Archive for the 'sticky wages' Category

More on Sticky Wages

It’s been over four and a half years since I wrote my second most popular post on this blog (“Why are Wages Sticky?”). Although the post was linked to and discussed by Paul Krugman (which is almost always a guarantee of getting a lot of traffic) and by other econoblogosphere standbys like Mark Thoma and Barry Ritholz, unlike most of my other popular posts, it has continued ever since to attract a steady stream of readers. It’s the posts that keep attracting readers long after their original expiration date that I am generally most proud of.

I made a few preliminary points about wage stickiness before getting to my point. First, although Keynes is often supposed to have used sticky wages as the basis for his claim that market forces, unaided by stimulus to aggregate demand, cannot automatically eliminate cyclical unemployment within the short or even medium term, he actually devoted a lot of effort and space in the General Theory to arguing that nominal wage reductions would not increase employment, and to criticizing economists who blamed unemployment on nominal wages fixed by collective bargaining at levels too high to allow all workers to be employed. So, the idea that wage stickiness is a Keynesian explanation for unemployment doesn’t seem to me to be historically accurate.

I also discussed the search theories of unemployment that in some ways have improved our understanding of why some level of unemployment is a normal phenomenon even when people are able to find jobs fairly easily and why search and unemployment can actually be productive, enabling workers and employers to improve the matches between the skills and aptitudes that workers have and the skills and aptitudes that employers are looking for. But search theories also have trouble accounting for some basic facts about unemployment.

First, a lot of job search takes place when workers have jobs while search theories assume that workers can’t or don’t search while they are employed. Second, when unemployment rises in recessions, it’s not because workers mistakenly expect more favorable wage offers than employers are offering and mistakenly turn down job offers that they later regret not having accepted, which is a very skewed way of interpreting what happens in recessions; it’s because workers are laid off by employers who are cutting back output and idling production lines.

I then suggested the following alternative explanation for wage stickiness:

Consider the incentive to cut price of a firm that can’t sell as much as it wants [to sell] 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.

I think that what I wrote four years ago is clearly right, identifying an important reason for wage stickiness. But there’s also another reason that I didn’t mention then, but whose importance has since come to appear increasingly significant to me, especially as a result of writing and rewriting my paper “Hayek, Hicks, Radner and three concepts of intertemporal equilibrium.”

If you are unemployed because the demand for your employer’s product has gone down, and your employer, planning to reduce output, is laying off workers no longer needed, how could you, as an individual worker, unconstrained by a union collective-bargaining agreement or by a minimum-wage law, persuade your employer not to lay you off? Could you really keep your job by offering to accept a wage cut — no matter how big? If you are being laid off because your employer is reducing output, would your offer to work at a lower wage cause your employer to keep output unchanged, despite a reduction in demand? If not, how would your offer to take a pay cut help you keep your job? Unless enough workers are willing to accept a big enough wage cut for your employer to find it profitable to maintain current output instead of cutting output, how would your own willingness to accept a wage cut enable you to keep your job?

Now, if all workers were to accept a sufficiently large wage cut, it might make sense for an employer not to carry out a planned reduction in output, but the offer by any single worker to accept a wage cut certainly would not cause the employer to change its output plans. So, if you are making an independent decision whether to offer to accept a wage cut, and other workers are making their own independent decisions about whether to accept a wage cut, would it be rational for you or any of them to accept a wage cut? Whether it would or wouldn’t might depend on what each worker was expecting other workers to do. But certainly given the expectation that other workers are not offering to accept a wage cut, why would it make any sense for any worker to be the one to offer to accept a wage cut? Would offering to accept a wage cut, increase the likelihood that a worker would be one of the lucky ones chosen not to be laid off? Why would offering to accept a wage cut that no one else was offering to accept, make the worker willing to work for less appear more desirable to the employer than the others that wouldn’t accept a wage cut? One reaction by the employer might be: what’s this guy’s problem?

Combining this way of looking at the incentives workers have to offer to accept wage reductions to keep their jobs with my argument in my post of four years ago, I now am inclined to suggest that unemployment as such provides very little incentive for workers and employers to cut wages. Price cutting in periods of excess supply is often driven by aggressive price cutting by suppliers with large unsold inventories. There may be lots of unemployment, but no one is holding a large stock of unemployed workers, and no is in a position to offer low wages to undercut the position of those currently employed at  nominal wages that, arguably, are too high.

