Sticky wages and the transmogrification of truth

22 Jul, 2012 at 22:25 | Posted in Varia | Comments Off on Sticky wages and the transmogrification of truth

In a post on his blog today Paul Krugman writes on a truly important methodological question in economics:

I’ve written quite a lot about sticky wages, aka downward nominal wage rigidity, which is one of those things that we can’t derive from first principles but is a glaringly obvious feature of the real world. But I keep running into comments along the lines of “Well, if you think sticky wages are the problem, why aren’t you calling for wage cuts?”

This is a category error. It confuses the question “What do we need to make sense of what we see?” with the question “What is the problem?”

So right, so right. I only wish this knowledge also found its way in to the standard economics textbooks.
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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