Trinity Papers No. 36 - 'Keynes, sticky money wages, behavioural economics ...'

Keynes, sticky money wages, behavioural economics and responding to the Global Financial Crisis.

Ian M. McDonald.

University of Melbourne.

Abstract This paper relates Keynes' thinking on wage setting with behavioural economics, a new field in economics that draws on psychology, and applies the resulting insights to the problem of dealing with the effects of the global financial crisis on unemployment in Australia. Using Keynes’ way of thinking, updated to the current time, the paper concludes that during 2009, as unemployment increases, reductions in money wages should not be resolutely resisted but that government, the RBA and the minimum wage authority should emphasise their long‐term policy of restoring the rate of inflation to the RBA’s target range as soon as the rise in unemployment ceases.

1. Keynes’ theory of wages and behavioural economics

In the General Theory, and the papers of Keynes associated with the General Theory,

there is relatively little discussion of the determination of money wages and prices. The main focus is on the determination of aggregate demand and on how the level of aggregate demand determines the rate of unemployment. However, in the subsequent literature on macroeconomics, the determination of money wages and prices has been a controversial topic and has attracted much attention. Much of this discussion has been in the debate on microeconomic foundations. Whilst the importance of aggregate demand is immense and is

the central contribution of Keynes’ General Theory, a coherent theory of aggregate demand and its employment effects requires an economic theory of the determination of wages and prices.

In 1968, at the inception of the microeconomic foundations debate, Friedman and

Phelps put forward an economic theory of the determination of wages and prices, which required, in order that changes in aggregate demand lead to changes in employment, a difference between actual prices and expected prices. These differences are called forecast errors. Friedman and Phelps argued that a change in nominal aggregate demand will only induce Homo Economicus to change his employment decision if he is deceived about the true levels of wages and prices. That is to say, monetary and fiscal policy, can only have a real effect if they create forecast errors.

Although the approach to macroeconomics based on forecast errors has dominated

macroeconomic research since 1968, in the practice of macroeconomics, in particular for the determination of the level of employment, forecast errors of wages and prices have been unimportant. Instead, for macroeconomic practice an approach more closely related to Keynes’ General Theory has been followed in which employment is determined directly by the level of aggregate demand, with no reference to forecast errors. This approach is followed, for example, in the IS‐LM model, the workhorse of macroeconomic practice, including the teaching of macroeconomics at first and second‐year university level.

Keynes argued that money wages will be sticky downwards because workers were

concerned about cuts in their wages relative to the wages of other workers. If changes in money wages are not synchronised, then the change in any particular wage would occur in isolation, with all other wages being unchanged. Thus with no synchronisation of the setting of wages, there will be resistance by workers to money wage cuts. However, this discussion is very brief.

Not only did Keynes devote little time to his theory of wage stickiness, but it is also inconsistent with his discussion in the General Theory of the actual pattern of wages and prices. It is clear from reading the General Theory that Keynes did not view wages and prices as downwardly rigid. Instead, an initial disturbance to aggregate demand was seen by Keynes as capable of causing changes in wages and prices. Thus he suggested that, at less

than full employment, “an increasing effective demand tends to raise money‐wages though not fully in proportion to the rise in the price of wage‐goods; and similarly in the case of a decreasing effective demand”, Keynes (1936, p. 301). However, this adjustment was seen by Keynes as short‐lived. Keynes said that at high rates of unemployment, prices “in response to an initiating cause of disturbance, seem to be able to find a level at which they can remain, for the time being, moderately stable”, Keynes (1936, p.250).1 Thus he was observing the pattern of flex followed by fix.

Keynes contrasted this behaviour with the flex‐price behaviour of classical theory using the expression “fall without limit” to describe classical flex‐price behaviour when the economy is at less than full employment, see eg Keynes (1936, p.253 and pp.303‐4). Keynes regarded the classical mechanism of price behaviour, “fall without limit”, as empirically irrelevant for an economy at less than full employment.

The reason that Keynes did not develop his theory of wage stickiness may have been

that he regarded the important determining factors as beyond the concepts of economic theory. Keynes alluded to the influence of the “psychology of the workers” Keynes (1936, p.301) but drew back from further analysis, saying that such considerations “do not readily lend themselves to theoretical generalisations”, Keynes (1936, p.302).

Today, however, the situation is different. The last decade has seen the growth of a

new area in economics called behavioural economics. Behavioural economics draws in particular upon psychology. The basic model of behavioural economics is prospect theory, developed by Kahneman and Tversky from evidence on human behaviour accumulated through a number of psychological studies. According to prospect theory, individuals in their decision‐making are very much concerned about reference points. Outcomes are judged relative to reference points. The importance of reference points in prospect theory suggests that it may provide a microeconomic foundation for Keynes’ theory of sticky wages.

Prospect theory also contains the concept of loss aversion. According to loss

aversion people suffer from falling short of their reference point by a greater amount than they gain from exceeding their reference point. This difference exists even for very small losses and gains, that is as losses and gains approach the limit of zero, the discreet difference between their valuations persists.

