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Article Excerpt
Expressionism was rooted in the new experience of metropolitan life that transformed Europe between 1860 and 1930. It [is] a visionary expression of what it feels like to be adrift, exhilarated, terrified in a fast-paced, incomprehensible world.
Jackie Wullschlager, 'The original sensationalists,' Financial Times
The modern economy began to supplant the traditional economy in several nations in the latter half of the 19th century--and many more in the latter half of the 20th. A system where self-employment and self-finance was typical gave way to a system of companies having various business freedoms and enabling institutions. This was the "great transformation" on which historians and sociologists as well as business commentators were to write volumes. The modern economy, where fully adopted, has indeed been transformative for nations (1)--but much less so for economics.
If there is a thread running through my publications, particularly the work discussed here, it is that I have tried in that work to bear in mind the distinctive nature of the modern economy. (2) What is its nature?
I. MODERN ECONOMIES AND MODERN ECONOMICS
Many of the early contrasts between the two kinds of economy were drawn by sociologists. The traditional economy was said to rest on a community of persons known to one other and engaged in mutual support--on Gemeinschaft--while the modern economy was said to be based on business, where people competed with one another--on Gesellschaft (Tonnies, 1887). (3) Social rank was said to count in a traditional economy but not in a modern economy (Weber, 1921/22). True or not, these sociological contrasts did not obviously call for a fundamental revision of standard economic models.
Economic contrasts between the two systems were drawn by economic historians. A traditional economy is one of routine. In the paradigm case, rural folk periodically exchange their produce for goods of the town. Disturbances, if any, are not of their doing and beyond their control--temperature, rainfall, and other exogenous shocks. A modern economy is marked by the feasibility of endogenous change: Modernization brings myriad arrangements from expanded property rights to company law and financial institutions. That opens the door for individuals to engage in novel activity in the financing, developing and marketing of new products and methods--commercial innovations. The emergence of this "capitalism," as Marx called it, in Europe and America ushered in a long era of stepped-up innovation from about 1860 to 1940; further waves of innovation have since occurred. The innovations undertaken were successful often enough that rapid cumulative economic change followed.
A few pioneering theorists, mostly from the interwar years, saw the commercial innovativeness and the ongoing economic change as having systemic effects that altered people's experience in the economy.
Innovativeness raises uncertainties. The future outcome of an innovative action poses ambiguity: (4) the law of "unanticipated consequences" applies (Merton, 1936); entrepreneurs have to act on their "animal spirits," as Keynes (1936) put it; in the view of Hayek (1968), innovations are launched first, the benefit and the cost are "discovered" afterwards. The innovating itself and the changes it causes make the future full of Knightian uncertainty (1921) for non-innovators too. Finally, since innovation and change occur unevenly from place to place and industry to industry, there is also uncertainty about the present: what is going on elsewhere, much of which is unobserved and some of it unobservable without one's being there. Thus, even if every actor in the modern economy had the same understanding ("model") of how the economy works, one would not suppose that others' understanding is like one's own. With modernization, then, another feature of a traditional economy--common knowledge that a common understanding prevailed--was lost. (5)
Innovativeness also transforms jobs. As Hayek (1948) saw, even the lowest ranking employees come to possess unique knowledge yet difficult to transmit to others, so people had to work collaboratively. Managers and workers too were stimulated by the changes and challenged to solve the new problems arising. Marshall (1892) wrote that the job was for many people the main object of their thoughts and source of their intellectual development. Myrdal (1932) wrote that "most people who are reasonably well off derive more satisfaction as producers than as consumers."
Far into the 20th century, though, economics had not made a transition to the modern. Formal micro-founded economic theory remained neoclassical, founded on the pastoral idylls of Ricardo, Wicksteed, Wicksell, Bohm-Bawerk and Walras, right through the 1950s. Samuelson's project to correct, clarify and broaden the theory brought into focus its strengths; (6) but also its limitations: It abstracted from the distinctive character of the modern economy--the endemic uncertainty, ambiguity, diversity of beliefs, specialization of knowledge and problem solving. As a result it could not capture, or endogenize, the observable phenomena that are endemic to the modern economy--innovation, waves of rapid growth, big swings in business activity, disequilibria, intense employee engagement and workers' intellectual development. The best and brightest of the neoclassicals saw these defects but lacked a micro-theory to address them. To have an answer to how monetary forces or policy impacted on employment, they resorted to makeshift constructions having either no microeconomics behind it, such as the Phillips Curve and even fixed prices, or to models in which all fluctuations are merely random disturbances around a fixed mean.
After some neoclassical years at the start of my career I began building models that address those modern phenomena. So did several other young economists during that decade of ferment, the 1960s. (7) At Yale and at RAND, in part through my teachers William Fellner and Thomas Schelling, I gained some familiarity with the modernist concepts of Knightian uncertainty, Keynesian probabilities, Hayek's private know-how and M. Polyani's personal knowledge. Having to a degree assimilated this modernist perspective, I could view the economy at angles different from neoclassical theory. (8) I could try to incorporate or reflect in my models what it is that an employee, manager or entrepreneur does: to recognize that most are engaged in their work, form expectations and evolve beliefs, solve problems and have ideas. Trying to put these people into economic models became my project.
