Sticky Wages are Good Wages

Justin Wolfers has a good piece in Bloomberg reminding us that the Fed is going to be undershooting its inflation target (by its own estimation) for at least three more years. But don't worry about deflation just yet. Looking at the Federal Reserve's projections, the bottom of the range of their projections for inflation is 1% - and this was revised up from June's lowest projection 0.8%, suggesting that inflationary pressures are (barely) increasing instead of decreasing.  But, moreover, our lived economic experience suggests that wage and price stickiness is a real thing. Paul Krugman deals with this a bit here. In his post, he notes a Brookings paper titled "the Macroeconomics of Low Inflation." I think that this paper deserves a more in-depth look.

In this paper, the authors do several things. First, they argue that the reluctance of firms to cut nominal wages and the reluctance of workers to accept cuts to nominal wages is a real phenomenon and has been empirically observed. By reviewing various BLS data, Akerlof and co. found that during the 60's, 70's, and 80's, wage cuts were very rare. Even during the severe recession of 1981-82, wage freezes were much more common than wage cuts.

Second, they argue that previous studies that show that wages don't show downward nominal rigidity (that wages can be cut and often are) were prone to reporting error - survey respondents would report wage cuts that didn't actually happen.

Third, they create two models - one that incorporates wages that aren't cut easily (sticky wages) and one that incorporates wages that can be cut easily (flexible wages) - and run them following the shocks of the Great Depression. While the model with flexible wages predicted massive deflation that never actually happened, the model with sticky wages tracked the actual inflation path of the US economy fairly well.

So what are the real world policy implications of wages that just refuse to be cut? The biggest implication is that we live in a world where the employment market can only adjust wages upward. If the employment market needs to adjust wages downward, then it's going to have no choice but to hold nominal wages steady and wait for inflation to bring real wages down to where they need to be. This could take quite some time if you're only getting inflation at 1% as we are now. A corollary to this is that an economy with complete price stability (zero inflation) will have no mechanism to adjust wages downward leading to a much more inefficient economy with a significantly higher level of unemployment.

If nominal wage rigidity causes such problems, can't we just get rid of it? This seems to be the radical conservative economic plan. By getting rid of unions, minimum wage laws, and other statutory reinforcements of nominal wage rigidity, wages will finally be free to adjust downwards and we can live in a utopia of stable prices and fully flexible wages. However, as much trouble as sticky wages cause, they save us from a much bigger problem: mass debt defaults. Your wages may be cut, but your mortgage payments stay the same. By preventing mass debt defaults, sticky wages serve as an important safeguard against greater damage to the financial system during times of high economic stress.