Greg Mankiw and Franco Modigliani

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Greg Mankiw has always been a smart guy. As a young man, he took a gap year between his undergraduate and graduate education to be a research assistant at the Congressional Budget Office. He wisely chose the macro unit I ran for his policy experience. He was a stand-out at the how-economic-theory-is-relevant-to-policymaking conversations I had with research assistants. It certainly did not surprise me that, much later as a distinguished Harvard Professor, he would cut through nearly a century-long tangle of debate and identify the central issue in Keynes’s 1936 masterwork: “When a modern economist reads The General Theory, the experience is both exhilarating and frustrating. On the one hand, the book is the work of a great mind being applied to a social problem whose currency and enormity cannot be questioned. On the other hand, although the book is extensive in its analysis, it somehow seems incomplete as a matter of logic. Too many threads are left hanging. The reader keeps asking, what, precisely, is the economic model that ties together all the pieces?”  (“The Macroeconomist as Scientist and Engineer,” Journal of Economic Perspectives (2006), p.31.) This post looks at Mankiw’s fundamental question.

Franco Modigliani, a colleague of mine in my own early years teaching at MIT, was also a smart guy, as indicated by his Nobel Prize. He was, to my knowledge, the first Keynesian to successfully address the need for an economic model that ties together the pieces of the General Theory. From his seminal 1944 article that helped organize Early Keynesian stabilization-relevant macroeconomics (p.47): “Unless there is ‘full employment’, the wage rate is not really a variable of the system but a datum, a result of ‘history’ or of ‘economic policy’ or of both.” What ties together the pieces of Keynes’s great book and, more generally, explains the macro-instability evidence produced by the highly-specialized economies created in the aftermath of the Second Industrial Revolution is rational labor pricing that occurs outside the labor market. That’s it. There is no other useful answer to Mankiw’s question.

O.K., why doesn’t Mankiw use meaningful wage rigidity to answer his own question. He got his PhD at MIT; he knew Franco Modigliani as well  as Paul Samuelson, Bob Solow, and the other EK theorists on the faculty who recognized that MWR is the keystone of their stabilization modeling. The reason why Mankiw doesn’t tie together the General Theory with nominal wage rigidity is important. He knew that no Keynesian of any school had figured out how to make MWR consistent with the fundamental tenets of macroeconomics – optimization, equilibrium, and market-centricity. Mankiw concluded that the task was impossible. A career devoted to the rational suppression wage recontracting was doomed to failure. He gave up on microfounding MWR.

Mankiw instead focused his research on rational market imperfections that produce product-price stickiness. He was a founder of “menu-cost” pricing, which argues that for small changes the administrative cost of changing list prices can exceed the revenue gained from the adjustment. The problem here, of course, is that product-price rigidity cannot produce involuntary job loss in response to nominal demand contractions. In particular, such inflexibility cannot rationally suppress the wage recontracting that is a necessary condition for the existence of forced layoffs. As a result, Mankiw’s make-do model cannot explain   size nor nature of recessions. It is “incomplete as a matter of logic”. The root failure in Mankiw’s work, as well as other Keynesian theorists, is that he never confronted the need in the world after the advent of inherently large bureaucratic firms to drop the assumption of market-centricity in the modeling of rational exchange.

The answer to “what, precisely, is the economic model that ties together all the pieces” of Keynes’ foundational General Theory has been provided by the GEM Project. The generalization of rational exchange from the marketplace to workplaces restricted by costly, asymmetric information roots MWR in optimization and equilibrium. The Project’s wage rigidity rationally suppresses wage recontracting. Involuntary job loss and the centrality of nominal demand management in managing macro instability – the primary objects of Keynes’ great book – are microfounded. All that is missing is the general acceptance of the generalized-exchange model by Mankiw’s generation of macro theorists.

Blog Type: New Keynesians Saint Joseph, Michigan

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