Helping a Great Economist: Ben Bernanke

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Great economists are not limited to model-builders making important contributions to economic theory. Economist policymakers who substantially enhance our collective well-being are eligible for inclusion in the Helping-Hand series.

No policymaker deserves being recognized as a great economist more than Ben Bernanke, who was Chairman of the Board of Governors of the Federal Reserve during the extreme instability that was organizing itself in 2008-09. He was the architect of and principal force behind the bold policies that prevented a second, and much worse, Great Depression. He ranks with the likes of George Marshall in the pantheon of U.S. civil servants.

Original Great Idea

Bernanke’s 1995 analysis of the Great Depression is the practitioner benchmark model of history’s most catastrophic mass-market failure. It was the basis for the Fed’s massive demand-oriented response to the 2008-09 Great Recession. His model critically identifies banking crises and meaningful wage rigidity (MWR) as the joint mechanisms by which nominal shocks, aggravated by the 1930s gold standard, had real (employment and production) effects.

Bernanke always admitted that his analysis is incomplete: “… it seems that, of the two channels, slow nominal-wage adjustment (in the face of massive unemployment) is especially difficult to reconcile with the postulate of economic rationality. We cannot claim to understand the Depression until we can provide a rationale for this paradoxical behavior of wages.” Years later, he was more succinct: “Still unresolved is why nominal wages did not adjust more quickly in the face of mass unemployment.”

GEM Helping Hand

The helping hand that most helps Bernanke’s Great-Depression analysis is, of course, rational-behavior MWR. GEM Project modeling microfounds MWR over (i) stationary disturbances in nominal demand (with inherently unchanged workplace reference standards (Ҝj)) and (ii) nonstationary contractions in total spending (producing permanent job loss that eventually forces long-lagged rational recalibration of Ҝj and wage givebacks). The slow adjustment process is central to Bernanke’s depression analysis.

Generalized-exchange theory demonstrates that, in economies that exploit production scale and thereby feature large, bureaucratic firms, the interaction of utility-maximizing employees and profit-seeking employers implies substantial intertemporal persistence of the efficiency/reference wage (Wń) and the consequent laggard nature of wage cuts despite chronic high unemployment.  Multiple sources of residual rents  that fund Ҝn durability, well into the medium term, are inherent to modern economies,  including investors’ hold-up problem, product-pricing power, industry wage cartelization, and increasing returns to scale.

An underappreciated, albeit powerful, source of Ҝn durability is investor choice under generalized risk, i.e., the hold-up problem. Rational investment in long-lived sunk capital necessitates investor expectations of sunk-capital rents needed to satisfy their required returns. (See Chapter 6 of the website’s e-book.) The more firm-specific is the purchased capital, the greater are the subsequent residual rents available to fund Ҝ persistence. Indeed, management’s rational expectations of rising labor rents is incorporated into required rate of profit; once the investment is made, the rent is available for the maintenance of established Ҝn. Moreover, risk aversion by equity owners incorporates some combination of (a) greater-than-expected interest rates and (b) less than expected product pricing and real demand into their investment analysis. Such risk management, to the extent that the adverse events are unrealized, is additionally available to fund Wn persistence.

Product-pricing power, to the extent that it exists in large, bureaucratic firms, implies some pass-through of rising wage rents to product prices, ameliorating the effect of higher labor costs on expected profits and the incidence of job destruction. Familiar sources of endogenous product-pricing are rooted in product-market imperfections, most notably modeled in monopolistic competition theory. As originally conceived by Edward Chamberlin (1933, 1963), investment in product differentiation (and other marketing methods) endows firms with a degree of pricing power. In such circumstances, price equals marginal cost scaled up by the limited product substitutability, generating increased capacity to fund Ҝn durability.

A related, but conceptually distinct, source of Ҝ-durability funding is the role of interpersonal reference standards in industry cartelization of labor costs, a phenomenon that Arthur Ross colorfully named “orbits of coercive comparison”. Given that industry product-demand elasticities are inherently lower than those constraining individual establishments, wage increases can be more easily passed on in higher product prices. Lower effective elasticity provides some insulation of profits from higher labor costs, enhancing Ҝn durability.

Finally, increasing returns are the most potent source of wage rents. Interdependent input indivisibilities, knowledge externalities, and improvements with respect to physical and human capital and workplace organization, singly or in combination, translate investments in greater scale/specialization into greater-than-proportional increases in output and profit. Despite its central role in economic growth, mainstream stabilization theorists have shied away from using increasing returns in formal analysis.

Generalized exchange is, happily, a much superior model class. Its residual, flexible distribution of sunk-capital rents is consistent both with optimizing continuous equilibrium and income distribution that always exhausts the available product. More generally, GEM thinking shows that large-scale production, factor specialization and specificity, worker investment in specific workplace capital (Ҝ), and firm investment in sunk physical capital are intrinsically related economic phenomena. Indeed, nonmarket labor pricing is activated by workplace information asymmetries and job routinization rooted in scale and input specificities, the same circumstances that produce outsized productivity gains, economic rents, and hold-up problems. Despite mainstream theorists’ ongoing efforts, the intertwined phenomena cannot be understood in market-centric isolation. (For an analysis of additional factors that rationally contribute to Ҝn durability and chronically high unemployment, see Chapter 3 of the website’s e-book.)

Is the Game Worth the Candle?

Bernanke made no secret that his theory of the 1930s depression needs a micro-coherent explanation of MWR. The model’s first part closely analyzes the Great Depression’s total spending collapse, assigning much of the blame to the gold standard. The second part assumes MWR  in order to induce two effects. It causally links nominal demand disturbance to forced job loss and same-direction changes in output, wage income, and profits. It additionally imposes long lags on the rational wage-giveback process in the face of chronically high unemployment. Bernanke sidestepped microfounding MWR. Inconsistency with optimization and equilibrium renders his model unacceptable to mainstream macro gatekeepers. Graduate students, confined to consensus market-centric general equilibrium thinking, will continue to have no analytic framework that adequately explains the Fed’s 2008-09 strategy that averted a 21st century depression until they are introduced to the second workplace venue of rational exchange. The introduction of that venue into Bernanke’s benchmark model is surely worth the candle.

Cumulative score: Worth it: 4, Not worth it: 0.

Blog Type: Wonkish Chicago, Illinois


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