A Useful Answer To Krugman’s Wage Puzzle – Real Wages Are, In Fact, Rising

The usual, and sensible, disclaimer here is that I as a mere scribbler tread on dangerous ground when I try to take issue with a Nobel Laureate on his own grounds of expertise. But in the hopes of illuminating my own thoughts if nothing else, here goes. We can solve Krugman’s puzzle over wage growth rather easily, simply by assuming that real wages are in fact growing.

That’s actually pretty obvious for the puzzle is that we’re not observing wage growth. So, we assume that there is that wage growth and there’s no puzzle, is there? At which tautologous moment economic discussion disappears up its own fundament and….ah, but wait, we actually are rather certain that real wages are growing more than our conventional measures tell us. In fact, we’re absolutely certain they are – our only puzzle is how much so?

The puzzle is that we expect wages to grow when unemployment is low. It is and they ain’t – that’s a puzzle. Krugman’s proposed answer makes sense :

OK, here’s one hypothesis: it’s partly about downward nominal wage rigidity.

The notion that firms are very reluctant to cut wages has a long history, for a very good reason: it’s true. That truth has been obvious to many observers; Truman Bewley made a systematic survey to confirm the point. Employers believe that actual wage cuts, as opposed to, say, letting real wages erode via inflation, are demoralizing and perceived as unfair. So there tends to be a zero lower bound on wage changes, except in the face of very high unemployment.

Until the Great Recession, most economists believed that this constraint, like the zero lower bound on interest rates, wasn’t that important in practice. But during the recession and aftermath, downward nominal wage rigidity became binding for a large share of the work force.

Yes, we know that’s true, we humans hate lower nominal wages. We’ll be grumpy about lower real wages as a result of inflation, sure, but we really hate declining nominal ones. That’s why one way out of a recession – hello! QE and all that – is for us to have a bit of inflation so that real wages decline even as nominal stay static. For a solution to a recession is that real wages decline which is why all the central banks were desperately trying to stoke up a bit of inflation those few years back.

So far so good therefore:

What employers learned during the long slump is that you can’t cut wages even when people are desperate for jobs; they also learned that extended periods in which you would cut wages if you could are a lot more likely than they used to believe. This makes them reluctant to grant wage increases even in good times, because they know they’ll be stuck with those wages if the economy turns bad again.

This hypothesis also explains something else that’s been puzzling me: widespread anecdotes about employers trying to attract workers with signing bonuses rather than higher wages. A signing bonus is a one-time cost; a higher wage, we now know, is more or less forever.

That definitely could be. As David Henderson says, there’s definitely something there.

Paul Krugman has an excellent post today titled “Is the Great Recession Holding Down Wages? (Wonkish)”, New York Times, May 4, 2018. It appears the same day that the Bureau of Labor Statistics reports an unemployment rate that has broken below 4 percent for the first time this century.

And now to turn to something entirely different. A time when I did in fact get something right as Brad Delong pointed out:

Tim Worstall is, I think, 100% right here. The key difference is between “Smithian” commodities–where it is a safe rule of thumb that the consumer surplus generated is about equal to the producer cost, so that GDP accounts that value goods and services at real producer cost will capture a more-or-less stable fraction equal to half of true standards of living–and… I might as well call them “Andreesenian” commodities, where consumer surplus is a much larger proportion of monetized value because what is monetized is merely an ancillary good or service to what actually promotes societal welfare. What is the proportion? 5-1? 10-1? Somewhere in that range, I think–at least.

We know very well that the digital revolution is producing value, value we get to consume, which is not well recorded in our usual economic statistics like GDP. Which is bad, because GDP is supposed to be the value of all consumption. Sure, we know it isn’t, there’s always that consumer surplus but we’ve assumed that the relationship between the two is constant. But what if it ain’t?

It turns out search engines are worth $17,530 a year to us, email $8,414 and digital maps $3,648. Therefore absolutely everything anyone says about GDP, economic growth, productivity and inequality is wrong.

This is indeed a problem:

In economic terms the best we can do here is to estimate the value we get to consume. As a proxy for that – and we really must note that it’s a proxy – we measure GDP, which is value created at market prices. This is a problem when there’s no direct market value for something. As Google’s chief economist Hal Varian has said, GDP has a problem with free.

We know that there’s some value being created by the existence of these free-to-use technologies. Our current measure of the value of that Google engine is, for example, the advertising revenue Google gains from operating it, which is about $25 per year per user.

Clearly this is somewhat different from the $17,530 in the NBER paper.

At which point a possible solution to the Krugman puzzle could be sketched out. It hinges on our definition of real wages.

The only useful definition of the real real wage – infelicitous though that is, sorry – is the value we get to consume as a result of our work and or mere existence. This is an entirely personal valuation as well. What you think I should value GMail at – or I you – means nothing. It is the value we think we’re getting which matters – utility is personally determined after all.

We really do know that we’re measuring the rises in real incomes wrongly, CPI is well known to be overestimated for example. But that’s a long running problem and isn’t something that particularly has gotten worse this past decade or two. Possibly the opposite in fact as changes to hedonic adjustment techniques have been incorporated. But we do still think that we’ve this other problem, the integration of digital goods and services into GDP and thus wages, real incomes and even real real incomes.

My favourite example being WhatsApp. There are no ads, no revenues. Some 200 people (I checked with them) inside Facebook work on it. We thus have costs of production arising and absolutely nothing in any economic figure as output or consumption as a result of those costs. This turns up as, remarkably, a reduction in productivity – we measure that as hours of work required to produce the value of production or consumption. Yet we’ve 200 people providing telecoms services to 1 billion people and we’re recording it as a reduction in productivity?

We know we’re wrong here. The only question is how wrong are we?

If this new NBER paper is correct – no, not a certainty – then we’re sufficiently wrong to solve the puzzle. The value of those digital services is such that real wages – OK, real real wages – are rising and rising strongly. Even as conventionally measured ones are not.

The inverse perhaps of that nominal and real wage thing when they’re falling. We hate nominal wages falling, we’re only grumpy about real doing so. We’re equally – perhaps – happy with slowly rising nominal wages, slowly real rising when measured in cash terms. But when real real wages are rising strongly then we’re just fine. We don’t do all the quitting one job for a better paid one elsewhere, don’t agitate for higher wages, we’re fine in fact. We can feel life as it is lived getting better and we’re copacetic with that.

Sure, there are assumptions in the above but there are also things we know are true. Those real real wages are rising faster than our conventional measures as a result of all that digital doohicky. This has been happening largely in this past decade and a bit. And we’re trying to explain why the reaction to slow nominal (or even real, but not real, real) wage growth is different this time at a time of near record lows in unemployment. I’d insist that this is at least partially true and I’d make a claim that it’s entirely so.

Living standards, consumption and thus real wages properly measured, are rising strongly. Thus there’s no puzzle to explain, is there?