Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 2 August 2017

Is a flexible labour market a problem for central bankers?

Recessions and milder economic downturns are typically a result of insufficient aggregate demand for goods. The only way to end them is to stimulate demand in some way. That may happen naturally, but it may also happen because monetary policymakers reduce interest rates. How do we know we have deficient aggregate demand? Because unemployment increases, as a lower demand for goods leads to layoffs and less new hires.

A question that is sometimes posed in macroeconomics is whether workers in a recession could ‘price themselves into jobs’ by cutting wages. In past recessions workers have been reluctant to do this. But suppose we had a more prolonged recession, because fiscal austerity had dampened the recovery, and over this more prolonged period wages had become less rigid. Then falling real wages could price workers into jobs, and reduce unemployment. [1]

This is not because falling real wages cure the problem of deficient aggregate. If anything lower real wages might reduce aggregate demand by more. But it is still possible that workers could price themselves into jobs, because firms might switch to more labour intensive production techniques, or fail to invest in new labour saving techniques. We would see output still depressed, but unemployment fall, employment rise and stagnant labour productivity. Much as we have done in the UK over the last few years.

It is important to understand that in these circumstances the problem of deficient demand is still there. Resources are still being wasted on a huge scale. Quite simply, we could all be much better off if demand could be stimulated. How would central bankers know whether this was the case or not?

Central bankers might say that they would still know there was inadequate demand because surveys would tell them that firms had excess capacity. That would undoubtedly be true in the immediate aftermath of the recession, but as time went on capital would depreciate and investment would remain low because firms were using more labour intensive techniques. The surveys would become as poor an indicator of deficient aggregate demand as the unemployment data.

What about all those measures of the output gap? Unfortunately they are either based on unemployment, surveys, or data smoothing devices. The last of these, because they smooth actual output data, simply say it is about time output has fully recovered. Or to put it another way, trend based measures effectively rule out the possibility of a prolonged period of deficient demand. [2] So collectively these output gap measures provide no additional information about demand deficiency.

The ultimate arbiter of whether there is demand deficiency is inflation. If demand is deficient, inflation will be below target. It is below target in most countries right now, including the US, Eurozone and Japan. (In the UK inflation is above target because of the Brexit depreciation, but wage inflation shows no sign of increasing.) So in these circumstances central bankers should realise that demand was deficient, and continue to do all they can to stimulate it.

But there is a danger that central bankers would look at unemployment, and look at the surveys of excess capacity, and look at estimates of the output gap, and conclude that we no longer have inadequate aggregate demand. In the US interest rates are rising, and there are those on the MPC that think the same should happen here. If demand deficiency is still a problem, this would be a huge and very costly mistake, the kind of mistake monetary policymakers should never ever make. [3] There is a fool proof way of avoiding that mistake, which is to keep stimulating demand until inflation rises above target.

One argument against this wait and see policy is that policymakers need to be ‘ahead of the curve’, to avoid abrupt increases in interest rates if inflation did start rising. Arguments like this treat the Great Recession as just a larger version of the recessions we have seen since WWII. But in these earlier recessions we did not have interest rates hitting their lower bound, and we did not have fiscal austerity just a year or two after the recession started. What we could be seeing instead is something more like the Great Depression, but with a more flexible labour market.

[1] Real wages could also be more flexible because the Great Recession allowed employers to increase job insecurity, which might both increase wage flexibility and reduce the NAIRU. Implicit in this account is that lower nominal wages did not get automatically passed on as lower prices. If they had, real wages would not fall. Why this failed to happen is interesting, but takes us beyond the scope of this post.

[2] They also often imply that the years immediately before the Great Recession were a large boom period, despite all the evidence that they were no such thing outside the Eurozone periphery

[3] J.W. Mason has recently argued that such a mistake is being made in the US in a detailed report.


  1. I think that a crucial issue is Footnote 1. Bargaining models of wage determination often used the level of unemployment as a proxy for workers' outside option and also kept the relative bargaining power of employers and employees constant.

