The Lost Generation

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I just reread Jordi Gali’s short 2011 book, Unemployment Fluctuations and Stabilization Policies, that he based on his Zeuthen Lectures. The GEM Blog has been hard on that book in the past. I remember being especially put off by its assumption, implied in the title, of stabilization-policy relevance.

I came away from my second reading more sympathetic. That does not mean the book should be used as a guide to stabilization policymaking. That would cause, especially in episodes of extreme instability, a lot of damage. Its roots in mainstream New Keynesian (NK) market-centric general-equilibrium modeling prevents Gali’s analysis from rationally accommodating the most important cyclical evidence. But maybe that does not matter. Readers of this Blog know that, after being pummeled by the Great Recession, stabilization authorities no longer rely on NK advice.

My new empathy results from thinking about the first generation of macro theorists trained by NK professors. When I attended graduate school, the governing macroeconomics was Early Keynesian (EK). Given that school’s admitted reliance on irrational labor pricing for its stabilization relevance, teaching and research emphasized the primary need for the derivation of meaningful wage rigidity (MWR), defined by its capacity to rationally suppress wage recontracting. The recognized unfinished nature of macro theory provided an environment open to nonmarket modeling. For example, I was able to take courses featuring the extraordinary work of the original intra-firm labor economists that became critical to my understanding of how highly specialized economies worked. That understanding was central to my career at the Federal Reserve and the Congressional Budget Office.

Consider the quite different circumstances facing Gali’s generation. The biggest disparity is that dominate New Keynesians, bruised by the decades-long macro wars, took the extraordinary step of declaring and enforcing that their rational-market-frictions enhanced general-market-equilibrium is finished theory. Theorists busy themselves constructing smokescreens for the obvious holes in that story, the most obvious being the absence of involuntary job loss and recognizably sized recessions. How did students navigate the real world? Their graduate training did not provide them any practical macro description of modern economies.

From that more generous perspective, his book has some admirable properties. Unlike many of his generation, he does not shy away from the obvious centrality of nominal wage rigidities in stabilization analysis. From Gali: “The analysis puts special emphasis on the role played by nominal wage rigidities in accounting for the volatility and persistence of unemployment. A conclusion of that quantitative exercise is that realistic wage rigidities may potentially generate fluctuations in unemployment with cyclical properties not much different from those observed in the US and euro area economies.”

Moreover, unlike almost all his contemporaries, Gali has sufficient integrity (and courage) to note the obvious uselessness of the ubiquitous NK attempts to explain the flood of layoffs in recession with labor-market search/match modeling. “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.” O.K., that is not as courageous as the facts call for. Gali is still feigning ignorance that the evidence shows cyclical unemployment to result from involuntary job loss while frictional joblessness is inherently voluntary. But we must recognize that any reservations about the much-honored Mortensen-Pissarides model class is not acceptable in the mainstream macro academy.

In his book, Gali does properly turn to wage rigidity to motivate his instability analysis, running head-on into the GEM Project maxim that MWR cannot be rational in market-centric general-equilibrium analysis. It cannot be derived consistent with optimization and equilibrium; it must be assumed. And that is what he does. “More specifically, and following Calvo’s formalism (Calvo, 1983), I assume that workers specializing in a given type of labor (or for the union representing them) reset their nominal wage with [an arbitrary] probability 1-S each period.” He has now made the fundamental NK mistake, from which his book cannot recover. He settles on a specification of wage rigidity based on convenience, rather than consistency with the evidence. Inattention to the proper nature of wage rigidity irreparably misleads to the point of uselessness the remainder of Gali’s analysis.

In particular, the use of Calvo’s instead of the generalized exchange version of MWR badly truncates Gali’s capacity to construct a stabilization relevant model of business cycles. His is irrational, the other is consistent with optimizing price-mediated exchange organized by general decision-rule equilibrium. His is very short-run, unable to support realistic recession size and persistence. (That failure helps explain the NK promotion of great moderations; see next week.) His assumption cannot accommodate involuntary job loss. His modeling cannot support chronic wage rents, cannot explain evidence-consistent factor income distribution, cannot support evidence-consistent Phillips curves, cannot explain evidence-consistent extreme-instability crises, cannot explain the existence of bureaucratic firms, cannot explain the evidence-consistent two-sector Lewis growth model, cannot explain the 1970s stagflation decade, cannot explain evidence-consistent existence of pure profit, cannot explain evidence-consistent determinants of consumption and investment, and more. All of those “cannots” are pieces of cake for the GEM version of MWR.

Blog Type: New Keynesians Saint Joseph, Michigan

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