The Quagmire of Market-Centric Wage Rigidities

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The New Keynesian (NK) wage analysis featured today is “Macroeconomic Dynamics with Rigid Wage Contracts,” By Tobias Broer, Karl Harmenberg, Per Krusell, and Erik Öberg in AER: Insights (2023). From the BHKO abstract: “We adapt the wage contracting structure in Chari (1983) to a dynamic, balanced-growth setting with recontracting as in Calvo (1983). The resulting wage-rigidity framework dampens income effects in the short run, thus allowing significant responses of hours to aggregate shocks. In reduced form, the model dynamics are similar to that in Jaimovich and Rebelo (2009), with their habit parameter replaced by our probability of wage-contract resetting. That is, if wage contracts are reset frequently, labor supply behaves in accordance with King, Plosser, and Rebelo (1988) preferences, whereas if they are never reset, we obtain the setting in Greenwood, Hercowitz, and Huffman (1988).”

The authors point to the “significant responses of hours to aggregate shocks” as the central achievement of their wage-rigidity (WR) model. They are also pleased with their approach to constructing the WR framework, which mostly amounts to recombining prominent labor-pricing research done by mainstream market-centric theorists since the ubiquitous Calvo staggered-wage model in 1983.

More from BHKO: “A widely held view is that there is significant short-run wage rigidity and that this rigidity is an important element of the transmission mechanism of macroeconomic shocks. There is so far no consensus, however, about the modeling of such wage rigidity…. In this paper, we propose an alternative framework for studying wage rigidity. In particular, we follow Chari (1983) in describing the ex ante wage-setting stage, in advance of observing macroeconomic shocks, as one of choosing a wage contract: a schedule of wage-hours pairs from which the firm, as shocks hit ex post, can choose one. Ex ante, there is perfect competition with the result that firms offer the contract that maximizes workers’ ex ante utility. With this setting, hours worked are demand-determined ex post—firms have the “right to manage….”

Problems with BHKO Modeling

In this critique of the BHKO analysis, it is useful to note that the Calvo 1983 model – their starting point – doesn’t came close to accomplishing the grand task of rationally modeling wage rigidities capable of generating, in combination with adverse aggregate demand disturbances, evidence-consistent macro instability. Guillermo Calvo’s paper doesn’t really try, instead simply positing a fixed randomly fraction (ϋ) of labor prices remain unchanged each period, permitting the remaining prices to be recalibrated to market conditions. The probability that any given price (product or labor) will be adjusted in any given period is (1- ϋ), implying strong restrictions on rational behavior. At any given time, pricing policies of some firms must ignore whatever happens since prices were last changed. Calvo’s staggered pricing enables tractable aggregation and appears to be, despite its dependence on deeply arbitrary free parameters, the market-friction mechanism of choice in many NK models.

The following bullet points summarizes representative problems with the BHKO modeling:

  • Start with an egregious issue that frequently compromises NK modeling. The BHKO object is explaining the rational (cyclical) behavior of hours at work. The object of Keynesian macroeconomics since the General Theory has been the rational explanation of mass involuntary job loss. The welfare implications of lost jobs differs from the loss of hours. Everybody, including BHKO, knows that. It is a problem that they attempt to distract from not knowing how to model involuntary unemployment by pretending that reduced workweeks will suffice in the useful analysis of wage rigidity.
  • The ‘intertemporal substitutability of labor” – their cyclical phenomenon of interest – does not reflect the nature and size of the actual welfare loss induced by the millions of involuntary lost jobs that have characterized modern recessions. Indeed, voluntary intertemporal substitutability does not reflect any kind of welfare loss.
  • Replacing a habit parameter with a probability of wage-contract resetting may (or may not) be an improvement, but it’s effect is tiny compared to the GEM Project’s replacement of the search-match infrastructure with a second (information-challenged) workplace venue of rational exchange. The resulting workplace-marketplace synthesis roots WR in optimization and equilibrium and enables the evidence-consistent modeling of macro instability.
  • Arbitrarily confining wage rigidity to the short-run, a common NK practice, is a damaging mistake, suppressing attention being paid to job downsizing that occurs in the millions in depression. Ignoring the 1930s Great Depression greatly compromises the credibility of mainstream macro theory. How can we placidly ignore something so important and obvious? Who are we fooling?
  • The preceding points help define a more general, debilitating BHKO problem. Their model’s wage rigidity cannot explain the most important instability evidence, starting with the mass involuntary job loss produced by stationary and nonstationary disturbances in aggregate demand.
  • That problem in turn leads to BHKO joining other NK theorists in degrading the importance of total nominal spending in the design of stabilization policy. That analytic error is sufficient on its own to disqualify NK theorists from advising policymakers.
  • Once they posit the centrality of firms’ inability to reset contracted wages in the circumstance of rising unemployment, neither BHKO nor other NK theorists give up rationally motivating that inability. They ignore the immediacy and power of accepting a reduction in wage rent in lieu of losing one’s job that powers continuous intra-firm wage recontracting in general market equilibrium. Even BHKO (in another context) agree: “… the restriction to a constant nominal hourly wage appears hard to square with actual work practices.”

