Last week’s blog considered, from the perspective of the GEM Project, Kartik Athreya’s (2013) four rules governing what makes a model acceptable to mainstream macroeconomists. This week’s installment illustrates the troubling choices those rules impose on modern theorists.
Robert Hall, a former colleague of mine at MIT, has taken on the difficult New Keynesian role of being one of the few consensus market-centric DSGE theorists still actively working on wage determination. He has had a tough row to hoe. Stabilization irrelevancy has long been the reward for adhering to the first, and primary, rule that wage modeling must be coherent. Hall’s struggles provide useful background to the GEM Project’s mission to gain broad acceptance for the generalization of rational exchange from the marketplace to the workplace.
The Project easily demonstrates that the market-centric DSGE model class cannot be simultaneously coherent and stabilization-relevant. (Chapter 1) Hall (2007, italics added) does not shy away from that troubling model-building conclusion in his restatement, just prior to the U.S. economy falling apart in the Great Recession, of Barro’s recontracting critique: “Sticky wages and prices are not a full explanation [for macro facts]… because they lack a deep rationalization. A sticky wage that keeps employment below a mutually desirable level creates an opportunity for a worker and an employer to make a Pareto improvement for themselves by adjusting employment upward – what matters here is the increase in employment. The same holds when a sticky price keeps the quantity of goods traded below its efficient level. The traditional sticky-price literature has not come to grips with the obvious tools that employers, workers, sellers, and customers possess to overcome inefficiently low employment or sales. The literature lacks a coherent theory of disequilibrium. Departures from equilibrium are an assertion, not a derived conclusion from fundamentals. Traditional sticky-wage and sticky-price theory has a strong descriptive claim but not a strong theoretical underpinning.”
Hall’s message remains true to the central tenet of the New Classical revolution that banished the Early Keynesians: Models lacking robust microfoundations must be rejected even if they robustly fit the evidence. For decades, the much debated choice between coherence and the evidence has been at the heart of the muddled state of modern macroeconomics. In my view, Hall’s deconstructionist argument is not easily dismissed if consensus theory is indeed constructed on rational behavior.
The table illustrates the “strong descriptive claim” of meaningful wage rigidity (MWR), which is a necessary condition of the suppression of wage recontracting and, therefore, involuntary job loss. The evidence powerfully indicates that forced job loss always plays the central role in rising unemployment during recessions. If you lack an explanation of involuntary job separation, you cannot hope to construct a stabilization-relevant macro model. That message was especially robust in the perilous 2007-09 extreme instability. Its six-million increase in involuntarily lost jobs account for more than three-quarters of the increase in total unemployment, pushing job-loss incidence up by 13 percentage points. Early on, Ohanian (2010) properly identified the exceptional size and incidence of job loss as the distinguishing characteristic, inadequately understood in mainstream modeling, of the Great Recession.
Experienced macroeconomists, of whom Hall is one of the best, know that meaningful wage rigidity enables intuitive aggregate modeling that closely corresponds to the available evidence and uniquely supports stabilization policymaking. Yet they also know that deriving a “strong theoretical underpinning” for such labor pricing has been the most elusive, unrewarding task in the history of macroeconomics. Forced to choose between MWR power and the compelling logic of coherent market-centric equilibrium, most modern theorists have ceased providing more than a black-box role for wages in their macro models, proactively marginalizing the role of involuntary job loss. The GEM Project has now come to the rescue, delivering New Keynesians from their Ptolemaic tradeoff. It demonstrates that the solution to the mainstream analytic dead-end is the generalization of exchange with its capacity to microfound meaningful wage rigidity and thereby reconcile coherence and stabilization-relevance. (Chapters 2 and 3) Bob Hall is invited to join the Project.
Blog Type: New KeynesiansChicago, IL