Keynes and many earlier economists emphasized that unemployment rises during recessions because nominal wage rates tend to be inflexible in the downward direction. The natural way that markets usually eliminate insufficient demand for a good or service, such as labor, is for the price of this good or service to fall. A fall in price stimulates demand and reduces supply until they are brought back to rough equality. Downward inflexible wages prevents that from happening quickly when there is insufficient demand for workers.Here's Mark Thoma, hitting back:
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.The mixed effect here centers around the fact that what we call a wage refers to two separate things. One is the wage paid by the employer. This is the price of employment; and Becker is correct to point out that the higher this price, fewer people will be employed. During recessions, companies are willing to pay much less for labor; but wages are fixed. So they lay off workers. If we could get this wage to go down in bad times, companies would be willing to hold on to employees and we wouldn't have ten percent unemployment.
However, there is also the wage received by employees. Lowering this wage reduces the purchasing power people have, so they cut consumption and prices fall. Brad DeLong and Lawrence Summers have a good paper estimating that effect.
Under normal situations, the two wages are the same, and it's not obvious what employment effect a wage decrease or increase will have (though some evidence suggests that raising wages didn't work in the Great Depression).
But there's a way around this--create a gap between what employers pay and what employees receive. This way, employers could cut their wages to employees during bad times, so employment would stay high. But employees would receive the same amount, so you maintain price stability.
One way of doing so is through a permanent payroll tax cut. Employers are now more likely to hire at the margin; and employees will spend and save more.
But the best way of creating this gap is through a direct wage subsidy. This allows employers to slash the wages they pay out; while keeping the wages employees receive fixed by having the government make up the difference. Labor market interventions like these are the dominant way Europe is responding to the recession (they have rather small stimulus projects); and they're keeping employment losses lower than America.
Obviously, this involves a fiscal cost. But the government is already taking on a huge fiscal burden through automatic stabilizers and a stimulus comprised of bad tax cuts and spending. These projects are much less effective than a direct wage subsidy in cost-effectively creating jobs and cutting unemployment.
Still, none of this is the best way to target unemployment--the best way would be to use monetary policy to generate inflation expectations to lower real interest rates below zero. This can be difficult when interest rates are already zero, but a number of scholars--among them Bernanke and Krugman--have advocated such policies in the past for countries like Japan. Yet Bernanke now rules out this policy out for the United States:
- D. Brad Delong, University of California at Berkeley and blogger: Why haven’t you adopted a 3% per year inflation target?
[Bernake] The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.This is a little puzzling. The Fed's mandate is to balance inflation and unemployment; yet inflation is at zero percent and unemployment is at ten. Yet Bernanke is fine with this balance, and will not do anything to reduce unemployment further--even though his academic work, which got him his job, emphasized exactly those policies.
So one way or another, all the ways to create jobs--fiscal stimulus, monetary policy, labor market intervention--are off the table. I would find this even more discouraging if I were unemployed.