That’s not how labor markets operate. Labor markets involve matching individual workers and individual employers more or less one at a time. If nominal wages fall, it’s not because of an overhang of unsold labor flooding the market; it’s because something is changing the expectations of workers and employers about what wage will be offered by employers, and accepted by workers, for a particular kind of work. If the expected wage is too high, not all workers willing to work at that wage will find employment; if it’s too low, employers will not be able to find as many workers as they would like to hire, but the situation will not change until wage expectations change. And the reason that wage expectations change is not because the excess demand for workers causes any immediate pressure for nominal wages to rise.

The further point I would make is that the optimal responses of workers and the optimal responses of their employers to a recessionary reduction in demand, in which the employers, given current input and output prices, are planning to cut output and lay off workers, are mutually interdependent. While it is, I suppose, theoretically possible that if enough workers decided to immediately offer to accept sufficiently large wage cuts, some employers might forego plans to lay off their workers, there are no obvious market signals that would lead to such a response, because such a response would be contingent on a level of coordination between workers and employers and a convergence of expectations about future outcomes that is almost unimaginable.

One can’t simply assume that it is in the independent self-interest of every worker to accept a wage cut as soon as an employer perceives a reduced demand for its product, making the current level of output unprofitable. But unless all, or enough, workers decide to accept a wage cut, the optimal response of the employer is still likely to be to cut output and lay off workers. There is no automatic mechanism by which the market adjusts to demand shocks to achieve the set of mutually consistent optimal decisions that characterizes a full-employment market-clearing equilibrium. Market-clearing equilibrium requires not merely isolated price and wage cuts by individual suppliers of inputs and final outputs, but a convergence of expectations about the prices of inputs and outputs that will be consistent with market clearing. And there is no market mechanism that achieves that convergence of expectations.

So, this brings me back to Keynes and the idea of sticky wages as the key to explaining cyclical fluctuations in output and employment. Keynes writes at the beginning of chapter 19 of the General Theory.

For the classical theory has been accustomed to rest the supposedly self-adjusting character of the economic system on an assumed fluidity of money-wages; and, when there is rigidity, to lay on this rigidity the blame of maladjustment.

A reduction in money-wages is quite capable in certain circumstances of affording a stimulus to output, as the classical theory supposes. My difference from this theory is primarily a difference of analysis. . . .

The generally accept explanation is . . . quite a simple one. It does not depend on roundabout repercussions, such as we shall discuss below. The argument simply is that a reduction in money wages will, cet. par. Stimulate demand by diminishing the price of the finished product, and will therefore increase output, and will therefore increase output and employment up to the point where  the reduction which labour has agreed to accept in its money wages is just offset by the diminishing marginal efficiency of labour as output . . . is increased. . . .

It is from this type of analysis that I fundamentally differ.

[T]his way of thinking is probably reached as follows. In any given industry we have a demand schedule for the product relating the quantities which can be sold to the prices asked; we have a series of supply schedules relating the prices which will be asked for the sale of different quantities. .  . and these schedules between them lead up to a further schedule which, on the assumption that other costs are unchanged . . . gives us the demand schedule for labour in the industry relating the quantity of employment to different levels of wages . . . This conception is then transferred . . . to industry as a whole; and it is supposed, by a parity of reasoning, that we have a demand schedule for labour in industry as a whole relating the quantity of employment to different levels of wages. It is held that it makes no material difference to this argument whether it is in terms of money-wages or of real wages. If we are thinking of real wages, we must, of course, correct for changes in the value of money; but this leaves the general tendency of the argument unchanged, since prices certainly do not change in exact proportion to changes in money wages.

