A Paradox of Flexibility or Central Bank Incompetence?

Paul Krugman and Mark Thoma are again making the case against increased wage flexibility in a depressed economy. They contend that rather than helping labor markets clear, increased wage flexibility in a slump will create wage cuts that only serve to lower incomes. In turn, spending will weaken and further stoke the existing deflationary pressures. Policy makers, therefore, should avoid the siren call of reforms that enhance wage flexibility.

This so-called “paradox of flexibility” dates back to John Maynard Keynes, was endorsed by James Tobin, and continues to be advocated by prominent New Keynesians like Gautti Eggertson. Despite this long pedigree, there is a big problem with this view: it assumes that central banks are incompetent. The only reason wage cuts should lead to deflation and a sustained decline in aggregate nominal income is because monetary policy allows it to happen. This very point was demonstrated by none other than Gautti Eggertson and his coauthors in a 2012 paper:

[C]onsider demand shocks. For an increase in price flexibility to be destabilizing we find that the key condition is that the central bank does not raise/cut the nominal interest aggressively enough in response to movements in inflation. Intuitively, what is going on is that a higher price flexibility can trigger unstable inflation expectations if monetary policy does not act aggressively to counteract this by raising/cutting interest rates.

So there is no “paradox” here, but just good old fashion policy failure. Even at the ZLB this is true, since there are policy options–both monetary and fiscal–that can hold back deflation. Even the Fed’s flawed approach over the past four years has done that. Fed polices have kept both deflation at bay and nominal income growing, even in the face of a shrinking structural budget deficit. So why fret about increasing wage flexibility? Reforms that improve the working of relative prices by enhancing wage flexibility should be no problem given the Fed’s track record. Yes, the Fed could be doing more, but that is far different than saying it would allow the collapse of the price level and aggregate nominal incomes needed for this “paradox of flexibility” to arise.

Given a competent central bank, increased wage flexibility is fully consistent with growth in aggregate employment and income. Moreover, it probably would hasten a quicker recovery than monetary policy alone could generate. This slump has been so long that many cyclically unemployed individuals may have become structurally unemployed. Labor market reforms that increase wage flexibility would help them. We can have our cake and eat it too when it comes to wage flexibility.

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