Responding to Jean-Claude Trichet

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Last week’s blog noted that the world’s preeminent central bankers have complained about the failure of mainstream theory to be helpful in stabilization policymaking. This week’s post looks more closely at Jean-Claude Trichet’s thoughtful critique. Trichet, of course, should command our attention, having been the head of the European Central Bank during the global instability crisis that began in 2007. He opened his annual Central Banking Conference in 2010 with a challenge to the economics community: “When the crisis came, the serious limitations of existing economic and financial models immediately became apparent. Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner. As a policymaker during the crisis, I found the available models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.”

Trichet continued: “We need to develop complementary tools to improve the robustness of our overall framework. In this context, I would very much welcome inspiration from other disciplines: physics, engineering, psychology, biology. Bringing experts from these fields together with economists and central bankers is potentially very creative and valuable. Scientists have developed sophisticated tools for analyzing complex dynamic systems in a rigorous way. These models have proved helpful in understanding many important but complex phenomena: epidemics, weather patterns, crowd psychology, magnetic fields.” Trichet experienced first-hand the real-world cost of the academy’s propagation of macro models that it knows, deep down, inadequately describe highly specialized economies.

Mainstream theorists’ response to Trichet has, so far, been divided. I’ll call one camp the good guys. Long troubled by the tenuous link between coherent market-centric dynamic stochastic general equilibrium (DSGE) modeling and actual instability, they have been questioning how macroeconomics is done. By contrast, the bad guys remain firmly committed to the coherent general market equilibrium paradigm, digging in to wait out the criticism. In that context, here is what most interests me about Trichet’s entreaty. Despite good intentions, it illustrates an important reason why the bad guys (despite their frightening record of failure) are winning. Along with a number of critics, he envisions a broad, complicated reformulation of the existing corpus of economic theory. He wants to push aside established modeling that has long provided great insight into many significant problems. Downplaying the manifest explanatory power of textbook analysis of rational price-mediated exchange broadly provokes economists’ distrust.

It is good news, then, that the GEM Project provides an effective response to Trichet’s challenge that does not throw the baby out with the bath. A model class has been constructed that crucially microfounds meaningful wage rigidity (MWR), involuntary job loss, and the centrality of nominal demand in business cycles. The Project uniquely enables simultaneous micro-macro coherence and stabilization-relevance. Its incremental innovation is intuitive, the generalization rational exchange from the marketplace to the large-establishment workplace. In the theory’s simplest version, all price-mediated exchange other than between highly specialized employers and employees occurs in the marketplace and is governed by familiar textbook analysis. Trichet’s call for relevance to the 2008-09 extreme instability is satisfied while retaining most of textbook economics. In the GEM model constructed in Chapters 2 and 3 in this website’s eBook, adverse nominal disturbances (rooted in a wide range of macro shocks that include financial crises) induce substantial market failure that can be corrected by the effective management of total spending.

Modeling heterogeneous workplace and marketplace venues of employer-employee exchange is not difficult. The two classes of rational exchange are complimentary, not contradictory. Both are needed to adequately describe modern economies. In the small-establishment venue (SEV), worker hours supplied and demanded are equilibrated in the labor market with short lags rooted in price-discovery frictions. That is, of course, the familiar textbook process that is consistent with continuous decision-rule equilibrium. Effective supervision bundles employee on-the-job behavior, restricting worker discretionary action to the marketplace and inducing rational investment in information acquisition related to stay-quit decisions and the on-going quest for rent-paying large-establishment-venue (LEV) jobs. Self-interested behavior generates labor churning, into and out of SEV jobs, into and out of unemployment, and into and out of the labor force. Market information costs limit workers’ grasp of the true state of the economy as well as their own opportunity costs, requiring stochastic decision-making.

Meanwhile, restricted by costly, asymmetric workplace information and routinized jobs, LEV cooperative labor input is rationally unbundled and cannot be measured by hours alone. Exchange must relocate from the marketplace to the workplace, a distinct venue constructed by bureaucratic firms to facilitate effective labor management. Profit-seeking establishments pay wages that minimize unit costs while workers use their latitude on the job to pursue axiomatic preferences, centrally including perceptions of fair treatment, that govern their satisfaction with management policies. (Chapter 2)

The optimizing LEV wage is derived from axiomatic preferences and technology to embody both cyclical downward rigidity and time-varying rents. Think of the ultimatum game writ large. Worker stay-quit decisions, for those who remain in the labor force, generally collapse to a rational decision to stay. Employers and employees both invest in acquiring information relevant to managing workplace reference standards and, consequently, to the transformation of labor hours into cooperative input. The LEV firm’s fundamental labor problem is understood by practitioners to be nonmarket in nature: How to induce, given costly, asymmetric workplace information and routinized jobs, employees’ acceptance of management’s goals? Effective macro modeling of highly specialized economies cannot ignore that question.  

Imperfect information makes rational choices with respect to both reference-standards and production-capability stochastic in nature. Firms play the averages with respect to OJB and unit labor costs, while their employment policies are motivated by stationary and nonstationary profit expectations. The latter critically influences the interdependent time-paths of wage rents and workers’ intertemporal substitution of consumption for equitable treatment. (Chapter 3) Downward LEV wage adjustment that reduces, rather than increases, unit costs requires voluntary employee recalibration of established reference standards and is motivated by job downsizing, not temporary layoffs.

Large-establishment compensation practices, rationally suppressing wage recontracting in lieu of forced job loss, powerfully constrain marketplace decision-rule optimization and generate crucial intermarket spillovers from temporary and chronic job/hours rationing. LEV constraints on household and small-firm decision-making permit the coexistence of dynamic general (decision-rule) equilibrium and the failure of markets to clear, featuring involuntary job loss and joblessness at both stationary and nonstationary frequencies. Putting the pieces together, interacting workplace and marketplace venues, especially as the economy adjusts to their inconsistent labor pricing, motivates much of what is stabilization-relevant in monetary theory. It is what Trichet was looking for.

Blog Type: Wonkish Chicago, Illinois


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