You say: “We actually have been doing an experiment with lowering wages to eliminate unemployment starting back in the early 1980s.” This natural experiment has already happened on a larger scale during the Great Depression. These natural empirical tests amount to a clear REFUTATION of commonplace employment theory.
In order to rectify employment theory, first of all the premises of both Walrasianism and Keynesianism have to be replaced. In methodological terms, what is needed is a paradigm shift.
The new analytical starting point is this: the most elementary configuration of the economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm and is defined by these three OBJECTIVE axioms:
A1. Yw=WL wage income Yw is equal to wage rate W times working hours L,
A2. O=RL output O is equal to productivity R times working hours L,
A3. C=PX consumption expenditure C is equal to price P times quantity bought/sold X.
The investment good sector comes in with the second step. So, what we have with A1 to A3 is the pure consumption economy as the most elementary economic configuration.
From these elementary, objective and absolutely transparent premises follows the BASIC version of the employment equation which is shown on Wikimedia. From this equation in turn follows: (i) An increase of the expenditure ratio rhoE leads to higher employment (the letter rho stands for ratio). (ii) Increasing investment expenditures I exert a positive influence on employment, (iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment. The complete AND testable employment equation is a bit longer and contains in addition profit distribution, public deficit spending, and import/export.
Items (i) and (ii) cover Keynes’s arguments about the role of aggregate demand. The factor cost ratio rhoF as defined in (iii) embodies the price mechanism which works very different from what is usually assumed. As a matter of fact, overall employment (in the world economy or a closed national economy) INCREASES if the average wage rate W INCREASES relative to average price P and productivity R.
What natural empirical tests and the rectified employment theory UNANIMOUSLY tell us is: unemployment is never the result of downward sticky wages but of upward sticky wages. Which means that standard economic policy advice has regularly AGGRAVATED depression/ unemployment.
Immediately preceding 'Sticky prices or sticky brains?'
It is long known that economists violate well-defined scientific standards on a daily basis: “In economics we should strive to proceed, wherever we can, exactly according to the standards of the other, more advanced, sciences, where it is not possible, once an issue has been decided, to continue to write about it as if nothing had happened.” (Morgenstern, 1941)
The issue that has been decided is that standard economics is formally and materially inconsistent. Standard economics is built upon this set of foundational propositions, a.k.a. axioms: “HC1 economic agents have preferences over outcomes; HC2 agents individually optimize subject to constraints; HC3 agent choice is manifest in interrelated markets; HC4 agents have full relevant knowledge; HC5 observable outcomes are coordinated, and must be discussed with reference to equilibrium states.” (Weintraub, 1985)
Methodologically, these premises are forever unacceptable. The ultimate reason can be stated as an impossibility theorem: NO way leads from the explanation of individual behavior to the explanation of how the economic system works.
It is pretty obvious that the Walrasian axiom set contains three nonentities: (i) constrained optimization (HC2), (ii) rational expectations (HC4), (iii) equilibrium (HC5).* Every model that contains only one nonentity is A PRIORI false. The discussion of models that contain nonentities is not different from a medieval angels-on-a-pinpoint discussion.
The microfoundations approach has already been dead in the cradle 140 years ago. Joan Robinson’s advice “Scrap the lot and start again” becomes more urgent by the day.
It is NO LONGER possible to apply constrained optimization/rational expectations/ equilibrium. Journals that accept papers which contain nonentities violate scientific standards. The issue has been decided and economists better get their heads around it. Romer is right: “There is trouble ahead for ALL of economics.”
* Auxiliary nonentities are for example: utility, expected utility, rationality/bounded rationality/animal spirits, well-behaved production functions, supply/demand functions, simultaneous adaptation, total income=value of output, I=S, real-number quantities/prices, ergodicity.
The microfounded employment theory is axiomatically false because it employs the nonentities constrained optimization/rational expectations/equilibrium or as Krugman put it “most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point.” So, most of what Krugman and many others do is provable false.
Methodologically, the Keynesian Revolution consisted in the move to macrofoundations: “there is no remedy except to ... work out a non-Euclidean” economics. (1973, p. 16)
Keynes defined the formal foundations of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (1973, p. 63)
This two-liner is conceptually and logically defective.* Allais clearly identified Keynes’s major fault: “... mais son insuffisance logique ne lui a pas permis de résoudre les problèmes que son intuition lui avait fait entrevoir.” (1993, p. 70). In other words, Keynes stumbled upon the problems but could not solve them because of his logical insufficiency.
Because Keynes’s approach, too, is axiomatically false his macrofounded employment theory is no better than the microfounded employment theory of the DSGE/RBC/New Keynesian type.
With correct macrofoundations one arrives at the TESTABLE result that ― for objective systemic reasons ― OVERALL employment INCREASES if the average wage rate INCREASES relative to average price and productivity (2012). Because of this, the sticky-wage argumentation of both Walrasians and Keynesians is entirely beside the point.
Allais, M. (1993). Les Fondements Comptable de la Macro-Économie. Paris: Presses Universitaires de France, 2nd edition.
Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL
Keynes, J. M. (1973). The General Theory of Employment Interest and Money. London, Basingstoke: Macmillan.
* For details see post ‘How Keynes got macro wrong and Allais got it right’