Deflation and Wage Stickiness

In a recent article on HubPages, I described what deflation is and the two types of deflation which are generally referred to as good deflation and bad deflation. While I go into more detail in the HubPages article, basically the term good deflation refers to falling prices resulting from increases in worker productivity while so called bad deflation is the result of falling aggregate demand.

A major obstacle to combating a major deflation resulting from a fall in aggregate demand is the so called stickiness of wages. Minimum wage laws, union contracts, government mandates and regulations, etc. all combine to prevent wages from falling.

Unlike other prices which fall when aggregate demand declines, wages tend to remain the same. Of course, while individual wages tend to remain unchanged, employers’ wage costs do adjust as workers are laid off and employers are freed from having to pay those laid off employees.

While no one, including me, likes the idea of having their wages fall, market forces will force a new equilibrium some way and the most common way is layoffs (I didn’t like that either when it happened to me during the major downturn in the late 1980s).

Here is a simple example showing how reducing wages or laying workers off each achieve the same result.. A company employs ten people, with each one earning $10 per hour. The total hourly wage bill for the company is $100 (ten employees times $10 pay per hour = $100 per hour wage bill). Now, if business is such that the employer can only afford a total wage bill of $90 per hour they have two choices.

The first choice is to reduce everyone’s pay by $1 which makes the wage $9 per hour. Since $9 per hour times ten people equals $90 the employees’ wages have been reduced to what the employer can afford to pay. This is the free market response and is one of the assumptions behind Say’s Law (which states supply creates its own demand and was named after the nineteenth century French economist Jean Baptiste Say).

The second choice is the Keynesian solution (after the mid-twentieth century British economist John Maynard Keynes) which is to keep the wages at $10 per hour but lay off one worker thereby leaving nine workers each earning $10 which results in the same $90 per hour wage bill that the employer can afford to pay.

While the initial result for the employer is the same under each option, namely that the total wages paid fall to what employer can afford to pay, the second choice, keeping individual wages unchanged causes a couple of problems.

First of all, unemployed people lose their wages and are now forced to cut back even more on their consumption which further reduces aggregate demand. At the same time, workers who are still employed remain fearful of losing their jobs so they also choose to hold money rather than spending it which reduces aggregate demand some more.

Unemployed workers frequently cannot afford to make the payments on their mortgages, car loans, etc. and the defaults on these loans, coupled with the decline in values of the assets securing these loans cause problems for banks as the value of their assets decline leading them to pull back on making more loans.

Second, even though the laying off of workers reduces payrolls to the amount that employers can afford in the new declining business environment, keeping wages at current levels makes it too costly for employers to rehire the laid off workers or for new businesses to hire new workers.

This fear or reluctance on the part of employers towards expanding and hiring new workers becomes a vicious circle in which aggregate demand falls because unemployed workers can’t afford to buy things which, in turn, causes employers to decide not to expand and increase output by hiring more workers.

The solution to this problem is to try to reverse the decline in aggregate demand with so called stimulus spending in which the government pumps millions of dollars into the economy in an attempt to artificially stimulate aggregate demand. This was the policy, that was prescribed by John Maynard Keynes during the Great Depression of the 1930s and followed, without success, by President Franklin D. Roosevelt and his New Deal Administration.

Instead, the solution, which President Ronald Reagan employed in fighting the stagflation of the 1970s and early 1980s, is to concentrate on calming fears and enacting policies designed to stimulate aggregate supply. This policy has been successful in the past while the Keynesian policies have never worked.

Links to My Other Articles on This Topic:

The Real Cost of Paying Employees

Deflation - What It is and Why We are Worried About It

Combating Deflation - Option I The Keynesian Prescription