Labor Market Rigidity: Psychology, Technology, and Peter Pan
Back in 2008, some of my favorite economists argued that unemployment wouldn’t rise much, even if there were a big nominal shock. Why not? “Labor markets are more flexible than they used to be.” Why? That was a little hazy, but the main reason seemed to be better management due to more advanced information technology.
I never bought this story, and unfortunately, as David Henderson points out, I was right. Today’s firms do have better management and more advanced information technology than they used to. But the most important cause of labor market rigidity, at least in the U.S., is psychology. People resent wage cuts, especially nominal wage cuts. This resentment varies over place and time, but even economists feel it. The awful unintended consequence of this resentment: Employers cut employment instead. If you talk to employers off the record, they often explain that wage cuts hurt productivity by angering workers, but lay-offs raise productivity by scaring them.
Why was I so skeptical of the view that labor markets had changed? Because cutting wages when labor demand falls isn’t rocket science. You don’t need computers or just-in-time inventory systems to do it. You don’t even need a calculator. Just cut wages by 2 or 3 percent, and see what happens. The upshot: If workers didn’t have a knee-jerk hatred for wage cuts, especially nominal wage cuts, employers would have solved the unemployment problem millenia ago. And given this knee-jerk hatred, all the computing power in the world isn’t enough to stabilize unemployment in the face of big nominal shocks.
Is labor market rigidity a market failure? I’m afraid so. But strangely enough, this market failure is largely caused by anti-market bias! The main reason workers hate wage cuts is that they imagine that wage-cutting employers are satanically “unfair.” If workers saw wage cuts for what they are – a full-employment mechanism – they’d sing a different tune. While they wouldn’t be happy to see their wages cut, they’d grudgingly accept that a little wage variability is a fair price to pay for near-total employment security. Once this economically enlightened perspective took hold, employers would eagerly cater to it – and the market failure would largely go away.
According to Peter Pan, “Everytime a child says ‘I don’t believe in fairies,’ there’s a little fairy somewhere that falls down dead.” As far as I know, he’s wrong about fairies. But if Peter had warned, “Everytime a person says, ‘I don’t believe in markets,’ there’s a worker somewhere that loses his job,” he wouldn’t have been far from the truth. Scoff if you must! People can and do cause market failure by believing in it.