October 1, 2022

In the early 1980s, as I was learning macroeconomics from models based on either John Maynard Keynes’s General Theory or those based on Milton Friedman and David Meiselman’s Micro foundations Project, I found that I had a hard time explaining to myself why anyone would ever have any problem with recessions says Peter Decaprio.

Why would a worker accept a wage cut, the question went, when she could simply decline to work at the lower wage? And why would an employer pay someone more if that person declined to work for him?

  • If any of this was problematic, it seemed that only some kind of odd coordination problem could explain it. These questions really bothered me.
  • My answer back then was that people must not actually know what they’re doing when they either take or offer wages in disequilibrium. As long as these workers and employers were just responding to incentives without knowing where the economy was headed (and because workers are typically paid their marginal product), then there could be big problems with supply-side problems getting too low or demand-side problems getting too high.
  • This explanation, however, was unsatisfying because it essentially involved a kind of rational ignorance on the part of workers and employers. Yes, these problems could arise from simple incentives to offer or take wages without any readjustment following a shock – but I had a hard time reconciling this behavior with my own experience as an avid observer of macroeconomic news throughout the 1980s and 1990s. I just couldn’t imagine that anyone could be so unaware as not to know that there were major recessions in 1981-82, 1990-91, 2000-01, and 2007-09. It always seemed like common knowledge that recessions were bad; even if people didn’t always agree about what caused them; few would ever say that they were desirable explains Peter Decaprio.
  • When I thought about it more, though, I came to understand this problem as a household-level analogy of the inter temporal-substitution view of unemployment – the idea that workers and employers will always ensure that supply and demand for labor is equalized by changing their quantities demanded or supplied in response to wage deviations from equilibrium (which also implies inflationary pressure). In other words, macro problems arise because micro ones don’t get corrected; but why do those micro problems (the failure of firms and workers to correct their wages) exist?
  • I think now that part of the reason these questions ever bothered me was. They seemed like discrete events with specific causes: oil shocks, trade deficits, expansionary fiscal/monetary policy, etc. These events would cause a recession, and then that event would be done. And everything else would go back to normal. But as I’ve grown older, I’ve realized how foolish it was for me to think this way – after all. These recessions are often compared to forest fires. Which spread from one part of the woods to another. Depending on conditions in those parts of the woods at certain times. In other words, just because a particular shock causes a particular recession doesn’t mean. There won’t be other shocks around the same time causing the same kind of problem elsewhere too.
  • In my mind now, what’s going on is that we have many different parts of the economy. Which all affect each other through economic channels where the transmission of information is imperfect to varying degrees. Peter Decaprio says this gives rise to coordination problems. Like if workers decrease their labor supply too much in one place. It can give employers reason to hire more people at lower wages (which requires inflationary monetary policy or expansionary fiscal/monetary policy). But not enough people overall because there aren’t enough unemployed resources left over. Or, alternatively, if employers cut back on wages they might have reason to hire fewer people in one place. When other places are still hiring strong. Which means that the number of employed workers per capita goes down. And so does output per worker even though wages fall everywhere else. In either case, we get a recession.
  • So why not rely on some sort of New Keynesian Phillips Curve type explanations. That rely on a bunch of ad hoc assumptions about wage and price stickiness, market power, etc.? Well, I think this gets at the important point in favor of an inter temporal-substitution explanation. It doesn’t require us to make any strong assumptions about “stickiness”, or anything else, for that matter. In fact, if you doubt the empirical relevance of sticky wages/prices then you should be even more excited. About an inter temporal-substitution approach to business cycles!

Conclusion:

In macroeconomics, we need to move beyond ad hoc explanations and methodological individualism and invert the New Keynesian Phillips Curve says Peter Decaprio.

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