1

The qualification “for the time being” is discussed below.

Bhaskar (1990) has shown that prospect theory can explain the downward rigidity of

wages. In this explanation, loss aversion plays a crucial role. Indeed, with no loss aversion there is no wage rigidity. A concern with relative wages is not sufficient for wage rigidity.

Thus Keynes’ theory of sticky money wages is incomplete.

It may be that Keynes’ thinking about how workers would regard cuts in money

wages was in line with the concept of loss aversion. Thus Keynes (1936, p.15) said “Every trade union will put up some resistance to a cut in money wages, however small” (my emphasis). This implies a discontinuity in the marginal utility of wages at the current level of the wage, which is precisely the implication of prospect theory and loss aversion as applied to wage determination in the prospect‐bargaining model. Had Kahneman and Tversky made their contribution of prospect theory in 1929 rather than in 1979, Keynes’ ideas on wage determination may have been clearer and more consistent.

However, the Bhaskar theory is not sufficient to explain the actual pattern of wage

and price adjustment observed by Keynes. It was noted above, that Keynes observed a flex‐ fix pattern of wage adjustment. For example, an increase in unemployment would initially cause money wages to fall, but subsequently, money wages would settle at a new lower level even although unemployment had increased. The Bhaskar theory does not have this richness.

The Bhaskar theory can be extended to deliver an explanation of the flex‐fix pattern

of wage adjustment by the incorporation of economies of scale in the firm's production, as in McDonald (2009). This extension is motivated by evidence that in practice firms do cut wages if their viability is threatened. Furthermore, if their viability is threatened, then it appears that workers will accept wage cuts. Bewley’s interviews with managers of firms and labour leaders revealed that workers will accept wage cuts if that relieves pressure to close down the firm or plant and so saves their jobs, see Bewley (1999, pp. 173, 181, 376, 380 and 395).

2. The Global Financial Crisis

At the current time, Australia is facing a considerable reduction in aggregate demand

caused by the global downturn. In line with the flex‐fix pattern of wage and price adjustment, as unemployment increases we can expect to see inflation moderating and even

turning negative. When unemployment stabilises the rate of inflation can be expected to stabilise. This pattern was observed in the recessions of the 1930s, the early 1980s, and the early 1990s in Australia and other countries, see figures 1, 2 and 3. To help appreciate the pattern the contraction phase is shown by thin lines connecting the end‐points of the contraction with the thicker lines showing the annual inflation‐unemployment outcomes that followed the contraction.

Whether reductions in wages in times of recession can improve or worsen economic

outcomes is a hotly disputed topic. In as far as government policy can influence the general movement in wages, views on the advantage or disadvantage of wage reductions as unemployment increases should be considered carefully by policy makers. In as far as economic forces on wage outcomes are independent of government policy, views on their efficacy are reasonably included in one's judgement of the overall benefits of capitalism.

With these points in mind, let us consider the advantages and disadvantages of wage reductions for an economy with falling aggregate demand and increasing unemployment.

1. Bewley's evidence, noted above, shows that at the level of the individual firm wage cuts agreed between workers and their employer can save the firm from being closed down. This mechanism can of course apply at the level of an individual plant of a firm. A centralised system of wage bargaining, as used to be the case in Australia, can prevent agreed wage cuts at a particular firm or plant being adopted. An example from not so long ago, was the SPC fruit canning plant. However, Australia now has a decentralised system of wage bargaining in which enterprise agreements play an important role. In this decentralised environment, one would expect to observe cases where agreed cuts in wages lead to the survival of a firm or a plant.

One danger with agreed wage cuts is the greed of the employer. A devious employer

may take advantage of his workforce by exaggerating to the workers the size of wage cuts required to prevent close down. Union representation can presumably play a positive part here. However, for unions to play a positive role, they should not adopt a blanket opposition to wage cuts.

This first point is about the value of wage cuts at the microeconomic level for

particular firms or plants. The debate about the desirability or not of wage cuts has been focused more at the macroeconomic level and it is now too macroeconomic considerations that we turn.

2. In Chapter 19 of the General Theory, Keynes argued that a general decrease in the

wage level could be counter‐productive in that it could reduce the level of aggregate demand. There are two mechanisms of importance. Firstly, a major component of aggregate demand is the expenditure on consumption goods and services by workers.

Reductions in wages will reduce this component of aggregate demand and will therefore increase the decrease in employment. Second, a negative rate of change of wages and the implied negative rate of change of prices may induce a negative expected rate of inflation.

This would increase the real rate of interest equivalent of any particular nominal rate of interest. Because zero, or slightly above zero, is the minimum for the nominal rate of interest, a negative expected rate of inflation can lead to a negative real rate of interest. A negative real rate of interest will discourage to some extent consumption spending, causing people to put off consumption until later periods when goods are cheaper. Furthermore, a negative rate of expected inflation implies a positive real rate of interest even if the nominal rate of interest has been reduced to its minimum value of zero. And when the nominal rate of interest has been reduced to its minimum, the effectiveness of further monetary expansions to increase aggregate demand is severely curtailed.

