In my recent post about Nick Rowe and the law of reflux, I mentioned in passing that I might write a post soon about price stickiness. The reason that I thought it would be worthwhile writing again about price stickiness (which I have written about before here and here), because Nick, following a broad consensus among economists, identifies price stickiness as a critical cause of fluctuations in employment and income. Here’s how Nick phrased it:
An excess demand for land is observed in the land market. An excess demand for bonds is observed in the bond market. An excess demand for equities is observed in the equity market. An excess demand for money is observed in any market. If some prices adjust quickly enough to clear their market, but other prices are sticky so their markets don’t always clear, we may observe an excess demand for money as an excess supply of goods in those sticky-price markets, but the prices in flexible-price markets will still be affected by the excess demand for money.
Then a bit later, Nick continues:
If individuals want to save in the form of money, they won’t collectively be able to if the stock of money does not increase.There will be an excess demand for money in all the money markets, except those where the price of the non-money thing in that market is flexible and adjusts to clear that market. In the sticky-price markets there will nothing an individual can do if he wants to buy more money but nobody else wants to sell more. But in those same sticky-price markets any individual can always sell less money, regardless of what any other individual wants to do. Nobody can stop you selling less money, if that’s what you want to do.
Unable to increase the flow of money into their portfolios, each individual reduces the flow of money out of his portfolio. Demand falls in stick-price markets, quantity traded is determined by the short side of the market (Q=min{Qd,Qs}), so trade falls, and some traders that would be mutually advantageous in a barter or Walrasian economy even at those sticky prices don’t get made, and there’s a recession. Since money is used for trade, the demand for money depends on the volume of trade. When trade falls the flow of money falls too, and the stock demand for money falls, until the representative individual chooses a flow of money out of his portfolio equal to the flow in. He wants to increase the flow in, but cannot, since other individuals don’t want to increase their flows out.
The role of price stickiness or price rigidity in accounting for involuntary unemployment is an old and complicated story. If you go back and read what economists before Keynes had to say about the Great Depression, you will find that there was considerable agreement that, in principle, if workers were willing to accept a large enough cut in their wages, they could all get reemployed. That was a proposition accepted by Hawtry and by Keynes. However, they did not believe that wage cutting was a good way of restoring full employment, because the process of wage cutting would be brutal economically and divisive – even self-destructive – politically. So they favored a policy of reflation that would facilitate and hasten the process of recovery. However, there also those economists, e.g., Ludwig von Mises and the young Lionel Robbins in his book The Great Depression, (which he had the good sense to disavow later in life) who attributed high unemployment to an unwillingness of workers and labor unions to accept wage cuts and to various other legal barriers preventing the price mechanism from operating to restore equilibrium in the normal way that prices adjust to equate the amount demanded with the amount supplied in each and every single market.
But in the General Theory, Keynes argued that if you believed in the standard story told by microeconomics about how prices constantly adjust to equate demand and supply and maintain equilibrium, then maybe you should be consistent and follow the Mises/Robbins story and just wait for the price mechanism to perform its magic, rather than support counter-cyclical monetary and fiscal policies. So Keynes then argued that there is actually something wrong with the standard microeconomic story; price adjustments can’t ensure that overall economic equilibrium is restored, because the level of employment depends on aggregate demand, and if aggregate demand is insufficient, wage cutting won’t increase – and, more likely, would reduce — aggregate demand, so that no amount of wage-cutting would succeed in reducing unemployment.
To those upholding the idea that the price system is a stable self-regulating system or process for coordinating a decentralized market economy, in other words to those upholding microeconomic orthodoxy as developed in any of the various strands of the neoclassical paradigm, Keynes’s argument was deeply disturbing and subversive.
In one of the first of his many important publications, “Liquidity Preference and the Theory of Money and Interest,” Franco Modigliani argued that, despite Keynes’s attempt to prove that unemployment could persist even if prices and wages were perfectly flexible, the assumption of wage rigidity was in fact essential to arrive at Keynes’s result that there could be an equilibrium with involuntary unemployment. Modigliani did so by positing a model in which the supply of labor is a function of real wages. It was not hard for Modigliani to show that in such a model an equilibrium with unemployment required a rigid real wage.
Modigliani was not in favor of relying on price flexibility instead of counter-cyclical policy to solve the problem of involuntary unemployment; he just argued that the rationale for such policies had to be that prices and wages were not adjusting immediately to clear markets. But the inference that Modigliani drew from that analysis — that price flexibility would lead to an equilibrium with full employment — was not valid, there being no guarantee that price adjustments would necessarily lead to equilibrium, unless all prices and wages instantaneously adjusted to their new equilibrium in response to any deviation from a pre-existing equilibrium.
