The New York Times / December 17, 2008
Economic Scene: Finding Good News in Falling Prices
By DAVID LEONHARDT
Very few Americans alive today can remember a time when prices across the economy were falling. But they're falling now.
The cost of fruits, vegetables, clothing and vehicles are all dropping. Housing prices have been falling for more than two years, and a barrel of oil costs about $45, down from $145 in July.
The inflation report released by the government on Tuesday showed that the Consumer Price Index was 3 percent lower last month than it had been three months earlier. It was the steepest such drop since 1933.
Note that most of the prices that are falling are "commodity" prices that are inelastically supplied and demanded (like those of gasoline, fruits, veggies, etc.) The economist Michal Kalecki (who developed a lot of Keynesian economics before Keynes) called this the "demand-determined price" sector. We should expect falling demand to hit this sector hardest.
In general, significantly falling prices have not spread to the manufacturing or service sector (where prices are mostly determined by costs), with the obvious exception of autos.
By the way, falling housing prices do not show up in a big way in the usual measures of the "cost of living," which only cover newly-produced goods and services. The falling house prices that Leonhardt points to are like falling stock prices in that they refer only to assets, not newly-produced items. So they don't show up in the CPI or similar measures.
The cost of living measures do not assume that each person buys a house each year (or some period like that). Instead, they measure what the statisticians believe people would pay if they rented the houses. Thus, as house prices fall, that might affect the rental cost of housing and the cost of living. But actual rents did not rise as much as the asset price of housing in the late bubble, so they're not likely to fall as much either. Most workers -- who are mostly renters -- won't benefit much.
In any event, falling house prices will not be a benefit to those of us who are strapped for cash due to lay-offs or stagnant income and have a really hard time borrowing. Mostly, they will hurt those who (partially) own houses, pushing them in the direction of being "upside down" (having negative equity in the house). Many have already achieved that fate. This encourages the recession by depressing consumer spending further.
These [price] declines have raised fears of a deflationary spiral — fears that help explain the Federal Reserve's surprisingly large interest rate reduction on Tuesday. And there is good reason to fear deflation. Once prices start to fall, many consumers may decide to reduce their spending even more than they already have. Why buy a minivan today, after all, if it's going to be cheaper in a few months? Multiplied by millions, such decisions weaken the economy further, forcing companies to reduce prices even more.
This "expectations effect" is only one reason why deflation is a bad thing. In addition, deflation raises the real value of the debts of the debtors. It's true that it also raises the real value of the assets of the creditors. But debtors are usually the bigger spenders, so the net effect is to depress demand. Further, as the debtors are squeezed, more and more of them go bankrupt. This undermines the real value of the winnings of the creditors, further depressing demand.
In simple terms, if you borrowed a bunch of money last year and your money income falls now, then you discover very quickly that your interest and principal payments have not fallen, pushing you to the wall.
One rule is that the more debt people and companies have accumulated in the past, the more they and the economy suffer due to deflation. We in the US have just ended a monumental debt-powered splurge, at least among consumers. So avoiding deflation is especially important.
In passing, it's interesting to note that the very orthodox economist Irving Fisher developed his "debt-deflation theory of great depressions" back during the last serious deflation (the early 1930s). Somehow, the role of debt has been elided.
But a truly destructive cycle of deflation is still not the most likely outcome. For one thing, the price of oil cannot fall by another $100 in the next few months. For another, the federal government will soon, finally, be fully engaged in trying to stimulate the economy.
In mechanical terms, the Fed's rate cut is actually a decision to pump more money into the economy (which will cause short-term interest rates to fall). Starting next year, the Obama administration is planning to spend hundreds of billions of dollars on public works and other programs.
It should be mentioned that the Federal Reserve has just run out of interest rate ammunition to stimulate the economy. Maybe "Helicopter Ben" can do something just by printing a lot of money, but we'll see how effective that is. On the other hand, Obama's stimulus plan will not happen for months... Who knows what will happen in the meantime or how large the deficit hawks will allow the stimulus to be.
All else being equal, more money sloshing around an economy causes prices to rise. In this case, it will probably keep them from falling as much as they otherwise would have.
