Why are wages sticky?

8 Feb, 2014 at 15:39 | Posted in Economics | 16 Comments

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.stickyThe 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 … 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 Glasner

That’s absolutely correct. There are  — as Glasner notes — unfortunately a lot of neoclassical economists out there, who still think that price and wage rigidities are the prime movers behind unemployment. And I’m totally gobsmacked every time I come across the even more ridiculous misapprehension that these rigidities should be the reason John Maynard Keynes gave for the high unemployment of the Great Depression. This is of course pure nonsense. For although Keynes in General Theory (1936) devoted substantial attention to the subject of wage and price rigidities, he certainly did not hold this view.

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.

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, unemploy-ment, 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.

Added 17:00 GMT: Lord Keynes has a great piece on the issue here [h/t Phil Pilkington]

16 Comments

  1. Pontus-

    “Lord Keynes” does not speak for anyone except himself. In particular, his us of labor supply in the definition of effective demand would not be accepted by Keynesian economists of any stripe, nor by Keynes for that matter.

    Keynes’ analysis is almost entirely in real terms, specifically in “wage units”.

    In the original presentation in the GT, Keynes describes businesses making a choice about employment for the next period. Part of employment is linked to current sales, and part is linked to other factors, most importantly the state of longer-term expectations and credit conditions. So the choice of employment depends in part on expectations of next period’s sales. Realized sales, on the other hand, will depend partly on expenditure that is fixed in the short period, and partly on expenditure that depends on employment, via the consumption function that says that a large and stable fraction of wage income is consumed. So for a given state of long-term expectations, credit conditions, and autonomous expenditure, there will be a unique level of employment at which businesses’ expectations are satisfied. We call that level of employment the state of “effective demand.” (Keynes is using effective here to mean “in effect”, not “having effect”.) Any change in the other parameters will change the level of effective demand.

    More recent Keynesian and Post Keynesian writers usually skip this short-run equilibrium story and use the terms effective or aggregate demand interchangeably to mean total expenditure, in a context in which expenditure determines output. In other words, as you say, aggregate demand just means the standard national income identity but with the stipulation that causality runs from right to left.

    This is normally understood in real terms, although among Old/Post/left Keynesians that point isn’t stressed. If you don’t think that price level changes bring aggregate demand to potential output (however defined), it doesn’t matter so much whether you think of expenditure choices as being made in nominal or real terms.

    In answer to your final question: The key thing is that expenditure responds strongly to current income. Once you introduce that relationship, there is no need for price or wage stickiness for employment to be constrained by demand. If you think there is a stable relationship between current real income and current real expenditure, then there is no reason to expect price-level changes to have any effect. To the extent that they do, it will come through some other channel, like the real value of the stock of debt or the exchange rate, which can carry you away from full employment as easily as toward it.

    Note that the Great Depression, the preeminent example of demand-constrained output in US history, is also the preeminent example of downwardly-flexible prices and wages.

    If you want a clear summary of Keynes’ own presentation, you can’t do better than Don Patinkin’s essay on effective demand, in his book Anticipations of the General Theory. If you want a classic statement of the Old Keynesian view (as against the neoclassical synthesis), I recommend Leijonhufvud’s essay “Effective Demand Failures.”

  2. Why don’t you address Krugman’s parable

    “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.”

    Gobsmacked?

    • There’s not very much to comment. Wage stickiness is a well-established empirical fact — as is involuntary unemployment. That “New Keynesians” need assumptions on wage stickiness to make their unemployment theories/models “consistent” is really, as I’ve argued repeatedly on this blog, a sign of deficient real world relevance. Involuntary unemployment to Keynes was quintessentially a question of lacking effective demand — with or without stickiness.

    • But simply saying “lacking effective demand” is a real cop out. You will have to explain the mechanism. E.g. is this real or nominal demand (surely it must be nominal)? So why doesn’t firm suggest wage cuts with simultaneous price cuts? That would restore demand and prevent unemployment from rising.

      (By the way, I sincerely hope you understand the fundamental errors made when claiming that “as nominal wages fell in the great depression and unemployment still rose” is evidence against a positive relationship between unemployment and (real or nominal) wages. Of course, if prices fell faster than wages – which they did! – real wages are not falling, but sharply increasing. In addition, the fact that “unemployment was still rising” is not evidence of anything; the counterfactual may as well be a faster rising unemployment.)

    • Nope, lord Keynes does not address any of the issues I raise. Empirical evidence of price or wage rigidity is nothing I contest, but more importantly, it’s irrelevant for the point you’re making: that aggregate demand matters even if prices and wages can fully adjust. Explain how? And is aggregate demand referring to a nominal or real quantity?

      • Hmm. Otherwise I thought passages like “Many New Keynesians believe that, if only wages and prices were perfectly flexible, then economies would adjust rapidly to full employment equilibrium. Post Keynesians, following Keynes himself, reject the view that perfectly flexible wages, prices and perfect competition would lead to full employment equilibrium. Even if there were perfectly flexible wages and prices, there could still be failures of aggregate demand” and “One must ask why should a “genuine argument against Keynes” (or, rather, New Keynesians) have to be made with respect to a “largely unfettered market”? Surely the relevant concept is “real world markets” gave some kind of hint …
        But maybe we don’t — to paraphrase Wren-Lewis — talk the same language …

        • Well you’re just repeating yourself. “It is a matter of aggregate demand”, “in the real world prices are rigid (but not that it matters)”, and so on.

