This essay elaborates on the previous post’s argument that theory carefully constructed on rational behavior provides powerful roadmaps for evidence-consistent macro modeling. Setting the stage, recall a crucial fact: in mainstream market-centric general equilibrium. wage recontracting cannot be rationally suppressed As Barro argued and Lucas emphatically reiterated, the much anticipated market friction is defeated by employees’ option to accept a wage-rent reduction in place of losing their jobs. The GEM Project has solved that market-centricity Achilles Heel by generalizing rational price-mediated exchange from the marketplace to workplaces restricted by asymmetric information and routinized jobs. Such workplaces inherently occur in large, highly specialized firms that became ubiquitous after the Second Industrial Revolution and are here denoted by LEV.
The two-venue theory has enabled the derivation of meaningful wage rigidity (MWR) consistent with optimizing employer-employee behavior organized by continuous general decision-rule equilibrium. GEM analysis most consequently generates both downward nominal wage rigidity and chronic wage rent. The two outcomes are essential in macro theorists’ efforts to construct rigorous, evidence-consistent models of macro instability.
Implications of Rational-Behavior in Macro Modeling
Careful workplace analysis has grounded employer-employee exchange in optimization and equilibrium. In an attempt to capture consequences of the existence or absence of rational-behavior research roadmaps, a dozen indicative economic vignettes drawn from the postwar development of macroeconomics are provided.
> The most consequential New Keynesian (NK) failure to build evidence-consistent macro theory was emphasized in Part I of this post. The consensus research roadmap provided by friction-augmented general-market-equilibrium (FGME) mechanics has inherently defaulted to search/match labor-market modeling that, among its many limitations, is restricted to voluntary unemployment. Involuntary unemployment, the central concern of Keynesian macroeconomics, is simply pushed aside. (See below.) Post-Lucas search/match theory, having little capacity to explain observable behavior inside modern workplaces, has become a rabbit hole of dashed aspirations to convincingly explain mass unemployment as well as a pile of other important macro facts. By contrast, The GEM modeling provides a roadmap to rational MWR and mass involuntary job loss (IJL) that comfortably fits what’s known about cyclical downturns. Frankly put, market search/match unemployment is a ridiculous parody of the forced layoffs and job downsizing that actually occur in recession and depression.
> Economists learn early in their careers the central lesson of Akerlof’s lemons, i.e., that rational market-centric pricing is deeply problematic in the context of asymmetric buyer-seller information. That dictum has become an unhappy paradox, both indisputable and frequently ignored. The two-fold objective of the generalization of rational price-mediated exchange responds to the academy’s negligence: first, by rooting nonconvex WERs in the tenets of optimization and equilibrium and, second, by demonstrating that information-challenged workplaces are a necessary presence in macro theory that is both stabilization-relevant and consistent with rational behavior.
> Defending Lucas’ advice that general-market-equilibrium theorists should ignore involuntary job loss. His relevant quote (1981, p.243): “Involuntary unemployment is not a fact or a phenomenon which it is the task of theorists to explain.” He is arguing, insightfully, that meaningful IJL cannot exist in general market equilibrium. If theorists choose to work within the FGME framework, which he believes Keynes did not, IJL must be ignored. The general-decision-rule-equilibrium governing the two-venue theory demonstrates that Lucas’ advice about the research roadmap limitations of FGME modeling is sound.
> Rational-behavior modeling identifies large-establishment-venue (LEV) workplaces as the almost exclusive home for MWR and IJL in periods of weakening nominal demand. Absent that rational-behavior roadmap, mainstream NK thinking informed by Calvo or some other convenient assumption is clueless about the actual location of both phenomena, badly informing any theorist interested in the true nature of labor pricing and involuntary job loss.
.> Chronic wage rents, an extraordinarily consequential characteristic of rational information-challenged workplaces, do not exist in market-centric general equilibrium. Mainstream NK advice that there is nothing to see here has greatly damaged efforts to explain crucial evidence. The labor-rent feature of GEM theory is, for example, necessary to adequately understand unemployment persistence in recessions and recoveries as well as the high incidence of laid-off workers being recalled. Wage rent is also what is rationally cut during periods of job downsizing. And, by far most consequential, rational wage rent motivates the chronic rationing of good jobs and hours on LEV jobs that frustrates labor-market optimization and equilibrium for all employees. Let’s get real. That the macro academy is clueless about modern labor markets being in chronic disequilibrium is not acceptable. Indeed, the mainstream absence of that rational-behavior model-building guidance, especially to young theorists genuinely interested in how highly specialized economies actually operate, borders on sadistic.
> Rational-behavior MWR advises theorists interested in factor-income distribution that, in highly specialized economies, textbook Wicksell-Wicksteed modeling is a special case thoroughly unsuited for general use. The rejection happily opens the door to the consequential existence of pure profit (defined as the surplus revenue after the firm pays all factors of production). Practitioners know that investment spending is largely motivated by the expectation of pure profit. Assigning the primary role instead to interest rates reflects a serious wrong turn by market-centric macro theorists. It is even more misleading to advise that interest rates are the primary driver of consumption. Rational-behavior two-venue analysis identifies the dominant determinant to be household income, reviving the Barro-Grossman (1971, 1976) Keynesian wage-rigidity modeling.