If this is the groundwork of the argument . . ., surely it is fallacious. For the demand schedules for particular industries can only be constructed on some fixed assumption as to the nature of the demand and supply schedules of other industries and as to the amount of aggregate effective demand. It is invalid, therefore, to transfer the argument to industry as a whole unless we also transfer our assumption that the aggregate effective demand is fixed. Yet this assumption amount to an ignoratio elenchi. For whilst no one would wish to deny the proposition that a reduction in money-wages accompanied by the same aggregate demand as before will be associated with an increase in employment, the precise question at issue is whether the reduction in money wages will or will not be accompanied by the same aggregate effective demand as before measured in money, or, at any rate, measured by an aggregate effective demand which is not reduced in full proportion to the reduction in money-wages. . . But if the classical theory is not allowed to extend by analogy its conclusions in respect of a particular industry to industry as a whole, it is wholly unable to answer the question what effect on employment a reduction in money-wages will have. For it has no method of analysis wherewith to tackle the problem. (General Theory, pp. 257-60)

Keynes’s criticism here is entirely correct. But I would restate slightly differently. Standard microeconomic reasoning about preferences, demand, cost and supply is partial-equilbriium analysis. The focus is on how equilibrium in a single market is achieved by the adjustment of the price in a single market to equate the amount demanded in that market with amount supplied in that market.

Supply and demand is a wonderful analytical tool that can illuminate and clarify many economic problems, providing the key to important empirical insights and knowledge. But supply-demand analysis explicitly – but too often without realizing its limiting implications – assumes that other prices and incomes in other markets are held constant. That assumption essentially means that the market – i.e., the demand, cost and supply curves used to represent the behavioral characteristics of the market being analyzed – is small relative to the rest of the economy, so that changes in that single market can be assumed to have a de minimus effect on the equilibrium of all other markets. (The conditions under which such an assumption could be justified are themselves not unproblematic, but I am now assuming that those problems can in fact be assumed away at least in many applications. And a good empirical economist will have a good instinctual sense for when it’s OK to make the assumption and when it’s not OK to make the assumption.)

So, the underlying assumption of microeconomics is that the individual markets under analysis are very small relative to the whole economy. Why? Because if those markets are not small, we can’t assume that the demand curves, cost curves, and supply curves end up where they started. Because a high price in one market may have effects on other markets and those effects will have further repercussions that move the very demand, cost and supply curves that were drawn to represent the market of interest. If the curves themselves are unstable, the ability to predict the final outcome is greatly impaired if not completely compromised.

The working assumption of the bread and butter partial-equilibrium analysis that constitutes econ 101 is that markets have closed borders. And that assumption is not always valid. If markets have open borders so that there is a lot of spillover between and across markets, the markets can only be analyzed in terms of broader systems of simultaneous equations, not the simplified solutions that we like to draw in two-dimensional space corresponding to intersections of stable supply curves with stable supply curves.

What Keynes was saying is that it makes no sense to draw a curve representing the demand of an entire economy for labor or a curve representing the supply of labor of an entire economy, because the underlying assumption of such curves that all other prices are constant cannot possibly be satisfied when you are drawing a demand curve and a supply curve for an input that generates more than half the income earned in an economy.

But the problem is even deeper than just the inability to draw a curve that meaningfully represents the demand of an entire economy for labor. The assumption that you can model a transition from one point on the curve to another point on the curve is simply untenable, because not only is the assumption that other variables are being held constant untenable and self-contradictory, the underlying assumption that you are starting from an equilibrium state is never satisfied when you are trying to analyze a situation of unemployment – at least if you have enough sense not to assume that economy is starting from, and is not always in, a state of general equilibrium.

So, Keynes was certainly correct to reject the naïve transfer of partial equilibrium theorizing from its legitimate field of applicability in analyzing the effects of small parameter changes on outcomes in individual markets – what later came to be known as comparative statics – to macroeconomic theorizing about economy-wide disturbances in which the assumptions underlying the comparative-statics analysis used in microeconomics are clearly not satisfied. That illegitimate transfer of one kind of theorizing to another has come to be known as the demand for microfoundations in macroeconomic models that is the foundational methodological principle of modern macroeconomics.

The principle, as I have been arguing for some time, is illegitimate for a variety of reasons. And one of those reasons is that microeconomics itself is based on the macroeconomic foundational assumption of a pre-existing general equilibrium, in which all plans in the entire economy are, and will remain, perfectly coordinated throughout the analysis of a particular parameter change in a single market. Once you relax the assumption that all, but one, markets are in equilibrium, the discipline imposed by the assumption of the rationality of general equilibrium and comparative statics is shattered, and a different kind of theorizing must be adopted to replace it.

