Most Embarrassing Question

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Each and every practicing macroeconomist must answer an embarrassing question. Why did mainstream theory fail, utterly, to be useful to stabilization authorities in the extreme instability of 2008-09? Readers may believe that the GEM Blog has already hammered home the answer, with its emphasis on the inability of consensus theorists to microfound meaningful wage rigidity and, as a result, rational causality from nominal demand disturbances to involuntary job loss and recognizable movement in employment, output, and income. That’s not a bad answer, especially when the recession in question generated 6 million forced layoffs. But there is a more instructive answer.

The problem with the obvious MWR answer is that mainstream labor economists showed how to model market wage rigidity many decades ago, long before the anti-Keynesian counter-revolution.  Original Internal-Labor-Market theorists (Clark Kerr, John Dunlop, Frederick Harbison, Charles Myers, and their colleagues) constructed their models on the readily apparent balkanization of the labor market, investigating labor pricing and use inside large, highly specialized firms and demonstrating why that important class of management would refuse to cut money wages.

Dunlop (1994, p.380) elaborated on the ILM enrichment of market-centric analysis with a second  venue of self-interested exchange: “The objective changes in the economy – within sectors, in the emergence of large enterprises and workplaces, and in the ideas and arrangements developed to govern and manage these workplaces – made it quite obvious to a new generation of economists in the 1940s, who were exposed in practical terms to labor markets and labor-management-government issues, that conventional (external) labor-market theory was grossly inadequate. It neglected a vast range of activities within the walls of organizations as well as their forms of interaction with exterior markets.”

For three decades after WWII, ILM thinking occupied the mainstream of American labor economics. The more instructive question implied by the uselessness of today’s consensus macro modeling is: Why was the powerful, obviously correct ILM labor-pricing narrative pushed out of the academy’s mainstream, into general obscurity, before it could be used by macro theorists to microfound MWR? In the 1970s, John Hicks came close. But today’s mainstream macro scholars’ understanding of labor economics is limited the market-centric ILM-replacement literature.

Gregg Lewis

In The Chicago School (2007), Johan Van Overtveldt identifies H. Gregg Lewis, who taught at the University of Chicago from 1936 to 1975, as playing a central role in driving ILM balkanization out of labor economics. His explicit object was to restore market centricity to dominance in mainstream modeling. To many, Lewis is the father of “analytical labor economics, in contrast to institutional labor economics.” (p.128)

From Sherwin Rosen (1994): “When Lewis entered the field in the early 1940s, he hardly was recognized as a labor economist, and his work remained outside the main thrusts of the field until the 1960s. Institutional approaches dominated labor economics prior to the 1930s and the mass  unemployment of the Great Depression and the rise in trade unionism made a thoroughgoing economic approach [italics mine] to labor unattractive to most economists. Rational models were ridiculed, marginal productivity and the theory of the firm were considered irrelevant by labor economists and wage determination was thought to be largely immune from competitive forces. Labor markets were balkanized.”

That is a badly misleading, albeit widely shared, caricature of labor economics when the early ILM theorists, not market-centric neoclassicists, ruled the roost. Balkanization inherently implies the coexistence of rational exchange in the marketplace and in large, specialized workplaces restricted by asymmetric information and routinized jobs. The core ILM innovation, supported by the practitioner testimony, is that the rational pursuit of self-interest in large-firm workplaces disables the neoclassical equality between labor’s marginal product and the disutility of work, sharply diminishing the role of market opportunity costs in wage determination. The critical difference between Kerr and Lewis is that Kerr recognized that, after the Second Industrial Revolution, many employees toiled in workplaces characterized by costly, asymmetric information (circumstances that first-year graduate students know prevents markets from rationally pricing labor) and that Lewis chose instead to suppress, in order to restore market centricity as the singular organizing force in mainstream theory, crucially important facts.

Market-Centricity Juggernaut  

I have searched for the right word to describe the enduring urge to market centricity in mainstream macro research. My current favorite is juggernaut, variously defined as a large overpowering, destructive force or anything requiring blind devotion or cruel sacrifice. The word is related to Jagannath, an idol of Krishna annually drawn on an enormous cart under whose wheels devotees are said to have thrown themselves to be crushed. The market-centricity juggernaut has crushed the capacity of the academy to explain instability, both garden-variety and extreme. Among the victims is the profession’s credibility.

I am going to be blunt. In modeling highly specialized economies, arbitrary market-centricity has nothing going for it but convenience and protection for mainstream human capital and academic reputations. It is supported by neither the logic of rational behavior nor relevant facts. (Chapter 2) It is no more than an article of faith that is evangelically propagated. It is not surprising that the war for dominance with the ILM labor economists was a take-no-prisoners affair. If the analytic goal is restricting rational exchange to the marketplace, ILM balkanization must be obliterated from mainstream research and instruction.

The GEM Solution

Reimagining the last quarter-century with microfounded MWR is a pleasant exercise. Armed with a generalized-exchange (balkanized) model class, mainstream macro theorists would not have been useless to policymakers who had to deal with the most perilous market failure since the 1930s depression. Nor would the profession have suffered the humiliation of returning, after memories had dulled a bit, to proselytizing for the same failed model class.

The obliteration of once-mainstream balkanization analysis has been a wellspring of debilitating problems. Our most renowned macroeconomists, motivated by blind faith in the market-centricity juggernaut, are destroying the credibility that was hard won by the previous generation of theorists, pushing another crucial question front-and-center. How do we get them to stop?

Blog Type: Policy/Topical Saint Joseph, Michigan


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