The Demand

To the employer there is nothing mysterious about the wage: it is a cost, the price of an input, a figure on the same ledger as rent and materials and power — and, like all those figures, to be kept as low as the work allows. This is not cruelty but arithmetic. Every pound paid in wages is a pound not kept as profit, and a firm that pays more than its rivals for the same labour will, all else equal, be undersold by them and driven under; so the discipline of competition presses, always, toward the lowest wage the firm can pay and still get the work done. And the pressure is not slight, for labour is, in most enterprises and in the economy entire, the largest cost there is — well over half of all the income a modern economy generates is paid out as wages and salaries.¹1Compensation of employees is the majority of national income — on the order of sixty per cent — and for the typical firm the wage bill is its largest controllable expense. Hence the standing competitive pressure to hold it down: to the one who pays it, the wage is the great cost. The wage is the great expense, and to the one who pays it, the case for holding it down is as plain as a column of figures.

Now step back from the single ledger to the whole economy, and a second nature of the wage appears, invisible from up close. The wages that every firm pays out do not vanish; they become the incomes of households — and households, having earned, spend. That spending is not a sideshow but the main event: consumer spending is roughly two-thirds of all the activity an economy like America’s produces, by far the largest source of the demand that firms exist to satisfy.²2Personal consumption is about sixty-eight per cent of US gross domestic product — the largest single component of demand — and it is funded, overwhelmingly, by wages. The worker the firm sees as a cost is, through the till of some other firm, the economy’s principal customer. And what funds that spending is, overwhelmingly, wages. So the worker, whom the firm sees only as a cost, is also — at one remove, through the till of some other firm — the customer. The wage paid at one factory buys the goods made at another; the cost on one ledger is the revenue on a second. Seen whole, the wage is not money leaving the economy but money circulating within it: out of firms as cost, into households as income, back to firms as demand, around and around.

One firm’s wages are another firm’s revenue.

Here the two natures of the wage collide, and the collision is one of the most consequential errors in economics. Each firm, reasoning soundly from its own ledger, concludes that cutting its wages will help it: lower costs, the same sales — for its handful of workers are a negligible part of the market for its goods — and so more profit. And each firm is right, about itself. But what is true of one firm is not true of all firms together; for if every firm cuts its wages, then every household’s income falls, and the spending that is every firm’s revenue falls with it. The saving each firm counted on is swallowed by the demand they all lose. This is the fallacy of composition, the mistake of assuming that what holds for a part must hold for the whole³3The fallacy of composition: what is true of a part need not be true of the whole. Keynes charged the classical economists with exactly this — taking the demand curve for a single industry, where a wage cut leaves sales untouched, and carrying it ‘without substantial modification to industry as a whole’ (General Theory, ch. 19). The paradox of thrift is its twin. — and it is the very error Keynes laid at the door of the economics of his day: taking the demand for a single industry, where a wage cut does no harm to sales, and carrying it over, unaltered, to industry as a whole, where it does. The same trap catches the thrifty. It is prudent for one household to save more; but if all households save more at once and no one spends, the demand for everyone’s labour collapses, and all are made poorer by their common prudence. Virtue in the part can be ruin in the whole.

There is a name for the moment this fallacy stops being academic: a depression. When demand weakens and firms, each acting prudently, cut wages and shed workers to defend their margins, the cut incomes mean cut spending, the cut spending means weaker demand, and the weaker demand invites the next round of cuts — a spiral turning downward, every turn of it justified, the whole of it catastrophic. This was the argument with which Keynes, in 1936, broke the orthodoxy of his age.⁴4Keynes, General Theory (1936), ch. 19, ‘Changes in Money-Wages.’ Against the ‘Treasury View’ that wage cuts would cure the mass unemployment of the Depression, he argued that the labour market does not clear like a market for goods, because the wage is also the source of demand — so cutting it can deepen a slump rather than end it. The classical doctors had prescribed, for the mass unemployment of the Depression, exactly what each firm’s ledger advised: cut wages, and the labour market will clear, as any market does when its price falls. Keynes answered that the labour market is not like the market for fish, because the wage is not only the price of labour but the wellspring of the demand for everything — so that cutting it does not merely lower a price, it lowers the spending of the very people whose spending the recovery requires. The cure, applied to all at once, could deepen the disease. To lower the wage in a slump might be, for the economy entire, to dismiss its customers in the name of sparing its costs.

The worker is also the customer.

And yet the demand-side argument, left to itself, curdles into its own kind of fallacy, and honesty requires the other hand. For the wage is a cost — really, not merely in appearance — and a cost cannot be wished into a pure blessing. The classical tradition Keynes attacked was not foolish; it held a truth he himself granted: that a wage cut can, in certain circumstances, restore employment, by making it profitable to hire again.⁵5Keynes conceded a wage cut is ‘quite capable in certain circumstances of affording a stimulus to output.’ And the famous proof of the demand argument — that Ford doubled his workers’ pay in 1914 so they could buy his cars — is a myth: he raised wages to stem a turnover that had reached 370 per cent, an efficiency wage; even had every worker bought a Model T, the higher wages would have cost more than the cars returned. Push the demand logic too far and it yields an absurdity: that an economy might enrich itself merely by decreeing higher wages — paying everyone more so that everyone may buy more, without end. But this is the fallacy of composition stood on its head. A single firm cannot conjure customers by overpaying its own workers, and an economy cannot conjure wealth by paying wages its production has not earned; it can conjure only inflation, or unemployment, as the wages it mandates outrun the value its work creates. Even the cherished proof of the demand argument — that Henry Ford doubled his men’s pay in 1914 so they could afford his cars — dissolves on inspection into a myth: Ford raised wages to stanch a ruinous flight of labour, and had every worker bought a Model T, the wages would still have cost him more than the cars returned. Wages are a real cost, paid for real reasons, and no economy can pay itself rich.

So the wage wears two faces, and both are true, and the difficulty is that no one who pays a wage can see both at once. From where the single firm stands, the wage is a cost, and the case for cutting it is sound. From where the whole economy stands, that same wage is a customer’s income, and the case for cutting it — all of them, together — can be ruinous. The firm is not wrong about the part; it is merely blind to the whole, because the whole is visible from no place inside it. This is why the question that divides the two faces — whether, in a given slump, wage flexibility will cure unemployment or deepen it — has stayed unsettled for the better part of a century,⁶6The quarrel endures between the heirs of Keynes and of the classics. Which face governs depends on the case — how deep the slump, how idle the capacity, whether falling wages and prices revive spending by other routes or merely drain it. Both faces are real; neither alone is the whole. fought between those who trust the market to clear and those who fear the spiral, the truth lying, as it usually does, in the changing particulars: how deep the slump, how idle the capacity, how frightened the saver.

And so the folio’s long anatomy widens, at the last, from the single wage to the sum of them all. We have followed the wage as a thing agreed between two parties — its justice, its hours, its trust, its compulsion, its amount, its boundary, its rigidity, its measure; the authority it buys, the risk it sheds, the machine that threatens it, the meaning it cannot hold. Here we find that the wage is never only a private bargain. It is also a public flow — the great circulating river of demand from which every seller drinks, including the very employers who, one by one, would dam it. The wage each firm pays is a cost to that firm and a livelihood to the economy; and the whole stands or falls on a sum that no single party to it was ever placed to see.