Monday, May 17, 2010

Assault of Thoughts - 5/17/10 - Special Wage Edition!

"Words ought to be a little wild, for they are the assault of thoughts on the unthinking" -JMK

How do surpluses go away? Prices fall. That's just about as basic an insight into the economy as you'll get. It's a great rule of thumb for just about any market, including the labor market. However, some people argue that it doesn't always hold true in the labor market, and that little wrinkle has been the source of a considerable amount of debate and research. I have a few links and thoughts on these sorts of wage questions to share today.

- David Henderson is one of many that vigorously hold to the view that if real wages were simply allowed to fall, unemployment would recede. He said as much in a reply to Brad DeLong here, citing the recession in the early 1980s. DeLong had previously asserted that declining real wage rates had not fixed the economy since 1920-21 (more on that episode below). Menzie Chinn concurs with DeLong, citing real non-farm business compensation. David Leonhardt disagrees and sides with Henderson, citing real production worker wages. For theoretical reasons I have to side with Henderson and Leonhardt (again - more on those reasons below), but Chinn's data should at least suggest to all parties that the amount of adjustment carried by real wage adjustments wasn't substantial. Chinn presents a much broader measure of wages than Leonhardt (who only looks at production workers), so I think the Chinn data should be given decent weight. I'm not accusing Leonhardt of cherry-picking, but it is conspicuous that he uses the narrower measure without explaining why.

- New Keynesians implicitly agree with Henderson that if real wages could simply be reduced, a lot of our unemployment problems would just go away. However, they make a point of highlighting the empirical finding that wages can in practice be quite rigid, and trying to explain the source and consequences of that rigidity. This week's release of new NBER working papers has an example of a New Keynesian flavored approach that cites how wage policies tied to tenure and other observable variables can introduce wage rigidity.

- My view on these New Keynesian approaches is mixed. Obviously if wages aren't adjusting, that can be bad news for employment (Krugman has a very depressing point about this with respect to Europe today). The fact that we can think up a million reasons why there would be rigidities is a good indication that there are actually rigidities, and that they are important. But there's something a little post hoc about the whole approach, isn't there? It's not entirely satisfying in that sense. Roger Farmer agrees, and presents a revised Keynesian model that does not depend on the New Keynesian wage rigidities for its results. He describes his unique approach very well in an essay at VoxEU:

"The equilibrium concept I have described sounds a lot like the one used in search models that have been widely studied in the literature... But my concept has fewer equations than unknowns. Decentralisation of the social planning solution requires the addition of two markets and two prices: One for the time of a searching worker and one for the time of a searching recruiter. The search equilibrium adds just one price; the money wage.

As a consequence, my model has many labour market equilibria in the steady state. A given number of jobs may be filled by many searching unemployed workers and a few searching recruiters. Or it may be filled by a few searching recruiters and a large number of unemployed workers. The relative prices that should direct market participants to the optimal mix of unemployment and vacancies are missing.

I believe that search theorists have missed this fact because we are trained, beginning in graduate school, to look for a model in which prices and quantities are uniquely determined by fundamentals. When confronted by an underdetermined model, existing theorists have chosen to add an equation in an attempt to bring the theory into line with existing general equilibrium models. Typically they make the assumption, that when a firm and a worker meet, they bargain over the wage. I believe that a more fruitful theory can be developed by throwing away this assumption and recognising that there is a pervasive labour market failure, and as a consequence, any unemployment rate can be an equilibrium. "

- Farmer's rejection of frictions and rigidities as an explanation of unemployment of course harkens back to Keynes, who noted the prospect and potential importance of rigidities but did not rest his theory on it as many people commonly suppose. Keynes considered the role of wage adjustments for a recovery in great detail in chapter 19 of the General Theory. He spends the chapter going through seven factors that will determine when wage reductions will reduce unemployment, and when they won't. Unfortunately, most people aren't closely familiar with this chapter, and the ones that are (Krugman is guilty of this) often point to it and say "in his Money Wages chapter Keynes shows that when you reduce wages you reduce demand so you don't fix anything". He doesn't actually say this. He splits the text pretty close to fifty-fifty between scenarios where wage reductions will help and when they won't. It's worth reading the chapter in its entirety. I've only read the General Theory all the way through once (I plan to again this fall), but I've read the Money Wages chapter many, many times at this point. Which brings me to:

- The episode that both David Henderson and Brad DeLong (and Daniel Kuehn and Keynes) agree on, namely, the 1920-21 depression (my new favorite economic catastrophe). As many of you probably know, I've drafted a paper on the 1920-21 depression. Comments are welcome, but I'll be submitting it to a journal as soon as I hear back from a colleague and make a few additional adjustments. The 1920-21 depression was sharp and quick, and it was notable in that a robust recovery was preceded by sharp wage reductions across all industries and regions. In this paper, I'm critiquing several authors who have claimed that the 1920-21 downturn "disproves" Keynesian economics, but my points are also relevant to guys like Henderson that put a lot of weight on this sort of episode as proof about the importance of wage adjustments in a recovery. I go over a lot of historical inaccuracies peddled in the recent literature on this depression, but the heart of my theoretical analysis is basically that (1.) 1920-21 was a perfect storm of the conditions that Keynes said would be required for wage adjustments to be successful in guaranteeing an economic recovery, but that (2.) because 1920-21 was a perfect storm of these conditions, it's not an appropriate counterfactual for situations like the Great Depression or the current downturn which happen to be a perfect storm of all the conditions that Keynes said would make wage adjustment ineffective. This post is getting long, so I won't go into detail here (you can look at the paper) - but the relevant factors that Keynes considered were things like the interest rate, price expectations, and the level of wages relative to foreign wages.

No comments:

Post a Comment

All anonymous comments will be deleted. Consistent pseudonyms are fine.