All the theory of general equilibrium tells us is that if all trading takes place at the equilibrium set of prices, the economy will be in equilibrium as long as the underlying “fundamentals” of the economy do not change. But in a decentralized economy, no one knows what the equilibrium prices are, and the equilibrium price in each market depends in principle on what the equilibrium prices are in every other market. So unless the price in every market is an equilibrium price, none of the markets is necessarily in equilibrium.
Now it may well be that if all prices are close to equilibrium, the small changes will keep moving the economy closer and closer to equilibrium, so that the adjustment process will converge. But that is just conjecture, there is no proof showing the conditions under which a simple rule that says raise the price in any market with an excess demand and decrease the price in any market with an excess supply will in fact lead to the convergence of the whole system to equilibrium. Even in a Walrasian tatonnement system, in which no trading at disequilibrium prices is allowed, there is no proof that the adjustment process will eventually lead to the discovery of the equilibrium price vector. If trading at disequilibrium prices is allowed, tatonnement is hopeless.
So the real problem is not that prices are sticky but that trading takes place at disequilibrium prices and there is no mechanism by which to discover what the equilibrium prices are. Modern macroeconomics solves this problem, in its characteristic fashion, by assuming it away by insisting that expectations are “rational.”
Economists have allowed themselves to make this absurd assumption because they are in the habit of thinking that the simple rule of raising price when there is an excess demand and reducing the price when there is an excess supply inevitably causes convergence to equilibrium. This habitual way of thinking has been inculcated in economists by the intense, and largely beneficial, training they have been subjected to in Marshallian partial-equilibrium analysis, which is built on the assumption that every market can be analyzed in isolation from every other market. But that analytic approach can only be justified under a very restrictive set of assumptions. In particular it is assumed that any single market under consideration is small relative to the whole economy, so that its repercussions on other markets can be ignored, and that every other market is in equilibrium, so that there are no changes from other markets that are impinging on the equilibrium in the market under consideration.
Neither of these assumptions is strictly true in theory, so all partial equilibrium analysis involves a certain amount of hand-waving. Nor, even if we wanted to be careful and precise, could we actually dispense with the hand-waving; the hand-waving is built into the analysis, and can’t be avoided. I have often referred to these assumptions required for the partial-equilibrium analysis — the bread and butter microeconomic analysis of Econ 101 — to be valid as the macroeconomic foundations of microeconomics, by which I mean that the casual assumption that microeconomics somehow has a privileged and secure theoretical position compared to macroeconomics and that macroeconomic propositions are only valid insofar as they can be reduced to more basic microeconomic principles is entirely unjustified. That doesn’t mean that we shouldn’t care about reconciling macroeconomics with microeconomics; it just means that the validity of proposition in macroeconomics is not necessarily contingent on being derived from microeconomics. Reducing macroeconomics to microeconomics should be an analytical challenge, not a methodological imperative.
So the assumption, derived from Modigliani’s 1944 paper that “price stickiness” is what prevents an economic system from moving automatically to a new equilibrium after being subjected to some shock or disturbance, reflects either a misunderstanding or a semantic confusion. It is not price stickiness that prevents the system from moving toward equilibrium, it is the fact that individuals are engaging in transactions at disequilibrium prices. We simply do not know how to compare different sets of non-equilibrium prices to determine which set of non-equilibrium prices will move the economy further from or closer to equilibrium. Our experience and out intuition suggest that in some neighborhood of equilibrium, an economy can absorb moderate shocks without going into a cumulative contraction. But all we really know from theory is that any trading at any set of non-equilibrium prices can trigger an economic contraction, and once it starts to occur, a contraction may become cumulative.
It is also a mistake to assume that in a world of incomplete markets, the missing markets being markets for the delivery of goods and the provision of services in the future, any set of price adjustments, however large, could by themselves ensure that equilibrium is restored. With an incomplete set of markets, economic agents base their decisions not just on actual prices in the existing markets; they base their decisions on prices for future goods and services which can only be guessed at. And it is only when individual expectations of those future prices are mutually consistent that equilibrium obtains. With inconsistent expectations of future prices, the adjustments in current prices in the markets that exist for currently supplied goods and services that in some sense equate amounts demanded and supplied, lead to a (temporary) equilibrium that is not efficient, one that could be associated with high unemployment and unused capacity even though technically existing markets are clearing.
