Archive for the 'wage stickiness' Category

Lucas and Sargent on Optimization and Equilibrium in Macroeconomics

Published July 31, 2022 Abraham Wald , Arrow-Debrew-McKenzie model , Franklin Fisher , general equilibrium , intertemporal equilibrium , Kenneth Arrow , Lucas Critique , macroeconomics , microfoundations , New Classical macroeconomics , Robert Lucas , Sonnenschein-Mantel-Debreu theorem , tatonnement , Thomas Sargent , Uncategorized , wage stickiness 3 Comments

In a famous contribution to a conference sponsored by the Federal Reserve Bank of Boston, Robert Lucas and Thomas Sargent (1978) harshly attacked Keynes and Keynesian macroeconomics for shortcomings both theoretical and econometric. The econometric criticisms, drawing on the famous Lucas Critique (Lucas 1976), were focused on technical identification issues and on the dependence of estimated regression coefficients of econometric models on agents’ expectations conditional on the macroeconomic policies actually in effect, rendering those econometric models an unreliable basis for policymaking. But Lucas and Sargent reserved their harshest criticism for abandoning what they called the classical postulates.

Economists prior to the 1930s did not recognize a need for a special branch of economics, with its own special postulates, designed to explain the business cycle. Keynes founded that subdiscipline, called macroeconomics, because he thought that it was impossible to explain the characteristics of business cycles within the discipline imposed by classical economic theory, a discipline imposed by its insistence on . . . two postulates (a) that markets . . . clear, and (b) that agents . . . act in their own self-interest [optimize]. The outstanding fact that seemed impossible to reconcile with these two postulates was the length and severity of business depressions and the large scale unemployment which they entailed. . . . After freeing himself of the straight-jacket (or discipline) imposed by the classical postulates, Keynes described a model in which rules of thumb, such as the consumption function and liquidity preference schedule, took the place of decision functions that a classical economist would insist be derived from the theory of choice. And rather than require that wages and prices be determined by the postulate that markets clear — which for the labor market seemed patently contradicted by the severity of business depressions — Keynes took as an unexamined postulate that money wages are “sticky,” meaning that they are set at a level or by a process that could be taken as uninfluenced by the macroeconomic forces he proposed to analyze[1]. . . .

In recent years, the meaning of the term “equilibrium” has undergone such dramatic development that a theorist of the 1930s would not recognize it. It is now routine to describe an economy following a multivariate stochastic process as being “in equilibrium,” by which is meant nothing more than that at each point in time, postulates (a) and (b) above are satisfied. This development, which stemmed mainly from work by K. J. Arrow and G. Debreu, implies that simply to look at any economic time series and conclude that it is a “disequilibrium phenomenon” is a meaningless observation. Indeed, a more likely conjecture, on the basis of recent work by Hugo Sonnenschein, is that the general hypothesis that a collection of time series describes an economy in competitive equilibrium is without content. (pp. 58-59)

Lucas and Sargent maintain that ‘classical” (by which they obviously mean “neoclassical”) economics is based on the twin postulates of (a) market clearing and (b) optimization. But optimization is a postulate about individual conduct or decision making under ideal conditions in which individuals can choose costlessly among alternatives that they can rank. Market clearing is not a postulate about individuals, it is the outcome of a process that neoclassical theory did not, and has not, described in any detail.

Instead of describing the process by which markets clear, neoclassical economic theory provides a set of not too realistic stories about how markets might clear, of which the two best-known stories are the Walrasian auctioneer/tâtonnement story, widely regarded as merely heuristic, if not fantastical, and the clearly heuristic and not-well-developed Marshallian partial-equilibrium story of a “long-run” equilibrium price for each good correctly anticipated by market participants corresponding to the long-run cost of production. However, the cost of production on which the Marhsallian long-run equilibrium price depends itself presumes that a general equilibrium of all other input and output prices has been reached, so it is not an alternative to, but must be subsumed under, the Walrasian general equilibrium paradigm.

Thus, in invoking the neoclassical postulates of market-clearing and optimization, Lucas and Sargent unwittingly, or perhaps wittingly, begged the question how market clearing, which requires that the plans of individual optimizing agents to buy and sell reconciled in such a way that each agent can carry out his/her/their plan as intended, comes about. Rather than explain how market clearing is achieved, they simply assert – and rather loudly – that we must postulate that market clearing is achieved, and thereby submit to the virtuous discipline of equilibrium.

