Paul Krugman queuing off of Matt Yglesias writes

. . . there would be no reason to expect a general fall in wages to raise employment.

Why? Don’t demand curves usually slope downward? Yes, but that’s because when you cut the price of something, it normally gets cheaper relative to other things, leading people to redistribute their spending toward the cheaper good.

But when you cut the price of everything — which is more or less what happens when wages fall across the board — there’s nothing else to substitute away from.

Krugman’s logic seem to go like this, wages fall in all industries, income falls, consumption falls and we hit a new equilibrium with lower wages and prices. However, real wages stay the same. In a liquidity trap purely nominal moves can’t help you.

The economic case presented in the GOP Staff Commentary isn’t that cutting government workers would push out aggregate demand by driving down the price level. Its that firing government workers would drive down  real wages in the private sector and thus drive up private sector employment. That is, to say that the fall in wages would be greater than the fall in prices.

Even in a recession of this magnitude that seems more or less correct. If we think that job market clears stochastically – sorry Ezra – then flooding the market with higher skilled workers should on net increase private sector employment.

It more or less must be the case that this come at the expense of total employment. We can imagine a human story to see how this works. The government fires a bunch of people. Many of them have a hard time finding work. However, one of them is a great statictian who the private sector would have loved to have, but she preferred the work she was doing at NOAA. Perhaps, the private sector could have lured her away with a multimillion dollar contract but it wasn’t willing to do that.

Now she is unemployed, needs to pay her mortgage and the private sector can snap her up at more or less market rate. This increases private sector employment, private sector productivity and private sector profits all in one swoop.

However, it does it both at the expense of this worker’s desired employment, the quality of the work done at NOAA and at the expense of other workers who are now on the unemployment line. The undertone in the commentary brushes aside but does not seem to deny these effects.

Further, the Staff Commentary seems to suggest that this effect is just one of several that will boost private sector employment. They seemed to be making the primary point that reductions now would raise the credibility of long term reductions and thus through permanent income effects raise spending.

However, again Progressives bury the lede. Here is the key phrase from the entire report, smack center in the conclusion.

Keynesians warn that significant federal spending reductions now would weaken the current economic recovery.  During the last two decades, however, numerous studies have identified expansionary “non-Keynesian” effects from government spending reductions that offset at least some and possibly all of the contractionary “Keynesian” effects on aggregate demand.

What do we learn from this

  1. The GOP staff is Keynesian even if they are not “Keynesian.” That is they readily accept that Keynesian effects occur even if they don’t want Keynesian policy.
  2. Their rejoinder is that there are some effects which offset some and possibly (read: I mean anything is possible) all of the contractionary Keynesian effects.
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