Where Does the GEM Project Fit?

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Where does GEM modeling, the source of the extensive analysis of macro policymaking that has occupied this blog since April, fit in the economics literature? The Project’s signature innovation is the rejection of the market centricity upon which mainstream macroeconomics is constructed. The upstart and the consensus model classes are both rooted in rational exchange organized by coherent continuous general equilibrium. The fundamental GEM argument is that, since the Second Industrial Revolution, a critical share of rational, price-mediated transactions has relocated to the large-establishment workplace, where the self-interested behavior of employers and employees is restricted by costly, asymmetric information and routinized jobs. As a result, the workplace and the marketplace are governed by heterogeneous decision rules, constraints, and mechanisms of exchange.

The GEM argument is irrefutable in modern economies. Given axiomatic preferences, imperfect information, and routinized jobs, rational labor pricing cannot be supported in the marketplace and, by default, must be moved inside the firm. The move microfounds nominal wages that are downward rigid over stationary cyclicality and reflect significant time-varying rents in excess of market-opportunity costs. Adverse demand disturbances now rationally (and uniquely) produce involuntary job loss and the other recognizably-sized features of recession.

In what school of thought does the obviously important generalized-exchange theory fit? At first blush, the answer may seem to be classic institutionalism. The Wisconsin School was certainly early in its recognition that institutions were playing, along with the market, a fundamental role in the pricing and allocation of scarce resources. The problem is that Early Institutionalists did not stop at seizing a significant share of exchange from the marketplace. They went on to largely reject the concept of rational exchange itself and to devote most of their firepower to the critique of market capitalism. The collective critique is important but falls well short of supporting a broad rejection of neoclassical market theory. (Pigou provided a more productive approach in his careful analysis of market breakdowns as externalities.) Classic institutionalism became less a coherent economic model than a political agenda. It is not a comfortable fit for the GEM model class which seeks to preserve most of textbook neoclassical theory.

Once early Wisconsin-School institutionalism is eliminated, there are five schools of thought that are possible homes for the GEM Project. First are the admirable New Institutionalists, Oliver Williamson et al., who reestablished coherence with mainstream neoclassical market theory by building on the insightful analysis of Ronald Coase. Coase reworked the nature of optimizing exchange by looking at the rational boundaries of resource pricing and allocation between large business establishments and the marketplace. The problem here is focus. New Institutionalists have never paid much attention to meaningful wage rigidity. There is surely a better fit in the literature for a model that assigns to MWR its keystone role.

Second is Organization Theorists, associated with Herbert Simon and his colleagues. They provide the best available investigation of what goes on in large bureaucratic corporations. It is a splendid advance in our understanding of how and why highly specialized economies behave the way they do. Once again, however, relatively little attention is paid to MWR. In addition, organization theory developed its own constituency that extends well beyond economists and, as a result, provides a less efficient fit for GEM modeling.

Third, ILM (internal labor-market) Theorists, associated with Clark Kerr, John Dunlop, et al., pioneered the neoclassical economic analysis of what goes on in the large, highly specialized workplace. Their work provides much of the content for the GEM reconstruction of continuous, coherent economic equilibrium. However, in a close call, I believe mid-century American labor economics is a relatively limited platform for a fundamental reconstruction of macroeconomics.

Fourth, Early Keynesians (EK), associated with Modigliani, Patinkin, Samuelson, Solow, et al., certainly worked on a sufficiently grand stage, establishing a second, coequal branch of economic theory. Their Neoclassical Synthesis became the mainstream, stabilization-policy-relevant theory for a generation of macroeconomists. Moreover, its analytic keystone is nominal wage rigidity sufficient to suppress, in the business-cycle timeframe, labor-price recontracting. Such suppression enabled Early Keynesians to reject the Second Classical Postulate and to focus on the causal link from demand disturbances to involuntary unemployment, putting the management of total spending at the center of macro policymaking.

Fifth are the New Keynesians (NK), who reject the Early Keynesian consensus as irreconcilable with rational market-centric exchange. For more than a generation, they have searched for coherent market frictions that reverse the classical real-to-nominal causation of Say’s Law. They particularly continue, albeit with understandably diminished enthusiasm, to look for a super friction capable of suppressing wage recontracting and microfounding involuntary job loss in response to adverse demand disturbances. We now know that the fundamental problem is NK theorists’ insistence on market-centric analysis, a requirement that is consistent with their acceptance of the New Neoclassical Synthesis. They point out that the revised Synthesis, which became today’s longstanding consensus, did after all end the difficult 30-year macro methodology war. But there is no plausible home in this literature. New Keynesians’ generally agreed-to market-centric modeling is antithetical to GEM thinking.

Putting it all together, the large Early Keynesian literature that once dominated stabilization macroeconomics is the proper home for the GEM model class. That is where the powerful generalized-exchange microfounding MWR is most incremental. Reviving EK thinking to be both coherent and stabilization-relevant is the central achievement of the GEM Project.

Blog Type: Wonkish Chicago, Illinois

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