Home > economics profession, Keynes, unemployment > New Keynesians, price stickiness and involuntary unemployment (wonkish)

New Keynesians, price stickiness and involuntary unemployment (wonkish)

from Lars Syll

There are unfortunately a lot of neoclassical economists out there who still think that price and wage rigidities are the prime movers behind unemployment. What is even worse – I’m totally gobsmacked every time I come across this utterly ridiculous misapprehension -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 in General Theory 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 John Maynard Keynes, 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, 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

People calling themselves “New Keynesians” ought to be rather embarrassed by the fact that the kind of microfounded dynamic stochastic general equilibrium models they use, cannot incorporate such a basic fact of reality as involuntary unemployment!

Of course, working with representative agent models, this should come as no surprise. If one representative agent is employed, all representative agents are. 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.

The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic modelbuilding is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems. If substantive questions about the real world are being posed, it is the formalistic-mathematical representations utilized to analyze them that have to match reality, not the other way around.

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  1. Mike Meeropol
    January 16, 2013 at 10:00 am | #1

    I think it is also important to understand that a logical extension of Keynes’ model is that should a particular economy succeed in actually reducing real wages across the board, this would create another distinction between the micro effects (should real wages in one firm or even one sector fall) and the macro effects (should real wages across the board fall).

    Given that wages are a very large proportion of personal income (don’t have the number handy right now), such a fall would produce a decline in consumption spending — especially if the fall were prolonged over a significantly long recession. This decline in consumption spending would ultimately damage business’s “animal spirits” resulting in a decline in “autonomous investment” (e.g. investment not responsive to changes in the rate of interest).

    Thus, absent significant increases in either net exports, or government spending, or consumer indebtedness, a decline in real wages will also not re-establish “full employment equilibrium.”

    Yes, one firm might prosper if they succeed in cutting real wages. Even an industry might right itself if it succeeds in cutting real wages (or total compensation) think of the airline industry in the US. But the entire economy cannot solve the problem of declining aggregate demand by reducing the real incomes of the majority of the population.

    (Here the underconsumptionists go it right!)

  2. Helene Clement-Pitiot
    January 16, 2013 at 11:36 am | #2

    “…one firm might prosper if they succeed in cutting real wages. Even an industry might right itself if it succeeds in cutting real wages (or total compensation)”. Germany has behaved as one of these enterprises, as a free rider in the European mismatch. To Follow the German example is a collective suicide for other Euro states. However the European Commissar is pushing to that suicide for what reason? Orthodox reasoning, classical economic views, equilibrium fanatism? Theory is out of concern there, it is just a justification of bureaucracy and democracy capture. From a long time European bureaucrats have been using pseudo-economic rhetoric to shape irreversibility at the core of Europe with the illusion that no other choice exist for the people despite evidences. Economic is a too young discipline, with greedy professionals that is the reason why it has been so easily instrumentalised. Rivalry, lack of cooperation between economists have paved the way of dishonors of the discipline with fundamental under-understanding of the reality. Reversing the path asked for more consciousness of the institutional problems. Smoky future!

  3. Max
    January 16, 2013 at 1:16 pm | #3

    Labor and capital are the two goods that no-one wants for their own sake. Capitalists don’t employ people or take out loans unless they expect to make a profit, which they don’t when demand is low

  4. Paul Schächterle
    January 16, 2013 at 9:24 pm | #5

    To me the neoclassical “theory” of the labour market has always been the pinnacle of absurdity.

    Do these people really believe workers will always offer less labour when the wage rate falls?

    Do they believe workers prefer to starve in their spare time if the wage rate is only low enough?

  5. derekrss
    January 17, 2013 at 4:30 am | #6

    Keynes appears to be talking about what we would now call “neoclassical” economists when he uses the term “classical”. True classical economists used a three-factor analysis of the economy and would have said that the wage level was governed by the productivity of freely available land since that is the alternative to employment. Silvio Gesell, whom Keynes mentions in book VI, chapter 23 of the General Theory, gives quite a good account of this sort of Ricardian argument for wage levels (which has as much to do with the productivity of marginal land as it has to do with the productivity of marginal workers) in The Natural Economic Order.

  6. January 17, 2013 at 12:04 pm | #7

    Lars says “The final court of appeal for macroeconomic models is the real world, and as long as no convincing justification is put forward for how the inferential bridging de facto is made, macroeconomic model-building is little more than “hand waving” that give us rather little warrant for making inductive inferences from models to real world target systems.”

    So a macro-economic model needs to account for everything, and SSADM-type systems analysis applied to PID control logic in principle does just that. It has convinced me, and my model by now indicates how the inferential bridging is to be made (i.e. via logical typing, language and communication); but “de facto” (as here Paul Davidson and Paul Grignon seem to know all too well) all communication in a foreign tongue is little more than “hand waving” while autistic Anglo-Economists won’t condescend to learn other people’s language. Well said on dishonourable rivalry, Helene.

    Here there are some interesting details and responses. Says Lars: “it is only adjustments of the hours of work that these optimizing agents make to maximize their utility”. If only. The reverse side of Paul Schacterle’s contribution is that only “these people”, i.e. those who have more than enough income already, who do that. Derek (doubtless to Carol’s satisfaction!) is on the nail both with classical wage levels being “governed by the productivity of freely available land, since that is the alternative to employment” and the significance of Gesell. Keynes himself said “I believe that the future will learn more from the spirit of Gesell than from that of Marx”. (General Theory, 1935, p.355).

    A pity then that Keynes did not comment on the 1934 book “Justalucky…”, in other threads, keeps so passionately urging us to read: Nobel-winning physical chemist Frederick Soddy’s The Role of Money. I did read it, and to my own excitement found Soddy coming to essentially the same Gesellian conclusions I have done, but 70 years earlier, and at exactly the same point in the 1930′s slump as we are in ours! What is more, he is refreshingly frank about the fraudulent nature of modern banking! The copy at http://archive.org/stream/roleofmoney032861mbp/roleofmoney032861mbp_djvu.txt is difficult to read, so I reformatted it to A4 as I read it, but I’ve since discovered it is now available on Kindle and has recently been republished in paper and hard-back formats. Obviously others are realizing its significance.

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