Evidence Review Part II

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This post continues to set the stage for our in-depth review of the evidence relevant to the GEM Project’s model class. Once generalized-exchange analysis is extended beyond its baseline,  optimization occurs over sequential periods of unchanged and variable reference standards (Ҝ), reflecting periodic downsizing and wage-givebacks. Input specialization and scale, the hold-up problem, industry labor-cost cartelization, product-pricing power, and government intervention motivate long lags from the organization of wage rents to permanent job loss sufficient to motivate Ҝ recalibration. The durability of the efficiency wage (Wn) is further strengthened by free riders, seniority-age heterogeneities, and employee decision-rule myopia resulting from workplace information asymmetries.

Evidence supportive of LEV dynamic labor-price optimization includes the existence of chronic, variable wage rents; path-dependent labor pricing; the low incidence of nominal wage cuts; labor-pricing sensitivity to adverse terms-of-trade shifts that is conditional on the wage structure and the nature of government intervention; and the existence of job downsizing that is sensitive to expectations of pure profit. Well-grounded theory is needed to avoid misinterpreting such economic evidence. In a notable example, GEM modeling has identified a variety of sources of downward wage flexibility in specialized economies: (a) labor-market-induced wage (nominal and real) flexibility, which is confined to small firms or those offering class-II employment; (b) product-market-induced (nominal and real) wage flexibility, which occurs in large establishments experiencing ongoing job destruction (eventually producing Ҝj recalibrations); (c) government intervention in the wage-determination process to facilitate wage restraint, frequently drawing on its capacity to enrich the nonwage outcome side of the fundamental workplace exchange; and (d) management innovations with respect to workplace organization, defined as a component of technical change (typically assumed to be exogenous), which reduces employee capacity to maintain Ҝj.

For rent-receiving LEV employees, effective hours-supply is price-inelastic; SEV labor supply is more responsive to wage variations. For LEV firms, pure profit exists and reflects residual rents claimed by owners of sunk capital. Consumption is largely driven by income and wealth; investment largely by profit expectations, which cost-effectively use all available information and are therefore influenced by hold-up problems and the nature and credibility of stabilization authorities. Investor confidence also plays an important role, especially in periods of uncertainty motivated by damaged real-side credibility of stabilization authorities, in extreme instability. Putting it all together, generalization of exchange from the marketplace to the information-challenged workplace is understood to be a wellspring of costly meta-externalities. Involuntary job loss exists, is consistent with continuous equilibrium, and is manifest either as cyclical layoffs or nonstationary job downsizing. Stationary and nonstationary demand disturbances produce same-direction changes in employment and output. Given the relatively compact wage structure of the early 1970s, substantial labor-adverse terms-of-trade shifts induced continuous-equilibrium stagflation, the existence of which turns out to have had little to do with the inflation credibility of the Federal Reserve.

Industry affiliation has a large effect on the existence and power of wage rigidities. A core innovation of the workplace-marketplace synthesis, i.e., continuous-equilibrium meaningful wage rigidity, deserves emphasis. While the missing model can be viewed as restoring nonmarket wages to their keystone role in Early Keynesian analysis, it must also be understood that labor pricing has come a long way from Modigliani’s convenient assumption that money wages are rigid. Building on true axioms, generalized exchange has enabled the derivation of chronic, variable wage rents that reflect LEV firms’ rational unwillingness to reduce the price of labor to its market opportunity cost. In the compact two-venue model, fully flexible labor pricing characterizes small firms, while large firms cut nominal wages only after job downsizing that is sufficient to convince workers to recalibrate their established reference standards (ҜJ). Macroeconomists know that the actual instability in employment and involuntary unemployment requires substantially, but not completely, restricted labor-price downward flexibility. We also know that the evidence does not fit simple Early Keynesian downward wage rigidity motivating Samuelson’s Neoclassical Synthesis.

GEM labor pricing requires particularly configured economies, generating specific, complex arrays of facts and institutions. The simple wage restrictions of Modigliani, Patinkin, Samuelson, and Calvo will not do. The economy must produce measurable wage rents, locating them in large establishments and influencing them with specific classes of macro shocks. The economy must produce good and bad jobs that have little to do with inherent or acquired human capital. Involuntary layoffs, not product-price reductions, characterize stationary nominal disturbances; and job downsizing, eventually inducing wage givebacks, occurs in response to adverse nonstationary nominal or real disturbances. (In depression, nominal wages must eventually fall but only after real wages rise.) Some firms are large and bureaucratic, with detailed personnel policies and practices; others are tiny and owner-managed. A modern economy cannot be effectively modeled as wholly one or the other. Labor unions, modern human-resources management, and hold-up problems (causing labor-cost bankruptcies and important meta-externalities) are familiar features.

Critical episodes that must be accommodated by proper macro modeling include the Great Depression, chronically low then high joblessness in postwar Europe, stagflation, the Thatcher revolution in Britain, the six million involuntarily lost jobs in the U.S. 2007-09 Great Recession, the sovereign-debt crisis in the Euro-zone, and the macro response to the COVID pandemic.

Wages have been pushed aside in mainstream macro modeling in part because macroeconomists have had no robust theory with which to organize their understanding of the available evidence. The interpretation of the empirical landscape of modern economies is much more intuitive, much more coherent, and much less Ptolemaic when guided by generalized-exchange rather than market-centric  modeling. GEM innovations boil down to solving the labor pricing conundrum posed by the Project’s Two-Venue Theorem. The central hypothesis is that generalized exchange is necessary to microfound nonmarket wages that are consistent with practitioner/household descriptions of their own behavior and fit the facts.

Blog Type: Wonkish Saint Joseph, Michigan


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