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334 Miscellanea
the flexibility of nominal wages on the down side does not exist, if it ever did,
and the same of course applies to prices which are very closely tied to wages.
The reasons why such a downward rigidity prevails, and why it is not grossly
inconsistent with rational behavior has been analyzed and explained in many
papers [e.g., Dreze 1999, Akerloff 2002], which it is not necessary to summarize
here, especially since the classical postulate is patently refuted by empirical evidence.
In fact, it was precisely the failure of wages to decline in England, despite
the great and persistent unemployment rate prevailing in the 20s and 30s and until
World War II, that inspired Keynes’s General Theory. The rigidity has certainly
not diminished since then. This conclusion is strikingly supported by the attached
table 15.1 (table 29 taken from the European Economy 2001, No. 72), which
reports the annual rate of change of “nominal compensation per employee” for
each of the 15 members of the European Union, the U.S., and Japan, a total of
17 ¥ 42 or 714 observations. Of these, only 3 were declines (Japan, 1998–2000),
and this, in a period where unemployment rates reached distressingly high level,
as high as over 20 percent, as can be seen from table 15.2, unemployment rate
(table 3 from the same source), and the same is largely true for prices. The experience
in the USA in the post-war period is just a confirmation of that in Europe.
The problem that Keynes confronted in the General Theory, is that of analyzing
the behavior of an economy in which wages are “downward rigid,” i.e. will
not fall or at best very slowly, in the presence of excess supply of labor (unemployment
above the minimal frictional level).
III.2 A Generalization of the Notion of Market Equilibrium
Keynes’s first step in the reconstruction is to recognize that the phenomenon of
price/wage rigidity in the face of excess supply requires a major redefinition of
the notion of “market equilibrium.” In the classical model there were two alternative
ways of characterizing market equilibrium: 1) when demand equals supply;
and 2) when price has reached a stable level (at least in the short run). But when
prices (wages) do not fall, despite the presence of an excess supply, the two
definitions are not equivalent. Keynes chooses the second definition of equilibrium,
which is applicable regardless of whether prices are rigid or flexible: a
market reaches equilibrium at a point where quantity and price stop adjusting,
independently of whether at that point there exists an excess demand or supply.
And the choice is a very appropriate and general one, since it applies equally to
the classical model of equilibrium with price flexibility or the Keynesian model
of price rigidity: that is, equilibrium can always be operationally inferred from
the (at least local) stationariness of price (and for Keynes, only from that).