Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Sunday, October 13, 2013

Thought rigidities in macroeconomics

Ah, a fine Sunday morning. Made the mistake of reading Wren-Lewis and Krugman. Usually they have some interesting things to say. But not always. And recently, they have said some rather strange things. Time to weigh in.

First, Simon Wren-Lewis complains (again)  about something that may or may not have been true at one time:
My first complaint is that too many economists follow what I call the microfoundations purist position: if it cannot be microfounded, it should not be in your model. Perhaps a better way of putting it is that they only model what they can microfound, not what they see. This corresponds to a standard method of rejecting an innovative macro paper: the innovation is ‘ad hoc’.
"Too many" economists. Like who, Simon? Give us names! A long list of names.

I don't think he can do it. He can't because all economic models and theories embed ad hoc assumptions. (Btw, I've addressed this complaint before, here.) So why does he say things like this? I'm not entirely sure. 
He seems to want to tell us that nominal wages are sticky, something that standard economic theory is evidently incapable of explaining, and that a set of economists belonging to some sort of commission have made terrible policy mistakes by ... um, refusing to admit that wages are sticky ... because economic theory cannot be used to support the observation? I am confused. 
I am also confused about what the following statement has to do with his opening complaint:
While we can debate why this [the sticky wage assumption] is at the level of general methodology, the importance of this particular example to current policy is huge. Many have argued that the failure of inflation to fall further in the recession is evidence that the output gap is not that large. As Paul Krugman in particular has repeatedly suggested, the reluctance of workers or firms to cut nominal wages may mean that inflation could be much more sticky at very low levels, so the current behaviour of inflation is not inconsistent with a large output gap.

Now, let's see if I understand. Some economists evidently believe that the "output gap" cannot be very big because, if it was, we should be seeing deflation. Let me point out that the very concept of an "output gap" relies on the presumption of sticky nominal prices -- an ad hoc assumption forming a center piece of NK theory. So what Wren-Lewis appears to be saying here is that his ad hoc assumption is better than their ad hoc assumption. This may very well be true--but again, what it has to do with his original complaint, I have no idea. 
No big deal. Wren-Lewis, who I think usually makes for a good read, was maybe a bit sloppy on this occasion. I can certainly relate. Let's just move on. 

Oh, but no. Nope. My favorite curmudgeon has to take an unsolicited hand-off and proceed to let loose his canon (ha ha) here: Sticky Wages and the Macro Wars
O.K, we get it. Nominal wages are sticky. But it is important to understand precisely what he means by this. In particular, he does not just mean that nominal wages appear not to move very much in the data. We can all see that. What he means is that the reason they do not move is beyond the comprehension of standard economic theory. He makes this explicit here, where he says:
I’ve written quite a lot about sticky wages, aka downward nominal wage rigidity, which is one of those things that we can’t derive from first principles but is a glaringly obvious feature of the real world.
Well, it is my humble opinion that he is just plain wrong. We've known since at least Barro (1977) that spot wages are not "allocative" in job-worker relationships, where bargaining (and not any auctioneer) determines the terms of trade and how these terms evolve over time (I discuss this at length here).  In short, wages can "look sticky" empirically, even if they are not theoretically. Let me also refer you to this interesting paper by Eichenbaum, Christiano and Trabandt (2013). This latter paper belongs to a class of papers (see Hall and Shimer, in particular) who "microfound" price rigidities via bargaining theory. In a nutshell, the details of the bargaining process matter and this is something that is (deservedly) receiving a lot of attention by theorists. (I may be wrong, but I never see Krugman citing such work. Either he finds it uninteresting, or wrong, or ... ). 
But enough of Krugtron. As for Wren-Lewis, I think his main message is for young economists: do not to be led into thinking that every macroeconomic theory needs to be "microfounded." That's fair enough advice. But by the same token, young economists should also not feel threatened or bullied into thinking a priori that social phenomena are beyond the reach of economic theory--especially when such sermons are delivered by bitter Nobel-prize economists still suffering from the intellectual wedgies applied to them in their youth. 


  1. "In short, wages can "look sticky" empirically, even if they are not theoretically. "

    Theoretically, anything goes. You could cook up a story to interpret the data in any which way you want. I think that's the point that Krugman makes when he says:

    "At no point was this rejection of Keynesianism driven by superior empirical performance; it was all about the principle, about refusing to incorporate anything that wasn’t derived from maximization all the way."

    But that's not really science, is it? It is just methodological bias.

    1. And you just believe what Krugman says, I suppose? What sort of science is that?

      As usual, he is wrong in his bald assertion. That brand of Keynesianism was rejected on empirical grounds: there was no permanent trade off between inflation and unemployment. This later prediction was a property of a competing model.