So amid all the legitimate worries about deflation, it's worth considering what may be the one silver lining in the incredibly bad run of recent economic news: The cost of living is falling.
Jobs are disappearing, bonuses are shrinking and raises will be hard to come by. But the drop in prices, which isn't over yet, will make life easier on millions of people. It's possible, in fact, that the current recession will do less harm to the typical family's income than it does to many other parts of the economy.
There's a lot of truth to this (Leonhardt's main point). My grandparents used to tell me about how they (who weren't hurt by the 1929 Crash or the 1929-33 Collapse) were able to get real bargains because of the deflation then, even buying luxury goods that they normally couldn't afford.
But a lot of other people suffered big time. My research has found that the amount of nutrition received fell significantly. Per capita food energy per day fell about 5% between 1929 and 1933.
The reason is something called the sticky-wage theory. Economists have long been puzzled by the fact that most businesses simply will not cut their workers' pay, even in a downturn. Businesses routinely lay off 10 percent of their workers to cut costs. They almost never cut pay by 10 percent across the board.
The Post-Keynesian economist Paul Davidson also praises the sticky money (nominal) wage as a nominal anchor that prevents deflation.
The stickiness of money wages is crucial, because without it, falling prices could start a downward wage-price spiral, with wages falling due to falling prices and prices falling due to falling wages. It's this spiral which represents true deflation, the kind of deflation that's been so destructive in the past. A merely temporary fall in prices does not have this kind of negative effect.
Traditional economic theory doesn't do a good job of explaining this [wage stickiness]. During a recession, the price of hamburgers, shirts, cars and airline tickets falls. But the price of labor does not. It's sticky.
In the 1990s, a Yale economist named Truman Bewley set out to solve this riddle by interviewing hundreds of executives, union officials and consultants. He emerged believing there was only one good explanation.
"Reducing the pay of existing employees was nearly unthinkable because of the impact of worker attitudes," he wrote in his book "Why Wages Don't Fall During a Recession," summarizing the view of a typical executive he interviewed. "The advantage of layoffs over pay reduction was that they 'get the misery out the door.' "
This makes a lot of sense. I hope that orthodox economists are going to follow this lead and return to the 1930s fashion of actually talking to businesscritters and workers as a way of finding out the nature of economic behavior, to supplement the standard abstract/deductive or statistical techniques.
However, it's not true that "Traditional economic theory doesn't do a good job of explaining" downwardly sticky wages. The problem instead is that the dominant schools of economists ignore a very traditional reason why workers resist or resent money-wage cuts (perhaps because of an obsession with "representative agent" models). It's a version of the prisoners' dilemma.
The standard story is that if workers accept a nominal wage cut, it will lead to falling prices, ceteris paribus. Thus, real wages won't fall much, but they will fall a bit, raising employment. The problem with this story is that each group of workers fear that no other groups of workers will take wage cuts. If one group takes a money-wage cut and others don't, prices won't fall much and the group will suffer real wage declines. There won't be a significant increase in employment (especially given the aggregate demand failure). Fearing this fate, most groups of workers resist nominal wage cuts. This means that the only price decreases are in the commodity sector (gasoline, food, etc.) and assets (houses, stocks, etc.)
If money wages in the manufacturing and service sectors don't fall, but the demand for products is falling, then employers will employ lay-offs because their profits will be squeezed. They will also refrain from expanding their operations (as they're doing right now). This encourages further falls in employment.
Lay-offs mean that the average money wage of the entire labor force (employed and unemployed) may fall even though that of employed workers does not. Falling asset prices will also hurt those workers who own houses or other assets, discouraging consumer spending. This encourages further production cut-backs and lay-offs. A downward spiral can occur even though money wages don't fall.
Wage stickiness, by the way, is likely less important in the U.S. economy than it was a generation ago. That's because of the "neoliberal policy revolution" of the 1980s and after (starting with the resistable rise of Paul Volcker to power in August 1979). This revolution has meant that more and more workers are treated as commodities. Fewer and fewer of them belong to labor unions (outside of the government sector). So it's more and more likely that nominal wages will fall during the current recession.