Because they could provide neither empirical evidence that equilibrium is continuously achieved nor a plausible explanation of the process whereby it might, or could be, achieved, Lucas and Sargent try to normalize their insistence that equilibrium is an obligatory postulate that must be accepted by economists by calling it “routine to describe an economy following a multivariate stochastic process as being ‘in equilibrium,’ by which is meant nothing more than that at each point in time, postulates (a) and (b) above are satisfied,” as if the routine adoption of any theoretical or methodological assumption becomes ipso facto justified once adopted routinely. That justification was unacceptable to Lucas and Sargent when made on behalf of “sticky wages” or Keynesian “rules of thumb, but somehow became compelling when invoked on behalf of perpetual “equilibrium” and neoclassical discipline.

Using the authority of Arrow and Debreu to support the normalcy of the assumption that equilibrium is a necessary and continuous property of reality, Lucas and Sargent maintained that it is “meaningless” to conclude that any economic time series is a disequilibrium phenomenon. A proposition ismeaningless if and only if neither the proposition nor its negation is true. So, in effect, Lucas and Sargent are asserting that it is nonsensical to say that an economic time either reflects or does not reflect an equilibrium, but that it is, nevertheless, methodologically obligatory to for any economic model to make that nonsensical assumption.

It is curious that, in making such an outlandish claim, Lucas and Sargent would seek to invoke the authority of Arrow and Debreu. Leave aside the fact that Arrow (1959) himself identified the lack of a theory of disequilibrium pricing as an explanatory gap in neoclassical general-equilibrium theory. But if equilibrium is a necessary and continuous property of reality, why did Arrow and Debreu, not to mention Wald and McKenzie, devoted so much time and prodigious intellectual effort to proving that an equilibrium solution to a system of equations exists. If, as Lucas and Sargent assert (nonsensically), it makes no sense to entertain the possibility that an economy is, or could be, in a disequilibrium state, why did Wald, Arrow, Debreu and McKenzie bother to prove that the only possible state of the world actually exists?

Having invoked the authority of Arrow and Debreu, Lucas and Sargent next invoke the seminal contribution of Sonnenschein (1973), though without mentioning the similar and almost simultaneous contributions of Mantel (1974) and Debreu (1974), to argue that it is empirically empty to argue that any collection of economic time series is either in equilibrium or out of equilibrium. This property has subsequently been described as an “Anything Goes Theorem” (Mas-Colell, Whinston, and Green, 1995).

Presumably, Lucas and Sargent believe the empirically empty hypothesis that a collection of economic time series is, or, alternatively is not, in equilibrium is an argument supporting the methodological imperative of maintaining the assumption that the economy absolutely and necessarily is in a continuous state of equilibrium. But what Sonnenschein (and Mantel and Debreu) showed was that even if the excess demands of all individual agents are continuous, are homogeneous of degree zero, and even if Walras’s Law is satisfied, aggregating the excess demands of all agents would not necessarily cause the aggregate excess demand functions to behave in such a way that a unique or a stable equilibrium. But if we have no good argument to explain why a unique or at least a stable neoclassical general-economic equilibrium exists, on what methodological ground is it possible to insist that no deviation from the admittedly empirically empty and meaningless postulate of necessary and continuous equilibrium may be tolerated by conscientious economic theorists? Or that the gatekeepers of reputable neoclassical economics must enforce appropriate standards of professional practice?

As Franklin Fisher (1989) showed, inability to prove that there is a stable equilibrium leaves neoclassical economics unmoored, because the bread and butter of neoclassical price theory (microeconomics), comparative statics exercises, is conditional on the assumption that there is at least one stable general equilibrium solution for a competitive economy.

But it’s not correct to say that general equilibrium theory in its Arrow-Debreu-McKenzie version is empirically empty. Indeed, it has some very strong implications. There is no money, no banks, no stock market, and no missing markets; there is no advertising, no unsold inventories, no search, no private information, and no price discrimination. There are no surprises and there are no regrets, no mistakes and no learning. I could go on, but you get the idea. As a theory of reality, the ADM general-equilibrium model is simply preposterous. And, yet, this is the model of economic reality on the basis of which Lucas and Sargent proposed to build a useful and relevant theory of macroeconomic fluctuations. OMG!

