Related to this post by Russ, Mario Rizzo's recent post over at ThinkMarkets is outstanding.
For persons who insist that aggregation at the high level at which it is typically done by textbook Keynesians (such as Krugman) is acceptable, I offer this Krugman piece as Exhibit A for why such aggregation is poisonous to sound economic reasoning.
As Mario points out, wage adjustments are best thought of not as all wages falling (or all wages rising). There is no lump of L in the economy hired to do some all-purpose task aimed at producing, in combination with a lump of K, a lump of Q to be bought by a lump of spending (C + I + G + [X - M]).
Even if some measure of average wages is falling, some wages fall relative to other wages (meaning, some wages rise relative to others). And all wages that fall do so relative to the prices of capital goods — some of which are complementary to labor, others of which are substitutes for labor.
Such changes in the pattern of wages are necessary to allocate labor from less-productive to more-productive tasks.
Moreover, the demands for some forms of labor are elastic over the relevant range of wages — meaning, that as wages for such labor fall, the increased quantity of this labor demanded by employers results in these employers paying out more in total wages than before the wages fell. (It would be as if, say, McDonald's cuts the price of the Big Mac by ten percent and the resulting increase in the quantity of Big Macs demanded by buyers is twenty percent.) If the total spending power of workers as a whole is a function of the total amount of wages paid to workers as a whole, then a fall in wages when demand for labor is elastic over the relevant range of wages means that these wage cuts will contribute to higher consumption spending.
I have more to say about this silly Keynesian take on wages — more that, time permitting, I might offer in a follow-up post.
Podcast RSS Feed
Full EconTalk Text
{ 30 comments }
The problem is, a worker's mortgage does not adjust to his lower wage, nor any debt.
K,
Just wait…
I know that a lot of bankers are earning a lot less this year! (which, according to Krugman is a "good" trend) I'll bet we see a lot of people in other industries magically end up below the administrations new higher tax bracket as well. So, if we could hypothetically adjust for those two factors, would the aggregate wage still be so deflated?
Also, if I make $500,000 and my income drops 20%, would that have the same effect on the economy as 10 people that earn $50,000 and see their wages drop 20%? How about if we assume those 10 people all have mortgages and credit card debt?
Is the Keynesian take on wages (aggregates) akin to classical economists being unable to understand why diamonds have a higher value on the market than bread or water?
In other words, classical economists thought in terms of all the bread vs. all the diamonds, in aggregates rather than on a marginal basis.
Just wondering. Thanks.
Who the hell is a Keynesian these days, anyway?
Sensible people typically accept the new neoclassical synthesis, which, you should know, is based on microfoundations.
And what is the problem in thinking in terms of aggregates?
Relegating labor and capital as "L" and "K", respectively, makes for less complex models. Indeed, Milton Friedman himself, in "Essays in Positive Economics" rejected testing models based on the realism of their assumptions in favor of the validity of their predictions.
In this sense, then, whether one takes wages in general to be falling, or some wages to be falling more than others in relative terms, the bottom line is that we have experienced a large reduction in aggregate demand, as predicted by our "poisonous" aggregates.
Everything else is tantamount to the classical veil. You could change the measurement of a mile into kilometers, or some other 'nominal' measurement, but that is no consolation for the fat person who must run it.
Some process must bring the economy back to the NAIRU. I think it is absolutely foolish to allow sluggish wage and price adjustments to do the job as a debt-deflation sets in.
In such a case, particularly in a financial meltdown, the economy can reach a new equilibrium far short of potential output for a long time.
"Such changes in the pattern of wages are necessary to allocate labor from less-productive to more-productive tasks."
Again, this process is not automatic in a recession in which the macroeconomy takes a protracted time to allocate these resources.
Having a laissez-faire attitude in a deep recession brought on by a financial crisis ain't a free lunch. The classical wage and price adjustments are not determined by some Walrasian auction, and in the presence of massive spillovers, people will demand that government do something.
