Price stickiness is not a mystery, and it is not psychology

I mean to write about something else today, so this will be short.

But I’d like to point out, as gently as possible, a mistake in the premise underlying this post by my friend Tyler Cowen. To be fair, it is not a mistake that is uniquely Cowen’s. Macroeconomists invoke price stickiness as an assumption in their models. They treat it as an axiom, a given, and therefore a mystery. Often they lazily fill in the darkness with catch-alls like “psychology” or “money illusion”, hypotheses about as useful as pomegranate seeds are as an explanation of seasons. Let’s not have the lazy conventions of macroeconomists stand in for actual thinking on a subject.

Downward price stickiness is a coordination problem, plain and simple. It has nothing whatsoever to do with illusions or cognitive biases or failing to spit after staring too intensely at a small child. Economic entities, both firms and humans, have liability structures rigid in nominal terms. A business has made forward-looking contracts — leases of facilities and equipment, price-stabilized arrangements to acquire raw materials, and yes, contracts with employers that cannot be altered without renegotiation. Businesses have also financed themselves in part with debt, and so taken on nominal obligations whose sustainability is based on forward-looking nominal prices of the goods and services they will sell. Individuals have signed rental agreements or taken mortgages. They have financed their education or their children’s, perhaps they have even taken on consumer debt. For both individuals and firms, these forward-looking nominal arrangements create a very large asymmetry between unexpected price adjustments upwards and downwards. For any economic unit, firm or individual, an unexpected price adjustment upwards in the commodities they sell to market is welcome news. The unit gets more money, its balance sheet expands in the happiest way of all, more assets matched by more equity. But for a leveraged economic unit — and we are nearly all leveraged economic units, if only because we are born short a future stream of housing and food — a downward nominal price shift may force deadweight adjustment costs, which may range from renegotiations of existing contracts to formal bankruptcy to discontinuous shifts in consumption of amenities like housing, education, and local community. (Since these amenities are marketed in sparse bundles, units are not able to continuously optimize consumption tradeoffs, and small changes in budget may lead to large changes of utility.)

Taking account of largely uncontroversial behavioral assumptions like habit formation and reference group anchoring reinforces this case, but is by no means necessary to it. Rational profit-maximizing firms exhibit downward price stickiness as do irrational left-wing humans, although how powerfully either exhibits it depends upon their solvency position and the flexibility of their capital structure, and upon a perceived probability distribution of revenue realizations under different prices. The naive microeconomic case why rational firms would not exhibit downward price stickiness — past arrangements are sunk costs, a rational firm will set prices to maximize future revenue in a forward-looking way — is flawed. It fails to take into account uncertainty surrounding the forward-looking revenue realizations. It ignores the fact that firms are usually quantity constrained in production over the short-term over which payments on their obligations come due. It ignores capital market imperfections, which yield correlations between access to external finance and downward price pressures that are unhelpful. For many firms, the costs and risks associated with an abrupt downward price adjustment are sufficiently large that the rational choice under a reduction of nominal demand is to gamble for the upside of their quantity-constrained revenue-realization distribution. So firms maintain prices higher than Marshallian scissors would advise, and try to sustain anticipated nominal revenues through marketing, product differentiation, and exercise of whatever market power they may have via relationships, network effects, etc. Of course, a strategy that is rational ex ante for firms with imperfectly flexible capital structures will only prove successful ex post for some fraction the firms that pursue it, which helps to explain why reductions of nominal demand tend to provoke consolidations in industries rather than mere rescalings of all the firms that contested the market in good times. When nominal demand collapses, prices fall less than naive economists would guess, some firms sustain quantities sold at the “too high” prices offered, others do not and start to experience large deadweight costs of insolvency. The winners can then buy the losers for a song and quickly dispell those costs.

