New Keynesians Are Stuck

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The New Neoclassical Synthesis, the 1990s peace treaty among New Classical, Real Business Cycle, and New Keynesian theorists, establishes mainstream macro model-building standards. In it, New Keynesians accept the necessity of micro-coherence in their work, while New Classical/RBC schools accept the NK emphasis on coherent market frictions. Both camps eschew replicating the Early-Keynesian reliance on free parameters.

With the easing of overt hostilities, New Keynesians have over time assumed a largely dominant position in consensus thinking, exerting the greatest influence on both policymakers and the modern research agenda. But, and here’s the rub, the consensus insistence on the coherent market-centric general-equilibrium framework, which is today the central gatekeeping standard in mainstream macro research and dissemination, has backed NK scholars into an analytic dead-end. Given the market-centric model’s inability to suppress wage recontracting, they have no micro-coherent access to meaningful wage rigidity (MWR); consequently, they have no access to the central stabilization issue of involuntary job loss and unemployment. Perhaps most telling, NK theorists have largely given up attempting to solve their once-keystone MWR problem. It is illustrative that the index of the recent Handbook of Monetary Theory shows that wage rigidity/stickiness is mentioned on only three pages of the 1,520-page two-volume set.

The GEM Project explores the methodological corner in which NK theorists find themselves, shedding light on the deep damage done to their policy relevancy. In a notable example, the Project carefully considers the problematic on-going effort to enrich job-matching theory sufficiently to make its characteristic voluntary unemployment account for labor-market cyclicality. The attempt is made bizarre by the well-known fact that most of the increase in joblessness in actual recessions results from involuntary job loss. Evidence that NK theorists must know makes the largest chunks of their labor-market research over the past two decades badly misleading to policymakers. The profession’s all-in campaign to defend its mainstream macro model, whatever the cost, is unconscionable.

After most NK theorists gave up searching for the MWR holy grail, the Keynesian program to identify micro-coherent market imperfections capable of inducing involuntary job loss and joblessness lost momentum. In that context, I recently reread Assar Lindbeck’s (1998) overview of the state of NK thinking. His major lament that NK theorists had failed to integrate involuntary job loss into coherent macro theory remains on target today. He (p.171) characteristically does not ignore the fundamental analytic problem: “It is hardly easier to explain the transmission of aggregate product-demand shocks to the labor market than to clarify the existence and persistence of (involuntary) unemployment.” Lindbeck continues: “The reason is, of course, that the conventional (notional) labour-demand function is derived from the standard marginal condition of profit-maximizing firms, which means that the labour-demand function simply reflects properties of the production function. Indeed, the development of macroeconomic theory in recent decades may to a considerable extent be seen as a long and cumbersome attempt to escape the ‘tyranny’ of the downward-sloping labour-demand curve and hence also to overcome the classical dichotomy.”

A substantial achievement of the GEM Project is its coherent, intuitive solution to Lindbeck’s tyrannical problem. (Chapter 3) Constrained by MWR and firm-specific, lumpy capital goods, capital services made available by the capital stock become the proper determinant for inclusion in the production function. Labor demand is then easily shown to be primarily determined by firms’ expected product-demand. For an elaboration, see “At Last, a Modern Theory of Production” in the First-Look Blogs on this website.

Finally, consider Lindbeck’s (pp.174-5) practical advice to macro theorists: “[It] is not unreasonable to base macroeconomic models on a sluggish response to aggregate nominal prices and wages to aggregate demand shocks even if we do not (yet) understand the observed sluggishness very well – a point that has been emphasized, e.g., by Malinvaud.” 21st century NK theorists have rejected that advice. Their substitute, the market-centric New Neoclassical Synthesis, powerfully damages the stabilization-relevancy of mainstream macroeconomics, badly distorting monetary-policy theorems and illustrating the importance of the GEM Project.

Blog Type: New Keynesian Saint Joseph, Michigan

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