Epistemic Funnel: Criticality of Rational Behavior

Last week’s post promised embellishment on the inclusion of rational behavior in the short list of crucial characteristics of stabilization-relevant macroeconomics. The GEM Project contends that inattention to rational behavior has greatly damaged mainstream New Keynesian (NK) modeling. Can a research priority really be so consequential? While this Blog has variously touched on that question, what follows provides a more fulsome answer using, given the limited space, the single example of meaningful wage rigidity (MWR), defined as the rational capacity to suppress labor-price recontracting.

Early and New Keynesians both purport to explain periodic instability in highly specialized economies. Both model classes are constructed within the venerable friction-augmented general-market-equilibrium (FGME) framework. Each resorts to irrational assumptions of nominal wage rigidity to explain critical business-cycle evidence such as forced layoffs. One outcome of that shared practice is particularly problematic. The absence of rational-behavior, evidence-consistent labor pricing has deprived theorists of crucial guidance in their attempts to usefully model cyclical, and to a lesser extent trend, aggregate behavior. Adequate macro analysis became more complex with the advent of large bureaucratic firms in the Second Industrial Revolution. New corporate forms enabled jumps in labor specialization and productivity that resist being effectively incorporated into general-market-equilibrium modeling.

Inadequate market-centric roadmaps, especially with respect to optimizing exchange occurring inside highly specialized establishments, made macro model-builders vulnerable to debilitating wrong turns. In an obvious example, microfounded MWR would have easily steered theorists clear of the costly wrong turn that resulted in the widespread, futile attempt to use labor search/match theory to explain forced layoffs in the aftermath of adverse demand disturbances.

The crucial EK-NK difference is methodological. The former emphasized that their Neoclassical Synthesis is unfinished macroeconomics, putting microfounding MWR at the top of their research priorities. NK theorists, by contrast, see their New Neoclassical Synthesis and its attendant friction-augmented dynamic stochastic general-market-equilibrium modeling as fundamentally finished theory. No core research remains to be done; none would be useful. The presumption of settled theory has effectively erased MWR microfoundations from the academy’s research agenda.

The erasure is a big mistake. The following annotated list provides substance to that claim. The inventory, limited to ten examples, can be understood my best shot at convincing the macro academy that the careful exploration of alternatives to market-centricity is a worthwhile endeavor.

• Meaningful wage rigidity itself leads off. A central Keynesian problem has long been that wage recontracting cannot be rationally suppressed in market-centric general equilibrium. The necessary super friction does not exist. Rejecting market-centricity, generalized-exchange theory has been able to derive MWR consistent with optimizing employer-employee behavior organized by continuous general decision-rule equilibrium.
• Absent the suppression of wage recontracting, the DSGME model class cannot accommodate involuntary job loss and, as a result, can only produce the mildest of recessions. That failure spurred NK interest in great moderations. It is unsurprising that mainstream macro modeling was ignored by grumpy stabilization authorities in 2008-09.
• Chronic wage rents, a powerful characteristic of microfounded MWR in information-challenged workplaces, problematically coexist with market-centric general equilibrium. Their absence has harmed efforts to explain a great deal of important evidence. Wage rents are, for example, necessary to adequately understand unemployment persistence in recessions and recoveries as well as the high incidence of laid-off workers being recalled.
• Microfounded MWR demonstrates that, in highly specialized economies, textbook Wicksell-Wicksteed factor-income distribution is a special case unsuited for general use. The rejection happily opens the door to the consequential existence of pure profit. Practitioners are not surprised by evidence that investment spending is largely motivated by the expectation of pure profit. Assigning the primary role instead to interest rates reflects a recklessly misleading wrong turn by NK theorists. It is even more misleading to pretend that interest rates are the primary driver of consumption. The GEM Project uses microfounded MWR to identify the dominant rational-behavior determinant to be household income, reviving the Barro-Grossman (1971, 1976) FWGE analysis.
• The GEM Project also demonstrates that Lucas’s rational-expectations Phillips curve is constructed on irrational employer behavior. Given his famous equation’s failure to explain actual wage behavior, many economists probably already harbored doubts about its usefulness. In a more reliable replacement innovation, inflation catch-up in periodic wage adjustments – a practice that aligns with actual behavior – has been microfounded in generalized-exchange modeling. Macro theorists can now join practitioners in ignoring problematic inflation forecasts in labor-pricing.
• In the GEM Project, microfounded MWR helps establish the policymaking need to separate nominal-demand disturbances into their stationary and nonstationary components. The latter motivates the Project’s continuous general-decision-rule-equilibrium modeling of the Great Recession. (For elaboration, see Annable and Schechter (2015).) Market-centric general equilibrium is inherently unable to model the extreme instability that characterized 2008-09.
• Absent close analysis of information-challenged workplace exchange, economic theory cannot accommodate the self-evident existence of profit-seeking labor practices in highly specialized, bureaucratic firms, thereby ignoring how substantial share of the labor force is supervised and perpetuating the gulf between economics departments and business schools. Market-centric general equilibrium can never effectively accommodate human-resource departments, always present in large bureaucratic firms, that govern labor-management relations, including pay. That fact goes hand-in-hand with the long-established message of neoclassical theory that, in the circumstances of workplace-information asymmetry, wages cannot be efficiently determined in the labor market. That message must not be, but almost always is, ignored. Looked at another way, mainstream market-centric thinking can never accommodate Herbert Simon’s Nobel-Prize winning, extraordinarily important organization theory. Isn’t too much information and analysis on how highly specialized economies behave being pushed aside as inconvenient?
• Along the same lines, rational market-centric theory can never adequately accommodate evidence-consistent labor-union modeling. Generalized-exchange theory can and does.
• Market-centric general equilibrium theory cannot integrate the powerful, also Nobel-prize-winning, Lewis two-sector growth theory, which is recognized by specialists as our best explanation of the transition out of subsistence, into mainstream macro thinking. For the generalized-exchange theory, such integration is a piece of cake. Wouldn’t it be a good thing to teach Sir Arthur’s important growth model to macro students?
• Microfounded MWR is central to the rigorous, evidence-consistent analysis of the second greatest instability crisis of the 20^th century, the stagflation decade that began in the early 1970s. My Price of Industrial Labor (1984), anticipating the subsequent work of the GEM Project, carefully explains that episode’s crucial price-wage-price spiral and provides an atypically accurate description of stagflation’s persisting market failure. NK theorists are unaware that stagflation is powerfully linked to the 1980s “rust-belt” downsizing crisis.

The incomplete list albeit provides a compelling account of wrong turns, given the absence of model-building guidance from microfounded MWR, made by NK theorists. It further aids the argument that generalizing rational exchange from the marketplace to information-challenged workplaces is intuitive and supported by the observable organization of modern, highly specialized economies around complex bureaucratic firms. Moreover, the hard work is already done. The GEM Project has carefully modeled, consistent with optimization and equilibrium, employer-employee behavior in workplaces restricted by costly, asymmetric information, microfounding MWR and rationally suppressing wage recontracting. Early Keynesians, at least, would be pleased.

MWR became uniquely powerful in macro theory in the aftermath of the Second Industrial Revolution and the emerging ubiquity of large, highly specialized firms. Has MWR lost explanatory power in subsequent technological (information and AI) revolutions? The GEM Project’s general rule is that MWR is relevant in any workplace restricted by costly, asymmetric employer-employee information that compromises direct OJB supervision.

Blog Type: New Keynesians Saint Joseph, Michigan