Those problems easily explain why, in BHKO words, “… there is so far no consensus … about the modeling of wage rigidity.” But there is an available rational-behavior model that is consistent with the range of the relevant evidence.

Generalized-Exchange Theory

Generalized-exchange theory, rooted in optimization and equilibrium, is the focus of the GEM Project. It is consistent with the relevant evidence as well as the descriptive analysis of the inside-the-firm labor economists that dominated mid-20th century labor analysis. It is the focus of the GEM Project. It provides a much more accurate treatment of large-establishment wage setting, and consequent wage rigidity, than market-centric NK modeling.

  • The model intuitively generalizes rational exchange from the labor market (with its full slate of NK frictions) to workplaces restricted by inherent employer-employee information asymmetries. Such workplaces have accounted for a majority of the total labor force since  the Second Industrial Revolution.
  • Information-challenged workplace equilibrium produces two classes of rational wage rigidities (WR), downward nominal inflexibility over stationary business cycles and chronic wage rent.
  • Generalized-exchange WR combine with adverse disturbances in nominal demand to produce two classes of involuntary job loss: temporary layoffs that occur in the millions in periodic recessions (consistent with stationary spending disturbances) and permanent job downsizing that occurs in the millions in catastrophic depressions (consistent with nonstationary spending collapse).
  • Generalized-exchange labor pricing is motivated by optimizing employer-employee workplace interaction organized by general decision-rule equilibrium. It is consistent with perfectly competitive labor markets. It is fundamentally consistent with the 1990s New Neoclassical Synthesis, which provides standards for macro modeling accepted by New Keynesian, New Classical, and Real Business Cycle theorists.
  • The NNS grand compromise paid particular attention to rational behavior. Indeed, if faced with a choice between rationality and the evidence, the jump ball goes to the former. While that always being the correct selection is debatable, a long career making sense out of difficult, high-stakes macro problems has persuaded me that close, not perfunctory, attention should be paid to rational behavior. Substituting assumptions of convenience, especially in wage analysis, almost always misleads, typically badly. At a minimum, such convenience must be carefully justified.
  • The fundamental mistake made by NK theorists deserves emphasis. Rational marketplace exchange is inadequate to the task of usefully modeling macro instability. Market-centric theory must be cojoined with rational workplace exchange restricted by information asymmetries. It is crucial to understand that the second venue is not some kind of elaborate market friction. What goes on in large-establishment venue (LEV) workplaces differs greatly from small-establishment (SEV) market activity. Preferences motivating worker conduct are especially unique to each sector. Detailed rules and systems of jurisprudence always constructed by profit-seeking LEV firms exist only in their most rudimentary forms in SEV enterprises. Moreover, LEV labor pricing dominates SEV wages, forcing small-firm workers into chronic market disequilibrium and creating virtual queues of SEV workers wanting rationed LEV jobs. It makes no sense to try to understand information-challenged workplace equilibrium and the role it plays in macroeconomics by thinking of it as some kind of elaborate market friction. The hard fact is that stabilization-relevant theory requires two distinct venues of exchange, and any attempt to advise policymakers using analysis rooted in only one is akin to professional malpractice.  

Critical Puzzle

A recurrent theme of the GEM Blog is that the casual scrapping of rationality, particularly in labor pricing, has robbed NK modeling of powerful guidance. Carefully pursued, rational behavior has a record of opening up analyses to important, often unanticipated, results. In that context, a progression of NK research illustrates a consequential puzzle in the 21st century development of macro theory.

As already noted, The GEM Project has successfully modeled and made available rigorous rational-behavior wage determination that is consistent with the available evidence. That two-venue approach generalizes rational exchange from the marketplace to information-challenged workplaces. The results of the workplace-marketplace synthesis can be incorporated into NK research, making mainstream analyses much more consistent with both the Neoclassical Synthesis and ever-accumulating macro facts at almost no cost. In so doing, and perhaps this is the rub, New Keynesians would be acknowledging that a fundamental requirement of the improved treatment of labor pricing after the Second Industrial Revolution is the intuitive cojoining of a second (workplace) venue of rational exchange to textbook market-centric modeling. The new venue is comprised of firms in which workplace employer-employee information is inherently asymmetric. That commonplace condition characterizes a substantial share of the total labor force in any modern, highly specialized economy.

Here is the puzzle. Why would mainstream market-centric theorists choose to exclude millions of workers in large, highly specialized firms, the home for almost all involuntary job loss, from their analysis? Paying attention to the fact of information-challenged workplaces would immediately upgrade a great deal of NK research to the elite status of macro modeling rooted in neoclassical tenets of optimization and equilibrium while simultaneously aligning with a full range of stabilization-relevant evidence. What’s not to like?  

Blog Type: New Keynesians

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