Relative prices matter

Mario Rizzo makes a simple but very important point over at the ThinkMarkets blog, Relative Prices Matter At All Times. Rizzo writes in response to a column by Paul Krugman stating that wage cuts at this time are a bad idea. Kruman's argue follows Keynes in that he claims that nominal cuts will do no good – they will not stimulate employment (or prevent unemployment) – because aggregate demand will fall. Real wages will thus remain unchanged.

Keep in mind that Keynes focused on across the board nominal wage cuts. This is quite understandable from his aggregate or macroeconomic perspective. But this misses the main point. Rizzo writes

However, the issue is not across the board wage cuts as if some central authority were issuing an edict. Furthermore, there is no empirical evidence that such a cut is occurring. From the perspective of resource allocation (something that Krugman seems to have suspended his concern for), relative wages need to be adjusted. Not primarily average wages relative to the price level, but wages in some sectors relative to others.

Yes, the wages of autoworkers, financial sector workers, and construction works should fall relative to “average” wages. How else to ensure a reallocation of resources out of areas that were lately over- expanded by low interest rate and other policies?

What Krugman appears to fear is deflation, that is, a decline in aggregate demand spiraling out of control. So he recommends more stimulus to, in effect, ratify the “high” wages. But how does any of this allow relative wages to change?

The big issue for Krugman, and many other similar thinking policy wonks, is a fear of deflation, bad deflation, that is, a decline in aggregate demand spiraling out of control. Rizzo points out, however,

If we focus narrowly we see that food and energy prices have declined and this weighs down the consumer price index. However, as Allan Meltzer points out, during the first quarter of 2009 the “less volatile” gross domestic price deflator rose by almost 3 percent. This is not deflation by my arithmetic.

Thus, if deflation is not a real threat then let relative wage adjustments take place. We should not suspend our belief in the price mechanism.

Changes in relative wages/prices will give the incentives needed to bring about the reallocation of resources that the US economy, and most other economies, need. Let the price mechanism do its work. This again emphasises the importance of not losing sight of the microeconomics that lie beneath the aggregate marcoeconomics.