I have finished reading a fascinating book by Truman Bewley called “Why Wages Don’t Fall During A Recession”. It’s an interesting book not only for its topic but also for the way in which the author conducted his research. Unlike most economists who conduct studies based on complicated mathematical models, Bewley did something unusual and interviewed business owners to understand more about how they run their business. Economists traditionally viewed the market as automatically self-adjusting so that wages and prices would easily change to the right level in response to market conditions. However, it has been found that wages are rigid and almost never decline so between 1992 and 1994 Bewley interviewed 336 people in the North East of the United States (the book was published in 1999). The studies were meant to be qualitative and as such are not random or representative. They provide a very interesting insight into the mind of business managers.
The data is slightly dated as it relies on a recession from 20 years ago. Our current recession is far more severe than the 1991 recession, but wages have risen by 10% in the EU since 2008 (Greece is the only country where wages have declined). Even Irish wages have not declined, instead lower demand has been reflected in higher unemployment.
A key point of the interviews was how much managers emphasises the importance of morale. They emphasised that workers couldn’t be treated like equipment or else productivity would suffer. Workers had to be treated well or else they could damage the company. A reputation for bad morale would make recruitment and retention of staff difficult. Even in recessions morale was important as unhappy staff would leave as soon as the economy recovered. Interestingly, when Bewley mentioned that psychologists found little link between morale and productivity, most managers believed the psychologists were wrong.
Most internal pay systems emphasised the importance of equity and fairness. Managers often imposed bureaucratic pay structures in order to avoid favouritism or overpayment and to provide clarity about how much everyone was earning. Contrary to economic theory, it was seen as harmful to pay workers their marginal productivity because this was a) unobservable and b) harmful to morale as people were suspicious of each other and why some were earning more than others. It was seen as more convenient to pay workers doing similar jobs the same wage to avoid some feeling underpaid.
External pay structures were less relevant than internal ones as workers didn’t have much information on other companies and much of their skills would be job specific. The strong ties between workers and their job, the difficulty of finding a new job and lack of information all contributed towards blurring of market forces. Employers didn’t want pay to be relatively too low as it would make it difficult to hire, keep turnover low and encourage the workers to join a union. One of the most interesting findings of Bewley’s research was that there was no such thing as a market wage. Employers and employees alike had only a vague idea of what other companies were paying. At most they only knew rough ranges, which Bewley found to be incredibly broad, the difference between the minimum and the maximum were anywhere between one-tenth and one-half. Interestingly the only place where a market wage exists is in unionised industries. Unions insist that workers doing the same job in different companies get the same pay. I found it amusing that unions which are usually blamed for distorting the market were the only ones who created the market conditions economists believe exist everywhere.
Workers are discouraged from seeking other jobs while still in employment as this is seen as disloyal. If a worker does receive a job offer from another company, managers are reluctant to give a counter offer even if the worker is valuable to the company. Counter offers antagonise existing staff who may want their wage to rise as well. Counter offers damage relations with the employer and even when they are made (which is usually to highly skilled staff) the employee usually leaves after a few months anyway.
A popular explanation of wage rigidity among economists is the Shirking Theory that employees are paid more in order to discipline them not to shirk or doss. Almost all managers disagreed with the theory and said it didn’t apply to them. They viewed the theory as relying on threats and punishments, which in their mind were the symptoms of bad management. Rather it was viewed that most people will work hard naturally if given the chance.
It is often considered by economists that businesses could hire new staff at lower wages in order to reduce the wage bill. However this is hampered by the need for internal pay equity, as new hires would soon become resentful at getting paid less for the same work. Existing staff would be made to feel insecure. Potential hires have little to bargain with as they rarely know what the established wage system is at the firm. New hires may get paid less during a training period but this is usually brought up to the rest as soon as they are trained in. Interestingly, Bewley found that not only did wages not fall, but in fact raises were often given. Even in a recession employers worried about their best staff leaving for other jobs or more likely, leaving as soon as the economy recovered.
