The last two weeks took a critical look at an elite New Keynesian theorist’s optimistic take on the state of mainstream macroeconomics. This week provides some Early Keynesian perspective, focusing on the estimable Bob Solow’s assessment of the same topic eighteen years earlier: “It seems to me that the original real business cycle theory project, to understand observed fluctuations as the efficient response of a well-functioning, intertemporally competitive economy to unforeseeable shocks to technology and tastes, has petered out after only minor gains. The main obstacles to success are probably the persistence of market imperfections in some sectors, especially the intrinsic implausibility of any attempt to represent labor-market outcomes as market-clearing, and the attempt to push forward-looking behaviors to a very distant horizon. To these I would add the suggestion that a commitment to representative-agent models is a serious mistake. Many of the frictions and occasional flip-flops that characterize macro behavior seem to stem from the heterogeneity of agents.” (Solow (2000), p.155)
Some observations. The GEM Project’s marketplace-to-workplace generalization of price-mediated exchange, crucially microfounding meaningful wage rigidity (MWR), effectively answers Solow’s familiar indictment of mainstream thinking and its insistence on micro coherence in macro theory. He is, of course, correct in asserting that it is futile to try to understand labor-market behavior as market-clearing. As indicated by the evidence, that market is in chronic excess supply. And we now know why. Generalized-exchange modeling has demonstrated the existence of optimizing, persistent wage rents that require the labor market to be simultaneously in continuous supply-demand disequilibrium and continuous decision-rule equilibrium.
We also know that Solow is correct in concluding that the RBC assignment of cyclical centrality to the real propagation of macro shocks is a terrible mistake. Microfounded MWR allows nominal-demand disturbances to resume their crucial, may I say obvious, EK role in macro shock propagation that features involuntary job loss and evidence-sized movements in employment and output. Stabilization-relevant macro theory cannot exist absent that nominal-demand centrality.
The Project’s two-venue perspective here can be briefly summarized. First, the New Classical/ RBC revolution has achieved critically important, hopefully enduring gains. Its theorists fundamentally and properly altered the path modern macroeconomics by restoring neoclassical discipline, clarity and persuasive power – all rooted in optimization and equilibrium – to consensus macro model-building. Second, the generalization of rational exchange has more recently contributed to that development. In particular, it restored Early Keynesian stabilization-relevance to NK rational-behavior thinking by deriving the continuous-equilibrium MWR from model primitives, microfounding involuntary job loss (both layoffs and downsizing) and the discretionary management of nominal demand. The powerful two-venue class of macro modeling is constructed on axiomatic technological heterogeneities to complement, not set aside, the explanatory capacity of competitive markets. The key is the GEM Project’s rejection of the NK restriction of rational exchange to the marketplace, an intuitively poor description of highly specialized economies. The other two fundamental tenets of economic theory, optimization and equilibrium, remain central in generalized-exchange macroeconomics.
GEM modeling also shows that Solow’s formidable intuition faltered in his identification of agent-heterogeneity as the most productive area for future research. The problem here is that my co-founder of original efficiency-wage theory gave up too soon on rational workplace exchange. Decades ago, EWT made a strong case that the most consequential heterogeneity in rational-behavior, stabilization-relevant macroeconomics is the important difference between low- and high-specialized firms that emerged in the aftermath of the industrial revolutions. Recognizing that tractable theories must carefully husband their use of heterogeneity, the GEM Project’s most critical model-building choice is its emphasis on fundamental diversities in production that generate a large subset of work establishments constrained by costly, asymmetric employer-employee information.
More from Solow. In his iconic “A Contribution to the Theory of Economic Growth,” Solow (1956, p.65) offers some good advice on the use of assumptions, simplifying and crucial, in economic modeling: “All theory depends on assumptions which are not quite true. That is what makes it a theory. The art of successful theorizing is to make the inevitable simplifying assumptions in such a way that the final results are not very sensitive…. A crucial assumption is one on which the conclusions do depend sensitively. It is important that crucial assumptions be reasonably realistic. When the results of a theory seem to flow specifically from a special crucial assumption, then if the assumption is dubious, the results are suspect.”
The GEM model class satisfies the Solow condition. Its simplifying assumptions, including the homogenization and aggregation of households, do not significantly distort its stabilization-relevant “final results”, which are rooted in the existence of MWR derived from optimizing workplace exchange. The crucial stabilization assumptions (costly, asymmetric employer-employee information and routinized jobs) that govern the workplace venue are more than reasonably realistic. They are axiomatic, so broadly accepted by practitioners to need no derivation. The axiomatic nature of the crucial assumptions of generalized-exchange modeling is good news for stabilization-relevant macroeconomics. By contrast, the NK casual, albeit crucial, assumption of wage rigidity has for a long time badly distorted mainstream model-building.
Blog Type: New Keynesians Saint Joseph, Michigan