Saturday, February 4, 2012

Noah Clue

Hey you guys! You know how unemployment has been, like, real high for years now, and nobody knows why? Noah Smith has figured it out:
an economic principle often overlooked by progressives: There is sometimes a tradeoff between wages and employment levels (which is another way of saying that labor supply curves slope up and labor demand curves slope down). If economic "frictions" or the actions of policymakers hold wages up when economic forces are trying to push wages down, unemployment will often result. 
I think he learned it in an economics class!

You remember how there were these economic forces in 2007 that decided wages had to go down, but we got all these new policies to raise wages like, you know, all those wage-raising things that Bush did? Well, that's why unemployment went up by 5 points in less than two years. 

I mean, it's so simple when you think about it. "Labor demand curves slope down," that's all you need to know. We learn that the first year of micro, supply curves slope up, demand curves slope down. Demand for labor, demand for cottage cheese, doesn't matter, they're just the same. Why do they even bother offering courses in macro?

It's funny, though: Wasn't there some guy who wrote a whole book about why lower wages don't raise employment? Maynard, or some weird name like that? Well, Noah's never heard of him, or of his book (the General Theory of something?) but he can't be worth bothering with, can he? after all, he didn't even realize that demand curves slope down! Which is all you need to know.

Of course, lower wages won't help employment if there is already an excess supply of labor. If people are already willing to work for less than the going wage, telling them they should accept less than the going wage can't be the solution. What would we call a situation like that? How about ... "involuntary unemployment"? But Noah Smith is too smart for that, he knows that could never happen. He knows that markets always clear, employment is always at the intersection of the labor supply curve and the labor demand curve, so the only way to raise employment must be to move the labor supply curve downward. It's just Econ 101, and Econ 101 is never wrong.

Of course, if you think that wages are equal to the marginal product of labor, the demand curve for labor will only slope downward when the marginal product of labor is falling -- which might not be the case when output is far from potential. But Noah Smith knows that demand curves always slope downward, so there can't be any range of output over which the mpl is more or less constant.

But wait, what if labor markets are monopsonistic? Then the observed labor demand curve can slope upward. And monopsony in labor markets doesn't require a company town, all it requires is that a firm's labor costs are rising in employment. Or in other words that if a firm cuts wages moderately, it will lose some but not all of its workers. (Crazy talk, I know.) Which is the natural result of labor market models with search frictions. This is one reason why the most rigorous empirical studies of legislated wage changes show no sign of a downward sloping labor demand curve. But Noah Smith doesn't need to trouble his beautiful mind with empirical evidence, or learn any of that silly labor economics stuff, because he knows that labor demand curves slope downward. He learned it in introductory micro!

And then there's that little difference between labor and cottage cheese, that wages make up the large majority of producers' variable costs. So we have to think general equilibrium here, not just partial. Prices, in the first instance, are set as a markup over marginal costs. [1] So if you reduce money wages, you don't reduce real wages by as much, because you reduce the price level as well. That means deflation, which is ... let's see, not always super great for employment. That Maynard dude wrote something about that too, I think, and so did some other old guy, Hunter or Trapper or something. Apparently there was this crazy idea that falling wages and prices were a problem back in Ancient Rome, or maybe the 1930s (same thing). But Noah goes to a good graduate school, so he knows that no real economist bothers with dusty old stuff like that. After all it's not like there are any lessons we could learn from the Great Depression, or the Punic Wars or whatever it was. Not when we know that labor demand curves slope down!

Oh and hey, there's another difference between labor and cottage cheese! (Who'd have thought?) Wages are also a source of demand. Pop quiz for Noah Smith: Which is a more important component of final demand, consumption out of wages, or net exports? Yeah, that would be door number one. So maybe, just maybe, whatever competitive advantage lower wages yield in lower unit labor costs might be offset by lower consumption demand by wage-earners? And that's assuming that changes in wages are fully passed through into the relative price of tradables, and that trade flows are price-elastic. [2] But hey, you know what happens when you assume: it makes you an ... economist. Now, if it were the case that wages were an important source of final demand, and if output is demand-constrained, then lowering wages might not raise demand for labor, even if labor markets were fully competitive and if changes in nominal wages translated one for one into changes in real wages. But that's unpossible! because, as we all know, the demand curve for labor slopes down.