The search for that different kind of theorizing is the challenge that has always faced macroeconomics. Despite heroic attempts to avoid facing that challenge and pretend that macroeconomics can be built as if it were microeconomics, the search for a different kind of theorizing will continue; it must continue. But it would certainly help if more smart and creative people would join in that search.

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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.

What Does “Keynesian” Mean?

Last week Simon Wren-Lewis wrote a really interesting post on his blog trying to find the right labels with which to identify macroeconomists. Simon, rather disarmingly, starts by admitting the ultimate futility of assigning people labels; reality is just too complicated to conform to the labels that we invent to help ourselves make sense of reality. A good label can provide us with a handle with which to gain a better grasp on a messy set of observations, but it is not the reality. And if you come up with one label, I may counter with a different one. Who’s to say which label is better?

At any rate, as I read through Simon’s post I found myself alternately nodding my head in agreement and shaking my head in disagreement. So staying in the spirit of fun in which Simon wrote his post, I will provide a commentary on his labels and other pronouncements. If the comments are weighted on the side of disagreement, well, that’s what makes blogging fun, n’est-ce pas?

Simon divides academic researchers into two groups (mainstream and heterodox) and macroeconomic policy into two approaches (Keynesian and anti-Keynesian). He then offers the following comment on the meaning of the label Keynesian.

Just think about the label Keynesian. Any sensible definition would involve the words sticky prices and aggregate demand. Yet there are still some economists (generally not academics) who think Keynesian means believing fiscal rather than monetary policy should be used to stabilise demand. Fifty years ago maybe, but no longer. Even worse are non-economists who think being a Keynesian means believing in market imperfections, government intervention in general and a mixed economy. (If you do not believe this happens, look at the definition in Wikipedia.)

Well, as I pointed out in a recent post, there is nothing peculiarly Keynesian about the assumption of sticky prices, especially not as a necessary condition for an output gap and involuntary unemployment. So if Simon is going to have to work harder to justify his distinction between Keynesian and anti-Keynesian. In a comment on Simon’s blog, Nick Rowe pointed out just this problem, asking in particular why Simon could not substitute a Monetarist/anti-Monetarist dichotomy for the Keynesian/anti-Keynesian one.

The story gets more complicated in Simon’s next paragraph in which he describes his dichotomy of academic research into mainstream and heterodox.

Thanks to the microfoundations revolution in macro, mainstream macroeconomists speak the same language. I can go to a seminar that involves an RBC model with flexible prices and no involuntary unemployment and still contribute and possibly learn something. Equally an economist like John Cochrane can and does engage in meaningful discussions of New Keynesian theory (pdf).

In other words, the range of acceptable macroeconomic models has been drastically narrowed. Unless it is microfounded in a dynamic stochastic general equilibrium model, a model does not qualify as “mainstream.” This notion of microfoundation is certainly not what Edmund Phelps meant by “microeconomic foundations” when he edited his famous volume Microeconomic Foundations of Employment and Inflation Theory, which contained, among others, Alchian’s classic paper on search costs and unemployment and a paper by the then not so well-known Robert Lucas and his early collaborator Leonard Rapping. Nevertheless, in the current consensus, it is apparently the New Classicals that determine what kind of model is acceptable, while New Keynesians are allowed to make whatever adjustments, mainly sticky wages, they need to derive Keynesian policy recommendations. Anyone who doesn’t go along with this bargain is excluded from the mainstream. Simon may not be happy with this state of affairs, but he seems to have made peace with it without undue discomfort.

Now many mainstream macroeconomists, myself included, can be pretty critical of the limitations that this programme can place on economic thinking, particularly if it is taken too literally by microfoundations purists. But like it or not, that is how most macro research is done nowadays in the mainstream, and I see no sign of this changing anytime soon. (Paul Krugman discusses some reasons why here.) My own view is that I would like to see more tolerance and a greater variety of modelling approaches, but a pragmatic microfoundations macro will and should remain the major academic research paradigm.

