Price rigidities and unemployment

3 May, 2016 at 15:11 | Posted in Economics | 4 Comments

There are unfortunately a lot of mainstream economists out there who still think that price and wage rigidities are the prime movers behind unemployment. What is even worse is that some of them even think that these rigidities are the reason John Maynard Keynes gave for the high unemployment of the Great Depression. This is of course pure nonsense. For although Keynes devoted substantial attention to the subject of wage and price rigidities in General Theory , he certainly did not hold that 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 – deteriorating management-union relations, expectations of on-going lowering of wages causing delay of investments, debt deflation, etc.

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 labour 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, 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.

J M Keynes General Theory

4 Comments »

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  1. “The outcome was the 1944 White Paper, Employment Policy (Cmd. 6527), which employed a Keynesian analysis of macroeconomic demand being the sum of private consumption, private investment, government expenditure, and the balance between exports and imports. However, it was pointed out that an expansion of internal demand would not be an appropriate remedy for loss of exports and might lead to inflation. A successful employment policy would depend on international collaboration to ensure expanding export markets, and also on British industry’s ability to compete in these markets and in the home market. Public investment would be planned to offset fluctuations in private investment, but the term ‘capital budget’ was avoided, in case politicians were tempted to place in it current items that ought to be financed from taxation. As a second line of defence against unemployment, private consumption could be maintained, perhaps through variations in social insurance contributions or rates of taxation. It was made clear, however, that while the budget for central government current expenditure need not balance every year, it should balance over a longer period.”

    George Peden, “Keynes and British Economic Policy,” in Cambridge Companion to Keynes, 2006.

    The argument from international macroeconomics, monetary policy and tariffs, etc, should blend in here also.

  2. I always did like that passage, with the “open or tacit agreement amongst workers” and the “Euclidean geometers in a non-Euclidean world”.

    You quote Keynes:
    “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 …”

    Scott Sumner redefines the Keynesian terminology, as if by doing so he can show Keynes is wrong:
    “We all agree that there were lots of people without jobs. We all agree that lots of them wanted to be working. We all agree that lots of them were miserable. I call that “involuntary unemployment.” But I think they were unemployed because of sticky wages, and that if workers collectively accepted lower wages then we would have had full employment in 1936.”

    Sumner is a problem because he is such a good BSer. He should be held up for ridicule and scorn at every possible opportunity.

  3. “During the depression money wages fell significantly and – as Keynes noted – unemployment still grew.”

    That may have been because prices were also falling so mitigating the fall in real wages, but I would not argue this way.

    The Classicals focussed on the effect of real wages on the demand for labour. However, a drop in real wages would also have a negative impact on real aggregate demand.

  4. When land is deliberately held out of use for purposes of speculation in its value, the land that is being used for production and residence becomes more costly to use (have access to). This means that the goods being produced on that land (urban as well as rural) become more costly and the quantity being sold reduces. This is what causes unemployment and poverty, drug-trading, petty crime and suicide.

    The theory of money being in short supply for investment in goods being made, is not correct. (See Wage-Fund Theory.) An entrepreneur will work with almost no invested capital in order for his activity to be rewarded by sales. This is the source of his earnings, not a prior investment to cover the wages. His wages are in the value of the product, which on being sold provides what has been earned in money form.


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