Gem Theory and Macro Methodology

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The 30-year macro war, in which the New Classical/RBC insurgents defeated the Early Keynesians, was fought over how properly to do macroeconomics. Today, in order to pass muster with gatekeepers in the  academy, model-building must be rooted in the coherent analysis of optimizing market exchange organized around continuous general equilibrium – what this website calls the formal economic method. Except for restricting rational exchange to the marketplace, the GEM Project happily accepts that FEM is the most productive methodology available to macro theorists; but that exception turns out to be important. The fundamental message of the Project is that the seemingly innocuous market-only constraint is not at all harmless. It has debilitating consequences, most notably preventing the accommodation of readily observable, most crucial facts about macro stability. It especially prevents recognition that broad, costly market failure, featuring involuntary job and income loss as well as lost output and profits, results from sufficiently adverse nominal demand disturbances. The docile acceptance by consensus theorists of their inability to model recognizable macro instability is inexplicable and, frankly, embarrassing.

It is unsurprising that the modern consensus has numerous critics. Many, emboldened by the 2008-09 debacle, assert (incorrectly) that the analytic suppression of forced job separation and consequent stabilization irrelevancy are inherent, unacceptable costs of insisting on micro-macro coherence. While those critics are wrong, it is nonetheless a foolhardy exercise in hubris for mainstream theorists to ignore today’s angry challenge to their consensus methodology.

Generations of Keynesian theorists, seeking to reconcile model coherence and stabilization relevancy, have worked on identifying an internally consistent market-centric Super Friction that rationally suppresses wage recontracting. It is time to accept what we already, deep down, know. The dogged research program has instead demonstrated the nonexistence of the crucial market imperfection. That conclusion, long apparent, has been ignored at great cost. The absence of meaningful wage rigidity has forced mainstream macroeconomics to become increasingly Ptolemaic, causing ever-greater damage to the profession’s credibility. That unhappy drift is perhaps best illustrated by the huge investment in the bizarre – there is no better word – effort to make the voluntary unemployment featured in search/match/bargain modeling account for actual employment instability.

The GEM Project provides an approach that actually reconciles coherence and stabilization-relevancy: the generalization of rational exchange from the marketplace to the workplace. The two-venue general-equilibrium (TVGE) model class, derived from axiomatic preferences and technology constraints, easily produces recognizable employment instability that is (i) induced by nominal-demand disturbances and (ii) consistent with continuous general decision-rule equilibrium. Scholars working within the academy’s dominant New Neoclassical Synthesis must, at some point, heed a critical message of the TVGE analysis. The generalization of exchange is a necessary condition for the preservation of the formal economic method. The stakes are high. Policymakers today need a consensus theory capable of explaining the metamorphosis of an apparently stationary demand disturbance into far more perilous nonstationary total-spending collapse that was spontaneously organizing itself in the United States during late 2008 and early 2009. (Chapter 6) Mainstream macroeconomists need such a theory to reestablish their credibility as worthwhile advisers in stabilization policymaking. (Chapter 10) Serious macro theorists need to get serious about modeling the nominal-to-real class of costly instability that, in its various manifestations, characterizes real-world market economies.

The Project offers generalization of exchange as the necessary next step in how properly to do coherent, stabilization-relevant macroeconomics. In retrospect, the particulars of the GEM theory’s construction seem pretty obvious, making the task of introducing the large-establishment workplace into textbook market-exchange modeling not all that difficult. Some economists have commented that incorporating employees’ preference for equitable treatment, via the instrument of reference standards, must have in prospect looked especially hard to do. I think I was lucky to have considered that problem first. I was introduced to it, and the associated modeling of what went on in the large-establishment workplace more than 40 years ago by Fitz Harbison at Princeton. That head start provided a pretty clear picture of how a workplace-equilibrium theory should look. Solow and I agreed long ago that the firm optimization conditions in an  “efficiency-wage” world were pretty straight-forward, and the derivation of nominal wage rigidity rationally capable of suppressing recontracting always seemed to me, despite taking a long time, to be inevitable. Somebody was going to look closely at rational exchange in the workplace and come up with the needed model. The theory was obviously correct; it fit too many facts and practitioner testimony to be wrong. Along those lines, Oliver Williamson (1975, p.249) provides an intuitive conclusion for this blog’s reiteration of the GEM Project’s fundamental message: “It is widely agreed that if mechanism B, not mechanism A, is thought to be generating the phenomena of interest, the intellectually respectable thing to do is to build theory B.” It is time to get respectable.

Blog Type: New Keynesian Saint Joseph, Michigan

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