Saturday, December 17, 2011

Rowe, Stiglitz, Caplan

Stiglitz has been arguing that growing productivity in agriculture was responsible for the Great Depression. Similarly, he argues that growing productivity in manufacturing is responsible for the Great Recession. The demand for manufactured goods is inelastic, so those in the manufacturing sector have lower incomes. Supposedly, their lower income reduces demand in the rest of the economy. Aggregate demand falls, firms produce less, so output and employment are depressed.

Nick Rowe takes him to task for failing to see that income equals output. Growing productivity in some sector raises aggregate output and generates the additional income necessary to purchase the output. Rowe recognizes that people may not want to purchase the added output, but that is the source of the problem, not the added productivity. Rowe, then, accepts that an increase in aggregate income or a change in the distribution of income might lead to increased saving. That could reduce spending on output to the degree it results in an increase in the demand to hold money.

(Those defending Stiglitz focus on this argument--he is providing a reason why the natural interest rate might be low. If the natural rate is low enough, conventional monetary policy is ineffective and results in real expenditure less than potential output.)

Caplan has been arguing that Keynesians should be calling for wage cuts. In Caplan's view, lower wages will result in higher employment. He has been challenging the argument that the lower wages will result in lower wage income and reduced spending on output. He argues that if employment grows. while each full-time worker might earn less, there will be more workers to earn income. And further, if the demand for labor is not elastic, and labor income does not rise with greater employment, then profits expand and the expenditures of the owners of the firms generates greater expenditure.

Rowe takes Caplan to task as well. If output is limited by demand--what can be sold--the lower wages will not raise demand for output, and firms won't hire workers to produce more if they cannot sell any more output. Assuming greater employment will not do. And lower wage income and higher profit income, leaving aside quite plausible differences in saving and willingness to accumulate money, just changes who purchases the output.

In my view, Caplan's macroeconomic understanding is sound. He is assuming that wages are sticky and prices are flexible. If nominal expenditure on output falls a given amount and then stays constant, prices of output fall immediately. But wages don't fall. This raises real wages, and the profit maximizing level of output falls. Given that lower level of output, the price level falls enough to sell this reduced level of output, but less than in proportion to the drop in nominal expenditure. With constant money wages and a lower price level, real wages have risen. The firms employ less labor in a way that is perfectly consistent with the lower production. It is basic micro-profit maximization.

Now, when wages fall too, the real wages fall. Costs have fallen and firms produce more and lower their prices. Given nominal expenditure, this is an increase in real expenditure on output. The firms, in aggregate, can sell more. The expansion in production and employment is perfectly consistent with microeconomic principles. If wages fall enough, the new equilibrium is identical to the initial one in real terms. Nominal prices and nominal wages wages are both lower, but real wages, real output, and real income are all at the initial level.

Of course, this argument assumes that lower prices and wages don't cause reduced expenditure on output. In the end, it must be based on given quantity of money and some sort of stable demand to hold real money balances. And the elasticity of the demand for labor and added expenditure out of possibly greater profits are irrelevant.

So, what is up?

Consider a different scenario. All prices and wages are quite flexible, except one problem. There are price floors on all final output. Velocity is constant and the quantity of money is reduced. The equilibrium price level is lower, but prices can't fall. Production falls to match reduced demand for output.

Firms need less labor to produce less output. Employment falls. There are surpluses in labor markets, and so wages fall. Prices are fixed, and so this is a reduction in real wages.

The reduction in wages reduce costs and increases the surpluses in product markets. Firms would like to sell more, but because they cannot reduce prices, their actual sales and production remain at the lower depressed level.

Assuming the supply of labor has the usual positive slope, then once real wages are low enough, the quantity of labor supplied falls enough to match the lower quantity demanded. If the supply of labor is perfectly inelastic or worse, has a positive slope, then real wages would drop to zero. Of course, that is the region where Malthusian effects--starvation--will reduce population enough so that the quantity of labor supplied matches the demand. In other words, real wages turn perfectly elastic at subsistence in the long run.

However, there is another process at work that will tend to clear up the surplus of labor. As real wages fall, it becomes more profitable to utilize more labor intensive production methods. Even assuming output doesn't rise, it will become profitable to use more labor to produce it at lower real wages.

If the supply of labor is assumed to be perfectly inelastic, (workers need jobs,) then real wages fall to a level where the quantity of labor demanded matches quantity supplied. Less capital intensive production methods will be used. Labor productivity falls enough so that full employment of labor results from producing the demand-constrained level of output. (Hopefully, the market clears at wages higher than starvation levels.)

And with the workers having lower real wages, who will be buying this output? Well, if we compare the workers' demand for output at full employment with a lower real wage to what they demanded at less than full employment at a higher real wage, the reduction in total labor income will be less than in proportion to the decrease in the real wage. While the less inelastic labor demand, the smaller the decrease in labor income in aggregate, elastic, or even unit elastic labor demand is implausible. Of course, if labor's share of the fixed income falls, the owners of the firms will be earning more profits, and so they can consume more.

And so, what is the characteristics of the new equilibrium? Real and nominal output and income are at the reduced level. Still, there is full employment, because more labor intensive methods of production are used and because at lower real wages fewer people choose to work. It is very likely that the labor share of income is lower, and workers consume less. The capital share of income is higher, and business owners live in bigger mansions, have bigger yachts, and fancier limousines. And maybe more servants too.

To some degree, the old, more productive capital goods would be abandoned, but it is likely that to some degree they just aren't replaced. In other words, the initial drop in real wages will be greater, and only gradually, as production technologies are shifted to those with lower labor productivity, will the quantity of labor demanded rise. Once the capital stock has readjusted, then there will be no excess capacity. Potential output will have fallen to match the demand-constrained level of output.

I certainly don't accuse Caplan of advocating something like the above. In fact, he advocates raising the quantity of money enough to reverse any decrease in nominal expenditure on output so that there is no need to decrease nominal wages. And, as I explained above, if that doesn't occur, so that we are left with the lower wage "solution," prices fall along with money wages, and either an assumed constant nominal expenditure on output or a real balance effect from a given quantity of money raises real expenditure on output. Still, some of his arguments about why lower real wages generate more employment would apply better to this quite ugly scenario.

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