An Insight from Robert Lucas

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This Blog has been hard on Robert Lucas, the famous University of Chicago economist and leader of the anti-Keynesians in the late 20th century macro wars. His success in making market-centric general-equilibrium modeling a faith-based choice justifies censure. Policy-relevant macro use of the beautiful theory of Walras and other great 19th century marginalists cannot be unconditional. It must depend, like all other practical theories, on how well the proposed use corresponds to real-world evidence, a test that Lucas flunks spectacularly.

His most egregious application of his faith-based model is his blithe advice to ignore involuntary job loss (IJL), the policy-crucial centerpiece of actual business cycles. Why turn your back on forced layoffs in recession? His answer is ready and unembarrassed. General-market-equilibrium (GME) analysis is inherently unable to accommodate that familiar market failure. It is therefore the duty of macro theorists to stop obsessing over IJL. Best faith-based practice is to simply ignore it. Lucas’s macro career is a triumph of the metaphysical over the empirical. Like most true believers. he is only interested in evidence that supports his faith.

Many economists who want to usefully advise stabilization authorities just ignore Lucas. I spent a big chunk of my career advising stabilization policymakers. I was good at it, partly because I paid close attention to all the relevant evidence. But I also continued to read Lucas. His rigorous turn of mind produced useful insights that rose above the silliness of pushing aside important facts to bask in the beautiful logic of market-centric general equilibrium. What follows looks at one of those insights.

Lucas loved to work through implications of rational choice in the labor market. In a speech included in his Collected Works (1981a, p.4), he dismissed Keynesian business cycles and the institutions thought to produce them, properly arguing that economic arrangements must be designed “precisely in order to aid in matching preferences and opportunities.” Consistent with Lucas, the GEM Project is constructed on nonmarket arrangements designed to match axiomatic preferences and opportunities, forswearing critical free parameters used by Early Keynesians to arbitrarily restrict the rational labor-choice set that enraged anti-Keynesian insurgents.

In the Project, price-mediated exchange is understood to be properly modeled in the workplace as well as the marketplace. Surely no serious scholar objects to removing arbitrary venue limits on self-interested behavior, especially when the expansion enables more complete analysis of rational employer-employee interaction and workplace mechanisms of optimizing exchange. A rich two-venue class of institutional/market arrangements is identified that facilitates the heretofore badly incomplete matching of axiomatic preferences and opportunities, crucially producing involuntary job- and income-loss in the aftermath of adverse nominal disturbances. As has been emphasized, that stabilization-crucial outcome is not available in the caricature of matched preferences and opportunities featured in market-centric, general-equilibrium theory.

The hard message is that rational-behavior general-market-equilibrium modeling cannot be stabilization relevant in modern highly-specialized economies. Over the past century-plus, faith-based market-centric analysis has increasingly got a great deal of labor-related activities wrong, a persistent error set rooted in the for-convenience suppression of workplace exchange. The shoe is now on the other foot. Market-centric, general-equilibrium modeling, given its arbitrary restrictions on “matching preferences and opportunities” in information-challenged workplace exchange, must be rejected in favor of the much less arbitrary GEM approach. Generalized exchange macroeconomics also provides a compelling alternative to the impulse among a few economists to see the employer-employee relationship as a problem best modeled as a noncooperative game. The game-theoretic approach is inherently weak, hampered by multiple, fragile (highly sensitive to small changes in assumptions) equilibria. It is also disassociated from what is known about intra-firm behavior, leaving way too much information on the table.

As the global economy has become more specialized, labor-related problems have been accumulating and long ago became debilitating, implicated in a large portion of the contemporary predictive and explanatory failures of market-centric macro theory. Textbook aggregate labor supply, still featuring Keynes’s Second Classical Postulate, must be recognized as fundamentally misspecified. Labor matters too much in the range of economic activities for macro theorists to continue to rely on a misleading caricature of worker behavior.

Yet a willful ignorance continues to be the norm, as little in consensus theory pays attention to what has been learned from a hundred years of experience on what goes on inside highly specialized workplaces. The evidence supports neither technologically fixed OJB nor endowing employees with a dominant preference to shirk. In their indifference to the facts and rejection of proper axioms upon which to build their models, mainstream theorists are not arguing that practitioners are wrong. That would be pretty stupid. Instead, Lucas and most other macroeconomists believe, conveniently, that practitioner knowledge is an unnecessary complication to an already satisfactory market-centric theory.

The unnecessary-complication belief is the nub of the stabilization problem that beleaguers mainstream theory. Incorporating continuous-equilibrium workplace behavior into consensus price-mediated market exchange disturbs the status quo. That reaction is not unusual. More than a century ago, when John Bates Clark, Alfred Marshall, and other great theorists were developing marginal analytics and the neoclassical market-centric method, many economists rejected their efforts. To them, it was simply axiomatic that wages, for example, were determined in competitive markets by the relative supplies of labor and capital. More analytic rigor was an unnecessary complication.

Departing from convention is difficult, no matter how badly the break is needed. It is not 1:1 hours-output mapping or inherent laziness that motivates real-world employment relationships. Macro theorists must think through why human-resource departments, both large and ubiquitous, exist. HR specialists design and implement institutional arrangements that govern a significant portion of the alignment of preferences and opportunities in modern economies. Well-read economists must know that their general market equilibrium models badly capture actual “matching preferences and opportunities” but, too frequently, do not care. Let well enough alone.

Unfortunately, well enough has turned out to be pretty bad. The maintenance of the status quo with respect to workplace behavior has had huge opportunity costs. Those costs were vividly illustrated in the Great Recession.  The Fed never provided its aggressive policymaking, which was remarkably successful in taming the total-spending propagation of the 2008-09 financial crisis, useful macro foundations. As a result, the central-bank actions have lacked mainstream academic support, especially on the existence of the rational MWR Channel through which nominal demand disturbances uniquely induce involuntary job- and income-loss. A better-informed consensus among macroeconomists would have helped contain the damaging, ill-informed Congressional criticism that followed the Fed’s virtuoso performance as well as helped foster investor/lender confidence in the stabilization credibility of the central bank’s expanded toolkit.

Blog Type: Wonkish Saint Joseph, Michigan

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