Last week’s post pushed the GEM Project’s agenda hard, hammering New Keynesian (NK) scholars for abandoning serious research on nominal wage rigidity capable of rationally suppressing labor-price recontracting. It argued that suppression is necessary for understanding the nature and consequences of the cyclicality that is inherent to highly specialized economies. The Early Keynesians were right. Meaningful wage rigidity (MWR) must play a keystone role in the construction of micro-coherent, stabilization-relevant macroeconomics.
My greatest unhappiness with leading NK theorists is that their deemphasis on MWR has pushed mainstream instruction, as well as research and its dissemination, ever further away from the profession’s practical macro core. NK vexation with their inability to microfound the suppression of wage recontracting has been allowed to increasingly, and embarrassingly, alienate consensus thinking from the most important evidence and effective policymaking. Let’s be clear about this. Leading macroeconomists are voluntarily choosing, out of frustration, to badly damage what is broadly taught to graduate students, sending them into the world with heads full of impractical nonsense. How do their mentors sleep at night?
The GEM Project identifies three principles that constitute the practical core of macro theory. The compact set effectively supports stabilization and growth policymaking, while still being fully microfounded by rational exchange organized by dynamic general decision-rule equilibrium. The first two are recognized as the familiar hypotheses from which Samuelson cobbled together his Neoclassical Synthesis in the early 1950s. (For elaboration, see Solow et al. (1997).) The third is the keystone generalized-exchange innovation that transforms the two assumptions into basic principles that are both micro-coherent and in harmony with the relevant evidence.
Practical Macro Core
First, the trend behaviors of total production and employment are predominately driven by the supply side of the economy, i.e., input dynamics and total factor productivity. In particular, potential-output macrodynamics depend on growth in labor-force and overall worker productivity, which in the GEM model class depends on capital accumulation, technological change, Lewis Transfer of labor from low- to high-productivity jobs, and the organization of large-scale production. The last two determinants are uniquely associated with the generalization of exchange. Intra-corporate optimization implies meaningful wage rigidity, rationed rent-paying employment, and the partial repeal of Keynes’s Second Classical Postulate. Public-policy implications extend well beyond stabilization theorems, including consequences for optimal taxation from pushing a substantial portion of the labor force off its neoclassical supply schedule.
Second, fluctuations around macro trends are predominately motivated by disturbances in total nominal demand. That core proposition necessitates stabilization-authority attention to both real-side and nominal objectives in the discretionary management of aggregate spending. The demand-causality idea has, for at least a century, stirred great controversy. Samuelson and other Early Keynesians simply assumed the centrality of nominal spending in their short-term macro modeling. More recently, the principal alternative view (supply-driven fluctuations) has been vigorously espoused by RBC theorists and, albeit less enthusiastically, by many of their NK colleagues. Given meaningful wage rigidity, employment and output fluctuations are understood to be almost entirely demand driven. That MWR has no coherent place in general market equilibrium is a problem that has consumed generations of theorists. The demand-centric thesis fits the evidence but is not micro-coherent, while the supply thesis is micro-coherent but flunks the test of the data. The shifting upper-hand in that fundamental debate has provoked periodic swings in the academy’s view of the usable macro core.
The third principle settles the longstanding debate. Careful, intuitive GEM analysis has demonstrated that MWR rationally exists and is the keystone of the usable macro core. Samuelson’s Neoclassical-Synthesis assumptions are converted into fundamental, fully microfounded principles of highly specialized economies. With the generalized-exchange derivation of a robust channel through which adverse nominal disturbances induce involuntary job-and-income loss, the argument that fluctuations are predominately supply, not demand, driven becomes an artifact of arbitrarily restricting rational exchange to the marketplace. The RBC thesis is rejected, this time definitively. Exchange generalization has produced a clear-cut winner in the long-standing debate over how to specify a practical macro core in which we all can believe.
Reflections on the Practical Core
RBC theorists, led by Prescott and Kydland, are rightly celebrated as providing the modern literature’s bedrock expression of coherent general market equilibrium, providing microfoundations for early 21st-century mainstream macro analysis in the academy. Fluctuations in equilibrium employment must be voluntary, and the various shocks and associated propagations inducing those variations are inherently nonmonetary. Labor behavior dominated by market search/match is reasserted. The rub is, despite its well-earned status as a major intellectual achievement, market-centric high theory has been, and always will be, in conflict with the most important evidence on the stability of specialized economies. It must exist outside the practical core of macroeconomics.
Conscientious New Keynesians, desiring stabilization relevance and the familiarity of market-centric general-equilibrium macrodynamics, made a career bet that they can identify one or more endogenous frictions capable of rationally suppressing wage recontracting. The will-o’-the-wisp Super Friction would enable reconciliation of significant elements of the usable macro core and coherent market-centric DSGE modeling, breaking down the classical dichotomy and generating forced job loss in response to adverse demand shifts. Such a friction would likely not fully correct the failure to explain stabilization in modern economies but would solve a range of associated problems, providing greatly improved analysis of garden-variety cycles.
The central difficulty with even such limited aspirations is that New Keynesians, like the great Early Keynesians who founded separate-branch macroeconomics, badly underestimated the commanding internal coherence of the market-centric model class. The sought-after Super Friction remains elusive simply because it does not exist. The inherent power of wage recontracting within the coherent general-market-equilibrium framework enforces its nonexistence. New Keynesians must someday, hopefully sooner rather than later, accept that working wholly within the single-venue model class arbitrarily restricts the central-bank policy brief to focus on how monetary interventions affect product-price behavior, resulting in a deeply misleading emphasis on inflation.
Blog Type: New Keynesians San Miguel de Allende, Mexico