Answering an Important Question

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GEM Blog posts vary widely in importance. This one really matters. It elaborates on last week’s identification of the crucial flaw in the second edition of Wendy Carlin and David Soskice’s Macroeconomics (2015). Readers must wonder how the existence of a research priority, i.e. the microfounding of meaningful wage rigidity (MWR), can be so consequential? Here’s my answer.

The Argument

Begin with a brief summary of past posts’ comparison of Early and New Keynesian models. Both seek to explain macro instability in highly specialized economies that organized themselves after the Industrial Revolutions. Both work within the enduring neoclassical framework centered on market-centric general equilibrium. Both seek stabilization-relevance and, failing to rationally suppress wage recontracting, assume some convenient (albeit irrational) version of nominal wage rigidity. It is a huge problem that the two dominant postwar macro frameworks have never microfounded MWR, defined by its capacity to rationally suppress wage recontracting. The absence of models informed by rational, evidence-consistent labor pricing has deprived theorists of crucial guidance in their attempts to construct useful macroeconomics. Stabilization analysis became much more complex after the industrial revolutions, tempting theorists with many wrong turns. An accurate roadmap is a must. In an example that particularly bugs me, microfounded MWR would have enabled modern macroeconomists to steer clear of the hugely wasteful wrong turn that resulted in the widespread use of labor search/match theory to explain involuntary job loss. I marvel that anybody thought that detour would not be embarrassing.

This post makes the case that the crucial EK-NK difference is that the former emphasized that their Neoclassical Synthesis was fundamentally unfinished macroeconomics, putting microfounding MWR at the top of their research agenda. NK theorists, by contrast, repeatedly declare their New Neoclassical Synthesis and its attendant dynamic stochastic general-market-equilibrium model class to be basically finished theory. No core research is yet to be done; none would be useful. The bold assertion has led to the erasure of MWR – a truly fundamental EK concept – from the academy’s research agenda. Illustrative of the success of the quiet shift away from EK  priorities, the 2016 Handbook of Macroeconomics has only two mentions of involuntary job loss, the rational existence of which requires MWR. Searching for  wage recontracting comes up empty, as do efficiency wages and wage rent. For practical purposes, MWR research no longer exists in the mainstream literature.

The List

I believe that the dogged pursuit of market-centric convenience in NK research has been extremely damaging. In this limited space, my argument summarizes the debilitating consequences that follow from the mainstream failure to inform modern macroeconomics with rational MWR. The GEM Project has shown rational meaningful wage rigidity requires the generalization of exchange from the marketplace to information-challenged workplaces. The following list, limited to ten outcomes, is my best shot at convincing mainstream theorists that careful exploration of alternatives to market-centricity is a worthwhile research effort. Taken together, the ten items demonstrate the stabilization-irrelevance of the NK microfounded macro model:

