Arnold Kling  

Bryan Caplan Crosses Nick Rowe

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Bryan writes,


Unemployment is just a labor surplus; since wages are the price of labor, the fundamental cause of unemployment has to be excessive wages.

Nick Rowe writes,

The only way to increase output in a demand-constrained economy is to do something that changes that relationship between output demanded and output, so that more output is demanded for any given level of output.

Emphasis in the original. And no, I don't understand it, either. Maybe there is something confusing about aggregate demand. Or maybe Nick was in a hurry to grade papers.

Bryan was trying to make a relatively simple point. In a world that thinks at the margin, lower wages should increase employment. First, there is the substitution margin, where you decide whether to use labor or other inputs. More energy or more labor? If wages are low, you pick labor. (Green jobs!) More capital or more labor? If wages are low, you pick labor.

Then, there is the expansion margin. With lower wages, your marginal cost goes down, enabling you to cut your price, sell more, and produce more. With more labor input.

One version of macroeconomics, which I call textbook macro, preserves this marginal analysis. In textbook macro, nominal wages are sticky, so that a drop in nominal demand raises real marginal cost and lowers output. Textbook macro is not terribly plausible in theory (it leans really hard on money illusion that even affects potential new employment relationships, not just existing ones), nor is it well supported empirically. We don't observe the strong countercyclical relationship between real wages and employment that is implied by textbook macro.

As an aside, I am not sure I accept the claim that a declining nominal wage is contractionary because of the damage it does to borrowers. Yes, deflation transfers wealth away from borrowers. But by the same token it transfers wealth to lenders. Why is that necessarily contractionary? In fact, if you think about government debt, the effect should go the other way. As you get deflation, the real value of government bonds goes up. If people are not Ricardian-equivalencers and view government bonds as net wealth, then deflation should be expansionary. It works like an increase in real government spending.

Once you leave textbook macro behind, I think you have to come up with a reason to deny that marginal analysis is operative. What Nick may be trying to say is that in the aggregate, demand is inelastic with respect to the nominal price level. Reduce all wages and prices by 10 percent, and nothing real should change (ignoring an increase in the ratio of outstanding money to the price level). I don't like thinking about macro that way, because we pretend that a whole bunch of things happen instantly, and I find that so unrealistic that I cannot get my head around it. I prefer to think about very slow adjustment processes.

The PSST story would be that labor is heterogeneous. The demand for labor with skill set x may be quite inelastic with respect to wages. Maybe skill set x does not even directly produce output (instead, it is Garett Jones labor, building organizational capital), so that lower wages for skill set x do not reduce your marginal cost. Maybe the industry that employed workers with skill set x has been so radically disrupted by new technology that firms are in the process of substituting away from workers with skill set x at almost any wage rate. No wage is low enough to bring back door-to-door encylopedia salesmen.

With the PSST story, unemployment exists because the economy is in the process of adjustment. Entrepreneurs have not figured out a good use for unemployed workers. They won't figure it out faster just because wages are reduced by a little bit. Short-run elasticities are low, so that workers with specific skill sets do not find much in the way of marginal responses to small wage cuts.

If wages are reduced dramatically, then entrepreneurs are likely to create jobs, but those could be the wrong jobs. Jobs that only make sense at ridiculously low wages are not really part of *sustainable* patterns of specialization and trade. In the long run, the economy might find jobs at better wages for those workers.


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COMMENTS (13 to date)
joeftansey writes:

Its because if you cut wages, then you cut overall nominal purchasing power. So you either consume less or lower prices. How do you know which one will happen?

What Rowe is *trying* to get at is that you don't want to cut wages if prices aren't going to fall too. And ideally, you want raising wages and falling prices, which is what he means by "more output is demanded for any given level of output".

Its not clear how this is supposed to happen. I think its just going to be an empirical combination of phenomena. So I don't feel safe recommending higher/lower wages/prices, but I do feel safe criticizing the incentive structure of the state.

Steve Roth writes:

"Yes, deflation transfers wealth away from borrowers. But by the same token it transfers wealth to lenders. Why is that necessarily contractionary? "

Because of the declining marginal propensity to spend at higher income/wealth levels. I know you know that answer, so I'm flummoxed why you ask that wide-eyed question.

Bill Woolsey writes:

Rowe is not saying anything much about lower nominal wages. He is saying that any analysis that shows that lower nominal wages raises employment in aggregate must appeal to the impact on the supply and demand for money.

I think that the "isoquant" approach applies at a given level of output. But shifting production technique to methods with lower labor productivity is a slow process.

