Labour skills and sticky wages: Is the problem worse now?

The mass unemployment in the 1930’s has sometimes been put down to “stick wages”. Fundamentally, the value of labour fell but the price didn’t – leading firms to cut back on employment at a faster rate than would have been socially optimal.

Since then, wage stickiness appears to have eased to some degree: Unions are less powerful than they were, and employees have a greater level of understanding about why firms may have to cut nominal wages – leading to less of a psychological impact (Note: These statements are just conjecture – if you don’t agree with them feel free to state in the comments, we could really do another post on it 🙂 ).

However, does that mean that the underlying issue of labour market adjustment has abated? The short answer is no.

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Remember history when thinking of Keynesian economics

Over at Think Markets Mario Rizzo follows the advice of Paul Krugman and discusses what Keynes has actually said about infrastructure spending (ht Greg Mankiw):

Organized public works, at home and abroad, may be the right cure for a chronic tendency to a deficiency of effective demand. But they are not capable of sufficiently rapid organisation (and above all cannot be reversed or undone at a later date), to be the most serviceable instrument for the prevention of the trade cycle

So infrastructural investment is good when we are in some sort of reinforcing hole where effective demand is deficient and “will not” go back to our primary equilibrium. However, Keynes appears to be deriding infrastructural investment as a way to smooth the “economic cycle”.

I see this quote as justification for the idea that, if we have multiple pareto ranked equilibrium and a large shock government can help – but if we have a temporary shock to demand infrastructural investment is not the way (furthermore it says nothing about structural shocks, which is part of the current story). I don’t actually think this conclusion leads to an ability to dismiss either the view of Krugman, or the views of Mankiw – given that they ultimately have different beliefs on what is the proper description of the current events we are facing …

A structure for our value judgments

Earlier I mentioned that Paul Walker and myself had different ideas surrounding the need for a stimulus in the US. Fundamentally I think he is completely against while I see scope for some stimulus.

Over at Brad Delong’s blog he mentions a description of the stimulus by Kevin Murphy.

The structure he describes is below:

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On the issue of crowding out

Eugene Fama has written a much maligned post on stimulus packages. As a medium-long term view there is really nothing wrong with it, but the large swath of criticisms that have appeared focus on the fact that the author appears to be implying that there is no short-term stabilisation possible from expansionary fiscal policy – namely, government investment is completely crowded out.

Given that everyone else is talking about it, I thought I would add my relatively inconsequential two cents 😉 . This is from an email I sent along to CPW.

I’m really with Greg Mankiw.

I think that the criticism that Brad Delong laid out – that inventory is counted as investment but is over-valued – is really a second order issue. The main issue with this is that the mix of credit rationing and a flight to quality does support the idea that there is not complete crowding out – contrary to what Fama implicitly assumes. This in turn implies that government spending can smooth the economic cycle.

How does this hold with the S=I identity? I would say that:

  • Given the existence of “low risk” government investment this (an increase in government investment) would lead to an increase in savings to match the increase in investment – people are more willing to loan to government than business after all,
  • Given the presumption of unemployed resources (and credit constraints) there is scope for an exogenous positive shock to invest (which government investment is) to lead to an increase in equilibrium savings and investment – given that the use of unemployed resources creates value which could not be picked up by the private sector because of credit constraints/catatonic fear.

Even if I thought that the US was at potential (which I don’t – I just think the output gap could be overestimated) the whole attitude to risk and credit rationing surely implies that complete crowding out does not hold – sure S=I always holds, but not complete crowding out.

I realise I’m not adding anything to the debate. However, this blog is a good place for me to store things the way I see them at a given point in time, and thats just what I’m doing damn it 😀

If anyone thinks I’m talking crack, feel free to tell me in the comments 😉

Note: In case it isn’t clear the first mechanism reduces consumption, so no instantaneous stimulus even in the face of no crowding out! However, it does allow for a “reallocation” from consumption to investment, if the price signal was screwy for some reason this could be optimal.

The second leads to an indeterminate change in consumption (given the first mechanism – the income effect in of itself will increase consumption), but a net stimulus.

These are important factors to note when we ask “is an increase in government investment increasing output” and furthermore “is an increase in GI increasing welfare” – which is the ultimate goal.

Note2:  There is also the case where public investment is more productive than private investment.  I don’t think this case is as unlikely as people say – given that the government may have easier access to some resources than the private sector (and given the possibility of increasing returns to scale, especially in a small place like New Zealand).

The morality play of the “non-morality play”

In an interesting piece over at Economist’s View the case is made from moving away from “morality arguments” and just looking at how we can pull ourselves out of the depression now.

Although the piece provides a clean argument, and involves discussions by economists as intelligent and convincing as Martin Wolf and Paul Krugman I have to admit I nearly completely disagree with it.

Fundamentally, I believe that these economists are making an implicit moral judgment when they state that we need to “improve current outcomes” through employment and consumption. I am not saying that they are wrong, however trying to make their conclusions sound value free is incredibly misleading.

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The upcoming war of succession and the future of Macroeconomics!

It appears that economics is on the verge of war … ok maybe I’m being melodramatic – but the change in tone of economists recently (well, actually mainly macroeconomists) has been startling!

During the credit crisis, more and more economists have moved towards a panicked position.  However, the first true indication that this might be different than a few little methodological spats came to me from these posts (Econlog and VoxEU).

These posts indicated that the very structure of economics was preventing research into valuable fields – we had failed to achieve knowledge by focusing on “equilibrium”, “mean reversion”, and/or the constant obsession by ignoring the depression when we analyse data.

There are two primary areas where I think the main set of criticism will fall – and the size and scope of this criticism will determine whether it is war, or merely an evolution of ideas.  These areas are 1) aggregation and stability conditions (so macroeconomics and its current foundations) and 2) behavioural assumptions (a more widely shared issue).  Tyler Cowen links on both issues to some degree 1,2.

Hopefully there is a realisation that economic methods and models are useful – even if the value judgments economists make aren’t always up to scratch.  My concern is that disputes about value judgments will lead to a situation where the entire framework is thrown to the side.  However, if this occurs it will be partially the result of some economists inability and unwillingness to describe their assumptions openly – something we should all keep in mind.