So that’s why I regard the term “sticky prices” and other similar terms as very unhelpful and misleading; they are a kind of mental crutch that economists are too ready to rely on as a substitute for thinking about what are the actual causes of economic breakdowns, crises, recessions, and depressions. Most of all, they represent an uncritical transfer of partial-equilibrium microeconomic thinking to a problem that requires a system-wide macroeconomic approach. That approach should not ignore microeconomic reasoning, but it has to transcend both partial-equilibrium supply-demand analysis and the mathematics of intertemporal optimization.
Uneasy Money 
By and large I agree with what you say.
Just a couple of caveats. The idea that Marshallian demand analysis amounts to partial equilibrium is today taken as gospel truth, not least because it has been repeated so many times by General Equilibrium theorists as a claim of superiority. Actually, Marshallian demand analysis is no less general than General Equilibrium theory. Both assume constant income and so it cannot be that they arrive at different results.
Read Section A of my work in progress “Some mathematical holes in General Equilibrium theory” to see the argument. It will seem unbelievable until you read it. http://www.philipji.com/holes-in-general-equilibrium
However, neither Marshallian demand analysis nor what passes for General Equilibrium is really the most general case of demand analysis. The only demand curve which makes no assumptions about aggregate demand is the rectangular hyperbola. And an analysis using the rectangular hyperbola yields involuntary unemployment as a matter of course. See http://www.philipji.com/involuntary-unemployment
The fact that the rectangular hyperbola is the most general demand curve also allows us to plot the demand curves for every individual, every commodity market, as well as aggregate demand on a single graph. This is by viewing the usual demand-supply space as a P.Q (P multiplied by Q space), instead of as a 2-tuple (P,Q) space as is usual. This circumvents the problem that in plotting aggregate demand we cannot plot prices (but only a price level) on the y-axis unlike demand curves for individuals or for commodity markets. The rectangular hyperbola has another interesting feature. Adding demand curves that are rectangular hyperbolas yields demand curves that are also rectangular hyperbolas. So microfoundations are, so to say, built into the mathematics.
The second link introduces so many new ideas that even in this long comment, I cannot do more than skim the subject.
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Possibly relevant here: https://en.wikipedia.org/wiki/Paradox_of_toil
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David: I’m in general agreement with you here. (And I think you might be reading things into my post, because I could be interpreted there as talking about partial equilibrium effects of price flexibility in particular markets, like the bond market that I had in mind. The bond market will clear, if bond prices are flexible enough, but it will not clear at the general equilibrium price of bonds.)
One important thing I would add is this: whether or not increased price flexibility is helpful depends very much on the monetary policy regime. Under a bad monetary policy regime (like fixing a nominal interest rate) increased price flexibility will make things worse.It is our job to figure out a monetary regime that works reasonably well given the actual existing degree of price flexibility/stickiness, and that ensures that price flexibility helps rather than hinders.
If we choose a monetary policy regime which makes the AD curve slope the “wrong” way (and it is easy to do that) then increased price flexibility makes things worse.
I don’t quite agree with this sentence: “Modern macroeconomics solves this problem, in its characteristic fashion, by assuming it away by insisting that expectations are “rational.””
That immediately makes me think of Neo-Fisherism. And it is true that there certainly is that tendency in some branches of modern macroeconomics, but I wouldn’t want say that of all modern macroeconomics. And I think it is wrong to put all the blame on rational expectations. I think they just assume it away period, and rational expectations just comes along for the ride. My slogan is: “Nash Equilibria don’t just find themselves”.
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Here’s a simple example of what I have in mind. I call it the Neo-Fisherian Beauty Contest:
Large number of players. Each player tries to pick a number that is 2 times the average number they pick. Neo-Fisherians are confident they will all pick zero, because that is the only Nash Equilibrium to this game.
(If there are sequential moves, in a repeated game, this is pretty much the same game as played by firms that choose prices in a New Keynesian model if the central bank pegs a nominal interest rate.)
The rest of us think it’s far more likely they will all end up chasing plus or minus infinity and refusing to play the game.
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I am a new subscriber to the blog, so I apologize if I have wandered into the wrong conversation. A couple of questions: (1) Was Dennis Robertson basically correct when he wrote, “Once more let us remind ourselves that the only proximate cause of any movement in prices is a decision made by some human being or group of human beings?” (2) Is there any value in macro model building to looking at B-school textbooks like “The Strategy and Tactics of Pricing” to see “at ground level” what real pricing decisions might actually look like? (3) How would we know when the price of a product, say “cheeseburgers,” was an “equilibrium” price? Would the “market” for “cheeseburgers” “clear”? And how would we know that?
