Edmund Phelps

Following last week’s post on Don Patinkin, the GEM Blog next acknowledges the Project’s debt to Edmund Phelps and his extraordinary body of work. He was fearless in his determination to introduce into macroeconomics labor pricing that is both micro-coherent and stabilization-relevant in modern economies. Phelps was tough-minded enough to reject the long-dominant mainstream strategy (largely rooted in some ill-considered simplistic assumption, frequently dressed up as Nash bargaining) of ignoring the nature of wage rigidity and how it does in fact rationally suppress wage recontracting.

Lured by that creative tough-mindedness, I have read almost everything that Edmund Phelps has written. His macroeconomics is a grand, cheerful quest for answers to really important questions. A decade ago, Phelps (2009, p.109) described his initial (undergraduate) contact with the study of economics: “I kept failing to understand the relationship of microeconomics to macroeconomics. I like to joke that I went to graduate school to get to the bottom of this relationship. However, after four or five years of graduate school, I realized that I still didn’t have the answer, and so I decided: very well, I’m going to have to try to solve this problem myself.” It was easy to root for Phelps in his pursuit of his ambitious goal. The familiarity of his ultimate lack of success makes his story especially disappointing. He never grasped that arbitrarily restricting his model-building to marketplace exchange necessarily implies that micro-macro coherence, however modeled, cannot be stabilization-relevant in highly specialized economies.

Throughout, Phelps’s career benefited from unusually good instincts about where interesting models are hiding. He always understood that constructing a coherent, stabilization-relevant macroeconomics requires scraping Keynes’s Second Classical Postulate. Phelps’s island parable, where arbitrarily geographic isolation of auction labor markets in his archipelago economy complicated the equilibration of marginal disutility of work and the market wage, was a forerunner of the Project’s powerful generalization of price-mediated optimizing exchange from the marketplace to information-constrained workplaces.

Despite an instinctual interest in what goes on in the workplace, he unfortunately never broke out of the familiar mainstream box of marketplace exchange. During the 30-year macro war, the power of wage recontracting and Phelps’s comfort with the familiar shirking branch of efficiency-wage theory apparently motivated his debilitating gamble, apparently suggested by Salop, that reconciling stabilization-relevancy and micro-macro coherence requires a nonmonetary theory of employment fluctuations. The break with Keynes and the Early Keynesians over the importance of total demand disturbances doomed Structural Slumps (1994), his attempt at an equilibrium theory of involuntary unemployment, to a short shelf life. Rereading Slumps, I am struck by how close Phelps was to his Holy Grail of capturing the relationship of microeconomics to macroeconomics in highly specialized economies. Simply substitute the morale-centric branch of efficiency-wage theory (readily available to Phelps in Solow 1976, 1990 and Annable, 1977, 1980) for his focus on the shirking branch, and his development of coherent macroeconomics would have followed a much more productive path. (For elaboration, see “At Last, a Modern Theory of Wages” in the Research-Exchange Section of this Website.) In retrospect, the Solow-Annable variant is the obvious choice for introducing modern labor pricing into rigorous macro thinking. Only it among the several branches of efficiency-wage theory can motivate the meaningful wage rigidity capable of rationally suppressing wage recontracting and microfound the channel through which nominal disturbances uniquely induce involuntary job loss and recognizably-sized recessions and depressions.

Blog Type: New Keynesians San Miguel de Allende, Mexico