GEM propagation of the 2008-09 financial turmoil and associated collapse of investor confidence is at the heart of the Project’s modeling of the Great Recession. (See the next post.) Mainstream macro theorists ignore crucial propagation dynamics and instead concentrate on pinning the blame for the financial crisis on badly underwritten nonstandard residential mortgages. As a result, they cannot explain why mark-to-market prices of nearly all non-Treasury assets quickly fell so sharply. In particular, the blame gamers cannot adequately explain how a relatively small number of exotic mortgages pushed the economy to the brink of depression.
Moreover, they conveniently ignore the actual default performance of the culprit exotic mortgages. From The Financial Crisis Inquiry Report (2011): “Overall, for 2005 to 2007 vintage tranches of mortgage-backed securities originally rated triple-A, despite the mass downgrades only about 10% of Alt-A and 4% of subprime securities had been ‘materially impaired’ – meaning that losses were imminent or had already been suffered – by the end of 2009.” (pp. 228-9) That fact remains below the macro academy’s radar but is relevant its consensus originating cause of the Great Recession. Popular “blame-game” books that do not answer the most important 2008-09 stabilization questions include Zuckerman (2009) and Lewis (2010),
It is further noteworthy in setting the stage that lost output and income in the 2007-09 U.S. recession is wholly attributed to reduced labor input; reduced productivity played no aggregate role. Jobs declined 6.7%, employee hours dropped 8.7%, and total product fell 7.2%. (In the average postwar U.S. recession, jobs contract 3.8%, output 4.4%, and hours 3.2%.) Fitting the Great Recession into the general-market-equilibrium business-cycle research program ultimately turns on the capacity of rigorous market-centric modeling to accommodate the size and nature of the labor-input contraction that we know to be overwhelmingly involuntary.
Mainstream market-centric analysis misidentifies the critical question posed by the Great Recession’s empirical configuration. Ohanian (2010, pp. 51-52) boldly illustrates the badly off-target thinking: “… hours worked during the 2007-2009 recession are much too low relative to the marginal product of labor. Thus, the key to understanding this recession is finding a factor that works like a large increase in the tax on labor income that depresses the incentive to work relative to the observed marginal product of labor.” Ohanian’s presumption that the reduced labor input resulted from voluntary job separation sharply contrasts with both GEM thinking and the facts. Reiterating the former, generalizing exchange from the marketplace to information-challenged workplaces enables grounding meaningful wage rigidity in optimization and equilibrium. It follows that MWR, confronting contracting nominal demand, rationally pushes employees off their neoclassical market supply schedule, compromising optimization at the consumption-leisure margin. In large, complex workplaces, employees instead optimize their OJB with respect to axiomatic preferences for both consumption and fair treatment, conduct that is broadly recognized by practitioners. Rational downward wage rigidity (DWR) and pure wage rent (PWR), structural features of profit-seeking LEV firms’ wage policy, imply that employees’ market-opportunity costs are chronically below labor’s marginal product. More significantly for this post, DWR provides the central nominal-real channel that critically propagated collapsing confidence and produced the 2007-09 mass involuntary job loss.
The message is clear. If they are to be both rational and stabilization relevant, macro models must be capable of suppressing wage recontracting. From the GEM perspective, the Fed’s prompt identification of the mutation of the early 2008 stationary demand disturbance (SDD) into a brewing nonstationary demand disturbance (NDD) was followed by its quick all-in effort to shore up collapsing financial markets and attendant confidence and total spending. To help present a balanced picture, an example of misidentifying the SDD→NDD problem occurred in 2002-05 when the Fed, fearing price deflation but lacking evidence of contracting aggregate demand, kept short-term interest rates extraordinarily (and improperly) low. The good news here is the substantial difference in the macro landscape between 2008-09 and 2002-05, suggesting that theSDD→NDDproblem class is not particularly difficult to identify. It should also be reiterated that GEM modeling relieves discretionary fiscal policy of Ricardian-equivalence constraints, making well-designed public tax- and spending-interventions an important stabilization tool, especially in recovery phases from extreme instability. GEM modeling also strongly emphasizes the need for effective federal budget surpluses when the economy is strong.
The Fed’s aggressive GR policy, utilizing its balance sheet to backstop critical financial institutions’ creditworthiness and to finance huge quantities of asset purchases, revived largely frozen credit markets and reversed the interrelated contractions of confidence and total spending. It was the rational response to the threat posed by the developing NDD crisis. Subsequent posts show that the aggressive use of warrants, as in the Great Recession, can help deal with distortions of financial firms’ incentives toward risk-taking.
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