Market-centric general equilibrium (GME), pioneered by Walras and infused with the genius of Arrow and Debreu, is a towering scholarly achievement. It has long been economists’ dominant model of rational price-mediated exchange. Like the succession of beautiful theories in physics, however, it carries seeds of its own demise as a general account of actual behavior. Moreover, as in physics, the nature of its gathering inconsistencies with important evidence points toward more useful models to come. A tip-off with respect to the future of stabilization-relevant macro-economics is Keynes’ prescient rejection of his Second Classical Postulate, the equality of wages and marginal disutilities of work. That pillar of neoclassical thought turns out to be the Achilles heel of GME analysis.
Rethinking the Second Postulate in the context of highly specialized economies stimulated the development an especially powerful economic tool: rational nonconvex Worker Exchange Relations. Readers newly acquainted with the WER are surprised by its real-world relevance. In commonplace LEV circumstances, employer supervision of on-the-job behavior is badly damaged by inherent information asymmetry. Ineffective oversight has compelled profit-seeking firms to turn to human-resource management (with its emphasis on fair treatment) that experience indicates pushes modal OJB toward consistency with firm objectives.
Scaled-up, highly specialized production aligns with that practitioner-familiar approach to motivating employees. Confining workplace analysis to economist-familiar market governance became, as the 20th century progressed, an increasingly debilitating mistake. For starters market centricity is compatible with neither effective downward wage rigidity (DWR) nor pure wage rent (PWR). Both have been shown to be necessary for the rational suppression of labor-price recontracting and, more generally, the satisfactory explanation of a full range of macro evidence, the nature of which has changed dramatically since the birth of economics.
For almost the entirety of human history, near subsistence worker living standards were the salient macro problem. In early nineteenth-century Britain, the time of Jane Austen’s enduring stories of English manners, the typical Englishman was a farm laborer who consumed some 1,500 calories a day – less than modern hunter-gatherer tribes in New Guinea. That worker’s material standard of living was little better than earlier experienced by a Roman slave. Malthus’s model of intertwined subsistence and the urge to procreate (or, in the subtler version, the economic advantages of children) features the inadequate productivity growth that dominated economies up to the industrial revolutions that took hold in the 19th century. Those seismic shifts required large bureaucratic firms to execute the aggressive pursuit of scale that enabled the huge transfer of labor from low-productivity agriculture to high-productivity manufacturing. New corporate forms (extended to services and other non-manufacturing) became home for a growing share of rational labor pricing and use, significantly reducing the dominance of market exchange.
Economists understand that industrial revolutions eventually broke most of the world out of the Malthusian trap. Theorists, however, have been slow to appreciate that the complexity of attendant firms is the carrier of daunting replacement macro problems. An especially costly new class of mass market failure is associated with rational LEV wage rigidities that are inherent to the emergent corporate forms. The robust capacity of nominal demand disturbances to induce proportional movements of unemployment necessarily follows.
Financial panics and macro contractions existed prior to the economic upheaval caused by the Second Industrial Revolution. The Austrian School provides an insightful friction-based description of early business cycles. From Lawrence White (2012, pp.76-77): “The Mises-Hayek theory was first and foremost a theory of the ‘upper turning point’; it aimed to explain why the cheap-credit boom must give way to bust…. The recession is a corrective period in which the needed readjustments take place. The firms that made nonviable investments must wind them down, perhaps go bankrupt, laying off workers and idling machines, leading to above-normal unemployment and unused capacity until those workers and machines are reabsorbed into more sustainable employment elsewhere. The more rapidly the economy adjusts wages and prices and reallocates resources, the shorter the recession will be.” The capacity of labor pricing to adjust was increasingly challenged in the early 20th century, culminating in the 1930s Great Depression. Even Hayek (1975, p.5) eventually recognized that extreme, decade-long market failure differed greatly from what the Austrians had in mind, apologizing for his 1930s laisse-faire policy advice: “At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed.”
The fundamentally altered production landscape eventually shifted a substantial share of macro research to modeling periodic mass involuntary job loss, an effort associated with Keynes that continues today to be obstructed by the inability of market-centric analysis to rationally suppress wage recontracting. Seeking stabilization relevance, Early Keynesians looked at the evidence and assumed downward labor-price rigidity, pushing aside proper microfoundations in order to causally link adverse demand shocks to mass layoffs. New Keynesians later repudiated that choice, restoring the centrality of friction-augmented general market equilibrium (FGME) while assigning priority to finding a super market friction capable of rationally suppressing wage recontracting.
Unsurprisingly, no such friction was found; and its priority status faded. Many theorists quietly accepted Lucas’s advice to ignore involuntary job loss. The macro academy’s research focus again shifted, this time to trying to figure out how to make do with the voluntary joblessness produced in labor-market search/match activity. Whenever the need to align that modeling with actual evidence becomes pressing, modern theorists quietly revive the disparaged EK practice of relying on some convenient (badly misleading) wage-rigidity assumption.
As developed in this Blog, the generalized-exchange theory is surely sufficient to reopen discussion on the proper foundations of macroeconomics. The modern absence of such give-and-take is the principal roadblock to attention being paid to rigorous workplace analysis. So far, the sparse reaction to the two-venue theory is that it is not wrong. The objection is that it is not needed. As already noted, FGME has for some time been aggressively pushed by prominent theorists, perhaps scarred by the post-stagflation macro wars, as settled theory. Nonmarket-exchange research is out of step with that ambition and dismissed as a waste of time.
NR workplace analysis is no waste of time. Clark Kerr and his colleagues deeply understood labor pricing and use in highly specialized economies. No market-centric economist, playing with half a deck, has ever come close. Their failure raises critical questions. How can theorists who understand and teach Akerlof’s market for lemons believe that rational OJB in information-challenged workplaces and its corollary wage rigidities are not worthy lines of inquiry? How can theorists who call themselves Keynesian not accept that exchange generalization, finally solving the great theorist’s keystone problem of mass involuntary job loss, has at least as much merit as ubiquitous search/match modeling that inherently focuses on voluntary joblessness? Why are the many macroeconomists who are frustrated by having fallen down the search/match rabbit-hole resistant to the compact power of rational DWR and PWR to explain the forced job loss that dominates recessions and depressions. Indeed, why aren’t they more generally upset about having no rigorous explanation for the Great Depression? Pulling it altogether, how can attention not be paid to workplace modeling that solves chronic policy-relevant problems while satisfying Edmond Malinvaud’s characteristics of great theoretical achievements: “clear foundations, consistency with many observed facts, unification of theories which previously appeared as fundamentally distinct”?
New Keynesians
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