Classical versus Keynesian Business Cycles

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Evolving macro instability. The Second Industrial Revolution is a fundamental, almost always ignored, dividing line in the on-going evolution of macro instability. Occurring initially in the United States, Great Britain, and Germany and eventually spreading globally, SIR is typically dated from the second half of the 19th century and centrally features the advent of large bureaucratic corporations with workplaces restricted by costly, asymmetric employer-employee information and routinized jobs.

The GEM Project has easily shown that, for the SIR class of enterprises, rational wages cannot be determined by the labor market. Labor pricing had to be moved inside the firm where the process becomes subject to objective functions, incentives, and constraints that differ from those found in the marketplace. The Project powerfully demonstrates that labor-management optimization in the workplace venue produces downward nominal wage inflexibility and chronic labor rents, microfounding causality from nominal demand disturbances to involuntary job loss, employment, output, and profit. The proper nature of stabilization policymaking has fundamentally changed from the pre-SIR period modeled by classical economists and is today largely organized around the management of total spending. Generalized-exchange modeling has become a necessary condition for macroeconomics that is both micro-coherent and stabilization-relevant.

Prior to the huge shift in production landscapes toward large, bureaucratic firms, financial panics and macro instability were rooted in the interaction of near mechanical procyclical liquidity dynamics and broad swings in confidence of investors and lenders that resulted in periodic episodes of bankruptcy and enterprise failures that generated involuntary job loss and underutilized physical capital. What follows looks at Classical macro instability, contrasting it with modern cyclicality rooted in meaningful wage rigidity.

Classical business cycles. The best description of classical macro instability is rooted in the work of Mises, Hayek, and other Austrian-school theorists. The Mises-Hayek market-centric macro theory was organized around an “upper turning point” in the credit cycle. They sought to elucidate why credit booms turn into busts, a period of contraction of employment and output in which wages and prices are reduced and resources reallocated. In particular, many enterprises that heavily committed to investments that proved nonviable go bankrupt and shut down, firing their workers and idling machines. The job loss is involuntary, generating an increase in unemployment and unused capacity until the idled resources are absorbed, at lower costs, elsewhere. Rational price discovery requires some period of job search for the newly unemployed workers, generating some persistence in cyclical joblessness. The length and depth of classical recessions depends on how quickly wages and prices are adjusted and resources reallocated.

Hayek and other Austrian theorists pushed the credit-cycle explanation of macro instability well past the Second Industrial Revolution, the emerging dominance of large, bureaucratic firms, and the spread of rational meaningful wage rigidity. The now chronic inability of labor prices to adjust thwarted classical  market adjustments and, in the absence of effective policies to jump start aggregate demand, high unemployment persisted beyond the time plausibly needed for price discovery.

By the 1930s, criticism of Austrian business-cycle theory was, unsurprisingly, increasingly insistent as the Great Depression dragged on. (Hayek published his credit-cycle model in 1932.) It became widely understood that a cyclical lengthening and shortening of the structure of production, an idea rooted in Böhm-Bawerk’s capital theory, cannot possibly account for the size and nature of employment/production variation in garden-variety recessions, let alone depressions. However, a lesser ambition of the Austrian School, i.e., describing the role of unfulfilled expectations with respect to investment projects toward the end of credit expansions, is more plausible and helps elucidate some recurring characteristics of modern macro instability. While the evidence indicates that Keynesian modeling of investment expectations more powerfully motivates cyclical behavior, there is no reason why the Keynesian and Austrian macrodynamics cannot work in concert.

The more fundamental problem is that, given their shared market-centric analytical framework, Austrian and Keynesian models, even if combined, remain badly incomplete. Along with Keynes, Mises and Hayek had little that was both relevant and coherent to contribute on the speed or nature of labor-price adjustments in a contracting economy. A half-century after “new corporate forms” were necessitated by the Second Industrial Revolution, Austrian theorists still did not recognize that deflation could no longer force a timely restoration of competitive wages and that the misguided attempt to do so would hugely damage economic welfare. As a result, they were unable to answer important stabilization-relevant questions, including why unemployment persists above its natural rate or, more generally, why adverse nominal disturbances induce involuntary job loss.

Hayek (1975, p.5) later apologized for his Depression-era stabilization advice, especially his opposition to monetary expansion to counter deflation, which he claimed resulted from naïveté about the nature of labor pricing in increasingly specialized economies: “At that time [early 1930s] I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed.”

Instructive episode. Generalized-exchange modeling encourages the reconsideration of an unhappy episode in the development of mainstream macroeconomics. The period in question featured the insightful modeling, and relatively quick crushing, of the Clower/Patinkin inspired fixed-wage general-equilibrium (FWGE) school. Once embedded in the GEM framework, the disparaged and discarded non-Walrasian equilibrium with rationing (also associated with young Barro, young Grossman, Malinvaud, Bénassy, Drèze, and other highly accomplished Keynesians) is transformed into the micro-coherent, stabilization-relevant macrodynamic equilibrium sought by Keynes, Hicks, Modigliani, Samuelson, Hayek, Robinson, Meade, Friedman, Solow, Tobin, Klein, Phelps, Lucas, Prescott, Akerlof, Stiglitz, Krugman, and almost everybody else. It turns out that Paul Krugman is right. Stabilization-useful microfoundations are not feasible in the micro-coherent market-centric analytical framework. (Krugman, however, is wrong about the need to abandon rational microfoundations.) The profoundly important, hugely underappreciated problems that result from arbitrarily restricting rational exchange to the marketplace have prevented significant progress on high theory since the Second Industrial Revolution.

The macro story, increasingly Ptolemaic over the last three-plus decades, features mistakes piled on mistakes. By now, it is surely evident that the banishment of Keynes and the Early Keynesians from serious study in our most respected graduate programs has been a profound blunder – an egregious overplaying of the RBC/New Classical victory in the macro methodology war. Can there be serious doubt that the mainstream disrespect of the great theorists who founded macroeconomics as a separate branch of economic theory has severely damaged modern thinking.

Blog Type: Wonkish San Miguel de Allende, Mexico

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