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Philip George: Let me say it this way:
If the prices are not all at the Walrasian market-clearing price vector, then there will be excess demand and/or excess supply in some or all markets, and then some agents will be unable to sell or buy as much of each good as they want to sell or buy at those prices, and those constraints on their purchases or sales in one market will spillover and affect their demands or supplies in other markets. The worker who is unable to sell his labour because there is an excess supply of labour, and so demands less consumption goods than he otherwise would at that price and wage, is just one example of this. And Walrasian General Equilibrium theory ignores those spillovers. It only constructs agents ‘notional’ demand and supply functions, based on the counterfactual assumption that they can buy or sell as much as they wish at any price vector.
Is that what you are saying? If so, it is correct. But it’s not new. It’s Patinkin, Clower, Leijonhufvud, Barro-Grossman, Malinvaud, etc disequilibrium macroeconomics. But nearly everyone has forgotten it, except a few old guys like me and David.
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David, have you seen Jason Smith’s Information Transfer framework (http://informationtransfereconomics.blogspot.com/)? It seems like a promising alternative to the sort of analysis that you’re discussing here. Intuitively, I love Jason’s idea of modeling economic actors as essentially random subject to hard constraints. I expect anyone who makes purchase decisions with relatives will find “random” to be a more satisfying characterization than “rational’.
Kenneth Duda
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Kenneth,
Jason may have replaced “rational” with “random”, but what happened to “reality”?
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Henry, in physics, gas molecules are modeled as random. Gas theory results in useful, empirically validated results that help us solve practical problems and build systems that work. Whether gas molecules are random in reality — who knows? Who can say?
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Phillip, I am sorry, but I disagree with just about everything you are saying. A rectangular hyperbola has the property that elasticity is equal to one at every point. It is a special case of the special class of demand curves which have a constant elasticity at every point, so it is a special case of a special case.
Michael, It is relevant, but it seems to me to be too clever by a half, but that is just my reaction after thinking about it for less than 30 seconds.
Nick, I actually did not mean to criticize anything you said substantively — sorry for not making that clear in the post — just the terminology of price stickiness that you were using. I’m not sure I follow your partial defense of rational expectations. It’s not as if we are asking people to guess a single number we are asking them guess an n-dimensional price vector where n is too large to be counted in a single lifetime.
Brian, I can’t think of any reason to disagree with Robertson. I don’t think there’s anything wrong with getting a ground-level view of how pricing decisions are made in the real world, but that’s a different problem from understanding pricing in a general equilibrium model. Clearly, when buyers are not able to buy all they want to and the posted price, the posted price is not an equilibrium price. Similarly if sellers can’t sell all they want to at the posted price, the posted price is not an equilibrium price. So it’s easier to identify a non-equilibrium price than it is to identify an equilibrium price.
Kenneth, Yes, I have seen some of Jason’s work. He occasionally drops by this blog and provides some helpful comments, and it’s always encouraging when I see that he and i have somehow come to similar conclusions on a number of different issues. It took me a long time to figure out what he was talking about, but after a while I began to catch on.
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“…….in physics, gas molecules are modeled as random.”
Kenneth,
All fine as far as gas molecules are concerned.
What has it to do with human behaviour?
Jason’s modelling just seems like another version of neoclassical economics, but married to stochastic processes governed by the Law Of Entropy.
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Nicke Rowe and David Glasner:
What I am saying is that the accusation against Marshallian demand analysis is that the demand for good i is a function of the price of only that good while demands and prices for all other goods remain constant. But what my analysis shows is that even in Marshallian demand analysis the demand for good i affects the prices and demands of all other goods. Why is this? The Marshallian demand curve for an individual for commodity i is drawn under the assumption of constant spending. But spending along a linear demand curve, for instance, varies from point to point. This means that demand and prices in other markets must change along with the price of good i in order to keep spending constant.
So Marshallian demand analysis and “General Equilibrium” theory amount to the same thing. They both make the assumption of constant income. It is no wonder that they both always yield equilibrium in all markets including labour.
The only demand curve that does not affect spending and prices in other markets is the rectangular hyperbola. This means that unlike other demand curves it is applicable whether the overall market is one of constant aggregate demand or not. It is the most general demand curve of all.
What I am saying may sound radical (or even wrong) but I suggest you spend some time thinking about it. The fact that it provides an explanation of involuntary unemployment without having to resort to price stickiness should be incentive enough.