Precisely the same dynamic accounts for adjustment to changes in labor demand on the extrinsic rather than on the intrinsic margin, for why we see unemployment rather than wage reductions in a recession. In the US (more, perhaps, than in other countries), workers’ lives tend to be leveraged against anticipated, uninsured, market incomes. Accepting a significant wage cut may imply selling a home into a bad market. (Here again, correlations between wage pressures and financial market developments are unhelpful.) It may imply pulling ones kids from schools, excision from civic and social communities, loss of difficult to replace health coverage, loss of ones automobile, and in extremis the humiliations and deadweight costs of personal bankruptcy. The operating and sometimes financial leverage of households sharply magnifies the loss associated with a wage cut, and the discontinuity of the bundles in which crucial amenities are offered magnifies that yet again. Even without invoking a Dunning-Krueger effect, these costs may be large enough that workers rationally prefer to gamble on staying employed at their anticipated wage rather than accept a very painful adjustment with certainty. Firms rationally accommodate this preference among workers, since grateful survivors make better employees on an ongoing basis than people bitterly distracted by their own insolvencies. By firing the workers on whom labor cost adjustment will fall, firms rationally externalize insolvency costs that they would be forced to partially bear if they retained those workers. Even among fired workers, it may be rational to hold out for wages high enough to restore solvency rather than quickly accept work at wages that render inevitable a disruptive adjustment. If they hold out and fail, they face a similar adjustment. But they might not fail. Holding out to search yields a valuable lottery ticket, for a while.

I said at the start that nominal price stickiness is a coordination problem, and it is. If nominal price reductions and nominal wage cuts were accompanied by simultaneous reductions in the nominal burden of each unit’s capital structures, the difficulty of downward price reduction would disappear. For a given household with no financial debt, if it were certain that existing housing, food, education, transportation, and health outflows would scale downward with a wage reduction, the household would rationally accept the wage reduction rather than risk unemployment. But even in a world where households don’t bear financial debts, even during a general depression, there is no assurance that prices will scale down with wage reductions. (On recent historical experience, there’s little evidence at all prices will scale down, that’s the equilibrium we’re in.) So it is rational for many households to resist wage reductions. The prevalence of nominal debt, which bears the stickiest price, renders resistance to downward price and wage adjustments more rational and more likely.

For both firms and individuals, resistance to downward price adjustment is often rational, even when at a macroeconomic level universal downward adjustment would be desirable (perhaps because the central bank and/or state have failed to accommodate the expected path of nominal incomes, perhaps because nominal exchange rates are rigidly misaligned). If we could wave a magic wand and have wages, prices, and especially debts all simultaneously scale downward, that might be awesome. But, unfortunately, we can’t.

If this sounds like some left-wing apologia of unreasonable wage demands (really? does it sound like that?), I’d note that the person who most famously made this argument was one Milton Friedman:

The argument for a flexible exchange rate is, strange to say, very nearly identical with the argument for daylight savings time. Isn’t it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock, even though all want to do so.


Note: I’ve written about this once before, see also an objection by the excellent RSJ.

Update: Nick Rowe generously discusses the ideas (and interacts with me in comments) in three new posts.

Update History:

  • 23-Jul-2015, 8:25 p.m. EEDT: Added bold update Re Nick Rowe’s posts.
 
 

28 Responses to “Price stickiness is not a mystery, and it is not psychology”

  1. Steve Roth writes:

    RSJ’s work is excellent, but:

    1. His final findings (excluding petroleum refineries with their “enormous downward price volatility”) show a statistically significant negative correlation between debt/equity of an industry and its downward price flexibility. His statement, that “the R^2 value [.08] is too low” to “read anything into it,” is a judgement call. We’re looking at a .28 correlation between the two variables.

    2. Far more significant, I think, his analysis ignores household debt dynamics. Looking just at the “real” economy — debt owed by households plus nonfinancial firms — outstanding debt is divided roughly 50/50 between the two. And that is putting aside the implicit leverage that we are all born with, which you mention.

    In my ongoing effort two condense SRW’s lengthy brilliance into tweets:

    Nominal debt explains downward price stickiness. Full stop.

  2. Morgan Warstler writes:

    Steve,

    Each instance that you point out causes price stickiness, is an example of a policy we should DISCOURAGE, and if you say “that’s human preference” you fall into the psychology debate.

