The Ratchet

Economics begins, in its simplest form, with a promise: that any market will clear if only the price is free to move. Too much wheat, and the price of wheat falls until the surplus is bought; too few buyers, and the seller lowers his asking until one appears. Apply the same logic to labour, as the classical economists did, and unemployment ought to cure itself — for when workers go begging, their wage should fall, cheap labour should tempt employers to hire, and the slack should be taken up, the labour market clearing like any other. It was a tidy promise, and the twentieth century broke it in plain sight: in the depths of slumps, with millions wanting work, wages did not fall nearly enough to clear the market, and the unemployment did not cure itself.¹1Downward nominal wage rigidity. Plot year-to-year pay changes and a spike appears at zero — a fifth or more of workers held at last year’s figure. Keynes (1936) called downward rigidity ‘the normal case.’ It is real but partial and historically variable: in the interwar slump wages were cut about as often as raised, modern wages are stickier, and its exact extent is still argued.

The reason is a stubborn fact: nominal wages almost never fall. Plot the year-on-year changes in workers’ pay and a strange pile-up appears exactly at zero — a great many workers whose wage is frozen, held at last year’s figure, and very few whose pay is openly cut. Wages rise; wages stall; but wages seldom retreat. The number behaves not like a price free to move either way but like a thing that can climb and cannot descend. Economists name this downward rigidity, which states the fact without explaining it. The explanation is stranger than the fact.

There is a small machine that does exactly what the wage does, and lends it its truest name: the ratchet. A toothed wheel or bar and a spring-loaded pawl resting against the teeth — the thing may move freely one way, clicking forward tooth by tooth, but the instant it tries to move back, the pawl drops into a tooth and locks it. Motion in one direction is easy; in the other, all but impossible. The wage is a ratchet of just this kind. It climbs, tooth by tooth, through the good years, and when the bad years come and the market leans on it to descend, it holds.

And a price that cannot fall has a consequence, for the pressure to lower it does not vanish when the wage refuses to move; it is diverted. If the cost of labour will not come down, then in a slump the employer reduces not the price he pays but the number he pays it to: the adjustment other markets make by lowering a price, the labour market makes by shedding people. The rigidity of the wage is paid for in jobs. But that is the consequence; the cause is what we must look at first — why the wage will not bend.

Every other price bends to the market. The wage digs in.

Why will it not bend? The deepest answer was found not by theorising but by asking. In the early 1990s the economist Truman Bewley, dissatisfied with the tidy models, went and interviewed more than three hundred employers, managers, union officers, and counsellors of the unemployed, and put to them the plain question: in a downturn, why not cut pay rather than cut jobs? The answer that came back, again and again, was not about productivity curves or the supply of labour. It was about morale.²2Truman Bewley, Why Wages Don’t Fall During a Recession (1999), built on some three hundred interviews. The dominant reason managers gave for not cutting pay was morale: the saving is outweighed by the damage to effort and loyalty, so firms prefer layoffs — which remove the aggrieved worker — to cuts, which aggrieve everyone who stays. A pay cut, the managers told him, devastates a workforce — not in proportion to the money lost, but out of all proportion to it — because employees receive it not as an adjustment to conditions but as an insult: a judgment that they are worth less, valued less, owed less than before. And a workforce that feels cheated does not work as it did: effort slackens, loyalty curdles, the best ones leave, and the small saving on the payroll is swallowed many times over by the damage to the spirit of the place.

This is why employers so often prefer the seemingly crueller course of laying people off. A layoff, brutal as it is, removes the aggrieved worker from the premises and leaves the morale of those who remain intact — even, at times, relieved. A pay cut keeps everyone and aggrieves them all. The logic is cold, but it discloses something warm at its centre: that the wage is bound up with a worker’s sense of worth so tightly that to lower it is to wound, and that the employer, needing willing rather than sullen hands, cannot afford the wound. The wage is not only what the worker costs. It is what the worker is told he is worth, and no number is read more personally.

There is a piece of evidence that shows just how far the wound lies in the telling rather than the sum. Suppose inflation is running at twelve per cent and an employer raises wages by five: the worker is, in real terms, seven per cent poorer than before, his money buying noticeably less. Now suppose instead that prices are flat and the employer cuts the wage by seven: in real terms, the very same loss. Yet people judge the two cases utterly differently. The raise-amid-inflation is felt as a raise, and accepted; the outright cut is felt as a robbery, and condemned as plainly unfair.³3Surveys find the asymmetry stark: Kahneman, Knetsch and Thaler (1986) report that a 7% pay cut when inflation is zero is judged far less fair than a 5% raise when inflation is 12% — though the two are equivalent in real terms. See also Shafir, Diamond and Tversky, ‘Money Illusion’ (1997), and Tobin’s (1972) argument that mild inflation ‘greases the wheels’ of the labour market. Economists call this the money illusion — the worker’s eye fixed on the face value of the wage rather than its purchasing power — but it is less an illusion than a moral instinct. A cut is something an employer does to you, an act with an author and a victim; inflation is weather, an impersonal drift with no one to blame. The first is an injury; the second, only a misfortune.