    Both of these may have changed in recent decades. Where wages are still set by collective bargaining, the threat of firms setting up overseas and/or the threat of losing out to imports may well have increased. Where wages are individually set, the increase in the unpleasantness associated with dependence on benefits may mean that at any particular unemployment rate there has been a fall in workers' value of the outside option. Similarly, at any particular unemployment rate, the growth in poorly paid and zero-hours jobs reduce the potential gains from refusing any particular job offer and trying to find another job. The fall in the relative earnings ofthe self-employed is also relevant.

    Now that I have retired, I no longer find it possible to keep up fully with the latest research. If anybody can provide a summary of any recent empirical research on such things as wage/profit rates, returns on capital etc. that might throw light on the question of bargaining power, I'd be very grateful


  2. In the UK, surely we would prefer to stimulate export demand, rather than domestic consumption?
    Has not UK household demand, fuelled by looser credit, hit some kind of limit, as per comments from BoE?
    We have already had two significant devaluations, after the Great Recession, and after the Brexit vote, but the consensus seems to be that neither have stimulated export demand very much.
    How then to stimulate demand for UK products and services?
    (Apart from reversing out of Brexit.)

    1. If private credit's played out, all the more reason for fiscal stimulus. Pretty hard to stimulate demand in a foreign country, whose economic policies you do not control, consider how growth on the continent is still weak. And try persuading Germans to consume more, or to import more...!

  3. I find this post puzzling. Are you saying that in the absence of an increase in aggregate demand, lower wages could mean a greater share of income goes to labour? This is, indeed, the classical theory, as I understand it, but surely the problem is the relationship between the marginal wage and the average wage.

    If the marginal wage is low enough the market must clear (or the input is destroyed by starving to death) but this lower marginal wage will, in a competitive market place, immediately put pressure on average wages. If these also fall then, until labour supply is sufficiently reduced through starvation (and sickness etc.) aggregate demand will also fall in a reverse wage-price spiral.

    I am beginning to wonder (without much evidence) if we are seeing the working-out, and negative consequences, of the longer term impacts of the extraordinary change in economic relationships represented by globalisation. The '90s and early '00s channelled amazing purchasing power to the West thanks to the willingness of Chinese and other Eastern workers to make things we wanted for virtually nothing. Now we no longer have the resources to buy them, or at least so many of them, but we have lost the skills to make them ourselves. As I say, I haven't worked this out yet, but I have a feeling there is a very large step-change in the old relationships.

  4. If you had an environment where you encouraged inflation as you suggest but without a commensurate response from wages; in other words what we appear to have now and have had for some time, this reduction in real wages would in itself provide a brake on the economy (aggregate demand) without any increase in interest rates.

    This is the rationale for the BOE "looking through" the inflation of 2011 and I assume they will follow a similar course now, despite what the MSM seems to think in terms of the imminence of interest rate rises.If they did put up interest rates in these circumstances then this would of course compound the effects on aggregate demand and might be regarded as overkill, and indeed policy error.

    The BOE are able to look through this increase in inflation presumably because there are no sustained second round effects on wages, which really would signal the need for interest rate rises (such wage increases would support any fall in unemployment; in other words they would be consistent with an uptick in aggregate demand).

    It is arguable that an increase in inflation may be a necessary but not sufficient condition for taking action under these circumstances; that changes in aggregate demand are also signalled by wage changes.

    You could say that the situation we have now, which is elevated inflation and quiescent wages, to possibly presage lower aggregate demand via the effect on real wages and, at the very least, gives pause so that a policy mistake is not made (As you indicate the Fed may be making this error) and interest rates are not increased.

  5. A fall in real wages would actually raise demand and for a reason explained by Arthur Pigou: falling wages and prices equals a rise in the real value of the monetary base (and a rise in the real value of another private sector asset, namely government debt, and as Martin Wolf and Warren Mosler explained, base and debt are almost the same thing). And a rise in those private sector owned financial assets would stimulate extra spending, not that that’s a practical way of dealing with recessions in the real world.

    Re the idea that lower real wages might cause employers to use more labour intensive methods, the problem with that idea is that labour is the ultimate cost (if one includes the “labour” of the entrepreneur). Thus an X% fall in the cost of labour results in an exactly equal fall in the price of machinery etc, ergo there is no change in the cost of labour versus cost of machinery ratio.

