Uneasy Money

At the end of my post a couple of days ago, I observed that the last two sentences of the footnote that I reproduced from Alchian’s “Information Costs, Pricing, and Resource Unemployment,” required a lot of unpacking. So let’s come back to it and try to figure out what Alchian meant. The point of the footnote was to say that Keynes’s opaque definition of involuntary unemployment rested on a distinction between the information conveyed to workers by an increase in the price level, their money wage held constant, and the information conveyed to them by a reduction in their money wage, with the price level held constant. An increase in the price level with constant money wages conveys no information to workers about any change in their alternatives. Employed workers are not induced by an increase in prices to quit their current jobs in the expectation of finding higher paying jobs, and unemployed workers are not induced to refuse an offer from a prospective employer, as they would be if the employer cut the money wages at which he was willing pay his current employees or to hire new ones. That subtle difference in the information conveyed by a cut in real wages effected by rising prices versus the information conveyed by a cut in real wages effected by a cut in money wages, Alchian explained, is the reason that Keynes made his definition of involuntary unemployment contingent on the differing responses of workers to a reduced real wage resulting from a rising price level and from a falling money wage.

Here is where the plot thickens, because Alchian adds the following comment.

And this is perfectly consistent with Keynes’s definition of [involuntary] unemployment, and it is also consistent with his entire theory of market adjustment processes . . . , since he believed wages lagged behind nonwage prices – an unproved and probably false belief (R. A. Kessel and A. A. Alchian, “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices,” Amer. Econ. Rev. 50 [March 1960]:43-66). Without this belief a general price-level rise is indeed general; it includes wages, and as such there is no reason to believe a price-level rise is equivalent in real terms to a money-wage cut in a particular job.

So, according to Alchian, Keynes’s assumption that the information extracted by workers from a price-level increase is not the same as the information extracted from a nominal wage cut depends on the existence of a lag in the adjustment of wages to an inflationary disturbance. Keynes believed that during periods of inflation, output prices rise before, and rise faster than, wages rise, at least in the early stages of inflation. But if prices and wages rise simultaneously and at the same rate during inflation, then there would be no basis for workers to draw different inferences about their employment opportunities from observing price increases as opposed to observing a nominal wage cut. Alchian believes that the assumption that there is a wage-lag during inflation is both theoretically problematic, and empirically suspect, relying on several important papers that he co-authored with Reuben Kessel that found little support for the existence of such a lag in the historical data on wages and prices.

I have two problems with Alchian’s caveat about the existence of a wage-price lag.

First, Alchian’s premise (with which I agree totally) in the article from which I am quoting is that lack of information about the characteristics of goods being sold and about the characteristics of sellers or buyers (when the transaction involves a continuing relationship between the transactors) and about the prices and characteristics of alternatives induces costly search activities, the holding of inventories, and even rationing or queuing, as alternatives to immediate price adjustments as a response to fluctuations in demand or supply. The speed of price adjustment is thus an economically determined phenomenon, the speed depending on, among other things, the particular characteristics of the good or service being sold and the ease of collecting information about the good and service. For example, highly standardized commodities about which information is readily available tend to have more rapidly adjusting prices than those of idiosyncratic goods and services requiring intensive information gathering by transactors before they can come to terms on a transaction. If employment transactions typically involve a more intensive information gathering process about the characteristics of workers and employers than most other goods and services, then Alchian’s own argument suggests that there should be a lag in wage adjustment relative to the prices of most other goods. An inflation, on Alchian’s reasoning, ought to induce an initial response in the prices of the more standardized commodities with price adjustments in less standardized, more informationally complex, markets, like labor markets, coming later. So I don’t understand Alchian’s theoretical basis for questioning the existence of a wage lag.

