Scott Sumner  

Conservatives better hope that wages and prices are sticky

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Macroeconomists are often lousy political philosophers. In previous posts I've discussed how macroeconomic views that are considered "liberal" or "conservative" actually have no obvious relationship to those political stances. For instance there's no obvious reason why "using monetary policy" (as Milton Friedman preferred) is less interventionist that a countercyclical budget deficit (as Keynes preferred.)

One of the most amusing examples of this phenomenon is the critical reaction to Friedman and Schwartz's Monetary History of the United States. When the book first came out the message was viewed as being "conservative". Thus the Great Depression (in their view) was not caused by the inherent instability of capitalism, but rather by bad monetary policy. All of the statist interventions of FDR were not needed, and indeed were often counterproductive. (That's still my view.)

By the 1990s, however, it was liberal economists who defended the book against conservative critics. By the 1990s, many of the right had moved past monetarism to flexible price "equilibrium models' of the business cycle, AKA, real business cycles. Keynesians kept insisting that because of sticky wages and prices, aggregate demand shocks still matter---and pointed to the Monetary History as supporting evidence.

If you survey the field of macroeconomics, circa 2017, you see economists on the left almost unanimously acknowledging that wages and prices are sticky and that demand shocks have real effects on output. On the right side of the spectrum, there are people like Greg Mankiw, John Taylor and I who believe that wages and prices are sticky, but also a large group who are skeptical about whether wage and price stickiness is a key issue in the business cycle.

In fairness, the stickiness skeptics hold views are often fairly nuanced, with some acknowledging price stickiness as a factor, but doubting its importance. Still, it's clear that on average the skepticism over sticky wage/price models of the business cycle is far more pronounced on the right than on the left.

An outsider might naively assume that this political dichotomy occurs because wage and price stickiness is what Al Gore would call an "inconvenient truth" for those on the right. Nothing could be further from the truth. I am mostly on "the right" in my economic philosophy, but that's only because I believe wages and prices are sticky. If someone convinced me that they are actually flexible, I might be inclined to become more of a socialist.

I believe that a combination of sticky wages and monetary shocks produce most of America's economic slumps, including the Great Contraction of 1929-33, as well as other big recessions like 1920-21, 1937-38, 1981-82 and 2008-09. I do not believe the capitalist system is "inherently unstable" and that big government is needed to stabilize it, rather I believe that it is naturally stable, as long as bad monetary policy doesn't interact with wage stickiness to produce business cycles.

But suppose it were shown that I am wrong, and that wage/price stickiness is not an issue---what then? That would be very bad news for my laissez-faire ideology. Now I'd have to concede that events like the Great Contraction of 1929-33 showed that capitalism is indeed inherently unstable, and that this problem could not be fixed with good monetary policy. Now I'd have to entertain other solutions, such as big government and or comprehensive economic planning.

To be fair, the real business cycle view that "technology shocks" cause business cycles is not necessarily identical to the left wing view that capitalism is inherently unstable. What RBC economists call 'technology shocks' could simply be bad economic policies by the government. And in my view they sometimes are bad policies. The NIRA caused the recovery to stall from July 1933 to May 1935, while Nixon's wage price controls led to an artificial boom in1972, and then a deep recession after they were removed and workers sought catch up pay increases.

But my reading of economic history is that it not possible to develop a general theory of the American business cycle based on bad government policies. Indeed even where bad policies play a role, such as Hoover's policy of high wages, high tariffs, and high taxes, they don't even come close to explaining the 1929-33 downturn. The same policies during a period of stable NGDP growth would have simply meant a bit of stagflation. And lots of periods of "big government" policies are associated with strong growth, such as the period of LBJ's Great Society (1965-69).

So thank God that the right is wrong about wage/price stickiness! It is a major issue, and when combined with bad monetary policy it leads to economic instability. Without wage price stickiness it pretty hard to argue in favor of conservative economic policies. The Great Depression directly led to immense human suffering and indirectly led to WWII, which caused even more suffering. Those things simply cannot be allowed to happen. Without wage price stickiness, the right would not have any persuasive arguments against those who want to use much more interventionist policies to prevent economic Depressions.

Without wage/price stickiness, capitalism really would be inherently unstable.

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COMMENTS (13 to date)
Radford Neal writes:

Just to be sure I understand, are you saying that without a belief that wages and prices were sticky in the past, it would be hard to justify capitalism?

But if I understand correctly, you're not saying that for capitalism to work, wages and prices need to be sticky in the future?

It's a significant point, since some people might advocate policies intended to reduce wage and price stickiness.

Lorenzo from Oz writes:
The Great Depression directly led to immense human suffering and indirectly led to WWII, which caused even more suffering. Those things simply cannot be allowed to happen.
Just like the Euro miseries might lead one to discount the pretensions and value of the EU.

If wages have got stickier over time (as I would have thought they have), does that mean monetary policy has got more important over time?

