Thursday, July 29, 2010

Is the Keynesian concept of price stickiness valid at extremes?

The one major contribution of The General Theory of Unemployment, Interest & Money (John Maynard Keynes, 1936), if I have to choose one, was the concept of “price stickiness”. In effect, Keynes gave a reason why changes in money supply would change output and not prices, effectively rebutting the basic premise of the Quantity Theory of Money. Keynes stated that because prices don’t change as rapidly as potential changes in money supply, an increase in money supply would result in higher demand which would increase output to match this increase demand. This concept was been the bedrock of monetary policy in the post-WWII world getting diluted only by the shift towards  Chartalism in the 1970s. Recent events and attempts at stimulus, however, have relied largely on this concept and mark a resurgence of Keynesian thought.

Price stickiness also included wage stickiness following the logic that a unit of work was as much a product as say, a car or a soda, and an increase in aggregate demand would allow entrepreneurs to increase production by hiring more labor without increasing the unit cost of labor. This would continue till such time labor supply reached its limit, at which point, labor costs will start rising. The inverse was held to be true for a recessionary environment, when a fall in aggregate demand would result in entrepreneurs shedding labor, and such shedding of labor would not change the price of labor. However, this concept is now being challenged.

Tyler Cowen, in a recent blog post, admits his forecasts for some European economies was a lot worse than their actual performance. And he believes this is due to his assumption that wages in these economies were far more sticky than they actually are. Evidence that nominal & real wages are falling is available across the cross section of these economies which leads him to believe that downward inflexibility in wages isn’t just a function of the employee’s readiness to accept less, but also caused by the fact that most employers don’t like to cut wages of existing employees unless absolutely required. This can result in large wage cuts being more common and more acceptable than small ones.

This is an extremely significant observation with an intuitive real world ring. Just as, ceteris paribus, it is improbable that an employee would change jobs for a marginally higher salary, it is equally improbable that an employer would risk damaging employee morale when required wage reduction is small. However, in both cases, if the difference is substantial, it may be well worth the risk. After the 2008 crisis, aggregate demand dropped sharply accompanied by a sharp jump in unemployment. Demand remains subdued, as does job creation, and it is extremely likely that out-of-work skilled workers, and see no hope of getting back to work soon, may be willing to accept much lower pay than their own earlier pay, or the existing pay of workers they can replace.  If this difference is substantial, employers would either ask their existing workers to accept a lower salary or replace them, since their savings would be large enough to offset any cost associated with damaged employee morale and the like. And when job creation is slow, existing employees may accept such a reduction willingly.

But this would also mean that Keynes’ “stickiness” works only in the case of gradual changes in aggregate demand, which can be effectively countered by stimulus and not when the change is sudden, significant and long lasting. In the latter case, it is extremely likely that the loss of aggregate demand will not only be accompanied by increased joblessness, but by lower wages as well.

This also implies that government stimulus in the latter situation, unless it is of a magnitude and duration large enough to have a pronounced and lasting impact, would actually be a complete waste of money. And if it is of such a magnitude, it would distort labor costs by not allowing them to fall to a market clearing rate possibly casting the nation’s lack of competitiveness in stone.

Either way, it can’t be good.

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