Two Keynesians, One Early, One New

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My former colleague at MIT, the late Franco Modigliani (1977) forcefully asserted that the economy “needs to be stabilized, can be stabilized, and therefore should be stabilized by appropriate monetary and fiscal policies.” As a charter member of the Early Keynesians who dominated the first quarter century of postwar macroeconomics, his fundamental concern was costly instability that is inherent in highly specialized economies. He would have been pleased that the GEM Project has at last microfounded meaningful wage rigidity and the causation from nominal-demand  disturbances to involuntary job loss and recognizably-sized same-direction movement in employment, output, income, and pure profit.

New Keynesians, while claiming the same lineage as Modigliani, have developed quite different research priorities.  Buying into the late-1990s consensus with New Classical and Real-Business-Cycle macroeconomists that is organized around the New Neoclassical Synthesis, NK theorists have allowed stabilization relevance to take a back seat to defending the mainstream micro-coherent, market-centric DSGE methodology that cannot accommodate the rational suppression of wage recontracting. The hard fact is that NK theorists have committed their reputations and human capital to a, stabilization-irrelevant model.

In the New Neoclassical Synthesis, price stickiness exists but only if it can be endogenously accommodated within the mainstream micro-coherent general market-equilibrium framework. After decades of research, NK theorists have been able to microfound bit of causality from nominal disturbances to real effects on employment and output. The GEM Project has closely investigated the limitations placed on macro fluctuations by mainstream market-centric thinking. Modern macro theory requires that recessions be sufficiently mild to avoid generating forced layoffs. Menu-cost or any other product-price stickiness thought to pass the test of market-centric micro-coherence cannot suppress wage recontracting and, therefore, cannot motivate recognizable cyclicality. It is an existential dilemma. Mainstream macrodynamics are far out of touch with instability actually produced in highly specialized economies.

Michael Woodford’s Interest and Prices (2003, p.5) is widely recognized as the New Keynesian bible. In it, he illustratively struggles with but ultimately accepts the mainstream detachment from the most important cyclical evidence, at least as a practical matter.  “[T]he existence of predictable real effects of shifts in monetary policy need not imply that policy should be based primarily on a calculation of its effects on output or employment. For the efficient aggregate level and sectoral composition of real activity is likely to vary over time, as a result of real disturbances of a variety of types. The market mechanism performs a difficult computational task – much of the time, fairly accurately – in bringing about a time-varying allocation of resources that responds to these changes in production and consumption opportunities. Because of this, variation over time in employment and output relative to some smooth trend cannot in itself be taken to indicate a failure of proper market functioning.” (p.5)

Woodford’s (p.13) goes on to use mainstream NNS analysis to argue, albeit cautiously, for the single-objective stabilization theorem: “… at least under certain circumstances, inflation stabilization eliminates any need for further concern with the level of real activity. This is because, at least under the conditions described more precisely in Chapter 6, the time-varying efficient level of output is the same (up to a constant, which does not affect the basic point) as the level of output that eliminates any incentive for firms on average to either raise or lower their prices. It then follows that there is no conflict between the goal of inflation stabilization and output-gap stabilization. Furthermore, because of the difficulty involved in measuring the efficient level of economic activity in real time – depending as it does on variations in production costs, consumption needs, and investment opportunities – it may well be more convenient for a central bank to concern itself simply with monitoring the stability of prices.”

The different takes on macro stability by Modigliani, the passionate Early Keynesian, and Woodford, the cautious New Keynesian, are instructive. Don’t we all know, deep down, that the test of any model’s stabilization relevance is whether it coherently accommodates a causal link from nominal disturbances to involuntary job loss and recognizably-sized movement in output, employment, and income?  Modigliani’s way of doing macroeconomics, with wage rigidity suppressing labor-price recontracting at its center, is stabilization-relevant. Woodford’s is not. Every macroeconomist is confronted with the fundamental Early versus New Keynesian choice. Make meaningful wage rigidity a keystone of your modeling and become eligible to advise stabilization authorities, or set MWR aside and become ineligible to do much of anything that is practical.

With the advent of generalized-exchange theory, a model class that is both coherent and stabilization-relevant, the fundamental choice has become clear. Modigliani’s view that recessions are rooted in wage rigidity and reflect broad market failure, best understood to be a meta-externality that requires public intervention, has carried the day. Since the Second Industrial Revolution, modern highly specialized economies need to be stabilized, can be stabilized, and therefore should be stabilized by appropriate monetary and fiscal policies.

Blog Type: New Keynesians Saint Joseph, Michigan


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