Krugman's paradox of wage cuts is untrue

This is comments on Paul Krugman’s “Falling wage syndrome”, Opinion, the New York Times, http://www.nytimes.com/2009/05/04/opinion/04krugman.html?_r=1&em, 4/05/2009. When I got to that site, unfortunately it was no longer accepting more comments. However, I like some of the thoughts below, so I would like to keep these comments for reference.

Yes, there can be quite a few paradoxes in the US now as the result financial and economic crises. The paradox of falling wages and paradox of deleveraging are similar to the paradox of thrift. That is to say, while it is a virtue if an individual does it, but if everyone does the same it becomes bad for the whole, as economic theories say.

Krugman’s argument goes as follows. As the paradox suggests, falling wages plus expectations of falling wages will reduce consumer spending, because they will have to pay higher interest burden relative to income on debts. The reduction in consumer spending will depress the economy and increase unemployment. This undesirable aggregate result of rising unemployment would result from the wage cuts that at the start will increase the competitiveness of those businesses that had the cuts earlier, but that competition advantage will disappear when everyone accepts wage cuts and no business will be more relatively more competitive than others.

Krugman argues that “mainly that stabilizing the economy isn’t enough: we need a real recovery”. He further says that “To break that vicious circle, we basically need more: more stimulus, more decisive action on the banks, more job creation.”

While I seem to understand some of the arguments, I got lost in some of the others. I offer a few points to illustrate my puzzles. Firstly, the argument that the loss of individual business competitiveness gained from wage cuts when every business cuts employee wages is only true in a close economy with little international trade in goods and services. Yes it is true that the US economy is world largest, and that the share of trade in that economy may be low compared to other more export oriented countries. But it would perhaps be a bit far fetch if it is assumed that the US economy is a closed one. The paradox of wage cuts in a closed economy may not be so paradox in an open economy, if other economies with which the US trade with don’t have wage cuts.

Secondly, the paradox of wage cuts, while seemingly sounding reasonable, may not necessarily be so paradox if the aggregate wage cuts can bring down interest rate and inflation (or result in deflation). A corresponding reduction in nominal interest rates can offset falling wages and keep the burden of interest payments largely remain unchanged, and therefore real consumption may not necessarily fall, nor will the rise of unemployment be a necessary result.

Thirdly, the paradox of thrift is true only if you look at equation of consumer savings and consumptions. If one puts the picture of the whole economy together, and the other parts of the economy are flexible enough, the paradox of savings and consumptions may not cause a paradox to the whole economy. There are a couple of factors that can work to avoid an economy wide paradox. One, government can use expansionary policies to increase government spending and create jobs. Two, business investment will increase as a result of lower interest rates if they take a longer term view, with the aid of some sort of rational expectations perhaps.

To conclude, I am not really sure the American wage cuts will pose a paradox to the US economy at all and will have a detrimental effect on the jobs and employment. By saying that I don’t mean the US is already out of the woods of the crisis and its economy and unemployment will not get worse. What I say is that they may be caused by other factors rather than as a consequence of economy-wide wage cuts.

However, I do agree with Krugman that the US basically needs to do more to lift itself out of the crisis: more stimulus, more decisive action on the banks, more job creation. There is no question in my mind at all that they need to do those, perhaps with a key focus on getting banking and financing operations as usual as early as possible. Other policies, though maybe non-conventional or orthodox from conventional economics point of view, may need to be implemented in the mean time. With the goal of promoting the welfare of the nation and keeping the whole economy in mind, some creativity is needed. I think we can break some paradoxes!