Here’s a really important question: Why do leading New Keynesian (NK) model-builders ignore so much relevant macro evidence? The poster child of this willful ignorance is, of course, mass involuntary job loss in the circumstance of contracting aggregate nominal demand. That linkage is of course real, hard-wired in highly specialized market economies. Every macroeconomist worth his/her salt knows that such market failure has periodically occurred in the millions and is extremely costly in lost production and income. The exception is many leading NK theorists who insist (but not too loudly) on a more convenient reality. In a huge pile of academic work, those experts (who want to be trusted to understand how to manage modern economies) embarrassingly insist that cyclical unemployment is inherently voluntary, the product of the time required to match workers searching for jobs with available openings.
The hard fact is the macro academy knows that its go-to explanation of the most crucial phenomena in macroeconomics is wrong, pushing this essay back to its opening question. How can an honorable profession persist in such consequential irresponsibility? In his insightful The Curious Culture of Economic Theory (2024), Ross Spiegler had the courage to say out loud what most of us know. Mainstream theorists who reject obviously true evidence do so because it conflicts with their established rigorous market-centric modeling. It is an entrenched convenience. As Lucas instructed, mass involuntary unemployment cannot exist in friction-augmented general-market-equilibrium (FGME) analysis. Many NK modelers respond to that fact by simply ignoring the central feature of macro instability.
Spiegler argues mainstream theorists have got it backwards. Legitimate science rejects established modeling whenever it is inconsistent with obviously true evidence, not the other way around. What leading NK model-builders may not realize in choosing convenience over the evidence is how many critical facts they are pushing aside. They seem not to grasp how the weight of so much ignored evidence is thwarting intellectual progress and destroying their brand.
Information-Challenged Workplace Evidence
The following facts, describing rational self-interested behavior in large, highly specialized firms, are essential knowledge for policy-relevant practitioners but willfully ignored by the mainstream macro academy. Readers recognize them as building blocks for the Project’s generalization of price-mediated exchange from the marketplace to information-challenged workplaces. Given that such workplaces are where involuntary job loss concentrates, inattention turns out to be a foolish model-building strategy.
• The standard textbook specification of employee preferences conveniently ignores an axiomatic desire for fair treatment. Absent real-world worker preferences. evidence-consistent wage modeling after the industrial revolution is not possible, dooming economists’ capacity to understand modern macro instability.
• A fatal mainstream error concerning production in large, highly specialized firms restricted by asymmetric workplace information is their inherently incorrect 1-1 mapping of H (worker hours) onto X (production). Axiomatic technological heterogeneities, preserved by the Project’s refusal to aggregate large and small establishments, bifurcate optimizing labor price/use decision rules and mechanisms of exchange.
• Rationally unbundled on-the-job behavior (denoted in generalized-exchange theory by Źj), derived from the nature of large, highly specialized establishments, is nowhere found in NK modeling, forcing the absence of cyclical downward wage rigidity, chronic time-varying wage rents, rationed good jobs, and human-resource departments. NK theorists never grasp that Wj and Źj are simultaneously optimized in workplaces restricted by asymmetric employer-employee information.
• By contrast, bundled Ź occurs whenever firms can cost-effectively monitor employee OJB, suppressing discretionary worker behavior and resulting in market-wage taking and unstable job tenure.
Model-Identified Evidence
The generalization of rational, price-mediated exchange from the marketplace to information-challenged workplaces identifies a great deal of the instability-relevant evidence that NK theorists destructively ignore. Evidence consistent with GEM preference and technical innovations is abundant, broadly consistent employers’ documented conviction that employee dissatisfaction is harmful to productivity. Some examples of the power of the GEM model’s consistency with real-world facts are:
• Large-establishment-venue (LEV) workplaces generate a substantial set of outcomes that are easily recognized by practitioners, including relatively long job tenure, reliance on catch-up to inflation that has already occurred (diminishing the role of inflation expectations) in the periodic firm adjustment of nominal wages, workplace (equity-based) mechanisms of exchange, and substantial firm investment in convincing employees to adopt its objectives as their own.
