Victory for the Chicago School

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In this post I make a perhaps startling claim for the GEM Project. Its two-venue general-equilibrium (TVGE) model class is more consistent with the famous Chicago-School credo than is the coherent market-centric DSGE theory that occupies the modern mainstream. From George Stigler (1982, pp.11-12): “The basis of the credo is simply the fact that an economic actor knows better the environment in which he is acting and the probable consequences of his actions than an outsider, no matter how clever the outsider may be.”

Extending the Chicago School. Generalized-exchange modeling extends Stigler’s maxim from the marketplace to large, specialized workplaces that have been characteristic of modern economies since the Second Industrial Revolution. In so doing, GEM thinking becomes a champion of the Chicago School’s credo, greatly expanding the reach of rational human behavior in the context of asymmetric information. The identification of the workplace and marketplace as distinct venues of rational, price-mediated exchange makes intuitive sense but has been long delayed. The holdup has largely resulted from the absence of a coherent optimizing model of on-the-job behavior (OJB) in the context of costly, asymmetric information and routinized jobs – the workplace environment of tens of millions of workers in the United States alone. Think about it. The GEM Project, deriving continuous-equilibrium self-interested OJB in large, specialized establishments, has been able to model the rational pricing and use of the substantial share of the labor force in routinized jobs who know their jobs and conduct better than does management. (Chapters 2 and 3) That class of employees embodies the Chicago credo and should excite serious Chicago-School theorists about the GEM Project’s generalization of rational exchange from the marketplace to the highly specialized workplace.

The excitement should be especially robust given that generalized-exchange modeling additionally makes great progress toward satisfying another important Chicago-School benchmark long emphasized by Milton Friedman (1974, p.11): “In discussions of economic science, ‘Chicago’ stands for an approach that takes seriously the use of economic theory as a tool for analyzing a startlingly wide range of concrete problems, rather than as an abstract mathematical structure of great beauty and little power; for an approach that insists on empirical testing of theoretical generalizations and rejects alike facts without theory and theory without facts.” Today’s mainstream market-centric DSGE model class, badly constricted by  its inability to coherently suppress wage recontracting and therefore accommodate involuntary job loss and recognizable unemployment, ignores too many critical facts to be stabilization-relevant. Don’t we all, deep down, know that? Why do we ignore that modern consensus macro theory is a bad fit with Friedman’s version of the Chicago School?

Illustrative implications. Extending Chicago-School principles to modeling price-mediated exchange in the large-establishment workplace helps generate a range of important results. Here, the broad impact is illustrated by two implications familiar to readers of the GEM Project Blog. First, the ubiquitous search/match/bargain model of the labor market is shown to be a deeply misleading framework within which to make sense of unemployment at business-cycle frequencies. Mainstream macro theorists surely already knew that S/M/B analysis is inherently rooted in voluntary joblessness and, as a result, cannot microfound stabilization-relevant macroeconomics. But, in the prolonged wait for the rational derivation of meaningful wage rigidity capable of suppressing labor-price recontracting, the Ptolemaic misuse of labor search theory got out of hand. The teaching and modeling of macroeconomics especially went off the rails once the reputations of leading macro theorists became intertwined with perpetuating the deception of S/M/B relevance to actual stabilization policymaking.

Second, and related, the Early-Keynesian (EK) attention to nominal-wage inflexibilities must now be understood to have been, since the Second Industrial Revolution, the focus necessary to enable construction of stabilization-relevant macro theory. Samuelson’s Neoclassical Synthesis was a useful hegemonic force in the early postwar period but fell into disgrace as a result of the persisting EK inability to reconcile optimizing exchange organized by continuous general equilibrium with the suppression of wage recontracting. It is good news, not to be ignored, that the GEM Project has finally corrected that crucial failure of the great Early Keynesians.

Summing up. The Chicago School should be celebrating the extension of its core methodology to the large-establishment workplace venue of rational exchange. By the numbers, it is the most significant expansion of the Chicago-School approach since the legendary 1959 Hyde-Park dinner hosting Ronald Coase. Coase’s analysis extending Chicago School thinking to nonmarket rational exchange was a tough sell then, and it will not be easy to breech the status quo preferred by many keepers of the Chicago flame today. But it will happen. Logic carried the day for Coase and will do so again, more than a half-century later, for the GEM Project.

Chicago School economists have asserted themselves as the guardians of the rational-behavior modeling, which they correctly understand to be the foundational building block in useful economics. With guardianship, however, comes responsibility. Gatekeepers must be alert to unfamiliar new ideas that use rational behavior in increasingly powerful ways. Stigler, Friedman, and their colleagues moved from skepticism to support of Coase’s analysis despite the uncomfortable fact that it curtailed market hegemony. They recognized that ceding territory to rational decisionmaking in large firms produced a superior expression of the fundamental Chicago-School methodology. The new generation of Chicago School economists now faces a similar challenge. My hunch is that, like their elders, they will eventually not shrink from it.

Blog Type: Chicago School San Miguel de Allende, Mexico

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