You May Not Care About NGDP, But NGDP Affects What You Do Care About

A recent article by Josh Barro called for a freeze on public sector wages.  I don’t disagree with anything in the article, but I also think it is important to take a step back and put this issue in a broader context.  Let’s start with this interesting observation:

Since the end of 2006, hourly total compensation (wages plus benefits) has risen 6.5% for private sector workers, essentially keeping pace with inflation. But state and local government workers saw their hourly compensation rise 9.2%.

Federal civilian workers (about 10% of the public sector civilian workforce) are excluded from the above measure, but they did even better, receiving Congressionally-approved wage rises totaling 9.9% over the same period.

Why have public sector wages grown so fast? In some cases, it’s because employees are receiving scheduled raises under contracts negotiated before the economic crisis. New York public employees will see a 4% pay increase in April, under a contract negotiated in the middle of the last decade.

Talk about sticky wages!  Here’s the way I see the problem.  Public employees and employers both know that for several decades the Fed has been allow roughly 5% NGDP growth.  They also know that the workforce grows at about 1% per year, meaning average incomes can grow at about 4%.  So they negotiated pay contracts on that basis.

Now suppose the Fed reduces NGDP 8% relative to trend.  If all wages and prices are flexible, then you would see an 8% reduction in all wages and prices relative to trend, and output wouldn’t be affected.  But wages and prices aren’t very flexible in the short run, and thus output will fall sharply.  You might think that once wage contracts are renegotiated, this problem would be solved.  But you would be wrong:

But in other cases, governments have agreed to pay increases during the recession, or been forced into them by arbitrators. Transit agencies in New York and Washington, D.C., have seen their budget crises exacerbated by arbitrator-mandated pay increases, leading to service cuts. And Congress just approved another 2% pay increase for federal workers, effective this month.

Why don’t public employees get an 8% pay cut relative to trend, once their contracts are renegotiated?  Because that would mean a big cut in their real wage.  Why should employees with secure jobs accept a sharp real wage cut?  In other words, there is a coordination problem.  If you are a factory worker you can’t save you job merely by making your wage flexible, you need to make all wages flexible.  And it will not be easy to get public employees to share your wage cut, unless all companies also reduce all prices 8% below trend.  But why should companies cut prices if workers haven’t cut wages?  More coordination problems.

Is there an easier way out of this mess?  It seems to me we have two choices:

1.  Inflict enough pressure on workers to accept wages rates that are 8% below trend.  This can be accomplished with threats of layoffs, union busting, high unemployment, cuts in unemployment benefits, cuts in the minimum wage, pressure on public employees, etc.  It will also require much lower prices.  The entire process will be painful and will take many years.

2.  Use monetary policy to boost NGDP back up to trend, or more precisely close enough to trend so that with the wage cuts that have already occurred we can regain reasonably full employment.  The entire process will seem much less painful, and will show results almost immediately.

In some ways the two adjustment programs are quite similar.  Indeed the term “money illusion” was coined to describe the inability to see that they were quite similar.   But I think the second option is much easier to accomplish, at it merely requires that we change one price—the price of money.  In addition, my commenter “statsguy” likes to remind me that option 2 also makes it much easier to address the debt crisis.

This isn’t a criticism of Josh Barro, if my bailiwick was fiscal policy I’d be making the same recommendation.  He probably views the downshift in NGDP as a fait accompli, and he is probably right.  But there is a deeper question that we still haven’t addressed, what is our policy toward NGDP?

It seems to me that we have to make up our minds about which way we want to go, lower wages or higher NGDP.  It also seems to me that we haven’t even come close to doing so; indeed most people don’t even know we face this dilemma.  How often have you heard a Congressman (or the President) angrily call on the Fed to sharply boost NGDP, or even the price level for that matter?  I haven’t either.  And have you ever heard a Congressman (or the President) angrily scold the public for making excessively high wages?  Me neither.  They think there is a third way, but there isn’t.

BTW, if you are thinking “Sumner’s just one of those right-wingers who thinks wage cuts are the answer,” then you haven’t understood anything I have been saying.  If you are a liberal, then you have probably read Krugman’s arguments that wage cuts aren’t the answer.  Does that contradict what I am saying here?  Not really, I am not trying to make a causality argument here (although in another setting I’d love to make that argument) rather I am trying to make an accounting argument.  And I very much doubt that Krugman would disagree with my accounting.  Indeed, Krugman is one liberal who has made some very pointed criticism of the Fed, and who clearly understands that there is a problem, and that monetary stimulus is the best way out of the crisis.

Krugman and I do disagree on wages, but we share a sense of exasperation that most of the country, and most policymakers in both parties, are pretty clueless about the situation we face.  You can’t have NGDP downshift 8% and keep the old wage structure.  And yet as far as I can see most politicians and policymakers want to do exactly that, they want to have it both ways.  You may not like what I have to say, or what Krugman has to say, or what Josh Barro has to say, but at least we are all in our own way trying to provide a solution to this problem.   The policymakers in Washington just seem to be crossing their fingers and hoping that the problem will magically go away.

Maybe we will get lucky in 2010 and NGDP will start growing fast, eliminating the need for further wage cuts.  Even if that occurs, I will still be asking this question:

Wouldn’t it have been better if the Fed had boosted NGDP back in October 2008?

About Scott Sumner 490 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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