Sticky Wages Explained

 Byran Caplan writes an excellent summary of Truman Bewley's Why Wages Don't Fall During a Recession:

T cover-to-cover.  The book is a miracle ...First published in 1999, the book builds on Bewley's interviews with over 300 employers, labor leaders, unemployment counselors, and business consultants during the mild recession of the early 1990s.  Everyone he interviewed had ample first-hand experience with real-world employment and compensation decisions.  The purpose of these conversations: To evaluate a wide range of labor economists' theories in light of practitioners' testimony.

...Bewley successfully answers not only the title question of his book, but scores of follow-up questions.  While I was sympathetic to his basic answer before I started the book, he made me appreciate several layers of complexity I'd previously missed.  In each case, he managed to elegantly resolve the very complexities he raised....

Question: Don't wages fall all the time?

Answer: Real wages fall all the time, and nominal wages often fall when workers change jobs.  But nominal wages hardly ever fall for a given worker at a given job - even when there's massive excess supply of qualified labor.

Question: OK, so why don't nominal wages fall for given workers at given jobs?

Answer: Because almost all employers realize that nominal wage cuts are terrible for morale - and bad morale is bad for worker productivity. 

Question: Why don't they cut wages, then fire workers who slack off?

Answer: Because labor productivity heavily depends on trust and reciprocity.  Firing can deter specific offenses, but can't make workers broadly promote their employers' interests.  Plus productivity is much easier to observe at the group level than the individual level.

Question: Why don't employers just cut wages for new hires, then?  Do new low-paid workers really have bad morale?  Do old workers really resent new low-paid co-workers?

Answer: Initially, there's no morale problem at all.  New workers are thrilled to land a job, even if the pay is low.  Old workers only resent new workers if the newbies outearn them.  The problems start once the new workers realize they're paid less than their co-workers for doing the same job.  After 3-4 months, this leads to bad morale for new hires.  The new hires' resentment then poisons old workers' morale as well.

Question: So why not just fire all the old workers and replace them with new workers?  Wouldn't this neutralize the resentment?

Answer: Yes, but it would be very expensive to retrain a whole workforce from scratch.  Plus employers worry this would give them a reputation as a bad employer and bad corporate citizen.

Question: So a few years worth of mild inflation would solve the problem?

Answer: I'm afraid not.  Even during recessions, most employers keep giving their current workers nominal raises.

Question: Why?

Answer: Failing to give raises hurts morale, too.  Not as drastically as a nominal pay cut would, of course.  But a firm that failed to give raises for three years in a row would spark resentment - and productivity would suffer.

Question: Can't firms at least create a two-tier wage system: Raises for existing employees, flat hiring pay for new employees?

Answer: Some have tried, especially during the 1980s.  But bad morale keeps raising its ugly head.  New workers are happy at first, but resentment of pay inequity kicks in after a few months. 

Question: Hold on.  Workers don't seem to deeply resent earning less than their CEO, do they?

Answer: Not really.  Most resentment comes from lack of "internal horizontal pay equity."  If two people in the same firm do the same job, people expect their pay to be roughly equal.  Other pay inequalities are tolerable unless they're extreme or change quickly.

Question: Can the job market really be that monolithic?

Answer: There is a major exception: the "secondary" labor market.  Part-time work, seasonal work, consulting, that sort of thing.

Question: How does the secondary labor market differ from the rest of the labor market?

Answer: In the secondary labor labor market, workers don't know each other well enough to compare their pay.  Furthermore, workers in this market rarely base their self-esteem on their careers, so they don't fret much about pay inequities if they discover them.

Question: So nominal wages do fall in the secondary market?

Answer: Not for the same worker for the same job.  But in the secondary labor market, employers often cut nominal wages for new hires.  In fact, some employers in the secondary market deliberately prod their longer-time, higher-paid workers to quit so they can replace them with new, low-paid workers.  They freely confessed it.

Question: Workers seem to prefer a small risk of unemployment to a large chance of a nominal wage cut.  Who are you to second-guess their utility function?

Answer: Everyone with first-hand experience said that lay-offs are devastating for workers - financially and otherwise.  Pay cuts, in contrast, mostly just wound workers' pride.  That's why workers react so much more negatively to nominal pay cuts than real pay cuts.

Question: You're still being pretty paternalistic, aren't you?

