This post wraps up, at least for now, a long run of examining the Ptolemaic nature of modern macro theory. The analogy is drawn from the famous attempt to construct and defend the geocentric theory of the solar system. In the second century A.D., Claudius Ptolemy wrote extensively about the motion of the known planets, putting the earth at the center of a system that dominated astronomy for centuries. The Ptolemaic system had a Rube-Goldberg look, featuring tiny circles in which planets would dance as they transversed their larger orbits around the earth. The goofy epicycles were critical to the defense of Ptolemy’s model, providing free parameters needed to periodically recalibrate the geocentric model to fit new evidence. The message for macroeconomists today is that models that rely on goofy behavior should be closely investigated for Ptolemaic intent.
The Ptolemaic woe, always, is evidence on actual behavior. It just keeps popping up. It keeps accumulating. For our purposes, it makes life a scramble for macro theorists committed to the maintenance, preservation, and policy-relevance of the coherent market-centric DSGE model class. Among the most troublesome is the strong evidence indicative of quantity rather than price adjustments to macro shocks. The employment-volatility puzzle, illustrated by the examples that follow, has long been one of the thorniest empirical problems confronted by mainstream theorists.
Indivisible labor supply. The favorite mainstream explanation for the puzzle remains the indivisible labor-supply hypothesis (Rogerson (1988)) that posits employee inability to adjust the length of his or her workweek. Costs of going to work or supervising worker OJB impose a binary choice on households (work full-time or not at all), reducing intertemporal work-leisure choice to a stay-quit decision and creating lumpiness in the optimization process. Such indivisibility transparently requires arbitrary free parameters, as indicated in a single example by the existence of overtime hours that routinely adjust the length of the workweek up and down.
The Ptolemaic nature of the lumpiness hypothesis is further indicated by the need to pretend ignorance of the apparent pro-cyclicality of voluntary job quits. Deep down, Rogerson knows that quits cannot play his posited cyclical role in the volatility of labor hours. Danthine and Donaldson (2001, p.64) provide a careful on-target assessment: “The literature has tended to prefer the indivisible labour hypothesis to the various non-Walrasian formulations that have been proposed…. This preference may not be robust, however, to the necessity of replicating other critical facts.” A more blunt assessment is that the indivisibility model has always been obviously wrong.
Solow residuals. The most ambitious Ptolemaic exercise in defense of mainstream macro modeling was undertaken to discredit the early Keynesian practice of separating stationary and nonstationary employment behavior in order to analyze volatility. Kydland and Prescott (1991) pioneered the bold line of research. They critically used Solow residuals which closely track variance in employment and output to support their argument that business cycles, like TFP growth, are caused by technological change. If valid, the Prescott-Kydland interpretation microfounds the classical dichotomy and fatally discredits the discretionary management of nominal demand. If valid, wage recontracting is alive and well in large specialized firms, involuntary job loss does not exist, job downsizing does not exist, pure profit does not exist, technical regress is the crucial macro shock, consumption and investment are almost exclusively determined by interest rates, and personnel departments focus on market wage surveys, labor recruitment, and matching job candidates with job vacancies. Each and every one of those outcomes is unrecognizable to practitioners, whose descriptions of what they do and how they do it fundamentally conflict with Kydland-Prescott thinking.
Here is a central question. How did Prescott, Kydland, Long, Plosser, and others effectively assert, absent adequate justification, the RBC claim on Solow residuals? That evidence has many potential fathers, notably including Solow’s early Keynesianism which powerfully explained employment volatility by combining nominal demand disturbances and sticky wages. Almost by definition, the success of Prescott et al. in pressing their claim is rooted in the Ptolemaic convention, which allows without further justification the presumption of market clearing, that emerged as a consensus guiding principle among mainstream gatekeepers in the 1990s.
The micro-coherent generalized-exchange version of Solow’s neoclassical growth model microfounds a much different interpretation of the stationary behavior of its residuals. (Chapter 3) In the two-venue narrative, continuous-equilibrium meaningful wage rigidity (MWR) interacts with fluctuations in nominal demand to generate Solow residuals absent toxic RBC restrictions. Simply put, the GEM Project provides much more robust business-cycles mechanics than does alternating technological advance and regress. It is not close.
Clearly wrongheaded. Blanchard (2009, p.224), unselfconsciously for a prominent mainstream gatekeeper, has openly struggled with the increasingly Ptolemaic nature of modern modeling: “Current theory can also deliver only so much. One of the principles underlying DSGE models is that, in contrast to the previous generation of models, all dynamics must be derived from first principles. The main motivation is that, only under these conditions, can welfare analysis be performed. A general characteristic of the data, however, is that the adjustment of quantities to shocks appears slower than implied by our standard benchmark models. Reconciling the theory with the data has led to a lot of unconvincing reverse engineering. External habit formation—that is, a specification of utility where utility depends not on consumption but on consumption relative to lagged aggregate consumption—has been introduced to explain the slow adjustment of consumption. Convex costs of changing investment, rather than the more standard and more plausible convex costs of investment, have been introduced to explain the rich dynamics of investment. Backward indexation of prices, an assumption that, as far as I know, is simply factually wrong, has been introduced to explain the dynamics of inflation. Because their introduction can then be blamed on others, these assumptions have often become standard, passed on from model to model with little discussion. This way of proceeding is clearly wrongheaded.”
I prefer goofy but wrongheaded will do. My guess is that Blanchard will be pleased, and relieved, when he discovers that the source of the wrongheadedness is not model derivation from first principles but, instead, the much more easily corrected, non-intuitive restriction of rational exchange to the marketplace.
Blog Type: Wonkish Saint Joseph, Michigan
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