Let’s Stop Fooling Journalists

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Two cheers for The Wall Street Journal. In an environment of crushing revenue shortfalls for print journalism, the WSJ continues to devote resources to the analysis of important issues of public policy. This week’s post, inspired by a front-page article by Ben Leubsdorf (“The Recession’s Economic Trauma Has Left Enduring Scars”, May 9, 2016), has been gestating for 6 months. Leubsdorf examines an apparent market failure that properly concerns policymakers and economists. He shows that employees who have been permanently displaced from their jobs suffer significant, lasting wage loss: “A pay gap persists, even decades later, between workers who experienced a period of unemployment and similar workers who avoided a layoff. Estimates vary, but by one analysis, people who [permanently] lost a job during recessions made 15% to 20% less than their nondisplaced peers after 10 to 20 years.”

Leubsdorf asks what’s going on here and what can be done about it. After surveying work on long-term unemployment in the academy since 1980, he quickly runs afoul of a problem that has damaged economic journalism for decades: the persistent failure of mainstream macroeconomics to be policy-relevant. In the academy, the foremost concern of macro theorists is to defend their consensus market-centric general-equilibrium model. If the pursuit of that objective requires conclusions that are inconsistent with the evidence, so be it. The coherent model that they teach to graduate students triumphs over facts. Actual behavior, practitioner belief, and intuition rooted in real-world observation have for a generation played a distant second fiddle to professional convenience.

In that unhappy environment, the consensus explanation of Leubsdorf’s lost-wage phenomenon features “hysteresis” (see below). That approach ignores the relevant evidence and is easily shown to be little more than a Ptolemaic exercise in defense of the consensus model. But mainstream agreement understandably impresses journalists, who in the era of print downsizing are ever more young and inexperienced. Leubsdorf didn’t stand a chance. Guided by the work of leading macro theorists, his effort to identify the causes and policy implications of the very real lost-wage problem is transparently foolish.

Hysteresis. Mainstream macroeconomists argue that involuntarily unemployed workers quickly experience substantial erosion of their job skills, a process theorists have named hysteresis. If true, the resulting lost productivity can explain subsequent lower wages in a way that is consistent with market-centric general equilibrium. The primary objective of modern macro analysis is satisfied; the consensus model is defended. It doesn’t much concern the academy that the eroding-skills explanation is obvious hogwash, inconsistent with practitioner testimony and the available evidence.

Human capital needed in the routinized jobs featured in long-term unemployment is mostly specific, not general. We know that persons who are recalled to their previous jobs after being laid-off do not endure destruction of relevant skills. No one really believes that the work habits developed in relatively high-paying routinized employment substantially erode after a year or two or three. If after three years displaced workers were returned to their original jobs, they would also return to their original productivity. They know it; their employers know it. And, deep-down, mainstream macro theorists know it. Nonetheless, macroeconomists doggedly continue to use hysteresis to explain the lost-wage phenomenon. Otherwise, they would need to admit to Leubsdorf, their students, and everyone else that their consensus thinking is not policy-relevant, something they are apparently unwilling to do.

A better theory. Generalized-exchange macroeconomics, featured in the GEM Project, could have rescued Leubsdorf’s article. It demonstrates that temporary or permanent involuntary job loss crucially occurs in firms that rationally pay chronic rents, i.e., wages greater than their employees’ market opportunity costs. The loss of jobs that pay wage rents and therefore must be rationed powerfully explains the pay gap “that persists, even decades later, between workers who experienced a [permanent job loss] and similar workers who avoided a layoff.” Even Leubsdorf’s quantification of the wage gap (15-to-20%) is consistent with the size of wage rents paid in rationed employment found by Katz and Summers in their careful analysis of evidence available in Current Population Surveys.

Wage rents do not exist in mainstream analysis. They violate the fundamental recontracting principle required for the existence of coherent market-centric general-equilibrium. In consensus modeling, all workers are paid the opportunity costs for their skills although, given involuntary permanent job loss, finding employment that pays that best available wage may require a period of search. The best modern theorists can come up with to explain the lost-wage phenomenon is a deterioration of workers’ human capital that occurs quickly and universally during their search for a new job. Does anybody think that explanation is anything but lame? Does anybody really think that, if his/her old job somehow became available, the typical displaced worker would be unable to fill it? If you do, take a more serious look at the evidence.

Righteous anger. Here’s what really upsets me. The wage-rent explanation of the lost-wage phenomenon, which accurately describes the real problem, implies a much different policy response than the convenient hysteresis explanation, which doesn’t come close to actual behavior. Yet hysteresis is still vigorously promulgated in the academy, a collective choice that reflects a troubling moral failure. Leubsdorf’s front-page chart summarizing the lost-wage problem screams the existence of wage rents being paid by downsizing employers. Talented mainstream macroeconomists, and there are a lot of them, know that rents must be the driving factor in the lost-wage evidence but do not care. Distorting the policy debate on an important socioeconomic problem for their own professional convenience should deeply shame leading macroeconomists.

Making the moral failure even more intolerable is that the GEM Project has constructed a coherent continuous general-equilibrium two-venue model that effortlessly accommodates wage rents. The better model is available. It should be happily accepted by anyone who understands the need to generalize rational exchange from the marketplace to workplaces that inherently feature asymmetric, costly information and routinized jobs. If mainstream gatekeepers would wake up to the superior model, the profession would have a powerful analysis of job-displacement dynamics that is consistent with the evidence and supportive of effective remedial policymaking. Macroeconomists could stop making an art form out of fooling Leubsdorf and his professional colleagues, who are after all are simply trying to do their important jobs.

Blog Type: Wonkish Saint Joseph, Michigan

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