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Study Guide for Failure of the New Economics, Chapter 2.

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Failure of the New Economics is Hazlitt’s expose of Keynes’s book General Theory. Both books are not the easiest. While a Study Guide has been written for Hazlitt’s work, it’s basically just a series of questions.

Which is why Smiling Dave is going to set up his version of a study guide, in the form of a dialogue between Keynes and Hazlitt. So K will be Keynes, H will be Hazlitt, SD will be Smiling Dave, and DA will be the straight man, Devil’s Advocate.

Note to my loyal readers. At first I thought of setting up some boring study guide, summarizing what Hazlitt said. But that’s no fun. So this study guide will not restate the simple stuff Keynes or Hazlitt say, but will focus instead on those places where one or both of them is obscure.

Chapter One of both books is easy to understand, so we begin with Chapter Two.

DA: Well, I have no clue what’s going on in this chapter. Big words, long sentences, intricate arguments.

SD: Do you know what supply and demand curves are?

DA: Yeppers.

SD: Then you’re good to go. This little study guide will see you through. And for those of you out there who don’t know what they are, you have some reading up to do before you can understand the discussion here.

K: We’re going to talk about wages. Let me summarize the view of the classical economists. Here is their take:

Like everything else, the wages, meaning the price paid for labor, is determined by supply and demand. You have the employers, and they are the ones demanding [=buying] labor. You have a demand curve, which shows how many workers they will hire at any given salary. Since I’m British, I’m going to call it a demand schedule, pronounced SHEDJOOL. You also have a supply curve, which shows the amount of workers who will agree to be hired at any given salary.

DA: So far, so good. What determines the actual points on those schedule? In other words, how do the employers decide if they will hire someone at a given wage, and how does a worker decide if he will accept the salary?

K: According to classical economics, the employer decides based on one simple thing. If paying X dollars a week, say, will bring in a profit, he will hire the guy. If it won’t, he won’t. And the worker decides based on one simple thing, too. If he feels he’s better off staying home than working for that pittance, he won’t take the job. If he feels he’s better off taking the job, because it pays well enough, he’ll do that.

SD: I don’t think Hazlitt understood you to be saying that. Sounds like you are using Mises’s insight that leisure is an economic good.

K: I know, right? Thank you for making my position clear and tenable.

DA: OK, sounds like a reasonable summary of the classic position. Why do you think that’s wrong, Maynard?

K: Because it’s all true for the individual worker, but it’s totally false when we talk about the workers in the aggregate.

DA: Huh?

K: That whole supply demand thing makes it sound like anyone can get a job if he is willing to accept a low enough salary.

DA: Isn’t that true?

K: It’s true if one guy does it, yes. But when you have masses of laborers knocking on the door, they won’t get the job, at least not for any length of time, no matter how cheaply they are willing to work. If we have a mass unemployment problem, it cannot be solved by everyone agreeing to work for less.

DA: Why not?

K: Ah, my son, because there are two ways to define a salary. One way is the dollar amount you get paid, the nominal wage, what I like to call money-wages.

DA: With you so far.

K: The other way is how much purchasing power you get with your salary, what I like to call your real wage.

DA: Isn’t that the same thing? I mean, a salary of ten dollars an hour will give me ten dollars of purchasing power an hour.

K: It is the same thing at the instant you are hired. But as time goes on, things may change. The prices of consumer goods, which I like to call wage-goods, may change after a while. And you are still getting the same dollar amount of salary. So although your nominal wage is the same, ten bucks, your purchasing power, your real wage, will change.

DA: Why is all this nominal wage and real wage stuff relevant to our discussion?

K: Because why is the boss the boss and the worker the worker? Because the boss is smart and the worker is dumb. The boss doesn’t care about the nominal wage; he cares about the real wage, about how much purchasing power he is giving the worker. And no matter what that comes to in dollars, he won’t give the worker more purchasing power than will net the boss a profit, measured in purchasing power, not in dollars. So when the boss is thinking salary, he’s thinking real wages, purchasing power.

DA: And the worker?

K: He’s a dumbkopf. He thinks in dollars. As long as he gets his ten bucks an hour, even if the purchasing power of that ten bucks is slipping away due to inflation, or rising due to deflation, he will think in terms of ten dollars an hour. He won’t ask for a raise if the purchasing power of those ten bucks goes down, and he will refuse to take a pay cut [measured in dollars] if the purchasing power of those ten bucks goes up.

DA: So basically the boss and the worker are talking past each other. They both say ten bucks, but they mean two different things. The boss means ten units of purchasing power, which may be more or less than ten dollars as time goes by, and the worker means ten paper dollars, no matter what their purchasing power.

K: Exactly. And that’s why those unemployed masses cannot get hired merely by taking a pay cut.

DA: Wait, what? How does that follow?

K: Simple. Say everyone takes the cut. What does that mean? Lower costs of production, which in turn will mean lower prices of consumer goods, which in turn means higher purchasing power for the workers. So that by taking a dollar pay cut, they paradoxically wind up increasing their real wages. Which means they will all be fired, because too high real wages was their problem in the first place, and here it is, right back again.

DA: So you’re saying they can never get paid less, in real wages, even if they wanted to.

K: Exactly. One person can take a pay cut, because what he does is a drop in the bucket and won’t influence the economy as a whole. But when we have massive unemployment, with huge numbers of people taking a pay cut in nominal terms, the problem I described kicks in.

Now you know why wages are sticky, and why these poor workers need a Keynesian™ solution to their problems.

DA: So let me see if I understand this correctly. You are saying, Maynard, that the claim of the classical economists is that the way to solve unemployment is to reduce wages.

K: Yes.

DA: You are claiming that if there is mass unemployment, and the masses agree to lower their wages from ten dollars an hour to nine dollars an hour, say, the problem would not be solved.

And your reason is that since prices of consumer goods are determined by costs of production, and the main cost of production is wages, then lowering wages from ten dollars to nine dollars would lower costs of production, which would lower prices of consumer goods, which means an increase in the purchasing power of the workers.

So paradoxically, by lowering their nominal wage, they wind up increasing their real wage. Thus, workers can’t take a pay cut [in real terms] even if they wanted to.

K: You got it.

DA: Are you sure Keynes said that, Dave?

K: I sure did, and let me quote myself:

Now the assumption that the general level of real wages depends on the money-wage bargains between the employers and the workers is not obviously true. Indeed it is strange that so little attempt should have been made to prove or to refute it. For it is far from being consistent with the general tenor of the classical theory, which has taught us to believe that prices are governed by marginal prime cost in terms of money and that money-wages largely govern marginal prime cost. Thus if money-wages change, one would have expected the classical school to argue that prices would change in almost the same proportion, leaving the real wage and the level of unemployment practically the same as before, any small gain or loss to labour being at the expense or profit of other elements of marginal cost which have been left unaltered.

DA: So do you have a refutation, Henry?

H: Later on in this chapter Keynes says he will talk about this more in Chapter 19, so I will reply there.

DA: Cop out!

SD: Allow me. The whole thing is a huge mistake. The market price for my product is $12. If I pay the workers ten dollars, I will lose money. That’s why I’m not hiring them. If they all take a pay cut to nine dollars, I can sell my product for $12 and stay in business. So why do you think that once I hire them I will lower the price of my product from twelve bucks, if that’s what I need to charge to stay in business?

DA: Well, if you put it that way, it does sound like Keynes has made some mistake here. Maybe he elaborates in Chapter 19.

H: See you there.


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