Imagine a recession on Planet Vulcan. Thanks to weak demand, an able and hard-working Vulcan subordinate is simply not doing enough business to justify his salary.
The Vulcan boss calls his subordinate into the corner office for a frank and logical discussion of the options. They agree that it would be illogical to continue under the present arrangements, and that the Vulcan employee will accept a pay cut of 20 per cent for the time being. Both congratulate themselves on avoiding the bizarre human practice of sacking marginally profitable workers rather than adjusting their salaries.
Back on Earth, people do get sacked in recessions, and the received wisdom is that this is because wages don’t adjust. Some economists talk about “voluntary unemployment”. This odd term calls to mind the scenario of the Vulcan deciding he would prefer to spend some time on the beach rather than take the pay cut. Other economists speak of “wage rigidity”. Whatever we call it, inflexible wages are a puzzle, as the Vulcan approach does seem to have logic on its side.
But still, the story many economists tell is that wages don’t adjust much in recessions, and this fact helps to explain why unemployment takes the strain, plunging and soaring with the economic cycle.
Nevertheless, even if stubborn humans refuse to allow their wages to be renegotiated, there could still be room for wage adjustment because people are always gaining and losing jobs. If employers make generous offers during booms and stingy offers during recessions, we should see more wage flexibility and smaller fluctuations in unemployment as the economy booms and busts. But we don’t.
Or do we? Christopher Pissarides of the London School of Economics points to research showing that workers who hop from one job to another during a boom enjoy a hefty jump in take-home pay, while workers who change jobs during a recession do not. That suggests, claims Pissarides, that wages (or at least the wages offered to new hires) are more flexible than many economic theorists assume.
Not so fast, respond those theorists. In a recent article, Mark Gertler and Antonella Trigari explained why the studies to which Pissarides points might not mean what he thinks they mean: “Suppose, for example, that a highly skilled machinist takes a job as a low-paid cab driver in a recession and then is re-employed as a high-paid machinist in a boom.” Quite so: it is possible for an individual to experience cyclical wages by switching between two professions which themselves might have rigid wages.
This is all good clean fun, as I am sure you will all agree. And I saw the latest contribution to the debate presented by Gary Solon at the recent Royal Economic Society conference. Solon (with Pedro Martins and Jonathan Thomas) has been looking at data that allow him to observe the same companies recruiting over and over again – perhaps many times in a year – for the same entry-level positions. Solon’s data, from Portugal, clearly show something to surprise the economic theorists: wages do fall in recessions after all. An increase in the unemployment rate by one percentage point seems to suppress the real wages offered to new employees by 1.8 per cent. In other words, an increase in unemployment from 6 per cent to 9 per cent would depress the wages for new hires by just over 5 per cent.
This does not mean that wages are as flexible as they should be. The Vulcans might point to our wildly fluctuating unemployment rates and suggest that wages are still not absorbing enough of the strain of economic downturns. After all, a wage cut hurts. Losing your job hurts more.
Also published at ft.com.