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Saturday, March 28, 2009

Barro, Krugman, Keynes and wage stickiness

Paul Krugman criticized Robert Barro writing

Update: I should also point out this, in Barro’s article:

John Maynard Keynes thought that the problem lay with wages and prices that were stuck at excessive levels. But this problem could be readily fixed by expansionary monetary policy, enough of which will mean that wages and prices do not have to fall.

Is it too much to ask that someone criticizing Keynes actually, you know, read Keynes — at least enough to know that he devoted a whole chapter to explaining why a fall in wages would not expand employment? Or that someone commenting on contemporary policy at least be aware that the whole reason we’re talking about fiscal expansion is that monetary policy has run out of room?

To be picky and display ultra nerdiness, I would like to note that Krugman got his citation a bit wrong. The chapter in question can only be Chapter 19 "Money-Wages" which comes after Chapter 18 "The General Theory of Employment Restated" and is explicitly a response to the natural critique of The General Theory that, if wages are flexible, involuntary unemployment is impossible.

However, the argument in chapter 19 is a bit feeble. Mostly Keynes argues that if one wants lower real wages it is better to drive up prices wtih monetary policy than to try to lower "money-wages" (nominal wages). He also claims that neither monetary policy nor wage cutting is a good approach to depressions because

Just as a moderate increase in the quantity of money may exert an inadequate influence over the long-term rate of interest, whilst an immoderate increase may offset its other advantages by its disturbing effect on confidence; so a moderate reduction in money-wages may prove inadequate, whilst an immoderate reduction might shatter confidence even if it were practicable.

Frankly that's not a convincing argument. At the UK Treasury they argued, among other things, that deficit spending would be bad for the economy because it would shatter confidence. Clearly confidence matters a lot, but if we allow anyone to declare him or herself the true profit of what the crowd will believe that the crowd will believe, we might as well give up debate and analysis and just make him or her economic dictator (fine by me for the duration of the crisis if the dictator were Krugman or Keynes brought back from the dead).

The valid argument, the argument to which Krugman appeals, does not appear in chapter 19 at all. It appears in, get this, the appendix to chapter 14 "The Classical Theory of the Rate of Interest" as a discussion of "the rate of interest in ... Ricardo's "Principles of Political Economy."

in the extreme case where money-wages are assumed to fall without limit in face of involuntary unemployment through a futile competition for employment between the unemployed labourers, there will, it is true, be only two possible long-period positions — full employment and the level of employment corresponding to the rate of interest at which liquidity-preference becomes absolute (in the event of this being less than full employment.)

Keynes says that flexible wages imply full employment unless we are in a liquidity trap. Keynes clearly considers the assumption that wages are flexible to be extreme and implausible, but he agrees that wage flexibility implies only two possibilities -- full employment and a liquidity trap.

Now really, even someone who actually "you know read Keynes"* might not remember that an appendix on the history of thought to a chapter on the rate of interest is key to understanding Keynes' views on the implications of wage flexibility.

*note how I have changed the meaning of Krugman by quoting him out of context. In context "read" was a present subjunctive (I think) in the present tense . Out of context it becomes a past perfect subjunctive (I think. I am fine with Italian grammar but never learned English grammar). As written it was to be pronounced "reed" and as quoted to be pronounced "red". Sneaky eh ?

update: Welcome economistsviewers. Also I have been a bit too kind to Barro as the argument in the appendix to chapter 14 isn't really the only time Keynes mentioned a liquidity trap. In Chapter 21 "The Theory of Prices," he asserts that wages have downward nominal rigidity and this is important. He also mentions what would happen if they were flexible

If, on the contrary, money-wages were to fall without limit whenever there was a tendency for less than full employment, the asymmetry would, indeed, disappear. But in that case there would be no resting-place below full employment until either the rate of interest was incapable of falling further or wages were zero. In fact we must have some factor, the value of which in terms of money is, if not fixed, at least sticky, to give us any stability of values in a monetary system.

So when asserting that there is nominal rigidity, he notes that less than full employment would be possible even if wages were flexible.

In Chapter 21 there is also a hint that low inflation in the 19th century was caused by persistent less than full employment due to "liquidity-preference" and ... well let's spin the tape

The tendency of the wage-unit was, as usual, steadily upwards on the whole, but the efficiency of labour was also increasing. Thus the balance of forces was such as to allow a fair measure of stability of prices; — the highest quinquennial average for Sauerbeck’s index number between 1820 and 1914 was only 50 per cent. above the lowest. This was not accidental. It is rightly described as due to a balance of forces in an age when individual groups of employers were strong enough to prevent the wage-unit from rising much faster than the efficiency of production, and when monetary systems were at the same time sufficiently fluid and sufficiently conservative to provide an average supply of money in terms of wage-units which allowed to prevail the lowest average rate of interest readily acceptable by wealth-owners under the influence of their liquidity-preferences. The average level of employment was, of course, substantially below full employment, but not so intolerably below it as to provoke revolutionary changes.

