Helping Great Economists: Franco Modigliani

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Franco Modigliani (1918-2003) was a colleague of mine at MIT. He was easy to admire and even easier to like. He left an indelible mark on macroeconomics, most notably with three contributions. His life-cycle theory of household saving fundamentally increased our understanding of consumer spending. The Modigliani-Miller theorems argued that the choice between equity versus debt financing to fund investments did not affect the market value of the firm. (Later, the neutrality finding with respect to a firm’s market value was extended to the choice between paying dividends versus retaining earnings.) Although his 1985 Nobel cited those first two contributions, I have always believed his earliest work in organizing Keynesian macroeconomics, my third entry on the contributions list, was most consequential.

The Great Idea

Early Keynesians (EK) established macroeconomics as a distinct branch of neoclassical theory by reversing, in important circumstances, its textbook real-to-nominal causality. Modigliani’s great idea was how to effectively organize originally scattered EK thinking. In his 1944 Econometrica article, he demonstrated that Keynes’s signature labor-market failure required meaningful wage rigidity (MWR), an assumption he put forward as the proper keystone of the emerging reconstruction of macro theory. That critical insight allowed the new school to orient of their stabilization modeling around causality from aggregate nominal demand to employment and output.

EK theorists secured stabilization-relevance by assuming labor-price inflexibility, enabling the existence of involuntary job loss (IJL) as well as recognizably-sized movements in total employment and output in response to nominal demand disturbances. Nominal labor-price rigidity was confined to the short-term. In the long-run, wages return to two-way flexibility. In the late 1950s, Paul Samuelson used his influential textbook to declare that macroeconomists had broadly accepted the Modigliani framework, despite its troubling intertemporal labor-price incoherence, as mainstream.

EK theorists were open about their difficulty rooting MWR in rational behavior. They argued that positing short-run wage stickiness was an expedient that explained a lot of the important evidence. Pledging that the assumption would be a temporary fix, EK theorists put MWR microfoundations at the top of their research agenda. Unfortunately, rationally suppressing wage recontracting proved more difficult than originally supposed. As progress stalled, cracks developed in the EK consensus. Patience with the wage-assumption shortcut waned, and a new generation of well-trained theorists vigorously challenged the mainstream tolerance of irrational exchange. The gathering opposition became overwhelming during the upheavals associated with the 1970s stagflation decade.

GEM Helping Hand

Rigid wages. Microfounded MWR, the signal achievement of the GEM Project, is of course what would have most helped Modigliani effectively organize Keynesian macroeconomics. As already noted, his 1944 Econometrica article used the assumption of nominal wage rigidity to provide a lynchpin around which Keynesian macroeconomics and its stabilization implications were organized. By the 1970s, irrational labor pricing had become the central target of the neoclassical counter-revolution, properly reasserting the criticality of rational-behavior modeling. Microfounded MWR would have prevented the huge damage to the stabilization relevancy of mainstream macro modeling that began in the 1970s with the rise of New Classical and RBC theorists. That damage continues today.

The GEM Project offers microfounded MWR as the obvious answer to the Early Keynesian rational-behavior problem. The offer, however, has a game-context caveat. It is plausible that the necessary help could instead have come much earlier from Modigliani’s contemporaries, i.e., the middle-20th century labor economists who used their economic training to model the rational employer-employee economic exchange that occurs in workplaces restricted by costly, asymmetric information.

No lunch. The original Internal-Labor-Market (ILM) theorists dominated American labor economics in the middle 20th-century. Their work, ignored in modern macroeconomics, provided a powerful roadmap for the intuitive generalization of rational exchange from the marketplace to the highly specialized workplace. Using their neoclassical training, they pioneered the economic analysis of rational workplace behavior in the large-establishment circumstance of information asymmetries and routinized jobs.

Serious academic research on large-establishment employee behavior naturally followed the Second-Industrial Revolution. Its origins can be roughly dated from the celebrated 1924-32 Hawthorne experiments. Conducted at the Hawthorne plant of the Western Electric Company, the study was originally designed to be technical in nature: to determine the relation between conditions of work and the incidence of fatigue and monotony among workers. As the study progressed, however, the technical factors – rest pauses, lighting, work scheduling, and so on – fared poorly as explanations for productivity variation. Much more important were worker attitudes and the role of informal work groups. The central issue changed from the design of the work environment to inducing employees’ acceptance of the firm’s objectives. (For elaboration, see Annable (1984).)

The impact of the Hawthorne experiments, others like it, and ongoing management learning-by-doing was substantial. Practitioner understanding of labor productivity shifted from a simple to a more complex view of worker conduct. As already noted, a critical branch of the growing research, using a neoclassical economic perspective to expand and, where needed, modify early analysis of the Hawthorne results, was soon forthcoming from a loose collection of American and British ILM scholars, including Clark Kerr, John Dunlop, Frederick Harbison, Charles Myers, Richard Lester, Lloyd Reynolds, Arthur Ross, Albert Rees, George Schultz, Henry Phelps Brown, and J.A.C. Brown. Writing largely from the 1930s into the1990s, they drew descriptions of employee on-the-job behavior (OJB) mostly from experience with war labor boards, government adventures into wage controls, and as arbitrators and researchers with broad access to the internal workings of large firms. They carefully investigated employee preferences and produced a remarkably detailed picture of what occurs in the highly specialized, information-challenged workplace.

Reference standards.  Many interrelated insights were forthcoming from the labor economists’ on-site observations and analysis, including market balkanization, internal labor markets, bounded mobility, the purpose and consequences of long-tenured employment, the repeal of the law of the single wage (i.e., large establishments paying more than small firms for market-equivalent labor), the ubiquitous practice of wage imitation and pattern setting, spontaneous and intentional industry labor-cost cartelization, the modeling of labor-union objectives, and the nature and organization of collective worker action. Of all the contributions of Kerr, Dunlop, et al., macro theory would most benefit from incorporating their finding that positional concerns, especially interpersonal and intertemporal wage comparisons, play a crucial role in employee satisfaction. In a notable example, John Dunlop (1957) emphasized the power and ubiquity of intra-firm reference standards in the determination of labor compensation, naming them “wage clusters”. The extensive literature documenting worker preferences and behavior identifies the interpersonal and intertemporal comparison of wages as centrally influencing employee utility.

The 20th century, hands-on labor economists were close to providing an early solution to what quickly became a persistent, debilitating class of labor-related deficiencies in macro theory. They uncovered the facts but ultimately failed to construct a coherent theory of rational workplace behavior. As a result, they worked increasingly outside the economic mainstream. Kerr (1988, p.21) recognized the difficulty: “Perhaps the most serious problem … was that the revisionists dealt bit by bit with pieces of the puzzle and never assembled them into an integrated statement, let alone into a model or a consistent theory; and it takes a new theory to replace or change an orthodox theory.”

Is the Game Worth the Candle?

Could a working lunch between Franco Modigliani and Charles Myers, both members of the MIT Economics Department, have led to an early solution to the wage microfoundations problem? I don’t know. But I do know that the GEM Helping Hand to Modigliani outlined above would have prevented the long, costly macro-theorist detour into stabilization-irrelevant general-market-equilibrium modeling. That alone makes it supremely candle worthy. Cumulative score: Worth it: 15 (Lewis, Solow, Harris-Todaro, Bernanke, Lucas, Samuelson, Kerr et al, Okun, Hicks, Sraffa, Hayek, Keynes, Burns, Robinson, Modigliani). Not worth it: 0.

Blog Type: New Keynesians Saint Joseph, Michigan


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