Lucas, in various writings, has actually disclaimed any interest in providing an explanation of reality, insisting that his only aim is to devise mathematical models capable of accounting for the observed values of the relevant time series of macroeconomic variables. In Lucas’s conception of science, the only criterion for scientific knowledge is the capacity of a theory – an algorithm for generating numerical values to be measured against observed time series – to generate predicted values approximating the observed values of the time series. The only constraint on the algorithm is Lucas’s methodological preference that the algorithm be derived from what he conceives to be an acceptable microfounded version of neoclassical theory: a set of predictions corresponding to the solution of a dynamic optimization problem for a “representative agent.”

In advancing his conception of the role of science, Lucas has reverted to the approach of ancient astronomers who, for methodological reasons of their own, believed that the celestial bodies revolved around the earth in circular orbits. To ensure that their predictions matched the time series of the observed celestial positions of the planets, ancient astronomers, following Ptolemy, relied on epicycles or second-order circular movements of planets while traversing their circular orbits around the earth to account for their observed motions.

Kepler and later Galileo conceived of the solar system in a radically different way from the ancients, placing the sun, not the earth, at the fixed center of the solar system and proposing that the orbits of the planets were elliptical, not circular. For a long time, however, the actual time series of geocentric predictions outperformed the new heliocentric predictions. But even before the heliocentric predictions started to outperform the geocentric predictions, the greater simplicity and greater realism of the heliocentric theory attracted an increasing number of followers, forcing methodological supporters of the geocentric theory to take active measures to suppress the heliocentric theory.

I hold no particular attachment to the pre-Lucasian versions of macroeconomic theory, whether Keynesian, Monetarist, or heterodox. Macroeconomic theory required a grounding in an explicit intertemporal setting that had been lacking in most earlier theories. But the ruthless enforcement, based on a preposterous methodological imperative, lacking scientific or philosophical justification, of formal intertemporal optimization models as the only acceptable form of macroeconomic theorizing has sidetracked macroeconomics from a more relevant inquiry into the nature and causes of intertemporal coordination failures that Keynes, along with many some of his predecessors and contemporaries, had initiated.

Just as the dispute about whether planetary motion is geocentric or heliocentric was a dispute about what the world is like, not just about the capacity of models to generate accurate predictions of time series variables, current macroeconomic disputes are real disputes about what the world is like and whether aggregate economic fluctuations are the result of optimizing equilibrium choices by economic agents or about coordination failures that cause economic agents to be surprised and disappointed and rendered unable to carry out their plans in the manner in which they had hoped and expected to be able to do. It’s long past time for this dispute about reality to be joined openly with the seriousness that it deserves, instead of being suppressed by a spurious pseudo-scientific methodology.

HT: Arash Molavi Vasséi, Brian Albrecht, and Chris Edmonds

[1] Lucas and Sargent are guilty of at least two misrepresentations in this paragraph. First, Keynes did not “found” macroeconomics, though he certainly influenced its development decisively. Keynes used the term “macroeconomics,” and his work, though crucial, explicitly drew upon earlier work by Marshall, Wicksell, Fisher, Pigou, Hawtrey, and Robertson, among others. See Laidler (1999). Second, having explicitly denied and argued at length that his results did not depend on the assumption of sticky wages, Keynes certainly never introduced the assumption of sticky wages himself. See Leijonhufvud (1968)

Price Stickiness Is a Symptom not a Cause

Published September 28, 2016 Alfred Marshall , expectations , Franco Modigliani , general equilibrium , incomplete markets , Keynes , rational expectations , sticky prices , sticky wages , temporary equilibrium , wage stickiness 37 Comments
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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.

Hicks on IS-LM and Temporary Equilibrium

Published October 14, 2014 expectations , general equilibrium , intertemporal equilibrium , IS-LM , J. R. Hicks , Keynes , temporary equilibrium , wage stickiness , Walrasian equilibrium 9 Comments
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Jan, commenting on my recent post about Krugman, Minsky and IS-LM, quoted the penultimate paragraph of J. R. Hicks’s 1980 paper on IS-LM in the Journal of Post-Keynesian Economics, a brand of economics not particularly sympathetic to Hicks’s invention. Hicks explained that in the mid-1930s he had been thinking along lines similar to Keynes’s even before the General Theory was published, and had the basic idea of IS-LM in his mind even before he had read the General Theory, while also acknowledging that his enthusiasm for the IS-LM construct had waned considerably over the years.

