The stickiness of wages seems to be one of the key stylized facts of economics. For some reason, the idea that sticky wages may be the key to explaining business-cycle downturns in which output and employment– not just prices and nominal incomes — fall is now widely supposed to have been a, if not the, major theoretical contribution of Keynes in the General Theory. The association between sticky wages and Keynes is a rather startling, and altogether unfounded, inversion of what Keynes actually wrote in the General Theory, heaping scorn on what he called the “classical” doctrine that cyclical (or in Keynesian terminology “involuntary”) unemployment could be attributed to the failure of nominal wages to fall in response to a reduction in aggregate demand. Keynes never stopped insisting that the key defining characteristic of “involuntary” unemployment is that a nominal-wage reduction would not reduce “involuntary” unemployment. The very definition of involuntary unemployment is that it can only be eliminated by an increase in the price level, but not by a reduction in nominal wages.
Keynes devoted three entire chapters (19-21) in the General Theory to making, and mathematically proving, that argument. Insofar as I understand it, his argument doesn’t seem to me to be entirely convincing, because, among other reasons, his reasoning seems to involve implicit comparative-statics exercises that start from a disequlibrium situation, but that is definitely a topic for another post. My point is simply that the sticky-wages explanation for unemployment was exactly the “classical” explanation that Keynes was railing against in the General Theory.
So it’s really quite astonishing — and amusing — to observe that, in the current upside-down world of modern macroeconomics, what differentiates New Classical from New Keynesian macroeconomists is that macroecoomists of the New Classical variety, dismissing wage stickiness as non-existent or empirically unimportant, assume that cyclical fluctuations in employment result from high rates of intertemporal substitution by labor in response to fluctuations in labor productivity, while macroeconomists of the New Keynesian variety argue that it is nominal-wage stickiness that prevents the steep cuts in nominal wages required to maintain employment in the face of exogenous shocks in aggregate demand or supply. New Classical and New Keynesian indeed! David Laidler and Axel Leijonhufvud have both remarked on this role reversal.
Many possible causes of nominal-wage stickiness (especially in the downward direction) have been advanced. For most of the twentieth century, wage stickiness was blamed on various forms of government intervention, e.g., pro-union legislation conferring monopoly privileges on unions, as well as other forms of wage-fixing like minimum-wage laws and even unemployment insurance. Whatever the merits of these criticisms, it is hard to credit claims that wage stickiness is mainly attributable to labor-market intervention on the side of labor unions. First, the phenomenon of wage stickiness was noted and remarked upon by economists as long ago as the early nineteenth century (e.g., Henry Thornton in his classic The Nature and Effects of the Paper Credit of Great Britain) long before the enactment of pro-union legislation. Second, the repeal or weakening of pro-union legislation since the 1980s does not seem to have been associated with any significant reduction in nominal-wage stickiness.
Since the 1970s, a number of more sophisticated explanations of wage stickiness have been advanced, for example search theories coupled with incorrect price-level expectations, long-term labor contracts, implicit contracts, and efficiency wages. Search theories locate the cause of wage nominal stickiness in workers’ decisions about what wage offers to accept. Thus, the apparent downward stickiness of wages in a recession seems to imply that workers are turning down offers of employment or quitting their jobs in the mistaken expectation that search will uncover better offers, but that doesn’t seem to be what happens in recessions, when quits decline and layoffs increase. Long-term contracts can and frequently are renegotiated when conditions change. Implicit contracts also can be adjusted when conditions change. So insofar as these theories posit that workers are somehow making decisions that lead to their unemployment, the story seems to be incomplete. If workers could be made better off by accepting reduced wages instead of being unemployed, why isn’t it happening?
Efficiency wages posit a different cause for wage stickiness: that employers have cleverly discovered that by overpaying workers, workers will work their backsides off to continue to be considered worthy of receiving the rents that their employers are conferring upon them. Thus, when a recession hits, employers use the opportunity to weed out their least deserving employees. This theory at least has the virtue of not assigning responsibility for sub-optimal decisions to the workers.