• In GEM macrodynamics, optimization occurs over sequential periods of unchanged and variable reference standards (Ҝ), implying evidence-consistent periodic wage-givebacks. Input specialization and scale, the hold-up problem, industry labor-cost cartelization, product-pricing power, and government intervention motivate substantial lags from the organization of wage rents to permanent job loss sufficient to motivate their recalibration.
• The evidence-consistent durability of the Project’s carefully derived efficiency wage (Wn) is further strengthened by free riders, seniority-age heterogeneities, and employee decision-rule myopia resulting from workplace information asymmetries.
• Evidence supportive of LEV dynamic labor-price optimization includes path-dependent labor pricing; the low incidence of nominal wage cuts; labor-pricing sensitivity to adverse terms-of-trade shifts that is conditional on the wage structure and the nature of government intervention; and the existence of job downsizing that is sensitive to expectations of pure profit and leads to wage givebacks.
• Well-grounded theory is generally needed to avoid misinterpreting economic evidence. In a notable example, two-venue modeling has identified a variety of sources of downward wage flexibility in specialized economies: (a) labor-market-induced wage (nominal and real) flexibility, which is confined to small firms or those offering class-II employment; (b) product-market-induced (nominal and real) wage flexibility, which occurs in large establishments experiencing ongoing job destruction (eventually producing Ҝ recalibrations); (c) government intervention in the wage-determination process to facilitate wage restraint, frequently drawing on its capacity to enrich the nonwage outcome side of the fundamental workplace exchange; and (d) management innovations with respect to workplace organization, defined as a component of technical change (typically assumed to be exogenous), which reduces employee capacity to maintain Ҝj.
• For rent-receiving LEV employees, effective hours-supply is price-inelastic; SEV labor supply is more responsive to wage variations. For LEV firms, pure profit exists and reflects residual rents claimed by owners of sunk capital.
• Consumption is largely driven by income and wealth; investment largely by pure profit expectations, which cost-effectively use all available information and are therefore influenced by hold-up problems and the nature and credibility of stabilization authorities. Investor confidence also plays an important role, especially in periods of uncertainty motivated by low real-side credibility of stabilization authorities in extreme instability.
• The two-venue generalization of exchange is understood to be a wellspring of costly meta-externalities. Involuntary job loss exists, is consistent with continuous equilibrium, and is manifest either as cyclical layoffs or nonstationary job downsizing. Stationary and nonstationary demand disturbances produce same-direction changes in employment and output.
• Given the relatively compact wage structure of the early 1970s, substantial labor-adverse terms-of-trade shifts induced continuous-equilibrium stagflation, the existence of which turns out to have had little to do with the inflation credibility of the Federal Reserve.
• We also know that the evidence does not fit simple downward wage rigidity. LEV labor prices can go down, but only infrequently and in response to poor profit prospects and a rising incidence of permanent job loss, contributing to the variability of chronic labor rents.
• Two-venue labor pricing results from particularly configured economies, generating specific, complex arrays of facts and institutions. The simple wage restrictions of Modigliani, Patinkin, Samuelson, and Calvo will not do. The economy must produce measurable wage rents, locating them in large establishments and influencing them with specific classes of macro shocks. The economy must produce good and bad jobs that have little to do with inherent or general human capital. Involuntary layoffs, not product-price characterize stationary nominal disturbances; and job downsizing, eventually inducing wage givebacks, occurs in response to adverse nonstationary nominal or real disturbances. (In depression, nominal wages fall while real wages rise.) Some firms are large and bureaucratic, with detailed personnel policies and practices; others are small and owner-managed. A modern economy cannot be effectively modeled as wholly one or the other. Labor unions, modern human-resources management, and hold-up problems (causing labor-cost bankruptcies and important meta-externalities) are familiar features
Critical episodes that must be accommodated by proper macro modeling include the Great Depression, chronically low then high joblessness in postwar Europe, stagflation, the Thatcher revolution in Britain, the six million involuntarily lost jobs in the U.S. 2007-09 Great Recession, and the macro response to the Covid mass shutdown,
Final Word
Wages have been pushed aside in mainstream macro modeling in part because macroeconomists have had no robust theory with which to organize their understanding of the available evidence. The interpretation of the empirical landscape of modern economies is much more intuitive, much more coherent, and much less Ptolemaic when guided by the two-venue, rather than the market-centric, model class.
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