An Exortation

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 Exchange generalization has enabled construction, long overdue, of the first evidence-consistent rational-behavior theory of wage determination in more than a hundred years, finally moving our understanding of employee pay out of the 19th century. While having a useful explanation of labor pricing is broadly important throughout economics, its most profound effect is on how to do stabilization-relevant macroeconomics.

In his essay on monetary policy and unemployment, Jodi Galí (2011, p.488) acknowledged the general problem while bungling the solution: “The existence of involuntary unemployment has long been recognized as one of the main ills of modern industrialized economies…. Despite the central role of unemployment in the policy debate, that variable has been – at least until recently [with the increased work on the S/M/B model class] – conspicuously absent from the new generation of models that have become the workhorse for the analysis of monetary policy, inflation, and the business cycle, and which are generally referred to as New Keynesian.”

The NK literature cited by Galí makes my point. It combines S/M/B labor-market mechanisms with wage rigidities that are either too tiny to affect labor-price recontracting (e.g., Hall (2005b)) or, in the recurring reversion of New to Early Keynesianism, are arbitrarily endowed with downward nominal wage rigidity. The first class cannot generate involuntary job loss, and the second is inconsistent with rational behavior, a fundamental violation of the New Neoclassical Synthesis (NNS) upon which the modern macro consensus is constructed. Free parameters used in conjunction with S/M/B modeling do not morph into anything more than free-parameters.

Two-Venue Theorem. Serious theorists in search of a coherent, stabilization-relevant monetary model of production have no choice. They must look beyond the mainstream market-centric general-equilibrium model class. A powerful replacement theory is motivated by the Project’s Two-Venue Theorem:

The existence of continuous optimizing macroeconomic equilibrium providing both analytic coherence and wage rigidity sufficient to support involuntary job loss implies the coexistence of market and nonmarket equilibria, with the latter governing the dominant subset of labor pricing.

Separate venues of price-mediated exchange are defined by fundamental heterogeneities in optimizing decision rules, constraints, and exchange mechanisms that impose boundaries on meaningful aggregation. The venue concept has been used used to construct a two-venue general-equilibrium model, extending rational price-mediated exchange from the marketplace to workplaces restricted by asymmetric information. The theorem is best understood in conjunction with Barro’s well-known wage-recontracting critique. It is offered, not modestly, as the most consequential labor theorem in macroeconomics. Its exploration has produced the modern theory of wage determination, and its concomitant meaningful wage rigidity (MWR), promised above.

Indeed, exploration of GEM analysis solves most of the stabilization-relevancy problems of the New Neoclassical Synthesis while coexisting with much of the GME framework. The MWR Channel becomes the keystone for the analysis of stationary business cycles. Adverse nominal disturbances induce a recognizably broad range of market failure that can be ameliorated by the effective management of total spending. That the market failure produced by the interaction of the generalization of exchange and nominal disturbances includes involuntary job loss and unemployment, making it recognizable, is critically important to the two-venue model’s stabilization relevancy. From Lucas (1987, p.31): “If we are serious about obtaining a theory of unemployment, we want a theory of unemployed people, not unemployed ‘hours of labor services’; about people who look for jobs, hold them, lose them, people with all the attendant feelings that go along with these events.” Rational MWR-rooted meta-externalities imply the rejection of activist stabilization policy must be restricted to demonstrating that monetary authorities are incapable of designing and implementing proper demand interventions.

An exhortation.  Generalized-exchange macroeconomics (GEM) can help deliver mainstream thinking from the comfort it provides to the dismayingly significant number of members of Congress who seek to limit, or even dismantle, the sort of innovative tools used by the Fed to halt and reverse the collapse in aggregate demand associated with the 2008-09 financial crisis.

The Fall 2011 issue of The Cato Journal provides an interesting collection of such criticism, rooted in general-market-equilibrium (GEM) thinking, of Fed behavior leading up to, during, and immediately after the Great Recession. For example, John Taylor (2011) calls for legislating a monetary-policy rule in order to protect the economy from a repeat of the Federal Reserve’s aggressive use of its balance sheet to stabilize total spending. Taylor’s criticism that those actions were problematically short-term reflects the inability of market-centric thinking to accommodate the SDD→NDD problem class, despite its huge welfare cost. From the perspective provided by the GEM Project, Federal Reserve policymaking in 2008-09 is easily understood to have been addressing a brewing NDD disaster that cannot in any meaningful way be understood as short-term. More disappointing than the drumbeat of attacks from a particular segment of the New Neoclassical Synthesis is the absence of a more broad-based, substantial response from more reasonable New Keynesians. The imbalance may reflect gathering discouragement by many mainstream macro theorists, resulting from not having much of a NNS story to tell about the greatest crisis of their professional careers.

Promises made by serious candidates for high office, notably during the 2012 Republican Presidential primaries, to fire Ben Bernanke for cause became commonplace in the aftermath of his extraordinarily successful handling of the crisis. The breakdown in informed political discourse on the proper functioning of the central bank has been, in no small part, enabled by the reluctance of many of our most honored macro theorists, a number of whom know better but are made timid by their broad commitment to coherent GME thinking, to establish consensus boundaries of basic reasonableness, consistent with the evidence, for ongoing debates about the proper government response to economic instability.

The contemporary absence of such boundaries is flat-out dangerous. Responsible macro theorists should get serious about stabilization-relevant modeling. Especially necessary, as frequently argued in this blog, are coherent models capable of identifying and accommodating the channel through which adverse demand shifts rationally induce involuntary job- and income-loss. Can there really be much doubt that the most crucial research agenda in macroeconomics requires the derivation, not the setting aside, of MWR, an outcome inherently beyond the reach of workhorse S/M/B modeling? The detachment of leading macro theorists from the actual functioning of specialized economies, rooted not in the rigor of the formal method but instead in the comfort of familiar market-centric analysis, is not acceptable. Macroeconomists can, and must, do better.

Blog Type: New Keynesians Saint Joseph, Michigan


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