My second complaint is that the microfoundations used by macroeconomists is so out of date. Behavioural economics just does not get a look in. A good and very important example comes from the reluctance of firms to cut nominal wages. There is overwhelming empirical evidence for this phenomenon (see for example here (HT Timothy Taylor) or the work of Jennifer Smith at Warwick). The behavioural reasons for this are explored in detail in this book by Truman Bewley, which Bryan Caplan discusses here. Both money illusion and the importance of workforce morale are now well accepted ideas in behavioural economics.
Read his whole post. The paragraph I quoted includes links that I did not transfer here. Pointer from Mark Thoma.
Some comments:
1. Just because something can be shown to exist at the micro level does not mean that it is important at the macro level. (This is in some ways equivalent to the point that just because you have what you think makes a neat microfoundation does not mean that it helps you with macro.)
2. In particular, if worker A at firm X suffers from money illusion, that does not imply that macroeconomic behavior will look like that worker and firm. There is plenty of exit and entry among firms as well as turnover in the labor force.
3. Indeed, I happen to agree with Robert Solow that what makes the DSGE framework so unpromising is that it typically insists on modeling a single consumer/worker/capitalist as representative of the entire economy. Obviously, you tend to forget about entry and exit and labor force turnover when you do that.
4. When one looks at macroeconomic data for evidence of money illusion, the results seem to me to be decidedly mixed.
A large output gap is extraordinarily effective at bringing inflation down from, say, 8% to 2%, but far less effective at bringing about a drop from 2% to -2%.
If that is true, then it looks like a point in favor of money illusion. To believe that it is true, you have to believe in the original Phillips Curve. That’s easy to do if your macroeconomic thinking was shaped by the 1960’s. Maybe it’s easy to do if your thinking was shaped by the last five years, although in that case you have only observed one region of the Phillips Curve. Looking at other time periods raises doubts.
b. If you put your chips on nominal wage stickiness to explain recessions, then I do not see how you avoid predicting a countercyclical share of labor income in GDP. That prediction is strongly violated by a number of downturns, including the current one.
c. Also, if you put your chips on nominal wage stickiness, youth unemployment should be relatively low in a recession. People who are just entering the job market are not comparing current job offers to previous salaries.
d. If there is money illusion, probably there are other illusions that allow employers to adjust at the margin without being able to reduce wages. As an employer, I can put more work on your desk. I can reduce bonus payouts. I can require a longer vesting period for stock options or pension benefits. I can reduce the match on your 401(K). I can increase what you have to contribute to health insurance. There seem to be enough margins available that sticky nominal wages should not matter.
5. On balance, I think that the case for wage stickiness as a crucial macroeconomic phenomenon is quite flimsy, notwithstanding the strong case for nominal wage stickiness that can be made by looking at micro behavior.
Good post. I think you missed a big one. How do you explain record corporate profits in a high-unemployment environment. Correct me if i’m wrong, but the entire reasoning behind lower real wages is the resulting increase in profits thus leads to hiring. Well, the profits already exist…where is the hiring? If you delink profitability and hiring then why do wages matter?
You can’t really separate sticky wages from sticky prices. That undermines your labor claims.
I’m pretty sure that nearly every employee would consider everything you mention in [4d] as a change in ‘compensation’. Personally, I felt extremely miffed when a previous employer stopped letting people work from home. [This could be a fallacy of projection; I *do* read a lot of econ blogs.]
The push to invest more in infrastructure has won over many local politicians, editorial writers and business groups, but it hasnt necessarily played as well among voters. Its a problem that transportation backers have seen on the national level, where they have struggled for years to turn increased transportation funding into a populist cause.