Over the past decade, I’ve been advocating what I call the “musical chairs model” of the business cycle. This is from a 2013 blog post:
You don’t need DSGE models to understand business cycles, it’s basically just a game of musical chairs. Nominal wages are very sticky and NGDP is very volatile. So when NGDP falls there is less money to pay workers, and rather than taking nominal wage cuts you get lots of workers sitting on the floor—unemployment.
Notice that the emphasis is on cash flows and the pay of existing workers, not the marginal cost of new hires. Tyler Cowen recently praised a new NBER paper by Benjamin Schoefer with this abstract:
I propose a financial channel of wage rigidity. In recessions, rather than propping up marginal (new hires’) costs of labor, rigid average wages squeeze cash flows, forcing firms to cut hiring due to financial constraints. Indeed, empirical cash flows and profits would turn acyclical if wages were only moderately more procyclical. I study this channel in a search and matching model with financial constraints and rigid wages among incumbent workers, while new hires’ wages are flexible. Individually, each feature generates no amplification. By contrast, their interaction can account for much of the empirical labor market fluctuations—breaking the neutrality of incumbents’ wages for hiring, and showing that financial amplification of business cycles requires wage rigidity.
The paper (p. 34) also contained this interesting observation:
A testable prediction is that financially constrained firms’ labor demand elasticities are higher due to the cash flow effect, and that encompassing wage changes, for all workers, have larger effects than marginal wage changes. Saez, Schoefer, and Seim (2019) provide some evidence for this prediction, studying net-of-payroll-tax wage changes from a payroll tax change that targeted young workers (but ended up boosting employment for all, even ineligible, worker groups, especially in financially constrained firms).
When nominal GDP falls sharply, firms receive less revenue. Even if new hires are willing to take pay cuts, the sticky wages of existing workers cause firms to reduce employment, often closing down money-losing units within the firm, such as factories. A mixture of labor market norms and training costs prevent firms from immediately reopening these closed factories with new hires at a lower wage level.
Nominal wage stickiness really does exist, and cannot be brushed aside.
READER COMMENTS
Jose Pablo
Aug 30 2021 at 8:00pm
Nominal wage stickiness really does exist and cannot be brushed aside. … maybe it can be brushed aside:
What is sticky is the “net-of-payroll-tax wage” but what affects the cash-flow of the companies is the “wages including payroll taxes”.
Being this the case the elimination of payroll taxes at the beginning of a crisis (a decisive, bold fiscal policy action) should do wonders in ironing out the business cycle.
Since payroll taxes are more than 30%, the “drainage” of the company funds can be significantly reduced without any need of brushing aside the “nominal wage stickiness”.
The payroll taxes could be increased at the peak of the cycle to compensate the lost revenue, kind of “anticiclical pay-roll taxes”, creating an even bigger “buffer” to be used in the next crisis.
Scott Sumner
Aug 31 2021 at 12:25am
Yes, but wouldn’t it be much easier to simply stabilize cash flow with monetary policy?
Jose Pablo
Aug 31 2021 at 8:12am
Well, if the “musical chairs model” is right, it seems a case of: “If you want X, don’t do Y and hope Y leads to X; do directly X”, no?.
robc
Aug 31 2021 at 9:40am
I agree, the direct fix seems more able to be targeted.
I am not sure the Fed or whoever would do a better job at payroll tax policy than they do at monetary policy, but I would think the removal of as many intermediate steps as possible would help.
Scott Sumner
Aug 31 2021 at 12:43pm
I have zero faith in Congress’s ability to manipulate the payroll tax in such a way as to stabilize the business cycle. In any case, there are other reasons for wanting to stabilize NGDP growth, so why make it complicated?
Jose Pablo
Sep 1 2021 at 7:06pm
I have zero faith in Congress ability too. But the Federal Reserve could be put in charge of managing this “payroll taxes buffer”. Congress would still be in charge of stablishing the payroll taxes it wants and the Central Bank could “pass them thru” to the companies or not, financing it (kind of a new kind of “quantitative easing”).
It would be a new “tool” not a new “mandate”. Maybe a very sharpen one if the musical chairs model is correct. The new mandate could very well be targeting NGDP. After all we don’t know how to manage NGDP much more than we know how to manage inflation or “maximum employment” (at least in the same way that we “know” how to land spacecrafts on Mars … “science” is pretty polysemic after all).
David S
Aug 31 2021 at 3:41am
This seems to dovetail with your other post on why the Fed shouldn’t have a rigid unemployment rate target. I may be reaching on this, but I’m thinking of a scenario where a mild bump in unemployment could be associated with a period where entrenched industries destroy themselves by having nominal wages that are too high and crappy products. Sort of like the US auto industry in the 70’s and 80’s—which lost market share to better and cheaper imports. (Although I don’t want to pursue a counterfactual on how monetary policy should have been different during that period)
I don’t want to talk myself into a model where there are “good recessions” that are necessary for wholesale Schumpeterian creative destruction. Stable NGDP growth would hopefully sustain a business environment where entrepreneurs can risk paying new employees lower wages with the credible promise of wage growth over time.
Scott Sumner
Aug 31 2021 at 12:45pm
The natural rate of unemployment usually changes very gradually over time, and doesn’t typically result in recessions.
Kenneth Duda
Aug 31 2021 at 5:33pm
Agree completely. Nominal wage stickiness is one reason why nominal income stability (NGDP targeting) is so important. Other reasons include that long-term contracts, such as lease and supply agreements, establish long-lived pricing stated in nominal terms; and debt contracts and other financial arrangements typically involve fixed nominal payments.
In other words, employment, finance, and commerce all require nominal income stability to operate efficiently. Nominal income instability leads to excess unemployment (for reasons explained in Scott’s post), and also failure to engage in mutually profitable commercial transactions (because of price rigidity from lease/supply contracts), and financial default (because of contractually fixed nominal payments). These inefficiencies are not merely artifacts for academics to study — they lead directly to massive pain to real people losing their jobs and homes.
It’s so frustrating that the Federal Reserve could provide nominal income stability at almost zero cost, and entirely in line with the dual mandate, we’ve understood all of this at least since 2008, and yet it’s 2021 and this still hasn’t happened.
-Ken
marcus nunes
Aug 31 2021 at 5:39pm
Ken, very true, but some insist on the wrong “strategy”!
https://marcusnunes.substack.com/p/reviving-a-higher-inflation-target
Scott Sumner
Aug 31 2021 at 7:01pm
Good point about long term contracts, which is another reason to stabilize NGDP growth, above and beyond nominal wage stickiness.
marcus nunes
Aug 31 2021 at 5:34pm
Scott, 7 yrs ago you thought the “musical chairs model” had broken down in Germany.
I argued it had not!
https://thefaintofheart.wordpress.com/2014/04/14/there-was-no-breakdown-in-the-musical-chairs-model/
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