Disheartened by Blanchard, Part II

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Olivier Blanchard is an admired economic theorist and gatekeeper, helping to guide New Keynesian (NK) thinking to mainstream status in macroeconomic research and dissemination. How then do we make sense out of his role in the costly NK failure to construct aggregate theory that is simultaneously micro-coherent and stabilization-relevant? What is his role in the NK failure to provide models that were useful to hard-pressed policymakers during the 2007-09 Great Recession?

My thesis is that frustration with the difficulty of microfounding meaningful wage rigidity, which is definitionally capable of rationally suppressing labor-price recontracting, caused exhaustion and a consequent shift in focus away from the centrality of MWR research. Even worse, Blanchard’s altered emphasis appears also to have spilled over into his gatekeeping responsibilities, especially at the AEJ:M. My take on Blanchard’s psyche, of course, is speculation. But, whatever the reason, it is a fact that leading NK gatekeepers have turned sharply away from research on the rational suppression of wage recontracting. The GEM Project has rigorously demonstrated what most Keynesians already knew. The mainstream choice to push aside MWR has doomed micro-coherent macro theory to stabilization-irrelevance. The most significant macro evidence must be collectively, and embarrassingly, ignored.

Perhaps most interesting about Blanchard is that suppression of MWR centrality is a relatively recent development. Writing ten years ago, he carefully identified three significant strands of research in labor pricing and use: search/match activities in the competitive labor market, collective bargaining, and efficiency wages. He observed that, over the previous three decades, theorist attention had been concentrated on the search/match approach; collective bargaining and efficiency wages have remained dormant. From Blanchard (2007, p.414): “… [the search/match] line of modeling will not be able to do the job by itself, and the two other lines…, namely collective bargaining and efficiency wages, are very relevant. First, collective bargaining remains, at least in continental Europe, essential to wage determination and, I believe, essential to an understanding of differences in unemployment evolutions across European countries. Second, the formalization of bargaining in the standard DMP model through Nash bargaining, while elegant and powerful, is a very poor description of reality. As a number of researchers have pointed out, real wages appear to move much less than is implied by Nash bargaining. Constraints coming from intrafirm efficiency-wage considerations look like plausible candidates to explain these wage rigidities.”

The nearly exclusive, huge investment by NK theorists in the search/match approach to modeling wages and unemployment is hardly surprising, despite broad recognition that it is a fatally deficient explanation of what actually happens in the pricing and use of labor in highly specialized economies.  Mainstream action in the DMP model class occurs in the marketplace and is, therefore, aligned with powerful NK model-building preferences. Meanwhile, progress on both (original) efficiency-wage and collective-bargaining theories has long been stalled by the absence of an optimizing, price-focused model of workplace exchange organized around continuous general decision-rule equilibrium, a nonmarket exercise that lies outside theorists’ comfort zone. (For a close review of the efficiency-wage literature, see Chapter 9.) Direct, formal modeling of workplace behavior, rooted in axiomatic restrictions on preferences and technology, is a necessary condition for constructing policy-useful theories of labor pricing and use in both nonunion and union circumstances.

It is relevant here that the generalization of rational exchange provides a powerful port of entry to formal economic theory for unions, resulting in a much more insightful description of labor-rent behavior in the circumstances of collective bargaining than does the empty-box, albeit still ubiquitous, Nash framework. (See Chapter 7.) Better results should not be surprising. Unions are fundamentally about the explicit organization of workplace behavior, providing decision rules, mechanisms of exchange, and constraints that are distinct from the marketplace. Absent the platform provided by a well-motivated theory of such intra-firm behavior, mainstream union models are doomed to market-centricity and must feature naïve objective functions and downright goofy activity sets. Mainstream macro descriptions of unions are unrecognizable to practitioners and produce explanations and predictions that public and private policymakers are smart enough to ignore.

Blanchard’s fundamental mistake was turning his back on efficiency-wage theory. The problem is illustrated by his most recent effort at microfounded, stabilization-relevant wage theory. Appearing in 2010 and co-authored with Jordi Galí, the model is a precipitous shift away from plausible labor pricing. As described by Galí (2011, p.497): “… the wage does not ‘automatically’ adjust to guarantee that all the labor supplied is employed. Instead, the wage is bargained bilaterally between individual workers and firms to split the surplus generated by existing employment relations. Employment is then the result of the aggregation of firms’ hiring decisions, given the wage protocol.” Their model is a typical NK effort that simply sidesteps wage recontracting and, as a result, cannot accommodate involuntary job loss and recognizably-sized business cycles. Substantial idiosyncratic human capital is posited, even for routinized jobs; readers must pretend along with the authors that the near universal large-firm posting wages for routinized-job vacancies does not exist. (The tacit agreement among NK gatekeepers to ignore obvious, devastating facts is the glue that holds today’s macro mainstream together.) The final conundrum from the Blanchard-Galí paper is that their nominal wages are downward flexible, enabling labor-price recontracting. Wow. A tough conclusion is unavoidable. “Labor Markets and Monetary Policy: A New Keynesian Model with Unemployment”  has nothing useful to say about stabilization-relevant unemployment or practical monetary policy. It makes no discernible positive contribution to macroeconomics that aspires to simultaneous micro-coherence and stabilization-relevance.

Blog Type: Wonkish San Miguel de Allende, Mexico


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