Counterfactual Development of Macro Theory

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The failure of modern macroeconomics is the outcome of a malfunctioning research strategy. It was decided decades ago that aggregate theory, to be eligible for mainstream dissemination, must be micro-coherent. That objective is admirable and in itself is not a problem. The damage instead resulted from the anti-Keynesian mainstream, cobbled together decades ago, requiring coherence in advance of solving the hard problem of microfounding nominal wage rigidity (capable of suppressing labor-price recontracting) and involuntary job loss. Physicists care too much about evidence to reject research on general relativity just because it contradicts quantum mechanics.

Economists rush to purity cost macro theory dearly. The modern microfounded version taught in graduate schools and dominating our most prestigious journals is not stabilization-relevance, badly out of step with broadly known facts. Don’t we all know that? Who doesn’t know, deep down, that market search theory, the modern incarnation of which is the go-to model of cyclical labor behavior, can only accommodate voluntary, not involuntary,  job separation? Who doesn’t know, deep down, that effective policy when confronting recessions must be organized around the management of nominal demand?

Consider two important facts. First, the Great Recession generated six-million involuntary job losers. Second, the ultimately successful containment of the Great Recession centrally resulted from the aggressive management of total spending by stabilization authorities, especially the Fed’s massive use of its balance sheet. Both facts are being written out of the mainstream description of the 2008-09 extreme instability. In the consensus narrative, unemployment is voluntary and demand management ignored. The Great Recession vividly demonstrates, as bitterly noted by many global stabilization authorities, the screwed-up state of modern macro theory.

This post argues that the embarrassing stabilization irrelevance, resulting from the impatient desire for micro-coherent macro modeling, was not carved in stone. It did not have to play out the way it did. Microfounding meaningful wage rigidity is not as show-stoppingly difficult as generally thought. Indeed, a powerful explanation of MWR that is consistent with both rational price-mediated exchange and the evidence existed in the labor-economics literature long before the anti-Keynesian revolution upended mainstream macro thinking. Building on last week, this post offers an alternative scenario for the timeline of formal macroeconomics. It is interesting because its happier outcome is not far-fetched. Indeed, it is surprising that it did not occur.

Counterfactual Development of Macroeconomics

As summarized last week, early internal-labor-market theorists (Clark Kerr, John Dunlop, and their colleagues) ambitiously modeled, guided by their neoclassical economic training, employee-employer behavior in large, specialized workplaces. Kerr et al. never derived a formal theory of the generalization of rational price-mediated exchange but did demonstrate that, in the intra-firm venue, optimizing decision rules, incentives, constraints, and mechanisms of exchange differ substantially from what governs behavior in the marketplace. Dunlop (1994, p.380) succinctly described the separate-venue modeling by the early ILM economists: “The objective changes in the economy – within sectors, in the emergence of large enterprises and workplaces, and in the ideas and arrangements developed to govern and manage these workplaces – made it quite obvious to a new generation of economists in the 1940s, who were exposed in practical terms to labor markets and labor-management-government issues, that conventional (external) labor-market theory was grossly inadequate. It neglected a vast range of activities within the walls of organizations as well as their forms of interaction with exterior markets.” Early ILM theorists’ research remains today central to proper macroeconomics.

Kerr’s (1950) foundational balkanization analysis that integrated workplace and market exchange appeared not long after Modigliani’s (1944) reorganization of Keynes’s aggregate-demand modeling around wage rigidity. By the early 1960s, when the Neoclassical Synthesis had been established as stabilization policymakers’ model of choice, the “Neoclassical Revisionist” (Kerr’s name) labor economists had assembled a powerful, albeit wholly descriptive, analysis of self-interested workplace exchange and rational labor-price insensitivity to labor-market conditions. It is surprising that, despite often being members of the same university economics departments, Kerr et al. failed to engage the Early Keynesians. Hicks (1955, 1974), Okun (1981), and Solow (1991) are notable exceptions.

The likely roadblock for almost all macro theorists was that the ILM workplace modeling was wholly literary, featuring much realistic detail. To the casual reader, the non-rigorous, hyper-descriptive approach indicated (incorrectly) that Kerr et al. were institutionalists, working outside the neoclassical framework. That greatly frustrated the ILM economists who knew they were working within neoclassical framework. Again from Dunlop (1988, p.80): “The work of the 1930-1960 period on labor markets and wage determination was in the mainstream of economics and an extension of still earlier mainstream work. It was not institutionalist.” But, despite that misunderstanding, the message of mid-century workplace analysis is accurate, powerful, and relevant. The disputatious course of macro theory could have been beneficially altered by more frequent faculty-club lunches, accompanied by serious conversation, between the Early Keynesians and the Neoclassical-Revisionist labor economists. Early on, the way to microfound MWR would have become clear; and mainstream macroeconomists would have avoided today’s unendurably-long credibility-damaging period of stabilization-irrelevance.

GEM Project

20th-century Keynesian theorists of all stripes failed to effectively tap the extensive early ILM literature and consequently never microfounded meaningful wage rigidity and involuntary job loss. Mainstream micro-coherent macroeconomics lost its way in the foolish Ptolemaic attempts to squeeze some counter-cyclical movement out of voluntary job quits and to beef up RBC non-monetary causes of recessions sufficiently for them to explain important evidence. Modern macro theory, nonintuitively confining rational exchange to the marketplace, was doomed to stabilization-irrelevance.

The GEM Project, guided by the work of the ILM theorists, generalizes rational price-mediated exchange from the marketplace to the bureaucratic workplace. It microfounds the suppression of wage contracting, the existence of chronic time-varying wage rents, the existence of involuntary job loss, and the centrality of aggregate nominal demand in the class of macro cyclicality that emerged in the aftermath of the Second Industrial Revolution. GEM moding is both micro-coherent and stabilization-relevant, an outcome that should not be ignored.

Blog Type: Policy/Topical Saint Joseph, Michigan

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