This is what I believe should happen. The postwar development of stabilization-relevant macroeconomics becomes divisible, like Caesar’s Gaul, into three parts. The first covers the dominance of the estimable Early Keynesians. EK theorists organized their research around the Neoclassical Synthesis, which confined their keystone assumption of downward wage rigidity to the short-term; in the long-run, wages return to neoclassical textbook two-way flexibility. Positing short-run meaningful wage rigidity (MWR) allowed them to reverse neoclassical real-to-nominal causation, enabling adverse demand disturbances to induce involuntary job loss as well as same-direction changes in output, employment, and income.
That reorganization, combined with good PR from Samuelson’s best-selling textbook, made macro theorists academic rock stars. But there was a rub. In the EK case, the outsized accomplishments came at the considerable cost of incoherent labor pricing. The keystone wage analysis was constructed on irrational behavior, violating a crucial tenet of economic theory. I am old enough to remember how much the mainstream reliance on irrationality bothered me.
The second period is the dominance of New Keynesianism. NK theorists organized their research around the New Neoclassical Synthesis, its commitment to rational behavior, and its rules of engagement for the emerging consensus that ended the macro wars. New Keynesians accepted neoclassical mechanics, i.e., the familiar optimizing, market-centric, general-equilibrium model class not distorted by free parameters. In return, the anti-Keynesians accepted that rational market frictions can delay market-clearing. The critical NK contribution to the development of macroeconomic has been the school’s progress in restoring the mainstream centrality of optimization and equilibrium, the fundamental, extraordinarily useful tenets of economic theory.
My third phase, the dominance of the GEM Project’s generalized-exchange modeling, is of course prospective and, at least for now, wishful thinking. But the case for its ascendancy is strong. GEM theory has microfounded MWR, allowing EK demand centricity and NK rational behavior to coexist. When GEM thinking becomes mainstream, the first two development phases will be celebrated, not rejected. Their plethora of insightful models, greatly contributing to modern macroeconomics, will be synchronized with one another in the big tent of generalized-exchange macro theory.
The fundamental Keynesian problem, Early and New, has always been that theorists never got a proper handle on MWR, which is deeply integrated with the core analysis of both schools. Now that the GEM Project has microfounded MWR and its rational suppression of wage recontracting, won’t well-intentioned mainstream theorists eventually recognize that it is time to move on to the available, more powerful macro consensus. If so, it would be useful if the generalized-exchange theory were easily understood. I believe that good theories accommodate compact descriptions, so here it goes.
Generalized-exchange macro modeling bifurcates both households and firms, each of which rationally pursues self-interests governed by axiomatic preferences and technology. Households are constrained by heterogeneous initial endowments of financial assets. For the largest class, earnings from wealth contribute little to household income; in the much smaller share of households, financial assets are the source of income. Meanwhile, much more crucially, firms are separated into two venues that reflect size-related heterogeneity, arising from specialization, capital indivisibilities, the nature of workplace information, and routinized jobs. The resulting organizational diversity is fundamental. Labor is point-of-hire homogeneous; Harris-Todaro transfer governs inter-venue worker flows. Generalized exchange locates large-establishment-venue (LEV) labor pricing in the workplace, where firms construct exchange mechanisms and pay the continuous-equilibrium efficiency wage (Wn) that equals rational employees’ reference wage (Wń) and translate into significant labor rents. Workplace-exchange also microfounds the keystone MWR channel that causally links total nominal demand disturbances to same-direction movement in employment and output. Meanwhile, small-establishment-venue (SEV) firms can do no better than paying workers’ opportunity cost, i.e., the market wage (Wm).
Macrodynamics are crucially enriched by rational MWR, which suppresses wage recontracting, uniquely motivates involuntary job loss in response to adverse nominal demand disturbances, and pushes workers off their labor-supply schedule. Keynes’s Second Classical Postulate and Wicksell-Wicksteed income distribution are both scrapped in generalized-exchange modeling. Income becomes, rationally, the primary determinant of consumption, and expectations of pure profit principally influence investment. Interest rates play secondary roles in each, while coherent, hold-up problems are powerfully introduced into production-capacity management. Stationary spending shocks are associated with temporary layoffs, while adverse nonstationary-demand disturbances generate permanent job downsizing as well as rationally recalibrated worker reference standards (Ҝ) and wage givebacks. Unemployment follows a continuous-equilibrium macrodynamic path. Labor is employed in rationed rent-paying LEV jobs or more readily-available market-wage SEV jobs, involuntarily/voluntarily unemployed, or voluntarily out of the labor force. Job quits are procyclical and play no significant role in the stabilization narrative. Job-matching efficiency also does not much matter, little influencing employment fluctuations.
Rational exchange in LEV workplaces produces dominant labor pricing and job rationing that constrain optimization in the marketplace, reconciling continuous decision-rule equilibrium and supply-demand disequilibrium. In the simplest GEM modeling, all rational exchange (except between LEV employers and employees) occurs in the marketplace and is largely governed by familiar textbook analysis.
The fundamental message, once the model pieces are assembled, is definitive. Macroeconomics that is both stabilization-relevant and consistent with the tenets of optimization and equilibrium is not feasible absent MWR and, consequently, the generalization of rational exchange from the marketplace to information-challenged workplaces? Doesn’t it follow the GEM model class would inform a powerful, necessary third phase in the development of macroeconomics?
Blog Type: Wonkish Chicago, Illinois