And an angry public starts to look to socialism as a viable alternative to what they view is a massive failure of the market. After all, a recession is a giant spillover cost since the reduction in aggregate demand is not reflected initially in wages and prices, but in unemployment.
–Pingry
I hereby award you the Swedish Chief National Bank Prize in Economic Science in Honor of Alfred Nobel.
You can tell all of your friends now that you are a "Nobel Prize" winner.
You nailed it.
murraymises wrote:
"Is the Keynesian take on wages (aggregates) akin to classical economists being unable to understand why diamonds have a higher value on the market than bread or water?"
See also Ricardo on the valuation of "land" and "capital" and "labor".
And an angry public starts to look to socialism as a viable alternative to what they view is a massive failure of the market…
Corporations too.
Pingry, you pointed at the elephant and I see it too.
There has to be pragmatism. Everybody wants liberty, but to reject the central roll of government, or to limit its roll to law and order is to deny the critical roll government has played in most of man's highest achivements.
Laissez-faire wrings out market efficiency by iterating over the signals again and again, naturally seeking a lower energy level.
How long would it have taken to crest the local minima to produce something akin to the public library? The feedback from that signal would travel at inter-generational speed, while adopting a somewhat socialist attitude toward knowledge would have the system up and running in no time.
Pingry: "I think it is absolutely foolish to allow sluggish wage and price adjustments to do the job as a debt-deflation sets in."
There is no choice. Accelerating price movements in one particular direction does not ensure that they are going the right way. It simply distorts them further.
To demonstrate. Take a spreadsheet of the S&P 500 for a day when it fell by a large amount. You will find in most cases that ~50% of the share price movements are up and ~50% are down. The same is true for a bad S&P 500 day. The difference is usually the magnitude of the drops and which companies they affect. The same sort of thing is true of other prices.
K Ackermann: "How long would it have taken to crest the local minima to produce something akin to the public library? The feedback from that signal would travel at inter-generational speed, while adopting a somewhat socialist attitude toward knowledge would have the system up and running in no time."
Charities can do that sort of thing quite quickly. In fact many public institutions of this sort where I live in Ireland were started as charities and subsequently nationalized.
don,
Will you have my babies?
K Ackerman,
"Everybody wants liberty, but to reject the central roll of government, or to limit its roll to law and order is to deny the critical roll government has played in most of man's highest achivements."
Yes, I do deny that government has played a critical roll. It seems to me that they just zoom in and take credit after the fact to justify their exploitation of those who have actually achieved. And of course, the evidence of massive government malfeasance throughout history is incontrovertible. Stop cherry picking. Consider all the evidence. Then tell me, why should I trust the political class? – any political class?
Ackermann,
Re: Firms that produce positive "externalities"
You might want to think about Cheung's paper on the "Fable of the Bees" or Coase's "The Lighthouse in Economics".
"Such changes in the pattern of wages are necessary to allocate labor from less-productive to more-productive tasks."
Yeah so when people who are fixing cars, stocking grocery shelves, driving trucks get too much money that's bad. But when they take pay cuts so billionaires on Wall Street can see their percent of profits and wages go up from 15% to 40% that's good. It means resources must be getting re-allocated to where they need to be. And of course since those billionaires always spend all their money compared to workers aggregate spending will not be affected. And since it worked so good for the economy as we can all see as we look out our windows it all makes sense and fits with the facts before us.
We've been seeing the "re-allocation" of resources/wages for 30 years now from productive workers to non-productive parasites. Krugmen correctly predicted this result and you guys have and continue to deny the facts.
And as predictions go Charles Dickens called this one quite astutely;
Hard times for these times By Charles Dickens: "Utilitarian economists, skeletons of schoolmasters, Commissioners of Fact, genteel and used up infidels, gabblers of many little dog's eared creeds the poor you will have always with you. Cultivate in them while there is yet time the utmost graces of the fancies and affections to adorn their lives so much in need of ornament or in the day of your triumph when romance is utterly driven out of their souls and they and a bare existence stand face to face reality will take a wolfish turn and make an end of you"
Don -
Not to beat a dead horse, but if you think that Keynesians see the world in terms of (C + I + G + [X - M]) and don't recognize that as a simplification, you're being very unfair and you're probably not listening. In the very Krugman article you cite, he recognizes that some wages go up and some go down, after all!!!
