Enough with the square peg and round hole (DSGE)

Posted in Economics at 9:44 pm

Re: Krugman and his sticky wage defense:

Recessions/depressions have nothing to do with “sticky wages” and Keynes went out of his way to point this out.  That’s what makes it so disappointing to see New Keynesians make this argument, for no reason other than to rescue their DSGE modeling methodology.

Here’s why involuntary unemployment is not the result of wages being downwardly rigid.

When someone says that the price of something is too high, in real terms, we must ask “too high relative to what?”  If wages (the price of labor) are too high, relative to what?  To the price of capital?  Can’t be, since the hallmark of recessions/depressions is unemployed labor and capital (e.g., idle factories or low capacity utilization).  So then we ask whether both labor and capital are both priced too high.  Again, relative to what?  To finished goods and services?  Nope.  Two problems – 1) inventories of goods tend to swell during a recession, with unsold goods sitting in warehouses and on store shelves, so they must be overpriced according to this line of thought, and 2) wages and returns to capital represent purchasing power, so cutting wages means even less demand and greater inventory buildups.

What next?  How can labor, capital, and finished goods all be overpriced?  Perhaps the currency itself is overvalued?  Ok, now we’re getting somewhere.  An overvalued currency and slumping exports are both characteristic of recessions/depressions.  However, this is only part of the story.  Exports make up a relatively small percentage of GDP for most countries, and it’s quite common for multiple countries to enter recession/depression at the same time.  So we’re on the right track, but not nearly there yet.  The issue is that money IN GENERAL is overvalued relative to everything else.  The excess supply of everything else (goods/services and factors of production) is the result of and balanced out by the excess demand for money.  In fact, we can take it a step further and ask WHY there is an excess demand for money and the answer is that the demand for money is not a transactional demand but a precautionary one; it is not money itself that is debing demanded but rather the liquidity it provides.  So a change in “liquidity preference” is what causes the economy to remain in a depressed state.

Now we’re right back to what Keynes actually said.  We’re also right back to where many of the positions Krugman advocates do make sense.  But let’s not pretend that it has anything to do with “sticky wages”.