This post begins with an egregious mainstream blunder in the macro model-building that still flies below the radar. Seeking to navigate the tricky terrain produced by coherent Friction-Augmented General Market Equilibrium (FGME) fundamentals, many influential theorists turned to emphasizing real shocks, somehow concluding that nonmonetary disturbances are the dominant cause of periodic cyclical downturns. A central FGME stabilization-policy message, at least prior to the wake-up-to-reality provided by the 2007-09 Great Recession, was unhappily organized around the imagined difficulty of distinguishing Pareto-optimal market adjustments from market failure. (See Hall (2007).) For many theorists, nominal-demand management directly targeting employment stabilization had become a problematic tool best set aside.
Some literature. That pushing real shocks to center stage was key part of the macro-academy costly missteps in its effort to be both policy-relevant and adhere to the New Neoclassical Synthesis (NNS) rational-behavior mandate should not be forgotten. Chari, Kehoe, and McGrattan’s (2009, p.244) policy guidance, published with remarkable chutzpah during the worst of the 2008-09 stabilization crisis, is representative: “The Old Keynesian view is eloquently and forcefully summarized by Franco Modigliani (1977), who argues that the fundamental, practical policy implication that Old Keynesians agree on is that the private economy ‘needs to be stabilized, can be stabilized, and therefore should be stabilized by appropriate monetary and fiscal policies.’ The neoclassical [FGME] economists, of course, recommend quite different policies: commitment to low average inflation rates on the monetary side and tax-smoothing on the fiscal side. Moreover, neoclassicals argue that even efficient allocations could fluctuate sizably.”
Chari et al. (2009, p.245) continue: “Something insufficiently appreciated today is that even though the New Keynesian model has many elements of the Old Keynesian stories, such as sticky [product] prices, the New Keynesian policy implications are drastically different from those of the Old Keynesians and are remarkably close to those of the neoclassicals.” RBC theorists were least shy about embracing the policy implications of GME thinking. Their reservations with respect to aggregate-demand management are emphasized in Prescott’s (2002, p.1) Ely lecture: “Business-cycle theory … provides little guidance to policy except for the important policy implication that a stabilization effort will have either no effect or a perverse effect.” This fever dream, which the well-informed in the Prescott’s audience knew to be inconsistent with a fair reading of the evidence, was the message of the 2001 prestigious Ely talk.
Further illustrative of the mainstream perspective, Woodford (2003, p.13) was more circumspect in his deprecation of using demand management to directly influence employment and output: “… because of the difficulty involved in measuring the efficient level of economic activity in real time – depending as this does on variations in production costs, consumption needs, and investment opportunities – it may well be more convenient for a central bank to concern itself with monitoring the stability of prices.” Woodford’s assessment of what is “more convenient” for central banks is consistent with the unavoidable FGME restriction that adverse cyclical shifts exclude involuntary job loss and must, therefore, be exceptionally mild.
Woodford (2003, pp.4-5) used his influential analysis of wage behavior to express now familiar reservations about using real-side nominal demand management, arguing that Phillips-curve relations have mistakenly been thought to imply that “monetary policy should be used to achieve output or employment goals, rather than giving priority to price stability. The present study argues instead for a different view of the proper goals of monetary policy. Its use to stabilize an appropriately defined price index is in fact an important end toward which efforts should be directed – at least to a first approximation, it should be the primary aim of monetary policy…. Moreover, the existence of predictable real effects of monetary policy need not imply that policy should be based primarily on a calculation of its effects on output and employment. For the efficient aggregate level and sectoral composition of real activity is likely to vary over time, as a result of real disturbances of a variety of types.”
Some generous souls point out that the brute reality of the Great Recession caused Woodford and other leading macro theorists to at least partially hide from Prescott’s fever dream. I advise caution to the soft-hearted here. Woodford et al. policy advice was rooted on well-known macro modeling that was always badly out of touch with how modern economies worked. Did their zeal for market-centric modeling entice them into to setting aside the most crucial instability evidence in their instability policy advice? Whatever the reason, their judgement in propagating indefensible macroeconomics was surely sufficiently bad to cast serious doubt on ever again taking them seriously.
Overriding obstacle. Problems most damaging to the stabilization-relevancy of the New Neoclassical Synthesis reflect long-characteristic hubris in the academy. We must accept that theorists who constructed and maintain the coherent FGME workhorse model are surprisingly ill-informed about 20th century labor economics. More to the point, they have only the sketchiest notion of the evolution of labor pricing in the global aftermath of the Second Industrial Revolution. As a result, many mainstream theorists have been, and continue to be, ill-suited to the necessary task of rigorously reconstructing Early Keynesian theory. They arbitrarily distrust the idea that wage rigidity can play a meaningful role in macroeconomics motivated by optimizing, price-mediated exchange organized by continuous general equilibrium. Consequently, many simply rule out a keystone role for nonmarket labor pricing. By making that model-building choice, NNS scholars are rejecting the intuition of a Who’s Who of insightful economists, including Marshall, Fisher, Hicks, Modigliani, Patinkin, Samuelson, Freidman, Solow, Clower, Malinvaud, Drèze, Fischer, Lindbeck, Stiglitz, Summers, Akerlof, and Phelps. Good economists do not shrink from the obvious. And a huge pile of evidence makes it obvious that adverse nominal disturbances produce involuntary job loss, the coherent modeling of which requires the rational suppression of wage recontracting.
Perhaps the major practical problem is that stabilization-relevant modeling turned out to be difficult. In response to the New Classical challenge to Early Keynesianism, research agendas were initially shaped by an invigorated quest for rational foundations for state-independent labor pricing. Despite much work by able theorists, proffering a variety of models including market misperceptions, implicit and staggered contracts, insiders-outsiders, and efficiency wages, the effort to provide a broadly recognized reconciliation of meaningful wage rigidity and optimizing price-mediated exchange had, at least until the recent GEM Project completion of original efficiency-wage theory, failed. Think about that list. Except for original efficiency wages, the various research programs to microfound MWR were all rooted in marketplace exchange. Failure was preordained.
Moreover, research in this area has slowed dramatically. With the Early and New-Keynesian chronic inability to identify a Super Friction capable of embedding meaningful wage rigidities in coherent market-centric modeling, good theorists tired of the unyielding problem and began setting aside the substantial accomplishments of the Neoclassical-Synthesis era, focusing instead on explanations for cyclical employment behavior that conveniently omit the role of labor-pricing inflexibilities. Hall (2003, p.149) captured the fundamental reorientation of mainstream research: “[T]he old idea of wage rigidity [is] … almost forgotten in modern theory where wages are continuously updated through a Nash bargain.” That consensus choice is short-sighted and, ultimately, self-defeating. Building coherent, stabilization-relevant macro models, if provided microfounded meaningful wage rigidity, is easy. Without MWR, the task is not possible. The GEM Project provides the path to stabilization-relevant, rational-behavior, evidence-consistent macro theory.
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