Originally appeared on the New Economic Perspectives Blog, Posted on November 26, 2013
Whether it be inflexible prices, wage rates that are too high and sticky, or interest rates that cannot become negative, they all have the common property of disrupting the smooth workings of the price mechanism, thereby causing recessions, preventing economic recovery, and creating unemployment. But what if there is no price mechanism that allocated scarce resources among competing ends? Then the ‘price problem’ would disappear and the causes of recessions and persistent unemployment would be quite different. Ignoring the issue whether scarce resources as defined in mainstream economics exist or not, I am going to interrogate the supposed existence of the price mechanism that lies at the theoretical core of all mainstream explanations of recessions and unemployment.
Clearly there can be momentary glitches in the working of the price mechanism; but I am not concerned with these correctable imperfections. Instead the issue is: when does the waywardness of prices, wage rates, and interest rates cease to be glitches in price mechanism and actually eliminate it altogether. Starting with prices, since the 1930s, it has been known that price stability dominate the industrial, wholesale, and retail areas of the American economy. The 40-50 studies in the past fifteen years by Alan Binder and others which cover developed countries around the world further support the existence of price stability. One basis for its existence is the administered cost-plus pricing mechanism (used by virtually all business enterprises to set the prices) which neutralizes the impact of changing sales on costs hence prices. So price stability and its underlying pricing mechanism are systemic features of developed economies such as the American economy resulting in a disjuncture between price and quantity.
Turning to wage rate stability, evidence of its existence goes to the 19th century. Moreover, from the 1980s, wage rate stickiness has been a major concern of mainstream economists; and since the early 1990s, numerous empirical studies have shown its widespread existence, thus, as in the case of price stability, making it an irrefutable economic fact. Other studies show that wage rates are of minor importance when enterprises make hiring decisions. On the other hand, studies in how wage rates are actually determined are few; but what can be gleaned from the human resource literature is that the marginal product of labor has no role in the determination process whatsoever. Altogether, the implication is that there is no connection between the wage rate and the demand for labor.
Finally there is the question of the interest rate and its connection to investment decisions in plant and equipment and research and development. Again, the empirical evidence on the investment decision process shows that enterprises take a great many variables into account, including the interest rate. But in the end, the significance of the interest rate in the final decision is almost reduced to nothing. This is in part due to the fact that enterprises finance their investment from retained earnings (thus avoiding the financial markets) and that going enterprises do not view financial assets as substitutes for ‘real investment’.
A working price mechanism requires price, wage rate, and interest flexibility and most importantly a direct and inverse law-like connection to outputs/sales, employment, and real investment. However, with price and wage rate stability, they are not connected to sales and employment; and interest rates (whether nominal or not) have little bearing on investment decisions. Mainstream economists have over the past 70 years come up with ad hoc explanations/theories why any one of these outcome may occur; but they have never come up with an explanation why all three occur at the same time and have been persistently occurring for at least the past 80 years (if not for the past two centuries). So instead of continually blaming some kind of temporary imperfections in the working of the price mechanism as the cause of a malfunctioning economy, perhaps it is time to drop the myth of the price mechanism and dismiss the fictitious ‘price problem’ and seriously consider that problems of economic recessions and unemployment are only heterodox/Post Keynesian effective demand problems.