The political economy of nominal wage rigidity

I’ve been reading up in recent months on monetary economics (I admit to have abandonned any interest in the field years ago, but my interest was sparked in light of the nomination of Janet Yellen). To the horror of my austrian friends, I admit that the “market monetarism” of Scott Sumner and Lars Christensen is the framework of analysis that I find the most theoretically compelling. Yet, there is one thing I am always amazed by with regards wage and price flexibility: there are no public choice approach to why wages and prices are flexible.

For all it seems, private sector wages are flexibleThey are not fully flexible, but they do exhibit a high level of flexibility. Similar outcomes have been observed in other countries. Scott Sumner has a reply to this issue, partially inspired from Krugman. Yet I am not convinced because there is no breakup of public and private sector employment.

I would not be surprised to find that there is little or no downward flexibility in wages for public sector employment. The reason for this is that public sector employment have a greater level of employment security. This was lobbied for by public sector unions, who by virtue of being the sole providers of public services, managed to coerce politicians into not only granting them employment security but also a wage premium (all things being equal). For example, the Fraser Institute institutes argues that the wage premium in the public sector is 12% in Canada. If public sector employment is 25%, this represents a 3% tax on the economy as a whole. In a recession, the premium stays stable. However, since private sector payrolls increase and profits collapse , the relative weight of the tax increases because the public sector is not affected by the downturn.  Hence, wages for public sector employees, which in countries like Canada represent a large chunk of total employment, are probably creating a high level of rigidity. The costs of rigidity and the wage premium (slower adjustments to changes in aggregate supply or aggregate demand and distorted relative prices) are assumed by the private sector. The benefits go to the sizeable minority of publicly employed individuals.  The costs, dispersed over a large population, are mininal on a per capita basis, but the distribution of welfare from this incites public sector unions to lobby and demand such rigidity. I believe there is a public choice argument to make about macroeconomics and wage rigidity – which I have yet to find in the literature.

This leads to a possible suggestion: when public sector employment is beyond the optimal point (where labour could be employed more productively elsewhere with or without a wage premium), public sector payrolls may contribute to prolong the recession. This would have the effect of working against any monetary policy designed to countermand any shocks on money velocity, hence “fiscal policy” (government spending) is conflicting with “monetary policy” that would aim to expand aggregate demand.

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