Arnold Kling  

Milton Friedman vs. PSST

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The "natural rate of unemployment, in other words," is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the cost of mobility, and so on.
That is, of course, Milton Friedman's famous Presidential Address to the American Economic Association in 1967, printed in the March 1968 American Economic Review. When I think in terms of Patterns of Sustainable Specialization and Trade, I find myself disputing this paragraph.

1. People are not employed by "the Walrasian system of general equilibrium equations." They are employed by entrepreneurs.

2. Do not think of the goods, services, jobs, and skill sets in an economy as if they were given, waiting for a Walrasian auctioneer to call out price vectors. Instead, they must be discovered by entrepreneurs and workers.

3. In addition to the market imperfections that Friedman lists, there is the fact that in many situations there is a large fixed cost involved in hiring. It may take a long time to train a worker. It may take a long time before what a worker is hired to do actually contributes to the profits of the firm. It may take a long time to know whether a worker is actually contributing, and indeed there may always be uncertainty about that. In short, hiring a worker is a speculative investment, with returns that are not known in advance, may not be known for a long time, and in fact may never be known.

4. Patterns of sustainable specialization and trade are constantly in flux. Some patterns become unsustainable, and other patterns become sustainable (for a while). The internal combustion engine changes the technology for transportation, and all sorts of old patterns become uneconomical while new patterns emerge. The Internet changes the technology for distributing information, and all sorts of old patterns become uneconomical while new patterns emerge.

5. Why are there cycles in employment? I think this is the hardest question for PSST to answer, and the one where I have to do the most hand-waving. Here goes.

Much of the time, it seems that the new patterns that emerge "balance" the patterns that become obsolete, so that there is little or no net change in total employment. There are some natural forces that would tend to produce this balance between expanding sectors and contracting sectors. However--and this is a key point--there is nothing automatic about such balance. Patterns that become uneconomical might have employed a lot more people than the patterns that are becoming economical (farms needed a lot more laborers when they relied on horses rather than tractors. See my partial equilibrium story). That means that there can be periods of high unemployment.

When there are a lot of people eager for work, then there is some incentive for an entrepreneur to find a way to profitably employ those people. However, there are issues with reservation wages, tax and benefit wedges, and the fixed costs mentioned above in (3). There are real costs of solving the problems mentioned above in (2). That is, there are real adjustment costs.

6. A lot of macroeconomic theory is designed to either prove or deny that monetary expansion will increase employment. With PSST, I am willing to be agnostic on the issue. It is possible that a monetary expansion can reduce the real reservation wage of workers, which might speed the process of finding profitable ways to put the unemployed to work. However, it is possible that, all things considered, this effect is pretty small.

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CATEGORIES: Macroeconomics

COMMENTS (7 to date)
jsalvatier writes:

"It is possible that a monetary expansion can reduce the real reservation wage of workers, which might speed the process of finding profitable ways to put the unemployed to work. "

It is critical that you understand that this is *not* how monetary economics works.

The expansionary effect of adding money to the economy does not come from any changes in any prices. It comes from people who hold more money than they would like trying to get rid of it. Nick Rowe has written about this many times.

Ed Bosanquet writes:

Arnold, I love this post.

It's my belief that monetary policy when done right can help stabilize towards PSST. If done wrong, will prolong the time to reach PSST.

The central question about monetary policy, should be "Is the force in control doing what's right or not?".

I think Ben Bernanke is very smart and much better at it than anyone else, however, he doesn't seem to have it right. In fact, it seems to me that no one is better than a flip of a coin. Only later is it realized what should have been done.

david writes:

Um, how is this not real business cycle theory with technology shocks?

D. F. Linton writes:

It really should be Constantly Evolving Patterns of Sustainable Specialization and Trade (CAPSST), since general equilibrium never emerges.

Arnold Kling writes:

As I understand it, real business cycle theory has one type of output, and the technology shock is a temporary decrease in productivity. That is different from an economy in which there are many sectors with the shocks being to productivity across sectors.

david writes:

Thank you for the reply! But multi-sectoral RBC theories are not new and RBC does not entail only one type of output.

(See a NK "mainstream" perspective (warning: PDF): scroll down to "Real Business Cycle Theories with Multiple Sectors". The flaw is as Mankiw notes - given PSST, we should observe a surge in resources directed towards pattern search (or whatever) during busts. This doesn't appear to be the case.)

Arnold Kling writes:

I just want to put it out there that a lot of comments of the form "Kling does not understand theory X" are coming from people who themselves have not demonstrated any grasp of the theories that I supposedly do not understand. I am getting a little tired of this. If you have written something that demonstrates your qualifications to expound on macro theory, then go ahead and link to it. Otherwise, try to restrain yourself from posting snide comments. This is not directed at david, who is citing specific work

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