It's just possible the neoliberal policy revolution, which aimed at returning the economy to its pre-1929 state, has brought back the deflationary disaster of the 1930s. Of course, we won't know until it happens. If the reflation efforts of the Fed and the federal government succeed, any undermining of the sticky wages phenomenon is irrelevant in practice.
If the anti-government rhetoric of the neoliberals is to be taken seriously, it's ironic that its policies have put so much responsibility has been put in the Fed's and federal government's hands.
Companies resort to cutting jobs and giving only meager pay increases, increases that are even smaller than the low rate of inflation that's typical during a recession. This recession may well be the worst in a generation — but thanks to the stickiness of wages, the pay drop for most families may not be much worse than that of a typical recession.
The forecasting firm IHS Global Insight predicts that prices will fall by an additional 1 percent in 2009. That would bring the total drop, from the summer of 2008 to the end of 2009, to roughly 4 percent. But you can be sure that most executives will not force their workers to take a 4 percent cut in their paychecks. The fears about morale will be too great.
Should we rely on this forecast? I doubt it. The accuracy of economic forecasts has dived even lower in recent years. Forecasts seem better measures of what people expect than of what might actually happen in the world.
Strange as it sounds, the drop in prices will keep real incomes — inflation-adjusted incomes — from dropping too much.
I don't mean to make things sound better than they are. The economy is bad and getting worse. A deflationary spiral remains a real threat, even if it's not the most likely result. No matter what, unemployment is headed much higher.
People who keep their jobs, meanwhile, will suffer through some stealth pay cuts — higher health insurance premiums, for instance. Raises will also remain meager in 2010, even if prices start rising again. Like every other recent recession, this one will force families to take an effective pay cut, and a significant one.
Alas, "stealth pay cuts" are not really stealthy: they hit people directly in the pocketbook, having the same effect as non-stealthy pay cuts. Higher health insurance premia reduce the amount of income left over for other purposes. And they're hard or impossible to avoid, just like a payroll tax increase. They encourage resentment -- and cut-backs in consumer spending -- just like non-stealthy pay cuts.
But the drop in prices will still soften the blow. And at this point, American families can use any bit of economic help that they can get.
Copyright 2008 The New York Times Company
True, but methinks that Leonhard is a tad too optimistic.
I'm commenting so that I can have comments sent to my e-mail.
Well, at least that is some good news. Lower prices! However, if it means that the dollar is worth less or that wages fall too, that is bad. This whole thing is so complex, I don't think anyone understands it!
If prices fall, that means that the purchasing power of the dollar increases. This happens in terms of foreign exchange rates, too, as long as other countries don't have more deflation than the US does.
What is all this talk about this "wage stickiness"? It's nonsense, wages fall all the time. They fall at the entry point.
You lay off a bunch of people and then you hire a bunch of new ones at lower wages. It's not complicated. In fact, sometimes they re-hire the same people.
I'm glad you're providing an opportunity for me to complain about Leonhardt's column.
If (a) wages are constrained from falling, and (b) prices are falling due to drop in demand, then it seems to me that *something* has to give -- employers are not going to voluntarily reduce their income so they can keep paying their employees the same amount while earning less for the sale of their products. What will give, of course, is employment levels: employers will stop hiring, and start laying off, which is what we can see when we read the newspaper.
So now how exactly does David Leonhardt see this as a *good* thing? I suppose that even at the worst of the Great Depression, the majority of willing workers were still employed -- if you define a "typical" family as one where its workers are still employed, you can say that this "typical" family is better off with lower prices. But that obscures the great inequality and misery created if lots of people -- even if not the majority -- are unable to find work.
In fact, it seems to me that a wage cut without re-hire would simply violate your employment contract. If they wanted to cut your pay, they would have to get you sign a new contract. But why would you sign it? They can't fire you for refusing to sign a contract with pay cut, there is no good reason for you to sign.
Off the topic, unless we are talking about the broader topic of depression, a friend of mine was at a meeting with a representative of the Minnesota construction industry yesterday. The guy said, the moment the Big Three bail out failed, lumber companies cut back on their purchases of lumber. Loggers up north are calling saying, "We've lost all our business. What are we supposed to do?"