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Do I understand correctly that you are saying economists/economic agents don’t have the ability to know/predict the future?
and that sticky prices are symptom of this lack of clairvoyance?
and that the limits of current intertemporal optimization and the incompleteness of futures markets are specific examples of this inability?
and that there has been a long ongoing discussion by prominent economists on how to deal with this inability?
and that sometimes, and rather ineffectively, some economists have assumed away the inability?
Isn’t the general view that this is an unsolvable ‘problem’, but one which presents at times in the right model and properly understood, as informatively modeled as some form of ‘known’ expectations. and also is an exciting and rather creative inspirational opportunity to propose ideas on how best to live and act in the face of uncertainty (in this case about the future).
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Phillip, You said:
“the accusation against Marshallian demand analysis is that the demand for good i is a function of the price of only that good while demands and prices for all other goods remain constant. But what my analysis shows is that even in Marshallian demand analysis the demand for good i affects the prices and demands of all other goods.”
I’m not sure what you mean. No one ever said that Marshall assumed that the demand for good x is a function only of the price of good x and not the prices of other goods. The assumption of Marshallian partial equilibrium analysis is that the change in the price of good x is a function of the excess demand for good x and that the market for good x is small relative to the rest of the economy so that a change in the price of good x will have approximately zero effect on the demand for other goods. Constant spending is not an axiom, it is an approximation which may or may not be appropriate depending on the circumstances.
Dan, I don’t know what you mean by “ability to predict the future.” If you mean can people form expectations about what will happen in the future, then obviously they can, and they do that all the time. Some people do it better than others. Are their expectations always correct? Obviously not.
I mean that the susceptibility of economic systems to break down which is sometimes attributed to “sticky prices” is not due to “sticky prices” per se, but to the inability of everyone to make plans that are mutually consistent and that can and will all be executed. Sticky prices isn’t the problem; it’s the uncertain environment in which people must make decisions and plans about the future. I agree that the problem is “unsolvable.” My objection is that modern macroeconomics is based on a rational expectations assumption that assumes away the problem
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What I meant by ‘can’t predict the future’ is that people can not form expectations that are either mutually consistent with each other or consistent with the future (when it arrives).
I see your point that people do clearly form expectations, however, I think the issue isn’t merely forming expectations, rather it is important that those expectations have a dubious relationship with that eventual unfolding of events.
I am intrigued by the notion that some individuals are better at forming expectations than others. I’m skeptical, but will give it some thought.
Mainly what I was trying to do was rephrase what you had said in the hope that I would be close to properly understanding your point.
It makes complete sense that this: “the inability of people to form mutually consistent expectations” is a source of instability in an economy.
I find the problem fascinating, I find Rational Expectations, about as exciting as they sound.
Let’s call this: “the inability of people to form mutually consistent expectations” Great Expectations;
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“The assumption of Marshallian partial equilibrium analysis is that the change in the price of good x is a function of the excess demand for good x and that the market for good x is small relative to the rest of the economy so that a change in the price of good x will have approximately zero effect on the demand for other goods.”
David,
That might apply when looking at a microeconomic situation, but were’re not doing that here. Aren’t you postingabout the situation where there is widespread retrenchment in markets – i.e. a recession or a depression.
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David Glasner:
You said: “The assumption of Marshallian partial equilibrium analysis is that the change in the price of good x is a function of the excess demand for good x and that the market for good x is small relative to the rest of the economy so that a change in the price of good x will have approximately zero effect on the demand for other goods.”
But that is exactly what a linear demand graph does not say. Its elasticity varies from infinity at one end to zero at the other. Therefore spending and prices in other markets have to vary accordingly to keep total spending constant. And the same can be said for every other commodity in the market. So the demand for commodity i is not f(p[i]) but f([p1],[p2],…,[pn)) which is exactly the result you get in General Equilibrium.
So Marshallian demand analysis is no less general than General Equilibrium analysis.
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We actually have been doing an experiment with lowering wages to eliminate unemployment starting back in the early 1980s. By the end of the 1970s, the economy was in bad shape and reeling from the high interest rates imposed to get rid of inflation. In the 1980s, unions were eliminated and wages for new workers were lower for the same job slot. Businesses would be closed and reopened with new, lower paid workers. Wages have NOT been sticky. They have been going down.
This process has continued. The original wage cuts were aimed at the low end of the labor force, high school dropouts and high school graduates. By the 1990s it was aimed at college graduates so that today a graduate degree gets one the same pay leverage as a college degree did a few decades ago. Since the financial crisis, wage cuts have been aimed at those making hundreds of thousands of dollars which may be why our national elites are finally starting to notice the economic problem.
