This lecture covers an important issue: why do firms adjust by cutting workers rather than by cutting wages?So far, I have been pushing an explanation for unemployment that relies on issues with adjustment. There is heterogeneity in the labor market. Demand rises for some occupations and falls for others. Some industries expand, while others contract. Within industries, some firms are successful, while others fail. The overall effect is that individual workers frequently change jobs; moreover, the occupational mix changes as some workers exit the labor force (when they retire, for example) and other workers enter the labor force.

The picture I have of a macroeconomic recession is one in which the need for these adjustments becomes overwhelming. The gains and losses in employment, which usually offset one another, get out of balance. Declines in certain sectors are too large and/or too rapid, so that aggregate employment declines. Moreover, this decline in employment has multiplier effects, as those who are unemployed cut spending.

A question is: why do worker cutbacks take the form of job losses, rather than wage cuts? There are many possible answers.

My first thought is that most of the time wage cuts are inappropriate. The overall trend is for productivity and living standards to rise. On average, salaries are increasing. One can see, particularly in longitudinal studies, a strong tendency for people to move on a rising escalator of income. (Longitudinal studies examine the same people over time. In contrast, many people wrongly conclude that incomes are stagnating when they examine snapshots of the distribution of income at different points in time, using Census data for example. One might find that the bottom 10 percent of the income distribution in 2000 is not far from the bottom 10 percent in 1980. However, many people at the bottom in 1980 moved up, and they were replaced by new workers and immigrants.)

For the most part, the market tells workers that they can expect to maintain or improve their standard of living. Doing so may require a willingness to adapt by changing firms, changing cities, or changing occupations. Overall, however, it is not normal to have to accept a permanent wage cut.

If the long-run trend of wages is upward, then as a manager you know that cutting wages at your firm means cutting them relative to other potential opportunities for your work force. If wages are not falling generally, then an absolute wage cut at your firm means that you are reducing wages relative to the market. Your workers are likely to bleed away, and the workers you lose first are likely to be your best workers. Better to choose which workers to lose and to lay them off.

In other words, keeping the same work force and cutting wages is typically not an option. The choice is between cutting the work force directly or having your work force decline in response to a wage cut. You probably are better off making direct cuts. Most of the time, cutting wages is a bad policy.

In addition, economists have considered a number of sociological reasons for maintaining wages. For example, wage cuts may demoralize workers and therefore harm productivity.

In any case, I find it plausible that under most circumstances wage cuts are not a good way for a firm to cope with adversity. Still, from a macroeconomic perspective, there are rare circumstances in which wage cuts are called for.

For example, if there is general deflation, then cuts in nominal wages are needed in order to keep wages from rising relative to prices and productivity. This may have been an issue during the Great Depression. One would expect that if real wages were too high, employment would fall and productivity would rise as firms attempt to economize on expensive labor. This seems to be what happened.

In addition, if there is a major sectoral decline that is too big for the rest of the economy to absorb, it might be better for wages to fall for a while in that sector in order to help maintain employment. In the long run, a decline in demand for cars relative to physical therapists should lead to fewer auto assemblers and more physical therapists. In the short run, an unusually large decline in auto demand (due, say, to permanently higher oil prices) might best be met with lower wages in the auto industry, which could bring down prices and enable firms to sell more cars than they would otherwise.

Even if the macroeconomic rationales for wage cuts may on occasion be legitimate, such cuts may be very difficult to implement. How is a worker to tell the difference between an appropriate, macro-determined wage cut and a raw deal?

In fact, the inability of workers to see through the reasons for wage cuts is at the heart of why workers are paid fixed-dollar salaries to begin with. Economists have long noted that there would be fewer employment fluctuations if workers instead were paid a share of corporate revenues or profits. In theory, if worker were paid in the form of the output of firms, there would never be layoffs!

As a worker, shifting some of my income from fixed-dollar wages to a share of corporate profits is adverse for two reasons. First, it makes my income riskier and dependent on things beyond my control. I may do my job perfectly well, but the company makes strategic errors, leading to no profits and little or no pay for me. Second, it imposes an information cost on me. I have to be able to audit the corporation’s accounting statements to make sure that the reported profits on which they base my pay are not misleading–perhaps the real profits are being disguised and held in a form that benefits shareholders but not me.

So here is my story for explaining why we observe swings in unemployment rather than short-term wage adjustments. Under normal circumstances, most labor market transitions are toward jobs with higher pay and/or more desirable non-wage characteristics. Millions of these transitions take place each month. Therefore, a wage cut is a destructive, unsustainable policy that will alienate the firm’s work force and cause its best employees to leave.

There are occasions where, from a macroeconomic perspective, a cut in wages, in either a large sector or across the board, would help to avert a surge in unemployment. However, there is no credible way for any firm to tell its employees, “You are getting a wage cut, but don’t worry. It’s just for macroeconomic reasons.”

If this view is correct, then in times of high unemployment macroeconomic policy should aim to boost prices, presumably by expanding the money supply. Printing money should help to avert a general deflation. With sectoral imbalances, printing money should cause prices to rise in high-demand sectors, effectively reducing real wages in low-demand sectors and maintaining full employment in the latter.

Note that if sectoral imbalances are a problem, and creating general inflation in order to reduce real wages in weak sectors is the solution, then there is a Phillips Curve–a trade-off between inflation and unemployment. This model of the Phillips Curve was articulated particularly clearly by James Tobin in his address as President of the American Economic Association.

Note, however, that the Phillips Curve trade-off does not necessarily exist every instant. In order for inflation to reduce unemployment, there has to be a sectoral imbalance that is too large to be resolved by normal market forces. That may not always be the case. In fact, it may only rarely be the case.

Further reading: Martin Weitzman’s book, The Share Economy, describes the macroeconomic advantages of having worker pay that varies with corporate performance. An excerpt from James Tobin’s address can be found here.