A Little Idea from Blanchard and Gali

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New Keynesians (NK) got the short end of the stick in the New Neoclassical Synthesis, the modern macro consensus featuring rigorous commitment to micro-coherent market-centric general-equilibrium modeling. NK gatekeepers cobbled the consensus together in the late 1990s with New Classical and Real Business Cycle theorists. Burdened by their relatively robust concern for stabilization relevance, NK analysts now spend much of their time looking for endogenous pricing imperfections that can microfound employment/output consequences from nominal demand disturbances. The most serious among the NK theorists go further and accept the need, in order to explain the pile of evidence on involuntary unemployment, to identify a super friction able to suppress wage recontracting, eschewing the standard mainstream practice of simply ignoring meaningful wage rigidity.

The standard practice is easy to understand. Constructing a mechanism that rationally suppresses wage recontracting within the market-centric general-equilibrium model class has proven to be the most discouraging problem in macroeconomics. Its resistance to solution led to the banishment of Early Keynesian thinking from graduate-school curriculums and cutting-edge journals. I always marvel at the chutzpah needed to ban Modigliani, Hicks, Patinkin, Samuelson, Tobin, Okun, Malinvaud, Solow, and others who proved to be, upon careful consideration, the best macroeconomists since Keynes.

Blanchard and Gali (2010) are among the small subset of New Keynesians who have tackled the EK keystone problem of meaningful wage rigidity. Despite some substantial claims, they have not been successful in microfounding the suppression of labor-price recontracting. They don’t come close to explaining involuntary job loss and recognizable business cycles. Their fate is sealed with the uninspired choice to look for the necessary market super friction within the ubiquitous search/match/bargain framework. In particular, they posit that hiring costs are increasing in labor-market tightness, creating a wedge between labor’s marginal product and opportunity cost within which unemployment can fluctuate.

We are supposed to ignore a big problem. The joblessness that B&G have taught to jump around a little in tune with the business cycle is wholly voluntary. We know, but are supposed to look the other way, that involuntary job loss has dominated the movement of unemployment over each and every postwar recession. (See Table 1.1 in the website’s eBook.) Maybe it’s just me, but it seems crudely deceptive to ignore that involuntary and voluntary joblessness are different, very different. That difference certainly matters greatly to stabilization authorities.

B&G follow the standard modern practice of simply setting aside the recontracting problem. Since being set aside does not make it disappear, their search/match macro model can never produce recognizable layoffs. They have trained their firepower on exceptionally mild, in practice undetectable, cyclical downturns stop short of producing forced job loss. Given such tiny output contractions, who cares? In B&G “recessions”, discretionary aggregate-demand management cannot reliably improve on market solutions, an outcome that is consistent with the RBC argument against activist monetary policy. It is interesting that the Blanchard-Gali simulations produce “large and inefficient movements in unemployment” resulting from monetary policy designed to stabilize inflation. While I believe that conclusion is correct, I know that it does not follow from the model constructed in their paper. It instead results, as usual, from the artful use of free parameters.

Blanchard and Gali claim labor-market realism as a central virtue of their model, a puzzling assessment they should reconsider. Their paper was published after the Great Recession, so their understanding of reality must include that extraordinarily challenging episode of broad market failure. Would any economist, reasonably informed and in good conscience, claim that the B&G model would have improved the Fed’s understanding and stabilization-management of the severe, not mild, 2007-09 instability that generated six-million lost jobs? Such involuntary job loss is fundamental to modern macroeconomics and cannot, must not, be pushed aside, especially by mainstream gatekeepers.

Neither can the role of micro-coherence in successful macro model-building be pushed aside. The New Classical insurgency taught us that useful macro research was badly served by the then-dominant Early Keynesian acceptance of fundamentally inconsistent micro and macro theories. Perhaps most notably, there is little doubt that the early satisfaction with the use of free parameters to suppress wage recontracting hindered the development of a proper understanding of meaningful (i.e., capable of suppressing wage recontracting) wage rigidities. Accurate MWR specification had to wait to be derived in the coherent continuous-equilibrium model class rooted in the generalization of price-mediated exchange from the marketplace to the workplace.

New Keynesians do their greatest damage by refusing to acknowledge that meaningful labor-price rigidity in market-centric microfounded models will always require free parameters. For reasons of convenience, reluctance to depreciate specific human capital, difficult-problem avoidance, an unshakable commitment to restricting rational price-mediated exchange to the marketplace, or whatever, leading macro theorists continue to assert the dominance of NNS modeling that, absent free parameters, neither usefully supports stabilization policymaking nor defends the discretionary management of aggregate nominal spending.

NK theorists, wishing to satisfy their urge for stabilization-policy relevancy, need to abandon Ptolemaic tinkering with endogenous market frictions and turn their attention to solving the fundamental problem of labor pricing capable of rationally suppressing wage recontracting.  Little ideas won’t do.  Indeed, nothing short of rethinking, and then rejecting, the mainstream commitment to the market-centric New Neoclassical Synthesis is necessary.

Blog Type: New Keynesian Saint Joseph, Michigan

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