As Keynes predicted, this has hurt aggregate demand. To compensate, women entered the workforce wholesale in the 1980s, not to improve living standards, but to maintain them. There was a phase shift in housing around 1980, for example, which went from 600 hours of labor per year to 800 (or more) hours of labor per year. Two incomes were only a stop gap. In the 1990s there was the wealth effect where people spent expected earnings from the rising stock market. In the 2000s there was massive borrowing against expected earnings from rising real estate prices. We have played most of our cards, but aggregate demand is still weak.
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A brief rectification employment theory
Comment on kaleberg on ‘Price Stickiness Is a Symptom not a Cause’
You say: “We actually have been doing an experiment with lowering wages to eliminate unemployment starting back in the early 1980s.” This natural experiment has already happened on a larger scale during the Great Depression. These natural empirical tests amount to a clear REFUTATION of commonplace employment theory.
In order to rectify employment theory, first of all the premises of both Walrasianism and Keynesianism have to be replaced. In methodological terms, what is needed is a paradigm shift.
The new analytical starting point is this: the most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm and is defined by these three OBJECTIVE axioms:
A1. Yw=WL wage income Yw is equal to wage rate W times working hours L,
A2. O=RL output O is equal to productivity R times working hours L,
A3. C=PX consumption expenditure C is equal to price P times quantity bought/sold X.
The investment good sector comes in with the second step. So, what we have with A1 to A3 is the pure consumption economy as the most elementary economic configuration.
From these elementary, objective and absolutely transparent premises follows the BASIC version of the employment equation which is shown on Wikimedia.* From this equation in turn follows: (i) An increase of the expenditure ratio rhoE leads to higher employment (the letter rho stands for ratio). (ii) Increasing investment expenditures I exert a positive influence on employment, (iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment. The complete AND testable employment equation is a bit longer and contains in addition profit distribution, public deficit spending, and import/export.
Items (i) and (ii) cover Keynes’s arguments about the role of aggregate demand. The factor cost ratio rhoF as defined in (iii) embodies the price mechanism which works very different from what is usually assumed. As a matter of fact, overall employment (in the world economy or a closed national economy) INCREASES if the average wage rate W INCREASES relative to average price P and productivity R.
What natural empirical tests and the rectified employment theory UNANIMOUSLY tell us is: Unemployment is never the result of downward sticky wages but of upward sticky wages. Which means that standard economic policy advice has regularly AGGRAVATED depression/unemployment.
Egmont Kakarot-Handtke
* Wikimedia https://commons.wikimedia.org/wiki/File:AXEC62.png
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Ken — in a coincidence, I was just writing up a discussion of (part of) this post. In it, I try to show how one can think about macro equilibrium, micro equilibrium, and trading at disequilibrium prices (with pictures).
http://informationtransfereconomics.blogspot.com/2016/10/thinking-about-equilibrium-and.html
David — when you say “[m]odern macroeconomics solves this problem, in its characteristic fashion, by assuming it away … “, this would be fine if the resulting theory was then useful for describing the data. In fact, in my own crackpot theory, I effectively make a similar assumption (the conclusion of my post at the link above) … but note that it is validated by looking at data.
In a physics analogy, you can assume away air resistance in a ballistics problem if your theory gives you a description that matches the data as well as you want your theory to work. Rational expectations would be fine if they led to a good description of the data. But the weird thing is that rational expectations are supposed to be the unique model-consistent expectations (agents expect the model result) so that if they don’t work, you are left with ‘model-inconsistent’ expectations … which makes no sense.
I end up getting around this by turning the equivalent of “rational expectations” into a bound on the outcome, therefore even failing to meet expectations doesn’t mean your result is inconsistent with the model. Effectively E p(t+1) = p(t+1) becomes E p(t+1) ≥ p(t+1), which would lead to something like a Friedman plucking model.
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This post may be more devastating in its critique of the state of macro today than Romer’s recent paper, The Trouble with Macro.
If I understand you. You’ve just thrown out everything relying on any currently formalized definition of expectations, most directly RE.
What is left?
You advocate for a “system wide approach to macro”.
Details?
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Economics as incantation of nonentities
Comment on Jason Smith
It is long known that economists violate well-defined scientific standards on a daily basis: “In economics we should strive to proceed, wherever we can, exactly according to the standards of the other, more advanced, sciences, where it is not possible, once an issue has been decided, to continue to write about it as if nothing had happened.” (Morgenstern, 1941)
The issue that has been decided is that standard economics is formally and materially inconsistent. Standard economics is built upon this set of foundational propositions, a.k.a. axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub, 1985)
Methodologically, these premises are forever unacceptable. The ultimate reason can be stated as an impossibility theorem: NO way leads from the explanation of individual behavior to the explanation of how the economic system works.