          Why can’t anyone provide an answer: is “effective demand” referring to a nominal or real quantity? And if real, how come the price elasticity of demand is zero? And if nominal, how come firms don’t lower prices and wages so to sell more?

          The thing is that effective demand movements can only have real effects if either demand is price inelastic (which it is not), or if prices/wages are sticky.

          But you seem to think that this is wrong and the main argument appears to be waving your hands and again repeated “effective demand”. That just won’t do in a scientific community.

          • “And if nominal, how come firms don’t lower prices and wages so to sell more?”

            The economy is a n-dimensional hyperspace that is acausal. You are asking the professor to provide you with causal relationships. It is either a trap you are trying to setup or you do not understand that he only cares about empirical evidence that refutes the asumptions of some models. You are trying to reverse the burden of proof which is a serious logical informal fallacy but often worse than a formal one.

            “how come firms don’t lower prices and wages so to sell more”

            It’s done every day. Sometimes it works, sometimes it doesn’t. It depends on where you are in the hyperspace. Think the case of a country where firms lower prices and wages but the government increases value added tax constantly and at the same time increases taxes. People have no money to buy at any price. They just buy food and energy. If you are making golden plated cellphones you are in trouble.

          • “So why doesn’t firm suggest wage cuts with simultaneous price cuts? That would restore demand and prevent unemployment from rising.”

            No, that is unlikely to restore demand for reasons as explained by Keynes in Chapter 19 of the GT:

            http://socialdemocracy21stcentury.blogspot.com/2014/01/the-general-theory-chapter-19-changes.html

            For one, it is unlikely to occur effectively on an economy wide scale.

            And secondly even if it did happen, as Keynes noted, even strong general wage and price deflation has perverse effects, thwarting the real balances effect:

            (1) distributional issues (between different classes of people with different marginal propensities to consume);

            (2) shocks to expectaions and business confidence, and

            (3) debt deflation.

            And furthermore, it just unrealistic anyway, because most firms shun flexible prices: they prefer to cut production and employment when demand for their product falls.

            And secondly, most firms shun nominal wage cuts as well, because it provokes labour difficulties and reduces morale and hence productivity:

            See Bewley, T. F. 1999. Why Wages Don’t Fall During a Recession. Harvard University Press, Cambridge, MA.

            A good summary of this book here:
            https://robertnielsen21.wordpress.com/2013/12/23/why-wages-dont-fall-during-a-recession/

          • This is really sad.

            Digital cosmology appears to have been sniffing glue: “The economy is a n-dimensional hyperspace that is acausal.” Lol. It’s like saying the economy is a collection of chaotic differential equations. As pompous as it is vacuous. Stop posturing.

            [and just to address you silly example with taxes: an ever increasing tax revenue must be allocated somewhere: Either by cutting debt (payback to private sector, so no contraction in demand); by cutting taxes (ditto, but with some benefits from less distortions), or by hoarding (=monetary contraction). Yeah, I agree that a monetary contraction in times of a crisis is a bad idea. So did Friedman. What else is new? Can you people please start thinking in at least a stock-flow consistent way?]

            As for “Lord Keynes”, you are again repeating the same old story. To summarize your arguments, here they are again:

            1, Price and wage cuts are unlikely on an aggregate scale.

            2, And even if this unlikely event would occur (which it wouldn’t, see (1) and (2)) it would not help.

            3, It’s unrealistic anyway (hey presto!).

            Now, I do not argue against any of these points. Neither does Krugman. But we both challenge the notion that there can be unemployment due to “effective demand” without price rigidities. Somehow post-Keynesians maintain this view without ever specifying the mechanism how.

            And no, I’m not too lazy, Mr Keynes (Sir Keynes? Lord Keynes? Your highness? I am unsure about the etiquette here.). But life is too short to read any internet nutter’s 20 article reading list to bring home a simple point. I have an academic job to entertain. But arguments should stand on their own two feet. So unless you’re too lazy, why don’t you distill them for me:

            1, Is “effective demand” a nominal or real quantity.

            2, If nominal, why don’t firms lower their prices and cut their wages to sell more stuff. (and don’t handwave yourself out of this by saying price cuts are “unlikely”, “wouldn’t help anyway”, or are “unrealistic”: we know all this, but understand why something happens is imperative for policy actions).

            3, If real, how come demand has a zero price elasticity? Any empirical measure suggests it doesn’t.

            • (1) first, effective demand as defined by Keynes and Post Keynesians is a point where the aggregate demand function intersects the aggregate supply function, and at which labour demand equals supply.

              Is that how you define “effective demand”? If not, explain what you mean.

              (2) because they mostly prefer to cut production and employment to match demand in recessions, and avoid all the instability and labour troubles that come from nominal wage cuts.

              We can assume at that this point that you have severe reading comprehension difficulties.

            • (1), Huh? I am supposed to define what post-Keynesians mean with “effective demand”? I always thought you guys were referring to the right-hand side – with its component – of the GDP identity. Feel free to correct this. But whatever you refer to, I never get if it’s nominal or real. And no one seems willing to answer!

              (2) So the reason effective demand has any traction is because firms “prefer to cut production and employment to match demand in recessions, and avoid all the instability and labour troubles that come from nominal wage cuts.”

              Sounds suspiciously like a sticky wage story to me. The question is, again, how can effective demand raise unemployment even if firms were willing to slash prices and cut wages?

    • Thanks! A nice piece indeed. I’ll make an addendum immediately to my post 🙂


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