Karl W. Smith: Pay cuts are better than layoffs in this recession

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Economists have long explained recessions in part by pointing to the reluctance of employers to reduce workers’ pay. This so-called market rigidity reverberates throughout the economy, creating waves of unemployment and declining growth that are worse than any pay cut.

That’s one reason that the recession caused by the response to COVID-19 might be different: Many companies are actually cutting pay, providing a glimmer of hope that the economy will rebound faster than usual.

It’s important to remember that recessions are complex. Even in a well-functioning economy, there will be times when shocks such as crop failures, oil embargoes or pandemics cause widespread hardship and declines in real income.

The key feature of modern recessions has been sharply rising unemployment, which creates a self-reinforcing spiral. Unemployed workers spend less, while those who still have jobs increase their savings out of fear that they might be next. This widespread decline in spending reduces the revenue businesses take in — leading to more layoffs and further spending declines. Recessions can cause unemployment to double or triple in matter of months, damage that takes even a healthy economy years to repair.

The pain could be mitigated substantially if, instead of cutting jobs, employers cut wages and prices at the same time. Businesses would have less revenue, but also lower costs. Employees would have lower incomes, but also spend less.

So why doesn’t that happen? Most economists believe that businesses are reluctant to reduce pay because it violates an implicit (and sometimes explicit) employment contract: If an employee comes into work, does a good job and budgets expenses responsibly, then her employer will pay her enough to meet her expenses.

If this understanding is broken, morale will collapse, productivity will fall and the most experienced and valuable workers will look for more secure opportunities once the economy recovers. By laying off a portion of the workforce, an employer is able to maintain its relationship with those that remain, who are often its most prized employees.

COVID-19 has changed this dynamic. In general, the sense of widespread sacrifice — which goes beyond any single business or industry — means that the damage of pay cuts to any employer-employee relationship is less than it might be. More specifically, federal payroll-support programs have allowed some businesses to reduce labor costs without shedding employees. The combination of more generous unemployment benefits and the (hopefully) limited duration of the shutdown has allowed the majority of employers to put workers on furlough rather than resorting to permanent layoffs.

All these factors imply that a strong economic rebound is possible — if there is some certainty about the duration of the crisis. Simply relaxing formal restrictions is not enough, and in some cases could be counterproductive. If businesses attempt to reopen but find themselves with few customers, the ordinary dynamics of a recession will take hold.

The key to avoiding that scenario is coordination, similar to the coordinated shutdown in the U.S. in mid-March. That shutdown wasn’t driven by stay-at-home orders — and the reopening won’t be, either. What is required is widespread agreement about the conditions that make reopening the economy safe, as well as a trusted authority (like the U.S. Centers for Disease Control) judging whether those conditions have been met.

America doesn’t have that level of agreement yet. But the consensus on shutting down the economy evolved rapidly over a few weeks, and so could one on opening it back up. If that happens, then the U.S. economy might well get out of this recession without the crippling long-term job losses that marked the last one.



Karl W. Smith, a former assistant professor of economics at the University of North Carolina and founder of the blog Modeled Behavior, is vice president for federal policy at the Tax Foundation.

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