    “leases of facilities and equipment, price-stabilized arrangements to acquire raw materials, and yes, contracts with employers”

    “Businesses have also financed themselves in part with debt, and so taken on nominal obligations whose sustainability is based on forward-looking nominal prices of the goods and services they will sell. Individuals have signed rental agreements or taken mortgages. They have financed their education or their children’s, perhaps they have even taken on consumer debt. For both individuals and firms, these forward-looking nominal arrangements create a very large asymmetry between unexpected price adjustments upwards and downwards.”

    Real time technology, digital tech, not only cause prices to fall, it makes it easier to operate without long term contracts FOR ANYTHING.

    LONG TERM CONTRACTS have many negative effects. What’s the value of a Taxi cab medallion?

    The point here is that long term contracts are ANTI-TECH growth, they cause NIMBY, they cause rent seeking, etc.

    In a world where firms and people live in real time TOTAL clearing of all markets, the loss of predictable pricing in future, is offset by faster falling prices bc of digital deflation. But also bc people themselves become more nimble, they ARE CHANGED by the world the live in, WE ALL BECOME UBER DRIVERS, working according to schedule, loading up and relaxing, week by week, day by day, hour by hour.

    Stop pretending there wont be overtime / surge pricing in a world where every asset in making real time end agency discussions about their activities. And please stop pretending that this doesn’t lead to better personal outcomes.

  3. Lord writes:

    There is also a cost to uncertainty whether in terms of calculation, return, or stress. Often we trade one uncertainty for another, such as more certainty in wages for less in employment, more certainty in housing occupancy for less in housing price, more certainty in control for less in value, or more in standard of living for less in wealth, and while nominal liabilities play a large part in these, we wouldn’t necessarily find the alternative better, being creatures of habit and routine. We always want to see ourselves on the winning side, and would rather the losses be concentrated on the unfortunate, often blaming them so we can credit ourselves for our success. We want to see a morality tale to feel better about ourselves.

  4. Benoit Essiambre writes:

    The way I like to describe it, is that if a 5% wage cut would save their job, workers would take it. They prefer losing 5% wages than losing their job. But for this pay cut to save the business when prices are dropping, all the workers in the business must take the wage cut and this is probably still not enough. All the worker’s in the business’ suppliers must also cut at the same time, as well as the suppliers’ suppliers. If you are not doing final consumer products, your customer’s employees also have to cut. If only a subgroup of the supply chain takes a cut, the cost saving burden is too concentrated on them and they have to cut unrealisticly deep to save their part of the industry.

    Who wants to be the first to cut their wages if it probably isn’t even going to save their job?

    Unless employees can coordinate their pay cut not only within their own employer but also coordinate across other companies in the supply chain to convince them to do the same, it probably won’t achieve much. What employee organisation is going to reach out to others to bargain down their industry’s wages?

    For individual workers then, the rational behaviour, the Nash equilibrium, is to extract as much money as they can from their current employer before they are laid off even if this behavior kills the business.

    The only way I can think of to do sufficiently coordinated wage cuts is through monetary policy.

  5. Brett writes:

    No, that sounds quite reasonable. Although I do have one question about the Employee side of this – wouldn’t an additional strategy be to take a lower income at the one job while seeking additional income to make it up? It has existed in some fashion in the US over time, like the old practice of lending out a spare room to a boarder or doing side-jobs. At least theoretically the “sharing economy” stuff could fill that role, if you could somehow excise that part of it from the part that’s making money off of regulatory arbitrage.

  6. […] at 2:46 on July 20, 2015 by Mark Thoma Price stickiness is not a mystery… – interfluidity Ireland and Greece – mainly macro The Euroskeptic Vindication – Paul Krugman […]

  7. jonny bakho writes:

    Awesome!
    Simple, Clear Explanation.
    Regarding the preferred rate of inflation: Is 2% too low to accommodate a large economic shock? With higher inflation rate,could more wages and prices could reset in a neutral or upward direction rather than encounter the stickiness of downward pressure?