All of these theories were powerfully challenged about eleven or twelve years ago by Truman Bewley in a book Why Wages Don’t Fall During a Recession. (See also Peter Howitt’s excellent review of Bewely’s book in the Journal of Economic Literature.) Bewley, though an accomplished theorist, simply went out and interviewed lots of business people, asking them to explain why they didn’t cut wages to their employees in recessions rather than lay off workers. Overwhelmingly, the responses Bewley received did not correspond to any of the standard theories of wage-stickiness. Instead, business people explained wage stickiness as necessary to avoid a collapse of morale among their employees. Layoffs also hurt morale, but the workers that are retained get over it, and those let go are no longer around to hurt the morale of those that stay.
While I have always preferred the search explanation for apparent wage stickiness, which was largely developed at UCLA in the 1960s (see Armen Alchian’s classic “Information costs, Pricing, and Resource Unemployment”), I recognize that it doesn’t seem to account for the basic facts of the cyclical pattern of layoffs and quits. So I think that it is clear that wage stickiness remains a problematic phenomenon. I don’t claim to have a good explanation to offer, but it does seem to me that an important element of an explanation may have been left out so far — at least I can’t recall having seen it mentioned.
Let’s think about it in the following way. Consider the incentive to cut price of a firm that can’t sell as much as it wants at the current price. The firm is off its supply curve. The firm is a price taker in the sense that, if it charges a higher price than its competitors, it won’t sell anything, losing all its sales to competitors. Would the firm have any incentive to cut its price? Presumably, yes. But let’s think about that incentive. Suppose the firm has a maximum output capacity of one unit, and can produce either zero or one units in any time period. Suppose that demand has gone down, so that the firm is not sure if it will be able to sell the unit of output that it produces (assume also that the firm only produces if it has an order in hand). Would such a firm have an incentive to cut price? Only if it felt that, by doing so, it would increase the probability of getting an order sufficiently to compensate for the reduced profit margin at the lower price. Of course, the firm does not want to set a price higher than its competitors, so it will set a price no higher than the price that it expects its competitors to set.
Now consider a different sort of firm, a firm that can easily expand its output. Faced with the prospect of losing its current sales, this type of firm, unlike the first type, could offer to sell an increased amount at a reduced price. How could it sell an increased amount when demand is falling? By undercutting its competitors. A firm willing to cut its price could, by taking share away from its competitors, actually expand its output despite overall falling demand. That is the essence of competitive rivalry. Obviously, not every firm could succeed in such a strategy, but some firms, presumably those with a cost advantage, or a willingness to accept a reduced profit margin, could expand, thereby forcing marginal firms out of the market.
Workers seem to me to have the characteristics of type-one firms, while most actual businesses seem to resemble type-two firms. So what I am suggesting is that the inability of workers to take over the jobs of co-workers (the analog of output expansion by a firm) when faced with the prospect of a layoff means that a powerful incentive operating in non-labor markets for price cutting in response to reduced demand is not present in labor markets. A firm faced with the prospect of being terminated by a customer whose demand for the firm’s product has fallen may offer significant concessions to retain the customer’s business, especially if it can, in the process, gain an increased share of the customer’s business. A worker facing the prospect of a layoff cannot offer his employer a similar deal. And requiring a workforce of many workers, the employer cannot generally avoid the morale-damaging effects of a wage cut on his workforce by replacing current workers with another set of workers at a lower wage than the old workers were getting. So the point that I am suggesting seems to dovetail with morale-preserving explanation for wage-stickiness offered by Bewley.
If I am correct, then the incentive for price cutting is greater in markets for most goods and services than in markets for labor employment. This was Henry Thornton’s observation over two centuries ago when he wrote that it was a well-known fact that wages are more resistant than other prices to downward pressure in periods of weak demand. And if that is true, then it suggests that real wages tend to fluctuate countercyclically, which seems to be a stylized fact of business cycles, though whether that is indeed a fact remains controversial.