EXPECTATIONS IN MODELS OF ACTIVITY
Unemployment determination in a modern economy was the main subject area of my research from the mid-1960s to the end of the 1970s and again from the mid-1980s to the early 1990s. The primary question driving my early research was basic: Why does a surge of "effective demand," that is, the flow of money buying goods, cause an increase in output and employment, as supposed in the great book by Keynes (1936)? Why not just a jump in prices and money wages?
Another question arose immediately: How could there be positive involuntary unemployment in equilibrium conditions--more precisely, along any equilibrium path? The answer implied by my model was that if there were not positive unemployment, employee quitting would, in general, be so rampant that every firm would be trying to out-pay one another in order to cut the high training outlay that comes with high turnover. To my mind, the argument did not rest on the "asymmetric information" premise that a worker could conceal his or her propensity to quit from an employer. (Employers might know better what quit rates to expect than the employees themselves.) It rested on the impossibility of a contract protecting the employer from all the excuses for quitting the employee might be able to claim. There are also the abuses the employer could inflict on employees to force them to quit. In a modern economy, therefore, agreements are unwritten, thus informal, or, where written, not entirely unambiguous.
My approach to the relation between "(effective) demand" and activity started from the observation that, faced with all sorts of innovations and change, the market place of the modern economy was not just "decentralized," as neoclassical economists liked to say. The beliefs and responses of each actor in the economy are uncoordinated: Walras's deus ex machina, the economy-wide auctioneer, is inapplicable to a modern economy in which much activity is driven by innovation and past innovation has left a vast differentiation of goods. This led to the point that the expectations of individuals and thus their plans may be inconsistent. Then, some or all persons' expectations are incorrect--a situation Marshall and Myrdal called disequilibrium. (9) Thus the economy--say, a closed economy, for simplicity--might often be in situations where every firm (or a preponderance of firms) currently expects that the other firms are paying employees at a rate less than or perchance greater than its own pay rate. In the former example, every firm believes that, with its chosen pay scale, it is out-paying the others.
In my first model having a labor market capable of disequilibrium (Phelps, 1968a), the effect of such an underestimate of the wage rates being set elsewhere is to damp the wage rate that every such firm calculates it needs to pay in order to contain employee quitting by enough to minimize its total cost (at present output)--the sum of its payroll costs plus turnover costs. In terms of a later construct, the "wage curve" is lowered by firms' underestimating what will be the going wage at their competitors. (10) Such a lowering of the wage curve serves to lower firms' cost curves, thus to lower the prices and, through the monetary block of the 1968 model, to increase output (achieved at first by moving employees from training to producing); employment gradually expands thanks to reduced quitting caused by employee expectations that wages are lower at other firms than at their own. Later firms may step up hiring (from the initially reduced level) in response to the reduced costs and thus higher profit margins. What seemed to be a simple model was quickly revealed to be full of subtleties, so that very few students fully master it. However, the point that expectations matter for wages, prices and activity has been grasped. The economy is boosted by underestimation of competitors' wages and by firms' underestimation in customer markets of their competitors' prices (Phelps and Winter, 1970). Similarly, the economy is dragged down by overestimation.
What would happen in this economy, with its potential for disequilibrium and, say, increased disequilibrium, if aggregate demand shifted onto a higher path? (11) I often studied an unidentified spending shock in the private sector that operated to increase the velocity of money and, if the central bank was slow to respond, would drive both the price level and money-wage level toward correspondingly higher paths--whether promptly or in a drawn out process. I supposed that this velocity shock would be neutral for quantities and relative prices if and when firms and workers formed correct expectations of the money-wage and price responses to the upward shift in the demand price. (12) Yet firms and workers have no way of perceiving such neutrality at the start.
What ensues? My models implied the following: (13) Every firm mistakenly infers that, as often happens, all or much of the increase in demand it observes is unique to it; so in deciding how much to raise its wage it is led to underestimate the rise of wage rates at the other firms. Similarly, every customer-market firm in deciding how much to raise its price is led to underestimate the extent to which the other firms are going to raise their price. As a result, the firm raises its price relative to what it believes the others are going to do but by little--by less than it would do if did not underestimate the rise elsewhere and less than the increase in its demand price; similarly it raises its wage but by little--by less than it would do if it did not underestimate the rise elsewhere. I added that "uncertainty" might induce a "cautious, gradual response in the firm's wage decision" (Phelps, 1968a, p. 688). (14)
Regarding quantities: The increase at each firm in customers' demand sparked by the velocity shock causes the firm to recognize that, at the initial price and output,...
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