Bryan Caplan  

PSST vs. the First Law of Wing-Walking

Shorter Diamond Age... Discontinuities...
For the last couple of years, Arnold has been energetically promoting a macroeconomic alternative to the standard AS-AD model.  He calls it PSST - "patterns of sustainable specialization and trade":

I focus on patterns of trade to try to avoid being shoehorned into defending a notion that the economy faces a skills mismatch. Yes, you are more likely to find a job these days if you are a nurse than if you are a construction worker, but that is not the whole story. The whole story is the need for the economy to grope its way toward new configurations that exploit comparative advantage. (more)

Mainstream macro focuses on nominal wage rigidity, but Arnold finds this approach deeply dissatisfying:

This sticky wage hypothesis is at the center of the whole mechanism. But it raises all sorts of questions. Why are wages sticky? For how long do they remain sticky? How is it that the same workers who refuse to take lower nominal wages at a fixed level of prices are happy to see the same nominal wages at higher prices?...

...[A]ggregate demand is not some deus ex machina that controls output regardless of anything else. The theory of aggregate demand and supply depends on the supply mechanism, which is quite tenuous.

My main problem with PSST: Despite Arnold's incredulity, he still needs nominal wage rigidity to make his story work. 

What happens if the Internet suddenly makes traditional industries uncompetitive?  According to Arnold, firms fail and unemployment jumps... until entrepreneurs figure out some new PSSTs.  And unfortunately, the last step can take years.  But if wages were as responsive to shocks as stock prices, firms and workers would have a far better alternative:

1. Cut wages in existing industries drastically enough to keep firms afloat and workers fully employed.
2. If and when entrepreneurs find new PSSTs, firms and/or workers move on to the newly discovered greener pastures.  If the PSSTs take a long time to discover, firms and workers say "Business as usual... for lower wages."

The simplest way to explain my critique: In Arnold's story, firms and workers violate the First Law of Wing Walking: Never let hold of what you've got until you've got hold of something else.  If you can find a new PSST, great.  But until you do, the smart move is to cut wages so you can stick with what you know.

To make his story work, Arnold needs the very assumption he's trying to escape: nominal wage rigidity.  With nominal wage rigidity, innovation affects employment and output, not just wages - and old industries contract before entrepreneurs discover greener pastures.  But if Arnold makes this move, PSST becomes a fruitful add-on for AS-AD, not a radical new approach.  Either he relies on the same "tenuous" assumption as mainstream macroeconomists, or he admits that nominal wage rigidity isn't so puzzling after all - especially in an economy with 99 weeks of unemployment benefits.
Arnold's writings on PSST are voluminous.  Maybe I've overlooked a post where he addresses this problem.  But the First Law of Wing-Walking objection seems awfully solid to me.  Arnold?
Update: The second-to-last link wasn't what I originally intended.  It's now fixed.

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The author at Eli Dourado in a related article titled Caplan on the ZMP Hypothesis writes:
    I’m puzzled by Bryan Caplan’s hostility (1, 2, 3) to the ZMP hypothesis. It is hard to think of another idea that is more Caplanian. This is after all the man who pointed out that “the lower deciles don’t contribute that much to... [Tracked on November 16, 2011 2:52 PM]
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Nathan Sumrall writes:

Arnold writes: "How is that the same workers who refuse to take lower nominal wages at a fixed price level are happy to see the same nominal wages at higher prices"

Im not sure this is the relevant question. I think it's reasonable to assume that a significant number of unemployed (and underemployed) workers would be happy to work for lower nominal wages, but they may be unable to do so because employers are uninterested. Firms that pay efficiency wages to a particular type of labor, for example, are not likely to reduce nominal wages just because a significant subset of that labor pool is willing to work for less.

Further, there is no perfectly reliable mechanism by which a firm can distinguish b/w a worker who is willing to work for lower nominal wages due to poor labor market conditions and a worker who is simply less productive than those who work for the prevailing market wage. Employers must factor thus risk into hiring decisions, which means they are unlikely to react quickly to a drop in the willingness to sell of any given type of labor. In the absence of a widespread nominal wage reduction for employed workers of that type, it seems that wages will be at least somewhat sticky independent of the willingness of unemployed workers to accept lower nominal wages.

Patrick writes:

You're assuming the marginal cost of labor has an impact. It could be that overhead alone costs more than the new alternative.

With Travel Agents, perhaps the machines bid the margins down to pennies per hour. Not able to cover office rent, the best alternative for the human agent is to get a different job.

With Construction, maybe houses weren't clearing even at the sum cost of materials. Developers then fired their work crews.

Seems like we need data on these prices / margins to gain some insight into the matter.