Uneasy Money 
Another wonderful post David. Your first point about Keynes and price flexibility is really important. Tobin made a very similar argument in a 1975 AER paper:
“Keynes tried to make a double argument about wage reduction and employment. One was that wage rates were very slow to decline in the face of excess supply. The other was that, even if they declined faster, employment would not – in depression circumstances – increase. As to the second point, he was well aware of the dynamic argument that declining money wage rates are unfavorable to aggregate demand. But perhaps he did not insist upon it strongly enough, for the subsequent theoretical argument focused on the statics of alternative stable wage levels.”
Tobin went on to develop a dynamic model of recessions with flexible wages, but it was not microfounded in the modern sense and did not get the attention it deserved. I discussed the paper in the following post:
http://rajivsethi.blogspot.com/2009/12/on-consequences-of-nominal-wage.html
Some recent work by Eggertson revisits the issue of destabilizing price flexibility, and cites the Tobin paper, but the general approach is quite different.
LikeLike
wages are flexible,
see What can wages and employment tell us about the UK’s productivity puzzle? by Richard Blundell, Claire Crawford and Wenchao Jin at http://www.ifs.org.uk/publications/6749 showing that in the Uk recession 12% of employees in the same job as 12 months ago experienced wage freezes and 21% of workers in the same job as 12 months ago experienced wage cuts.
Their data covered 80% of workers in the New Earnings Survey Panel Dataset. Larger firms lay off workers; smaller firms tended to reduce wages
see too Pissarides, C (2009), The Unemployment Volatility Puzzle: Is Wage Stickiness the Answer?, Econometrica who argues the wage stickiness is not the answer since wages in new job matches are highly flexible:
1. wages of job changers are always substantially more procyclical than the wages of job stayers.
2. the wages of job stayers, and even of those who remain in the same job with the same employer are still mildly procyclical.
3. there is more procyclicality in the wages of stayers in Europe than in the United States.
4. The procyclicality of job stayers’ wages is sometimes due to bonuses, and overtime pay but it still reflects a rise in the hourly cost of labor
to the firm in cyclical peaks
how do existing firms survive in competition with new firms who can start workers on lower wages? Industries with many short term jobs and seasonal jobs would suffer less from wage inflexibility
LikeLike
David,
Excellent post. I think the formulation at the end (firms can gain market share, workers don’t) makes sense. In the context of today, however, two questions remain:
1) Can “excess” unemployment be explained by wage stickiness five years after a recession?
2) Does it make sense to talk about sticky wages in the context of peak profits to gdp?
On the latter point, profits to gdp are average profit. The implication of sticky wages is that marginal profit is dramatically lower than the average. In other words, firms have little incentive to expand output and employment even though their current production is at record-high profitability. In order to expand output, they need to improve that marginal profitability by lowering the marginal cost of labor. The fact that they can’t do that stands in the way of expansion. Meanwhile, wages to gdp are at the lowest level in history (again, average), but the marginal cost of labor is the problem. Does this narrative make sense to you?
LikeLike
But the basic question is why is there unemployment ro, why does the labor market fail to clear. Why are wages sticky is a secondary question.
Wouldn’t this make the repeated failure of labor markets to clear the key economic stylized fact of interest?
More generally, the interesting stylized fact of economic interest is that markets do fail to clear.
Respectfully, the econ profession is full of overheated intellectualizing directed at theorizing as to why this is (or pretending its not).
Is it wrong to spend time trying to further our understanding on the failure of markets? why of course not. But it’s too easy a task. Let’s get the market clearing first, at the same time, right away.
For anyone who is not an economist, it’s hard not to be drawn to the ineluctable conclusion that the solution to having a labor market that hasn’t cleared is to hire people.
To the best of my knowledge, hiring people has reduced unemployment 100% of the time.
LikeLike
Rajiv, Thanks. I am aware that others have already pointed out that wage stickiness was not essential to Keynes’s argument. But it is odd that the defining characteristic of Keynesian theory has come to be an assumption that Keynes went out of his way to deny was necessary to reach the conclusions he was advancing. At any rate, that point was just thrown in as part of an introduction to my own (possibly novel) explanation for the stickiness of wages.
Jim, You may be right. But if you are, you have your work cut out for you in convincing everyone else that wages are not sticky. Good luck.