He concludes the chapter with "But the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners.[2]" the footnote reads "Cf. the nineteenth-century saying, quoted by Bagehot, that “John Bull can stand many things, but he cannot stand 2 per cent.”"

I think that John Bull had better learn to stand 2% and 1% too for that matter. The refusal to accept 2 % would be achieved by holding wealth as cash if the nominal interest rate were below 2%.

I'm sure Keynes didn't resist the tendency to give uhm Keynes the credit for the post WWII persistent low unemployment, but the logic of The General Theory suggests that the economy was helped by 2 key things. First a bit of inflation which reconciles a low real interest rate with the nominal interest rate required to get the money out from under people's mattresses, and, second, deposit insurance made checking accounts as good as cash enabling the banks to get the money to firms.


Anonymous said...

March 27, 2008

Tim Geithner Is Not a Tool of Wall Street

Edward Luce writes -

"America’s liberals lay into Obama: * The liberal backlash against President Barack Obama has begun with many prominent left-leaning economists in the US attacking the administration’s plans to bail out the banks.

"Paul Krugman describes the toxic asset purchase plan as 'cash for trash.' Jeffrey Sachs calls it 'a thinly veiled attempt to transfer hundreds of billions of US taxpayer funds to the commercial banks.' Robert Reich depicts Tim Geithner, Treasury secretary, as a prisoner of Wall Street while Joe Stiglitz says the plan 'amounts to robbery of the American people' " ....


-- Brad DeLong

[The supposed liberal academic thought police are busy policing thought. Please do not report me.]

Anonymous said...

Robert..."Mostly Keynes argues that if one wants lower real wages it is better to drive up prices with monetary policy..."

Carried out over generations, this policy ineluctably results in a gradually lower median standard of living (per hour worked). This is exactly what has happened (lower real wages). It now takes 2 jobs plus overtime to support a family, when one job used to be enough. Many retirees were pushed to near subsistence level.

Even if Keynes was correct that this will reduce unemployment a bit (unproven), is it worth it? Do we really want the median consumer to suffer a gradually declining standard of living with each successive generation?

Scott Sumner said...

Nice post. In defense of Barro, Keynes' views regarding an "immoderate increase in money" are vague. Most of the time he seems to imply that immoderate increases would definitely be inflationary, particulary under a fiat money regime. (Keynes abhorred fiat money throughout his career.) If so, then the liquidity trap concept is pretty meaningless (except where policy is constrained, as under a gold standard.) BTW, his "confidence" comment probably refered to higher rates associated with the Fisher effect, which Keynes did not understand very well. Your point that fiscal policy could also shake confidence is very pertinent. Keynes recognized that possibility in a comment he made around 1930.
You are right that the logic of the GT is that moderate inflation would prevent liquidity traps. Of course Keynes never saw that logic. With a forward-looking moderate inflation target, almost nothing in the GT would make sense. The fiscal multiplier would be zero, there would be no paradox of thrift, etc. Any non-monetary shock would cause the central bank to change policy enough to keep expected inflation on target. And with a high enough trend rate of inflation they could do that, as liquidity traps would be ruled out.

Robert said...

"Robert..."Mostly Keynes argues that if one wants lower real wages it is better to drive up prices with monetary policy..."

Carried out over generations, ..."

I should have written "In Chapter 19, Mostly Keynes ..." Note "better" means "better than trying to cut nominal wages" not good. Keynes supported public investment (I think mostly in public housing but he isn't very clear) as a way to have full employment.

He definitely assumed that real wages would grow as capital accumulated and technology progressed. Everyone did. They were right except about the USA in the past 35 years.

I think it is clear how Keynes would react to the huge increase in inequality over the past 30 years in the USA -- he advocated making the tax system more progressive, in order to speed the reduction of inequality. I'd guess that were he alive he would advocate making it much more progressive to reverse the increase.

Robert said...

Thanks Scott Sumner.

I just can't figure out why Keynes didn't advocate steady modest inflation (say an n% rule ?). I think it must have been that actually advocating inflation was too radical for Keynes.

He also tends to seem to assume that expected inflation must be zero except during a hyperinflation. I think those were the two cases which had occurred when he wrote. We have since managed persistent predicted moderate inflation partly via improved published price indices and cost of living adjustments which they make possible.

I don't know about Keynes, but I sure am confused by Keynes on Fisher and the Fisher effect. I'm working on it.