Providing the mainstream literature’s go-to explanation for trend macrodynamics in developed economies is Robert Solow’s (1956, 1957) neoclassical growth theory. Once a colleague of mine at MIT and co-founder of morale-centric Efficiency Wage Theory, Solow is best known for his 1950s analysis that broke the mechanical link between saving and economic growth.

__Original Great Idea__

Bob Solow’s great idea, awarded the Nobel Prize in 1987, introduced the centrality of technical change to growth theory. In its Harrod-neutral formulation, the Solow model is: *X*(t)=ƒ(*K*(t), *A*(t)*H*(t)), where *X* denotes real output, *K* is capital, *H* is labor hours, and *A* is hypothesized to represent technology. (In their lowercase versions, the variables represent rates of change.) Solow (2000, p.103) later usefully expanded his definition of *A* to include “… worker skills and attitudes toward work, managerial and administrative habits, interpersonal attitudes, social norms and institutions, and no doubt many other hard and soft characteristics of the economic and social environment.”

Assuming constant returns to scale and diminishing returns, the model’s dynamic path is: *x*(t)≅ *a*(t)–*S*_{K}(t)*k*(t)–*S*_{Ḥ}(t)*h*(t). Rearranging the equation, *a*(t)≅*x*(t)–*S*_{K}(t)*k*(t)–*S*_{Ḥ}(t)*h*(t), where *a* is the rate of change of the shift factor that in the literature almost always represents technical change, *S*_{K }is the share of total income paid to capital, and *S*_{Ḥ} is labor’s income share. Versions of the Solow model have been widely used in estimation exercises, which quickly became a growth industry for macroeconomists.

Solow’s great idea was quickly recognized as an important advance in macrodynamic thinking, replacing “knife-edge” growth paths with more robust steady-state paths motivated by capital accumulation and technological change. The approach showcased the longstanding liberal economic agenda of free markets, free trade, and sound money. The Nobel-Prize citation interestingly emphasized Solow’s “framework within which modern macroeconomic theory can be structured”. The framework continues to have broad appeal as a guide to aggregate analysis.

The simple model, however, notably stumbles when asked to account for some notable phenomena, including the mid-19^{th} century growth acceleration often referred to as the Great Fact. (See website’s e-book, chapter 1.) Limitations of the Solow model tend to be rooted in its construction within a market-centric framework. Mainstream general-market-equilibrium modeling provides room neither for the increasing returns to scale nor two-venue labor transfer that combined to enable the crucial acceleration in global productivity and living-standards gains that began nearly two centuries ago. The GEM Project’s two-venue general-equilibrium modeling, by contrast, provides the heterogeneous marketplace and workplace venues of rational price-mediated exchange needed to accommodate increasing returns and Lewis inter-sectoral labor transfer.

__GEM Helping Hand__

A strength of the Solow framework is its remarkable versatility, enabling its relevance well beyond mainstream market-centric analysis. Most critically, substituting the GEM Project’s *behavioral efficiency of labor *(*Z=E/H*) into the core equation, more explicitly motivating the “effectiveness of labor”, makes Solow production consistent with trend *and *cyclical macrodynamics: *X*(t)=ƒ(*K*(t), *A*(t)(*E*(t)/*Z*(t))). Recall that extending the Lewis growth model to accommodate the full (trend and cyclical) timeline of modern macrodynamics was the GEM contribution to Sir Arthur’s great idea. Also note the GEM helping hands to Solow and Lewis reveals a powerful convergence of the two iconic growth models.

In the GEM-enhanced Solow version, *A* is now understood to reflect the *technical efficiency of labor*, once the influence of capital-labor intensity is held constant. (Recall the post two weeks ago.) The combination of *A* and* Z* produces general worker effectiveness and is the vehicle through which optimizing employee-employer workplace behavior introduces microfounded meaningful wage rigidity. MWR combines with nominal demand disturbances to induce periodic real-side macro instability.

It is now obvious that, in empirical exercises, the Solow residual is influenced by macro instability. The MWR nominal-to-real channel along with capital investment, technological change, scale economies, and inter-venue labor transfer (the last three are also reflected in estimation residuals) enables intuitive, policy-relevant modeling of trend and cyclical macrodynamics. Properly generalizing labor input (*H*=*E*/*Z*) endows Solow’s model with analytic range well beyond his original aspirations (2001, p.19): “… it was clear from the very beginning what I thought [the neoclassical growth model] did not apply to, namely short-run fluctuations in aggregate output and employment, what used to be called the business cycle…. In those days I thought growth theory was about the supply side of the economy, whereas the business cycle was mostly to be analyzed in terms of changes in aggregate demand.”

The analysis has segued into the most important contribution of the GEM helping hand to Solow. Generalizing exchange exposes the staggering late 20^{th} century fraud of Real Business Cycle (RBC) theorists in insisting that the Solow residual only measures changing technology. Given that interpretation, the residual provided the central, evidence supporting real business cycles. The GEM helping hand makes clear that the cyclical behavior of *A* is instead capturing actual business cycles, not ridiculously large, high-incidence technical regress. The damage to stabilization-relevant macro theory from the RBC fraud was huge and continues today. Textbook analyses of macro shocks almost always begin with technological change, despite the absence of serious supportive evidence.

__Is the Game Worth the Candle?__

The GEM Project’s provision of a rational-behavior, evidence-consistent interpretation of the Solow residual debunks the RBC explanation of convenience. Driving macro instability with periodic technological regress provided damaging wrong-turn guidance to many macro model-builders. That debunking is surely worth innumerable candles.

Cumulative score: Worth it: 2, Not worth it: 0. As the score builds, keep in mind the major objection of mainstream theorists to generalized-exchange macroeconomics: Adding a second (workplace) venue of rational exchange is too much work. Its benefits are not worth the effort.

Blog Type: New Keynesians Chicago, Illinois

## Write a Comment