The wage-slashing route to recovery
REPUBLICANS, some of them at least, seem to have put together a plan to generate economy recovery that isn't likely to endear them to the American public. The strategy, in a nutshell, seems to be to 1) sack a bunch of public sector workers to force them into the private sector so that, 2) private sector wages will fall, leading to 3) an increase in hiring.Matt Yglesias writes:America is just too big to adjust primarily through the currency channel. So one possible route is nominal deflation. You cut nominal public sector salaries, lay off public sector workers, and reduce nominal transfer payments (Security Security, SNAP, etc.). This ought to drive down wages in the private sector, too, and eventually everyone is making sufficiently little money that it makes sense to start hiring more people.Mr Yglesias isn't advocating this; he's simply suggesting that this is one way adjustment might work. Paul Krugman chides him:[W]hen you cut the price of everything — which is more or less what happens when wages fall across the board — there’s nothing else to substitute away from.Yes, economics textbooks typically show a downward-sloping “aggregate demand curve”. But the reasons for that curve’s downward slope aren’t the same as for your ordinary demand curve. It’s a process that works like this: lower prices -> lower demand for money -> lower interest rates -> higher spending. And that process doesn’t operate when, as is currently the case, short-term interest rates (which are the ones that matter for money demand) are zero.I think Tyler Cowen has a good series of responses on this. The question would seem to be whether a general deflation results; the Fed may be able to maintain inflation expectations. If wages fall relative to output, hiring should increase. Of course, and as Scott Sumner notes in Mr Cowen's comment section, the idea that wage decreases are still needed means that more inflation, and a looser monetary policy, is needed.There's no question that the Republican plan would mean a more painful and less effective road to recovery than is necessary. Given that it's also likely to be a political dud—do voters really hate public sector workers so much that they're willing to suffer pay cuts in order to punish them?—it's a peculiar economic policy line to adopt.