Archive for the 'sticky prices' Category

Krugman on Mr. Keynes and the Moderns

UPDATE: Re-upping this slightly revised post from July 11, 2011

Paul Krugman recently gave a lecture “Mr. Keynes and the Moderns” (a play on the title of the most influential article ever written about The General Theory, “Mr. Keynes and the Classics,” by another Nobel laureate J. R. Hicks) at a conference in Cambridge, England commemorating the publication of Keynes’s General Theory 75 years ago. Scott Sumner and Nick Rowe, among others, have already commented on his lecture. Coincidentally, in my previous posting, I discussed the views of Sumner and Krugman on the zero-interest lower bound, a topic that figures heavily in Krugman’s discussion of Keynes and his relevance for our current difficulties. (I note in passing that Krugman credits Brad Delong for applying the term “Little Depression” to those difficulties, a term that I thought I had invented, but, oh well, I am happy to share the credit with Brad).

In my earlier posting, I mentioned that Keynes’s, slightly older, colleague A. C. Pigou responded to the zero-interest lower bound in his review of The General Theory. In a way, the response enhanced Pigou’s reputation, attaching his name to one of the most famous “effects” in the history of economics, but it made no dent in the Keynesian Revolution. I also referred to “the layers upon layers of interesting personal and historical dynamics lying beneath the surface of Pigou’s review of Keynes.” One large element of those dynamics was that Keynes chose to make, not Hayek or Robbins, not French devotees of the gold standard, not American laissez-faire ideologues, but Pigou, a left-of-center social reformer, who in the early 1930s had co-authored with Keynes a famous letter advocating increased public-works spending to combat unemployment, the main target of his immense rhetorical powers and polemical invective.  The first paragraph of Pigou’s review reveals just how deeply Keynes’s onslaught had wounded Pigou.

When in 1919, he wrote The Economic Consequences of the Peace, Mr. Keynes did a good day’s work for the world, in helping it back towards sanity. But he did a bad day’s work for himself as an economist. For he discovered then, and his sub-conscious mind has not been able to forget since, that the best way to win attention for one’s own ideas is to present them in a matrix of sarcastic comment upon other people. This method has long been a routine one among political pamphleteers. It is less appropriate, and fortunately less common, in scientific discussion.  Einstein actually did for Physics what Mr. Keynes believes himself to have done for Economics. He developed a far-reaching generalization, under which Newton’s results can be subsumed as a special case. But he did not, in announcing his discovery, insinuate, through carefully barbed sentences, that Newton and those who had hitherto followed his lead were a gang of incompetent bunglers. The example is illustrious: but Mr. Keynes has not followed it. The general tone de haut en bas and the patronage extended to his old master Marshall are particularly to be regretted. It is not by this manner of writing that his desire to convince his fellow economists is best promoted.

Krugman acknowledges Keynes’s shady scholarship (“I know that there’s dispute about whether Keynes was fair in characterizing the classical economists in this way”), only to absolve him of blame. He then uses Keynes’s example to attack “modern economists” who deny that a failure of aggregate demand can cause of mass unemployment, offering up John Cochrane and Niall Ferguson as examples, even though Ferguson is a historian not an economist.

Krugman also addresses Robert Barro’s assertion that Keynes’s explanation for high unemployment was that wages and prices were stuck at levels too high to allow full employment, a problem easily solvable, in Barro’s view, by monetary expansion. Although plainly annoyed by Barro’s attempt to trivialize Keynes’s contribution, Krugman never addresses the point squarely, preferring instead to justify Keynes’s frustration with those (conveniently nameless) “classical economists.”

Keynes’s critique of the classical economists was that they had failed to grasp how everything changes when you allow for the fact that output may be demand-constrained.

Not so, as I pointed out in my first post. Frederick Lavington, an even more orthodox disciple than Pigou of Marshall, had no trouble understanding that “the inactivity of all is the cause of the inactivity of each.” It was Keynes who failed to see that the failure of demand was equally a failure of supply.

They mistook accounting identities for causal relationships, believing in particular that because spending must equal income, supply creates its own demand and desired savings are automatically invested.

Supply does create its own demand when economic agents succeed in executing their plans to supply; it is when, owing to their incorrect and inconsistent expectations about future prices, economic agents fail to execute their plans to supply, that both supply and demand start to contract. Lavington understood that; Pigou understood that. Keynes understood it, too, but believing that his new way of understanding how contractions are caused was superior to that of his predecessors, he felt justified in misrepresenting their views, and attributing to them a caricature of Say’s Law that they would never have taken seriously.

And to praise Keynes for understanding the difference between accounting identities and causal relationships that befuddled his predecessors is almost perverse, as Keynes’s notorious confusion about whether the equality of savings and investment is an equilibrium condition or an accounting identity was pointed out by Dennis Robertson, Ralph Hawtrey and Gottfried Haberler within a year after The General Theory was published. To quote Robertson:

(Mr. Keynes’s critics) have merely maintained that he has so framed his definition that Amount Saved and Amount Invested are identical; that it therefore makes no sense even to inquire what the force is which “ensures equality” between them; and that since the identity holds whether money income is constant or changing, and, if it is changing, whether real income is changing proportionately, or not at all, this way of putting things does not seem to be a very suitable instrument for the analysis of economic change.

It just so happens that in 1925, Keynes, in one of his greatest pieces of sustained, and almost crushing sarcasm, The Economic Consequences of Mr. Churchill, offered an explanation of high unemployment exactly the same as that attributed to Keynes by Barro. Churchill’s decision to restore the convertibility of sterling to gold at the prewar parity meant that a further deflation of at least 10 percent in wages and prices would be necessary to restore equilibrium.  Keynes felt that the human cost of that deflation would be intolerable, and held Churchill responsible for it.

Of course Keynes in 1925 was not yet the Keynes of The General Theory. But what historical facts of the 10 years following Britain’s restoration of the gold standard in 1925 at the prewar parity cannot be explained with the theoretical resources available in 1925? The deflation that began in England in 1925 had been predicted by Keynes. The even worse deflation that began in 1929 had been predicted by Ralph Hawtrey and Gustav Cassel soon after World War I ended, if a way could not be found to limit the demand for gold by countries, rejoining the gold standard in aftermath of the war. The United States, holding 40 percent of the world’s monetary gold reserves, might have accommodated that demand by allowing some of its reserves to be exported. But obsession with breaking a supposed stock-market bubble in 1928-29 led the Fed to tighten its policy even as the international demand for gold was increasing rapidly, as Germany, France and many other countries went back on the gold standard, producing the international credit crisis and deflation of 1929-31. Recovery came not from Keynesian policies, but from abandoning the gold standard, thereby eliminating the deflationary pressure implicit in a rapidly rising demand for gold with a more or less fixed total supply.

Keynesian stories about liquidity traps and Monetarist stories about bank failures are epiphenomena obscuring rather than illuminating the true picture of what was happening.  The story of the Little Depression is similar in many ways, except the source of monetary tightness was not the gold standard, but a monetary regime that focused attention on rising price inflation in 2008 when the appropriate indicator, wage inflation, had already started to decline.

Price Stickiness Is a Symptom not a Cause

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.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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