Macroeconomic faith

Pretty much everything in AS/AD is riding on the hypothesis that labor supply is highly elastic at the nominal wage and labor demand is reasonably elastic at the real wage. There is nothing for entrepreneurs to figure out–they will employ more workers as long as you can trick those workers into taking lower real wages.

That is Arnold Kling, here is more.  Many Keynesians like to poke fun at the RBC or rational expectations ideas of unemployed workers taking a "voluntary vacation" during a downturn.  Yet Keynesian theory has a no less serious problem, namely that workers take a "stupid voluntary vacation" during the downturn, due to their stubbornness on nominal wage cuts.  Reflation, if it comes, is doing no better for them in real terms than if they cried Uncle in the first place and simply lowered their wage demands.

The more dire a story you tell about the costs of unemployment, the more embarrassing the puzzle becomes on the side of positive economics.

Aggregate demand macroeconomics works in many cases and it almost always "works" (predicts well) when the macro forces are pointed toward destructive ends.  We are not sure why it works at all, or if it always works, and yet we see a great fervor of belief in it and a demonization of those who are skeptics.

Comments

Do you think this dynamic is behind why you hear a lot less "sticky-wage Keynesianism" now and a lot more "old-school Keynesianism" than you used to?

The one saving grace of a sticky-wage argument, I think, is that in a way it's a collective action problem. What exactly would a worker gain by volunteering for a wage cut? It's very likely they'd gain nothing. If they were promised "you will be retained if you take this wage cut" and there were some sort of arrangement to that effect, then I think you would see less sticky wages. But without that sort of arrangement it's not "stupidity" - it's a concentrated cost and a dispersed benefit.

Workers may rationally take a "vacation" instead of a nominal wage cut because nominal wage cuts reduce your income over the long term. Merit raises and promotion raises are usually in percentage not absolute terms. Even if you change jobs, your new employer will ask what your current salary is.

Or, people may be relucant to believe that their time isn't worth as much as it was a year ago. In a normal economy this is adaptive, because holding out for a better offer makes sense even if unemployment sucks; but in a severe recession it isn't.

Well said.

I don't hear the Keynesians taking a stance against rat exploits in all cases. Surely there must be a phase in any cyclic pick-up wherein workers will disdain lower pay. I don't really see that anybody is to be excused of anything. Except for young children, innocents, etc. Everybody else should do the spending cuts at the same time they get the tax cuts.

What if companies sold "Sticky Bonds" to their employees.

Rather than taking a wage cut, you could buy a short-term bond and the funds would ostensibly be used to support employment.

You'd be a hero rather than a sucker and there'd be no long-term impact on your salary growth.

For a worker with any contract obligations, they would work for less if those with the contracts, whether mortgage, car loan, rent, school loan, credit card would do the rational thing and accept lower payments to fulfill the contract obligations.

Why isn't Kling attacking the bankers and rental agents and businesses for failing to accept lower payments for the current outstanding debt so workers can afford to work for less?

If bankers cut the principle and payments for all debts in half and the stores cut all prices in half, then lots of workers, employed and unemployed would work for half the wage. If the bankers are waiting for workers to move first, then the bankers and corporations should set the example and first cut their compensation in half.

But these discussions always come down to the solution that got us to the present economy: we raise prices, but limit wage increases, and promote added debt to pay for the higher prices, using the somewhat higher wages to pay interest.

Reaganomics has turned out to be the road to serfdom - more and more people are indentured to a smaller and smaller landed ruling class.

This suggests that employers are actually flexible enough to hire employees at nominally lower wages. Many aren't. You will not get hired by telling an employer you are willing to work for less than the others -- not in the corporate world.

Wage stickiness is not simply a matter of stubborn workers.

But, tell you what. Let's do a natural experiment and abolish tenure. Invite young graduate PhD's without employment to compete with formerly tenured professors for their jobs. Prices will decline and the market will clear.

...and research will boil down to pursuing short-term achievable goals. Wait, it's already the case with this stupid grant system.

But "works" is defined as lowering unemployment while there is stimulus, not as providing a best or even nearly best level of employment over the next ten years. IMHO the problem with Keynesian economics has always been what happens when you stop the stimulus. Didn't work so well in 1937-38. And at some point, you do have to stop the stimulus; you can't run 12% deficits forever.

Real wages have been declining, but you don't notice it, and it isn't recorded in the labor statistics.

Increased co-pays for health insurance, increased cost sharing on insurance, conversion of defined benefit to defined contribution programs, elimination of job categories or step promotions, reclassification of jobs, discontinued health plans, etc.

Now, if we can just increase social security taxes and/or cut social security benfits so that they offset the tax cut for the top 1%, we'll be in the state of perfect equilibrium.

I do agree with mulp above regarding executive foreign compensation in relation to US compensation. Not only are foreign executives paid less, but foreign (particularly Asian) corporations are much, much flatter. Nor are their golden parachutes, either, or generous executive retirement and severance packages. Foreign executives obtain psychic compensation by being the head of the organization. Also, my foreign clients really are tight and watch every penny. The only foreign client I had, though, who did over reward executives was a family owned corporation which used management positions as a way to distribute money to the brothers in the family, but aside from this, foreign executives aren't paid as well, and have a difficult time accepting (and often resist) higher pay for their foreign sales and marketing staff in the US.

