Transmogrification of truth in economics textbooks

18 June, 2012 at 21:52 | Posted in Economics | 7 Comments

Among intermediate neoclassical macroeconomics textbooks, Chad Jones textbook Macroeconomics (2nd ed, W W Norton, 2011) stands out as perhaps one of the better alternatives, by combining more traditional short-run macroeconomic analysis with an accessible coverage of the Romer model – the foundation of modern growth theory.

Unfortunately it also contains some utter nonsense!

In a chapter on “The Labor Market, Wages, and Unemployment” Jones writes:

The point of this experiment is to show that wage rigidities can lead to large movements in employment. Indeed, they are the reason John Maynard Keynes gave, in The General Theory of Employment, Interest, and Money (1936), for the high unemployment of the Great Depression.

This is of course pure nonsense. For although Keynes in General Theory devoted substantial attention to the subject of wage rigidities, he certainly did not hold the view that wage rigidities were “the reason … for the high unemployment of the Great Depression.”

Since unions/workers, contrary to classical assumptions, make wage-bargains in nominal terms, they will – according to Keynes – accept lower real wages caused by higher prices, but resist lower real wages caused by lower nominal wages. However, Keynes held it incorrect to attribute “cyclical” unemployment to this diversified agent behaviour. During the depression money wages fell significantly and – as Keynes noted – unemployment still grew. Thus, even when nominal wages are lowered, they do not generally lower unemployment.

In any specific labour market, lower wages could, of course, raise the demand for labour. But a general reduction in money wages would leave real wages more or less unchanged. The reasoning of the classical economists was, according to Keynes, a flagrant example of the “fallacy of composition.” Assuming that since unions/workers in a specific labour market could negotiate real wage reductions via lowering nominal wages, unions/workers in general could do the same, the classics confused micro with macro.

Lowering nominal wages could not – according to Keynes – clear the labour market. Lowering wages – and possibly prices – could, perhaps, lower interest rates and increase investment. But to Keynes it would be much easier to achieve that effect by increasing the money supply. In any case, wage reductions was not seen by Keynes as a general substitute for an expansionary monetary or fiscal policy.

Even if potentially positive impacts of lowering wages exist, there are also more heavily weighing negative impacts – management-union relations deteriorating, expectations of on-going lowering of wages causing delay of investments, debt deflation et cetera.

So, what Keynes actually did argue in General Theory, was that the classical proposition that lowering wages would lower unemployment and ultimately take economies out of depressions, was ill-founded and basically wrong.

To Keynes, flexible wages would only make things worse by leading to erratic price-fluctuations. The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labor market.

To mainstream neoclassical theory the kind of unemployment that occurs is voluntary, since it is only adjustments of the hours of work that these optimizing agents make to maximize their utility. Keynes on the other hand writes in General Theory:

The classical school [maintains that] while the demand for labour at the existing money-wage may be satisfied before everyone willing to work at this wage is employed, this situation is due to an open or tacit agreement amongst workers not to work for less, and that if labour as a whole would agree to a reduction of money-wages more employment would be forthcoming. If this is the case, such unemployment, though apparently involuntary, is not strictly so, and ought to be included under the above category of ‘voluntary’ unemployment due to the effects of collective bargaining, etc …

The classical theory … is best regarded as a theory of distribution in conditions of full employment. So long as the classical postulates hold good, unemployment, which is in the above sense involuntary, cannot occur. Apparent unemployment must, therefore, be the result either of temporary loss of work of the ‘between jobs’ type or of intermittent demand for highly specialised resources or of the effect of a trade union ‘closed shop’ on the employment of free labour. Thus writers in the classical tradition, overlooking the special assumption underlying their theory, have been driven inevitably to the conclusion, perfectly logical on their assumption, that apparent unemployment (apart from the admitted exceptions) must be due at bottom to a refusal by the unemployed factors to accept a reward which corresponds to their marginal productivity …

Obviously, however, if the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment – if there be such a thing (and who will deny it?). The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight – as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

Unfortunately, Jones macroeconomics textbook is not the only one containing this kind of utter nonsense on Keynes. Similar distortions of Keynes views can be found in , e. g., the economics textbooks of the “new Keynesian” – a grotesque misnomer – Greg Mankiw. How is this possible? Probably because these economists have but a very superficial acquaintance with Keynes own works, and rather depend on second-hand sources like Hansen, Samuelson, Hicks and the likes.

Fortunately there is a solution to the problem. Keynes books are still in print. Read them!!

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  1. “The basic explanation for unemployment is insufficient aggregate demand, and that is mostly determined outside the labor market.”

    The problem is that firms do not care about aggregate demand. They care about their demand. And firms that experience a reduction in demand can of course simply lower prices and hence sell more. So if “demand” is really a problem, one has to be able to answer the question why firms do not lower their prices? One, to me reasonable, answer is that by lowering prices they also lower profits. But this answer is only valid if a firm’s costs, i.e. intermediate goods, are unchanged or, as it’s called, “sticky”. Are they? The hands-down absolutely most important intermediate good from a cost perspective is labour. So if labour would become less expensive, firms could reduce prices and therefore also sell more. The demand crisis would be averted.

    But every time I mention this to a post-Keynesian, they mumble something about violent fluctuations in prices that (after something inexplicable and almost magic happens) reduces investments! To me, that sounds like a leap of faith. And why an individual firm would even believe that his own prices for a pack of chewing gum will have an impact on the volatility of macroeconomic aggregates is beyond me. But that, folks, is the post-Keynesian story.

