Why is it that wages exhibit backward inertia? How come workers don’t demand that their wages be tied to inflation, and instead just take their chances with fixed nominal wage contracts? In their book Animal Spirits, George Akerlof and Robert Shiller discuss (amongst much else) the phenomenon of ‘money illusion’.
They argue that people are not perfectly rational when it comes to inflationary expectations and consequence wage demands, supported by empirical evidence. However, there may be more conventional explanations for the behaviours they observed.
When workers contract into fixed nominal wages, it might not be the case that they are oblivious to inflation – or suffering from ‘money illusion’. It could be argued that such contracts allow a kind of diversification of inflation risk between employer and employee.
After all, inflation doesn’t necessarily increase the prices of all goods and services uniformly throughout the economy.
If the firm is doing well out of the inflationary period and revenue is booming, no doubt that workers will inevitably demand renegotiation of wage agreements and working conditions. It would be difficult for the firm to avoid passing on some benefits to workers under these conditions.
If the company is doing badly, with costs rising and prices not compensating sufficiently, workers will be happy to take a drop in real wages. If they really wish to, they can take up employment elsewhere (under a new salary regime). Alternatively, they take part of the hit for the employer as the real value of their wages fall – thus reducing pressure on the firm caused by inflation and allowing them to keep their job.
Regardless of the effect that inflation has on their particular industry (which workers may not be able to foresee), they will be insured against unemployment risk in the event of a downturn while keeping their options open too.
Given that in practice inflation can be damaging to competitiveness, it would be foolish for workers to try and lock their employers into paying wages that they can’t afford. The only likely outcome would be unemployment in the event that the firm doesn’t want to pay, so it makes sense to compromise according to conditions.
Meanwhile, if firms were forced to tie wages to inflation, they won’t want to end up at the wrong end in the event that their industry does not see sufficient increases in prices. Thus, they might offer fewer jobs because of the uncertainty. This benefits no-one.
Under fixed nominal wage contracts, they have more freedom to adapt to changing conditions. For their part, firms accept a certain amount of pressure to increase wages when inflation pushes up living costs. The benefits are reciprocal, so the costs are too.
If it seems that people are acting in an irrational manner, it might be that Akerlof and Shiller are simply not looking hard enough for an explanation – or they might not want to find one.
© The Free Marketeer 2009