It is pretty obvious that the Walrasian axiom set contains three nonentities: (i) constrained optimization (HC2), (ii) rational expectations (HC4), (iii) equilibrium (HC5).* Every model that contains only one nonentity is A PRIORI false. The discussion of models that contain nonentities is not different from a medieval angels-on-a-pinpoint discussion.
The microfoundations approach has already been dead in the cradle 140 years ago. Joan Robinson’s advice “Scrap the lot and start again” becomes more urgent by the day.
It is NO LONGER possible to apply constrained optimization/rational expectations/equilibrium. Journals that accept papers which contain nonentities violate scientific standards. The issue has been decided and economists better get their heads around it. Romer is right: “There is trouble ahead for ALL of economics.”
Egmont Kakarot-Handtke
* Auxiliary nonentities are for example: utility, expected utility, rationality/bounded rationality/animal spirits, well-behaved production functions, supply/demand functions, simultaneous adaptation, total income=value of output, I=S, real-number quantities/prices, ergodicity.
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«in principle, if workers were willing to accept a large enough cut in their wages, they could all get reemployed»
That’s obviously true if we admit the possibility of a wage of $1 per year, or zero, or workers paying employers for every hour they work and not viceversa; after all if there is a market demand for working in jobs, someone will supply jobs for a suitable rent to people who just want to work.
But there is a fundamental hypocrisy in any discussion about employment: people as a rule don’t want work in itself, they want wages, and work and employment is mostly a means to earn wages.
So discussing in terms of unemployment is mostly unhelpful.
And that was the point opf J Keynes’ rejection of the “so-called” Say’s law: it is not production that creates demand, it is wages that create demand, and demand that in turn creates wages. But while wages create demand quite directly, demand creates wages only indirectly, via the expectations of employers as to future demand, which is uncertain (in JM Keynes’ sense) and thus there can be a massive coordination problem there. Therefore there can be situations in which wages and demand settle at somewhat arbitrary levels.
Employment in terms of hours worked and their distribution among individuals is of course not insignificant but of somewhat secondary importance compared to wages. After in the aggregate wages are flexible: during recession average wages go down a lot, if one averages across employed and unemployed workers. And that is precisely the problem that JM Keynes was trying to illustrate, that what makes recessions persistent is precisely wage flexibility (in the aggregate), not wage rigidity.
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“It is not price stickiness that prevents the system from moving toward equilibrium, it is the fact that individuals are engaging in transactions at disequilibrium prices.”
I think you’re saying that trading at disequilibrium prices means prices are not sticky in the sense that trade does takes place at various non-equilibrium prices.
And I assume that the orthodox theory defines (implies?) price stickiness as equilibrium prices not attained – without directly referencing the attainment of disequilibrium prices.
Your point seems like a good one, but isn’t this also a matter of different logical definitions for price stickiness?
One is the non-attainment of equilibrium prices (orthodox). The other is the attainment of disequilibrium prices (yours).
At the same time, how can the non-attainment of equilibrium prices imply anything other than the attainment of disequilibrium prices? To assume otherwise would be to claim that no trade whatsoever takes place.
It also seems to be the case that economists use the term equilibrium while freely availing themselves of the option of assuming the term implies either full employment or assuming the term does not imply full employment – depending on context. This seems to be a gross abuse of generalization in terminology.
What you say about the relationship between microeconomics and macroeconomics makes good sense.
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I meant:
One is the non-attainment of equilibrium prices (orthodox) i.e. sticky
The other is the attainment of disequilibrium prices, whether or not equilibrium prices are attained (yours) i.e. not sticky
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Hi David, I have recently started following your posts and reading your posts give me intense pleasure. I have a small clarification in this blog though. You mention that
” It is not price stickiness that prevents the system from moving toward equilibrium, it is the fact that individuals are engaging in transactions at disequilibrium prices.”
Later in the blog you also use the term non-equilibrium prices for disequilibrium prices. Does the non-equilibrium prices here mean non-efficient prices? Because if the transactions are taking place at any price level there has to be some kind of equilibrium which exists (may not be an efficient/ full employment one). So technically prices are at equilibrium (with price stickiness) but it is an inefficient one. Since it is difficult to move from this non- efficient equilibrium state to an efficient one automatically (except some god sent exogenous shock hit the economy) the role of policy intervention is required. Please clarify.
