Cutting Wages Is Hard to Do: Why That's Bad for Unemployment

Even with the recession and bumpy recovery, it’s hard to cut pay

In Jackson Hole, Wyo., this August, Janet Yellen, chair of the Federal Reserve, gave a speech explaining just how hard it is to understand unemployment. She made passing mention of an idea only an economist could love: “downward nominal wage rigidity.” In plain English, that means it’s hard for any company to cut pay, even in a recession. Economists sometimes call this “wage stickiness.” Depending on your brand of economics, stickiness either makes no sense and therefore only happens because of bad policies, or it’s a significant, enduring problem that worsens unemployment. Yellen seems to be leaning toward “enduring problem.”

In her speech, she cited a paper by the San Francisco Fed’s Mary Daly and Bart Hobijn. They took a 20-year-old formula for measuring stickiness and ran it through the years from 1986 to 2012. Hobijn was surprised at how few pay cuts he found in the most recent recession. “The only thing that’s really shifted is that it’s surpassingly binding,” he says. Wages, he means, are even stickier than he thought.

Already in the 1930s, John Maynard Keynes pointed out that workers resisted pay cuts even when times were bad, forcing companies to save money instead through layoffs. His answer was monetary policy—inflation. What workers really dislike is a nominal wage cut, a visible drop in income from one paycheck to the next. But if wages remain the same, inflation alone can make them less costly to the employer, making it easier to retain workers. This “cut” is less visible, and therefore more acceptable to workers.

Keynes’s prescription lost favor in the 1970s, when high inflation in the U.S. failed to lead to the hiring that would cure high unemployment. And economists from the school of rational expectations found it irrational that workers and management would accept a layoff rather than bargain for a pay cut. Wages were still hard to trim, but it wasn’t clear why, or what effect this stickiness had on the economy.

In the late 1990s, Yale professor Truman Bewley did something radical for an economist. He talked to people. Business owners in New England told him they avoided wage cuts not because of labor’s intransigence or misunderstanding, but out of basic business sense. Pay cuts hurt morale, and bad morale hurts production. At about the same time, George Akerlof (Yellen’s husband), William Dickens, and George Perry wrote an influential paper that refined Keynes’s argument. If a company can’t cut pay in a downturn, they said, it doesn’t immediately fire that many workers. Rather, the company finds that because it’s keeping wages high, it has to keep prices high. If this happens to enough companies, high prices reduce the total demand for goods, compounding the recession and causing more layoffs. This would be particularly true, they predicted, in a low-inflation recession—such as the one we just had.

Dickens, a professor at Northeastern University, says he’s seen nothing since 2007 that would change his prediction. “The only thing new is, we’ve got a lot more people piled up at zero than in the past,” he says. That is, of all the possible outcomes between a huge raise and a huge pay cut, the largest number of workers have seen zero change in their wages. “It’s very difficult to explain what’s going on,” Dickens says, “if you don’t believe in downward nominal wage rigidity.”

The increased interest in wage rigidity has prompted a turn toward new sources of data—with findings that challenge the consensus. In the past, researchers tended to use surveys, but these introduce the error of estimation: People are bad at remembering exactly what they got paid last year. More recently, some economists have looked to payroll records. Last year, Donal O’Neill, an economics professor at the National University of Ireland at Maynooth, worked with two colleagues through pay data for every employee in that country. “I’m quite convinced that in Ireland, stickiness fell during the recession,” he says. That is, about 50 percent of Irish workers took a wage cut. Many of these were government employees, but “construction workers have been pounded,” O’Neill says, and so have people in real estate. It’s hard to compare stickiness among countries. Ireland’s recession was particularly severe, and even Bewley, the economist who talked to people, said that companies will cut wages when they are in mortal fear for their continued existence.

The U.K. went through a downturn more like that of the U.S., and it has a similar economy. Mike Elsby, a professor at the University of Edinburgh, looked at U.K. payroll records with two co-authors last year. Elsby was surprised, too, by the substantial number of people who’d actually taken a pay cut—20 percent—regardless of occupation, gender, or union membership. “When we presented this,” he says, “the overwhelming response was incredulity.” Elsby suspects that the same method, applied to the U.S., would produce similar results. “There’s just a shred of evidence,” he says, “that we’ve been spending too much time thinking about downward nominal wage rigidity.”

“Elsby is wrong,” says Dickens, who defends the accuracy of survey data. There are ways of cleaning up such information, he says, that can account for any reporting errors. Moreover, the train is already puffing out of the station. Dickens says policymakers are slowly coming around to the idea that stickiness matters enough to be addressed, just as Keynes suggested, through higher inflation.

Stephanie Schmitt-Grohe, who teaches at Columbia, has written two paper-length pleas in the last year to persuade the European Central Bank to do just that. She points to the experience of the Great Depression, during which the countries that left the gold standard earlier—devaluing their currencies and sparking inflation—fared better. According to her, stickiness is a fact of life, with a monetary solution. “Something has to give,” she says, “and we conclude that there should be a little bit of inflation.”

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