Bob Hall’s Brookings Papers article, “How Much Do We Understand about the Modern Recession” (2:2007) is must read for all macroeconomists. The recommendation is not because readers will learn much about the nature modern recessions. They won’t. His description of instability that occurs in highly specialized economies, including the 2007-09 Great Recession, is way off-base. Nor will readers learn how to tame recessions. Almost all of his conclusions about effective policy design are easily discredited.
It is the paper’s honesty about its inherent shortcomings, especially its choice to shrink from tough problems, that makes it must reading. It powerfully demonstrates why mainstream macro theory is not ready for prime-time. Hall’s article makes clear why modern consensus thinking should never be used to guide policymakers and should be kept away from students and non-economists looking to be informed about the periodic instability of highly specialized economies.
Rejecting Early Keynesianism
Hall’s analysis is forced off the rails by his mainstream rejection of the core of Early Keynesian macro modeling. Keynes identified the most damaging element of textbook neoclassical theory, naming it the Second Classical Postulate. Breaking that beautiful W=VMP=VMRS model-building stranglehold imposed by the estimable 19th century marginalists was a central EK research goal. But microfounding W=VMP>VMRS turned out to be really difficult. After decades of frustration, a new generation of macro theorists rejected the fundamental ad hocery of the then-mainstream EK modeling that assumed, rather than derived, meaningful wage rigidity.
In the 1990’s, prominent macroeconomists, tiring of the prolonged war between the New Classical and New Keynesian theorists, joined up. They agreed to abide by the New Neoclassical Synthesis that restricted research and gate-keeping dissemination of scholarly work to fully micro-coherent general-market-equilibrium modeling. The implications of the new consensus were profound. Most critically the EK strategy of sacrificing micro-coherence for stabilization relevance was scrapped. Samuelson’s organizing Neoclassical Synthesis assumed, but did not rationally motivate, two interrelated phenomena needed to explain cyclical evidence: meaningful wage rigidity (capable of suppressing wage recontracting) and the involuntary job loss resulting from adverse nominal demand disturbances. Samuelson and everybody else thought the use of crucial free parameters would be temporary. New research would relatively quickly figure out how to microfound MWR. It is forgotten today that the Early Keynesians had, during the early postwar period, remarkable success guiding effective stabilization policy. Arthur Okun (1981, p.4) correctly described the patched-together Neoclassical Synthesis as a “workable set of macroeconomic tools that gave the right answers to the big questions of practical relevance.”
The New Neoclassical Synthesis pursued the opposite strategy. Insist that macro models be fully microfounded and rely on new research to identify rational market imperfections robust enough to suppress wage recontracting. Decades later, it is clear that the NNS strategy has failed. Prominent scholars have been slow to recognize that the hoped-for rational market imperfection capable of suppressing wage recontracting (and thereby microfounding the causality from nominal demand disturbances to involuntary job loss and, more generally, to recognizably-sized same-direction movement in employment, output, income, and pure profit) is a will-o’-the-wisp. The mainstream NNS consensus never anchored stabilization-policy design in the management of nominal demand. Absent meaningful nominal wage rigidity, mainstream theorists have focused on, and became comfortable with, two badly misleading conveniences: wholly voluntary job separation/ unemployment produced by their go-to search/match modeling of labor behavior and the non-monetary propagation of real shocks in recession. Those Ptolemaic short-cuts pushed the most important instability evidence beyond the reach of mainstream modeling.
It is incomprehensible that mainstream theorists no longer concern themselves with involuntary job loss. Yet, for all practical purposes, it no longer exists in the broadly disseminated macro literature. Prominent macroeconomists increasingly and unforgivably attempt to pass off their foolish analysis, the principal goals of which are to induce job quits to dance a bit in a pro-cyclical direction and to bury out of sight the implausible assumptions used to ape the actual size and persistence of recessions, as stabilization-policy relevant.
Hall’s Open Kimono
Mainstream theorists understand that their micro-coherent, general-market-equilibrium theory accommodate neither nominal wage rigidity capable of rationally suppressing wage recontracting nor causality from demand disturbances to involuntary job loss. Absent microfoundations, those Keynesian concepts cannot pass muster in modern analysis. It is deeply embarrassing that most prominent theorists now simply ignore MWR, forced job loss, and aggregate-demand causality, hoping that nobody would notice that their models set aside the most important characteristics of macro instability. Micro-coherent, market-centric DSGE models purporting to explain actual cyclicality have a lot to hide, and most mainstream scholars keep their kimonos tightly belted.
Not Bob Hall, perhaps the most honest mainstream macro theorist active today. In the Brookings paper (2007, italics added), he illustrates the tension between mainstream macro methodology and stabilization-relevance in a restatement 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.” Models lacking micro-coherence must be rejected even if they uniquely fit the evidence. Microfounded models must be used even if they are stabilization-irrelevant and provide damaging policymaking advice.
Two points close this essay. First, mainstream theorists are choosing micro-coherence over stabilization relevance. Theorists must be given latitude, so I guess I should stop criticizing that choice. What I will not stop criticizing, however, is peddling the results of that misleading research to policymakers. Second, the GEM Project has generalized rational exchange from the marketplace to the bureaucratic workplace, reconstructing macroeconomics to be simultaneously micro-coherent and stabilization-relevant. Once macro gatekeepers accept that intuitive, practitioner-recognized generalization, macro theorists of all stripes will no longer embarrass themselves by choosing micro-coherence over stabilization-relevance.
Blog Type: New Keynesians Chicago, Illinois