Early Keynesians’ dogged quest for policy relevancy was greatly abetted by their practicality. Whenever microfounded macro theory capable of providing useful advice was not available, they were not shy about using assumptions aligned with observable behavior to make existing models stabilization-relevant. In the most significant example of effective pragmatism, almost all EK theorists posited downward sticky wages – a crucial phenomenon for which they lacked the tools to make consistent with the tenets of optimization and general equilibrium.
Early Keynesians also used, usually in tandem with sticky labor pricing, arbitrary time separation to meld their market-disequilibrium analysis into general market equilibrium. EK theorists believed that most spells of mass involuntary unemployment were recognizably short-run phenomena while economic growth was best understood as longer-term. They knew that the time-separation patchwork could not be reconciled with rationality. (When and how did the short-run become the long-run? How could dynamic cycles and trends not coexist?) But EK time-separation modeling was thought to provide useful policy advice in the interim period needed for theorists to figure out how to make nominal wage rigidity (WR) consistent with optimization and equilibrium.
>Samuelson introduced the time-separated Neoclassical Synthesis (NS) with little examination of its underlying content in the third edition of his popular textbook (1955).
>Hicks looked at the evidence and simply posited short-period WR in constructing powerful Keynesian analytic tools He argued that neoclassical economists “did work far too much in terms of [the general-market-equilibrium] model; the qualifications due to the relative rigidity of wages (and some other prices) which should have been evident even from their experience did not receive enough attention …. The full employment theory always received more attention than the short-period theory.” (1967)
>Patinkin provided the most ambitious statement of the time-separation hypothesis, wherein workers in the short-term can be involuntarily trading off their market supply curve as a result of inherently sluggish wage adjustment. His influential book, Money, Interest, and Prices (1956), was still the principal text used in the graduate macro course when I was a student at Princeton.
>Solow, perhaps the most pragmatic Early Keynesian, teamed with Samuelson to work through the policy implications of time-separation macro modeling.
During and after the 1970s stagflation, the time-separation convenience was blown out of the water by aggressive young New Classical theorists led by Robert Lucas. The anti-Keynesian movement culminated in the consensus replacement of Samuelson’s Neoclassical Synthesis. From Woodford (2009): “… there has been considerable convergence of opinion among macroeconomists over the past 10 or 15 years…. The cessation of methodological struggle within macroeconomics is due largely to the development of a new synthesis by Marvin Goodfriend and Robert G. King, called ‘the New Neoclassical Synthesis [NNS],’ that incorporates important elements of each of the apparently irreconcilable traditions of macroeconomic thought.” The foremost element of the synthesis is that New Keynesians accept the modeling necessity of coherent dynamic stochastic general-market-equilibrium (DSGE) microfoundations, while New Classical/RBC theorists accept the use of NK rational market frictions. Both should eschew replicating the Early-Keynesian reliance on consequential free parameters.
I have always agreed with the principal objective of the NNS. Mainstream macro theory needed to be better aligned with the neoclassical tenets of optimization and general equilibrium. But the new tools necessary to accomplish that objective consistent with important stabilization-relevant evidence, especially mass involuntary job loss, have proved beyond the grasp of market-centric Keynesians and anti-Keynesians. The IJL problem motivated important, almost always ignored, advise from Lucas. The anti-Keynesian crusader called on his fellow theorists to ignore involuntary job loss. He was, of course, too careful to deny the obvious existence of IJL. His relevant quote (1981) is: “Involuntary unemployment is not a fact or a phenomenon which it is the task of theorists to explain.” He was arguing, insightfully, that meaningful IJL cannot exist in general market equilibrium. If theorists choose to work within that framework, which he believed Keynes did not, IJL must be ignored.
Macroeconomists, perhaps unsurprisingly, got stuck. Fortunately, the GEM Project eventually identified a path forward for macro thinking (i) rooted in the neoclassical tenets of optimization and general equilibrium and (ii) sufficiently consistent with the evidence to provide useful advice to stabilization authorities. It turns out that in the aftermath of the Second Industrial Revolution a second venue of rational exchange, i.e., workplaces restricted by asymmetric employer-employee information and routinized jobs, had to be cojoined with venerable market-centric analysis. In the two-venue rational-behavior theory, both downward-rigid nominal wages (in the context of stationary disturbances in nominal demand) and chronic wage rent are paid by large, highly specialized firms. Rational WR implies that workplace-venue labor pricing dominates market-venue wages. It follows that workers in small, less specialized firms (permitting effective oversight of on-the-job behavior) are trapped in permanent labor-market disequilibrium.
The bottom line is that GEM analysis provides the analytic tools needed for macroeconomics to be consistent with optimization and equilibrium as well as being stabilization relevant. It is at last a practical, microfounded general macro theory. Market-centric analysts, notably including Keynes, have long sought (albeit unsuccessfully) generality for their modeling. From De Vroey (2016): “Keynes could simply accomplish no more than what was possible given the state of economic theory at the time. The program he pursued was extremely ambitious, more than he realized, and he lacked the means to achieve it.”
The most important new macro tool that powers the first general macro theory is the nonconvex workplace-exchange relation that governs labor pricing in large, highly specialized firms. The rational-behavior WER enables the derivation of rigorous and stabilization-relevant macro modeling that is consistent with coexisting cycles and trends.
Blog Type: New Keynesians