    • It’s so simple and still you get it so wrong. But since you’re so fond of simple models, Pontus, here’s a really simple Keynes model:
      Let’s assume that a fish seller sells 20kg of fish at a price of €10 on a weekly basis. Thus his weekly turnover is €200. To keep it really simple, let us also assume that wages are his only costs. He employs 10 workers at a weekly rate of €15, making total costs equal to €150 and his profits equal to €50. If for some unspecified reasons the demand for fish drops, he will have to reduce the price from €10 to e. g. €8. The weekly turnover drops to €160 and his profit margin declines to €10 (160-150). The fish seller is unhappy with this and cuts down on employment to 8 workers. His costs fall from €150 to €120 (8×15). If the unemployed workers want to be reemployed, they have to work for €11 instead of €15. Accepting this offer the total wage bill (= costs) for the fish seller becomes €110 (10×11), restoring his profit to €50 (160 – 110). Although it may appear as though unemployment has been avoided by cutting wages, this is not so. The total incomes of the workers have been reduced from €150 to €110, which reduce their demand. The demand problem of the fish seller will become general. The wage cuts solution only makes the unemployment problem worse.

  2. Well that’s simple enough for me. And simple enough to falsify too!

    While it appears obvious that “demand” has fallen as wages plummet, you ignore the distinction between nominal demand, and real demand. Nominal demand is a vacuous concept, while real demand is not. In the example above, nominal demand has fallen from 200 to 160 (110 in wages and 50 in profits). This appears disastrous to society. But how much fish can now be bought for 160 euro? Well, as prices fell from 10 to 8, real demand is 160/8 = 20kg. That is, a simultaneous fall in both prices and wages (i.e. an internal devaluation) can easily parry the initial fall in nominal demand and leave real demand unaffected.

    • “Real demand” of the workers drop from 150/10 = 15 to 110/8 = 13.75 and “real demand” of the fish seller rises from 50/10 = 5 to 50/8 = 6.25.
      This of course means that aggregate “real demand” for consumption goods declines since the propensity to consume consumption gooods is greater among workers than fish sellers. In general that means the unemployment problem gets worse when wages are cut.Or as Keynes (General Theory p. 262) has it: “What will be the effect of this redistribution on the propensity to consume for the community as a whole? The transfer from wage-earners to other factors is likely to diminish the propensity to consume.”

      • More and more logical fallacies!

        1, If fish-sellers have a lower propensity to consumer, where do the money end up? I can see two possibilities: a) as investments, which is part of the demand, and your argument shatters to pieces, or b) as cash hoardings kept in the mattresses (carrying no interest).

        2, If your answer is b), and the mpc of fish sellers is k (let’s assume that the mpc is one for workers), then even before the fall in demand total purchases equalled only k*50+150<200. Thus there was more income than spending which is, by pure accounting, an impossibility. This again shatters your argument.

      • Neoclassical economists usually have a very simple solution for unemployment – people just need to be willing to work for less. Supply creates its own demand and if people are unemployed, it’s because they refuse to take the jobs offered.

        As Keynes convincingly showed in GT this is a faulty explanation:

        “The completeness of the [classical] victory is something of a curiosity and a mystery. It must have been due to a complex of suitabilities in the doctrine to the environment into which it was projected. That it reached conclusions quite different from what the ordinary uninstructed person would expect, added, I suppose, to its intellectual prestige. That its teaching, translated into practice, was austere and often unpalatable, lent it virtue. That it was adapted to carry a vast and consistent logical superstructure, gave it beauty. That it could explain much social injustice and apparent cruelty as an inevitable incident in the scheme of progress, and the attempt to change such things as likely on the whole to do more harm than good, commended it to authority. That it afforded a measure of justification to the free activities of the individual capitalist, attracted to it the support of the dominant social force behind authority.

        But although the doctrine itself has remained unquestioned by orthodox economists up to a late date, its signal failure for purposes of scientific prediction has greatly impaired, in the course of time, the prestige of its practitioners. For professional economists, after Malthus, were apparently unmoved by the lack of correspondence between the results of their theory and the facts of observation;—a discrepancy which the ordinary man has not failed to observe, with the result of his growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed by observation when they are applied to the facts.

        The celebrated optimism of traditional economic theory, which has led to economists being looked upon as Candides, who, having left this world for the cultivation of their gardens, teach that all is for the best in the best of all possible worlds provided we will let well alone, is also to be traced, I think, to their having neglected to take account of the drag on prosperity which can be exercised by an insufficiency of effective demand. For there would obviously be a natural tendency towards the optimum employment of resources in a society which was functioning after the manner of the classical postulates. It may well be that the classical theory represents the way in which we should like our economy to behave. But to assume that it actually does so is to assume our difficulties away.”

        I rest my case with this comment, concluding that it seems as though the level of reasoning on unemployment among Cambridge economists has deteriorated significantly since the 1930s …

      • The Keynesian logic, at least in its simplest form, fell out of fashion as it was littered with logical pitfalls. These are the ones modern economist are trying to address. You see; the macroeconomy is, whether you like it or not, a closed system. My spending is your income, and your spending is my income. Things are not magically vanishing or being added. It’s pure accounting. And any deviation from that principle will lead to misleading and factually wrong conclusions.

        You won’t answer my questions as you do not have an answer. Despite their incredible simplicity.
        I would expect a lot more from a professor of economics. And so should your students.


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