Thursday, February 9, 2012

The Paradox of Toil

Gauti Eggertsson at the New York Fed has a provocative new paper entitled "The Paradox of Toil," which argues, in parallel with Keynes's "Paradox of Thrift," that while a single individual can work a little more, if everyone looks for more work, the result won't necessarily be an increase in total employment.

Eggertsson's "paradox of toil" is an example of the fallacy of composition: if you generalize from what one individual does to what will happen in the aggregate if everybody does it, you won't necessarily get the right result.  One person can increase his saving by reducing his spending because this has no effect on his income.  But if everyone reduces their spending, everyone's income will fall, which makes saving more difficult.

Here's the logic behind Eggertsson's paradox of toil: "Everybody trying to work more . . . puts downward pressure on current and future wages . . . Firms cut their prices today and in the future and stand ready to supply whatever is demanded at those prices. . .  This leads to expectations of deflation, which increase the real interest rate . . . and the central bank can’t offset this by cutting the nominal rate because the rate cannot be below zero.  Higher real interest rates lead to lower demand because people prefer to spend in the future rather than today, since prices are expected to be lower in the future . . . Because of lower spending today, firms demand less labor.  Thus, more labor supply leads to lower wages, more deflation, and higher real rates, which leads to less spending, which leads to less hiring of workers.  Therein lays the paradox."

The fallacy of composition is an under-appreciated concept with broad application: 
  • Although one country can devalue its currency to improve its trade balance, every country can't do this
  • One person can increase her liquidity by selling her assets for cash, but everyone can't do this because the community's assets must be held by someone
  • Although one firm can increase its sales revenue by reducing its wage costs, if every firm attempts this, total wage income and total sales to workers will decline
Keynes, himself, made all these points, and while he's usually characterized as a partial equilibrium theorist in the Marshallian mode, these fallacies of composition all arise from failing to take account of general equilibrium considerations.