Second, my memory is a bit hazy, and I will need to check his article on the wage lag, but I do believe that Alchian pointed out that there is a problem of interpretation in evaluating evidence on the wage lag, because inflation may occur concurrently, but independently, with another change that reduces the demand for labor and causes the real wage to fall. So if one starts, as did Keynes in his discussion of involuntary unemployment, from the premise that a recession is associated with a fall in the real demand for labor that requires a reduction in the real wage to restore full employment, then it is not clear to me why it would be rational for a worker to increase his reservation wage immediately upon observing that output prices are increasing. Workers will typically have some expectation about how rapidly the wage at which they can find employment will rise; this expectation is clearly related to their expectation of how fast prices will rise. If workers observe that prices are rising faster than they expected prices to rise, while their wage is not rising any faster than expected, there is uncertainty about whether their wage opportunities in general have fallen or whether the wage from their current employer has fallen relative to other opportunities. Saturos, in a comment on Tuesday’s post, argued that the two scenarios are indeed symmetrical and that to suggest otherwise is indeed an instance of money illusion. The argument is well taken, but I think that at least in transitional situations (when it seems to me theory supports the existence of a wage lag) and in which workers have some evidence of deteriorating macroeconomic conditions, there is a basis, independent of money illusion, for the Keynesian distinction about the informational content of a real wage cut resulting from a price level increase versus a real wage cut resulting from a cut in money wages.  But I am not sure that this is the last word on the subject.

In my previous post, I reproduced a footnote from Armen Alchian’s classic article “Information Costs, Pricing and Resource Unemployment,” a footnote explaining the theoretical basis for Keynes’s somewhat tortured definition of involuntary unemployment. In this post, I offer another excerpt from Alchian’s article, elaborating on the microeconomic rationale for “slow” adjustments in wages. In an upcoming post, I will try to tie some threads together and discuss the issue of whether there might be, contrary to Alchian’s belief, a theoretical basis for wages to lag behind other prices, ata least during the initial stages of inflation. Herewith are the first four paragraphs of section II (Labor Markets) of Alchian’s paper.

Though most analyses of unemployment rely on wage conventions, restriction, and controls to retard wage adjustments above market-clearing levels, [J. R.] Hicks and [W. H.] Hutt penetrated deeper. Hicks suggested a solution consistent with conventional exchange theory. He stated that “knowledge of opportunities is imperfect” and that the time required to obtain that knowledge leads to unemployment and a delayed effect on wages. [fn. J. R. Hicks, The Theory of Wages, 2d ed. (London, 1963), 45, 58. And headed another type – “the unemployment of the man who gives up his job to look for a better.”] It is precisely this enhanced significance that this paper seeks to develop, and which Hicks ignored when he immediately turned to different factors – unions and wage regulations, placing major blame on both for England’s heavy unemployment in the 1920s and 30s.

We digress to note that Keynes, in using a quantity-, instead of a price-, adjustment theory of exchange, merely postulated a “slow” reacting price without showing that slow price responses were consistent with utility or wealth-maximizing behavior in open, unconstrained markets. Keynes’s analysis was altered in the subsequent income-expenditure models where reliance was placed on “conventional” or “noncompetitive” wage rates. Modern “income-expenditure” theorists assumed “institutionally” or “irrationally” inflexible wages resulting from unions, money illusions, regulations, or factors allegedly idiosyncratic to labor. Keynes did not assume inflexibility for only wages. His theory rested on a more general scope of price inflexibility. [fn. For a thorough exposition and justification of these remarks on Keynes, see A. Leijonhufvud, On Keynesian Economics and the Economics of Keynes (Oxford, 1968).] The present paper may in part be viewed as an attempt to “justify” Keynes’s presumption about price response to disturbances in demand.

In 1939 W. H. Hutt exposed many of the fallacious interpretations of idleness and unemployment. Hutt applied the analysis suggested by Hicks but later ignored it when discussing Keynes’s analysis of involuntary unemployment and policies to alleviate it. [fn. W. H. Hutt, The Theory of Idle Resources (London, 1939), 165-69.] This is unfortunate, because Hutt’s analysis seems to be capable of explaining and accounting for a substantial portion of that unemployment.

If we follow the lead of Hicks and Hutt and develop the implications of “frictional” unemployment for both human and nonhuman goods, we can perceive conditions that will imply massive “frictional” unemployment and depressions in open, unrestricted, competitive markets with rational, utility maximizing, individual behavior.

So Alchian is telling us that it is at least possible to conceive of conditions in which massive unemployment and depressions are consistent with “open, unrestricted, competitive markets with rational, utility maximizing, individual behavior.” And presumably would be more going on in such periods of massive unemployment than the efficient substitution of leisure for work in periods of relatively low marginal labor productivity.