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““It is not price stickiness that prevents the system from moving toward equilibrium, it is the fact that individuals are engaging in transactions at disequilibrium prices.””
JKH,
This might be the case, but it doesn’t mean prices are not sticky. I don’t think David is arguing this as such.
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Henry,
“the small changes will keep moving the economy closer and closer to equilibrium, so that the adjustment process will converge. But that is just conjecture, there is no proof showing the conditions under which a simple rule that says raise the price in any market with an excess demand and decrease the price in any market with an excess supply will in fact lead to the convergence of the whole system to equilibrium. Even in a Walrasian tatonnement system, in which no trading at disequilibrium prices is allowed, there is no proof that the adjustment process will eventually lead to the discovery of the equilibrium price vector. If trading at disequilibrium prices is allowed, tatonnement is hopeless. So the real problem is not that prices are sticky but that trading takes place at disequilibrium prices”
that reads to me like prices that are not sticky but just don’t converge to the equilibrium price
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Conversely, if price stickiness is defined simply as the non-attainment of equilibrium prices, then its contradictory to claim that “it is not price stickiness that prevents the system from moving toward equilibrium”.
I’d like to see a clear definition of price stickiness that fits with the thesis here.
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JKH,
Look at the title to this blog. David is saying that price stickiness is a symptom, so there is price stickiness.
With your quotes and the title, it’s a little confusing.
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More than a little confusing.
Expanding on the dynamics of the path of disequilibrium prices and the non-attainment of equilibrium prices is interesting for sure. I think that’s the message of the post. That part is clear. That’s not what’s confusing.
If prices are defined to be sticky in that context (which seems to be the case as the term is still used in the post and its title), then stickiness must be relative to the non-attainment of equilibrium prices.
So in that context, I’m not sure what “symptom but not a cause” is supposed to mean. That assumed definition of price stickiness certainly doesn’t preclude non-equilibrium price activity. Rather it suggests it.
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dan thorn, Some people may be better at forming expectations than others because of a whole variety of circumstances, not only because of some innate superiority, and being better at forming expectations than another person is no guarantee that the predictions of the better predictor are always closer to actual outcomes than those of the inferior predictor. But the key point is just that different people have different expectations of the future, and by ignoring those differences, the rational expectations principle misses something essential to the understanding of economic fluctuations.
Henry, I agree, and I am pointing out the limitations of Marshallian partial equilibrium as a method of analysis for macroeconomics.
Philip, We are obviously not communicating. The linear demand assumption does no. Partial equilibrium analysis has nothing to do with the shape of a demand curve, and it has nothing to do with the number of prices of other products that have to be included in the demand for the given product under discussion. Partial equilibrium analysis is simply saying that the market under consideration is small enough relative to the rest of the economy that the repercussions of the change in the price and quantity can be assumed to be approximately zero, while the assumption that all other markets are in equilibrium allows one to assume that there will be no substantial change in demand and supply conditions caused by the adjustments in other markets.
kaleberg, That’s an interesting reading of the last 40 years, but I have my doubts about whether it is fully consistent with the evidence.
Jason, I don’t see why model inconsistent expectations don’t sense.
Dan, I’m sorry I don’t have details of what a system wide approach to macro would be like. It would require enough heterogeneity among agents and among commodities to make for interesting interactions among agents and markets. But I unfortunately I can’t point to any model that does what I would like to see a macro-model do.
Blissex, I think it is still an open question whether wage flexibility would enhance or worsen macroeconomic stability. And I think the answer would probably depend on conditions specific to the economy in question.
JKH, You are right that it is hard to talk about an operational definition of what constitutes price flexibility or price rigidity, which is another reason why I don’t think the concept is very helpful. You are also right that the multitude of equilibrium concepts, which are not necessarily all logically consistent with one another, is a further recipe for confusion.
Sargam, I don’t think that in principle equilibrium and efficient should be synonymous. There certainly can be equilibria that are not efficient. I am not sure what else I can say to make things clearer for you.
JKH and Henry, The problem with sticky prices is that even if the price in every market with an excess demand rises and the price in every market with an excess supply falls, so that prices are not “sticky” in some operational sense, it is not clear that the process of price adjustment will lead the economy to equilibrium. Making sticky prices more flexible does not necessarily solve the coordination problem. When I say that price stickiness is a symptom, not the problem, I mean it can be a symptom of a disequilibrium not necessarily a cause of disequilibrium. But my title might not have been the most appropriate title for the argument I was trying to make in the post. But it seemed like a catchy phrase that people could latch on to.
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