Background. A powerful late 20th-century run of model-building choices by New-Classical, Real Business Cycle (RBC), and New-Keynesian (NK) theorists culminated in the New Neoclassical Synthesis, which is constructed wholly within the coherent friction-augmented general-market-equilibrium (FGME) framework. Most modern macroeconomists share the conviction, having deep roots in Walras and others working in the Continental tradition, that economic exchange is best understood as the outcome of intermarket equilibrium. Rejecting as an atheoretic convenience the assumption of downward-sticky wages that is central to the original Neoclassical Synthesis (NS), next-generation academics were bold enough to challenge Early-Keynesian (EK) hegemony by asserting the obvious. Macroeconomics cannot coherently differ from fully specified general-equilibrium microeconomics. Factoring in endogenous frictions that may prevent markets from always clearing, the space of marketplace decision rules is thought to be best represented in the context of continuous, endogenously constrained equilibrium.
Approaching the turn of the century, leading theorists (beginning in the United States) effectuated a truce in the 30-year macro-modeling war by cobbling together a working consensus. The NNS mandated two critical areas of compromise between the RBC/New Classical and New-Keynesian camps. The latter acknowledges that macro models must be constructed on rational intertemporal microfoundations, motivating Woodford’s well-known conclusion that “the methodological stance of the New Classical and real-business-cycle theorists has become the mainstream.” Meanwhile, in victory, RBC/New Classical theorists must recognize that effective modeling can legitimately “incorporate a variety of [endogenous] adjustment frictions that allow these models to provide fairly realistic representations of both short-run and long-run responses to economic disturbances.”
In practice permissible frictions must be consistent with general market equilibrium, implying that New Keynesians should eschew using free parameters to produce interesting results. From Woodford (2009, p.270): “What is important is having general-equilibrium models in the broad sense of requiring that all equations of the model be derived from mutually consistent foundations, and that the specified behavior of each make sense given the environment created by the behavior of the others.” Free parameters, especially those used to arbitrarily suppress wage recontracting, damage model coherence, and eliminate any meaningful distinction between the Early and New Keynesians.
Serious problems arose when mainstream research demonstrated that Lucas’ longstanding warning is correct: friction(s) that endogenously suppresses wage recontracting in the circumstances of general market equilibrium do not exist. Absent the necessary super friction, NNS scholars’ proper insistence on model coherence produces an array of interrelated macro outcomes that many macroeconomists (especially those working for stabilization authorities or private enterprises that insist on evidence-consistent analysis) found incapacitating, most notably including the nonexistence of involuntary job loss. Demand-related cyclical contractions that are restricted to Lucas-class money illusion or costly price discovery are embarrassing explanations of real-world behavior. Outside of the entrenched macro academy, no one believes that market-centric NNS analysis comes close to usefully describing actual economies.
Reiterating for emphasis, the problem is that no FGME-coherent Super Friction has materialized and, worse, never will. Nonexistence is inherent to the nature of the rigorous market-centric model. Given employee choice between losing their jobs and wage-rent reductions that do not violate opportunity costs, there is a single rational outcome. And, given the nature of profit-seeking market exchange, employers must offer that choice. Super-friction prospects for the New Keynesians adhering to the New Neoclassical Synthesis are no better than they were in the much maligned Early Keynesian quest to microfound their original Neoclassical Synthesis rooted in the assumption of wage stickiness. A lot of FGME work by a lot of skilled economists has produced discouragingly, albeit instructively, little stabilization-relevant analysis.
Most modern theorists, giving in to exhaustion, now simply sidestep rational labor pricing. Many have turned, when needing to induce some involuntary unemployment, to the ubiquitous Calvo price-setting mechanism in which rotating subsectors of the economy arbitrarily suppress wage recontracting, simply ignoring the basic irrationality of that suppression. Many theorists concluded that the accommodation of crucial instability evidence requires scrapping the New Neoclassical Synthesis.
Woodford (2003, p.141) illustrates the NK shifty reluctance to come to grips with the inappropriateness of the NNS in mainstream market-centric macro modeling: “While I give detailed attention to the consequences of assumed delays in the adjustment of prices and/or wages, I do not attempt to say anything new here about the underlying reasons for these delays. My assumptions about the frequency with which firms adjust their prices or the time lag that may be involved between the decision about a price and the time that the new price takes effect are treated as structural features of the environment in which firms sell their products, with the same status as their production functions.” That extraordinary rationale motivates a kind of meta-assumption to suppress rational recontracting that is surely a step backward from Early Keynesians simply positing wage stickiness.
Question answered. In this tale of woe it is should be good news that the means of reconciling the New Neoclassical Synthesis and its core message of rationality with the available evidence is readily available in the literature. Given the high stakes, it is dispiriting that the academy chooses to ignore the intuitive generalization of rational exchange from the marketplace to information-challenged workplaces. Accommodating the second venue of rational makes the rational-behavior NNS operational.
It comes as no surprise to readers of this blog that the answer to the question posed in the title of this post is yes. The core message of the NNS, i.e., that productive macro analysis is best rooted in exchange rooted in general decision rule equilibrium, holds – once such exchange is generalized from the marketplace to information-challenged workplaces.
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