And what Keynes had to say then is as valid as ever: under
depression-type conditions, with short-term interest rates near zero,
there’s no reason to think that lower wages for all workers – as opposed to lower wages for a particular group of workers – would lead to higher employment.
Suppose that wages across the US economy had been, say, 20 percent
lower than they actually were. You might be tempted to say that this
would make hiring workers more attractive. But to a first
approximation, prices would also have been 20 percent lower – so the
real wage would not have been reduced. So how would lower wages lead to
higher demand for labor?
Well, the real money supply would have been larger – but the normal
channel through which this might increase demand, lower interest rates,
was blocked by the zero lower bound. Yes, there would have been a
slight Pigou effect: real private sector wealth would have been higher,
because cash under the mattress (or wherever) was worth more. But on
the other hand, real debt burdens would also have been higher, probably
exerting a contractionary effect. Overall, there’s no good reason to
think that lower wages would have helped raise employment.
That is Paul Krugman and also here. That is correct but note the argument requires lower wages for all workers, exactly as Krugman states. He does not go through a change in wages for only some workers and indeed that scenario is very different and not necessarily Keynesian. When unemployment is present, lower wages for some workers can stimulate renewed employment and — depending on elasticities — possibly greater purchasing power as well or at least not proportionally diminished purchasing power. (Each worker earns less but there are more workers employed.) There won't in general be much of a deflation. The hiring of some workers can also lead to an upward spiral in production, employment, and again purchasing power, as outlined by W.H. Hutt in his books on Keynes.
Krugman and others wish to argue that the New Deal years were ones of recovery; that is fine but it increases the chance that the Hutt scenario and not the Keynes scenario would apply at that time.
The simplest version of the Keynesian argument on money wages also relies on labor as the primary source of marginal cost (true in many but not all sectors) and lack of market power for retail prices, among other assumptions about market structure. Yet another scenario is that some nominal wages fall and entrepreneurs (with some market power) invest more in response and hold retail prices relatively steady.
I believe Keynes's "falling nominal wages-falling prices-constant real wages-constant unemployment" scenario does hold for some of the 1929-1932 period and indeed I have argued as such in print. But once we get into the Roosevelt era, we have government propping up some wages above market-clearing levels and thus higher than necessary unemployment. Note that the Roosevelt policies applied only to some workers and by no means to all or even most workers, which again suggests the Hutt analysis is more relevant than the Krugman/Keynes analysis.
Krugman asks why Keynes's point, presented in 1936, is not more widely recognized today. But the limitations of Keynes's argument — including its reliance upon particular assumptions about cost and market structure — were pointed out by Jacob Viner in…1937 (see pp.161-162 JSTOR).
Viner, I might add, was hardly a laissez-faire denialist. He favored an active government response to the depression, and he admits Keynes's results can hold but needn't hold. He is the one who stakes out the sophisticated middle ground, not Keynes. So we're still trying to catch up to 1937, not 1936.
Addendum: It turns out I am blogging chapter 19 of the General Theory; I am looking forward to our forthcoming book club too much!