> The generalization of rational exchange also usefully advises model-builders that Lucas’s rational-expectations Phillips curve is badly misleading, constructed on irrational employer behavior. Given the famous equation’s failure to explain actual wage determination – in particular, that inflation catch-up dominates inflation expectations in periodic wage adjustment – some economists probably already harbor doubts about its usefulness. Given the more reliable GEM roadmap, inflation catch-up is shown to be uniquely consistent with rational behavior. Macroeconomists can now join practitioners in ignoring problematic inflation forecasts by employers and employees in labor-pricing.
> Absent close analysis of information-challenged workplace rational exchange, economic theory cannot accommodate the consequential existence of profit-seeking labor practices in highly specialized, bureaucratic firms, thereby ignoring how a substantial share of the labor force is priced, allocated, hired, laid off, and fired, perpetuating the curious gulf between economics departments and business schools. Market-centric general equilibrium cannot meaningfully accommodate evidence-consistent human-resource departments. HR specialists govern labor-management relations in highly specialized, bureaucratic firms, strongly indicating that what they know is relevant to macroeconomists. That fact goes hand-in-hand with Nobel Laureat Herbert Simon’s organization-theory maxim that profit-seeking management in large, highly specialized firms must invest in convincing employees to adopt the firm’s objectives as their own.
> Along the same lines, rational market-centric theory can never adequately accommodate evidence-consistent labor-union modeling. That important subset of labor-related behavior was once robustly represented in descriptive rational-behavior labor economics but has today disappeared from mainstream modeling. Generalized-exchange theory’s pursuit of rational intrafirm behavior reintroduces that literature into modeling consistent with optimization and equilibrium.
> Market-centric general equilibrium theory cannot integrate the powerful, also Nobel-prize-winning, Lewis two-sector growth theory, which is recognized by specialists to be our best explanation of the transition out of subsistence, into mainstream macro thinking. For the generalized-exchange theory, such integration is a piece of cake. Wouldn’t it be a good thing to teach Sir Arthur’s important growth model, now grounded in rational behavior, to macro students?
> Rational-behavior MWR is central to the rigorous, evidence-consistent analysis of the second greatest instability crisis of the 20th century, the stagflation decade that began in the early 1970s. My Price of Industrial Labor (1984), anticipating the subsequent work of the GEM Project, rationally explains that episode’s centerpiece price-wage-price spiral and uniquely provides an evidence-consistent description of stagflation’s persisting market failure. NK theorists appear unaware how the actual stagflation episode is rooted in rational behavior and powerfully linked to the 1980s “rust-belt” downsizing crisis.
> Rational-behavior MWR is also central to the rigorous, evidence-consistent analysis of the greatest instability crisis of the 20th century, the Great Depression decade that began in 1929. Ben Bernanke (2000) authored the macro academy’s most useful model of the Great Depression. He identifies two channels that combined to produce the 1930s debacle. First is the nonstationary collapse of nominal demand, with the gold standard playing a starring role. His first-channel analysis has stood the test of time and, even absent the gold standard, provided an effective framework for understanding the proper policy response to the perilous 2007-09 recession. Bernanke, however, admitted that his second channel, featuring nominal wage rigidity, is much less adequate. He acknowledged lacking the analytic tools necessary to construct rational MWR that supports causality from nonstationary demand contractions to high, persisting unemployment and rising real wages.
Those twelve waystations in the development of postwar macro theory do not exhaust the anecdotal case for rational-behavior research roadmap but surely provide a cumulating feel for the many wrong turns made by mainstream theorists hampered by their tolerance for irrationality. It further supports the argument that generalizing rational exchange from the marketplace to information-challenged workplaces is both intuitive (recall Akerlof’s lemons) and supported by the observable organization of modern, highly specialized economies around complex bureaucratic firms. Moreover, and this is key, the hard work of modeling the second venue is already done. The GEM Project has carefully modeled, consistent with optimization and equilibrium, employer-employee behavior in workplaces restricted by costly, asymmetric information and routinized jobs that rationally suppresses wage recontracting. Powerful guidance to the construction of evidence-consistent macro models has been provided. Early Keynesians, at least, would have been pleased.
Closing Word
The rational-behavior generalized-exchange theory is surely sufficient to reopen discussion on the proper foundations of macroeconomics. The modern absence of such give-and-take has been the biggest roadblock to attention being paid to consequential workplace analysis. So far, the sparse reaction to the two-venue theory is that it is not wrong. Instead, the objection is that it is not needed. FGME has for some time been aggressively pushed by prominent NK theorists, apparently scarred by the post-stagflation macro wars, as settled theory. Research on nonmarket exchange is out of step with that ambition and dismissed as a waste of time.
Rational-behavior workplace analysis is no waste of time. Two-venue theory supports a deep understanding of labor pricing and use in highly specialized economies. No FGME economist, limited to playing half a deck, has come close. Their fundamental problem, reiterating for emphasis, is the reckless abandonment of rational behavior as an essential building block for useful macro theory. The convenience of Calvo’s irrational MWR assumption, and others like it, is surely damaged beyond repair by its consistently misleading influence on useful model-building.
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