Sunday, June 27, 2010

A Genealogy of Sticky Wages

In my post on sticky wages, Mattheus asks:

"Is the assumption of general wage and price rigidity a pillar of Keynesian economics? I always thought you had to assume wage stickiness to be a Keynesian, but I might be wrong"."
I think the short answer is “no, it is not a pillar of Keynesian economics, but yes, almost all modern Keynesians assume it in some form”.

It's a very odd story. Between Marshall and Keynes, economists had always highlighted wage stickiness as a reason for involuntary unemployment. The reason is obvious - if there can be no price adjustment, all the adjustment has to come through a shift in quantity. It's a very nice, very clean explanation with a lot of intuitive support (you simply don't see that much nominal wage cuts in real life - it's as if there's some sort of inherent psychological barrier to it).

In the General Theory, Keynes talks about wages in the chapter I linked. The chapter is specifically dedicated to what happens when nominal wages are cut, so there's clearly no blanket assumption of rigid wages there. One of the critiques he raises, though, is that in certain sectors wages are going to be more rigid than in other sectors (this is partly why he preferred modest inflation to reduce real wages than nominal wage cuts: inflation would fall on all workers relatively equally, and therefore avoid price distortions). In the General Theory, departure from full employment was driven entirely by liquidity preference and aggregate demand.

New Classical macroeconomics challenged Keynesianism from a microeconomic perspective, introducing "representative agents" with rational expectations in models that contradicted Keynesian findings. The Keynesian response had to be directed towards microfoundations (well, they thought it did at least). So guys like Stiglitz and Mankiw and Summers dreamed up all kinds of microeconomic frictions which, in representative agent models, would produce the same "Keynesian" results. Sticky wages came center stage again. Asymmetric information became very important. We had efficiency wages, insider-outsider models. Critiques of rationality assumptions aren’t exclusively tied to this literature, but they’re important for it. All of these frictions cobbled together is more or less what is known as “New Keynesian” economics, which is really the economics of just about everyone that calls themselves “Keynesian” today. You can think of it as what The General Theory might have been if it was written from a micro perspective rather than a macro perspective.

I think there’s a lot of good to say about a lot of New Keynesian economics. It has made economics considerably more realistic. Just the other day I was very favorably citing Stiglitz and Weiss’s credit rationing model, which has a distinctly New Keynesian flavor to it. I’ve blogged on efficiency wages in the past. And I think a lot of wages probably are pretty sticky. But I think people can legitimately call themselves “Keynesian” without a lot of this (people did for about three decades, after all!). Classical Keynesianism (that really feels oxymoronic to type!) has no need at all for sticky prices. The only people that need sticky prices are the ones who get their panties in a twist when guys like Lucas, Kyndland, and Prescott raise bogus (or at least weak) critiques. There’s a reason why Greg Mankiw is such a fan of A.C. Pigou. It’s because New Keynesianism is really New Marshallianism as much as it is anything else (and that’s fine – Keynes himself said of Marshall that he was “a true sage and master, outside criticism”).

Earlier I had said that New Keynesianism was what The General Theory might have looked like if Keynes has taken a microeconomic approach rather than a macroeconomic approach. I want to modify that a little. If Keynes had written from a microeconomic perspective, I think we would have gotten something more along the lines of the work of Edmund Phelps. Phelps worked on distinctly Keynesian themes: wage and price expectations at the microeconomic level, and uncertainty about future wage and price changes. I don’t know to what extent Phelps utilized sticky wages (his work was in the 1960s and 1970s, before sticky wages became a real staple), but it’s certainly never highlighted as essential to his work (I haven’t read any myself – I need to). I think if Keynes went the micro route, you would have seen something more like Phelps than Stiglitz – although I think Keynes (who always liked paradoxical conclusions) still would have liked and agreed with Stiglitz’s work especially, if not all the New Keynesians.

That’s my take on the intellectual history. It’s somewhat self-taught. My History of Economic Thought course (six years ago now!) stopped around Keynes, so this comes from what I’ve picked up since then. I’d be interested in hearing about any obvious mistakes, or even just differences of interpretation on all this.

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