  6. we could all be much better off *is* demand -- if*

    might say that they would still know *their
    8 was inadequate demand --- there*

    There is a *full* proof way -- *fool

    1. Thanks. Rather a lot for one post. If only I did this for a newspaper that would pick up these.

    2. As a layman I will tell you that job flexibility looks like the end of careers that pay wages that support mortgages ...
      I think this will launch the mother of all tsuanmis in the future.
      Seemingly all young scientists and most people are paid minimum wages in mcjobs . This will demolish asset prices IMHO..

  7. Would lower wages in one country address the AD problem by boosting demand from abroad ?

  8. I'm rather surprised you didn't bring up Keynes opinions regarding wages being sticky.

  9. Thank you for setting out so clearly, why central bankers should watch realised inflation closely, not unemployment. I wish central banker remuneration could include a performance component for ensuring that realised inflation does in fact come within the target range!

  10. asocialdemocraticfuture3 August 2017 at 10:06

    Link to report in footnote 3 is worth reading: point made in pp66-67 appears - when translated to UK current policy context - particularly pertinent:
    As Blanchard (2016) argues, structural changes in the U.S. economy have weakened the relationship between unemployment and inflation. Policymakers also need to consider the risks of overestimating potential output versus underestimating it. It no longer seems to be the case that when unemployment falls below the NAIRU level, that will reliably lead to a substantial rise in inflation. So while historically it may have been the case that the goals of stabilizing inflation and stabilizing unemployment lined up, today “the Fed faces a tradeoff between stabilizing unemployment and stabilizing inflation,” and there is no reason to think that hitting its price stability target perfectly is the socially optimal policy. If lowering unemployment by one point would raise inflation by only 0.2 points, as Blanchard estimates, that presents “a very attractive tradeoff between inflation and unemployment.” Given the existence of hysteresis, there is an argument “to lower unemployment below the natural rate for some time".

  11. .
    Is it possible that this entire conversation is an indication of a government funding and economic control model that is no longer optimal?

    The mechanisms currently in place, while adequate, do not seem to be working as well as one would like.

    Would a Bond Funded Model be intrinsically more inclined to keep the economy at maximum output and unemployment at a minimum?

    Crude Description Here:

    And excerpted:



    The government funding model we currently use is like an engine designed to run cool/slow with levers to heat/speed it up when needed.

    We are now finding that the economic environment/engine is stuck on low output and the heat/speed levers are not working.

    Perhaps the old model is obsolete.

    Why not have an economic system/government funding model designed to run hot/fast with plentiful unquestionably effective levers to cool it down when needed?

    Perhaps a bond funded model should be adopted.

    A bond funded government funds the majority of its needs through bonds, paid off when due via monetization. This is the engine designed to run hot.

    Inflation, the only real concern, is held in check through interest rates, reserve requirements, loan to value constraints, asset taxes and transaction taxes - absolutely no income taxes. All these measures, and others, vary dynamically with the inflation rate. These are the cooling levers.

    The central bank would have to be ceded the power to access these levers at will.

    This solves many problems:

    1) Zero lower bound, secular stagnation and fiscal dominance go away. Interest rates would have to be higher, no debt means no fiscal dominance and secular stagnation is unlikely in an environment where the government is free to invest, constrained only by inflation.

    2) Low inflation and deflation go away, unless the government is too gridlocked to float the bonds and spend. Note that debt can no longer be used as an objection to spending.

    3) Fiscal constraints and debt constraints would not exist - the only constraint is inflation.

    4) Redistribution would no longer be possible, it would be distribution.

    5) Greater public investment and the resulting economic effervescence would impel great private investment.

    6) All income tax avoiding and evading activities would cease, along with all the associated conflicts.

    7) A zero income tax regime would attract industry, thus boosting middle income wages, equality and employment.

    8) Bond Funded Government would provide great economic certainty.

    9) Demand would be greatly boosted as all entities were freed from income taxes.

    10) Returns would be less structurally constrained because of the lack of income tax.

    11) All of the above would countervail slow growth situations.

    I think a bond funded government would be much more likely to keep an economy at maximum performance and it would have a plethora of tools to avoid exceeding the economic redlines.

    If you took a poll, I suspect that literally everyone would risk higher interest rates and more difficulty getting a loan if income tax could be abolished.




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