This post carries on last week’s look at NK theorists who argue that meaningful wage rigidity is not a necessary condition of coherent, stabilization-relevant macroeconomics. It has two parts. The first directly responds to the seminal article (Greenwald and Stiglitz, 1993) that makes the anti-MWR case. The second considers, and rejects, Keynes’s famous MWR dismissal.
Quoting Greenwald and Stiglitz
First quote. “Different strands of research within new Keynesian economics have taken two broadly different approaches. The first argues that nominal price rigidities are the essential way in which market economies differ from the Walrasian Arrow-Debreu model. Without such rigidities, the argument goes, flexible prices would allow the economy to adjust quickly to whatever shocks it experiences, maintaining all the while full employment and economic efficiency.”
Generalized-exchange modeling (GEM) coherently features, in the large-establishment venue (LEV), downward nominal wage rigidity over stationary business cycles and chronic, time-varying wage rents. It explains crucial evidence, including forced job loss and involuntary unemployment, than coherent market-centric analysis must ignore. The GEM Project does not assert that, absent MWR, “flexible prices would allow the economy to adjust quickly to whatever shocks it experiences, maintaining all the while full employment and economic efficiency”. It instead usefully works through the implications of the most powerful price rigidity produced in highly specialized economies.
Second quote. “… nominal price rigidity theories describe how the economy will recover from a recession as wages and prices eventually fall enough that consumption recovers, or as capital goods wear out to the point where gross investment is required to replace even the small amount of capital required for the low level of output. However, neither the sources of the shocks, nor the mechanisms by which falling prices and wages would restore the economy to equilibrium, have received extensive attention; implicitly, in most of the models, it appears as a hidden real balance effect.”
The GEM model class identifies contracting nominal demand, which MWR uniquely translates into the involuntary job loss that is the engine of rising unemployment in recession, to be most consequential macro disturbance. It follows that the reliable stabilization mechanism that restores full employment in the entire range of cyclical downturns is increasing nominal demand. Don’t we all, at least deep down, know that? Real-balance effects play their familiar trivial role.
Third quote. “Good macro-theories should do more. A host of other facts clamor to be explained; for instance, good macro-theories must explain why variations in the number of hours worked should take the form of layoffs rather than work-sharing; why layoffs tend to be concentrated among certain parts of the labor force; why investment in general, and inventories and construction in particular, should be so volatile; and more. Beyond that, the micro-foundations from which the aggregate behavior is derived can often be tested directly. A rejection of the underlying micro-hypotheses should suffice to cast doubt on the validity of the derived macro-theory.”
That wish list of what macro theories should explain allows generalized-exchange macro theory, uniquely microfounding MWR, to tower above the market-centric modeling favored by G&S. Absent MWR, forced layoffs cannot exist in coherent modeling. The introduction of large bureaucratic corporations in the GEM Project goes a long way toward explaining layoff concentrations, which in G&S remain a mystery. The GEM model also easily identifies the most volatile sectors of spending and production.
Fourth quote. “Incorporating the newer micro-foundations is the principal task ahead of new Keynesians. The challenge is to choose between the myriad of ways in which markets can be imperfect, and to decide on the central questions and puzzles to be explained.”
The real challenge in constructing coherent, stabilization-relevant macroeconomics is breaking away from arbitrarily restricting price-mediated exchange to the marketplace. The G&S conclusion indicates that crucial, non-intuitive markets-only assumption is nowhere on their radar, repeating the ubiquitous fundamental mistake of mainstream macroeconomists.
Rejecting Keynes’s Rejection
The GEM model class pushes forward at least two counter-arguments to the assertion of Keynes that nominal wage rigidity may, in fact, significantly mitigate the real effects of recession by supporting total consumption spending. First, purchasing capacity gained from avoiding wage cuts is more or less offset by the decreased spending power resulting from job loss. The size of the net effect is an empirical question. More significant, Early-Keynesian macrodynamics, rooted in nominal wage rigidity, does not require the weakened nominal demand in recession to be motivated by consumption. (At least in garden-variety recessions, household spending is understood to be relatively stable.) Faltering demand is rooted in sharply contracting investment outlays, motivated by existing unused capacity and expectations of shrinking profits. Inherently volatile investment and animal spirits are, of course, critical features of the General Theory.
Second, MWR is needed to suppress rational wage contracting, making it a necessary condition for the coherent existence of involuntary job loss and its attendant involuntary unemployment that result from adverse demand disturbances. Otherwise, rational employees must, in lieu of losing their jobs, accept any wage cut that does not violate their opportunity costs. Wage recontracting is a central pillar of market-centric neoclassical theory and its suppression turns out to critically support Keynes’s rejection of his Second Classical Postulate as well as his assertion of the centrality of discretionary demand management.
John McDonald (“Keynesian Theory and Policy”, SSRN, 2009) provides an insightful assessment of Keynes’ feelings on wage rigidity: “Keynes opposed a policy of wage cuts to restore full employment because they had not been effective and because they were painful.” The GEM Project microfounds that conclusion as well as the two-fold central message of The General Theory: the reversal of classical macro causation, i.e., nominal demand disturbances induce same-direction changes in employment and output, and the absence of effective market mechanisms that assure total spending, especially given the inherent volatility of investor confidence, will yield full employment.
Blog Type: New Keynesian San Miguel de Allende, Mexico