Well, but demand doesn't matter, since Noah knows -- he learned it in school -- the economy is always at full employment. If we observe fewer people working, it can't be because aggregate demand has fallen, it can only be because an artificially high price of labor has led to substitution away from labor to other factors of production. It couldn't possibly be the case that when unemployment is high, capital is underutilized as well too, could it? Because that would mean that the wage share and the profit share were both too high, which is like saying that x>y and y>x. So no, we couldn't possibly observe anything like this:


Because we know -- it's economics 101 -- that high unemployment can only ever be the result of substitution away from labor because of changes in relative prices, not a lower level of output for the economy as a whole. Altho, gosh, it sure looks like capacity utilization falls in recessions just like employment does, which would suggest that cyclical unemployment has nothing to do with the relative price of labor.

So, ok, we can forget Keynes and all that old nonsense. And let's ignore the effect of nominal wage changes on prices. And put out of our mind any question about whether the marginal product of labor is really declining over current levels of output, or about imperfect competition in labor markets. And we'll ignore the role of wages as a source of demand. And we'll unlearn any information we might have accidentally picked up about the empirical relationship between wages and employment, or about the Great Depression. And we'll stick our fingers in our ears if anyone suggests that unemployment today is associated with demand constraints on output rather than substitution away from labor. And then we can be as smart as Noah Smith! And we'll know how to fix unemployment:
In Germany, labor unions often negotiate wage cuts in order to preserve long-term employment levels. I think we should look at doing something similar.
You guys, wage concessions! Has anybody in the US labor movement ever thought of that? I bet it will work great! It's pretty ballsy of Noah Smith to stand up against Big Labor, but someone's got to, right? I mean, unions represent almost 7 percent of the private workforce. If someone is holding wages above the level that Economic Forces want them to be at, who else could it be?

Hey, I wonder if any other countries are getting advice from smart economists like Noah Smith, and are fixing all their problems by cutting wages? You know, I think there are some. How about Latvia? The authorities there were all, like, wages are going down. And guess what? While in the US unemployment has gone from 5% in 2007 to over 8% today, in Latvia it went from 5% to ... 14%? Well, who cares about some little Baltic country, let's talk about the UK. They got real wages down by 2.7 percent last years (2.1 percent nominal growth less 4.8 percent inflation.) And hey, look at employment -- it's skyrocketing continuing to fall, and now the lowest it's been since 2003.

Um.

You know what? I'm beginning to think that "labor demand curves slope down" might not be the best way to think about unemployment. Maybe it is helpful to know something about macroeconomics, after all.


[1] Or equal to marginal costs if you like; the point is the same.

[2] I've presented some evidence on whether trade flows are responsive to relative costs in practice in these posts.

19 comments:

  1. You certainly do a righteous rant.

    I think I gave the very, very short version in my comment to Noah: "The other thing about your post is that, taken to an extreme, isn't it the exact reasoning of Hayek's Great Vacation theory of unemployment during the Great Depression?"

    Cheers!
    JzB

    ReplyDelete
  2. I don't know enough econ to really critique your argument. But I do know that you sound like a dick. You might want to turn the seething contempt knob down from 11 by a few notches. Krugman does it better than you and HE can barely pull it off.

    ReplyDelete
  3. Hey anonymous, go blow a dolphin.

    Dear JW Mason, please keep up the seething contempt. It is most enjoyable.

    ReplyDelete
  4. Seething contempt is certainly called for. More seething contempt, please.

    ReplyDelete
  5. You mockingly write, "An artificially high price of labor has led to substitution away from labor to other factors of production." Shouldn't there be some mention of the Cambridge Capital Controversy in the original post? Even if markets were competitive and prices were non-sticky, explaining wages by the interaction of supply and demand functions for labor would be nonsense.

    ReplyDelete
  6. Spunky, and well-deserved.

    "Has anybody in the US labor movement ever thought of that?"
    Eleven links in one sentence? Sweet! That must be some kind of record.

    Prob'ly shouldn't ask, but didn't some other guy say something about "a tradeoff between wages and employment levels"? Phil something? Phil Ipscurve, maybe?

    ReplyDelete
  7. Do I detect a trace of sarcasm in this post? Just barely detectable.
    :)

    ReplyDelete
  8. You too need some correction. Read Nick Rowes response to Noah's post.

    ReplyDelete
  9. So enjoying this! Found a new hobby -- watching economists whack each other on the tubes!

    ReplyDelete
  10. Your "Noah" pun is not nearly as clever as the title of my blog. In fact, you simply substituted "Noah" for "no" in a phrase that wasn't a very creative or potent insult in the first place.

    So I'd say I easily win the "making puns with my own name" competition. NEENER! :P

    ReplyDelete
  11. Jazzbumpa, G, Bruce, Arthur-

    Thanks!