Hicks discussed both the similarities and the differences between his model and IS-LM. But as the discussion proceeds, it becomes clear that what he is thinking of as his model is what became his model of temporary equilibrium in Value and Capital. So it really is important to understand what Hicks felt were the similarities as well as the key differences between the temporary- equilibrium model, and the IS-LM model. Here is how Hicks put it:

I recognized immediately, as soon as I read The General Theory, that my model and Keynes’ had some things in common. Both of us fixed our attention on the behavior of an economy during a period—a period that had a past, which nothing that was done during the period could alter, and a future, which during the period was unknown. Expectations of the future would nevertheless affect what happened during the period. Neither of us made any assumption about “rational expectations” ; expectations, in our models, were strictly exogenous.3 (Keynes made much more fuss over that than I did, but there is the same implication in my model also.) Subject to these data— the given equipment carried over from the past, the production possibilities within the period, the preference schedules, and the given expectations— the actual performance of the economy within the period was supposed to be determined, or determinable. It would be determined as an equilibrium performance, with respect to these data.

There was all this in common between my model and Keynes’; it was enough to make me recognize, as soon as I saw The General Theory, that his model was a relation of mine and, as such, one which I could warmly welcome. There were, however, two differences, on which (as we shall see) much depends. The more obvious difference was that mine was a flexprice model, a perfect competition model, in which all prices were flexible, while in Keynes’ the level of money wages (at least) was exogenously determined. So Keynes’ was a model that was consistent with unemployment, while mine, in his terms, was a full employment model. I shall have much to say about this difference, but I may as well note, at the start, that I do not think it matters much. I did not think, even in 1936, that it mattered much. IS-LM was in fact a translation of Keynes’ nonflexprice model into my terms. It seemed to me already that that could be done; but how it is done requires explanation.

The other difference is more fundamental; it concerns the length of the period. Keynes’ (he said) was a “short-period,” a term with connotations derived from Marshall; we shall not go far wrong if we think of it as a year. Mine was an “ultra-short-period” ; I called it a week. Much more can happen in a year than in a week; Keynes has to allow for quite a lot of things to happen. I wanted to avoid so much happening, so that my (flexprice) markets could reflect propensities (and expectations) as they are at a moment. So it was that I made my markets open only on a Monday; what actually happened during the ensuing week was not to affect them. This was a very artificial device, not (I would think now) much to be recommended. But the point of it was to exclude the things which might happen, and must disturb the markets, during a period of finite length; and this, as we shall see, is a very real trouble in Keynes. (pp. 139-40)

Hicks then explained how the specific idea of the IS-LM model came to him as a result of working on a three-good Walrasian system in which the solution could be described in terms of equilibrium in two markets, the third market necessarily being in equilibrium if the other two were in equilibrium. That’s an interesting historical tidbit, but the point that I want to discuss is what I think is Hicks’s failure to fully understand the significance of his own model, whose importance, regrettably, he consistently underestimated in later work (e.g., in Capital and Growth and in this paper).

The point that I want to focus on is in the second paragraph quoted above where Hicks says “mine [i.e. temporary equilibrium] was a flexprice model, a perfect competition model, in which all prices were flexible, while in Keynes’ the level of money wages (at least) was exogenously determined. So Keynes’ was a model that was consistent with unemployment, while mine, in his terms, was a full employment model.” This, it seems to me, is all wrong, because Hicks, is taking a very naïve and misguided view of what perfect competition and flexible prices mean. Those terms are often mistakenly assumed to meant that if prices are simply allowed to adjust freely, all  markets will clear and all resources will be utilized.

I think that is a total misconception, and the significance of the temporary-equilibrium construct is in helping us understand why an economy can operate sub-optimally with idle resources even when there is perfect competition and markets “clear.” What prevents optimality and allows resources to remain idle despite freely adjustming prices and perfect competition is that the expectations held by agents are not consistent. If expectations are not consistent, the plans based on those expectations are not consistent. If plans are not consistent, then how can one expect resources to be used optimally or even at all? Thus, for Hicks to assert, casually without explicit qualification, that his temporary-equilibrium model was a full-employment model, indicates to me that Hicks was unaware of the deeper significance of his own model.

If we take a full equilibrium as our benchmark, and look at how one of the markets in that full equilibrium clears, we can imagine the equilibrium as the intersection of a supply curve and a demand curve, whose positions in the standard price/quantity space depend on the price expectations of suppliers and of demanders. Different, i.e, inconsistent, price expectations would imply shifts in both the demand and supply curves from those corresponding to full intertemporal equilibrium. Overall, the price expectations consistent with a full intertemporal equilibrium will in some sense maximize total output and employment, so when price expectations are inconsistent with full intertemporal equilibrium, the shifts of the demand and supply curves will be such that they will intersect at points corresponding to less output and less employment than would have been the case in full intertemporal equilibrium. In fact, it is possible to imagine that expectations on the supply side and the demand side are so inconsistent that the point of intersection between the demand and supply curves corresponds to an output (and hence employment) that is way less than it would have been in full intertemporal equilibrium. The problem is not that the price in the market doesn’t allow the market to clear. Rather, given the positions of the demand and supply curves, their point of intersection implies a low output, because inconsistent price expectations are such that potentially advantageous trading opportunities are not being recognized.

