The GEM Blog has spent the last two months sampling the tsunami of Ptolemaic modeling that has accompanied the destruction of the stabilization-relevancy of consensus macroeconomics. For decades, the primary objective of the conduct and dissemination of mainstream macro research has been the defense of the micro-coherent, market-centric general-equilibrium theory that has dominated graduate-school curriculums and cutting-edge journals. Making that defense indefensible is the inability of the consensus model class to accommodate the most important evidence produced by the instability of modern, highly specialized economies.
Who is responsible for making what was once the most policy-relevant branch of economics largely useless today? There can be little doubt that New Keynesians must shoulder most of the blame. That is not a happy conclusion. New Keynesians are generally good people who inherited an admirable tradition of stabilization-relevance from Keynes and the original Keynesians. It is important to understand how their research program got so screwed up?
The 1990s peace treaty among New Classical, Real Business Cycle, and New Keynesian schools is a good place to start looking for answers. The New Neoclassical Synthesis (NNS) sets out acceptable model-building practices for the macroeconomic mainstream. New Keynesians accepted the necessity of micro-coherence captured in the go-to dynamic stochastic general-market-equilibrium (DSGE) model class, while New Classical/RBC theorists accepted the use of micro-coherent market frictions. Both camps eschewed replicating the original Keynesian reliance on model-inconsistent free parameters. Many critics have blamed subsequent policy-irrelevancy on the New Keynesian acceptance of the mandate that macro models must be micro-coherent. Close analysis, however, indicates that frequent objection is thankfully groundless. Macro theory that usefully explicates aggregate instability is not doomed to be inconsistent with microeconomics that powerfully explains rational market exchange.
After accepting the NNS, New Keynesians relatively quickly established a generally dominant position in consensus thinking, exerting far more influence than their New Classical or RBC counterparts on both policymaking and the modern research agenda. Their ascendancy is rooted in their greater attention paid to the imperfect speed and nature of price adjustments and their somewhat improved capacity to track stabilization evidence. But, and here’s the rub, consensus NNS thinking has backed NK scholars into an analytic dead-end. They cannot figure out how to introduce meaningful wage rigidity (MWR) and the rational suppression of wage recontracting into the micro-coherent, market-centric general-equilibrium model class that is the gatekeeping standard in mainstream debate and dissemination As a result, they have no coherent explanation for Keynes’s central issue of involuntary job loss (IJL) and unemployment (IU) caused by adverse nominal-demand disturbances. New Keynesians have pretty much given up trying to solve Keynes’s longstanding layoff problem, despite its solution being a necessary condition of stabilization relevancy. In the index of the recent 1,500 page Handbook of Monetary Theory, wage rigidity/stickiness appears only twice.
The extraordinarily damaging methodological corner in which NK theorists find themselves has not been completely ignored. It is being explored in depth by the GEM Project. In a notable example, the Project helps us understand how the New Keynesian analytic dead-end helps explain the enormous effort that has been invested in the attempt to enrich S/M/B theory sufficiently to make its characteristic voluntary job quits and search/match unemployment account for at least a tiny bit of labor-market cyclical evidence. It is, of course, best not to hope for much from S/M/B modeling. Everybody knows that most of the increase in joblessness in actual recessions results from involuntary job loss. In a predictable outcome of their dogged pursuit of macroeconomics absent microfounded MWR and IJL, New Keynesian research has become embarrassingly Ptolemaic. The GEM Project fortunately provides a way out of that box.
The first part of the Project’s core message continues to be demonstrated by the New Keynesians. Stabilization-relevant macroeconomics cannot be properly done absent MWR, a bit of logic that has been understood by the best economists for a long time. Once optimal MWR has been derived, attention must then be paid to its widespread effects on rational behavior, including the altered nature of labor supply, labor demand, product pricing, intertemporal substitution among the arguments in employees’ utility function, factor-income distribution, pure profits, determinants of consumption, determinants of investment, the real-nominal nexus, the role of aggregate demand, the role of money, and much more.
The second part of the GEM message is that the Project restores MWR to its keystone status by identifying and correcting the weakest link in the modern macro consensus. The issue is not coherence; the Project persuasively argues that macro models should be micro-coherent. Instead, the fundamental problem is arbitrarily restricting rational, price-mediated exchange to the marketplace, an obviously invalid, badly misleading assumption dating from the spread of the nineteenth-century Second Industrial Revolution. It cannot be defended on grounds other than convenience. Getting rid of market-exchange centricity in the modeling of modern, highly specialized economies allows macro theory to be simultaneously coherent and stabilization-relevant. It puts macro research on a remarkably productive path. The GEM Project delivers NK theorists from the terrible Ptolemaic fate in which the primary objective of research is defense of the mainstream micro-coherent, market-centric DSGE model class that can never be stabilization-relevant.
Blog Type: New Keynesian Chicago, Illinois