Diego, Thanks. I think I see what you are getting at. My general take is that employers are reluctant to hire, because they are afraid that they will have to lay off workers if they can’t sell the extra output, and, for a variety of reasons, they regard layoffs as being very costly, and a lower wage wouldn’t necessarily change that calculation by much.
Dan, If a market fails to clear, economists think that it is because price isn’t adjusting to clear the market. In other words, the price is sticky. So it sounds to me as if you are just using different terminology.
LikeLike
“If I am correct, then the incentive for price cutting is greater in markets for most goods and services than in markets for labor employment.”
David, it might be worth looking in more detail at the behavior of firms in the US (post 2008) and Japan (1990s). When the US downturn hit, firms reduced headcount very quickly resulting in a fall in their output but it allowed profit margins to grow again. As a result there was less deflationary pressure in the US. (Stiglitz has picked up on this point that there is no necessary deflationary pressure in a downturn – if capacity is reduced)
However in the 1990s Japanese firms did not cut headcount (or wages) hence their route to try and generate some return on prior investment was through lower prices. Your above statement implies that firms will cut prices in a downturn and not wages. Although this may be true in some markets, those firms that cut capacity (headcount) may see little need to reduce wages or even prices.
LikeLike
That seems more like a definition than an explanation.
In any case, if you want to use that terminology it frames the question differently which is the basic point. If you want to clear a market you can lower the price of the supply to some point of larger demand, or you can increase the amount of demand at a given price. starting with sticky wages, rather than a failed market, implies the problem is supply refusing to lower the price. Why frame the question so one-sidedly?
The supply price of anything has a zero-lower bound determined by profitability.
For example, The Green River Formation in a stretch of largely vacant federal lands in Utah, Wyoming, and Colorado may hold more recoverable oil than all the rest of the world put together according to the USGS [U.S. Geological Survey] estimates of about about 3 trillion barrels of oil in place.
But where are all the economists complaints about the downward nominal price rigidity of the Green River oil supply seizing up the market? Everyone understands that no one is going to sell that oil below cost, and the cost while not fixed absolutely, changes very slowly.
Obviously labor is the same way, why should it be a big mystery that labor doesn’t cut it’s price of supply below it’s cost, and for all the same reasons as for the GRF oil, those costs change only very slowly.
Talking about the sticky wages is just an unnecessary distraction that focuses the attention on the wrong aspect of the problem.
If you want to remove the zero lower bound on labor, lower labors costs, slash all the costs of living. Would that work theoretically? yeah of course, but it’s the hard way to go about it and will have huge disruptive effects and cause chaos and be slow and painful to implement. Just as exchange rate shifts are the far more elegant way to adjust a whole country’s relative cost structure and internal devaluation is brutal and costly and slow, so too the obvious way to adjust for clearing the labor market is to hire more people at the current cost structure, even though of course you can try to lower the cost of living, or do what really happens which is absolutely nothing but wait and hope that demand slowly rises to absorb the supply at the price offered. This strategy is politically possible, but outrageously damaging.
Oh well, my proposal is idle hot air until FDR returns. Style is as stylized.
LikeLike
Thanks David, I would very much like to be persuaded that nominal wages were indeed downward rigid:
• I and several friends were in downsizings at our various employers had the choice of a large pay cut (or a long pay freeze) or a lay-off.
• Most of my friends in the private sector are on bonus schemes were 70%+ of the bonus are based on company profitability.
• My wife is at a power company where everyone from the CEO down loses their bonus if there is a fatal workplace accident.
The British data I mentioned showed widespread wage cuts dated back to the 1980s. Recent Irish data also shows extensive wage cuts among many job stayers.
Alchian and Woodward’s 1987 ‘Reflections on a theory of the firm’ says:
“… the notion of a quickly equilibrating market price is baffling save in a very few markets.
Imagine an employer and an employee. Will they renegotiate price every hour, or with every perceived change in circumstances?
If the employee is a waiter in a restaurant, would the waiter’s wage be renegotiated with every new customer? Would it be renegotiated to zero when no customers are present, and then back to a high level that would extract the entire customer value when a queue appears?
