The Bedrock Two-Venue Theorem

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Involuntary job loss is at the heart of macro theory’s monetary-stabilization muddle. For policymakers, the socioeconomic problems of employment and income loss rooted in market failure are central to business-cycle pathology. The GEM Project demonstrates, contrary to many critics of modern thinking, that the mainstream inability to accommodate the nature and behavior of joblessness does not result from the consensus mandate that acceptable macroeconomics be micro-coherent. The germane problem is less profound, rooted instead in the arbitrary restriction of rational exchange to the marketplace, and is more readily corrected. Solving that basic problem microfounds intuitive stabilization policy while preserving the formal economic method grounded in rational behavior.

The critic of the formal economic method with the biggest megaphone is Paul Krugman (2009, p.37): “… economists will have to learn to live with messiness. That is, they will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‘theory of everything’ is a long way off.” Akerlof and Shiller (2009) and Caballero (2010) also notably illustrate the powerful post Great Recession critique of economic rationality. Generalized-exchange modeling avoids throwing out the baby with the bath water.

The bedrock theorem.  The organizing proposition for GEM rethinking of macro theory and its implications for stabilization policymaking is named the Two-Venue Theorem, which uses the modern interpretation of economic equilibrium as a rest period in the space of optimizing decision rules:

The coexistence of continuous optimizing economic equilibrium (providing analytic coherence) and nominal wage rigidity (sufficient to support involuntary job loss) implies the existence of a nonmarket equilibrium governing the dominant subset of labor pricing.

Venues of price-mediated exchange are defined by fundamental heterogeneities in optimizing decision rules, constraints, and exchange mechanisms that impose boundaries on meaningful aggregation. The intuitive venue concept is central to generalized-exchange macroeconomics. (Chapter 5) The theorem is probably best understood in conjunction with Barro’s wage-recontracting critique. It is offered, not modestly, as the most consequential labor theorem in macro modeling. Perhaps most notable, it has motivated the first theory of rational wage determination that is consistent with the Second Industrial Revolution and its extraordinary global aftermath. Pulling the profession’s understanding of labor pricing out of the 19th century, where it is understood by practitioners to no longer belong, is itself a good thing.

Limits to aggregation are critical to the case that modeling restricted to single-venue (marketplace) exchange inadequately supports stabilization-relevant macro theory. Think about it. The fact of forced layoffs implies the existence of meaningful wage rigidity, which in turn implies the existence of wage rents and job rationing, suppression of work-leisure substitution, nominal non-neutralities, and spillover effects that disturb other markets. Such a macro environment, surely more Keynesian than Walrasian, is an impossible fit with the single-venue general market equilibrium that dominates macro analysis in the academy.

Missing venue. The intuitive location for the Two-Venue Theorem’s nonmarket class of equilibrium exchange is the large, specialized workplace. Big bureaucratic firms are broadly understood to pay close attention to nonmarket factors in their wage policymaking. Employers learned early in the past century that, in circumstances of imperfect contracting and supervision, labor prices embody information that influences workplace, distinct from marketplace, incentives.

Workplace knowledge, in vast amounts, has accumulated since “Speedy” Taylor’s (1911) time-and-motion studies and the famous 1924-32 Hawthorne experiments conducted at a large Chicago factory. (Chapter 2) The robust literature provides a well-documented, detailed description of intra-establishment behavior and practices that conflict fundamentally with the single-venue general-equilibrium (SVGE) modeling of the macro mainstream. Modern theorists’ stubborn belief that labor pricing and use can be adequately understood wholly as market phenomena reflects a collective hubris that has irreparably damaged their stabilization relevance.

New research program. Building on the two-venue theorem, the generalization of rational exchange from the marketplace to the large-establishment workplace motivates the fourth micro-foundations research program in the past half-century. It joins the New Classical, Real Business Cycle, and New Keynesian projects. Unlike the NC, RBC and NK efforts, however, the GEM macro model class is simultaneously coherent and stabilization-relevant.

That the GEM Project is successful where NC, RBC and NK theorists have failed results from its shift in focus from rational expectations, representative agents, or market competition to the nonintuitive, deeply restrictive assumption that all rational exchange must occur in the marketplace. Once optimizing price-mediated exchange organized by rational expectations and coherent continuous equilibrium is generalized from the marketplace to the workplace, most of the problems that have plagued mainstream macro analysis throughout the turbulent NC-RBC-NK saga are easily resolved.

Most notably, GEM uniquely microfounds meaningful wage rigidity, which provides the causal link from nominal demand disturbances to involuntary job loss and thereby justifies the activist management of total spending. The particular stabilization analyses of Lucas, Prescott, and Woodford are pushed aside. (Chapters 2, 10) Moreover, the two-venue theory powerfully informs an intermediate-run featuring, on the one hand, expectations of trend profit that motivate investment and growth (as described in the Solow model) or, on the other, downsizing and restructuring along the lines of the Thatcherite revolution in Britain or the 1980s wave of labor-cost bankruptcies in basic industries in the United States.  (Chapters 3, 10) The GEM Project explains a lot of macro behavior, easily more than its NC, RBC, and NK predecessors combined.

Blog Type: Wonkish Chicago, Illinois

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