Answer: Employers often openly compared their workers to children.  I suspect they're on to something. [Disclaimer: Bewley is probably too gentlemanly to actually say this, but it's very consistent with his findings.]

Question: OK, what happens when employers go ahead and cut nominal wages despite the expected morale problems?

Answer: It's hard to say with much confidence because nominal wage cuts are very rare.  I deliberately sought out firms that cut nominal pay, and found two very different patterns.

Question: Namely?

Answer: Firms in blatant financial distress found that pay cuts worked as long as they clearly explained the situation to their workers.  Otherwise, pay cuts failed from employers' own point of view.

Question: Do pay cuts cause any additional problems besides bad morale?

Answer: Yes.  Employers expect their best workers to leave first.  With lay-offs, in contrast, employers make their worst workers leave first.  (Exception: Unionized firms usually lay-off on the basis of seniority, not productivity).

Question: Doesn't this suggest that the better-paid employees were underpaid?

Answer: Absolutely.  Internal horizontal pay equity norms depress pay for good workers and inflate pay for bad workers.

Question: I'm confused.  Don't lay-offs hurt morale, too?

Answer: Yes, but the damage is relatively short-lived.  Wage cuts keep misery close to home. Lay-offs "get misery out the door." 

Question: Is that the whole story?

Answer: No.  Lay-offs are bad for morale if they drag on, or if workers see no light at the end of the tunnel.  But a big quick wave of lay-offs, followed by reassurances of job security for everyone remaining, only hurts morale for a few weeks or months.  Many employers sweeten the deal by using the cost savings of lay-offs to fund raises for remaining workers!

Question: So human psychology, not government intervention, is the sole cause of unemployment?

Answer: That's too strong.  Employers of low-skilled workers often cite the minimum wage and transfer payments as important factors.  For skilled workers, though, government policy isn't very relevant.

Question: Bottom line: All we need to do to end the scourge of involuntary unemployment is replace human workers with Vulcans?

Answer: Maybe.  I deliberately bypass this high-level macroeconomic question to focus on easier-to-answer micro questions.  But none of my evidence contradicts the view that involuntary unemployment would disappear if the workers of the world had a more mature attitude. 

Lump of Labor Fallacy and Immigration

The lump of labor fallacy is the idea that there is a fixed amount of work to be done and so population growth (or larger workforce participation by women, immigrants, or the elderly) reduces jobs and increases unemployment for working-age men.  That was approximately true during Malthusian times when almost everyone was a farmer.  There was only a limited amount of work that could possibly be done on a farm to produce food.  But the economy today is completely different.  Moneybox reports:

Workforce participation among older Americans has gone up since the 1990s due to diminished wealth and perhaps some demographical factors, and some people see it as something that "squeezes" younger workers out of jobs. But Suzy Khimm writes that a study from the Center for Retirement Research shows the opposite and "the evidence suggests that greater employment of older persons leads to better outcomes for the young in the form of reduced unemployment, increased employment and a higher wage."

This is is important because it intersects with two other issues that are a much bigger deal in terms of scale—formal legal curbs on international immigration and informal curbs on domestic migration via anti-density policies. Part of why people misunderstand the policy issues in those areas is that they have this same suspicion that more workers competing for a fixed pool of jobs will hurt the incumbents. But while there are certainly specific scenarios you can devise in which that's the case, the general case is the opposite. If more people come somewhere wanting to work—or more of the people who are already there decide they want to work—that has a positive impact on the other people around.

To see why, start with a time when things were different. During the Black Death, wages rose as population fell because the key input to the medieval economy was arable land. When the population is dense, all the returns go to the entrenched landowners and normal people need to live on a subsistence diet of grain. But eliminate a huge share of the population and suddenly there's plenty of land available for grazing animals and everyone gets to eat meat and cheese and butter along with their bread. Hooray!

But a modern, advanced economy is mostly made up of people. People are the key customers for the services that the majority of us produce for a living. And we produce things in teams that are composed of diverse clusters of labor. Slate has writers and copy editors and developers and art people and sales people, and we can only scale so far in any given direction without scaling across the board. A scarcity of qualified developers or skilled ad sales reps could stop us from being able to hire more writers. An ambitious sous chef might get hired as a head chef at a new restaurant but only if there are waiters and busboys to hire to staff the rest of the place. More workers means more dry cleaning gets done, and more people in town means more customers who prefer your particular approach to styling hair. Doctors are more productive when there's an ample supply of good nurses and health care technicians, and the arrival of more doctors means a greater demand for the skills of everyone else in the health care value chain. You lose out as a worker when more people with your exact skill profile show up. (Higher flows of Latin American immigration, for example, appear to depress the wages of a metro area's existing stock of Latin American immigrants.) But you win when people with different skill profiles arrive in the workforce.