This single quirk has a vast and largely benign consequence: it is the reason a little inflation eases the workings of the labour market. Because wages can be lowered in real terms by stealth — held flat while prices drift upward — but not in nominal terms by decree, an economy with gently rising prices can quietly bring real wages down where a slump requires it, and spare itself the unemployment that an attempt at open cuts would bring. The wage’s refusal to fall is got around, humanely, by never asking it to fall in the only terms it watches.

It was John Maynard Keynes who saw that this one rigidity was enough to overturn the classical promise. If the wage will not fall, he argued in 1936, then the labour market has no mechanism to clear: nothing drives the price of labour down to the level at which all who want work are hired, and so a slump can settle into a grim equilibrium of idle hands and willing workers — unemployment that persists not because the jobless are too choosy or too dear, but because the wage, across the whole economy, will not descend to meet them.⁴4J. M. Keynes, The General Theory of Employment, Interest and Money (1936): with money wages rigid downward, the labour market need not clear, and involuntary unemployment can persist. Keynes’s own remedy was not to force wages down — he thought it futile and destructive — but to raise demand to meet the rigid wage. His own remedy, notably, was not to force wages down — he thought the attempt both futile and destructive — but to lift demand until it met the rigid wage, and the idle hands were wanted once more.

The theorists who came after filled in why the wage holds, and their answers, though dressed in the cool language of models, all circle the same human core. The efficiency-wage school showed that an employer may pay above the market on purpose and never cut, because a well-paid worker who fears to lose a good thing works harder and shirks less — so that a little unemployment becomes, perversely, the discipline that keeps the employed honest; others modelled the wage as a gift exchanged for loyalty, above-market pay repaid in above-ordinary effort.⁵5Efficiency-wage theory: Shapiro and Stiglitz (1984) modelled unemployment as a ‘worker-discipline device’ — firms pay above market so that the threat of job loss deters shirking; Akerlof (1982) modelled the wage as a ‘partial gift exchange,’ above-market pay reciprocated with above-minimum effort. Each is a fragment of the same picture Bewley’s managers drew in plainer words: that the wage buys not only hours but willingness, and that willingness is wrecked by a cut. None of this, it should be said, makes the rigidity total. Wages do fall sometimes — for those who change jobs, for the newly hired, and in the harshest depressions even for those who stay; in the slumps of the nineteenth century pay was cut about as readily as it was raised. The wage is sticky, not frozen, and how sticky is argued still. But stickier than other prices it plainly is, and that difference is the whole of the puzzle.

It is, of all prices, the one with a conscience.

Set all the explanations side by side and they converge on a single sentence: the wage will not fall because it means too much. Other prices are only prices — the meeting of supply and demand, indifferent to the dignity of the thing priced. The wage alone is also a verdict, a relationship, a daily statement to a person of how much they are valued; and a statement of that kind cannot be revised downward without insult, however the market may be moving. The ratchet is the shape this meaning takes when it is drawn: the wage rises with good fortune and locks against bad, because to unsay what it has said — to tell a worker he is worth less than last year — is a thing that workers and employers alike will go to great lengths to avoid.

But a conscience can have its victims, and this one does. The same rigidity that spares the employed the insult of a cut loads the whole weight of a downturn onto another group — those who lose their jobs, and those who cannot find one. If wages fell a little for everyone, more might keep working; because they do not fall, fewer do, and the cost is borne in full by the unemployed, the young, the outsiders who would gladly have worked at the lower wage the insiders refused.⁶6The insider–outsider theory (Lindbeck and Snower, 1988): incumbent ‘insiders,’ protected by the costs of replacing them, can keep their wages high, so the burden of adjustment in a downturn falls on ‘outsiders’ — the unemployed, who cannot bid their way in. The wage’s dignity is real, and so is its price, and the price is paid by those it has shut out — who receive no verdict at all, because they receive no wage. The folio has watched this one number measure value, sell time, stake trust, compel obedience, settle by power, and draw the bounds of work; here it does the strangest thing of all. It declines to fall, out of respect for the worker — and lets the unemployment it thereby causes fall, instead, upon the workers it does not have.