You come at this from a micro/IO perspective. Of course if you're concerned with more compositional questions aggregation isn't going to be as helpful. But it's a tool for questions that have less to do with the composition of the market. It's very easy for you to crassly write that off when you're not personally concerned with those questions.
The models that the Fed runs (believe it or not), are actually not the (C + I + G + [X - M]) models that you find in an intro undergrad textbook. They do differentiate between wages in different locations, occupations, and industries. Obviously, even that's an aggregation, but it takes care of a considerable portion of the underlying heterogeneity you're talking about.
But to reiterate – models are tools. An aggregation can't answer all questions, but it does a good job at answering many questions.
As long as you continue to insist on tilting at windmills, you're not going to get much recognition for these critiques, except from those who already agree with you on most things. There is a lot about Keynesianism and subsequent syntheses and revisions that is open to criticism. Pretending that these guys actually oversimplify the world to a model that is introduced in the second week of a freshman college course is not the way to go about criticizing them. It's shorthand, and as shorthand it's useful. When the question at hand requires more detail, use more detail!
And an angry public starts to look to socialism as a viable alternative to what they view is a massive failure of the market. After all, a recession is a giant spillover cost since the reduction in aggregate demand is not reflected initially in wages and prices, but in unemployment.
Pingry, I think you realize that the debate over the veracity of everything you wrote in your post before this statement is purely academic. Your last statement is, in practice, the only relevant one. It seems to me that the eagerness of the public to embrace socialism is in direct negative proportion to how much socialism they've had in the past. The people with the least amount of faith in socialism are the ones who have been exposed to copious amounts of it.
Here's my hypothesis.
"muirgeo" is Soros paid troll.
This is the brain dead excuse for really bad economics that economists have been drooling since Samuelson.
If we want to used the "tools" trope, lets call these "tools" what they are — 5th wheels, broken Tinker Toys without a function, fake "tools", etc.
Daniel writes:
"to reiterate – models are tools"
Daniel Kuehn: "The models that the Fed runs (believe it or not), are actually not the (C + I + G + [X - M]) models that you find in an intro undergrad textbook."
To some extent that is true. They are rather more complicated, but they are not conceptually much different.
They don't really address the concerns of those who criticise aggregation in any fundamental way.
Read a textbook on New Keynesian economics and you'll see what I mean.
Daniel Kuehn: "But to reiterate – models are tools. An aggregation can't answer all questions, but it does a good job at answering many questions."
Does it? Which ones?
Greg Ransom -
So, what's your point exactly? That the tools are imperfect? What's the alternative – to acknowledge what everybody knows: that society is complex and heterogeneous and that an order emerges out of these complex interactions?
I think this perspective is actually very widely held – but you can't get much mileage out of that insight on it's own, except to just repeat it's truth. So you turn to more bastardized models to get more detailed answers to more specific questions. And then you evaluate how well those models actually perform.
What's wrong with that? You think the "tools" argument is a trope? What else would you propose? You can recognize "everyone is different" and that there are fundamental problems with aggregation all you want – we all understand that. But where does that plea get you? How does that help you answer any real questions about the economy? How is that useful?
Greg -
RE: ""muirgeo" is Soros paid troll."
Very good! Usually the "Soros" concerns come out in run of the mill conservative sources. You don't hear it as much at places like Cafe Hayek. I appreciate the variety! Vague references to "statists", "socialists", and "fascists" get tiring after a while. I'm glad you're getting more specific
Current -
RE: "To some extent that is true. They are rather more complicated, but they are not conceptually much different. They don't really address the concerns of those who criticise aggregation in any fundamental way."
