The Badly Premature New Neoclassical Synthesis

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The mid-1990s New Neoclassical Synthesis has been accepted by most macroeconomists as a necessary upgrade from the original Neoclassical Synthesis. The 1950s NS was formulated by Paul Samuelson as a practical framework for Early Keynesian model-building in the aftermath of Keynes’ General Theory. The NNS was thought by many to be the death knell for EK modeling. Especially damaging to the old order is the NNS  mandate to root all analysis, no exceptions, in the neoclassical tenets of optimization and equilibrium. Assumptions rooted in strong evidence rather than rational behavior were ruled unacceptable.  For decades, Early Keynesians had been positing downward wage rigidity (DWR) to causally link demand contractions to mass involuntary job loss (IJL). Many New Keynesians, deprived of that critical evidence-consistent assumption while being stuck on how to make meaningful DWR consistent with rational behavior, have chosen to follow the advice of Robert Lucas and simply avoid mass IJL in their mainstream stabilization modeling.

Pretending that IJL does not exist is much too debilitating to ignore. Given that significant wage rigidity had yet to be microfounded, pushing forward the NNS governing framework was devastatingly premature. NK market-centric economic tools did not in the 1990’s, and do not today, effectively support the rigorous analysis of macro instability. Playing by NNS rules, New Keynesians can accommodate neither mass IJL nor the centrality of aggregate-demand management to deal with it. Absent rational foundations for meaningful DWR, NNS analysis blundered badly – perhaps most harmfully by promulgating the inherent ineffectiveness EK demand-centric stabilization-policy.

Fortunately for the self-respect of the macro academy, not all reputable theorists wanted to ditch all that the EK theorists achieved in the quest for market-centric purity. Given the absence of adequate analytic tools, empirical and policymaking research had no choice but to continue positing wage rigidity. Notably among the cooler heads is the late Herschel Grossman (2001), who in the midst of the Real Business Cycle craziness championed practical model-building: “Keynesian economics has two distinctive features: (1) The factual observation that monetary policy, and other factors that affect aggregate demand, also affect real economic activity, not only prices and wages, In short, Keynesian economics starts with the observation that money is not neutral at the business-cycle frequency. (2) The theoretical hypothesis that the observed non-neutrality of money results from the stickiness of nominal wages and/or prices and manifests itself in the failure of markets to clear in response to purely nominal disturbances.” 

I would nitpick only Grossman’s lack of alarm about the destructive rush of many of the profession’s most prominent theorists (think of Olivier Blanchard’s research during this dark period) to marginalize mass IJL, focusing instead on the search for some market friction capable of rationally generating at least a tiny bit of (usually voluntary) unemployment. It became standard practice to ignore the central instability fact: In highly specialized market economies, mass involuntary job loss exists and periodically manifests itself in millions of involuntarily unemployed workers,

 The GEM Project demonstrates how to get out of this mess: generalizing rational exchange from the marketplace to information-challenged workplaces. The second venue produced an exceptionally powerful new economic tool, i.e., the nonconvex workplace exchange relation, that roots meaningful wage rigidity in optimization and equilibrium. More specifically, nonconvex WERs motivate meaningful downward wage rigidity at business-cycle frequencies and wage rent chronically paid by large, highly specialized firms. It is the missing macro tool that rescues mainstream theorists from being made ridiculous by their adherence to the New Neoclassical Synthesis. It is the rational-behavior innovation for which Samuelson and the Early Keynesians were explicitly waiting to provide guidance on how to properly suppress wage recontracting, freeing those estimable theorists from the placeholding Neoclassical Synthesis.  

It is clear that the mid-1990s adoption of the New Neoclassical Synthesis was badly premature, not fundamentally wrong. Substituting the NNS for Samuelson’s Neoclassical Synthesis prior to guidance from microfounded meaningful wage rigidity led to embarrassment, perhaps most demonstrated by the conclusion that the stabilization policies of the Early Keynesians were inherently useless. Now that the GEM Project has made its game-changing contribution to our understanding of wage rigidity, a less dogmatic NNS can acceptably replace the NS as the proper framework within which stabilization-relevant research is conducted, Samuelson insisted the NS was never more than a temporary placeholder that provided stabilization relevance while awaiting guidance from macro theory that rationally accommodates meaningful wage rigidity. The premature adoption of the NNS before the nonconvex WER became available was an ill-conceived exercise in impatience that has cost the profession dearly.

Blog Type: New Keynesians

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