Neil Irwin’s Shame, Part IV

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As argued in earlier posts, Neil Irwin’s shame is rooted in the know-nothing approach that has long been one of Irwin’s hobby horses. He appears to derive satisfaction in reporting on mainstream economists’ struggling with some contemporaneous problem that he then attributes to the issue being inherently incomprehensible. His hobby horse is that modern economies are too complex for human understanding. As recently as October 15, he clearly restated that theme: “… macroeconomics, despite the thousands of highly intelligent people over centuries who have tried to figure it out, remains, to an uncomfortable degree, a black box. The ways that millions of people bounce off one another — buying and selling, lending and borrowing, intersecting with governments and central banks and businesses and everything else around us — amount to a system so complex that no human fully comprehends it.”

His Know-Nothing urge overcomes professional caution about opening the door to crackpot theories, complicating the task of stabilization policymakers. The urge also overcomes his analytic sense. Doesn’t he see the error in jumping from macro theories that are not working to concluding that macro problems are inherently incomprehensible? That a theory is not working is more likely the result of an alternative that does work having not yet been developed. Or, as is frequently the case, the theory that does work exists but has no yet been adopted by the macro mainstream.

Irwin’s New York Times piece (“The 57-Year-Old Chart That Is Dividing the Fed”, October 24, 2015) puts his hobby horse front and center: “[The chart displays] the Phillips curve, one of the most important concepts in macroeconomics. It shows how inflation changes when unemployment changes and vice versa. The intuition is simple: When joblessness is low, employers have to pay ever higher wages to attract workers, which feeds through into higher prices more broadly. And inflation is particularly prone to rise when the unemployment rate falls below the “natural rate” at which pretty much everybody who wants a job either has one or can find one quickly…. [As] Janet L. Yellen put it in a 2007 speech the Phillips curve ‘is a core component of every realistic macroeconomic model.’ Except it doesn’t work.”

The GEM variant of the Phillips Curve is a representative case of improved existing theory. Simply put, it does work. (See below.) Its existence demonstrates that, at least in this turn of Irwin’s hobby horse, the problem at hand is not inherently incomprehensible. Crackpot theories beware.

GEM Phillips curve modeling.  Combining labor pricing in large- and small-establishment venues identifies the respective determinants of baseline (unchanging ҜJ) nominal compensation growth:

w(t)=Φ(t)rnJ+Φ(t)βσpnķJ(t)+Φ(t)β(1−σ)pmķK(t)+Φ(t)(1−β)pIJ(t)+ (1−Φ(t))(γmK(t)+pm(t))+

(1−Φ(t))(a1(UN(t)−U(t))+(1−Φ(t))a2Δμ(t).

Endogenous ҜJ (Chapter 3) requires some rewriting of the nominal macro wage equation:

w(t)=Φ(t)rnJ(t)+Φ(t)βσpnķJ(t)+Φ(t)β(1−σ)pmķ(t)+Φ(t)(1−β)pIķ(t)+(1−Φ(t))(γmK(t)+

(1−Φ(t))(a1(UN(t)−U(t))+(1−Φ(t))a2Δμ(t).

The two-venue generalization of rational exchange microfounds a continuous-equilibrium entrant to the huge literature on single-equation wage modeling. The baseline equation, which features Ҝ durability and is confined to stationary macro disturbances, is most consequently restricted by downward wage rigidity and chronic wage rent derived in the GEM Project. In order to align the equation with the Phillips literature,  posit that terms of trade remain unchanged (pn=pm=pI), as do small-firm trend labor-productivity growth (Δγm(t)=0), relative sector size (ΔΦ(t)=0), the natural rate of unemployment (ΔUN(t)=0), and government intervention (Δμ(t)=0). The simplified equation is the GEM variant of the Phillips curve:

w(t)=bo+b1(UN−U(t))+b2pķ(t), such that wn(t)≥0 and Wn(t)>Wm(t).

The improved version is constructed on inactive reference standards Ҝ consistent with stationary business cycles. In the most fundamental innovations, LEV nominal wages are rationally restricted to be downward rigid and always greater than SEV labor pricing for equivalent workers. In the Phillips curve proper, labor-market conditions occupy a significant, albeit  diminished, place. More notably, price expectations disappear. Efficient wage-setting arrangements mandate that catch-up to past inflation rationally replaces expectations in the periodic adjustment of nominal wages, a prediction that is confirmed by the evidence. The number and nature of the restrictive assumptions indicate the cautious use of the single-equation wage model.

Most relevant to modern Phillips-curve debate, equation (4.16) is constructed on (i) preferences and technology that are invariant with respect to the conduct of monetary policy and (ii) employer-employee decision-rule outcomes that are rationally informed by central-bank policies. The model happily replaces the arbitrary time-separation used by Early Keynesians to meld money neutrality and non-neutrality in the Neoclassical Synthesis: a short-term real-nominal tradeoff generated by (assumed) wage stickiness coexisting with the longer-term return to wage recontracting, eliminating the tradeoff, in neoclassical growth theory. Given a reasonable take on the other branch of the wage-price nexus (Δp(t)/Δw(t)>0), generalized exchange easily motivates inflation persistence: (Δp(t)/Δw(t))(Δw(t)/Δpķ(t))=Δp(t)/Δpķ(t)>0. Inertial product-price inflation is compatible with the evidence and is relevant to the proper design and implementation of stabilization policies.

Other properties of the GEM Phillips curve.  Nonconvex WERs, rooted in neoclassical tenets of optimization and equilibrium, imposes a tight structure on bi in Phillips equation beyond MWR and PWR. The constant term (bo=Φrn+(1−Φ)γm) reflects the interaction of trend LEV real wage growth (rnJ, embedded in Ҝ), small-firm trend productivity growth, and relative venue size. To the extent that any of those factors change in an estimation period, bo will be unstable. The most critical source of destabilization is Ҝ recalibration, which has been shown not to occur in stationary business cycles that provides the usual context for Phillips analysis. Also, the employment coefficient (b1=(1−Φ(t))a1) helps explain the relatively small, albeit significant, estimated influence of measured joblessness on aggregate wage behavior.

The specifications of inflation catch-up (pķ(t)=Φ(t)βσpnķ(t)+Φ(t)β(1−σ)pmķ(t)+Φ(t)(1−β)pIL(t)) and LEV terms-of-trade dynamics (þķ(t)=βσpnķ(t)−Φβ(1−σ)pmķ(t)−(1−β)pIķ(t)) provide interesting restrictions on the GEM equation. Domestic or international shifts in labor’s terms of trade make b2 unstable. As a result, the two-venue Phillips curve, with its simplifying assumptions, could not have adequately explained or predicted the stagflation that greatly challenged monetary policymaking in the 1970s and early 1980s. GEM Phillips specification also properly eliminates the use of price expectations.

Finally, generalized-exchange Phillips macrodynamics underscores the significance of the implicit interaction between growth in LEV productivity (γnT) and the real wage (rn). In the GEM model, ΔγnTrn exerts upward pressure on pure profit (ΠJ), increasing common equity, capital investment, and aggregate spending and income, reinforcing Ҝ durability. If ΔγnTrn, there is downward pressure on profit, equity value, investment, income, and spending. It is easily shown how such circumstances eventually induce job downsizing, Ҝ recalibration, and wage givebacks.

Blog Type: Wonkish Chicago, Illinois

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