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Peter Crabb: The good thing about lower wages

More Keynesian economics is planned. Speaking before the AFL-CIO this week, President Obama promised more government spending designed to spur economic activity, including “a new American clean- energy industry.”

However, a key tenet of the Keynesian theory — that government spending leads to economic growth — is falling apart. Wages are no longer sticky.

Steven Greenhouse reports in The New York Times this week that many government agencies and businesses are getting agreements with their employees for lower wages in order to avoid layoffs. The story includes news from General Motors that new employees are receiving $14 an hour, which is half the rate paid to the company’s longer-term workers.

John Maynard Keynes’ treatise, The General Theory of Employment, Interest and Money, included as part of an overall theory of the business cycle the idea of sticky wages. This theory says that when overall demand in an economy falls, the price level temporarily raises real wages, which in turn leads to reduction in production and employment. That is, recessions occur when firms’ employment costs are too high relative to what they can sell, leading to layoffs and unemployment.

At first, the recession of 2008–2009 bore out what Keynes predicted. Rather than lower wages, we saw a high number of layoffs and increasing levels of unemployment. Keynes wrote his theories in response to the deep economic problems of the early 1930s. Massive layoffs around the world at the time supported Keynes’ idea that wages were not adjusting to slowing demand.

Today’s economic conditions don’t match that of the ’30s. Unemployment remains high and stubbornly persistent, but wages are adjusting. Wages even rose during the recent recession, the opposite of the supposed sticky-wage theory experience in the 1930s.

The U.S. Department of Labor reported this week that total compensation costs for civilian workers increased 0.5 percent for the second quarter of 2010. In June, wages and salaries, which make up 70 percent of total compensation, were 1.6 percent higher than the same month last year.

Idaho also saw increasing wages through the recession. Between 2008 and 2009, the most recent periods for which local data is available, average entry-level wages in the Boise-Nampa area rose from $8.60 per hour to $9.08, according to the Idaho Occupational Employment & Wage Report from the Idaho Department of Labor. This rise occurred while local unemployment rose from around 7 percent to more than 9 percent.

But with the unemployment rate holding high, many Idaho businesses and government organizations are following the national trend and lowering wages, rather than issuing more furloughs or layoffs. Private employers don’t usually publish such actions, but area school districts have announced salary cuts, and the governor himself is scheduled for a 4 percent pay cut.

A possible drop in overall wages, or slow growth at best, is supports the contention of some Federal Reserve officials that the greatest risk to the economy today is deflation, not inflation. At their meeting this month, and for the foreseeable future, the Fed is expected to keep interest rates near zero.

Activity in the futures markets suggest only a 20 percent chance the Fed will raise interest rates in April 2011 and a 44 percent chance of an increase in July 2011. The Fed has little reason to raise rates if prices, particularly the price of labor, fall.

If wages and other prices are allowed to adjust, the economy can improve. Lower prices for labor and goods will encourage firms to invest, and with investment comes economic growth.

More Keynesian economic policies are likely to just keep prices and unemployment too high.

Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.