Thus, within the mainstream, there is no basic difference in how to create a macroeconomic model. The difference is just in how to tweak the model in order to derive the desired policy implication.

When it comes to macroeconomic policy, and keeping to the different language idea, the only significant division I see is between the mainstream macro practiced by most economists, including those in most central banks, and anti-Keynesians. By anti-Keynesian I mean those who deny the potential for aggregate demand to influence output and unemployment in the short term.

So, even though New Keynesians have learned how to speak the language of New Classicals, New Keynesians can console themselves in retaining the upper hand in policy discussions. Which is why in policy terms, Simon chooses a label that is at least suggestive of a certain Keynesian primacy, the other side being defined in terms of their opposition to Keynesian policy. Half apologetically, Simon then asks: “Why do I use the term anti-Keynesian rather than, say, New Classical?” After all, it’s the New Classical model that’s being tweaked. Simon responds:

Partly because New Keynesian economics essentially just augments New Classical macroeconomics with sticky prices. But also because as far as I can see what holds anti-Keynesians together isn’t some coherent and realistic view of the world, but instead a dislike of what taking aggregate demand seriously implies.

This explanation really annoyed Steve Williamson who commented on Simon’s blog as follows:

Part of what defines a Keynesian (new or old), is that a Keynesian thinks that his or her views are “mainstream,” and that the rest of macroeconomic thought is defined relative to what Keynesians think – Keynesians reside at the center of the universe, and everything else revolves around them.

Simon goes on to explain what he means by the incoherence of the anti-Keynesian view of the world, pointing out that the Pigou Effect, which supposedly invalidated Keynes’s argument that perfect wage and price flexibility would not eventually restore full employment to an economy operating at less than full employment, has itself been shown not to be valid. And then Simon invokes that old standby Say’s Law.

Second, the evidence that prices are not flexible is so overwhelming that you need something else to drive you to ignore this evidence. Or to put it another way, you need something pretty strong for politicians or economists to make the ‘schoolboy error’ that is Says Law, which is why I think the basis of the anti-Keynesian view is essentially ideological.

Here, I think, Simon is missing something important. It was a mistake on Keynes’s part to focus on Say’s Law as the epitome of everything wrong with “classical economics.” Actually Say’s Law is a description of what happens in an economy when trading takes place at disequilibrium prices. At disequilibrium prices, potential gains from trade are left on the table. Not only are they left on the table, but the effects can be cumulative, because the failure to supply implies a further failure to demand. The Keynesian spending multiplier is the other side of the coin of the supply-side contraction envisioned by Say. Even infinite wage and price flexibility may not help an economy in which a lot of trade is occurring at disequilibrium prices.

The microeconomic theory of price adjustment is a theory of price adjustment in a single market. It is a theory in which, implicitly, all prices and quantities, but a single price-quantity pair are in equilibrium. Equilibrium in that single market is rapidly restored by price and quantity adjustment in that single market. That is why I have said that microeconomics rests on a macroeconomic foundation, and that is why it is illusory to imagine that macroeconomics can be logically derived from microfoundations. Microfoundations, insofar as they explain how prices adjust, are themselves founded on the existence of a macroeconomic equilibrium. Founding macroeconomics on microfoundations is just a form of bootstrapping.

If there is widespread unemployment, it may indeed be that wages are too high, and that a reduction in wages would restore equilibrium. But there is no general presumption that unemployment will be cured by a reduction in wages. Unemployment may be the result of a more general dysfunction in which all prices are away from their equilibrium levels, in which case no adjustment of the wage would solve the problem, so that there is no presumption that the current wage exceeds the full-equilibrium wage. This, by the way, seems to me to be nothing more than a straightforward implication of the Lipsey-Lancaster theory of second best.

Paul Krugman and Roger Farmer on Sticky Wages

I was pleasantly surprised last Friday to see that Paul Krugman took favorable notice of my post about sticky wages, but also registering some disagreement.

[Glasner] is partially right in suggesting that there has been a bit of a role reversal regarding the role of sticky wages in recessions: Keynes asserted that wage flexibility would not help, but Keynes’s self-proclaimed heirs ended up putting downward nominal wage rigidity at the core of their analysis. By the way, this didn’t start with the New Keynesians; way back in the 1940s Franco Modigliani had already taught us to think that everything depended on M/w, the ratio of the money supply to the wage rate.