    Robert-

    You're right, the claim that "economic forces" want wages to be at a particular level really deserved more of the mock. You're right, there's no such a thing as an aggregate "labor demand function." I should probably write a calmer post laying out the substantive issues here. (Or you should!)

    Jazzbumpa-

    You're right, he's just echoing (without realizing it) Hayek. Or you could say, he's just saying liquidate labor -- there's no difference in the underlying analysis, such as it is. That's what's so frustrating about this -- all these same arguments about how unemployment must the result of artificially high wages, and that the solution was to make labor markets more flexible, were made over and over in the 1920s and 1930s, along with the (ultimately successful) efforts to explain why that didn't work. I don't want to sound like some kind of Maynard-worshipper, but chapter 19 of the General Theory is all about changes in money wages, why people might expect them to affect employment, and why in practice the effects are weak or perverse. But Noah Smith would never read that, or even be aware of its existence, because of the way mainstream programs deliberately cultivate ignorance of anything outside a very narrow canon of contemporary economics. So when they have to answer any question outside the little bag of math tricks they've been taught, they find themselves reinventing the wheel.

    So it's not the substance of his position that aggravates me so much (altho I disagree with it) as his smug assumption that the only reason anyone might thing differently is ignorance of economics 101. A normal person who thinks they've hit on a perfectly obvious one-sentence answer to an intractable social problem, will say "It probably isn't that simple, I should see how this has been discussed before and why this solution hasn't already been adopted." Whereas a well-trained economist says, "Haha, everyone else is so dumb."

    ReplyDelete
  12. Re Nick Rowe, I did read his comment. It's certainly more substantive than Noah S.'s post, but what it boils down to is if the central bank believes the economy is already operating at potential, then it will be impossible to raise wages without lowering employment. I don't think this is true as a matter of principle -- it should be possible to redistribute income from profits to wages even in a supply-constrained economy -- but clearly it is true in certain contexts. E.g. the late 1990s, where Greenspan explicitly justified allowing unemployment to fall below (what was then believed to be) the NAIRU on the grounds that "traumatized" workers would not use lower unemployment to demand higher wages. You could certainly describe that as a kind of a tradeoff between unemployment and wages.

    But while Nick R., unlike Noah S., has a valid point, it's irrelevant for two reasons. First, it might apply to employment in the 1990s, but it definitely does not apply to unemployment today, when the central bank is either unable to achieve its objective or is not pursuing a coherent objective at all. Nick is basically assuming that the central bank always keeps the economy at potential; to put a finer point on it, he's saying that there can't be involuntary unemployment because monetary policy always operates to eliminate any involuntary unemployment. That might have looked right in the Great Moderation, but it obviously is not right today. And secondly, in the context of the present rant, Nick's claim has nothing to do with the fatuous claim that "labor demand curves slope downward."

    Noah-

    Oh I know! I really struggled with the punning title, but I'm not happy with it either. So yeah, I'll grant you that one.

    ReplyDelete
  13. I'm not an economist - just came across this by accident but I do think falling wages help some vectors of unemployment. I work for a strategy agency in the UAE (Dubai) and have several Indian and Chinese clients and there is a lot of interest from my clients to hire in the US versus Europe or even Mexico because the lower cost with high productivity is attractive. I closed three proposals last year opening up 100+ employee facilities around Detroit versus in the UK. Sure, my work doesn't represent global trading practices (Automative software testing, 2nd stratus) but I can say that lower wages have put us into markets that 5 years ago were not cost competitive. The US is a great place to do business - if it comes at a discount to other places it will be much easier for me to shift business to a new low cost center.

    Im at heart a trader - show me low wages and I can move jobs. My company did it for years from the US to Asia and we are doing it again back to middle America.

    ReplyDelete
  14. Arama - Your practical post brings sanity to this silly academic shouting. Keynes accepted protectionism as the second best employment policy; free trade was first unless it caused unemployment. Policy makers in the US badly missed the impact of lost jobs to Asia and now are overwhelmed by lost tax revenues, defaulted mortgages and "less than optimal" use of skill sets.

    ReplyDelete
  15. Could I have some more seething contempt please?

    ReplyDelete
  16. Should have gone with "Noah's Myth"... ;)

    ReplyDelete
    Replies
    1. I think the pun we are looking for probably involves an ark, but I haven't found it yet either.

      Delete
    2. Very late to this, but "Noah Snark" maybe?

      Delete
    3. Why didn't I think of that?!

      (Now I am going to have to write another post attacking him, just to use that title.)

      Delete