Eh. My recollection from wage concessions in the 1970s and 1980s was that pretty much all proceeds went to management and executive bonuses rather than, oh, say, reduced product prices or increased share value. I'm not saying it happened all the time but it happened often enough, and publicly enough, that wage concessions feel even stupider than "stupid vacations" do. Suspicion and bad faith make unilateral concessions much harder to extract.

Counterexamples where wage concessions resulted in corresponding price reductions at scales large enough to measurably impact the economy would of course be welcome because then a public case could be built for unsticking wages. I don't know of any but that's part of the problem, right?

The other problem, it seems to me, is that if we all just cut wages, let's say, by 20% then it would either become the equivalent of a corresponding decrease in consumer demand, or else prices would drop by 20% in which case we'd be back to square one. Except, of course, for mulp's concern that fixed prices (mortgages and other loans, for instance) would not drop -- resulting once again in what amounts to a 25% increase in fixed costs and a corresponding further decline in consumer spending.

I dunno. Seems to me that Keynesian policies exist to counteract exactly the irrational labor supply and consumer-demand side problems Kling is upset about. But then if rational self-interest pertained we'd never find ourselves in circumstances where Keynes's proposals pertained.

figleaf

You don't need to posit employee stupidity to explain resistance to nominal wage cuts, only self-interest. Suppose an employer gives his employees a choice: either everyone takes a 10% pay cut or I lay off 10% of the employees. A self-interested employee would prefer the layoffs to the wage cuts so long as he thinks he has a less than 10% chance of being laid off. Most employees wouldn't think they would be among the layoffs, and so would favor layoffs over wage cuts.

To put it another way, if an employer cuts everyone's wages by 10% everyone will resent him. If he lays off 10% of his employees that 10% will really resent him, but they won't being working for him anymore so that's not such a big deal.

Aggregate demand macroeconomics works in many cases and it almost always "works" (predicts well) when the macro forces are pointed toward destructive ends. We are not sure why it works at all, or if it always works

Um, no, this is wrong. Downward price/wage rigidity is not the only market imperfection in Keynesian economics. The other critical imperfection is monopolistic competition in the product market (and possibly in factor markets as well).

Monopolistic competition due e.g. to downward-sloping average costs forces firms to set product prices higher than marginal costs. Similarly, if the average revenue product for some factor slopes upwards, the price paid to that factor has to be lower than marginal product.

This drives a wedge between marginal costs (or marginal revenues) vs. product prices (or factor incomes). Thus, an increase in "aggregate demand" can improve welfare (if prices are sticky). The general equilibrium analysis of monopolistic competition is quite complex, but all such models feature a "macroeconomic externality": by lowering the price charged for its products, a firm relaxes consumers' income constraints and rases demand (and profit) for the products of all other firms--a positive externality.

Mulp is right.

This "demonization" ... wasn't there a blog post recently by Robin Hanson about that sort of thing?

The concept of AS is problematic at best. What does it mean to aggregate the supply of workers in various industries, as well as the supply of heterogeneous capital goods, and consumers goods?
Why should the elasticity referred to be the same throughout the economy?
Aggregation, shagregation.

"Aggregate demand macroeconomics works in many cases and it almost always "works" (predicts well) when the macro forces are pointed toward destructive ends. We are not sure why it works at all, or if it always works, and yet we see a great fervor of belief in it and a demonization of those who are skeptics."

Per Drum and Yglesias on Twitter, these are remarkable sentences. When the economy is in dire straits, the usefulness of theories affects millions of lives. Attacking a theory that works, and that by working buttresses actions that can make millions of lives better, is a moral act.

You can be wrong in practice and probably in theory while still serving a purpose, but it is perverse to focus on the primacy of decorum (not "demonizing") in these matters.

Per Drum and Yglesias on Twitter, these are remarkable sentences.

If by remarkable you mean "wrong", then I agree. Aggregate demand effects in macro are quite well-understood (my previous comment provides a brief introduction to the issue).

Of course people can disagree about the effectiveness of so-called "demand-stimulative" policies, but that's another kettle of fish, really.

IMHO the problem with Keynesian economics has always been what happens when you stop the stimulus. Didn't work so well in 1937-38. And at some point, you do have to stop the stimulus; you can't run 12% deficits forever.

Keynesian theory is not in conflict with monetary theory - in 1936 the Fed pursued a tight monetary policy to head off inflation. The Fed testified to Congress they had not intended the tight bank credit to result from the policy moves, and defended their actions to the press, but they did ease in 1938.

Given Eccles policy of monetizing all deficits, deficit reduction would have resulted in unintended reduction in money supply growth, but the deficit reduction occurred after the downturn began. The Fed increased reserve requirement in two steps in 1936.

And Tyler again bashing his AS/AD windmills. Wake up, buddy. Keynesian Macro has left the AS/AD building a long time ago.

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