So for Hicks to assert that his flexprice temporary-equilibrium model was (in Keynes’s terms) a full-employment model without noting the possibility of a significant contraction of output (and employment) in a perfectly competitive flexprice temporary-equilibrium model when there are significant inconsistencies in expectations suggests strongly that Hicks somehow did not fully comprehend what his own creation was all about. His failure to comprehend his own model also explains why he felt the need to abandon the flexprice temporary-equilibrium model in his later work for a fixprice model.

There is, of course, a lot more to be said about all this, and Hicks’s comments concerning the choice of a length of the period are also of interest, but the clear (or so it seems to me) misunderstanding by Hicks of what is entailed by a flexprice temporary equilibrium is an important point to recognize in evaluating both Hicks’s work and his commentary on that work and its relation to Keynes.

Explaining the Hegemony of New Classical Economics

Published September 30, 2014 Keynes , microfoundations , New Classicals , New Keynesians , rational expectations , wage stickiness 16 Comments
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Simon Wren-Lewis, Robert Waldmann, and Paul Krugman have all recently devoted additional space to explaining – ruefully, for the most part – how it came about that New Classical Economics took over mainstream macroeconomics just about half a century after the Keynesian Revolution. And Mark Thoma got them all started by a complaint about the sorry state of modern macroeconomics and its failure to prevent or to cure the Little Depression.

Wren-Lewis believes that the main problem with modern macro is too much of a good thing, the good thing being microfoundations. Those microfoundations, in Wren-Lewis’s rendering, filled certain gaps in the ad hoc Keynesian expenditure functions. Although the gaps were not as serious as the New Classical School believed, adding an explicit model of intertemporal expenditure plans derived from optimization conditions and rational expectations, was, in Wren-Lewis’s estimation, an improvement on the old Keynesian theory. The improvements could have been easily assimilated into the old Keynesian theory, but weren’t because New Classicals wanted to junk, not improve, the received Keynesian theory.

Wren-Lewis believes that it is actually possible for the progeny of Keynes and the progeny of Fisher to coexist harmoniously, and despite his discomfort with the anti-Keynesian bias of modern macroeconomics, he views the current macroeconomic research program as progressive. By progressive, I interpret him to mean that macroeconomics is still generating new theoretical problems to investigate, and that attempts to solve those problems are producing a stream of interesting and useful publications – interesting and useful, that is, to other economists doing macroeconomic research. Whether the problems and their solutions are useful to anyone else is perhaps not quite so clear. But even if interest in modern macroeconomics is largely confined to practitioners of modern macroeconomics, that fact alone would not conclusively show that the research program in which they are engaged is not progressive, the progressiveness of the research program requiring no more than a sufficient number of self-selecting econ grad students, and a willingness of university departments and sources of research funding to cater to the idiosyncratic tastes of modern macroeconomists.

Robert Waldmann, unsurprisingly, takes a rather less charitable view of modern macroeconomics, focusing on its failure to discover any new, previously unknown, empirical facts about macroeconomic, or to better explain known facts than do alternative models, e.g., by more accurately predicting observed macro time-series data. By that, admittedly, demanding criterion, Waldmann finds nothing progressive in the modern macroeconomics research program.

Paul Krugman weighed in by emphasizing not only the ideological agenda behind the New Classical Revolution, but the self-interest of those involved:

Well, while the explicit message of such manifestos is intellectual – this is the only valid way to do macroeconomics – there’s also an implicit message: from now on, only my students and disciples will get jobs at good schools and publish in major journals/ And that, to an important extent, is exactly what happened; Ken Rogoff wrote about the “scars of not being able to publish stick-price papers during the years of new classical repression.” As time went on and members of the clique made up an ever-growing share of senior faculty and journal editors, the clique’s dominance became self-perpetuating – and impervious to intellectual failure.

