August 24, 2015

It’s the wage-price-productivity mechanism, stupid!

Comment on Mark Thoma on ‘The Fed Looks Set to Make a Dangerous Mistake’


The current situation is a clear refutation of both employment and quantity theory. It is an eerie déjà-vu: when things get tough it becomes self-evident that economists have no idea how the economy works.

There is not much use discussing defunct theories any further. The most elementary version of the correct Employment Law is summarized on Wikimedia AXEC62: #1
This equation tells us three things:
(i) An increase in the expenditure ratio ρE leads to higher employment. A ratio ρE>1 means deficit spending. This option has been exhausted.
(ii) Increasing investment expenditures exert a positive influence on employment. This option, too, has been exhausted.
(iii) An increase in the factor cost ratio ρF≡W/PR leads to higher employment.

The factor cost ratio formally represents the price mechanism which, however, works quite differently from what standard economics assumes. As a matter of fact, overall employment increases if the average wage rate W increases relative to average price P and productivity R. This is a systemic law and not a behavioral assumption. With price inflation greater than wage inflation unemployment increases. Translated into a political slogan: price inflation is a bad thing, wage inflation is a good thing.

The core of the employment problem is that the price mechanism does not work as the textbook cliche says. It is contrary to habitual economic intuition (which rests on the Fallacy of Composition), yet there is no way around it: UPward wage rate stickiness produces unemployment and deflation. It is the wage rate and not the interest rate that is crucial in the current situation. Courtesy of the U.S., we now participate in the biggest real-life test in economic history and the most expensive refutation of silly economic theories.

Egmont Kakarot-Handtke

#1 Major Defects of the Market Economy

For details of the big picture see cross-references Employment/Phillips Curve.