Iron Law of Wage Recontracing

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Macroeconomists after the 1930s Great Depression invested heavily in labor-market research. Franco Modigliani’s 1944 Econometrica article organized the Early Keynesian (EK) research program around nominal wage rigidity, a market failure that crucially enables causation from nominal demand disturbances to involuntary job loss and recognizable unemployment. With its tight focus on nominal wage rigidity, EK labor-related modeling developed into one of the most consequential micro research programs of the postwar period. It quickly became a cornerstone of the new macroeconomics founded to better explain and respond to the forced job loss and joblessness of the Great Depression.

A coherent explanation of involuntary job loss, however, was elusive. The stumbling block was wage recontracting (WR), defined as profit-seeking firms offering and utility-maximizing employees accepting, in lieu of losing their jobs, a wage cut that does not violate their opportunity costs. We know that rational employees respond to wage reductions from their market opportunity costs by quitting, voluntarily moving to alternative, now better-paying positions. Involuntary job loss plays no role. Moreover, if workers are receiving wage rents, they must rationally accept any pay cut, in lieu of job loss, that does not violate their opportunity costs. Forced job separation continues to play no role.

Introducing meaningful involuntary job loss into coherent modeling requires the textbook labor-market story to be altered in two ways. First, for whatever reason, some employees rationally receive wage rents. Second, firms’ capacity to offer wage reductions that reduce or eliminate those rents in lieu of job loss must be rationally suppressed, implying circumstances in which excess labor supply cannot induce wage cuts. Meaningful wage rigidity (MWR) is defined by those two characteristics, which make it capable of suppressing wage recontracting. A core problem of economic research, which has proven to be very difficult, is to microfound MWR.

Wage recontracting is the iron law of coherent market-centric general equilibrium. Suppressing it is not easy. In particular, there is no model-consistent market imperfection powerful enough to repress recontracting and inducing involuntary job loss. Neither information costs/asymmetries nor inherent coordination nor any other plausible lags can derail the intimate, fundamentally rational process. By its nature, no labor-market auctioneer spontaneously arranges the recontracting process; it is intentionally organized by profit-seeking management in order to provide its employees a mutually beneficial choice. That choice is clear and its consequences are important.

A super market friction capable of defeating wage recontracting has always been a will-o’-the-wisp, explaining the modern exhaustion of the once-vibrant New Keynesian research program targeting its identification. MWR and forced joblessness have today almost wholly disappeared from mainstream macro modeling. The most recent Handbooks of Macroeconomics and Monetary Economics, tasked to review the state of the art in each field, are illustrative of the remarkable decline in wage-related research. The subject index of the former (1,745 pages) mentions fixed or rigid wages only once each. The latter (1,520 pages) cites sticky wages twice, a sharp contrast with the 45 cites for sticky product prices.

An obvious corollary of the iron law is bad news. The aspirations to stabilization relevance so dear to macroeconomists working within the coherent market-centric DSGE model class are doomed. The hard fact is that even the most prominent mainstream theorists should not offer advice rooted in their  consensus models to stabilization authorities and, if they do, the guidance should be ignored. Recall that is pretty much what Bernanke did in the Fed’s successful campaign in 2008-09 to pull the economy back from the brink of depression.

The good news is that GEM Project has identified how to beat the iron law of recontracting and make macroeconomics stabilization-relevant. It is more good news that the mainstream problem is not, as so many Keynesians believe, the consensus insistence on model coherence. That is shown to be a good thing and should be preserved. The true problem turns out to be the longstanding consensus practice of arbitrarily restricting rational, price-mediated exchange to the marketplace. Once market exchange is generalized to the large establishment workplace, well documented management best practices provide a robust roadmap for construction of the missing model of optimizing large-establishment labor pricing.

The two-venue theory exhausts all available gains from trade, microfounding meaningful wage rigidity and the causal link from adverse nominal demand disturbances to continuous-equilibrium involuntary job loss and unemployment. Don’t misunderstand that message. Those crucial outcomes require the generalization of exchange. It is time for New Keynesians to acknowledge that the global production landscape is hugely, consequentially altered from the late 19th century and get on with coherent and stabilization- relevant two-venue modeling.

The design of the GEM Project’s research agenda pays attention to some good advice from William Fellner (1976, pp. 51-52): “What is needed is a distinction between unemployment that can and unemployment that cannot be reduced by expansionary demand policies over a reasonable time horizon.” At the root of that distinction in highly specialized economies is the iron law of wage recontracting.

Blog Type: New Keynesian Saint Joseph, Michigan

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