I don’t disagree that there has been intellectual repression, and that this has made professional advancement difficult for those who don’t subscribe to the reigning macroeconomic orthodoxy, but I think that the story is more complicated than Krugman suggests. The reason I say that is because I cannot believe that the top-ranking economics departments at schools like MIT, Harvard, UC Berkeley, Princeton, and Penn, and other supposed bastions of saltwater thinking have bought into the underlying New Classical ideology. Nevertheless, microfounded DSGE models have become de rigueur for any serious academic macroeconomic theorizing, not only in the Journal of Political Economy (Chicago), but in the Quarterly Journal of Economics (Harvard), the Review of Economics and Statistics (MIT), and the American Economic Review. New Keynesians, like Simon Wren-Lewis, have made their peace with the new order, and old Keynesians have been relegated to the periphery, unable to publish in the journals that matter without observing the generally accepted (even by those who don’t subscribe to New Classical ideology) conventions of proper macroeconomic discourse.

So I don’t think that Krugman’s ideology plus self-interest story fully explains how the New Classical hegemony was achieved. What I think is missing from his story is the spurious methodological requirement of microfoundations foisted on macroeconomists in the course of the 1970s. I have discussed microfoundations in a number of earlier posts (here, here, here, here, and here) so I will try, possibly in vain, not to repeat myself too much.

The importance and desirability of microfoundations were never questioned. What, after all, was the neoclassical synthesis, if not an attempt, partly successful and partly unsuccessful, to integrate monetary theory with value theory, or macroeconomics with microeconomics? But in the early 1970s the focus of attempts, notably in the 1970 Phelps volume, to provide microfoundations changed from embedding the Keynesian system in a general-equilibrium framework, as Patinkin had done, to providing an explicit microeconomic rationale for the Keynesian idea that the labor market could not be cleared via wage adjustments.

In chapter 19 of the General Theory, Keynes struggled to come up with a convincing general explanation for the failure of nominal-wage reductions to clear the labor market. Instead, he offered an assortment of seemingly ad hoc arguments about why nominal-wage adjustments would not succeed in reducing unemployment, enabling all workers willing to work at the prevailing wage to find employment at that wage. This forced Keynesians into the awkward position of relying on an argument — wages tend to be sticky, especially in the downward direction — that was not really different from one used by the “Classical Economists” excoriated by Keynes to explain high unemployment: that rigidities in the price system – often politically imposed rigidities – prevented wage and price adjustments from equilibrating demand with supply in the textbook fashion.

These early attempts at providing microfoundations were largely exercises in applied price theory, explaining why self-interested behavior by rational workers and employers lacking perfect information about all potential jobs and all potential workers would not result in immediate price adjustments that would enable all workers to find employment at a uniform market-clearing wage. Although these largely search-theoretic models led to a more sophisticated and nuanced understanding of labor-market dynamics than economists had previously had, the models ultimately did not provide a fully satisfactory account of cyclical unemployment. But the goal of microfoundations was to explain a certain set of phenomena in the labor market that had not been seriously investigated, in the hope that price and wage stickiness could be analyzed as an economic phenomenon rather than being arbitrarily introduced into models as an ad hoc, albeit seemingly plausible, assumption.

But instead of pursuing microfoundations as an explanatory strategy, the New Classicals chose to impose it as a methodological prerequisite. A macroeconomic model was inadmissible unless it could be explicitly and formally derived from the optimizing choices of fully rational agents. Instead of trying to enrich and potentially transform the Keynesian model with a deeper analysis and understanding of the incentives and constraints under which workers and employers make decisions, the New Classicals used microfoundations as a methodological tool by which to delegitimize Keynesian models, those models being insufficiently or improperly microfounded. Instead of using microfoundations as a method by which to make macroeconomic models conform more closely to the imperfect and limited informational resources available to actual employers deciding to hire or fire employees, and actual workers deciding to accept or reject employment opportunities, the New Classicals chose to use microfoundations as a methodological justification for the extreme unrealism of the rational-expectations assumption, portraying it as nothing more than the consistent application of the rationality postulate underlying standard neoclassical price theory.

For the New Classicals, microfoundations became a reductionist crusade. There is only one kind of economics, and it is not macroeconomics. Even the idea that there could be a conceptual distinction between micro and macroeconomics was unacceptable to Robert Lucas, just as the idea that there is, or could be, a mind not reducible to the brain is unacceptable to some deranged neuroscientists. No science, not even chemistry, has been reduced to physics. Were it ever to be accomplished, the reduction of chemistry to physics would be a great scientific achievement. Some parts of chemistry have been reduced to physics, which is a good thing, especially when doing so actually enhances our understanding of the chemical process and results in an improved, or more exact, restatement of the relevant chemical laws. But it would be absurd and preposterous simply to reject, on supposed methodological principle, those parts of chemistry that have not been reduced to physics. And how much more absurd would it be to reject higher-level sciences, like biology and ecology, for no other reason than that they have not been reduced to physics.