… But what is the right interval for renegotiation or change in price? The usual answer ‘as soon as demand or supply changes’ is uninformative.”
Alchian and Woodward then go on to a long discussion of the role of protecting composite quasi-rents from dependent resources as the decider of the timing of wage and price revisions.
Alchian and Woodward explain unemployment to the side effect of the purpose of wage and price rigidity, which is the prevention of hold-ups over dependent assets. They note that unemployment cannot be understood until an adequate theory of the firm explains the type of contracts the members of a firm contract with one another.
Benjamin Klein’s theory of rigid wages in American Economic Review in 1984 is one of the few that explored rigid wages as an industrial organisation issue. Klein treated rigid wages as a response to opportunism and hold-up problems over specialised assets and are forms of exclusive dealership or take-or-pay contracts.
How can downward wage rigidity be a scientific hypothesis if extensive international evidence of widespread wage cuts since the 1980s and 30%+ of the workforce on performance bonuses is not enough to refute it?
LikeLike
One well-known economist admitted, “Let’s say I get a four percent raise in a seven-percent inflation environment. It makes me feel the employer “tried” to keep me abreast and valued my services. A two percent cut in no inflation environment would be a punitive action.”
Of course the two percent cut is the better deal.
Hence, wage stickiness—even Novel Prize economists know you cannot cut nominal wages.
LikeLike
A point to remember is that modern manufacturing plants (even in China!) have made most line workers into specialists. Upon hiring, a new employee goes through a series of training programs each of which qualify the worker on specific machines. The certificate of completion of training on each machine is then placed on the worker’s file. So, a lathe operator can only replace another lathe operator without the company incurring additional training costs. If the company cuts rates for all lathe operators, there is a loss of morale among lathe operators, leading to a loss of productivity, e.g., increase in scrap rates, for example. In a balanced line, this will adversely impact the productivity of all workers. If the company lays off some or all lathe operators and hires replacements at lower rates, additional training costs and production delays reduce the net savings. It is also not possible to ask the lathe operators to work longer hours at no increase in pay (mandatory overtime at regular rates, for example), because the production process requires simultaneous operation of a number of different machines. This is also why a layoff involves all operators on a number of production lines, not shedding of a fraction of lathe operators, for example. I am excluding here line balancing activities that go on all the time, to take advantage of process innovations and continuously increasing productivity in most well run plants. So, to measure and model wage stickiness or lack thereof, it is necessary to model the wages of groups of workers, or include time dependent interaction of one worker’s wages with others in the same plant in the model.
LikeLike
Jim I was looking at the paper, it’s pretty interesting. The argument they make is that wages have acted differently in this recession-in Britain-than previous ones. In past recessions then wages were ‘sticky’ but in this one they’re ‘flexible.’
However, they’re talking about real wages-I thought the idea is that nominal wages are sticky?
LikeLike
How do economists manage to be so utterly confusing?
I am pretty sure Keynes point was that lowering wages isn’t the best way to respond to a labor market that wasn’t clearing. So at most if something is startling it is a semantic surprise.
And isn’t your point simply an indirect way to get to real prices? producing more at the same price is a real devaluation. So we’re right back where we started. People are unemployed, and economists don’t want to tell people to do the obvious; hire people.
Maybe Keynes was a genius not because of his insights – no one can even agree what he was saying apparently, and in any case Sweden had already followed his prescribed course a few years before his prescription – but because he was a novelty: an economist who prescribed action.
What would happen if only those people who take action to reduce the current and outrageous unemployment could be called economists.
The difference between economics and physics is that without physicists we would not have nuclear energy, without economists we woudn’t have??? we’d still have an economy, and clearly we still have high and prolonged unemployment.
There has been a lot of soul searching about the question, how did economists not foresee the crash? Well, where does the question stack up, how did economists not manage to prevent the devastatingly costly unemployment? Even though they foresaw it.
LikeLike
David: “So what I am suggesting is that the inability of workers to take over the jobs of co-workers (the analog of output expansion by a firm) when faced with the prospect of a layoff means that a powerful incentive operating in non-labor markets for price cutting in response to reduced demand is not present in labor markets. ”
Isn’t that just what workers do after layoffs? They are handed the work formerly done by the laid-off workers, and told to do it, in addition to what they are already doing.
