A supply shock in Depression Economics...how a rise in nominal wages can be stabilising

A few months ago many posts were written, primarily by Krugman, in response to conservatives like Amity Shlaes on the theory of wages in depression economics. In normal times, a rise in nominal wages all round the board is akin to a supply shock, reducing output and raising prices. Such a rise in wages is due to some institutional factor, like Unionisation, or an increase in unemployment benefits or a minimum wage. Or it could be due to an increase in the expected price level, as perhaps firms believe inflation is to rise, and to keep real wages constant, unions demand higher nominal wages.

Using the AD-AS model applied in Fiscal Stimulus part 1, we have

AS: P=P (e)*F (1-Y/L, z)*(1+m)

The AS curve is shifted up by the increase in the expected price level, in the case above. Another case in which it can be shifted is via the cartelising of labour, in which the formation of cartels, or unions, requires controls on wages, in this case, to either be fixed or to grow at a pre-determined rate. Now, the effect on income in the short-run is dependent on the shape of the aggregate demand curve. In normal times, the AD curve is downward sloping (As a reduction in price level raises real money supply, leading to a lowering of the interest rate and increased investment), however, there are reasons to believe the AD curve is vertical or even upward sloping.

i) Given that we are at the 0 lower bound, it means that the real money balance effect has no effect, as increases in real money supply do not translate to lower interest rates. This effect is due to an infinite elasticity of Money demand to the interest rate at the 0 lower bound.

ii) Another determinant of the AD curve is the interest rate sensitivity of investment. The sensitivity of Investment is lower in a recession simply because the variables of confidence and risk play a greater role in determining Investment. This also reduces the effect of price level on AD.

iii) Thirdly, there is the Pigou effect. This looks at the wealth effect of a reduced price level. Krugman makes back-of-the envelope calculations, in which he estimates that with a $800B Monetary Base, and a 20% fall in prices, a wealth effect of 0.05 translates to 800*0.2*0.05=$8 B. Even with a multiplier of 2, the increase in income is $12B, or roughly 0.12% of GDP. If anything the pigou effect is overwhelmed by the Fisher Debt-Deflation effect, where reduced prices increase the real value of debt, and constrain borrowers, and the fact that deflation increases real interest rates and constrains consumption and investment.

The fact that the AD curve is not downward sloping, but rather vertical, has important implications for wages policy. Now the upward shift of the AS curve does not incur a short-run reduction in output.

Thus this model clearly shows that there is no short-run cost in cartelising labour in depression economics.

Now, let us get into this in more detail. First of all, notice the parallel between cartelising labour and the protectionism outlined in my previous topic. The idea of cartelising labour is simply to promote the welfare of those employed, at the cost of others who seek employment but cannot due to labour demand falling in response to higher wages. It is this channel- where rising wages increase unemployment- which is what people like Amity Shlaes argue prolonged the Depression. However, it is clear that protection of Labour has minimal, if any, short-run reduction in Output in a liquidity trap situation.

There are in fact some very stabilising effects of cartelising of labour that may seem hidden. The problem with Shlaes argument is that there is no way a reduction in wages can increase labour demand and can increase employment if it is across the board. If it is concentrated in one particular sector, than we would expect that there is an increase in employment concentrated in that sector. Krugman explains this nicely.

Suppose that wages across the US economy had been, say, 20 percent lower than they actually were. You might be tempted to say that this would make hiring workers more attractive. But to a first approximation, prices would also have been 20 percent lower –so the real wage would not have been reduced. So how would lower wages lead to higher demand for labour? (Krugman)

Thus one must keep in mind that any nominal wage reductions would be in response to deflation, which will essentially maintain real wages, resulting in no AS shifts and no real effect on output. Now, as far as I can tell, cartelising labour has 3 benefits:

i) Firstly, is the fact that cartelising labour can indirectly try to anchor inflationary expectations (as nominal wages usually try to level changes in the expected price level/inflation). Thus it can be an effective policy at getting the economy out of a deflationary trap

ii) Secondly, by being a policy that reduces supply, it brings the economy closer to internal balance. Given that the economy is suffering from insufficient demand, reducing supply via cartelising labour can reduce the output gap.

iii) Thirdly, there are the incentive effects of higher real wages, which, seen as efficiency wages, can try to muster the enthusiasm required for increased work effort. Also, there are significant problems in cutting nominal wages, as it may induce people to leave work as they demand higher wages, or cause unnecessary discomfort or strikes by workers (it may promote worker dislocation, where workers try to move to places offering higher wages or labour cartels). Other supply side effects include reducing worker turnover (As being part of a union requires to remain in the job)

Of the 3 benefits, the first 2 are intrinsically related. Basically, the idea of trying to stabilise prices is useful, as firms set their prices based on labour costs. If labour costs go up, it prevents them from cutting prices- even in light of reducing demand. This prevents a deflationary spiral, and consequently increases the effect of demand-side policies, particularly monetary policy, to achieve internal balance.

There are, however, some problems of cartels (or more generally unionisation). There are long-term costs involved, with Larry Summers, in an academic paper citing that ‘one long-term cause of unemployment is unionisation’. The idea is that unions do increase the natural rate of unemployment, by keeping wage levels up it naturally reduces labour demand. Subsequently it makes it harder for non-union workers to find jobs, as wages tend to be streamlined across union and non-union workers. Also is the fact that given that there is no protection for non-union workers, they are the most likely candidates for lay-offs in light of any constraints a firm faces.

Another problem could be hidden effects on investment demand. Mankiw raises this point by considering what impact the formation of a cartel would have on long-term business investment, which he believes is likely to reduce in light of labour movements. Krugman rebuts this by noting that there was excess capacity and under investment throughout the 1930s (even before labour movements began), and believes that there were more important factors, such as business confidence and profitability, that overwhelmed any labour movement effects. Plus, private investment in fact picked up as Roosevelt went into office, thus further invalidating the idea that the labour movement reduced investment incentives.

There are reasons to favour the claim that unionisation may be a positive move in current circumstances. The ultimate argument is of course whether the short-run benefits of increasing wage growth and hence inflation exceed the long-term costs of unionisation. The key here is whether the increase in Government intervention and initiatives in response to this crisis will recede once we return to normal circumstances, where the private sector is independent and fully de-regulated, and monetary policy returns to being the primary stabiliser. This is a tough question to answer, but as far as I’m concerned, the costs posed by unionisation are minimal and reversible, and is necessary to prevent a deflationary spiral.