Missing Macro Tools

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In A History of Macroeconomics (2016), Michel De Vroey blamed inadequate analytic tools for the failure of Keynes’ General Theory to explain mass involuntary unemployment: “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….  In other words, he perceived that involuntary unemployment should be accounted for in general equilibrium terms (although he did not use this expression); but its origin had to be sought in other parts of the economy than the labor market.” Existing tools, largely rooted in neoclassical market-centric modeling, were not sufficient for such nonmarket analysis.

The General Theory is probably the most famous example of the common practice of blaming deficient economic tools for preventing macro theory from being both (i) rooted in the core tenets of optimization and equilibrium and (ii) consistent with critical instability evidence. It does not matter which school of thought has acceded to dominance in the literature, the failure to be rational while accommodating well-known macro facts is typically chalked up to the theorists’ lack of appropriate tools. Blog readers surely recognize this as the problem class that the GEM Project’s generalization of rational exchange from the marketplace to information-challenged workplaces was constructed to solve.

A full inventory of powerful macro tools that are both debilitatingly missing in mainstream New Keynesian modeling and centrally provided in GEM theory would include:

  • The game-changing second venue of rational exchange. i.e., workplaces restricted by costly, asymmetric employer-employee information and routinized jobs, that is cojoined with rational marketplace exchange;
  • Routinized-jobs modeling that captures the particular nature of jobs typically offered by large, highly specialized firms;
  • The centerpiece nonconvex Workplace Exchange Relation (rooted in optimization and equilibrium) that governs wage determination in large, highly specialized firms that have accounted for the dominant share of total employment since the Second Industrial Revolution;
  • The two components of rational-behavior nominal wage rigidity produced by nonconvex Workplace Exchange Relations, i.e., downward-inflexible wages (DWR) over stationary cyclicality and chronic wage rent (PWR);
  • Location of rational wage rigidity exclusively in firms restricted by costly, asymmetric employer-employee information;
  • The critical separation of layoffs (temporary involuntary job loss resulting from stationary disturbances in nominal demand) and job downsizing (permanent involuntary job loss resulting from nonstationary contraction in nominal demand).

Each of those macro tools powerfully and uniquely help explain the nature of macro instability since the Second Industrial Revolution. They come with a disconcerting fact. Nothing prevents today’s mainstream NK theorists from simply importing those rational-behavior workplace tools into their various analyses. Workplace-exchange contributions would solve a host of debilitating mainstream model-building problems while opening powerful frontiers for productive, policy-relevant research.  

As it stands, the ignored tools are a fundamental rebuke to mainstream macroeconomists. It is especially damning given the aggressive NK campaign to gain acceptance of their friction-augmented general-market-equilibrium (FGME) modeling as fundamentally finished theory. A working agreement appears to have evolved that there is no need to continue debating macro foundations. More to the point, there is no need to invest in the human capital that would support the effective introduction of an information-challenged workplace venue into modern analysis. Most NK theorists seem satisfied that, despite its inability to rationally accommodate mass involuntary loss as well as many other critical macro facts, FGME modeling is just about as good as it is going to get.

In that context, the cases for and against the more general use of the powerful results of the workplace-marketplace synthesis must be understood. Their joint message needs to be hammered home. The general argument for usage is its consistency with Malinvaud’s  great theoretical achievements frequently featured in this Blog. The two-venue model grounds wage setting in optimization and general decision-rule equilibrium, protecting model-builders from being misled by convenient, arbitrary, evidence-inconsistent descriptions of labor pricing. It provides a rich environment for productive analysis. The  cornucopia of consequential interrelated, rational-behavior LEV facts to be built upon features downward nominal wage rigidity over stationary business cycles, chronic wage rent, the existence of involuntary job loss in the millions in response to aggregate demand disturbances, the critical distinction between stationary and nonstationary total-spending contractions, the related existence of both temporary layoffs and permanent job downsizing, the exclusive location of rational wage rigidities and involuntary job loss in large, highly specialized firms restricted by information-challenged workplaces, and the recognized existence of large human-resources departments that design intra-firm exchange mechanisms and set a substantial share of wages in modern economies.

The generalization of rational exchange from the marketplace to workplaces restricted by information asymmetries furthermore accommodates extreme  instability that can transform garden-variety recessions into depression. The 1930s depression as well as the 1970s stagflation, the 1980s great downsizing, the 1990s virtuous cycle, the 2008-09 Great Recession, its painfully slow recovery, and the 2020s rapid recovery from the mass COVID shutdown are provided much more evidence-consistent explanation than does market-centric NK theory.

What argues against using the powerful, intuitive analytic tools provided by the workplace generalization of rational exchange? Little objection has been raised about the intra-firm model itself. NK theorists familiar with the generalized-exchange theory accept that it is not wrong. Instead, they argue that it is insufficiently useful to justify the cost of introducing the second (workplace) venue. That cost centrally includes the investment in human capital needed to understand what actually goes on inside large, highly specialized establishments. Herbert Simon and his colleagues in their close study of rational behavior occurring inside large, complex organizations have alerted economists to the inherently great difference from goings-on in the marketplace. Despite the substantial share of total employment and wage income that occurs in firms with human-resource departments, leading NK theorists still insist on assigning little significance to the necessity of the workplace venue to accommodate the substantial incidence of asymmetric employer-employee information. That must be a conundrum for economists who teach as doctrine Akerlof’s market for lemons.

Blog Type: New Keynesians 

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