Paul Krugman delivers another breakthrough economic insight, solving a puzzle that has vexed economists for generations. The question - why don't labor markets clear during depressions and recessions when demand for labor falls? Why do we have long-term unemployment?
And here is Krugman's lightning bolt:
For example: if unemployment is high because people are unwilling to work, reducing the supply of labor, why aren’t wages going up?
Spoiler alert - maybe labor supply fell but demand fell even more? Don't peek ahead! If wages aren't rising then the notion that some people are unwilling to take a pay cut to go back to work must be false. Who knew?
This paper provides evidence on the behavior of reservation wages over the spell of unemployment using high‐frequency longitudinal data.
Job offers are more likely to be accepted if the offered wage exceeds the reservation wage... In comparison to a calibrated job search model, the reservation wage starts out too high and declines too slowly, on average, suggesting that many workers persistently misjudge their prospects or anchor their reservation wage on their previous wage.
In other words, some people are too slow to take a pay cut and end up with an extended period of unemployment. Is that even possible in an environment where wages are not rising? Surely, per Krugman, their withdrawal from the labor market will prompt wages to rise for others.
Or not, and stop calling him Shirley. Imagine (caution - may induce a 2008 flashback...) that economic conditions change and there is a large drop in the demand for labor (we assume a conventional downward sloping demand curve - all else equal, employers will hire more if wages are lower, although employers get sticky about imposing pay cuts during periods of slack demand).
On the supply side, suppose some people have a "sticky" wage expectation and remain confident that they will find employment at the same (or higher!) wage as previously. This is the reservation wage concept explored by Krueger.
We also assume that the supply curve for labor slopes upward, so that at lower wages people are inclined to substitute other activities, such as leisure or do-it-yourself projects - for example, doctors ought to hire a kid to cut their lawn while they head to the OR, but that is less true for a Walmart greeter whose pay has been cut.
So - in a recession the big drop in downward-sloping demand will intersect with the upward-sloping supply curve at a lower wage, with reduced total employment. IF the sticky wage folks, such as Krueger, are correct then the supply of labor is, we might say, sub-optimal because some people are clinging to an unrealistic wage expectation.
On the other hand, there are classicists who would argue that if people don't want to work at a lower wage, well, more power to them. Let's note that these classicists include progressives on some days of the week, when they celebrate the projected decision of lower-earners to optimize their ObamaCare subsidies by working fewer hours. That said, back when JM Keynes was pondering 20% unemployment the notion that all was for the best in this best of all possible worlds was harder to sustain.
To come back to Krugman's quiz question:
[I]f unemployment is high because people are unwilling to work, reducing the supply of labor, why aren’t wages going up?
One possible answer is that although some people have unrealistic wage expectations relative to what is being offered, which effectively reduces labor supply, wages don't rise because demand for labor has also fallen. That said, wages are higher (i.e., fell less) than they would have been had some people not sidelined themselves. Krugman has written many times about the shortfall on the demand side in the current economy, so the slack aggegate demand notion can't be controversial. Presumably, his point is that the downward pressure on wages and total employment is due entirely to the drop in demand and has nothing to do with sticky wages.
If the people with unrealistic expectations re-entered the labor market with diminished expectations, then (all else equal) total employment would rise and wages would fall further. That is not an unambiguous win for the good guys, whoever they may be. However, it seems likely that a combination of diminshed aggregate demand as well as demand for labor coupled with unrealistic expectations among the unemployed are raising unemployment.
And the Republicans are making the Tough Love argument that extending unemployment benefits for those with unrealistic expectations will not guide them home to the new reality.
Its another Nobel for the Professor.