And since people who are different from you outnumber the people who are the same, more people means more opportunities.

Discimination Against the Unemployed

Kevin Drum cites a new study that shows, "If you've been out of work for a year, ...It's just really hard to get anyone to give you a chance." 

The red line is how likely employers are to call back when the economy is bad (during a recession). In bad times employers do not discriminate much against people who have been out of work a long time.  They don't call anyone back much!  The blue line shows that employers greatly discriminate against people who have been out of work for more than twelve months.  Is it statistical discrimination?

licensure and labor mobility

Moneybox:

one consequence of occupational licensing rules is to make it difficult to move from state to state. A licensed interior decorator in southeastern Georgia might be considering a move to nearby Jacksonville, FL but then she'd have to get a new license. This turns out to be particularly burdensome on military families since they tend to move around so much. Last week the Department of Defense and the Treasury Department teamed up to release a report on this, noting that 35 percent of military spouses in the labor force are in licensed occupations and that military spouses are ten times more likely than their civilian counterparts to have moved across state lines in the last year. ...It's quite possible that civilian families would be more likely to relocate if they weren't burdened by licensing concerns. Historically a very high level of internal labor mobility has been one of the strengths of the American economy, but our mobility rate has declined for the past few decades... The federal government has only a very limited role to play in this issue, but I'd love to see more federal efforts to shed light. I could easily imagine this being an issue that a nice bipartisan blue ribbon commission could actually tackle in effective way. I don't think anyone in America has a strong ideological stake in the yacht broker licensing issue, but these rules tend to just grow denser and denser over time if nobody pays attention.

Boom-Towns & Baby-Booms vs. Immigration

People do not think a baby boom is as worrisome as immigration.  Nor intranational migration. Yglesias:

When people hear about a town that's attracting many new residents, they say it's "booming" not that the newcomers are poaching a fixed supply of jobs. Nobody in Texas seems to have proposed trying to close the state to migrants from the Northeast and Midwest; rather, they see the state's attraction to migrants as one of its strengths. The "foreign-ness" of newcomers from other countries distracts people from fundamental dynamics that they understand in other contexts.

Mandel:

I started writing about tough times for young college grads in 2006, when I was at BusinessWeek. Seems like a different day and age, doesn’t it?  Since then things have only gotten much much worse.  By my latest calculations:

• Real earnings for young male college grads are down 19% since their peak in 2000.
• Real earnings for young female college grads are down 16% since their peak in 2003.

These figures are for full-time workers, ages 25-34, with a bachelor’s degree only. See the charts below.
I want to ask an economic question, a political question, and a policy question.  First, no one has given me a good explanation yet of why young American college grads should have been hit so hard. Is there increased competition with young college grads around the world?  Are new college grads lower quality than their predecessors? Has information technology reduced the need for young grads? I really would like to know.
Politically, Obama captured the imagination of this group in 2008. Are young college graduates going to sit out the next presidential election in disgust?  Is there any candidate that can excite them?
Finally, if  we were going to design some economic policies to help young college grads, what would they be?

Nutty PhD in Humanities?

Author Louis Menand On Reforming U.S. Universities : NPR:

an enormous number of new campuses opened up in the 1950s and 1960s. ...Then after 1970, the system started to slow down and even go backwards, and you ended up with an enormous number of PhDs for a declining number of slots.
...the number of PhDs awarded has been going up pretty steadily since the 1970s, and the number of job openings has more or less been going down.
...the time it takes to get the PhD has been increasing steadily since the 1970s so that the median time to get a PhD in a humanities discipline, like philosophy, English, art history, is nine years.
...Now, if you think that you can get a law degree and argue a case before the Supreme Court in three years, get a medical degree and cut somebody open in four years, why should it take nine years to teach poetry to college freshmen?
...only about half the people who enroll in graduate programs in English actually get the PhD - only five percent of those ended up teaching in research universities, which is really what we're training our students to do.