Lower prices are not going to help these guys or the small towns in Northern Minnesota.
abb1 said: > What is all this talk about this "wage stickiness"? It's nonsense, wages fall all the time. They fall at the entry point. You lay off a bunch of people and then you hire a bunch of new ones at lower wages. ... In fact, sometimes they re-hire the same people.<
The statistical studies of the question suggest that money wages don't change quickly in response to changes in demand (though I don't know enough to vouch for the validity of those studies).
It's true that employers can -- and do -- cut wages by laying off people and then rehiring them (or replacements), but the second step seldom occurs during a recession. The idea in orthodox economics is that if the employees took a nominal wage cut up front, there would be no need for the lay-offs (or the hiring of new people). Profits could be maintained without lay-offs.
The image burned into orthodox retinas is that of an auction, a special one where prices instantly change in response to demand (unlike in e-Bay). Then a theory "wage stickiness" is brought in to explain a key difference between the real world and the ideal. But the real world was never like an auction (and never will be). Most prices are sticky. When they aren't -- and go into free-fall during a recession -- then suddenly Irving Fisher's debt-deflation theory of great depressions becomes relevant.
By the way, if you re-hire the same people at lower wages, that is likely to drastically hurt morale. That's one major reason why Circuit City filed for chapter 11.
abb1 also says: >In fact, it seems to me that a wage cut without re-hire would simply violate your employment contract. If they wanted to cut your pay, they would have to get you sign a new contract. But why would you sign it? They can't fire you for refusing to sign a contract with pay cut, there is no good reason for you to sign.<
Part of the macroeconomists' theory of wage stickiness is that most wage-workers outside of the government sector don't have contracts. They might have "implicit contracts," but then the resultant wage stickiness has to be explained.
Alex R said:
>If (a) wages are constrained from falling, and (b) prices are falling due to drop in demand, then it seems to me that *something* has to give -- employers are not going to voluntarily reduce their income so they can keep paying their employees the same amount while earning less for the sale of their products. What will give, of course, is employment levels: employers will stop hiring, and start laying off, which is what we can see when we read the newspaper.<
Both Leonhardt and I talked about that.
>So now how exactly does David Leonhardt see this as a *good* thing? I suppose that even at the worst of the Great Depression, the majority of willing workers were still employed -- if you define a "typical" family as one where its workers are still employed, you can say that this "typical" family is better off with lower prices. But that obscures the great inequality and misery created if lots of people -- even if not the majority -- are unable to find work.<
In his defense, Leonhardt only sees falling prices as a good thing only in the sense that it's a silver lining on the mushroom cloud. He didn't see this as the whole story.
Eleanor said: > Off the topic, unless we are talking about the broader topic of depression, a friend of mine was at a meeting with a representative of the Minnesota construction industry yesterday. The guy said, the moment the Big Three bail out failed, lumber companies cut back on their purchases of lumber....<
What's the connection between the Detroit 3 and lumber? I do know that lumber is a commodity and the demand for almost all commodities is falling (driving down prices and revenues drastically), but how are autos relevant? They're not made out of wood anymore.
>Lower prices are not going to help these guys or the small towns in Northern Minnesota.<
Right. They only help if (a) they keep their jobs and (b) they don't have large amounts of debt compared to the value of their assets.
Disregarding the fire and rehire scenario, maintaining wage levels while laying off a portion of the employees certainly seems to have a far greater likelihood of benefiting a business than does reducing wage levels across the board to achieve a lilke savings in labor costs. Employee morale has already been mentioned. Those left behind may feel a bit "guilty" at their retention, but will still feel good about being kept on. The fact that some percentage of employees are laid off is most lilkely to energize those who remain as a means to validating management's decision to continue their employment.
Thinking forward management wanting to reduce labor costs by say 15% may recoginze that a reduction of 10% of the work force may stimulate the remaining employees sufficiently to achieve productivity gains equivalent to the additional 5% reduction in costs that were initially sought.
Reducing wages by any amount is only likely to increase work place dissatisfaction with a possible reduction in productivity.
