Reinventing the wheel

In both the UK and US, wage inflation has stayed low despite apparently low unemployment – to the puzzlement of believers in the Philips curve. Felix Martin in the FT says there's a reason for this. The “dirty secret of economics,” he says, is “the central importance of power.” Inflation, he says, is “society’s default method of reconciling, at least for a while, irreconcilable demands.” And because workers don't have the power to make big demands, we haven’t got serious inflation.

What's depressing about this isn’t just that it’s right, but that it needs saying at all.

Economists of my age were raised to see that inflation was a matter of power. The very idea of the Nairu arose from a paper (pdf) written by Bob Rowthorn in 1977 (He didn’t actually coin the phrase “Nairu”, but the idea is there). “Conflict over the distribution of income affects the general level of prices in advanced capitalist economies” he wrote. “Power plays a central role in the determination of wages and prices.”

His insight was taken up. In a textbook that grew from some of the few lectures I actually attended in the mid-80s, Wendy Carlin and David Soskice wrote:

In an economy in which both workers and firms have market power…each group will attempt to get hold of particular share of the economy’s product…Suppose that the competing claims are inconsistent ie that the claims of workers to real wages and firms to real profits sum to more than is available in output per head. The each side will attempt to secure its claim by using its market power – workers will secure higher money wages and firms will put their prices up. The result is rising inflation. (Macroeconomics and the Wage Bargain, p6)

In this view, the Nairu is the unemployment rate necessary to secure peace in “the battle of the mark-ups*”.

Anyone who knows anything about the genealogy of the Nairu would therefore know that insofar as it is a useful idea at all, power is indeed central to it.

And yet Felix has a point; this fact has been glossed over by later fancier theories. This is yet another example of something I’ve said before – that technocrats have a blindspot about power.

But there’s another point here. This shows why the history of economic thought matters. It’s because the creators of economic thought sometimes had ideas which subsequent thinkers ignored. Intellectual progress is not guaranteed.

The tendency of some new Keynesians to ignore the role of power in determining inflation is just one example of this.

Another example is the IS-LM model. Among its faults, this contrived to efface what was perhaps Keynes most important point – that our knowledge of the future “is usually very slight and often negligible.”

A recent paper (pdf) by Oscar Valdes Viera gives another example. Neoclassical economists who tried to “construct economic laws that would validate the existing capitalist order as universal, natural, and harmonious” led us away from Adam Smith’s insights that people are social beings motivated by more than mere egotistic self-interest. If economists had more accurately followed Smith rather than be misled by ideological motivations or mathematical elegance, they wouldn’t have needed to rediscover the importance of institutions and complex (pdf) motivations (pdf).

I don’t write all this to decry mathematical economics: I think it has a (limited) role. Instead, I’m appealing for economists to be a little more aware of the history of their discipline. Doing so can save us from having to reinvent the wheel.

* I'm not sure who coined this phrase: it might have been Richard Layard and Steve Nickell.

Comments

[James Webber]

That quote from Bob Rowthorn dates back to the days when he was a fervent Marxist. I wonder if he still thinks that!

[pml20]

But, but, but...bargaining power is central to search and matching models of the labor market: bargaining over the match surplus is what closes the model. The Beveridge curve is essentially a marked-up labor demand curve (when mapped into unemployment/wage space instead of unemployment/vacancies) , and the Nash-bargaining based wage determination curve a marked-up labor supply curve, with the markups depending on how the pie is divided between worker and firm (and markups are endogenous, since they depend on labor market tightness, thus on the labor variable itself). I suspect many labor search economists would not agree with you brushing aside the past thirty years of their discipline.

[Blissex]

«The “dirty secret of economics,” he says, is “the central importance of power.”»

There is an excellent quote from a long time ago by Joan Robinson about the absence of power, and indeed the brazen assumption that there is no market power for anybody, in neoclassical Economics. Unfortunately I can no longer find it.

«Inflation, he says, is “society’s default method of reconciling, at least for a while, irreconcilable demands.”»

That is what S Johnson also wrote in his article in "The Atlantic" some years ago:

http://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/307364/
«Yet the economic solution is seldom very hard to work out. No, the real concern of the fund’s senior staff, and the biggest obstacle to recovery, is almost invariably the politics of countries in crisis.
Typically, these countries are in a desperate economic situation for one simple reason — the powerful elites within them overreached in good times and took too many risks. [ ... ] They reckon — correctly, in most cases — that their political connections will allow them to push onto the government any substantial problems that arise. [ ... ] Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk — at least until the riots grow too large.»

[Blissex]

«led us away from Adam Smith’s insights that people are social beings motivated by more than mere egotistic self-interest. [ ... ] wouldn’t have needed to rediscover the importance of institutions and complex motivations»

As to that I have always been astonished that the "rational economic actor" assumption is that they would maximize their personal welfare, because real people have children and have profound instincts as to maximizing their progeny too. But "rationbal economic actors" are supposed to be not just rational, but immortal too, and even "generational" models that some "brave" Economists have attempted to introduce don't account for the links between generations that genetics in reality creates.

[Blissex]

«Neoclassical economists who tried to “construct economic laws that would validate the existing capitalist order as universal, natural, and harmonious”»

BTW that is exactly the opposite of how Economics works in practice: a theory in Economics must be validated by being able to prove the eternal and obvious truthiness of JB Clark's "three fables" (aka "capitalist order as universal, natural, and harmonious"), not viceversa.