But reductionism is what modern macroeconomics, under the New Classical hegemony, insists on. No exceptions allowed; don’t even ask. Meekly and unreflectively, modern macroeconomics has succumbed to the absurd and arrogant methodological authoritarianism of the New Classical Revolution. What an embarrassment.

UPDATE (11:43 AM EDST): I made some minor editorial revisions to eliminate some grammatical errors and misplaced or superfluous words.

Why Are Wages Sticky?

Published February 6, 2014 efficiency wages , implicit contracts , involuntary unemployment , Keynes , search theories , Truman Bewley , wage stickiness 46 Comments
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The stickiness of wages seems to be one of the key stylized facts of economics. For some reason, the idea that sticky wages may be the key to explaining business-cycle downturns in which output and employment– not just prices and nominal incomes — fall is now widely supposed to have been a, if not the, major theoretical contribution of Keynes in the General Theory. The association between sticky wages and Keynes is a rather startling, and altogether unfounded, inversion of what Keynes actually wrote in the General Theory, heaping scorn on what he called the “classical” doctrine that cyclical (or in Keynesian terminology “involuntary”) unemployment could be attributed to the failure of nominal wages to fall in response to a reduction in aggregate demand. Keynes never stopped insisting that the key defining characteristic of “involuntary” unemployment is that a nominal-wage reduction would not reduce “involuntary” unemployment. The very definition of involuntary unemployment is that it can only be eliminated by an increase in the price level, but not by a reduction in nominal wages.

Keynes devoted three entire chapters (19-21) in the General Theory to making, and mathematically proving, that argument. Insofar as I understand it, his argument doesn’t seem to me to be entirely convincing, because, among other reasons, his reasoning seems to involve implicit comparative-statics exercises that start from a disequlibrium situation, but that is definitely a topic for another post. My point is simply that the sticky-wages explanation for unemployment was exactly the “classical” explanation that Keynes was railing against in the General Theory.

So it’s really quite astonishing — and amusing — to observe that, in the current upside-down world of modern macroeconomics, what differentiates New Classical from New Keynesian macroeconomists is that macroecoomists of the New Classical variety, dismissing wage stickiness as non-existent or empirically unimportant, assume that cyclical fluctuations in employment result from high rates of intertemporal substitution by labor in response to fluctuations in labor productivity, while macroeconomists of the New Keynesian variety argue that it is nominal-wage stickiness that prevents the steep cuts in nominal wages required to maintain employment in the face of exogenous shocks in aggregate demand or supply. New Classical and New Keynesian indeed! David Laidler and Axel Leijonhufvud have both remarked on this role reversal.

Many possible causes of nominal-wage stickiness (especially in the downward direction) have been advanced. For most of the twentieth century, wage stickiness was blamed on various forms of government intervention, e.g., pro-union legislation conferring monopoly privileges on unions, as well as other forms of wage-fixing like minimum-wage laws and even unemployment insurance. Whatever the merits of these criticisms, it is hard to credit claims that wage stickiness is mainly attributable to labor-market intervention on the side of labor unions. First, the phenomenon of wage stickiness was noted and remarked upon by economists as long ago as the early nineteenth century (e.g., Henry Thornton in his classic The Nature and Effects of the Paper Credit of Great Britain) long before the enactment of pro-union legislation. Second, the repeal or weakening of pro-union legislation since the 1980s does not seem to have been associated with any significant reduction in nominal-wage stickiness.

Since the 1970s, a number of more sophisticated explanations of wage stickiness have been advanced, for example search theories coupled with incorrect price-level expectations, long-term labor contracts, implicit contracts, and efficiency wages. Search theories locate the cause of wage nominal stickiness in workers’ decisions about what wage offers to accept. Thus, the apparent downward stickiness of wages in a recession seems to imply that workers are turning down offers of employment or quitting their jobs in the mistaken expectation that search will uncover better offers, but that doesn’t seem to be what happens in recessions, when quits decline and layoffs increase. Long-term contracts can and frequently are renegotiated when conditions change. Implicit contracts also can be adjusted when conditions change. So insofar as these theories posit that workers are somehow making decisions that lead to their unemployment, the story seems to be incomplete. If workers could be made better off by accepting reduced wages instead of being unemployed, why isn’t it happening?

