Nominal wage rigidity and the 2007 crisis

After talking a lot about employment here is some nice insight on wages.

The authors point out how nominal wages have been rigid to go lower despite a massive crisis:

Real wage growth, that is, wage growth after accounting for inflation, has held up surprisingly well in the recent recession and recovery. Despite modest economic growth and persistently high unemployment, real wage growth has averaged 1.1% since 2008. As Figure 1 shows, this pattern contrasts notably with previous decades, when real wage growth slowed substantially in response to business cycle downturns.

One reason real wage growth has been so solid is that inflation has been low, with the personal consumption expenditures price index increasing at an average annual rate of 1.8% since the start of 2008. Low inflation means that employers cannot reduce real wages simply by letting inflation erode the value of worker pay. Instead, if they want to reduce real labor costs, they must cut the actual dollar value of wages. Employers generally avoid doing so because cuts to nominal wages can reduce morale and prompt resistance even in difficult economic times (Kahneman, Knetsch, and Thaler 1986).

But this has its own problems:

The inability or unwillingness of employers to reduce nominal pay is known as downward wage rigidity. When economic conditions are poor, this rigidity can disrupt normal labor market functioning, especially in a low-inflation environment. If wages are downwardly rigid, workers may receive false signals about the value of remaining in a particular occupation or industry. For example, consider construction workers who are less productive now than they were five years ago because of the bursting of the housing bubble. If their wages fell, they might seek jobs in other industries. Because of downward wage rigidity, they may stay in construction instead. On the labor demand side, employers that can’t cut wages may delay expanding payrolls as conditions improve. Either way, downward nominal wage rigidities can result in misallocation of resources in the economy.

In this Economic Letter, we describe how economists identify nominal wage rigidities. We then update evidence of downward nominal wage rigidities over time, focusing on the behavior of nominal wages since the start of the recent recession.

They show how this recession has been different with nominal wages not going down. So, whether we look at worker by education  or by industries, nominal wages have been rigid. (see the amazing graphs as well)

This phenomenon has affected a broad range of workers during the recent period. Figure 4 plots the share of workers receiving no wage change by education. Less-educated workers have historically been more likely to get no yearly wage change. Recently though, the percentage of workers with no wage change has increased markedly at all education levels. This contrasts with the business cycles of the early 1990s and 2000s, when more-educated workers were shielded to a greater extent from increases in nominal wage rigidities. In fact, in the recent period, zero wage changes increased almost as much for college-educated workers as for workers with less than a high school education. That has not been seen in any other period in our sample, suggesting that a broad range of employers in a variety of sectors might feel pressure to cut wages, but are unable to do so because of downward nominal wage rigidity.

The breadth of the increase in workers reporting no wage change suggests that downward nominal rigidities pervade a broad array of industries. Nonetheless, there is also evidence that downward rigidities are more common in industries hit hardest by the recession, such as construction. If this is true, downward rigidities may be preventing necessary adjustments across industries in the economy.

 As nominal wages do not decline, we need a higher inflation to allow real wages to fall:

The distribution of the dollar value of wage changes suggests that a significant fraction of workers are affected by downward nominal wage rigidities. Our analysis, based on data through the end of 2011, suggests that downward nominal wage rigidities have affected a much larger share of the workforce in recent years. The fraction of workers reporting a wage change of zero is higher now than at any point in the past 30 years. This may partly explain why real wage growth has not significantly declined since the onset of the recession in December 2007 and why hiring has been slow since the start of the recovery in mid-2009. Because nominal wage growth for a large fraction of workers has been held to zero, a somewhat higher rate of inflation would grease the wheels of the labor market by allowing real wages to fall (Akerlof, Dickens, and Perry 1996).

Hmm. Another reason for a higher inflation target..

Here is a different interpretation from Krugman on this paper. He says this rigidity shows why the crisis is a demand one. And why Europe option of internal devaluation is difficult to do.

Interesting stuff as always from FRBSF. Wish all papers could be written the way FRBSF does econ letters and this includes working papers from FRBSF!

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One Response to “Nominal wage rigidity and the 2007 crisis”

  1. populareconomicsblog Says:

    I can’t believe economists still focus on ways to cut wages as a means to stimulate demand. Supply-siders lost this argument during the Reaganomics era, yet conservatives still want to make the wealthiest even wealthier. Focus on corporations’ record profits instead (from which the 1% have profited), drop wage earners’ effective tax rates, while raise that of corporations by abolishing their loopholes. Overproduction is what caused the busted bubbles, so transfer some of that wealth back into the economy where it does some good, instead of in pockets of Wall St. speculators. Krugman is saying wages have to rise to stimulate demand, not be lowered via inflation, which occurs when demand rises sufficiently. Read Rutger’s Econ Historian James Livingston to understand why these wrenching bubbles have occurred.

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