The Lost Generation, Part II

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We know that mainstream macro theory, rooted in friction-augmented market-centric general equilibrium, cannot accommodate meaningful wage rigidity. We know that MWR is defined by its capacity to rationally suppress wage recontracting. We know that the absence of MWR mandates the rational nonexistence of involuntary job loss and recognizably sized employment and output responses to nominal-demand disturbances.

We also know the bottom line. New Keynesians (NK), who have dominated macroeconomics for decades, are in a pickle. They own the inadequate market-centric analysis. Moreover, they have doubled-down on their bad bet by insisting that their model is fundamentally finished theory. There is no need for additional research on its micro foundations. Published work of the mainstream academy has long emphasized “perfecting” its core model, identifying market frictions and diverting attention from its inherent stabilization irrelevance. The most frequently used shiny object has been the ubiquitous attempt to use textbook labor-market search/match theory to explain cyclical unemployment.

Mainstream stabilization uselessness has forced a generation of macro theorists, who have been trained in the NK market-centric general-equilibrium canon, to have a high tolerance for hypocrisy and embarrassment. This post looks at an illustrative unhappy episode for Jordi Gali, a prominent member of the lost generation featured in last week’s post.

Three Choices

The new generation of NK theorists, both ambitious and idealistic, wants to attack the market-centric general-equilibrium model class’s stabilization irrelevance, most notably its inability to accommodate evidence-consistent employment and output responses to weakening nominal demand. That effort has been limited to three research strategies. First, they have sought to identify a rational market friction that microfounds MWR, which the good ones figure out is a necessary condition of causality from nominal demand disturbances to evidence-consistent forced layoffs and associated production cuts. Unfortunately, they discover what older Keynesians learned before them. The rational suppression of wage recontracting cannot occur in the neoclassical marketplace. The crucial market super friction capable of rationally suppressing wage recontracting simply does not exist.

Second, they attempt to force labor-market search/match theory to explain cyclical unemployment. Many try this route; the related PhD theses seem innumerable. This research strategy has also failed, as it must in the context of optimization and equilibrium, largely as a result of two facts. Search/match activities can only generate voluntary joblessness, and the increased unemployment that occurs in recession is always dominated by involuntary job loss. For example, in the Great Recession (2007-09), the nearly six-million involuntarily layoffs accounted for more than three-quarters of the increase in total unemployment – a share consistent with previous recessions that occurred since the late 1960s when the BLS began counting job losers.


Monthly Peak-to-Trough Change in:

Unemployment Rate   Job Losers (000)


1969-70   +2.4 points          +1,230

1973-75   +3.8 points          +2,599

1980        +1.5 points          +1,315

1981-82   +3.6 points          +3,433

1990-91   +1.3 points          +1,373

2001         +1.2 points         +1,423

2007-09    +4.8 points        +5,807


Recall Gali’s 2011 cautious assessment in last week’s post: “It is important to recognize, however, that the findings of the recent literature on labor market frictions suggest that frictional unemployment is not enough to generate unemployment fluctuations of the size and persistence observed in the data, and that suggest need for some kind of wage rigidity.”

Third is the most far-fetched. Some NK theorists have hypothesized that recessions underwent a fundamental metamorphosis after the 1981-81 downturn. A largely unspecified Great Moderation (GM) occurred that sharply reduces the output and employment response to nominal demand disturbances. It was considered good form for NK theorists to buy into this convenient argument as some kind of great fact that lessened the importance of their inability to model realistically sized business cycles by pretending that the actual economy has fundamentally changed to look more like mainstream theory. The attractiveness of that convenient story persisted until the extreme instability of 2007-09 blew the fairy tale out of the water. Since then, the Great Moderation pipedream had been a particular source of embarrassment, revealing the lengths to which New Keynesians will go to assert the practical usefulness of their market-centric general-equilibrium model class. Surely most people agree that trying to fool stabilization policymakers is a truly despicable strategy.

The Great Moderation

Jordi Gali took one for the NK team in the initial issue of the American Economic Journal: Macroeconomics. In a collection of articles featuring supposed advances made by NK theorists, Gali coauthored “On the Sources of the Great Moderation” with Luca Gambetti. From the summary: “The Great Moderation in the US economy has been accompanied by large changes in the comovements among output, hours, and labor productivity. Those changes are reflected in both conditional and unconditional second moments as well as in the impulse responses to identified shocks. Among other changes, our findings point to an increase in the volatility of hours relative to output, a shrinking contribution of nontechnology shocks to output volatility, and a change in the cyclical response of labor productivity to those shocks. That evidence suggests a more complex picture than that associated with ‘good luck’ explanations of the Great Moderation.” That summary describes a hand-waving search for evidence that supports the Great Moderation hypothesis while deliberately ignoring much more powerful contrary data. Selective data mining to support the Great Moderation idea was common practice until 2008-09.

In retrospect, it must be embarrassing to have taken the Great Moderation idea (conveniently dated from the end of the severe 1981 recession) seriously, given the flimsy support provided by the 1990-91 and 2001 downturns. What aggravates the embarrassment, clearly revealing the NK Ptolemaic intent, is that the Gali-Gambetti article was published in 2009, near the bottom of the 2007-09 Great Recession, the actual extreme instability that blew the Great Moderation idea out of the water. Why wouldn’t the editors allow Gali to withdraw the clearly foolish article? What did they gain by forcing that credulity blot on his reputation?

Blog Type: New Keynesians Saint Joseph, Michigan

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