Tom Cullis writes:

Patrick hits the main point concisely. The argument behind PSST relies on the first S- sustainable. In a PSST/recalculation argument the period from 2002-2006 doesn't represent a sustainable patter and attempts to move back to that pattern by tinkering with the margins of the cost of labor isn't likely to work. The major flaw in your thinking is here

And unfortunately, the last step can take years. But if wages were as responsive to shocks as stock prices, firms and workers would have a far better alternative:

The difficulty in production is predicting what future consumers will want and what prices will they pay for it. Slashing prices doesn't automatically convey enough information to make these decisions profitably while it also sends the incorrect signal to current employers. If current employers see all their labor costs reduced broadly via inflation they end up with the mistaken assumption that their business model is acceptable (profitable) as profit margins return to the black. What happens then when the new PSST takes hold or starts to take hold? Their general costs should start rising again meaning the most marginal producers fall out of business and the "recovery" never gains traction.

It is organizers of capital that have the most valuable skill set in the economy. This story certainly sounds familiar to events under this crisis, Japan for the past two decades and the US in the 1970s.

Thomas DeMeo writes:

The obsession is to focus on wages only, but the real idea here only works if the overall costs in the supply chain are lowered enough for demand to meet a higher supply, not just labor. Such price adjustments would be uneven and unpredictable and would become overwhelmingly complex to deal with. An entrepreneur would be looking at a situation where all their information about how to make money is constantly destroyed. Who can really manage a business in a world where most costs are not sticky? Who is that smart?

This isn't just wage stickiness, it's human beings trying to retain information they can depend on.

Joe In Morgantown writes:

Add debt financing to the list of non-wage rigidities.

A debt financed firm often can not gracefully shrink to a smaller firm with thinner margins.

After bankruptcy, the firm could be reorganized, but that addition of capital is an entrepreneurial guess.

RPLong writes:

Given that nominal inflation never stops happening, ever, thanks to central banking, how can Bryan insist that wages aren't highly responsive in a way consistent with PSST?

It would take a lifetime to try to tease real wage rates out of the macroeconomic data. Taking the shortcut and using CPI or something does not do the trick because the very first thing every employee spends his/her paycheck on is food and energy, excluded from the deflator.

I think a lot of macroeconomists miss this point. We really don't have a good idea of what's happening with inflation, wages, and price responses because our calculations are perpetually undermined by inflationary policy.

Silas Barta writes:

@Joe_In_Morgantown: You're right about debt financing (at fixed interest) being a rigidity, but I think the lesson to take away is debt financing carries a (widely unappreciated) cost: the inability to tolerate shifts in the business environment. This would seem to violate the "sustainable" bit.

(I'm not sure if I'm arguing against something you actually endorse here, but that's usually the reason people bring up debts as an undesriable rigidity.)

Chris Stucchio writes:

Bryan, you focus on wages. But wages are not necessarily the relevant price. The relevant price is the total cost of the old production process.

An example: At my company, we previously relied on Indian laborers to categorize items in our catalog before we found a cheaper process. Suppose our workers lower their wages one hundredfold to 1 rupee/hour, which is far below India's statutory minimum wage and is also well below subsistence levels. The cost would still be 1500 rupees/month on labor plus tens of thousands of rupees/month for an office.

The new PSST is simple: I pay my laptop about 10 rupees worth of electricity and the Bayesian learning system I built has replaced 90% of the old human labor.

No matter how cheap human labor is, it can't compete with my laptop. Those workers simply have no choice - they need to find a new line of work.

(Luckily for them we had other jobs for humans, so we just changed their roles and decided not to create jobs. On net, # of jobs still went down.)

SWH writes:

"the smart move is to cut wages so you can stick with what you know" is often the least likely event. Most workers have a life that depends rigidly on their current wage. If their employer drastically cuts wages, rather that stick with "what they know" that will lead to bankruptcy/divorce, etc. most workers will quit to either: 1) hopefully replace the needed wage or 2) complain that it isnt their fault that they are unemployed. Employers know this....hence sticky wages. This is history.

Daublin writes:

If an existing firm only needs 10 employees when it used to need 100, why would lower wages cause them to hire more? They'll just stay in business and not hire as many people. Perhaps they'll pay those 10 less, on account of the unemployment. Perhaps they'll pay them more, because they're choosing the creme de la creme and it's competitive at the time.

It's good to be the 10 that stayed on. I don't see how floating wages will help the other 90, though. Their expertise is in an area where it's not needed at any price.

bryan willman writes:

" not needed at any price" - that is the key.

i have harped on this at length - economists seem to constantly miss that in some set of circumstances labor has a negative value - as in the person would have to pay me to come work for me.

it is, i suppose, the worst sort of deflation....

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