Epistemology is defined as the investigation of the origin, nature, methods, and limits of human knowledge. In 2018, Jonathan Rauch wrote about epistemology in the context of current events in National Affairs. “The Constitution of Knowledge” argues that societies of all sorts, public and private, have epistemic regimes that construct rules for weighing evidence and building knowledge.
Rauch writes that epistemic regimes operate like a funnel, with only a relatively narrow group of ideas making it through. “We let alt-truth talk, but we don’t let it write textbooks, receive tenure, bypass peer review, set the research agenda, dominate the front pages, give expert testimony or dictate the flow of public dollars.” Rauch’s analysis is easily generalized to the macroeconomics academy, notably the inability of its mainstream friction-augmented general-market-equilibrium (FGME) theory to explain critical evidence or support effective policymaking.
What We Know about Stabilization-Relevant Macroeconomics
Over a long career, I have learned a lot about the U.S, economy, especially in economic crises, and what it takes to support effective monetary, fiscal, and business policymaking. My lessons learned are rooted in the construction and use of rigorous, evidence-consistent, two-venue macro theory, the most advanced version of which is featured in the GEM Project. What follows is a set of realities that adequate modeling must accommodate.
- The centerpiece of useful stabilization theory is always total nominal spending. Adverse demand disturbances, from whatever source, combine with meaningful wage rigidity (MWR) to uniquely produce involuntary job loss and evidence-consistent output and employment contractions in recession.
- Another requisite model component is pure profit, the expectation of which is the principal driver of investment spending. Outlays on equipment, structures, and software exert the most powerful influence on total demand disturbances.
- It is additionally necessary to identify household income as the dominant determinant of consumption. In 1971, Barro and Grossman demonstrated that rational-behavior centrality of income requires interaction with MWR, a crucial finding that the academy has ignored for decades.
- Also improperly unheeded is the powerful role played by chronic wage rent in instability mechanics, including the puzzling persistence of cyclical unemployment.
- Macro modeling that aspires to be relevant to monetary policy must explain the relatively weak role interest rates factually play in instability mechanics. Zero-bound problems experienced by the central bank, despite greatly concerning mainstream theorists, do not much matter when pure-profit expectations are weak. Attention must not be focused on interest rates but, instead, on effectively intervening (via whatever means) in total spending.
- A New Keynesian innovation – i.e., making the central bank objective of low and stable product-price inflation paramount – is one of the most damaging errors of the academy’s epistemic regime. The GEM Project has demonstrated that investor and lenders’ perception of the credibility of stabilization authorities’ real-side (trend full employment) objective is more crucial, especially in preventing nonstationary collapses in total spending that result in depression. Adequate macro theory must assign a central role to such real-side perceptions.
- The final fact continues to surprise some readers of this Blog. Adequate macro modeling must be motivated by the fundamental neoclassical tenets of rationality and equilibrium.
That partial list, taken together, powerfully challenges the FGME theory that the macro academy has for decades used as its epistemic funnel in the development of macroeconomics. FGME guidance on making sense of actual stabilization dynamics is extraordinarily flawed. It cannot accommodate meaningful wage rigidity, cannot accommodate the centrality of aggregate demand, cannot accommodate forced job loss, and cannot accommodate evidence-sized employment and output contraction in recession. It cannot accommodate pure profit (making investment a mystery), cannot accommodate the centrality of income in the determination of consumption (making household spending a mystery), and cannot accommodate chronic wage rent (making a lot of labor behavior a mystery). It incorrectly makes interest rates all powerful, ignores the crucial importance of the credibility of stabilization authorities’ real-side (trend full-employment) objective, and badly overstates the relative importance of the inflation objective. Concluding this incomplete list, casual efforts to adjust the FGME model class to better correspond to cyclical facts, especially imposing arbitrary restrictions on nominal wage flexibility, turns out not to have made mainstream theory consistent with evidence-consistent behavior.
The macro academy’s epistemic regime has long been rooted in the friction-augmented general-market-equilibrium model class. It incentivizes research topics consistent with FGME thinking for self-interested macro theorists by controlling the effective distribution of mainstream analysis. The dynamic is illustrated by the content of mainstream literature. A stark example is that the most recent two-volume Handbook of Macroeconomics has no mention of involuntary job loss. No mention of the single most important piece of business-cycle evidence! The critically important topic is ignored simply because it cannot be accommodated by mainstream market-centric modeling. It cannot pass through the macro academy’s epistemic funnel.
As already noted, another interesting question concerns the bastardized versions of the FGME model that introduce casual guesswork about the nature of MWR by suspending the assumption of rational behavior. Why doesn’t this irrational version suffice? Why must adequate macro modeling be rooted in the neoclassical tenets of optimization and equilibrium? Next week’s post provides what I believe is a persuasive answer to those fundamental questions.
Blog Type: New Keynesians Saint Joseph, Michigan