Home > Uncategorized > Price rigidities and unemployment

Price rigidities and unemployment

from Lars Syll

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

 

  1. Paul Davidson
    May 6, 2016 at 5:41 pm

    At the beginning of chapter 19 [entitled “Changes in Money Wages” of THE GENERAL THEORY on p. 257 Keynes writes:

    “For the Classical Theory has been accustomed to rest the supposedly self-adjusting character of the economic system on an assumed fluidity of money-wages; and, when there is rigidity, to lay on rigidity the blame for maladjustment….My difference from this theory is primarily a difference of analysis….”

    As I demonstrate in my textbook POST KEYNESIAN MACROECONOMIC THEORY and in my latest book POST KEYNESIAN THEORY AND POLICY , Keynes’s “difference of analysis” involves what Keynes called “The Essential Properties” of all liquid assets [see chapter 17].

  2. Paul Schächterle
    May 6, 2016 at 7:35 pm

    Quote: “But a general reduction in money wages would leave real wages more or less unchanged.”

    Why do you say that? The wage share could decline and the capital gains (profits, exec bonuses and interest payments) could rise. That would lead to a *real* decline in wages.

    Also a reduction in *real* wages would also *not* lead to more employment.

    The whole assumption that high wages lead to high unemployment is a “business-friendly” single employer point-of-view without theoretical foundation regarding society as a whole.

    In the real world the wage share has significantly decreased in the last decades and unemployment has increased significantly at the same time.

    Certainly lowering *real* wage rates does not lead to a decrease in labour “supply”. Why do workers work? The need the money! So if one needs to raise a certain amount via wage labour and the wage rate declines… Does one try to work less? Or maybe more?

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