Rowe's point is that a lower wage can allows a single firm (or industry) to lower relative price and so raise quantity demanded of output and so employment, this doesn't work for all firms or industries at once. They can't all lower their prices in relation to one another.

Similarly, it is quite possible that lower real wages would make firms want to produce and sell more output and hire more workers, but they won't hire the workers if they can't sell the output.

Why do lower prices allow firms to sell more output in aggregate? It has to do with the quantity of money and the demand to hold it.

david writes:

I think you are being disingenuous in skipping over the entire three-equation macroeconomic framework that has moved beyond Hicks a la EC10 - a framework which happens to be the dominant paradigm which you are allegedly seeking to replace.

Jon writes:

Nicks point is not about relative prices; all industries could cut real wages. The point is that unexpected deflation causes money demand to rise. When money demand rises it displaces output demand. The result is less production and therefore lower demand for labor.

This is a self reenforcing spiral.

The trouble is: the old keynesian yarn makes use of this argument to establish that markets arent always self-correcting. Then the chapter changes and we're treated to nonsense about demand stimulus (directly driving real output).

That idea might have had merit when we were still operating under gold parity but it hasn't had merit since Nixon closed the gold window.

Steve Sailer writes:

There are huge fixed costs associated with hiring someone, often hard to forecast: health costs affecting your firm's insurance premiums, the risk of paying out lifetime disability, the risk of being sued for discrimination or sexual harassment or whatever ...

One strategy for fighting unemployment would be to lower those fixed costs.

Jonathon Hunt writes:

@ Roth

It's only contractionary in short-term statistics, such as GDP for the next month. The point Kling is trying to get across is that you're merely doing a short and long term tradeoff, where the long term is definitely the more efficient choice. Putting the money into the hands of people with higher MPCs may help in the short run, but this would have relatively larger costs than promoting long-term investment, which starts off the usual chain reaction of economic growth. In other words, keep 10 jobs now, or abstain consumption now to increase savings and hire 20 workers later? Thus, it does not follow that it is necessarily contractionary.

Snorri Godhi writes:

"I am not sure I accept the claim that a declining nominal wage is contractionary because of the damage it does to borrowers. Yes, deflation transfers wealth away from borrowers. But by the same token it transfers wealth to lenders. Why is that necessarily contractionary?"

Yes, I was going to make the same point in my comment to Bryan's post; but I am more interested in the 2nd order effect: by transferring wealth from lenders to borrowers, Keynesian policies create a disincentive to save.

A finer point is that this wealth transfer is mostly from small investors to the government and people with losers' mortgages: the incentives of the rich and of big business are not much affected.

"In fact, if you think about government debt, the effect should go the other way. As you get deflation, the real value of government bonds goes up."

This is another can of worms, since government incentives should also be taken into account. The government has considerable influence on inflation/deflation, but bond holders are aware of this gov. power, and the interest rates they demand are in relation to this power. This is why I do not think that a return to the drachma would be a good idea for the Greek government.

Nick Rowe writes:

Sorry for the delay in responding, and for not making my original post clearer. One shouldn't complain about grading exams, since it's the only bad part of an otherwise very good job, but...I don't like doing it.

Bill Woolsey basically says what I'm trying to say. With a bit of Jon thrown in too, as an additional point.

Why does the labour demand curve slope down? Let's consider Arnold's two margins:

1. When wages fall, relative to the price of other inputs, firms use more labour-intensive methods of producing the same level of output (moving along the isoquant).

Sure, that reduces unemployment of labour, but increases unemployment of land and capital. It just redistributes unemployment. And since total output is the same, total income is the same. Depending on the elasticity of substitution, labour's share of that given income will either rise or fall, but absent any distribution effects, it's a wash at the macro level.

2. When wages fall, relative to the price of output, firms want to hire more labour and sell more output. W/P=MPL. But this only works if they can actually sell more output. If they can't sell any more output, firms won't want to hire any more labour, even as the wage falls to zero. And if there is no excess demand for output originally, firms *won't* be able to sell any more output, unless, maybe, the price falls.

So let's consider:
3. When wages fall, firms cut prices too. For the individual firm, this works fine. Buyers of output substitute away from other firms' output and buy more of our firm's output. But can it work in aggregate, if all firms cut prices? That's when you have to start talking about the AD curve. Why does it slope down, if it does? And that's when you have to start talking about the demand and supply of money, because if people want to buy more output, at a given level of output (i.e. income), then they must be planning to get rid of some of their stocks of the medium of exchange.

The normal textbook story is that when P falls, holding M constant, M/P rises, and this creates an excess supply of money, so people try to get rid of that excess stock of money by buying more goods.

