Generalizing rational price-mediated exchange from the marketplace to workplaces restricted by costly, asymmetric employer-employee information and routinized jobs is an intuitive exercise that is essential if macroeconomics is to be simultaneously micro-coherent and stabilization-relevant. The GEM Project’s reconstruction of aggregate modeling has enhanced both the supply- and demand-sides of macro thinking, contributions that are particularly relevant to the proper design of stabilization policy.
The supply-side innovation is most familiar to readers of this Blog. Microfounding meaningful wage rigidity (MWR), enabling the rational suppression of labor-price recontracting in the large-establishment venue (LEV), produces downward nominal wage rigidity over stationary business cycles and chronic, time-varying labor rents. MWR crucially motivates causality from adverse nominal-demand disturbances to involuntary job loss, the central welfare-damaging outcome of recessions. Optimizing MWR also implies same-direction shifts of employment, output, and profit in response to movement in total spending. (Chapter 6.) Microfounding and reviving core Keynesian macrodynamics has occupied the lion’s share of the Project’s attention.
The demand-side contribution, however, should not be ignored. The Project uses its reconstructed Keynesian macrodynamics to inform the rational modeling of nonstationary contractions in total nominal spending. (Chapters 6, 10) Extreme spending instability is a necessary condition of depressions and was clearly being spontaneously organized in second half of 2008 and early 2009. Generalized-exchange macroeconomics identifies the reversal of collapsing demand as the over-riding objective of stabilization authorities confronting the Great Recession.
Modeling Nominal Demand Disturbances
Macro shocks are usually promulgated by stationary demand disturbances (SDD) that combine with keystone wage/price rigidities to yield familiar, contained business cycles. In the familiar Keynesian narrative, adverse shifts in total spending are corrected, after relatively short lags, by automatic stabilizers augmented by central-bank “lean-against-the-wind” intervention. Stabilizers include lower interest rates and higher public deficits, income-support programs triggered by involuntary job- and income-loss, and other counter-cyclical transfer payments. Meanwhile, the central bank seeks to speed recovery via open-market purchases of short-term Treasury debt, increasing system liquidity and further reducing interest rates. Both outcomes encourage investment and consumer-durables spending.
The second propagation category, much less frequent but extraordinarily costly, showcases nonstationary demand disturbances. NDD features contracting aggregate spending that overwhelms automatic stabilizers and orthodox central-bank intervention. If not contravened, extreme instability induces rapidly cumulating forced job and income loss, collapsing output and profits, gathering price deflation, debt default, wealth destruction, and cataclysmic depression. NDD circumstances, which also impair lending by and funding for financial institutions, require very aggressive, very prompt nominal-demand management to prevent massive welfare loss. (Chapters 5, 10)
The GEM Project identifies especially important role that market-traded financial assets play in NDD-propagation mechanics, influencing wealth, investment prospects, corporate valuations, and creditworthiness which in turn influence total spending. Their mark-to-market nature makes them especially vulnerable to feedback volatility. Beginning with the fundamental heterogeneity of spending disturbances, the NDD analysis builds on two recent contributions, by Nancy Stokey and Roger Farmer, that enhance our understanding of collapsing demand.
From Stokey (2009) we know that, as investors/lenders become less certain about macro prospects, simple inaction becomes increasingly rational. In particular, buyers of financial assets respond to uncertainty inherent in a nontrivial possibility of unchecked NDD by moving to the sidelines, waiting for the emergence of a credible floor under prices. (A maxim of veteran traders is not to try catching a falling knife.) The GEM Project critically enriches Stokey’s analysis by rooting rational inaction in the breakdown in stabilization authorities’ real-side credibility. Asset buyers’ moving to the sidelines provides low-risk opportunities for short-sellers, imposing outsized downward pressures on mark-to-market asset pricing. Moreover, if and when stabilization policymakers are successful or the NDD threat otherwise dissipates, the rebound in asset prices will be correspondingly rapid and large.
Meanwhile, Farmer (2010b, p.18) argues that confidence exerts a “separate, independent” influence on rational behavior. In particular, he posits investor confidence is effectively tracked as an increasing function of mark-to-market financial asset prices, rooted in a positive feedback relationship with those prices. An illustrative version of Farmer’s feedback mechanism is:
C(t)=ƒ(V(t-1),ΔV(t-1)) such that ΔC/ΔV>0, ΔC/Δ(ΔV)>0, and
V(t)=ƒ(P(t),C(t), F(t)) such that ΔV/ΔP>0, ΔV/ΔC>0, 0<F≤1,
where C denotes investor confidence, Ѵ represents composite asset prices, Δ denotes change, P represents discounted, inflation-adjusted expectations of future profits (subject to a known probability distribution), and F measures notional investor perceptions of the real-side credibility of the stabilization authority. F mediates the relative power of P and C in the determination of V. Stabilization authorities’ real-side credibility, once damaged, introduces uncertainty into the valuation process. When credibility is high (F=1), investors’ expectations of the macro future are governed by known probabilities; and asset pricing is wholly driven by profit fundamentals. As credibility erodes, investors become uncertain; and asset-price dynamics are increasingly driven by investor confidence. An instructive linear version of the feedback system is:
V(t)=F(t)P(t)+(1-F(t))[a1V(t-1)+a2ΔV(t-1)], such that a1+a2=1.
The GEM Project easily extends C–V feedback from asset pricing to total nominal spending, the focus of the acute-instability analysis. In the enriched framework, investment outlays are also determined by P, C, and F, with policymaker credibility again mediating the relative influence of profit fundamentals and confidence. In addition, consumption spending is influenced by household wealth and is, therefore, sensitive to mark-to-market asset prices. Finally, in episodes of contracting aggregate demand, incomes throughout the economy are destabilized by powerful macro multipliers. Putting the pieces together, broad macro uncertainty produces a second, more extensive destabilizing feedback, this time between confidence (C) and aggregate demand.
In garden-variety SDD business cycles, the credibility of stabilization authorities’ real-side objective remains robust, significantly containing the welfare loss from the spending disturbance. NDD circumstances, however, inherently feature a breakdown in such credibility, causing investor/lender uncertainty and consequent inaction to become a driving force in collapsing investment and overall spending. In the 2008-09 crisis, investors used existing information to negatively assess the credibility of real-side stabilization policies. The real-time question was government’s capacity to manage nominal demand, halting and reversing the rapid contraction in total spending that was interacting with price rigidities to produce hemorrhaging job loss. From the acute-instability model’s perspective, investors’ distrust of monetary/fiscal competence is clearly manifest in the 50% collapse in equity prices, a deterioration that cannot reflect economic fundamentals. (Chapter 6) Some sort of confidence feedback is needed to explain the collapse, and quick rebound, of equity prices in 2008-09. The proper design of measures to prevent/contain extreme instability must take the evident feedback mechanisms into account.
Recall the GEM Blog’s recent critique of mainstream macroeconomist advice to central banks to adopt a single, low-inflation stabilization objective. That implication of consensus micro-coherent, market-centric general-equilibrium modeling looks especially foolish in light of the centrality of a robust real-side central-bank objective in extreme-instability macrodynamics.
Blog Type: Wonkish San Miguel de Allende, Mexico