Practical Macro Core

The GEM Project intuitively generalizes rational, price-mediated exchange from the marketplace to the workplace. That powerful innovation identifies three principles that constitute the practical core of macroeconomics. Two are recognized as hypotheses from which Samuelson cobbled together his Neoclassical Synthesis in the early 1950s. The third is the Project’s keystone derivation that transforms the first two assumptions into fundamental principles that are both micro-macro coherent and consistent with the relevant evidence.

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 the labor-force and overall worker productivity, which in the GEM model class are motivated capital accumulation, technological change, inter-venue labor transfer, and the organization of large-scale production. The last two determinants are closely associated with exchange generalization. Optimization in the large-establishment venue (LEV) has been shown to induce meaningful wage rigidity (MWR), payment of chronic labor rent, rationing of good jobs, and the repeal of Keynes’s Second Classical Postulate. Beyond stabilization, GEM public-policy implications are far-reaching. One example is the consequences for optimal labor-income taxation that result from pushing a substantial portion of the labor force off its neoclassical supply schedule, overturning central public-finance theorems that have long been gospel in mainstream market-centric thinking.

Second, employment and output fluctuations around macro trends are predominately motivated by same-direction disturbances in total nominal demand. That core proposition necessitates the careful construction of real-side as well as nominal objectives by stabilization authorities, informing the discretionary management of aggregate spending that includes a more inclusive range of macro instability. The idea of nominal-to-real causality has, for at least a century, stirred 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 Real Business Cycle and, perhaps a bit less enthusiastically, other New Neoclassical theorists. Given meaningful wage rigidity, employment and output fluctuations can be broadly understood as largely demand driven. While we all know that, the problem has been that the MWR Channel has no coherent place in market-centric DSGE modeling. That dilemma has consumed generations of theorists. The demand-causality thesis fits the evidence but lacks market-centric microfoundations, while the supply thesis is mainstream-model coherent but flunks the test of the data. The shifting upper-hand in that fundamental debate has provoked century-long periodic swings in the academy’s treatment of the usable macro core.

The third principle settles the crucial debate. The MWR channel exists in coherent macro modeling and is the keystone of the usable macro core. Samuelson’s critical Neoclassical-Synthesis labor-pricing assumption is transformed in the GEM model class into a fundamental, fully microfounded principle of highly specialized economies. With the generalized-exchange derivation from axiomatic model primitives of a robust channel through which adverse demand disturbances uniquely induce involuntary job loss, the argument that fluctuations are predominately supply, not demand, driven becomes little more an artifact of arbitrarily restricting rational exchange to the marketplace. The mainstream market-centric fluctuations thesis is rejected. Exchange generalization has produced a clear-cut winner in the longstanding debate over how to specify a usable macro core in which we all can, and should, believe.

Some parting thoughts on the limited market-centric model class reinforce the Project’s main argument. RBC theory pioneered by Prescott and Kydland is rightly celebrated as the literature’s bedrock expression of coherent market-centric thinking, providing foundations for early 21^st-century mainstream macro analysis in the academy. But there are fundamental, deeply embarrassing problems. Fluctuations in equilibrium employment must be voluntary, and the various shocks and associated propagations inducing business cycles are inherently nonmonetary. Despite its well-earned status as a significant intellectual achievement, RBC high theory has been, and always will be, in conflict with the most important evidence on the stability of specialized economies. It is irrelevant to practical stabilization policymaking and must, by definition, exist outside the usable core of macroeconomics.

Conscientious New Keynesians, desiring both stabilization relevance and the familiarity of single-venue general-equilibrium macrodynamics, have made a career bet that they can identify one or more market frictions capable of rationally suppressing wage recontracting. That will-o’-the-wisp Super Friction would enable reconciliation of significant elements of the practical macro core and micro-macro coherent general market equilibrium, breaking down the classical dichotomy and generating forced job loss in response to adverse demand shifts. Such a friction would probably not fully correct the failure to explain stabilization in modern economies but would solve a range of embarrassing problems, providing greatly improved analysis of garden-variety business cycles.

Even such limited aspirations, however, must founder. The New Keynesians, like the Early Keynesians who proceeded them, have badly underestimated the commanding internal coherence of the general-market-equilibrium model class. The sought-after Super Friction remains elusive simply because it does not exist. The inherent power of wage recontracting within the coherent mainstream framework enforces its nonexistence. New Keynesians must someday, hopefully sooner rather than later, accept that working wholly within the market-centric 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 Keynesian Dalmatian Coast, Croatia