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.