    Is price stickiness a good argument for inflation target above 2%?

  8. Oliver writes:

    Price stickiness, coordination problem. Apart from the discussion with RSJ, which I find interesting, I’d like to make a point on semantics. An anti Morgan Warstler point.

    It seems to me that both phrases take for granted that flexible prices and the supposed coordination needed to achieve them represent a boon to an economy. My suspicion is that it is once again the economist’s model that is telling us how we are supposed to behave and not the other way around.

    Why isn’t price stability the coordination problem at hand? Why isn’t price instability a problem? My suspicion is that it rests on a fallacy of composition / a failure to distinguish between absolute and relative prices.

  9. Nick Rowe writes:
  10. JP Koning writes:

    John Cochrane had an interesting post on price stickiness in relation to Greece:

    http://johnhcochrane.blogspot.ca/2015/07/calomiris-and-sticky-prices.html

    “If you think prices and wages are “overvalued” in Greece, and a “devaluation” is all it takes for Thessaloniki to start exporting Porsches to Stuttgart, then an overnight, coordinated, price and wage change is a very nice alternative policy that we might start taking more seriously.”

  11. Paine writes:

    Comp stat is the wrong paradigm here btw
    See nick Rowe

    This can be a purely dynamic complication

    Spontaneous Long
    Runs are too long and a little imposed co ordination mechanism can improve welfare paths

    For a mechanism see A Lerner Colander MAP
    Which can be easily extended to include an entire inter temporal obligations grid

  12. Paine writes:

    Keep up the over views randy
    Thy’re always provocative and insightful
    We need more social philosophy and less formal manipulations

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  15. Redwood Rhiadra writes:

    In a world where firms and people live in real time TOTAL clearing of all markets, … WE ALL BECOME UBER DRIVERS, working according to schedule, loading up and relaxing, week by week, day by day, hour by hour. … And please stop pretending that this doesn’t lead to better personal outcomes.

    You think a world in which we are all living hand to mouth, making six bucks an hour after expenses, is “better personal outcomes”? Because that’s what Uber drivers make. (Uber claims their drivers make more than that, of course, but deliberately ignores the expenses that they don’t compensate their drivers for – in particular gas and additional wear-and-tear on their car. Most drivers remember the gas, but forget about the wear and tear – which is a significant expense. And that six bucks an hour doesn’t even count the commercial insurance that drivers are required by law to pay for – and which most don’t.)

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  18. Unanimous writes:

    Should banks lend in exchange for a percentage of future income rather than a fixed repayment schedule? I presume they don’t in the case of individuals because it would leave them vulnerable to people overstating their income prior to borrowing, and understating it after. Possibly legal access to enough information could help to the point of making this practical, as it does when large companies finance themselves. But, even though companies can finance themselves for a percentage of future income (stocks) or a fixed repayment schedule, they choose a combination of both. So, banks changing their lending contracts likely won’t fix sticky prices, but perhaps it would help to some extent.

  19. Tom Warner writes:

    The coordination problem you’re describing is far, far more important than money illusion, but you go too far with the absolutist “nothing whatsoever to do with ..” language and claiming Tyler made a mistake. My read of his post was that he was listing econ theses that exist and opining about whether they implied flattering or unflattering attitudes towards the poor. That is he wasn’t saying which are true or not. The thesis that you’re rejecting, that people are psychologically more likely to accept a real cut in pay when it’s delivered to them without any nominal cut, definitely has supporters. I think it’s true albeit not nearly as important as the coordination problem.

  20. Scott Sumner writes:

    There is overwhelming evidence that money illusion and menu costs of price changes exist. But it is still hard to explain the existing degree of nominal stickiness without something else–probably coordination failure. The interaction of all three is what does the job.

    I’m skeptical of the notion that bringing in debt stickiness adds much to the unemployment puzzle, although obviously it’s really important for fianncial stability.

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  25. Gary writes:

    I’m fairly sure that Kahneman Loss Aversion (https://en.wikipedia.org/wiki/Loss_aversion) drives a significant amount of wage stickiness.

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