Second Fundamental Neoclassical Tenet

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Begin with a reiteration, from last week, of E.K. Hunt and Mark Lautzenheiser’s (2011, p.434) summary of the three fundamental tenets of neoclassical theory: “… the faith that the invisible hand of the competitive market harmonizes all interests through free exchange, creates rational prices, and leads to an efficient allocation of resources; the faith that the free market will automatically create a full-employment equilibrium; and the belief that the wage rate is equal to the value of the marginal product of labor and that the profit rate (or interest rate) is equal to the value of the marginal product of capital – hence, by implication, each social class gets the value created by the factors it happens to own.”

This post looks at the second tenet – the capacity of competitive markets on their own to assure reasonably full employment. To the surprise of many non-economists, this tenet continues to greatly influences modern macro modeling. Mainstream micro-coherent, general-market-equilibrium theory rules out the causal link from adverse demand disturbances to involuntary job loss (IJL). It cannot, as a result, accommodate recognizable cyclicality of joblessness. It is a great, albeit ignored, embarrassment that the neoclassical treatment of  unemployment receives so little support from relevant evidence, which over the past century-plus shows a pattern of periodic broad market failure during which  weakening demand forces job loss and persisting joblessness.

Competitive markets. The neoclassical macro narrative, in its original form featuring fully flexible prices that enable Say’s Law and “automatic” full employment, is well understood by economists. So is its New Keynesian variant that uses rational market imperfections, most frequently rooted in price discovery, to produce departures from full employment. But the NK analysis blithely continues the central neoclassical premise that rational exchange is confined to the marketplace and is, as shown by the GEM project, inherently unable to accommodate IJL. NK employment variations that are too small to do much damage and cannot to be effectively smoothed by discretionary management of total nominal spending.

In the aftermath of the Second Industrial Revolution (SIR) and its large, bureaucratic firms, the second tenet became a fairy tale. Something significant happened in the late 1800’s that macro theorists must stop ignoring. Illustrative is the British early 19th-century restoration of the gold standard (well before the SIR), which immediately resulted in an overvalued pound. The policy was successful because it forced timely wage reductions and thereby avoided persisting unemployment. In the post-SIR 1920s, by contrast, Winston Churchill (then Chancellor of the Exchequer) attempted to reinstate the gold standard with an overvalued, pre-war pound exchange rate. This time wages broadly resisted being cut, and Britain suffered through many years of double-digit unemployment even before the global Great Depression.

The second fundamental tenet (and its more mild NK variant) has no useful place in highly specialized post-SIR economies. Stabilization policymakers worth their salt must reject it whenever it pops up. Fortunately, a much of the remaining neoclassical story is preserved by the generalization of rational exchange from the marketplace to workplaces restricted by costly, asymmetric information and routinized jobs. Microfounded MWR suppresses wage recontracting and uniquely induces rational causality from nominal demand disturbances to involuntary job loss and recognizably-sized cyclical movement in employment, output, and income. Two-venue rational exchange, the lion’s share of which is still governed by the neoclassical framework, motivates what we have been looking for – micro-coherent, stabilization-relevant macro theory. That must be good news.

Extreme instability. The GEM Project identifies nonstationary demand disturbances (NDD) as a particularly challenging meta-externality, facilitating the identification of the proper policy mix between stability and efficiency effects of regulation. The Project demonstrates that it is the duty of the central bank, and other stabilization authorities, to prevent the class of nonstationary demand disturbances most recently demonstrated by the 2008-09 extreme instability. Effectively combating a brewing collapse of total nominal spending, whenever it occurs, prevents broad market failure generating huge loss of employment, output, income, and wealth. The Project also demonstrates how the Fed can effectively combat extreme instability. It should today be assembling the most powerful available demand-management toolkit, while aggressively communicating to investors and lenders globally its enhanced capacity and institutional commitment to halt and reverse collapses in nominal demand while they are being spontaneously organized, likely as a result of some idiosyncratic financial crisis.

Hayek apologized. The culminating classical model of the business cycle macro instability was published in 1932 by Friedrich Hayek, building on the work of insightful Austrian-school theorists. His market-centric theory was organized around an “upper turning point” in the credit cycle. He focused on why credit booms turn into busts, a period of contraction of employment and output in which wages and prices are being reduced and resources reallocated. In particular, many enterprises that heavily committed to investments that proved nonviable go bankrupt and shut down, firing their workers and idling machines. Higher joblessness and unused capacity persist until the idled resources are absorbed, at lower wages and prices, elsewhere. Rational price discovery requires some period of job search for the displaced workers, generating some persistence in cyclical unemployment.

Hayek’s model is pretty cool. Its critical price-discovery lag, however, is way too short to capture the persistence of unemployment and excess capacity in recessions/depressions occurring after the Second Industrial Revolution. His model is innocent of the severe welfare damage caused by the periodic downturns that actually occur. Adequate micro-coherent modeling of post-SIR instability requires rational MWR, which was beyond the Austrian theorist’s analytic grasp.

Hayek (1975, p.5) later apologized for his Depression-era stabilization advice, especially his opposition to monetary expansion to counter deflation that he said resulted from naïveté about the nature of labor pricing in increasingly specialized economies: “At that time [early 1930s] 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.”


Blog Type: New Keynesians Saint Joseph, Michigan

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