In the GEM Project’s rational-behavior modeling, extreme instability is a hugely damaging mass-market failure that results from nonstationary contractions of nominal demand. New Keynesian theorists do not have much that is useful to say on this crucial phenomenon. They do not agree on how to characterize it – or even its existence. Lacking nontrivial wage rigidities rooted in optimization and equilibrium, they shy away from relying on total spending in their explanation of macro instability. Instead, they persist in attempting to fit real shocks (technological disruptions, government spending, etc.) into the primary causal role for business-cycle downturns. Real shocks, failing to persuade with respect to relatively mild downturns that still produce layoffs in the millions, graduate to being glaringly silly when asked to induce depression generating permanent job downsizing in the tens of millions. That unhappy propensity to silliness is not surprising given that NK go-to friction-augmented general-market-equilibrium (FGME) theory can accommodate neither temporary or permanent involuntary job loss. The current state of NK stabilization theory is pathetic.
Building on that ugly foundation, rational market-centric macro modeling has not, at least since the Second Industrial Revolution, come close to delivering sound advice to stabilization authorities. Policymakers have learned, especially when confronted with the prospect of extreme instability, to ignore NK theorists.
I can attest from my own Washington experience that stabilization authorities very much want guidance from useful macro modeling. It is therefore good news that the GEM Project’s workplace-marketplace synthesis has provided powerful, practical direction for managing extreme instability. Three aspects of that guidance are most noteworthy:
>The criticality of aggregate-demand management. In GEM modeling, rapid effective support for total nominal spending upon signs of emerging nonstationary contracting of total demand must be provided by the central bank. In such crises, its overriding objective is to do whatever it takes to halt and reverse collapsing spending.
>The criticality of credibility with respect to the central bank’s commitment to trend full employment. This is a crucial, albeit under-appreciated, factor in how stationary demand contractions morph into nonstationary total spending collapse. Direct, vigorous attention must be paid to the interventions needed to prevent damaged credibility. In this context, recall the New Keynesian treatment of the central bank’s inherently dual objectives. NK theorists proudly deduced from their market-centric thinking the primacy of the nominal over the real-side commitment, making that ranking a central principle of their reworking of Early Keynesian modeling. That advice ranks with the most foolish mistakes ever made by mainstream macro theorists.
>The criticality of the size, nature and timing of proactive government spending in assuring an adequate recovery from conditions of extreme instability. In GEM modeling, a critical part of proper fiscal policy is motivating satisfactory recoveries from episodes like the 2008-09 Great Recession. The shortfall of aggregate demand can be used to calibrate the size of the spending stimulus; policymakers must not shy away from a large number. The funds should be allocated in ways that moderate the build-up of business and household debt as both sectors struggle to survive the deep instability. Estimated program cost should be net of the gains generated by a more rapid recovery.
The remainder of this post looks more closely at aggregate-demand management. The rational existence of nominal wage rigidities in highly specialized economies implies that central-bank management of total spending must be the primary tool with which policymakers deal with macro instability. The criticality of wage rigidity in cyclical analysis was broadly accepted by Early Keynesians, motivating their promised-to-be-temporary use of irrational labor-price stickiness to provide the causal link from demand disturbances to forced layoffs.
Having effectively abandoned the quest for microfounded wage rigidities, NK general-market-equilibrium modeling turned to rational market frictions, such as time-consuming job search, government regulations, menu-cost pricing, advertising, etc., to motivate a bit of plausible macro cyclicality. Largely due the capacity of wage recontracting to overcome market frictions, the mainstream effort has failed to explain actual instability. A crucial message of the GEM Project is the necessity of a second (workplace) venue of exchange in evidence-consistent, stabilization-relevant analysis.
The two-venue macro infrastructure produces big changes in the profession’s collective research agenda, in part increasing the effort to adequately understand the nature of total spending disruptions in highly specialized economies. That used to be a focus of EK research that has for decades been pushed to the sideline by dominant NK focus on market frictions. There is a shorter, more harsh way to make the same point. Real Business Cycle theory, assigning the causal role in instability analysis to rational market frictions and substantially incorporated into mainstream NK thinking, provides fatally damaging guidance to stabilization authorities. Seriously providing that advice amounts to egregious professional malpractice.
As a result of its arbitrary restriction on the scope of rational exchange, FGME analysis misidentifies the critical question posed by the empirical configuration of the Great Recession. From Ohanian (2010, pp. 51-52): “… hours worked during the 2007-2009 recession are much too low relative to the marginal product of labor. Thus, the key to understanding this recession is finding a factor that works like a large increase in the tax on labor income that depresses the incentive to work relative to the observed marginal product of labor.”
The GME presumption that reduced labor input must result from voluntary job separation sharply contrasts with the facts and common sense. Coming to the rescue, generalized-exchange modeling microfounds meaningful wage rigidity that interacts with adverse nominal demand disturbances to generate involuntary job loss in the millions.
Hamstrung by the absence of rational wage rigidities and, consequently, the proper centrality of aggregate demand in episodes of instability, NK theorists have struggled to come up with policies to deal with extreme instability. A foolish (there is no better word) consensus, in the aftermath of the Great Recession, formed around beefing up the macro analysis of bank failures. The idea is to anticipate problems in time to prevent them. Prevent Lehman Brothers from accumulating a subprime-loan heavy portfolio and you prevent the Great Recession.
Here is a hard fact. Prevention of financial-institution failures, short of eliminating risk, is simply beyond government reach. No experienced bank regulator takes the idea seriously. They cite, for example, that the rapidly growing shadow banking system (which is huge, capable of rapid changes, and presents the biggest risk of destabilizing failure) that profit-seeking institutions use to escape federal regulation. Perhaps even more important, the NK failure-prevention solution forgets that regulated banks are not the exclusive cause of extreme instability. How about pandemics?
Fortunately for policymakers, the stubborn naiveté of leading macroeconomists does not much matter. In well-established practical monetary policy, containing and reversing contracting aggregate demand that critically propagates financial crises is central. The rational wage-rigidity channel through which adverse nominal disturbances induce involuntary lost jobs critically propagated the 2008-09 financial crisis, helping to transform it into the most perilous instability since the 1930s depression. GEM propagation of the financial turmoil and associated collapse of confidence reconciles continuous-equilibrium analysis with actual events.
Blog type: New Keynesians
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