Basil Halperin on sticky wage models

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I frequently argue that price inflation doesn’t matter; we should target NGDP. I’ve also argued that if we must target inflation, it is wage inflation that matters. Because nominal hourly wages are sticky, a sudden drop in NGDP will tend to result in fewer hours worked, not lower nominal wages. In 1995, I published a paper in the obscure Journal of Business and Economics advocating using monetary policy to target an index of nominal wages. And I wasn’t the first:

Thomas Attwood (1818) and John Rooke (1819; 1824) appear to have been the first to suggest that the central bank attempt to maintain a stable aggregate wage level. They argued that since nominal wages tend to be sticky in the short run, deflation can result in substantial periods of unemployment. The best way to avoid long and painful adjustments in the aggregate nominal wage rate is to establish a monetary policy that precludes the need for such adjustments. In this view, the (presumably more flexible) price level would act as a shock absorber to accommodate required changes in the aggregate real wage rate. The nominal wages paid by individual firms would still be allowed to fluctuate according to local conditions.More recently, Hawtrey (1932), Glasner (1989), and Selgin (1990) have discussed several other possible advantages of wage index targeting. Hawtrey and Selgin evaluate a broad range of policy targets ranging from a policy of stabilizing total income (GDP targeting), to a “productivity norm” (stabilizing income per capita), to a policy of stabilizing factor prices. Glasner proposes a “labor standard” that would explicitly target the aggregate nominal wage rate.

AFAIK, Attwood and Rooke were the first people to advocate any sort of monetary regime that targeted a macroeconomic aggregate, and this was done roughly a century before Irving Fisher’s famous “Compensated Dollar Plan”. Although I did not know it at the time, Earl Thompson (1982) revived modern interest in wage targeting with a brilliant working paper that was never published. The best two-page economics paper ever written?

So why has wage targeting never caught on with the broader economics profession? David Beckworth directed me to a 2021 paper by Basil Halperin, which shows that much of the economics profession is operating under a misconception, the idea that the sticky wage theory of recessions has been discredited by a mix of theoretical and empirical studies. In fact, the most well-known arguments against the sticky wage model were refuted decades ago, but few people paid attention. Here is Halperin’s summary of the paper:

TLDR:

1. Intuitively, wage stickiness seems more important than price stickiness
2. The first microfounded ‘new Keynesian’ models did use wage stickiness, not price stickiness; but in the mid-1980s there was a transition to sticky price models, which dominate today
3. But that transition was based on a set of arguments which today are regarded as wrong!

1. The policy implication: Taking wage stickiness seriously implies we should ensure stable nominal wage growth, not stable price inflation

Halperin suggests that the switch to sticky wage models was based on two factors:

Two critiques of sticky wage models led to the adoption of sticky price models:

1. The empirical critique that aggregate real wages were basically acyclical, and
2. The theoretical “Barro(-Hall) critique”

At the time, it was wrongly believed that sticky wage models implied countercyclical real wages. During a recession you might expect real wages to rise as prices fell at a time when nominal wages were stable, and this would lead firms to lay off their now more expensive workers. In that case, you would expect to see high real wages during recessions, and vice versa. Halperin points out that this assumption was incorrect for no less than three reasons, with the first one being my favorite:

1. Identification: the source of the shock matters!Recessions caused by tight monetary policy should cause real wages to increase and be too high, leading to involuntary unemployment. Recessions caused by real supply-side shocks should cause real wages to fall and nonemployment to rise.If the economy experiences a mix of both, then on average the correlation of real wages and recessions could be anything.Maybe in 1973 there’s an oil shock, which is a real supply-side shock: real wages fall and nonemployment rises (as in the data). Maybe in 2008 monetary policy is too tight: real wages spike and unemployment rises (as in the data). Averaging over the two, the relationship between real wages and unemployment is maybe approximately zero.This view was around as early as Sumner and Silver (1989) JPE, where they take a proto-“sign restrictions” approach with US data and find procyclical real wages during the real shocks of the 1970s and countercyclical real wages during other recessions.But: while Sumner-Silver was published in the JPE and racked up some citations, it seems clear that, for too long a time, this view did not penetrate enough skulls. Macroeconomists, I think it’s fair to say, were too careless for too long regarding the challenge of identification.My sense is that this view is taken seriously now: e.g. in my second-year grad macro course, this was one of the main explanations given. At the risk of overclaiming, I would say that for anyone who has been trained post-credibility revolution, this view is simply obviously correct.

Shorter version: Never reason from a price level change.

Why did it take so long for the Sumner-Silver paper to “penetrate skulls”? I think Halperin is being polite. While the JPE was the top economics journal back in 1989, the authors of that article were teaching at an obscure college. Pedigree matters.

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