LikeLike
Tom, Thanks, you raise an interesting point. But reducing capacity involves more than just shedding workers.
Dan, You said:
“If you want to clear a market you can lower the price of the supply to some point of larger demand, or you can increase the amount of demand at a given price.”
It is not clear to me who “you” is referring to the theorist with the model or the agent in the model. In any case, if you posit a demand curve, and posit that quantity demanded is less than amount supply, as I believe we are both doing, you – and I mean _you_ — can’t just say that the theorist or the agent can increase the amount demanded at a given price. Demand curves don’t just move. If the theorist posits a demand curve, and a situation in which the amount demanded exceeds the amount supplied at the prevailing price, the theorist is not at liberty to posit a shift in the demand curve to eliminate the disequilibrium. And certainly the agent has less control over the demand curve than theorist does. So you really need to explain to me what you mean, because I can’t figure it out.
“starting with sticky wages, rather than a failed market, implies the problem is supply refusing to lower the price. Why frame the question so one-sidedly?”
I’m sorry, but again I have no idea what you mean.
Or what this means:
“The supply price of anything has a zero-lower bound determined by profitability.”
And your use of the term “zero-lower bound” in this context completely mystifies me.
There’s a lot of shale oil in the Green River Formation, I don’t know whether the oil is not being extracted because the government is not allowing drilling or because at current prices, it is not profitable to extract the oil. In either case, I don’t see the relevance the question whether currently unemployed workers looking for employment could not become employed by accepting wages and salaries lower than the wages and salaries being earned by those now employed.
Jim, I am not trying to persuade you of anything. All I am saying is that it has been accepted as a fact for over two centuries that wages are rigid or sticky especially in a downward direction. I am also saying that many economists going back two centuries posited the stickiness of wages as a major reason that business cycle depressions involve not just reduced total spending, but also reduced total output and employment. Accordingly it is anachronistic and directly contrary to Keyne’s own detailed arguments on the subject of wage rigidity to attribute that explanation for cyclical unemployment to Keynes. I have no particular comment on the data that you cite, except that the wage stickiness argument does not assert that wages never fall, just that they fall less rapidly in the face of declining demand than other prices. So you need to do more than provide evidence that wages fall, you have to show that wages are falling as fast as or faster than prices.
Thanks for the references to Alchian and Woodford and to Klein. I will to get hold of them and read them.
Benjamin, Fair point. But notice that you are implicitly assuming some kind of long-term relationship between the employer and the employee which does not exist between transactors in markets for soybeans or cotton fiber. Dennis Carlton showed in a number of papers that prices tend to be rigid in markets when suppliers and demanders are in a long-term relationship and there is an expectation on both sides that the relationship will continue. The supplier expects the customer not to switch to someone else for a small price advantage, and the demander expects the supplier to keep supplying him when supplies are tight at a reasonable price. This I think is what Alchian and Woodford had in mind in the papers cited above by Jim.
Amitava. Another good point. Employers invest in their workers by training them. If they are any good, the firm does not want to lose them or to reduce their incentive to be productive.
Mike, You are right, usually wage rigidity refers to nominal wages, but in periods of high inflation expectations, the Friedman/Phelps argument implies real wage rigidity.
Dan, I agree with you economics is not physics and economists are not physicists. Economics is harder than physics, and physicists are probably smart enough to figure out that economics is too intractable a subject for problems to be solved in an intellectually satisfying way. At any rate, as Donald Rumsfeld (my citation of Rumsfeld does not imply endorsement or approval of the way he discharged his public duties as a high government official) once said you go to war with the army you have. So I guess we’re stuck with the economists we have.
LikeLike
Thanks David, how much downward wage cuts are enough to refute the wage rigidity hypothesis? In Popper’s terms, what does the hypothesis strictly forbid?