The consensus among managers was that pay cuts would cost the firm more than it would save them. It was felt that pay cuts would cause damage morale and lose the business their best workers. Interestingly unions were not mentioned as a reason for resistance (probably due to the small number of unionised workers). It was felt that it was not possible to cut the wages of all but the best as this would create tension in the workforce. It was felt that pay cuts would be interpreted as an insult and make enemies out of the employees who would resent the company. It would damage the bond between employees and their work, making them feel that their company didn’t stand by them, so why stand by it?
Instead of cutting wages, managers preferred to lay people off, though interestingly, they did not see any trade off between wages and employment. This was primarily due to the fact that labour costs were often a small percentage of total costs and product demand was not very elastic. It was felt that during a recession there is less demand and therefore less work to be done, so it makes sense to fire unneeded staff rather than cut wages. If the firm only cut wages, they would be left with people standing around with nothing to do. It was also felt that layoffs would do less damage to morale and productivity. Interestingly, the idea of cutting prices was rejected by most managers as it would either not be effective (due to inelastic demand) or start a price war. None of the companies offered their employees a choice between layoffs or pay cuts (most were astonished at the thought).
Firing staff and replacing them with cheaper workers was rejected by most managers as damaging the relations between employer and employee. They felt it would be seen as damaging to morale, heartless and disloyal. It would make employees feel like they were replaceable machines and therefore put less effort into their work. It was noted that the recession increased the labour supply and the quality of job applicants. Bewley uncovered a surprisingly refusal among many employers to hire people they considered over-qualified. It was felt that they would be unhappy with the job and quit as soon as they found something better. It was feared that they may disrupt the hierarchy and cause trouble for their supervisors.
Unemployment was generally seen as a bad sign among job applicants. Managers felt that only the worst employees get fired and good workers would have quickly found jobs. Government welfare was not believed to be a disincentive to work; the only exception to this was the employers of low wage temporary labour. Employers disliked using public advertisements for job positions as they usually received a deluge of applicants. Rather they used personal contacts and word of mouth. References from previous employers were not considered helpful as employers were reluctant to criticise past employees for fear of being sued for libel.
Bewley found little evidence to support many popular labour economic theories. He mentions that he “found no support for real business cycle theory. During hundreds of hours of contact with businesspeople, I never heard one description of an exogenous productivity decline.” Lucas-Rapping theory of unemployment (that it is caused by workers voluntarily quitting their job) is found to have little basis in reality. Unemployment is primarily caused by layoffs and quits actually decline during a recession. Nor do workers quit rather than accept a pay cut as they are never given the choice. Unemployment is an unpleasant situation that no one chooses; rather most unemployed were desperate for work. The main theories of strikes were also found to be inaccurate. Strikes do not occur as there is information asymmetries over the financial health of the company (which is usually known) or to test the profitability of the firm (unprofitable firms were as reluctant to compromise as profitable ones which had greater resources to fight the strike).
Bewley finds that most labour economic theories are inaccurate and fail due to unrealistic assumptions. The only exception to this is the morale model of Solow and Akerlof. Bewley criticises the traditional economic view of people being self-interested and having to be either bribed or coerced into performing tasks. Instead he found that employers ascribed different motivations to their staff. Instead they focused on building good relationships with their employees and encouraged them to take pride in their work and to enjoy their job. They want their employees to show initiative and to perform tasks without having to be constantly told to do so. They felt that treating workers like just another expense like equipment would be counterproductive. As intuitive it may be to ordinary people, it is surprising to economists that people resent being treated like machines whose only purpose is to make money.
In conclusion, Bewley has written a fascinating book that contains many insights in how labour markets work in reality. It reveals major holes in economic theory beyond the simple belief that wages adjust until they are in equilibrium. Bewley has made a great contribution to explaining downward wage rigidity and I would highly recommend his book.