Edward Prescott once derided monetary easing as no more “effective in bringing prosperity as rain dancing is in bringing rain”. He is, of course, correct if the monetary stimulus is conducted within the mainstream micro-coherent, market-centric, general-equilibrium model class. By its nature, consensus theory cannot accommodate the suppression of wage recontracting, cannot accommodate downward nominal wage rigidity over stationary business cycles, cannot accommodate chronic time-varying labor rents, cannot accommodate causality from nominal demand disturbances to involuntary job loss and recognizably-sized same-direction movement in employment, output, income, and pure profit. If you dance hard enough, monetary easing may produce a sprinkle or two; but it will never make it rain.
Prescott’s critique, of course, has nothing to do with the actual capacity of central banks to stabilize employment. It is instead an on-target LOL at efforts of New Keynesians, having agreed to work within the consensus micro-coherent, market-centric, general-equilibrium theory, to demonstrate that discretionary management of total spending improves the overall welfare produced by markets left alone. After decades all they have demonstrated is, first, that meaningful wage rigidity has not been derived in the mainstream model class and, second, that (absent MWR) explanations of the most important cyclical evidence remains out of reach. The deal the NK theorists cut with their New Classical and RBC counterparts dooms them to stabilization irrelevance.
Costs of the Anti-Keynesian Revolution
Much was discarded in the New-Neoclassical rush to mandate that, to be eligible for mainstream dissemination, research must be micro-coherent. Most harmful to the profession’s credibility outside the academy was the rejection of the pragmatism of the Early Keynesians, who simply assumed MWR in their macro modeling while they actively searched for how to rationally suppress wage recontracting. Samuelson, Hicks, Modigliani, Patinkin, and the other great Keynesians were the 20th-century’s most stabilization-relevant mainstream theorists, explaining evidence that became critically important after the Second Industrial Revolution and the advent of large bureaucratic firms. Early Keynesian scholarship, with its nominal-to-real causation and consequent centrality of aggregate demand, easily rejects Prescott’s rain dance as silliness rooted in being trapped in a model that badly captures highly specialized economies.
With the victory of the anti-Keynesian insurgents, EK pragmatism was discarded. Mainstream market-centric macro modeling now must be micro-coherent. Woodford (2009, p.270) reiterates the fundamental model-building rule: “What is important is having general-equilibrium models in the broad sense of requiring that all equations of the model be derived from mutually consistent foundations, and that the specified behavior of each make sense given the environment created by the behavior of the others.” Woodford and others largely push aside that the new consensus can no longer accommodate involuntary job loss or the centrality of nominal demand disturbances to the recognizably-sized cyclicality of output, employment, income, and pure profit.
New Keynesian macro thinking, putting micro-coherence first, stumbled badly as it became clear that a market super-friction capable of rationally suppressing wage recontracting is apparently a will o’ the wisp. Modeling relevant labor microfoundations proved hard, and our best theorists eventually threw in the towel. Research agendas increasingly ignored MWR and involuntary job loss, and both crucial facts moved to crepuscular corners of modern macroeconomics. Theorists increasingly focused on beefing up venerable job-search-matching models, seeking to induce job quits and voluntary unemployment to move, at least a little, in a counter-cyclical fashion. In a related capitulation, they increasingly abandoned aggregate-demand disturbances as the principal vehicle of propagating real shocks prior to coming up with an adequate substitute.
Reviving Early Keynesian Thinking
The solution to the collapsing credibility of mainstream macroeconomics is to revive Early Keynesian modeling. Doesn’t every experienced macroeconomist know, deep down, that the EK emphasis on the discretionary management of total spending most effectively organizes stabilization policymaking. Such knowledge would explain the absence of a mainstream objections to the Fed’s use of the rejected Keynesian approach in combating the 2008-09 extreme instability. That is why Robert Lucas concluded in 2008 that “everyone is a Keynesian in a foxhole”.
A necessary condition of an EK revival is the reconciliation of the short- and long-run branches of Samuelson’s Neoclassical Synthesis. In other words, microfound MWR. Such reconciliation has admittedly proved very difficult. Indeed, many talented macro theorists have concluded that the task is not feasible. In his famous “The Death of Keynesian Economics” (1980), Lucas concluded that reconciliation was hopeless: “I think the problem in a nutshell was that the Keynes-Samuelson view involved two distinct, mutually inconsistent theoretical explanations of the determinants of employment. For a time, we thought that we could find a new theory that would unify or reconcile these two – but the more progress was made the more difficulties came into view, dragging us further under. By now, it is fairly clear that the attempt is hopeless – that, with hindsight, it was misleading from the beginning. As a result, new talent is not attracted to refining, developing Keynesian economics. That is what we mean by the ‘death’ of a scientific idea.”
Now that the GEM Project has microfounded MWR, finally reconciling the two branches of the Neoclassical-Synthesis, the widespread belief that irreconcilability is too difficult to solve has morphed into the problem of getting mainstream theorists, especially the new generation that has been taught to reject EK thinking as a matter of course, to pay attention to the generalization of rational price-mediated exchange. Mainstream gatekeepers will, of course, eventually pay attention. Even outside foxholes, the revival of EK modeling is too powerful and too necessary for stabilization-credibility to be snubbed forever. Think about it. The GEM-enabled EK model now features microfounded MWR and rational causality from nominal-demand disturbances to involuntary job loss and recognizably-sized same-direction movement in employment, output, income, and pure profit. As a bonus, it also microfounds chronic labor rents, pushing a large share of the labor force off the neoclassical supply curve, which explains a lot. Indeed, the revived model, rationally rejecting Keynes’s Second Classical Postulate, explains every critically important instability fact that micro-coherent general-market-equilibrium theory must ignore. What’s not to like?
Blog Type: New Keynesians Chicago, Illinois