The question, following the observation that UK real wages have fallen substantially, is “In the traditional Keynesian story, stimulus lowers real wages through nominal reflation. Is that the Keynesian view here? If so, why do Keynesians believe that British real wages need to fall more than 8.5%?”
Actually I think this question has nothing especially to do with the UK, and a great deal with Keynesian theory, or at least how Keynesian theory is often taught. The problem in the UK and nearly everywhere else right now is lack of aggregate demand, not the level of real wages. Why, asks Tyler, are not more workers being hired if real wages are so low? Well low real wages are having some effect – it is one factor behind the ‘productivity puzzle’ that is widely discussed in the UK. But when the problem is aggregate demand, low and declining real wages will not ensure ‘full employment’. Firms may employ more labour, but there is no reason to expect the labour market to clear.
I think what lies behind this question is the idea that aggregate demand matters because sticky wages are preventing the labour market clearing. So, to rephrase Tyler’s question, falling UK real wages do not look very sticky, so where is the problem? When I was studying macro, there were these debates about whether it was sticky wages, or sticky prices, which underpinned Keynesian theory.
The answer I would give, at least at the zero lower bound under inflation targeting, is neither. To get technical, imagine a toy model with imperfectly competitive firms who set a constant mark-up on labour costs, and a linear technology. Nominal wages could fall forever, but firms would cut prices to match, so the real wage would not change. So the question is then whether falling prices will raise aggregate demand. But why should they, particularly if nominal interest rates are stuck at zero, and the central bank puts a lid on expected inflation.
The price that is ‘wrong’ when aggregate demand is deficient is the real interest rate. This is one area where New Keynesian theory has helped sort out old Keynesian confusions. If falling wages and prices do nothing to change real interest rates, then aggregate demand need not rise. And if aggregate demand does not rise, unemployment can persist. But at the zero lower bound, with a central bank mandated to target inflation (and a government showing no signs of changing that mandate), the real interest rate cannot be reduced. So expansionary fiscal policy is needed to raise demand, not lower real wages. Or, in the case of the UK at the moment, contractionary fiscal policy is currently reducing demand and therefore output.