LikeLike
“the theorist is not at liberty to posit a shift in the demand curve”
Isn’t a fiscal stimulus package intended to shift the demand curve? Isn’t monetary policy an indirect shot at shifting the demand curve? Aren’t there many different ideas about how to shift both nominal and real AD?
Using zero lower bound, was an unnecessary distraction intended as a metaphor – but my point was to agree with how you characterize type-one firms as having a lower limit to how low they will drop prices. Such a supply curve would slope downwards and then go horizontal much like the L-M curve when drawn postulating a ZLB.
I suppose the Green River oil deposits was a similarly bad metaphor, but the point was to offer a reason for why people would not accept lower nominal wages. The reason the Green River oil is not sold is because the cost of production is higher than the market price of oil. Why would someone choose not to work for a lower nominal wage? because their cost of living is higher than the wage offered. if you have a mortgage payment of $3,000/month, why accept a job that pays $3,000/month? you’d be better off declaring BK. or if you wanted a policy directed at making wages less sticky, you could simply reduce mortgage balances.
In sum I have managed to be more incoherent and confusing than the objects of my complaint.
Working through it, I think I agree with your conclusion, if I understand you, on why wages are sticky.
I still think there must be room to theorize on shifting demand. It does seem that some agent of collective action would be needed, but that wouldn’t have to be the government, it could be a business association, or dare I say it, confidence.
I like the Rumsfeld quote, It’s actually a good army as well. It does seem to me that economic theory has tipped too far towards examining what has been and rather too far away from engaging with what could be.
I wish economists compared themselves more to architectects and less to physicists.
“economics is too intractable a subject for problems to be solved in an intellectually satisfying way.” Do most people in the profession feel this way? I think one of the main sources of criticism of the economics profession is that they communicate to the rest of the world intellectual satisfaction with answers that common sense and curiosity make unsatisfactory to the non-economist. There is a fascinating blog post and discussion in your statement.
But when has having an answer ever been intellectually satisfying in any case? asking questions and looking for answers are the things that satisfy.
LikeLike
This is an excellent post, David Glasner. I’m also pleased that you referred to Book V of The General Theory of Employment, Interest, and Money. It’s an underrated section of The General Theory which deserves more analysis. And speaking of analysis, here are three articles published in the History of Economics Review in Australia which examine Book V in depth…
Click to access 21-A-4.pdf
Click to access 24-A-4.pdf
Click to access 25-A-13.pdf
LikeLike
Prof Glasner: “At any rate, as Donald Rumsfeld (my citation of Rumsfeld does not imply endorsement or approval of the way he discharged his public duties as a high government official) once said you go to war with the army you have. So I guess we’re stuck with the economists we have.”
And how did that turn out?
I’ll stick with Marshall, who sacked one-third of US Army generals from 1939-1941, and another third by the end of the war.
LikeLike
Barry, Yes, but in the sticky wages view, the retained workers don’t offer to take a lower wage and do the work done by other workers.
Jim, I don’t think that theories have been worked out in sufficient detail to make such a quantitative test. That’s one example of why economic theories are generally less susceptible to empirical testing than physical theories.
Dan, The fiscal stimulus is an exogenous policy tool designed as an alternative to or a substitute for the endogenous adjustment of the market price. The question is whether markets would equilibrate themselves through price adjustment without any fiscal (or monetary) stimulus.
I don’t have my finger on the pulse of the economics profession, so you can’t infer too much about what most economists think from anything I say. I have probably grown a little bit more skeptical over the years about whether economists really do know what they are talking about, but I am not ready to give up on them.
Blue Aurora, Thanks. I was actually thinking of you when I referred to those chapters. I remember reading chapter 19 very carefully at one time, and not being completely persuaded by the argument. I don’t have much recollection of chapters 20 and 21. I do want to read Brady’s work, but right now there is other stuff I want to read as well.
Barry, I assume that your question was rhetorical. Marshall was a great man, but he wasn’t perfect either.
LikeLike
“The fiscal stimulus is an exogenous policy tool designed as an alternative to or a substitute for the endogenous adjustment of the market price.”
But we are talking about macro – the government is an endogenous agent (A really big fat one I suppose) in macro.
They have their grubby little hands in every little micro market too.