    2. But clearly Krugman is not criticizing Milton Friedman or Ed Phelps. Friedman in particular followed a very strict scientific route to defend his ideas. He first assembled a large quantity of empirical evidence and then came up with sensible models. Krugman agrees with Friedman on the absence of a permanent trade off between inflation and unemployment (as does every other economist I imagine).

      Krugman is criticizing what came after Friedman and Phelps. The Lucases, Prescotts, and Barros of the world. They did not gather strong evidence for their theories like Friedman did. They were mostly content with proposing stories presented in very sophisticated and elegant terms.

      I am willing to recognize their methodological innovations and consider them deservedly recognized by the profession, but agree with Krugman they did not advance our practical knowledge and distracted the whole profession with their focus on technique.

    3. I disagree with you. I believe that Lucas, Prescott, Barro and indeed even Krugman have advanced our knowledge in their respective fields. I am really at a loss to understand how you can say otherwise. Perhaps you have not read their work or, if you have, you have not understood its significance. To me, it just sounds like you are relying on Krugman's pontifications. But I could be wrong. If so, please elaborate.

  2. As I said in my previous post I do recognize the methodological innovations of Lucas, Prescott and Barro. Regarding theory and technical tools they did advance our knowledge tremendously by showing the profession how to model dynamic, stochastic competitive economies. I think that is an important contribution that has been justly recognized. Regarding the practical knowledge needed to conduct policy in the real world I don't think they were as successful. They remained confident in the logical consistency of their models and didn't provide compelling evidence for their assumptions, unlike Friedman. It is very unlikely that markets clear all the time as the "New Classicals" assume. That is why the whole field of IO can exist! Of course you can imagine a story to interpret the data in a way consistent with your prior of market clearing, but that's just adding more assumptions. Empirical work is what we need, not more theories. Until then everybody's policy recommendations are suspect.

    1. Their contributions went beyond the purely methodological. And you are too narrow in your view if you restrict "empirical" to mean "numerically represented data." Data can also be qualitative. And showing us different ways in which to interpret it, and what these different interpretations mean for policy advice, is an important task of economics.

  3. The relevant explanation for sticky wages and prices in Alchian (1969) is there are three ways to adjust to unanticipated demand fluctuations:
    • output adjustments;
    • price adjustments; and
    • Inventories and queues (including reservations).
    There is no reason for wags and price changes to be used regardless of the relative cost of these other options:
    • The cost of output adjustment stems from the fact that marginal costs rise with output.
    • The cost of price adjustment arises because uncertain prices and wages induce costly search by buyers and sellers seeking the best offer.
    • The third method of adjustment has holding and queuing costs.

    There is a tendency for unpredicted price and wage changes to induce costly additional search. Long-term contracts including implicit contracts arise to share risks and curb opportunism over sunken investments in relationship-specific capital. These factors lead to queues, unemployment, spare capacity, layoffs, shortages, inventories and non-price rationing in conjunction with wage stability.

    Alchian and Woodward’s 1987 ‘Reflections on a theory of the firm’ says:
    “… the notion of a quickly equilibrating market price is baffling save in a very few markets. Imagine an employer and an employee. Will they renegotiate price every hour, or with every perceived change in circumstances? If the employee is a waiter in a restaurant, would the waiter’s wage be renegotiated with every new customer? Would it be renegotiated to zero when no customers are present, and then back to a high level that would extract the entire customer value when a queue appears? … But what is the right interval for renegotiation or change in price? The usual answer ‘as soon as demand or supply changes’ is uninformative.”
    Alchian and Woodward then go on to a long discussion of the role of protecting composite quasi-rents from dependent resources as the decider of the timing of wage and price revisions.

    Alchian and Woodward explain unemployment to the side effect of the purpose of wage and price rigidity, which is the prevention of hold-ups over dependent assets. They note that unemployment cannot be understood until an adequate theory of the firm explains the type of contracts the members of a firm contract with one another.

    Walter Oi has also written on slack capacity as being productive and he included references back to W.H. Hutt. Oi’s work on retailing and supermarkets spends a lot of time explaining how an empty store is efficient because the owners are waiting for a mass of customers to arrive at unpredictable time.
    Oi redeveloped the term the economies of massed reserves to describe this. Oi thought that this was a better term than Hutt’s pseudo-idleness.

    Oi argued that all resource idleness could, in principle, be eliminated, but to accomplish this, the synchronization of the arrival rates of customers, sales clerks, and just-in-time inventories would be prohibitively expensive.

    Benjamin Klein’s theory of rigid wages in American Economic Review in 1984 is one of the few that explored rigid wages as an industrial organisation issue. Klein treated rigid wages as a response to opportunism and hold-up problems over specialised assets and are forms of exclusive dealership or take-or-pay contracts.

    The labour market is better understood by forgetting it is the labour market and treating it as a market for long-term contracts for relationship-specific services, firm-specific human capital and mutually dependent assets owned by multiple parties.