  • Meaningful wage rigidity itself leads off. The central Keynesian macro problem has long been that MWR simply cannot exist in market-centric general-equilibrium theory. By dropping market-centricity, the GEM Project has derived MWR consistent with optimizing employer-employee behavior organized by continuous general decision-rule equilibrium.
  • Involuntary layoffs, requiring the suppression of wage recontracting and typically resulting from weakening nominal demand, also cannot exist in market-centric, general-equilibrium macro theory. Consequently, mainstream DSGME modeling cannot produce recognizable recessions, a failure that spurred NK interest in great moderations. It is understandable that the academy’s macro modeling little interested stabilization authorities in 2008-09.
  • Chronic significant wage rents, a powerful consequence of the existence of microfounded MWR in information-challenged workplaces, do not exist in mainstream market-centric general equilibrium. Their absence has been debilitating to efforts to explain important evidence. For example, recognition of such rents are necessary to an adequate understanding of unemployment persistence during and after recessions and the high frequency of recalls following layoffs. Let’s face it. The picture being painted here is that NK theorists cannot explain what actually goes on in recessions.
  • Rational MWR makes clear that textbook Wicksteed-Wicksell factor-income distribution is irrational, usefully reviving the existence of pure profit. Everybody outside of the economics profession knows that (i) investment spending is largely determined by the expectation of pure profit and (ii) assigning the primary role instead to interest rates have been badly misleading wrong turns by NK theorists. It is equally misleading to pretend that interest rates are the primary driver of consumption. The GEM Project uses microfounded MWR to identify that main driver to be household income, reviving the insightful, but now moribund, Barro-Grossman (1971, 1976) EK analysis of rational behavior in the context of meaningful wage rigidity.
  • The GEM Project shows Lucas’s famous rational-expectations Phillips curve to be rooted in clearly irrational employer-employee behavior. Along with Wicksteed-Wicksell, it becomes a special perfect-information case. Given the inability of the RE Phillips curve to track actual wage behavior, many economists must have always harbored heretical doubts about Lucas’s keystone innovation. If so, they will be pleased to discover that inflation catch-up in wage determination – behavior that practitioners tell us is consistent with actual behavior – has been microfounded in generalized-exchange modeling.
  • Microfounded MWR encourages the powerful separation of nominal-demand disturbances into their stationary and nonstationary components. The latter motivates the GEM Project’s continuous general decision-rule equilibrium modeling of the Great Recession. (See “The Basic NDD Model”, GEM Blog (3/21/2019) or, more comprehensively, the website’s e-book, chapter 6.) Mainstream market-centric general equilibrium can never be capable of adequately explaining the extreme instability that characterized 2008-09.
  • Absent modeling of information-challenged workplace exchange, macro theory cannot accommodate the existence of profit-seeking labor practices in bureaucratic large firms, thereby ignoring a substantial share of the labor force and perpetuating the embarrassing gulf between economics departments and business schools. Looked at another way, market-centric general equilibrium theory can never effectively accommodate the ubiquitous large human-relations (personnel) departments that are always present in large bureaucratic corporations and that govern labor-management relations, including compensation. An established message of rigorous neoclassical theory is that, in the circumstances of workplace-information asymmetry, labor prices cannot be rationally determined in the marketplace. It must not be, but always is, ignored. Looked at a third way, mainstream thinking will never accommodate the Herbert Simon’s Nobel-Prize winning organization theory – a huge loss. Taken together, that is too much information on how highly specialized economies work to simply push aside.
  • Along the same lines, rational macro theory can never accommodate evidence-consistent labor-union modeling. (See the website’s e-book, chapter 7.)
  • Market-centric general equilibrium theory cannot integrate the powerful Nobel-prize-winning Lewis two-sector growth theory, which is broadly recognized as our best explanation of the transition out of subsistence, into mainstream macro thinking. For the generalized-exchange theory, such integration is a piece of cake. Wouldn’t be nice to teach Sir Arthur’s important model to economics students? We would be actually doing our job of explaining important economic phenomena.
  • Microfounded MWR is central to rigorous, evidence-consistent analysis of the second greatest instability crisis of the 20th century, the stagflation decade that began in the early 1970s. My Price of Industrial Labor (1984), anticipating the subsequent work of the GEM Project, explains that episode’s crucial price-wage-price spiral and provides an atypically accurate description of stagflation’s huge, persisting market failure that subsequently fueled the 1980s downsizing crisis. (See the website’s e-book, chapter 4.)

The incomplete list makes a powerful case that the Early Keynesians were right. MWR is the lynchpin of useful macroeconomics. (Compare it to imposing rational expectations on the NK Phillips curve.) The concept’s role in providing insightful guidance to stabilization-relevant macro model-building is crucial, and its absence in the modern academy has been debilitating. MWR criticality must be recognized and high-priority research must resume.

Summary Questions

Are the thumbnailed consequences sufficiently debilitating to restore MWR microfoundations to their former critical-research status? Isn’t the list a convincing accounting of the consequential wrong turns made by mainstream theorists in the absence of model-building guidance from microfounded MWR? Doesn’t it help the GEM Project case that generalizing rational exchange from the marketplace to workplaces restricted by costly, asymmetric information is intuitive and supported by how highly specialized economies are organized around complex bureaucratic firms?  Does anybody truly familiar with the GEM model class believe that actual macro behavior is better described by market-centric general-equilibrium modeling?

Blog Type: New Keynesians Chicago, Illinois

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