The term I came up with is “conundrum macroeconomics”. The heretofore nameless phenomenon refers to analysis with models that lack the capacity to accommodate, at least coherently, the existence of the activity being studied. The urge to name that curious practice became acute with the juxtaposition of the macro thinking that dominates modern graduate-school curriculums and the devastating 2008-09 episode of extreme macro instability. The Great Recession is understood to have been the most perilous edge-of-depression market breakdown since the 1930s.
A deeply troubling conundrum of the friction-augmented general-market-equilibrium (FGME) model class, aka dynamic stochastic general equilibrium (DSGE), is its inability to accommodate the six million involuntarily lost jobs that occurred during the 2008-09 crisis. Barro formulated his famous critique of arbitrarily suppressing wage recontracting lest we forget Lucas’s message that the nonexistence of forced job loss is a requirement of market-centric general equilibrium. After huge New Keynesian investment of time and resources, mainstream theorists have discovered no market super friction able to overturn the rational decision rule requiring an employee to choose a wage cut, rather than job loss, if the reduced wage does not violate his or her opportunity costs. Consensus theory becomes a conundrum exercise whenever tasked to explain contraction phases of business cycles, which always feature involuntary job loss and consequent unemployment.
Conundrum macroeconomics is best understood as the result of the century-long conflict between two model-building methodologies. One side has usefully emphasized analytic rigor, coherently modeling aggregate behavior guided by optimizing market exchange organized around general equilibrium. The other has stressed, also usefully, stabilization relevancy, accepting irrational wage rigidities in order to link spending disturbances to job- and output-instability and thereby justifying discretionary management of nominal demand. The arguments of each side are largely valid, a tricky situation that motivated a prolonged macro civil war that produced the mainstream rejection of Early Keynesianism. If the two approaches now internalized in New Keynesian theory remain unreconciled, the pendulum of theoretic dominance will continue to swing between the opposing camps. The promise of macroeconomics will remain unfulfilled.
The truncated scope of rational exchange has, for some time, been poisoning the macro well. Beyond the failure to come close to adequately explicating the 2007-09 (or any other) recession, it is alarming that obvious shortcomings of modern macro thinking have been generating deep dissatisfaction among the coming generations of economists. The bleak message of David Colander’s (2005, p.180) survey of and interviews with graduate students at seven top-ranked North American economics programs is that potential customers simply reject the product: “In the interviews, macro received highly negative marks across schools. A typical comment was the following: ‘The general perspective of the micro students is that the macro courses are pretty worthless, and we do not see why we have to do it, because we don’t see what is taught as a plausible description of the economy. It’s not that macroeconomic questions are inherently uninteresting; it is just that the models presented in the courses are not up to the job of explaining what is happening. There’s just a lot of math, and we can’t see the purpose of it.’” Another student was more succinct: “Macro sucks.” (Colander (2007), p.174) Nothing has changed from that assessment, supporting a central message of the GEM Project. The costs of counterfactually restricting macro theory to a single (market) venue of exchange are profound and broadly debilitating.
It is good news that the GEM macroeconomics effectively deals with the longstanding conundrum. Most fundamentally, it demonstrates that there is no inherent conflict between the analytic rigor of rational exchange organized by dynamic general decision-rule equilibrium and the stabilization relevancy provided by meaningful wage rigidities. Reconciliation is made possible by the generalization of optimizing exchange from the marketplace to workplaces restricted by costly, asymmetric employer-employee information and routinized jobs. Arbitrarily restricting price-mediated transactions to the marketplace turns out to be the principal reason why, since the Second Industrial Revolution, rational-behavior macro models have not been up to the task of elucidating recurring, costly instability in highly specialized economies.
By contrast, the two-venue theory easily explains involuntary job loss and easily complies with Michael Woodford’s (2009, p.269) gatekeeping rule governing consensus macro model-building: “… it is now widely agreed that macroeconomic analysis should employ models with coherent intertemporal general equilibrium foundations. These make it possible to analyze both short-run fluctuations and long-run growth within a single consistent framework.”
Blog Type: New Keynesians Saint Joseph, Michigan