Sunday, 4 December 2016

Why Economic Modelling of Wages is so Political

Noah Smith recently wrote a post about the theory of the labour market, one of the building blocks of Economics 101, and how it has been empirically falsified. He points to two pieces of evidence; first that new immigration does not push down wages as predicted, second that minimum wages do not tend to reduce employment as predicted.

I think that he is completely correct here. The strange part really is how this could have been taught for so long as standard theory. The root of the problem is that Econ 101 teaches the job market like it is a market for goods. If the price is low, demand for the goods will be higher. Ditto, therefore, for workers.

The reason that it is wrong, is that, as Kalecki wrote so well about, workers are also consumers. Not only are they consumers but they are consumers who spend nearly all of their income on consumption. This means that the more is spent on wages, the more will be spent on goods on services, thus increasing demand for labour. This is exactly the opposite effect that Econ 101 teaches. Although higher minimum wages may mean some people lose jobs, they also potentially create more jobs.

Standard labour theory actually argues that there is no such thing as medium term involuntary unemployment, only people choosing more leisure time. It is one of those things that is funny when you read it, but has very serious consequences. The model says that real wages will fall to a level where everyone who wants to can be employed, therefore involuntary unemployment is impossible.  When faced with real life job queues, the answer given by the basic model is that it is because of labour market frictions. For frictions read that wages are artificially high. If only wages were allowed to fall low enough, everyone would be employed.

This is patently not true. Although lowering wages is often suggested/forced on countries in crisis, as Greece shows, the result is to depress demand further into a downward spiral. The only possible way it can work is in a very open economy, where lowering of wages and a devaluation of currency crush workers wages to an extent that exports can make up for lost demand. However the cost of this policy is that the country is poorer by the end.

In response to Smith's post, some economists did argue that he was misrepresenting what they actually teach; that this goes beyond the basic theory. That they use a 'general equilibrium model' in which, for example immigration can increase demand as well as worker supply.

However, this really doesn't go far enough. To explain why, you need to look at the basic equilibrium model that mainstream economics uses. It says that an economy is always at full employment, with the exception of short term shocks to the system. There is a natural rate of unemployment, for every economy and this depends on the frictions caused by unions (or sometimes employers to retain staff) making wages too high and achieving workers rights.

How did they just assume full employment, you may ask? Well, the model was built looking at the time since 1945 when Keynesian fiscal policy allied to large private sector credit expansion, meant that the economy more or less was always running at full employment. But they didn't realise it was because of credit expansion that they were getting the full employment, so instead they just assumed it was natural.

Incredibly, credit expansion is not in mainstream economic models as a driver of growth. Inflation comes from increase in the base money supply or something. This is a major problem, as the economy is a flow of money and new credit is the main driver of growth. Steve Keen's graphs where he plots credit expansion against unemployment, house prices and GDP growth (eg here) are eye-opening in this regard.

So they assumed full employment. This is a very pernicious assumption. Why? Because it laid the groundwork for the financialisation of the economy and for the rentier-capitalist economy that we appear to have been working towards since the 1980s.

The assumption of full employment means that wages can be kept as low as you want without affecting demand. If demand is assumed then the only thing that is important is that supply is kept high. The eventual conclusion from this is the Chamley Judd theorum, which states that taxes on capital should be zero as the more money that goes to investors, the more they will invest and the more supply we will have. The same is true for the rich, a.k.a. the 'Wealth Creators'. Reaganomics is given backing by the economics profession.

Supply side stopped being about building infrastructure and education, and became about giving tax cuts to rich people.

In this model, fiscal deficits are only necessary to counteract short term shocks and monetary policy (private sector debt) must be used instead.
What was the effect of this? Demand shrank even further. Economic growth since the 1980s has been considerably slower than the period between 1945 and 1975, and the growth that was achieved required larger and larger (eventually unsustainable) private sector debt.

So the problem with Econ 101 goes much deeper than that it gets wages wrong. The assumption of full employment is the one that gives free reign to rentier capitalism. Why do economists teach it? Kalecki has a theory here too.


  1. Great analysis. Another consequence of the Greenspan Culture.

  2. Is your twitter down?come back on it!

    1. Ha ha, thanks for noticing! Just off for Christmas - back in new year.


Sorry, I have had to moderate comments because of an annoying pest spammer who keeps posting American football matches links.