Johnthan Schlefer in his The Assumptions Economists Make (2012, p.189) provides a familiar, albeit flawed, interpretation of an important episode in the development of Keynesian macroeconomics: “All economists who espoused Keynesian theory in the 1930s saw in it a hope to combat the Depression, but they disagreed about what it meant. When it left Cambridge England … it was a theory about a profoundly uncertain future, an indispensable but perilous thing called ‘money’, and an economy that might settle at any level of unemployment, good, bad, or indifferent. When it arrived in Cambridge, Massachusetts (I use that town to designate Harvard, MIT, and their allies), it was an addendum to neoclassical theory. It assumed that economies gravitate toward a unique equilibrium but may be impeded along the way by imperfections, such as a temporarily excessive interest rate that discourages investment, or temporarily high wages that cause unemployment, Cambridge, England saw capitalism as inherently troubled; Cambridge, Massachusetts, came to see capitalism as merely in need of ‘fine-tuning’.”
Schlefer’s story correctly identifies the shared desire to effectively combat the Great Depression as well as Keynes’ idea that market unemployment follows a path characterized by multiple levels of equilibrium. He errs badly by downplaying Keynes’ centrality of aggregate nominal demand in the explanation of macro instability and his strong belief in the superiority of both capitalism (properly managed) and macro modeling rooted in core neoclassical tenets of rationality and equilibrium. Keynes, Cambridge UK, and Cambridge US believed that textbook macro theory required substantial reworking in order to be useful in understanding modern, highly specialized economies; tinkering at the margins of mainstream general-market-equilibrium theory would not do.
My interest here is not to criticize Schlefer, whose training is political science and is probably doing the best he can with a difficult subject. Instead, I want to investigate how Schlefer’s story would be informed by the macro tool featured on this Blog. Readers know that the tool (the nonconvex workplace exchange relation) is derived from generalizing rational exchange from competitive markets to workplaces restricted by asymmetric employer-employee information. This second venue is, of course. much more than an addendum to established neoclassical theory. The NWER enables rational downward nominal wage rigidity (DWR) and chronic wage rent (PWR), both of which are evident in large, highly specialized firms that had become ubiquitous in the Second Industrial Revolution. The origin story on both sides of the Atlantic would have been substantially altered if Keynesian theorists of all stripes had access to the NWER macro tool.
Instability. The new tool imbues Keynesian economics with the stabilization relevance that is, along with rational-behavior modeling, the most crucial outcome of paying attention to the workplace venue of exchange. The following selection of NWER contributions makes that case:
- Extreme instability (manifest in depressions) in highly specialized economies is caused by nonstationary contractions in aggregate nominal demand, which aligns with Keynes’ intuition . The failure of Early Keynesians to establish the centrality of total spending in their interpretation of the General Theory opened the door for the low point in the development of macroeconomics: Real Business Cycle modeling and its spectacularly damaging policy recommendations.
- In Schlefer’s story, change “addendum” to neoclassical theory to “fundamental addition” to reflect the necessary generalization of rational exchange from competitive markets to workplace restricted by asymmetric employer-employee information.
- Rational DWR, a product of generalized exchange that is concentrated in large, highly specialized firms, translates collapsing demand into mass involuntary job loss accompanied by a proportional reduction in total output.
- GEM wage rigidity is consistent with the neoclassical tenets of optimization and equilibrium and is necessary to evidence-consistent instability macroeconomics, usefully and uniquely identifying the location of mass involuntary unemployment to be large, highly-specialized firms. Cambridge US reliance on irrational “temporarily high wages” proved to be a deeply misleading convenience, not an effective model-building strategy.
- As in Keynes, GEM income multipliers magnify the total spending collapse.
- Keynes’ assertion of equilibrium unemployment is revived and strengthened in GEM modeling, featuring robust continuous-equilibrium NWER. Equilibrium involuntary job loss has always been particularly contentious in the United States. Samuelson summarized his early rejection of Keynes’ modeling: “What I resisted in Keynes the most was the notion that there could be equilibrium unemployment.”
- High-unemployment decision-rule (not market) equilibrium occurs when reduced output/employment becomes consistent with the depressed level of total spending
- The effective remedy to depression is a massive, carefully designed increase in nominal spending.
Each element has Keynesian roots that cannot be assembled into a coherent, evidence-consistent whole without the marketplace-to-workplace generalization of rational exchange modeled in the GEM Project.
Rationality. The second important outcome is that the two-venue modeling is rooted in rational behavior. The GEM Project is committed to optimizing, price-mediated exchange organized by continuous general decision-rule equilibrium as its core modeling principle. A persuasive argument supporting the use of rationality to motivate model behavior results from thinking through the alternatives. Irrationality, the replacement that comes most quickly to mind, is surely not a viable model-building option. Other virtues of rational behavior include its clarity and persuasive power, as well as the capacity to systematically interpret evidence and to distinguish among competing theories.
Those are strong arguments. But they omit the strongest one. The most important virtue of rational behavior is the unmatched power of the guidance it provides in the construction of useful economic theories, helping to better explain and extrapolate important economic phenomena. That conclusion is vividly illustrated by the checkered history of wage analysis in macroeconomics. The default mainstream (NK) approach has for some time been convenient, albeit irrational, assumptions that suppress wage recontracting. The modern go-to assumption has been provided by Guillermo Calvo (1983). He posited a rotating fixed fraction (ϋ) of wages to remain unchanged each period, permitting the remaining wages to adjust to changing market conditions. The probability that any given labor price can be recalibrated in any given period is (1- ϋ), implying strong restrictions on rational behavior. Calvo’s staggered pricing helps facilitate aggregation and has become, despite its dependence on arbitrary free parameters, the labor-pricing mechanism of choice in modern New Keynesian (NK) modeling.
The broad acceptance of the badly irrational Calvo assumption is surprising, especially among theorists who claim to be governed by the New Neoclassical Synthesis (NNS) that clearly emphasizes the importance of proper microfoundations over the capacity to fit available evidence. Calvo’s free parameter prevents wage adjustments in circumstances of mutual benefit and cannot be consistent with optimizing behavior. His mechanism particularly runs afoul of rational behavior in its arbitrary suppression of wage recontracting. It differs little from Early Keynesian (EK) toleration of irrationality in the original Neoclassical Synthesis that led to the EK banishment from modern graduate-school curriculums and cutting-edge journals. Especially given their proclaimed rejection of EK expedient irrationality, New Keynesian theorists’ casual, undefended use of Calvo pricing is a badly damaging mistake, dashing mainstream hopes for stabilization relevance.
Back to Schlefer. The absence of the nonconvex workplace-exchange relation that has been shown to be essential to the task of rationally explaining extreme instability and its consequent depression-scale mass involuntary job loss suppresses a great deal of policy-relevant macro analysis. In Schlefer’s analysis, it hopelessly muddles the differences between the Cambridge UK and Cambridge US response to The General Theory. Capitalism may or may not be “inherently troubled” but Cambridge UK efforts along those lines had little to do with the huge problem at hand – the large-scale chronic involuntary unemployment that Keynes set out to solve. Nor can the answer be reduced to any reasonable meaning of “fine-tuning”. The GEM Project demonstrates that adequate understanding of the causes, consequences, and amelioration of depression-sized unemployment requires the hard work of fundamentally reworking of market-centric macro theory relied upon by economists on both sides of the Atlantic.
Blog Type: New Keynesians
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