You are the experts, but somehow I suspect that even if the contract is implicit they can't do a pay cut on the fly (except for the bonuses and such) without expecting a lawsuit. And that has got to be their motivation to avoid doing it.
Morale is not important; low morale is something you improve with bullshit speeches, threats to close the company and so on.
Unless you're running a software start-up, morale it not that important.
This is an odd thread all around. Leonard's column looked to me like plain vanilla money illusion. Prices are going down, so if we can just keep our incomes from going down, think how rich we'll all be. I sentence him to 20 hours of staring at the circular flow diagram like a zombie.
Peter Dorman said: >... Leonard's column looked to me like plain vanilla money illusion. Prices are going down, so if we can just keep our incomes from going down, think how rich we'll all be...<
If prices are falling somewhere else (such as the primary products sector), it's not money illusion within the sectors of the U.S. that do not producing primary products (commodities).
For example, if world oil prices fall (as they have been doing), then the price of gasoline falls inside the U.S. For those workers outside of the oil-producing sectors (in Texas, Louisiana, etc.), there is a clear rise in real incomes, all else constant.
Of course, as usual, all else may not be constant. The obvious case I can think of (at time in the morning with insufficient caffeine in my system) is that falling oil prices would help the U.S. current account balance, causing the foreign exchange rate of the dollar to rise (all else constant, natch). If that happens, that allows an even greater rise in U.S. real wages outside of the oil patch, since the international purchasing power of workers' dollars rises. Of course, there's more going on with exchange rates, so the actual direction of change can't be assumed so blithely.
By the way, in his book on the previous great depression (The World in Depression), the late Charles Kindleberger pointed to the deadly effects of a possible asymmetry in the above scenario. Given falling house prices, their debts, and the banks' intensified non-price rationing of credit, for example, workers in the non-oil world might not increase their spending very much as oil prices fall. This could easily exceed the extent to which people in the oil world (here standing in for the sector producing primary commodities) cut their spending as their incomes fall. If so, this would cause further recession and perhaps deflation.
Jim, it's true that in an open economy not all domestic price changes correspond to domestic income changes. But: (a) you are describing a favorable change in the US' terms of trade, not deflation, and (b) in any case the Leonhardt article wallowed in money illusion by treating falling prices in general as "good for consumers". His argument is based on not recognizing the circular flow.
Peter says: >... (a) you are describing a favorable change in the US' terms of trade, not deflation, and (b) in any case the Leonhardt article wallowed in money illusion by treating falling prices in general as "good for consumers". ...<
I'm not defending Leonhard, but I see nothing wrong with restating his viewpoint as saying that "deflation as we in the US non-primary sectors see it can be good for consumers there." From the point of view of consumers or workers in the US non-primary sectors, it's a change in the the average price level (which, if sustained, equals deflation). But from a larger point of view (including the privary sectors), it's a change in the terms of trade.
It really doesn't matter what we call it, since consumers can benefit (if they keep their jobs without significant wage cuts or significant speed-ups or stretch-outs of the work process).
What's scary (or exciting!) is the possibility that an improvement of the terms of trade of the US non-primary sector could cause a more general deflation, following Kindleberger's story, which adds to the other (macroeconomic) deflation stories that I limned.
In that case, US consumers not in the primary-product sector would benefit from falling prices -- until their bosses reacted by cutting wages or intensifying work. Then they would lose. The whole mess would turn into a downward wage/price spiral, in which employed workers would intermittently benefit as prices fall faster than money wages -- but generally lose as unemployment soars.
Jim, we should probably let it rest for now -- this matter could become absolutely clear over a beer or two in a couple of weeks -- but I remain perplexed that you see price and income changes as anything other than the same thing: wages are a price, after all, and everything has to go somewhere. Obviously there can be sectoral impacts (especially if you call classes sectors, as in working sectors of all countries unite), but the aggregates are identically equal, not equal in equilibrium or after a lag or anything like that. Maybe we are using the same words to mean different things....
16 comments comparing the effects of layoffs versus wage reductions and not a single recognition of the most obvious in between solution to the dilemna. Reduction of wage hours for all emploees while maintaining the hourly rate.