Yes and no. As I said – it's still aggregation and I realize Don and others will still have problems with that. But if you're concerned with the practical problems of aggregation )that lumping everyone together in a single index ignores minute differences that lead to emergent behavior), breaking aggregates out by location, occupation, industry, education level, etc. accounts for a large and important portion of that individual heterogeneity. So does it solve the problem? No. But if your real concern is practical predictive power – the bias that's introduced by aggregation – these more realistic models are a good thing. If you're just philosophically opposed to the idea of aggregation because you think it says something about the modelers rejection of individualism or liberty… well… I can't do much to convince people on that count.
RE: "Read a textbook on New Keynesian economics and you'll see what I mean."
No doubt about it. I'm not saying "Old Keynesian" economics is somehow an ideal. I see it all as the same basic movement, and I'd assume if Keynes were around today he'd embrace New Keynesian economics. You can't blame him for not saying something that nobody had thought of yet! But even the earlier Keynesians weren't ignorant of the aggregation problem. You need look no further than Hick's Value and Capital – right? The point is you don't throw everything out the window because you realize there are problems with this kind of simplification.
Do we toss out Newton because we have relativity or quantam mechanics? Of course not. It still has value. And I think this post demonstrates a dangerous unwillingness to accept that despite its failings, it has very real value. It's fundamentally a very philosophical concern – not a pragmatic one at all.
RE: "Does it? Which ones?"
Questions like – "what will GDP growth be next quarter"
Hey there have simply been two major US economic crashes both of which occurred after stagnating wages for the middle class and rising wages for a the upper tiers. The evidence is clear. Examples of the same exist around the world and through out history. Everything here amounts to whistling in the dark, propping up ideologies and re-interpreting or re-writing history and nothing more.
Yes, I do deny that government has played a critical roll. It seems to me that they just zoom in and take credit after the fact to justify their exploitation of those who have actually achieved. And of course, the evidence of massive government malfeasance throughout history is incontrovertible. Stop cherry picking. Consider all the evidence. Then tell me, why should I trust the political class? – any political class?
I've seen that sentence somewhere before… oh, yeah:
Yes, I do deny that corporations have played a critical roll. It seems to me that they just zoom in and take credit after the fact to justify their exploitation of those who have actually achieved. And of course, the evidence of massive corporate malfeasance throughout history is incontrovertible. Stop cherry picking. Consider all the evidence. Then tell me, why should I trust corporations? – any corporation?
muirgeo,
you miss the fact that both of those two major economic crashes were driven by the loose monetary policy of the federal reserve. this led to an overallocation of resources to wall street, an increase in inequality (only a symptom, not a cause), and theft of purchasing power from the lower classes via expansion of credit. this is hardly a free market result, rather it is the result of your precious government trying to avoid any downturn in the economy over the past 30 years.
as far as aggregation goes, in the current circumstances, falling wages will lead to more defaults because the debt stock is fixed in nominal terms. absolute prices do matter. that is not to say i disagree with allowing prices to readjust in relative terms, but it is important to recognize that in a credit money economy, when credit makes up the vast majority of the money supply, absolute prices and wages are very important. how do you fix it? i don't know if it's possible. it just might be the case that we need to press the reset button, and allow deflation to run its course. the one thing that i know is that central planners certainly aren't going to solve the problem.
Daniel Kuehn: "No. But if your real concern is practical predictive power – the bias that's introduced by aggregation – these more realistic models are a good thing. If you're just philosophically opposed to the idea of aggregation because you think it says something about the modelers rejection of individualism or liberty… well… I can't do much to convince people on that count."
I don't have any big philosophical objection to aggregation. I don't think though that it is particularly useful.
Also, I don't think that practical predictive power is as important as mainstream economists assume.
The mainstream view was the first economic view I learnt. This is how I understand it. First the economist observes various process and variables in the world. Then he or she constructs a model. That model is defined in terms of aggregates. Then the economist measures to see if the predicted aggregate relationships occur. Then the economist knows how to answer policy questions.