Andrew_FL writes:

My problem with the idea of "price stickiness" is not that prices are "not sticky" it's that it is merely a description of historical price behavior-that prices do not behave as if set by a Walrasian auctioneer, which funnily enough, everyone *before* Walras understood just fine-but it is not a theory of why prices do eventually change. The process of price adjustments is the actual thing that requires our attention.

To be fair, the real business cycle view that "technology shocks" cause business cycles is not necessarily identical to the left wing view that capitalism is inherently unstable.

You don't give them enough credit, actually. The thing is that if they were correct about business cycles, it would in fact imply that there is nothing for doing anything about business cycles, that they are simply a fact of nature under any economic system.

Nick Rowe writes:

Scott: "But suppose it were shown that I am wrong, and that wage/price stickiness is not an issue---what then? That would be very bad news for my laissez-faire ideology. Now I'd have to concede that events like the Great Contraction of 1929-33 showed that capitalism is indeed inherently unstable, and that this problem could not be fixed with good monetary policy. Now I'd have to entertain other solutions, such as big government and or comprehensive economic planning."

Interesting new thought, for me.

ChrisA writes:

I think the "inconvenient truth" part arises over the idea of the need for a guiding hand in running the economy, like the Fed being able to steer monetary policy in the right as opposed to the wrong direction. Its smacks of central planning. The problem for these commentators is that they agree with you that sticky wages/prices demand the need for the this "coordinator", which they don't like. So if we can get rid of sticky wages, we can get rid of the coordinator. In terms of historical events showing the need for such a coordinator, like the great recession, I think their response would be that there was such a coordinator and it made things worse, or at least didn't solve the problem, so proving their point.

I have some sympathy with at least some of this thinking, if you say linked currency to gold, it is in theory less effective than a fiat currency system in responding to shocks, but in practice it could be less politically manipulatable and thus, if only by chance, would avoid some of the errors of a technocratic system, which could actually be pro-cyclical.

The good thing I think though is that market monetarism avoids both of these problems, firstly there is a counter cyclical part built in, and second the technocrat discretion is removed.

David R. Henderson writes:

@Scott Sumner,
Radford Neal asks the key question above. I would be interested in your answer.

AntiSchiff writes:

I am also interested in ideas about mandating wage flexibility. Forgetting the political reality for the sake of conversation, why do so few economists support the idea of say, making it illegal to cut hours or jobs during downturns, requiring every employee to take equal wage cuts instead? Isn't this something Germany's had some success with?

AntiSchiff writes:

Dr. Sumner,

I was mistaken about Germany's policy. Apparently they allow hours to be cut during downturns.

But, what if they didn't allow hours or jobs to be cut? Or, to take this further, which if wages were required to be paid in real terms, rather than nominally?

Scott Sumner writes:

Radford, Yes, your first point is correct. If wages and prices have not been sticky, then business cycles are due to some other factor, which would be really bad for advocates of capitalism. I actually think wage/price flexibility is desirable, so I'm not advocating stickiness.

Lorenzo, Yes, good point.

Andrew, I don't agree with your view of RBC theory. It implies that demand side policies do not stabilize the economy, but does not rule out other policies.

Thanks Nick.

AntiSchiff, I think it would be far more feasible to make monetary policy more stable, then to try to make wages more flexible. I often use the analogy of airplanes. It's easier to improve the reliability of airplanes than to do something about gravity. Wage stickiness is like gravity--a given that needs to be taken into account.

Yaakov Schatz writes:

Thanks for the post, which increases my economic understanding. Though, I would like to disagree and suggest a different direction.

You mention the Great Depression as the reason that intervention is necessary, not the 1920-21 or 1981-82 recessions. What if without Hoover's policies and the Nira the Great Depression would have been a much milder recession? Would it still warrant intervention, with all the risks and misery that come with such intervention? Would we not be better off with laissez-faire and those mild business cycles? I assume that would depend on what percentage of the Great Depression you attribute to sticky wages.

AntiSchiff writes:

Dr. Sumner,

That is interesting. So, the enforcement of such a law wouldn't be feasible? Presumably, this is a widely held view, since I don't recall a single economist calling for mandated wage flexibility. Yet, when it comes to monetary policy, while the concept of how to run good monetary policy seems simple, most central banks have far from exemplary records.

Thaomas writes:

I'd like to hear Scott's view of how damaging a supply shock like NIRA would have been if the Fed had been carrying out and was know to be carrying out an optimal monetary policy (keeping NGDP stable, or growing at x%.) Of course it was not, but then how much of the damage that occurred after NIRA was the shock and how much the monetary policy. A similar question could be asked about FDR's move to austerity with the tax increase aiming at reducing the deficit.

Jose writes:

Prof. Sumner, you said "So thank God that the right is wrong about wage/price stickiness! It is a major issue, and when combined with bad monetary policy it leads to economic instability."

But if wage/prices stickness did not exist, why would we need monetary policy? If that were not true, wouldn't it be better just to abolish the monetary authority and have free banking ?

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