That said, wage stickiness plays a bigger role in The General Theory — and in modern discussions that are consistent with what Keynes said — than Glasner indicates.

To document his assertion about Keynes, Krugman quotes a passage from the General Theory in which Keynes seems to suggest that in the nineteenth century inflexible wages were partially compensated for by price level movements. One might quibble with Krugman’s interpretation, but the payoff doesn’t seem worth the effort.

But I will quibble with the next paragraph in Krugman’s post.

But there’s another point: even if you don’t think wage flexibility would help in our current situation (and like Keynes, I think it wouldn’t), Keynesians still need a sticky-wage story to make the facts consistent with involuntary unemployment. For if wages were flexible, an excess supply of labor should be reflected in ever-falling wages. If you want to say that we have lots of willing workers unable to find jobs — as opposed to moochers not really seeking work because they’re cradled in Paul Ryan’s hammock — you have to have a story about why wages aren’t falling.

Not that I really disagree with Krugman that the behavior of wages since the 2008 downturn is consistent with some stickiness in wages. Nevertheless, it is still not necessarily the case that, if wages were flexible, an excess supply of labor would lead to ever-falling wages. In a search model of unemployment, if workers are expecting wages to rise every year at a 3% rate, and instead wages rise at only a 1% rate, the model predicts that unemployment will rise, and will continue to rise (or at least not return to the natural rate) as long as observed wages did not increase as fast as workers were expecting wages to rise. Presumably over time, wage expectations would adjust to a new lower rate of increase, but there is no guarantee that the transition would be speedy.

Krugman concludes:

So sticky wages are an important part of both old and new Keynesian analysis, not because wage cuts would help us, but simply to make sense of what we see.

My own view is actually a bit more guarded. I think that “sticky wages” is simply a name that we apply to a problematic phenomenon for ehich we still haven’t found a really satisfactory explanation for. Search models, for all their theoretical elegance, simply can’t explain the observed process by which unemployment rises during recessions, i.e., by layoffs and a lack of job openings rather than an increase in quits and refused offers, as search models imply. The suggestion in my earlier post was intended to offer a possible basis of understanding what the phrase “sticky wages” is actually describing.

Roger Farmer, a long-time and renowned UCLA economist, also commented on my post on his new blog. Welcome to the blogosphere, Roger.

Roger has a different take on the sticky-wage phenomenon. Roger argues, as did some of the commenters to my post, that wages are not sticky. To document this assertion, Roger presents a diagram showing that the decline of nominal wages closely tracked that of prices for the first six years of the Great Depression. From this evidence Roger concludes that nominal wage rigidity is not the cause of rising unemployment during the Great Depression, and presumably, not the cause of rising unemployment in the Little Depression.

farmer_sticky_wagesInstead, Roger argues, the rise in unemployment was caused by an outbreak of self-fulfilling pessimism. Roger believes that there are many alternative equilibria and which equilibrium (actually equilibrium time path) we reach depends on what our expectations are. Roger also believes that our expectations are rational, so that we get what we expect, as he succinctly phrases it “beliefs are fundamental.” I have a lot of sympathy for this way of looking at the economy. In fact one of the early posts on this blog was entitled “Expectations are Fundamental.” But as I have explained in other posts, I am not so sure that expectations are rational in any useful sense, because I think that individual expectations diverge. I don’t think that there is a single way of looking at reality. If there are many potential equilibria, why should everyone expect the same equilibrium. I can be an optimist, and you can be a pessimist. If we agreed, we would be right, but if we disagree, we will both be wrong. What economic mechanism is there to reconcile our expectations? In a world in which expectations diverge — a world of temporary equilibrium — there can be cumulative output reductions that get propagated across the economy as each sector fails to produce its maximum potential output, thereby reducing the demand for the output of other sectors to which it is linked. That’s what happens when there is trading at prices that don’t correspond to the full optimum equilibrium solution.

So I agree with Roger in part, but I think that the coordination problem is (at least potentially) more serious than he imagines.


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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