Where Economics Went Wrong

I was attracted to the title. Not wanting to commit too quickly, I turned to SSRN and found Marianne Johnson’s review of Collander and Freedman’s Where Economics Went Wrong (2019). For our purposes, her first paragraph adequately summarizes the work:

“David Colander and Craig Freedman … tell a sweeping story that takes us from John Stuart Mill to Frank Knight to Paul Romer. In doing so, the authors conjure two favorite bête noires—the idea that economics has taken a wrong turn and the Chicago school of economics. Economics went wrong, Colander and Freedman suggest, by losing the classical liberal “firewall” that separated scientific theorizing from the craft of policy making. Economic Policy should not and cannot follow from economic theory alone. Rather, it must borrow from all the social sciences, blending knowledge with judgment and a sound understanding of social forces. Colander has long advanced the idea that applied economics should be classified neither as positive nor as normative economics. Instead, it should be placed in a third category, ‘the art of economics’; art requires vision and acumen in addition to knowledge and technique, and is thus more akin to engineering than to the natural sciences.”

Being familiar with the authors, I am confident they’ve written a good book. But it is not what I hoped. A better use of the provocative title would have been an analysis of where mainstream economics stopped being useful to policymakers – both public and private – attempting to understand the nature of macro instability, its consequences, and what to do to ameliorate the huge cost of mass market failures.

Where Economics Really Went Wrong

The GEM Project focuses on a much more important interpretation of where economics went wrong. It identifies the crucial wrong turn as occurring during the short heyday of Efficiency-Wage Theory from the late 1970s to the mid-980s. Hindsight makes clear that the original EWT literature provided a make-or-break choice for theorists: To continue the longstanding practice of confining rational exchange to the marketplace or to follow the pile of evidence emerging from the Second Industrial Revolution and generalize rational exchange from the marketplace to workplaces restricted by asymmetric employer-employee information.

The macro academy’s choice to stick with optimizing general-equilibrium, market-centric modeling, rejecting the need for a second venue of rational exchange (optimizing general-equilibrium, workplaces), is where economics – at least with respect to macro instability and its periodic multi-trillion-dollar losses – went wrong.

Readers of this Blog are, of course, familiar with the generalized-exchange theory. So a single sentence summary should suffice here: Asymmetric information characterizing large, complex workplaces offering routinized jobs – comprising a great deal of the modern labor force – motivates a theory of on-the-job behavior that generates both rational downward nominal wage rigidity (DWR) over stationary business cycles and the rational payment of chronic wage rent (CWR). The New Keynesian (NK) academy, choosing to ignore workplace exchange, consequentially decided to analyze instability without DWR and CWR and in effect abandoned evidence-consistent, policy-relevant modeling.

Case For and Against Generalized Exchange

Consider the case for and against the more general use of the powerful results of the workplace-marketplace synthesis. The bae argument for usage is its consistency with Edmond Malinvaud’s (1977) insightful description of superior theory: “…the characteristics of great theoretical achievements [are] clear foundations, consistency with many observed facts, unification of theories which previously appeared as fundamentally distinct.”

The two-venue model grounds wage setting in optimization and general decision-rule equilibrium, protecting the theory from being misled by convenient, arbitrary, evidence-inconsistent labor pricing. It provides a rich, evidence-consistent environment for productive analysis. The  cornucopia of consequential new, rational-behavior facts to be built upon features downward nominal wage rigidity over stationary business cycles, chronic wage rent, the existence of involuntary job loss in the millions in response to aggregate demand disturbances, the critical distinction between stationary and nonstationary total-spending contractions, the existence of both temporary layoffs and permanent job downsizing, the exclusive location of rational wage rigidities and involuntary job loss in large, highly specialized firms restricted by information-challenged workplaces, and the existence of large human-resources departments that design intra-firm exchange mechanisms and set a substantial share of wages in modern economies.

The generalization of rational exchange from the marketplace to workplaces restricted by information asymmetries furthermore accommodates extreme  instability that can transform garden-variety recessions into depression. The 1930s depression, the 1970s stagflation, the 1980s great downsizing, the 1990s virtuous cycle, the 2000s Great Recession, its subsequent slow recovery, and the 2020s rapid recovery from the mass COVID shutdown are provided more evidence-consistent explanations than does market-centric NK theory.

What argues against the use of the intuitive workplace generalization of rational exchange? Little objection has been raised about the  intra-firm model itself. NK theorists familiar with the generalized-exchange theory accept that it is not wrong. Instead, critics argue that it is insufficiently useful to justify the cost of introducing the second (workplace) venue. That cost includes investment in human capital needed to understand what actually goes on inside large, highly specialized establishments. Herbert Simon and his colleagues in their close study of rational behavior occurring inside such organizations have alerted economists to the inherently great difference from goings-on in the marketplace. Despite the substantial share of total employment and wage income that occurs in firms with human-resource departments, leading NK theorists still insist on assigning little significance to the necessity of the workplace venue to accommodate the substantial incidence of asymmetric employer-employee workplace information. That choice, along with the multitude of other drawbacks, is surely something of a conundrum for economists who teach as doctrine Akerlof’s market for lemons.

Blog Type: New Keynesian