of Bewley’s arguments and makes a fairly compelling case for the existence of sticky wages.

Sticky wages have been a thorny problem for libertarians. On the one hand, basic economics would suggest that profit maximizing employers will simply lower wages in the face of falling demand. On the other hand, compelling arguments have been presented that suggest that employees may (somewhat irrationally) resist nominal wage cuts or become demoralized and unproductive when they are administered.

Even more problematic is the suggestion that voluntary interactions among adults can cause periodic economic crises and involuntary unemployment.

So what is my take on the issue? While I haven’t yet read Bewley’s book, I am familiar with many of the arguments in favor of sticky wages. Admittedly, I find them to be somewhat compelling though I don’t think it’s appropriate to place anywhere near the degree of emphasis on them that most macroeconomists do.

Why Wages Don't Fall During a RecessionWhy do I say this? Well, contrary to most mainstream macroeconomists, I don’t believe our economy crashed in 2008 because we suffered a random demand shock. Neither do I believe most recessions (if any) are brought about this way. I find the Austrian Business Cycle Theory (ABCT) to be a much more convincing explanation of the business cycles in general and especially the recent housing bubble (and dot com bubble before that).

For those that reject ABCT, there’s not much left to explain recessions. The Real Business Cycle theory may explain some lesser events but it hardly explains the 2008 collapse. I think these people look around and say “what else is there”? Absent any other plausible explanations, they’re only left to conclude that it must have been a demand shock coupled with some extremely sticky wages.

Bob Murphy had a great analogy in his Gnome Thought Experiment. If, while we were sleeping, mischievous gnomes rearranged all of our resources, we would wake up to a collapsed economy. Our macroeconomists would almost certainly conclude that we just suffered massive demand shock because, “what other explanation could there be?”

If, however, you recognize that there is another more plausible explanation for recessions, the degree of emphasis that you place on sticky wages has to be much less. That doesn’t mean sticky wages don’t exist, but it does mean that they are likely to be less of a problem than most economists think.

I like to think of it in terms of scale. On one side you have completely rigid wages, on the other you have complete wage flexibility. You can see where I place myself on the scale.

Fexibility Scale

One last point on wages, it’s interesting to me that during 1920-21 depression, in which the Fed actually raised interest rates, wages fell fairly rapidly. I can’t help but wonder if the phenomenon of sticky wages isn’t a result of a century of people having been conditioned into expecting price inflation as opposed to mild deflation.

I want to wrap up on a related note and ask why is it that some economists reject ABCT? We don’t have to rack our brains to figure out why Krugman rejects it, but what about otherwise strong, unbiased thinkers like Bryan Caplan who’s awesome on just about every other issue? If you look at some of the criticisms that have been made of the theory, it’s pretty clear to me that the critics simply don’t understand it. Consider Bryan’s famous Why I’m Not An Austrian paper. He writes:

Even more striking is the Austrian theory’s inability to explain why output declines during a depression; instead, it predicts a short-term increase.[51] Bohm-Bawerk’s capital theory, on which Rothbard wisely built his work, implies that actually the short-run effect of switching to consumer goods production would be a period of greater production, followed by a period in which production is less than it would otherwise have been if longer period products had been used instead.[52] In short, the Austrian theory all-too-glibly identifies the period of artificially low interest rates with the boom, and the period of re-adjustment with the bust. Without extra assumptions, the theory does not predict an increase in employment during the boom, or a decrease during the bust. Moreover, it predicts an actual increase in current output during the bust. These are puzzling implications, to put it mildly, and they follow from the ABC.

His criticism is correct as far as it goes, but there’s just one problem — he isn’t criticizing ABCT, but rather some theory of garden variety sectoral shifts. The exact same misinterpretation of the theory has been made by Tyler Cowen and Paul Krugman.

I like to point people Roger Garrison’s powerpoint presentation of ABCT which I think conveys it in the clearest manner possible. Notice how in his model, malinvestments are undertaken in the early stages while increased consumer demand simultaneously drives a consumption boom. Those who ask, “doesn’t this theory imply that consumption should fall during the boom and increase during the bust?”, have simply misinterpreted the theory.

If you ask me, I think the main reason for this misinterpretation is Murray Rothbard. There are a few obscure passages in Rothbard’s writings where he alludes to elevated consumer demand pulling resources towards the consumer, but in most of his popular writings he portrays ABCT in the manner described by Caplan, Cowen, and Krugman. Given Rothbard’s position within the Austrian School, I suspect this may be the cause of the great misunderstanding.

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