If government is exogenous by rule in Macro, it’s inconceivable to me that I could be persuaded that is the correct way to model it. I am rather inclined to think Macro died when they took political out of political economy.
LikeLike
The question is whether markets would equilibrate themselves through price adjustment without any fiscal (or monetary) stimulus.
Where does government end and fiscal stimulus begin in this test? what about anti- stimulus that has caused the labor market to fail in the first place? and where does the normal fed end and monetary stimulus begin?
But let’s ask the rather narrow question let’s say the fed and the treasury are ruled by rule and so they don’t change or fluctuate in any way with economic activity but only with time. What would the labor market do?
Is there any doubt that it would fluctuate? has anyone ever seen an equilibrium anywhere?
It would actually be fun to see a full employment situation with companies forced to respond to wage inflation by making productivity investment rather than the fed tapping on the brakes. I don’t know whether history has an example of an extended period of over full employment – I like the idea, why should capital have all the fun?
LikeLike
Dan, There is no rule that says certain adjustments have to be endogenous or exogenous. Everything depends on the context. The context here is the question whether the adjustment of market price is sufficient to restore equilibrium to an economy beset by widespread unemployment. In that context government fiscal policy is clearly exogenous.
LikeLike
I would be interested in your view of the practice, common in Germany and other European countries, of cutting hours for all workers rather than laying some of them off. The hourly wage remains constant, but the total labor cost goes down. This approach is widely viewed as morally superior to layoffs, by both employees and employers.
LikeLike
Reducing hours worked by all workers seems to be a more effective way to reduce overall cost of production than laying off a fraction of the workforce. Replacement cost of workers are avoided, know-how ( a key contributor to employee productivity) is retained, and operating costs of the facility are reduced by developing a rapid shut down procedure when employees are off work.
LikeLike
David, I haven’t really thought about it. I see nothing obviously wrong with the idea, and I think it’s certainly worth considering.
agupta, Good points. Thanks.
LikeLike
david, how does wage rigidity differ from ed lazear’s economics of offer matching.
An announced policy of “no offer matching” discourages attempts by employees to raise their salaries by obtaining outside offers at higher wages with no actual intention .of quitting.
LikeLike
I thought this discussion was an excellent primer on a difficult topic. You note that employees are like the type-one firms, in that: “Would such a firm have an incentive to cut price? Only if it felt that, by doing so, it would increase the probability of getting an order sufficiently to compensate for the reduced profit margin at the lower price. Of course, the firm does not want to set a price higher than its competitors, so it will set a price no higher than the price that it expects its competitors to set.”
I think there is merit to this. My experience as an employer in a couple different industries points to two additional factors.
One is psychological. I haven’t met an employee, except very highly compensated ones (and then only rarely), who did not have an deeply emotional response to the possibility of ratcheting downward in any given year (i.e., making less money). It seems that, once one has ratcheted up, conserving one’s place becomes very important. This strikes me as human nature for a good deal of people.
The second is more like your firm analogy, but a firm is potentially immortal. A worker only has a set amount of peak earning years. I think that employees resist taking jobs at lower wages because they (correctly) suspect that starting at a lower wage is going to reduce their potential earnings for peak years. Note that this might not be a completely rational intertemporal optimization, but I have little doubt that it occurs. People know that their future compensation is often a function of their current compensation and are reluctant to jeopardize their future potential, whether or not this make sense.
LikeLike
There’s another detail here: the ability of a firm to cut its prices is contingent on it still being able to turn a profit at the lower price. A firm cannot remain in business selling its goods for less than the cost of production. How does this relate to wages? Many workers have made financial commitments based on their nominal wages, commitments which are not mitigated by a deflationary environment. If you have a mortgage, your mortgage payment doesn’t decrease just because your salary decreases, nor because the market value of your house has decreased. Thus, while the overall CPI may be -2%, the worker’s own cost of living may only decrease .5%, which would mean a 2% pay cut is not breaking even, but rather a 1.5% decrease in real wages. The situation is even worse with student loans, because there is no way to unwind the contract when the market goes bad.
LikeLike