Efficiency wages posit a different cause for wage stickiness: that employers have cleverly discovered that by overpaying workers, workers will work their backsides off to continue to be considered worthy of receiving the rents that their employers are conferring upon them. Thus, when a recession hits, employers use the opportunity to weed out their least deserving employees. This theory at least has the virtue of not assigning responsibility for sub-optimal decisions to the workers.

All of these theories were powerfully challenged about eleven or twelve years ago by Truman Bewley in a book Why Wages Don’t Fall During a Recession. (See also Peter Howitt’s excellent review of Bewely’s book in the Journal of Economic Literature.) Bewley, though an accomplished theorist, simply went out and interviewed lots of business people, asking them to explain why they didn’t cut wages to their employees in recessions rather than lay off workers. Overwhelmingly, the responses Bewley received did not correspond to any of the standard theories of wage-stickiness. Instead, business people explained wage stickiness as necessary to avoid a collapse of morale among their employees. Layoffs also hurt morale, but the workers that are retained get over it, and those let go are no longer around to hurt the morale of those that stay.

While I have always preferred the search explanation for apparent wage stickiness, which was largely developed at UCLA in the 1960s (see Armen Alchian’s classic “Information costs, Pricing, and Resource Unemployment”), I recognize that it doesn’t seem to account for the basic facts of the cyclical pattern of layoffs and quits. So I think that it is clear that wage stickiness remains a problematic phenomenon. I don’t claim to have a good explanation to offer, but it does seem to me that an important element of an explanation may have been left out so far — at least I can’t recall having seen it mentioned.

Let’s think about it in the following way. Consider the incentive to cut price of a firm that can’t sell as much as it wants at the current price. The firm is off its supply curve. The firm is a price taker in the sense that, if it charges a higher price than its competitors, it won’t sell anything, losing all its sales to competitors. Would the firm have any incentive to cut its price? Presumably, yes. But let’s think about that incentive. Suppose the firm has a maximum output capacity of one unit, and can produce either zero or one units in any time period. Suppose that demand has gone down, so that the firm is not sure if it will be able to sell the unit of output that it produces (assume also that the firm only produces if it has an order in hand). Would such a firm have an incentive to cut price? Only if it felt that, by doing so, it would increase the probability of getting an order sufficiently to compensate for the reduced profit margin at the lower price. Of course, the firm does not want to set a price higher than its competitors, so it will set a price no higher than the price that it expects its competitors to set.

Now consider a different sort of firm, a firm that can easily expand its output. Faced with the prospect of losing its current sales, this type of firm, unlike the first type, could offer to sell an increased amount at a reduced price. How could it sell an increased amount when demand is falling? By undercutting its competitors. A firm willing to cut its price could, by taking share away from its competitors, actually expand its output despite overall falling demand. That is the essence of competitive rivalry. Obviously, not every firm could succeed in such a strategy, but some firms, presumably those with a cost advantage, or a willingness to accept a reduced profit margin, could expand, thereby forcing marginal firms out of the market.

Workers seem to me to have the characteristics of type-one firms, while most actual businesses seem to resemble type-two firms. So what I am suggesting is that the inability of workers to take over the jobs of co-workers (the analog of output expansion by a firm) when faced with the prospect of a layoff means that a powerful incentive operating in non-labor markets for price cutting in response to reduced demand is not present in labor markets. A firm faced with the prospect of being terminated by a customer whose demand for the firm’s product has fallen may offer significant concessions to retain the customer’s business, especially if it can, in the process, gain an increased share of the customer’s business. A worker facing the prospect of a layoff cannot offer his employer a similar deal. And requiring a workforce of many workers, the employer cannot generally avoid the morale-damaging effects of a wage cut on his workforce by replacing current workers with another set of workers at a lower wage than the old workers were getting. So the point that I am suggesting seems to dovetail with morale-preserving explanation for wage-stickiness offered by Bewley.

If I am correct, then the incentive for price cutting is greater in markets for most goods and services than in markets for labor employment. This was Henry Thornton’s observation over two centuries ago when he wrote that it was a well-known fact that wages are more resistant than other prices to downward pressure in periods of weak demand. And if that is true, then it suggests that real wages tend to fluctuate countercyclically, which seems to be a stylized fact of business cycles, though whether that is indeed a fact remains controversial.

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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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