Keynes Was Right – On One Thing At Least

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A contention of JM Keynes was that people hate, really just hate, their wages to go down. This also being subject to the money illusion. It’s that we hate nominal wages, that amount of £s or $s that we get, going down. Doesn’t matter if the prices of everything else more than halve we’ll be mighty pissed off at still being better off if our own nominal wages halve. This is of course silly but it’s very human.

The effect of this is that in a recession we need wages to fall. This is actually one useful definition of a recession and the associated unemployment. That wages are too high and must fall. In a proper free market system wages would fall and there wouldn’t be recessions – wages would fall immediately and all would be well. The New Classicals and RBC types aren’t right. Because we do have recessions and the reason we do is because we’re dealing with human beings.

Well, that’s the story anyway. Thing is, it turns out that it’s right:

A key part of the explanation for nominal wage rigidity lies in perceptions that wage cuts are unfair and reduce worker productivity. The study presented 396 agricultural laborers and employers in 34 villages across six districts in India with scenarios about wage-setting behavior, and asked them to rate the behaviors as fair or unfair on a 4-point scale.

The results suggest that nominal wage cuts violate fairness norms. For example, the majority of respondents thought it was unfair to cut nominal wages after a surge in unemployment or during a severe drought. In contrast, relatively few people thought that a real wage cut was unfair if it were achieved through inflation. Respondents also expressed a strong belief that workers decrease effort when fairness norms are violated.

The research findings indicate that real wages adjust in response to market forces and play an allocative role. But in cases when nominal rigidities bind, thereby distorting real wages, this affects employment. This in turn leads to increased unemployment levels, higher employment volatility through boom and bust cycles, and the potential for additional labor market imperfections through misallocation of labor across farms.

The higher unemployment that results from nominal wage rigidity could be addressed by counter-cyclical employment programs, and by modest levels of inflation that allow real wages to adjust in a way that avoids too much harm to workers.

And there’s the argument that we should have a low but constant inflation rate. Or that we should deliberately engender inflation in a recession. Not because it’s just or right but because we’re humans with all the little foibles that entails.

Closer to home this also tells us something. The constant whining that wages aren’t where they were in 2007. Hasn’t anyone noted that we had a recession? A big and bad one? Meaning that wages had to fall. And given the above they had to do so by us having a bit of inflation rather than nominal wages falling.

That wages aren’t where they were isn’t the problem it’s the point.