The argument of Keynes in Chapter 19 of the General Theory was hypothetical.

Keynes was taking on people who advocate wage cuts as the sole policy measure required by governments to tackle economic downturns. However, in the current environment, as the huge rescue packages enacted by many governments aimed at increasing the level of aggregate demand show, governments accept Keynes' discovery of the importance of aggregate demand and the value of governments acting to influence the level of aggregate demand to influence the aggregate level of activity in the economy. Thus in as far as general declines in wages reduce aggregate demand, governments can act through monetary and fiscal expansion to offset this negative effect.

In the 1990s Japan suffered from a zero or slightly negative expected rate of inflation.

This brought into play the mechanism described above about the ineffectiveness of monetary policy when the nominal interest rate has reached its minimum. Japan suffered from a sustained depression, from the early 1990s up to the present day. Various fiscal expansions were tried, albeit with varying degrees of enthusiasm by policy‐makers, but were unable to restore the Japanese economy to full employment. However, this experience of the Japanese economy is not a good guide to Australia's prospects, because during this

period of time the saving rate in Japan was very large. Given Japan's limited investment opportunities, due partly to the slowdown in the rate of population growth, a level of aggregate demand that would ensure full employment was only attainable by Japan running an enormous current‐account surplus. This possibility, commentators argue, would not have been allowed by other major economic powers.

As noted above, the evidence on previous downturns suggests that when the

downturn finishes inflation will stabilize. Because of the dangers from a negative expected rate of inflation it is to be hoped that inflation stabilises at a positive rate. Indeed, a rate greater than 2% is desirable because a positive rate of inflation of 2% or slightly more has the net beneficial effect on the economy of facilitating structural adjustment. Inspection of Figures 1 and 2 reveals that in the recessions of the 1930s and 1980s, inflation increased when unemployment stopped increasing. In both cases, it would seem that inflation returned to equal an expected rate of inflation that had not been reduced by as much as the actual rate of inflation. In the 1990s, inflation did not increase when unemployment stopped increasing. But in that event, evidence suggests that the expected rate of inflation had decreased by an amount similar to the decrease in the actual rate of inflation. So the general rule appears to be that at the end of the downturn the rate of inflation will return to the expected rate of inflation. Thus, at the end of that GFC downturn, to know at what rate inflation will stabilize we need to know what the expected rate of inflation will be.

Monetary policy in Australia is guided by an inflation target. This guidance has been

in effect since 1993, that is for 16 years. During that time, the actual rate of inflation has tended to be within the target range of the inflation target, which is from 2 to 3%. In as far as people believe that the Reserve Bank of Australia will be able to return inflation to this target range, then they will reasonably expect that the expected rate of inflation will be within its target range, that is around 2.5%. A credible inflation target will therefore prevent the actual rate of inflation remaining negative when unemployment has ceased to rise.

About 10% or more of the Australian workforce have their wages determined by the

minimum wage. During a downturn it may be reasonable, to reduce the number of firm closures, for some downward adjustment in the minimum wage. In as far as the minimum wage authority takes this course of action, it should make it clear that this is a deviation from the inflation target due to be exceptional economic conditions, and that the long‐term policy is to increase the minimum wage in line with the inflation target.

The advantage of reductions in wages is to save some firms from closure. When the

downturn has ceased, this advantage becomes of lesser importance and so the case for wage reductions ceases. At that point a return to positive inflation is desirable.

3. Conclusion

In conclusion, it appears, using Keynes’ way of thinking, updated to the current time,

that during 2009, as unemployment increases, reductions in money wages should not be resolutely resisted but that government, the RBA and the minimum wage authority should emphasise their long‐term policy of restoring the rate of inflation to the RBA’s target range as soon as the rise in unemployment ceases.

Figures

Figure 1 The flex-fix mix in the 1930s recession Wage inflation, annual percentage change

15

10

5

0

-5

UK: 19 to 33, 33 to 40

-10

US: 29 to 32, 32 to 40

Australia: 26/27 to 31/32, 31/32 to 41/42

-15 0

5

10

15

20

25

30

Unemployment, percent

Figure 2 The flex-fix mix in the 1980s recession 20

Wage inflation, annual percentage change

UK: 80 to 85, 85 to 89

18 16 France: 80 to 86, 86 to 89

14

Australia: 81 to 83, 83 to 85

Canada: 80 to 83, 83 to 87

12 10 US: 79 to 83, 83 to 85

8 Japan: 79 to 83, 83 to 89

6 4 Germany: 80 to 85, 85 to 89

2 0 0

2

4

6

8

10

12

14

Unemployment, percent

Figure 3 The flex-fix mix in the 1990s recession 10

Wage inflation, annual percentage change

Australia: 89 to 93, 93 to 95

UK 90 to 93, 93 to 95

8 Canada: 89 to 93, 93 to 95

6

France: 90 to 94, 94 to 99

US: 91 to 93, 93 to 95

4

Japan: 91 to 02, 02 to 07

2

Germany: 91 to 97, 97 to 01

0 0

2

4

6

8

10

12

14

-2

Unemployment, percent