This view has many flaws. To begin with the aggregates themselves are "theory laden". Secondly, there is not the only form of valid economics. There are many other ways it can be done without any need to predict particular aggregate variables.
Daniel Kuehn: "Do we toss out Newton because we have relativity or quantam mechanics? Of course not. It still has value. And I think this post demonstrates a dangerous unwillingness to accept that despite its failings, it has very real value. It's fundamentally a very philosophical concern – not a pragmatic one at all."
Newtonian mechanics is a good representation of the world we live in. It is actually useful. In my view Keynesian economics doesn't fall into a similar category.
Current: "Does it? Which ones?"
Daniel Kuehn: "what will GDP growth be next quarter"
You have fallen into my trap (maniacal cackle).
I don't deny that aggregate methods can estimate what GDP growth will be next quarter. I don't think though that this is particularly useful information.
GDP itself is an aggregate. The value in tracing movements in it and in it's growth only comes if the number GDP itself is useful.
I think it is useful only in very rough ways. For example, I live in Ireland which has a much higher GDP per capita than the UK where I come from. I see little everyday evidence that it is actually richer though. Evidence from things like "genuine progress indicators" bears me out here.
Without a solid theory behind it showing it's relevance the measurement of GDP is not really so useful. It is like the measurement of inhered labour value by those economists who believe in the labour theory of value.
In fact, the whole use of GDP by mainstream Keynesians is really quite odd. It's measurement derives from Marshallian economics which is quite different from modern ideas.
The idea that growth can be defined by changes in GDP is laughable. GDP can go up and down for all kinds of reasons, including some that are, in the long term, destructive to wealth.
Lee Kelly: "The idea that growth can be defined by changes in GDP is laughable. "
To be fair Daniel Kuehn talked about changes in "GDP growth". That said I think he implicitly made the error you point to.
Also, it's curious that supporters of New Keynesianism also support GDP measurements.
The two are theoretically contradictory. In New Keynesianism the aggregate demand curve is seen as coming into existence because of the existence of sticky prices.
Sticky prices mean that prices do not adjust sufficiently quickly. This represents a lost opportunity cost to price setters in particular and the whole economy in general.
GDP however ignores sticky prices. The "real GDP" is calculated by deflating the money GDP. It is assumed that the real GDP accurately represents the amount of utility going into consumption and future production. The existence of sticky prices however indicates otherwise.
"Hey there have simply been two major US economic crashes both of which occurred after stagnating wages for the middle class and rising wages for a the upper tiers."
Or we have two crisis following periods of lose monetary policy that creates artificial asset bubbles in which those who have first access to credit and leveraged investments (rich people) benift from prior to general wage inflation, and then the bubble comes crashing down destroying the dollar value of those rich people's inlfated assests bringing the wealth divide back into greater equilibrium. "The evidence is quite clear." Get your causation in the right order.
People, people, my argument is not that socialism, in particular, is a viable solution, or that the public will embrace it.
Of course socialism is a big scam, and I just used it as a proxy for increased government.
My argument is that when people see the kind of meltdown that we have seen, as unemployment gets worse and worse, and in the short-run it does given inflexible wages and prices, then people will start to look for a system which they believe will work.
Many people, for example, embraced socialism and central planning in the past as an alternative to capitalism, with spectacularly bad economic results and oppressive government.
But, when the system undergoes intense stress, and people feel that it isn't working for them as unemployment keeps increasing, they become more receptive to other systems….and right now, the antiglobalization movement is gaining adherents.
This is one reason why I am angry with people in finance: They put capitalism and globalization in jeopardy.
We have worked so hard to convince people that free markets and globalization are the way to go, and a bunch of douchebags in finance go and create massive spillovers for innocent people.
I mean, there are many people dying because of this crisis, in both developed and developing countries. Is that reflected in the prices in financial markets, along with unemployment and other hardships borne to people who can least afford it, and who had nothing to do with the crisis?