But this all depends on the money demand function and the money supply function.

My point is that you can't talk about whether (aggregate) wage cuts reduce unemployment without talking about the demand and supply of money.

Paul Krugman would argue, for example, that the demand for money currently in the US is perfectly interest-elastic, so a fall in W and hence in P and increase in M/P will not create an excess supply of money. And if a fall in P created expectations of a further fall in P, it would increase the demand for money, and make unemployment worse.

Nick Rowe writes:

BTW, when you talk about changes in the distribution of income affecting aggregate demand, it is not differences in marginal propensities to *consume* that matter.

Keynesians sometimes tend to get a bit muddled on this point. "Consume" is not a synonym for "spend". "Save" is not (in economics) a synonym for "not spend" either. Nor is "consumption plus investment" a synonym for "spend".

What matters is the marginal propensity to *hoard* the medium of exchange. You cannot think clearly about deficiencies of aggregate demand without recognising that they are an excess demand for the medium of exchange.

Nick Rowe writes:

Oh, and let me explain what I meant by this bit:

"The only way to increase output in a demand-constrained economy is to do something that changes that relationship between output demanded and output, so that more output is demanded for any given level of output."

Output demanded Yd depends on income Y, and on other things X.

Yd=F(Y,X)

Income Y is the same as output actually sold, which is the lesser of output supplied (the quantity firms *want* to sell) Ys, and output demanded (the quantity people *want* to buy) Yd.

Y=min{Ys,Yd}

In a demand-constrained economy, Ys>Yd, so:

Y=Yd=F(Y,X)

There is (presumably) a solution for Y that satisfies that equation.

If we want to increase Y, we have to increase X, in order to (as I said) "...do something that changes that relationship between output demanded and output, so that more output is demanded for any given level of output."

That's what I meant.

Yes, this looks like the old Keynesian Cross. But what is X? X is something to do with the demand and supply of the medium of exchange.

Liquidationist writes:

RE: Bill "Rowe's point is that a lower wage can allows a single firm (or industry) to lower relative price and so raise quantity demanded of output and so employment, this doesn't work for all firms or industries at once. They can't all lower their prices in relation to one another."

I don't understand this point. If (for example) all wages fell and all other prices and quantities sold stayed the same then profits would increase at the expense of wages as a share of national income and AD would stay the same (as it assumed that all the additional profits are spent and not hoarded). However if the change in wages came from the supply of labor curve moving to the right and the demand for labor curve is not vertical then more labor will be supplied at this lower price.

There will be a substitution effect between labor and other original factors but I find it hard to see how real GDP would not rise.

The totality of wages, profits and returns to other factors will be sufficient to buy all the increased production and so total demand will have increased a a result of a fall in wages.

Depending upon how the above process affects the demand for money then prices may fall (or even rise) but that seems irrelevant to the overall analysis.


TSgt Ciz writes:

Disclaimer: I am not an economist, nor do I play one on TV. I am, however, a real person who has experienced long term unemployment due to severe contraction of the technology industry in my area.


In my humble opinion, the number 1 issue holding back a large number of unemployed workers from going back to work is unemployment checks and the Credit Reporting system in the US.

During my stint as an unemployed worker for 2 years, 2 months, and 2 weeks, I encountered several oportunities to go back to work. I did not take them because it would have been more destructive than remaining unemployed. The amount of money I recieved from unemployment was more than what I would have recieved from gainful employment after taxes. I was consuming my savings and available credit at a rate that meant I could hold out for as long as the unemployment checks flowed. But if I went back to work, I would certainly lose my house. Now losing the house was not in itself the worst thing that would happen. I would also lose my excellent credit rating. If I lost the house, I could buy another one in a couple years, with a new job perhaps in a new town. But only if I could protect my Credit Rating. To do that I would need to sell my house before it foreclosed, which is not possible in an area where the housing market has been severly contracted. Despite the fact that I went into the Recession owning >40% of my homes value, I am now upside down on the mortgage. I considered surrendering the house several times, but the hit on my credit would mean higher auto insurance, higher Credit Card rates, and a far less likelyhood of even being interviewed for most good paying jopbs. So regardless of any other oportunity, I had to defend the home loan for as long as I could, and the unemployment check was the best possible choice to that end.

My point is, contracting the wages while leaving the debt fixed *AND* having a exptremely punative
Credit Rating system, garuntees labor will not come off the unemployment rolls until wages for the available jobs rises, and that wont happen until a large number of unemployed come off unemployment and take those open jobs, depleating the available labor reserves. A catch 22 situation created by Washington DC over the last 5 to 7 years.

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