Backward Macro Modeling

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This post is an irresistible addendum to my month-long look at the Phillips curve. It keys off Robert Lucas’s quote from a 1996 interview by John Cassidy (2010, p.192). In it, Lucas modestly describes his Nobel-honored introduction of rational expectations into the Early Keynesian Phillips curve: “I write down a bunch of equations, and I say this equation has to do with people’s preferences and this equation is a description of the technology. But that doesn’t make it so. Maybe I’m right, maybe I’m wrong. That has to be a matter of evidence.” Especially when applied to reconstructing the keystone Keynesian wage equation, Lucas’s approach helped mire a generation of macro theorists in stabilization-policy irrelevancy.

Backward modeling. Lucas’s fundamental error is constructing his innovative model backwards. Textbook methodology is clear on the need for assumptions to be either axiomatic or strongly supported by the evidence. The application of evidence to inform his critical assumptions should have been his first, not last, step. The mistake is important. The use of unsupported, albeit convenient, specifications of preferences and technology has long been a wellspring of bad advice to stabilization policymakers. Especially damaging is the pushing of the Keynesian emphasis on interacting nominal demand disturbances (NDD) and meaningful wage rigidity (MWR) far from macro theory’s center stage. We conveniently forget that the combination uniquely generates involuntary job loss, the avoidance of which mainstream macro theorists have raised to an art form.

It is instructive to take a closer look at the assumptions that most render Lucas’s treatment of nominal wages badly misleading in the analysis of highly specialized economies. First is his reductionist technology that omits how large complex firms fundamentally differ from their small counterparts, thereby restricting rational exchange to the marketplace. Second is ignoring what practitioners long ago figured out and evolutionary biologists and behavioral economists have more recently learned, i.e., the criticality of perceptions of fair treatment in employee preferences.

Workplace exchange. We know that bureaucratic firms rationally exist to take advantage of a rich variety of scale-related economies and synergies. We also know that optimizing employer-employee exchange in large, complex workplaces is constrained by costly, asymmetric information, preventing efficient pricing of worker time in the labor market. Profit-seeking wage-setting must be moved inside the firm, motivating construction of human-resource departments that formulate wage policies and promulgate workplace rules.

Absent a specification of technology that allows for fundamental size-related differences among firms, it is not possible to construct models that adequately capture labor pricing in highly specialized economies. Critically missing are the substantial share of wages that rationally demonstrate downward nominal rigidity and chronically exceed market opportunity costs. (Chapters 2, 3)

Preference for fair treatment. Behavioral economists introduced the preference for perceived equity to most economists via the ultimatum game. Recall that there are two players and that the first is given a sum of money and a choice. He or she has to give some of the money to the second player, who then also has a choice. If the cash offer is accepted, both players keep the allocated money. If rejected, each gets nothing. The mainstream neoclassical subgame-perfect equilibrium of the ultimatum game dictates that the minimum be offered and accepted. Utility functions are motivated parsimoniously with the preference of more money to less.

Contrary to the textbook predictions, ultimatum-game experiments found a strong desire for fair treatment as well as a powerful urge to retaliate when denied that outcome. Those experiments established the modal offer to be an even division. Ultimatum-game experiments, and related research, should cause economists to rethink their off-the-cuff formulations of preferences, especially given the ubiquitous practical application of the game. A version of it, enriched by established workplace reference standards, incomplete information, and available gradations of retaliation, is played every day in large work establishments. In the workplace game, worker desire for fair treatment is strengthened by the near-zero expected costs associated with reciprocal reductions in cooperation if management fails to pay the established equitable wage. Market opportunity cost is the minimum offer, but neither employers nor employees believe that the market wage is an optimal solution to the real-life game.

Large-firm management, in the trial-and-error development of profit-seeking wage policies, long ago accepted the criticality of the perception of fairness. Experience with what worked in convincing employees to adopt the firm’s objectives as their own convinced management that wage equity was necessary. As a result, rational labor pricing in big, complex firms both became downward rigid over stationary business cycles and embody significant, time-varying worker rents. (Chapters 2, 3)

GEM Project. Generalized-exchange macroeconomics recognizes the employee preference for fair treatment, especially in a corporate hierarchy of authority, and the asymmetric information that is also characteristic of large, complex workplaces. Those axiomatic, evidence-consistent assumptions are much superior to the arbitrary assumptions of convenience used in mainstream coherent market-centric modeling. As a result, the GEM Project has produced the first macro theory, in the era of modern, highly specialized economies, to be both stabilization-relevant and coherent, fully reconciling the rational behavior of microeconomics and the aggregate-demand focus of Keynesian macroeconomics.

It is notable that GEM modeling is incremental. It draws heavily on the work of a prominent school of neoclassically-trained economists that includes Clark Kerr, John Dunlop, Lloyd Reynolds, Frederick Harbison, Charles Myers, and others, whose extensive workplace analysis occupied the mainstream of American labor economics in the middle 20th-century. Lucas fondly recalls that the inspiration for his reworking of Keynesian wage and employment equations was taking Mel Reder’s labor course at the University of Chicago. The most interesting point of that story is that a powerful literature and much evidence on large-firm wage policymaking, producing rational rigidities and rents that are inconsistent with market-equilibrium outcomes, were available to Lucas as he readied his rational-expectations revolution. His backward modeling, irrationally ignoring important evidence in the construction of assumptions upon which his “bunch of equations” rested, put modern macro research on a stabilization-irrelevant path for more a generation.

Blog Type: Wonkish Saint Joseph, Michigan


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