The X-file of the American Labor Market

Who says Americans cannot live prudently? As the turbulence of the economic crisis spreads from Wall Street, many Americans have learned to tighten their belts overnight. No matter how many discounts retailers offer, everyone simply keeps a tight grip on his or her dollars and change.

American malls are shouting out for business with their “Cut Prices,” “Below Cost” and “Fire Sale” banners. Other than gifts for the children, all expenditures are made only when necessary and only economically.

At this point in time, tightening of the purse strings is the most important thing to do. Things would be worse if there were only a handful of people doing this. But here we have many millions of consumers holding back on their consumption, magnifying the impact.

Americans have been getting used to falling prices over the past two years. Housing prices have been declining for two years with no bottom yet. Recently, automotive prices joined the Fall party, and the Big Three would collapse if not for the lifeline from the government.

Gas prices are falling, too. I paid $4.05 USD per gallon when I returned to China for the summer Olympics. It was $1.69 USD per gallon when I passed by that same gas station yesterday.

“Buy” recommendations for houses and cars by the economists fell on deaf ears. (During an economic recession, consumers find themselves extremely devoted to the principle of “buy high, don’t buy low” because they don’t understand?). They don’t understand why prices are falling across the board. Naturally, this is the first time since the Great Depression of 1933 that the U.S. economy has seen such widespread deflation.

Economics of Sticky Wages

Market economics follows this economic maxim: when supply outstrips demand, prices will fall. However, wages in the U.S. market are an exception. They have seldom been affected by economic recession.

When the economy turns sour, employers may moderate, or annul, wage increments and/or may lay off staff, but they rarely reduce the wages of those who remain.

Theoretically, wages should fall alongside with profits. Why are wages able to defy the law of supply and demand?
Reducing wages is a way corporations could cut cost. Why do U.S. companies prefer retrenchment over wage cuts, which could reduce or even avoid retrenchment?
Why not have all workers draw flexible wages to achieve a win-win situation?

On the surface, this looks like a simple question. It is a renowned issue that has puzzled economists for many years.

American economists never like to approach issues using simple or layman methods. They prefer to employ more scientific methods such as complex mathematical models and aloof theoretical inductions. In this way, economists have devised all sorts of econometric models to explain why lowering wages are not viable in the current U.S. economic setting.

In the labor market, wages, like commodities, should be determined by the forces of supply and demand. If there is a large demand for labor, wages will be high, and vice versa. In reality, wages hardly react to changes in the economic environment of demand and supply in a timely and effective manner.

Economists call this phenomenon “Sticky Wages.” According to them, wages may be flexible, but companies are concerned that their employees will choose to leave if wages are too low. At low wage levels, workers think that they are better off staying unemployed than employed.

Therefore, reducing wages is no good. It will cause an exodus of valuable staff that companies want to keep. Some economists attribute wage stickiness to seniority of workers who pressure the management to resist hiring new employees, in their bids to resist wage cuts.

In fact, older workers are often the first to be shown the door by American companies. Higher wages earned by workers who have seniority constitutes a larger impediment to companies’ turnaround than lower wages earned by newer workers.

Some blame labor unions, work contracts and minimum wages for the stickiness of wages.
Other labor models include the “Shirking Model”, the “Relative Wage Model” and the “Hidden Contract Model” and so forth. Most of these so-called economic models fail to stand the test.

Explanation from an Economist

Professor Truman Bewley of Yale University has offered the most convincing and creative explanation to wage stickiness.
Bewley is one of the most outstanding economists in the U.S. He was the editor of “Econometrica” for many years, and he has made important contributions in the areas of general equilibrium in infinity space and micro-foundation on macroeconomics topics.

Would an established economist like Bewley offer an explanation for wage rigidity so obtuse that few could understand? Bewley confessed that he had “wasted years” formulating theories to explain why employers prefer to resort to retrenchment, rather than pay cuts.

After a futile search through the existing literature, Bewley decided to talk to the companies and their decision-makers directly. Other than teaching and doing research, he devoted the rest of his time to interviewing company owners.

This exercise took him eight years, covering 336 corporate managers. He published the findings from these interviews in a book named “Why Wages Don’t Fall During a Recession.”

The final conclusion of the book is an eye-opener: “My findings do not support existing explanations, except one. The exception is the model that says wage cuts would harm staff morale and reduce their initiative.”

If employers reduce wages during downtime, employees might perceive it as an act to “fish in troubled water." While retrenchment endangers staff morale, its impact is less severe, and more short-lived, than wage cuts.

Interviewees felt that wage cuts would distract employees from their work. One of the managers interviewed said that “while retrenched staff feels more miserable, they are out the door, and it is none of my concern. I am more concerned about the mood of those who stayed behind.”

Indeed, economic issues are seldom as clear-cut as mathematical problems.

The author is a professor at Pennsylvania State University.