Bad News: The Real Wage Rate Is Rising

The U.S. rate of unemployment has been rising since March 2007, when it stood at 4.4 percent. In 2007 it rose slowly, then in 2008 and 2009 much more quickly. In August 2009 it reached 9.7 percent. The increase in unemployment represents for most people the most troubling aspect of the current recession.

However, during the past year, so much attention has been focused on the financial debacle in its various dimensions, and on the Fed’s and the Treasury’s efforts to deal with it, that the growing unemployment – now amounting to approximately 15 million persons – has become almost a footnote to the welter of troubles besetting the economy, and the labor market itself has received relatively little attention. Of course, the government’s “stimulus” spending programs purport to be aimed at restoring employment, and, if we subscribed to vulgar Keynesianism, we might expect them to do so.

Sound economists know, however, that, as some of them like to say, the labor market clears in the labor market, not in the product market or the bond market. When we seek to understand changes in the volume of employment (and by loose implication, the amount of unemployment), we are well advised to pay closest attention to what is happening in the labor market.

When we shift our gaze there, we behold an interesting, almost totally neglected, yet critical fact: while unemployment has been rising steadily, the real hourly wage for all workers employed in private industries has also been rising. According to the Bureau of Labor Statistics, the average hourly earnings of workers in all private industries rose from $17.23 in March 2007 (when the rate of unemployment was 4.4 percent) to $18.59 in July 2009 (when the rate of unemployment was 9.4 percent). During this same period, the consumer price index for all urban consumers rose by about 5 percent. Using this index to adjust the earnings data, we find that real hourly earnings rose by 2.8 percent during this 28-month period of deepening recession.

Even introductory economics courses teach students that the quantity of labor services demanded is a negative function of the real wage rate. If the real wage rate rises, other things being equal, employers will demand a smaller quantity of labor services. Thus, in view of the rise in the real wage during the past 28 months, we might well have expected employment to fall – and hence the unemployment rate to rise – simply because labor services were becoming more expensive.

However, other things were not equal during this period. Because the demand for labor services is derived from the demand for the goods and services that the laborers produce, and because that final demand has declined recently, the effect of the increase in the real wage has been magnified. The obvious question: why, in a situation of falling demand for labor services, has the real wage risen? This outcome is not what we would expect to see in a freely functioning labor market. Economists have advanced a variety of explanations to account for this anomalous occurrence (as observed on other occasions), but they have yet to agree on how it may be understood best.

We might well note, however, that an increase in the real wage at a time of deepening recession is an occurrence first observed in the United States between 1929 and 1933, during the Great Contraction. Economists from that time onward, including C. A. Phillips, T. F. McManus, and R. W. Nelson (1937), Murray Rothbard (1963), Lowell Gallaway and Richard Vedder (1993), and most recently Lee Ohanian (2009 unpublished), as well as yours truly (1987 and later works), have attributed a large part of the responsibility for the depth of the Great Contraction to this failure of the real wage rate to fall – as it invariably had fallen in economic downturns before 1929, including the sharp but brief contraction of 1920-21. It is scarcely reassuring to see that in the present contraction, the labor market is, in this regard, mimicking its behavior during the Great Contraction.

In 1937, Phillips, McManus, and Nelson wrote: “The brutal truth is that the standard of life for the American people has fallen drastically since 1929 for the simple reason that the policy of maintaining high wage rates has resulted in reduced employment and decreased production of the goods and services that constitute ‘real income’” (p. 225). Today, although we have not yet suffered the same reduction in living standards that our forebears suffered during the Great Depression, essentially the same brutal truth is haunting us again. Whether the increased real wage rate of the past two years reflects government policies or other causes, it has exacerbated the decline of real output. A reduction of the real wage rate would hasten a recovery from our present economic misfortunes.