Tuesday, July 16, 2013

Relative versus absolute changes

Paul Krugman:
One implication of all this is what Gauti Eggerstsson and I (pdf) call the paradox of flexibility: making it easier for wages to fall, as Hazlitt demanded then and his modern acolytes demand now, doesn’t just redistribute income away from workers to the wealthy (funny how that happens); it actually worsens the economy as a whole.
I think this is a very good example of cases where relative advantage and absolute advantage are confused.  Any one firm can become more competitive by reducing costs.  But if everyone reduces costs then there is no advantage.  Things only get interesting if railroad workers and teachers are out of alignment on wages and you can change the wages of one relative to the others. 

But there isn't a clear reason that this has to be due to dropping wages.  The difference in wage increases over time can address this misalignment without causing massive hardship in a world where obligations are in nominal dollars. 

So I think Paul Krugman is right to be skeptical about deflation as a solution.  

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