Instead of the suggestion that Jack made ( quoted below ) the workers could recieve a 10% hours reduction, while maintaining the hourly rate. An extra 5% productivity increase might then be realized by the improved morale that the workers understood that the company officials were acting proactively to save total jobs while cutting costs. Productivity and morale might also be boosted if a 36 hour work week left workers more refreshed and productive than the 40 hour week.
See numerous postings by Sandwichman that explain the wide reaching effective stimulus benefits that should be produced through reduction in the average hours of the work force by reducing the length of the work week instead of decimating the labor force.
"Thinking forward management wanting to reduce labor costs by say 15% may recoginze that a reduction of 10% of the work force may stimulate the remaining employees sufficiently to achieve productivity gains equivalent to the additional 5% reduction in costs that were initially sought.
Reducing wages by any amount is only likely to increase work place dissatisfaction with a possible reduction in productivity."
Thebigmook writes: >16 comments comparing the effects of layoffs versus wage reductions and not a single recognition of the most obvious in between solution to the dilemna. Reduction of wage hours for all emploees while maintaining the hourly rate. <
Employers are finding that in some cases, cutting hours can help their bottom lines, though there are other ways of attaining their goals. See http://www.nytimes.com/2008/12/22/business/22layoffs.html. One exerpt: "A growing number of employers, hoping to avoid or limit layoffs, are introducing four-day workweeks, unpaid vacations and voluntary or enforced furloughs, along with wage freezes, pension cuts and flexible work schedules. These employers are still cutting labor costs, but hanging onto the labor."
> Instead of the suggestion that Jack made ... the workers could recieve a 10% hours reduction, while maintaining the hourly rate. An extra 5% productivity increase might then be realized by the improved morale that the workers understood that the company officials were acting proactively to save total jobs while cutting costs. Productivity and morale might also be boosted if a 36 hour work week left workers more refreshed and productive than the 40 hour week... <
That sounds like a good idea. However, it seems to require some sort of "meeting of the minds" between employers and groups of workers. Thus it's hard to imagine it being put into practice in the current political landscape (few unions, with shrinking political and economic power). Or maybe I'm dense: how do you see this arrangement being arranged?
It seems more likely to me that rising unemployment will put the fear of the gods into those employees who keep their jobs. This encourages them to work more intensively (without an increase in pay), to put up with not being paid for all the hours they show up to work during, etc., just so they can keep their jobs. This lowers labor costs per unit of output, helping employers to protect profits in a period of falling demand.
Of course, the rise in labor productivity (marketable output per hour of paid labor-time) means a fall in paid hours when demand for output is flat or falling.
Keeping labor on, even at reduced hours, is more cost effective and saves a company money when economic activity turns up again. No need to train, or retrain, new hires.
Also, having fewer employees has quite another impact no one seems to acknowledge. The company's product/service gets crappier.
This isn't a zero/sum game going on here.
And please, don't tell me I don't know what I'm talking about. I've seen this cycle about five times in my life, and it always plays out the same. The company loses ground versus the competition when it lets employees go wholesale. All sorts of services are lost, as are all sorts of opportunities.
You keep your employees, somehow, until there is simply no other choice but the worst one: Letting them go away, probably forever.
beezer said: >Keeping labor on, even at reduced hours, is more cost effective and saves a company money when economic activity turns up again. No need to train, or retrain, new hires. Also, having fewer employees has quite another impact no one seems to acknowledge. The company's product/service gets crappier...<
Yes, but Leonhardt was talking about why money wages aren't cut much in a recession. It is best from the firm's perspective to keep the current employees on rather than laying them off. But the usual labor-management relationships don't allow it. Usually, cutting hours (beyond ending overtime) is off the agenda too. So lay-offs are used, with hope of bringing back the same people (so that no new training is needed). But temporary lay-offs often become permanent, contrary to anyone's intention, especially in a general recession.
(By the way, one reason why employers accept the existence of unemployment insurance despite their having to pay taxes for it is that it helps to keep laid-off workers around.)
>And please, don't tell me I don't know what I'm talking about.<
You do know what you're talking about.
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