Milton Friedman vs. PSST
By Arnold Kling
The “natural rate of unemployment, in other words,” is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is imbedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the cost of gathering information about job vacancies and labor availabilities, the cost of mobility, and so on.
That is, of course, Milton Friedman’s famous Presidential Address to the American Economic Association in 1967, printed in the March 1968 American Economic Review. When I think in terms of Patterns of Sustainable Specialization and Trade, I find myself disputing this paragraph.
1. People are not employed by “the Walrasian system of general equilibrium equations.” They are employed by entrepreneurs.
2. Do not think of the goods, services, jobs, and skill sets in an economy as if they were given, waiting for a Walrasian auctioneer to call out price vectors. Instead, they must be discovered by entrepreneurs and workers.
3. In addition to the market imperfections that Friedman lists, there is the fact that in many situations there is a large fixed cost involved in hiring. It may take a long time to train a worker. It may take a long time before what a worker is hired to do actually contributes to the profits of the firm. It may take a long time to know whether a worker is actually contributing, and indeed there may always be uncertainty about that. In short, hiring a worker is a speculative investment, with returns that are not known in advance, may not be known for a long time, and in fact may never be known.
4. Patterns of sustainable specialization and trade are constantly in flux. Some patterns become unsustainable, and other patterns become sustainable (for a while). The internal combustion engine changes the technology for transportation, and all sorts of old patterns become uneconomical while new patterns emerge. The Internet changes the technology for distributing information, and all sorts of old patterns become uneconomical while new patterns emerge.
5. Why are there cycles in employment? I think this is the hardest question for PSST to answer, and the one where I have to do the most hand-waving. Here goes.
Much of the time, it seems that the new patterns that emerge “balance” the patterns that become obsolete, so that there is little or no net change in total employment. There are some natural forces that would tend to produce this balance between expanding sectors and contracting sectors. However–and this is a key point–there is nothing automatic about such balance. Patterns that become uneconomical might have employed a lot more people than the patterns that are becoming economical (farms needed a lot more laborers when they relied on horses rather than tractors. See my partial equilibrium story). That means that there can be periods of high unemployment.
When there are a lot of people eager for work, then there is some incentive for an entrepreneur to find a way to profitably employ those people. However, there are issues with reservation wages, tax and benefit wedges, and the fixed costs mentioned above in (3). There are real costs of solving the problems mentioned above in (2). That is, there are real adjustment costs.
6. A lot of macroeconomic theory is designed to either prove or deny that monetary expansion will increase employment. With PSST, I am willing to be agnostic on the issue. It is possible that a monetary expansion can reduce the real reservation wage of workers, which might speed the process of finding profitable ways to put the unemployed to work. However, it is possible that, all things considered, this effect is pretty small.