Replacement Theory Part II

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This post continues my brief summary of why generalized-exchange theory should replace general-market equilibrium as the profession’s dominate macro model. This concluding instalment focuses on when and how market-centric macroeconomics became inadequate to explain mass  market instability. The crucial event was the advent of the extraordinarily disruptive, but curiously underappreciated, Second Industrial Revolution (SIR) that occurred  a century and a half ago. As made clear last week, economists understand that the industrial revolutions eventually broke most of the world out of the Malthusian trap. Macro theorists, however, have been unhappily slow to understand that SIR-attendant complex firms are carriers of daunting replacement stabilization problems.

Critical replacement problem. An especially costly new class of mass market failure is associated with rational LEV wage rigidities that are inherent to the SIR-emergent corporate forms. The capacity of nominal demand disturbances to induce proportional, lingering movement in employment and output necessarily followed.

Financial panics and macro contractions, of course, existed prior to the economic upheaval caused by the Second Industrial Revolution. The Austrian School provides an insightful market-friction description of early business cycles. From Lawrence White (2012, pp.76-77): “The Mises-Hayek theory was first and foremost a theory of the ‘upper turning point’; it aimed to explain why the cheap-credit boom must give way to bust…. The recession is a corrective period in which the needed readjustments take place. The firms that made nonviable investments must wind them down, perhaps go bankrupt, laying off workers and idling machines, leading to above-normal unemployment and unused capacity until those workers and machines are reabsorbed into more sustainable employment elsewhere. The more rapidly the economy adjusts wages and prices and reallocates resources, the shorter the recession will be.”

The capacity of labor pricing to adjust was increasingly challenged in the early 20th century, culminating in the 1930s Great Depression. Even Hayek (1975, p.5) eventually recognized that extreme, decade-long market failure differed greatly from what the Austrians had in mind, apologizing for his 1930s laisse-faire policy advice: “At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed.”

The SIR-altered production landscape eventually shifted a great deal of macro research to modeling stubborn periodic mass involuntary job loss, an effort led by Keynes that continues today to be obstructed by the inability of market-centric analysis to rationally suppress wage recontracting. Seeking stabilization relevance, Early Keynesians swallowed hard and assumed downward labor-price rigidity, pushing aside proper microfoundations in order to causally link adverse demand shocks to recognizable mass layoffs. New Keynesians later repudiated that choice, restoring the centrality of friction-augmented general market equilibrium (FGME) while assigning priority to identifying a super market friction capable of rationally suppressing effective wage recontracting.

Unsurprisingly. no such friction was found; and its priority status faded. Many theorists today quietly accept Lucas’s advice to ignore involuntary job loss. Lucas typically gets a bad rap here. He is too careful to deny the obvious existence of involuntary job loss (IJL). His relevant quote (1981, p.243) is: “Involuntary unemployment is not a fact or a phenomenon which it is the task of theorists to explain.” He is arguing, insightfully, that meaningful IJL cannot exist in FGME modeling. If theorists choose to work within that market-centric framework, which he believes Keynes did not, IJL must be ignored. The macro academy’s research focus again shifted, this time trying to figure out how to make do with the voluntary joblessness produced in labor-market search/match analysis. Whenever the need to align modeling with actual evidence becomes pressing, modern theorists usually revert to the disparaged EK practice of relying on some convenient, always badly misleading, wage-rigidity assumption. (Prominent examples include Calvo (1983), Christiano, Eichenbaum, and Evans (2005), Hall (2005); Hall and Milgrom (2008); Christiano, Eichenbaum, and Trabandt 2016). See also Gali (2011).)

Workplace equilibrium modeling. Despite innovations that appear to break substantially with established macro theory, generalized-exchange modeling is best understood as incremental. Its debt to the mid-century intrafirm analysis of the Neoclassical-Revisionist labor economists has been emphasized in this Blog. In his take on what’s fatally missing in the NR literature, Clark Kerr (1988, p.21) anticipated the workplace-equilibrium theory: “Perhaps the most serious problem … was that the Revisionists dealt bit by bit with pieces of the puzzle and never assembled them into an integrated statement, let alone into a model or a consistent theory; and it takes a new theory to replace or change an orthodox theory.” Kerr’s essay  appears in Bruce Kaufman, How Labor Markets Work (1988, p.21), my favorite introduction to Neoclassical Revisionist research. In correspondence that followed publication of my 1984 book, Kerr encouraged me to extend that analysis to constructing a rational-behavior workplace-equilibrium theory. I deeply regret being unable to do so while Kerr could have experienced the much needed NR revival.

As developed in the GEM Project, the new (generalized-exchange) theory is surely sufficient to reopen serious discussion on the proper foundations of macroeconomics. The modern absence of such give-and-take is the principal roadblock to attention being paid to rigorous workplace analysis. So far, the sparse reaction to the two-venue theory is that it is not wrong. Instead, the objection is that it is not needed. FGME has for some time been aggressively pushed by prominent theorists, perhaps scarred by the post-stagflation macro wars, as settled theory. Nonmarket-foundations research is out of step with that ambition and dismissed as a waste of time.

NR workplace analysis is no waste of time. Clark Kerr and his colleagues deeply understood labor pricing and use in highly specialized economies. No market-centric economist has ever come close. That discrepancy motivates critical questions. How can theorists who understand (and teach) Akerlof’s market for lemons believe that rational OJB in information-challenged workplaces and its corollary wage rigidities are not worthy lines of inquiry? How can theorists who call themselves Keynesian not accept that exchange generalization, finally solving the great theorist’s keystone problem of mass involuntary job loss, has at least as much merit as the ubiquitous labor-market search/match modeling that inherently focuses on voluntary joblessness? Why are the many macroeconomists who are frustrated by having fallen down the search/match rabbit-hole resistant to the singular power of microfounded DWR and PWR to explain the forced job loss that dominates actual recessions and depressions? For that matter, why aren’t they more upset about having no rational explanation for the 1930s Great Depression? Most generally, how can attention not be paid to workplace modeling that solves chronic policy-relevant problems while providing clear foundations, consistency with observed facts, and unification of theories that previously seemed to be fundamentally distinct? Well-read readers may recognize those characteristics of “great theoretical achievements” identified by the late, greatly admired French theorist Edmond Malinvaud (1977, p.vii).

Blog Type: New Keynesians San Miguel de Allende, Mexico


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