Starting Point for Macro Modeling

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Generalized-exchange theory should be easy to love. Most significant among its many attributes, rational wage determination in the large-establishment venue (LEV) is derived from true axioms, producing both downward nominal inflexibility over stationary business cycles and chronic, time-varying wage rents. Macroeconomics is profoundly enriched, so much so that a compelling case can be made that GEM should be the starting point for all macro model-building. (Chapters 2, 3) Meaningful wage rigidity (MWR), dominating labor prices ground out in the labor market and pushing employees off their market supply schedule, powerfully anchors macrodynamic analysis. (Chapter 5)

It is interesting to think through how using GEM labor pricing as a model-building starting point would have altered iconic contributions to macro theory, especially the contentious microfoundations literature. What follows is an exercise in what-could-have-been.

John Maynard Keynes (1936) is, of course, the place to begin. The General Theory centrally reversed Say’s Law real-to-nominal causation, providing an activist role for government in economic stabilization. Given Keynes’ desire to rout classical macro theorists, wages play a muddled role in his masterwork. He famously concluded that wage rigidity is not necessary for the existence of involuntary job loss (IJL) yet assumed downward inflexibility in his core analysis. He never demonstrated why labor-price recontracting, i.e. rational workers accepting wage cuts that do not violate their opportunity costs in lieu of job loss, does not prevent forced layoffs in response to weakening demand. The classical exception to the suppression of recontracting as a necessary condition of IJL is employing firms going out of business, a much more frequent cause of job loss in macro panics prior to the Second Industrial Revolution.

Keynes instead focused his analysis on why, in highly specialized modern economies, cutting money wages would be an ineffective response to the unemployment produced by contracting total nominal demand – a different and much more defensible argument than rejecting MWR as a condition for IJL existence. The obvious reason has always been that wage-cut implementation inherently lags behind, and becomes a partial cause of, multiplier-fueled spending contractions. A more fundamental reason has emerged recently. In the circumstances of stationary business cycles, nominal wage cuts in large, specialized firms (the location of most layoffs) have been shown to be irrational, violating LEV profit-seeking.

If rational LEV labor pricing had been the starting point of Keynes’s analysis, The General Theory would have been transparently coherent, explaining a much broader range of important phenomena. The less muddled book would have been invulnerable to New Classical criticism and would be read by graduate students today.

John Hicks (1937, 1939, 1974), given access to generalized-exchange continuous-equilibrium modeling, could have microfounded his IS-LM interpretation of The General Theory, avoiding the devastating New Classical attacks that gathered unstoppable momentum during the 1970s stagflation. Banishing Hicks’s demand apparatus from graduate-school reading lists exemplifies the intolerably petty mainstream overreaching that would have been avoided by intuitively generalizing rational exchange from the marketplace to workplaces inherently restricted by costly, asymmetric information and routinized jobs.

Moreover, Hicks would have been comfortable with the new workplace venue. As early as 1974, he provided an outline of large-establishment nonmarket wage determination that captured many features of generalized-exchange labor pricing, albeit falling short of the needed derivation from model primitives.

Don Patinkin (1956) is the greatest macroeconomist about whom modern graduate students have never heard. He assumed a fixed nominal wage and then assembled an aggregate-demand model that explicates the rationing that results from demand shocks. He outlined the foundations needed to support the then-dominant Keynesian Neoclassical Synthesis as well as intermarket effects inherent to rationally adjusting to nominal disturbances. Endowed with GEM labor pricing, Patinkin would today be a primary micro-coherent reference in macroeconomic instruction, research, and dissemination. A great deal of stabilization-irrelevant or duplicative analysis could have been avoided.

Herschel Grossman and Robert Barro (1971, 1976) attracted considerable attention, reflected in the number of citations, by integrating intermarket spillover effects from employment rationing into a general-equilibrium framework in support of the Keynesian consumption function. They assumed wage rigidity to motivate the rationing process, and their thinking was consequently banished by mainstream macro gatekeepers. The authors themselves hastily concurred with that judgment. Had dominant optimizing workplace labor pricing been available in the early 1970s, G&B analysis would today have an important place in modern graduate-school reading lists.

Robert Lucas (1972, 1976) played the starring role in reconfiguring consensus macro thinking around micro-coherence by championing the rational expectations (RE) explored by John Muth. The GEM Project shows how the New Classical misuse of expectations greatly damaged stabilization-relevant macroeconomics. Once the rational expectations of inflation replaced catch-up to past inflation in the Samuelson-Solow Phillips equation, attention paid involuntary job loss and its link to nominal disturbances began to wane. Had New Classical theorists not arbitrarily and nonintuitively restricted rational exchange to the marketplace, it would have become apparent that RE cannot play their assigned role in periodic large-establishment adjustments of money wages for inflation. They would have accepted the impeccable rationality of catch-up. (Chapter 4) Had the generalized-exchange model class been available, the substantial harm caused by the irrational application of rational expectations to the construction of mainstream research agendas would have been avoided.

Edmund Phelps (1994) is perhaps the most important pioneer in information-theoretic microfoundations. In his underappreciated masterwork, Structural Slumps, he used and was misled by the Shapiro-Stiglitz shirking version of efficiency wages to model continuous-equilibrium unemployment. He got stuck with exclusively voluntary job loss and could microfound no causal link from nominal demand disturbances to recognizable cyclical joblessness. (Chapter 9) If he had used the fact of generalized-exchange labor pricing as his starting point, Structural Slumps would have been stabilization-relevant as well as micro-coherent. It would have received the attention it deserves.

Ben Bernanke (2000) readily acknowledged that his important two-part theory of the 1930s depression needs a coherent explanation of MWR. The model’s first part closely analyzes the Great Depression’s total spending collapse, assigning much of the blame to the gold standard. Using GEM-Project terminology, the second part features the assumption of meaningful wage rigidity to induce two critical effects. It causally links the nominal demand disturbance to involuntary job loss and same-direction changes in output, wage income, and profits. It additionally imposes long lags on the rational wage-giveback process. (Chapter 3) Bernanke understood that MWR must exist but sidestepped microfounding it. He readily conceded his depression theory is incomplete, awaiting the emergence of a robust analysis of actual labor pricing. Failing the crucial test of coherence rendered his otherwise important model unacceptable to mainstream gatekeepers. Graduate students, confined to consensus market-centric general-equilibrium macro thinking, continue to be bewildered by the Fed’s 2008-09 strategy that successfully averted another 1930s-class depression.

Blog Type: Wonkish San Miguel de Allende, Mexico


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