PSST vs. the First Law of Wing-Walking
By Bryan Caplan
For the last couple of years, Arnold has been energetically promoting a macroeconomic alternative to the standard AS-AD model. He calls it PSST – “patterns of sustainable specialization and trade”:
I focus on patterns of trade to try to avoid being shoehorned
into defending a notion that the economy faces a skills mismatch. Yes,
you are more likely to find a job these days if you are a nurse than if
you are a construction worker, but that is not the whole story. The
whole story is the need for the economy to grope its way toward new
configurations that exploit comparative advantage. (more)
Mainstream macro focuses on nominal wage rigidity, but Arnold finds this approach deeply dissatisfying:
This sticky wage hypothesis is at the center of the whole
mechanism. But it raises all sorts of questions. Why are wages sticky?
For how long do they remain sticky? How is it that the same workers who
refuse to take lower nominal wages at a fixed level of prices are happy
to see the same nominal wages at higher prices?…
…[A]ggregate demand is not some deus ex machina that controls output regardless of anything else. The theory of aggregate demand and supply depends on the supply mechanism, which is quite tenuous.
My main problem with PSST: Despite Arnold’s incredulity, he still needs nominal wage rigidity to make his story work.
What happens if the Internet suddenly makes traditional industries uncompetitive? According to Arnold, firms fail and unemployment jumps… until entrepreneurs figure out some new PSSTs. And unfortunately, the last step can take years. But if wages were as responsive to shocks as stock prices, firms and workers would have a far better alternative:
1. Cut wages in existing industries drastically enough to keep firms afloat and workers fully employed.
2. If and when entrepreneurs find new PSSTs, firms and/or workers move on to the newly discovered greener pastures. If the PSSTs take a long time to discover, firms and workers say “Business as usual… for lower wages.”
The simplest way to explain my critique: In Arnold’s story, firms and workers violate the First Law of Wing Walking: Never let hold of what you’ve got until you’ve got hold of something else. If you can find a new PSST, great. But until you do, the smart move is to cut wages so you can stick with what you know.
To make his story work, Arnold needs the very assumption he’s trying to escape: nominal wage rigidity. With nominal wage rigidity, innovation affects employment and output, not just wages – and old industries contract before entrepreneurs discover greener pastures. But if Arnold makes this move, PSST becomes a fruitful add-on for AS-AD, not a radical new approach. Either he relies on the same “tenuous” assumption as mainstream macroeconomists, or he admits that nominal wage rigidity isn’t so puzzling after all – especially in an economy with 99 weeks of unemployment benefits.
Arnold’s writings on PSST are voluminous. Maybe I’ve overlooked a post where he addresses this problem. But the First Law of Wing-Walking objection seems awfully solid to me. Arnold?
Update: The second-to-last link wasn’t what I originally intended. It’s now fixed.