The GEM Project’s key contribution to stabilization-relevant macroeconomics is its derivation of meaningful wage rigidity, capable of rationally suppressing wage recontracting, from axiomatic first principles. MWR enables the reconstruction of aggregate supply to better reflect the highly-specialized, large-scale production of goods and services that has, since the Second Industrial Revolution, become globally ubiquitous. MWR interacts with nominal demand disturbances to produce opposite-direction movements in involuntary job loss and unemployment and same-direction changes in employment, output, and profit. The first modern theory of wage determination generates a large set of significant policy implications.
The Project’s contribution to the modeling of aggregate demand is by contrast more modest, focusing on extreme instability of total spending that in a recent example distinguished the 2008-09 Great Recession from garden-variety downturns. GEM advances in demand-side modeling are motivated by three uncomplex ideas. The first is rooted in recent work by Nancy Stokey (2009). Once investors/lenders become uncertain about future macro trends, especially the adequacy of total demand, they become more inactive, postponing acquisition of assets until the uncertainty dissipates. Second, as noted above, is the microfounded nominal-to-real causality that powerfully propagates macro, often financial, shocks. The third, also featured in the GEM Project, links investor/lender macro uncertainty to the loss of credibility of stabilization authorities’ trend real-side objective. Such credibility, denoted by Ƈ in the Project, is increasing in the degree to which the future states of the macroeconomy are believed to be consistent with stabilization authorities’ objectives. (Chapter 6)
If Ƈ is important, why do modern theorists relegate central banks’ trend full-employment objective to playing a distant second fiddle to the low, stable inflation goal? Here is the tough-love answer. Given that consensus market-centric DSGE modeling cannot coherently accommodate MWR or otherwise rationally suppress wage recontracting, theorists avoid model incoherence by downplaying nominal-to-real causality in their cyclical narrative, pushing aggregate demand and involuntary job loss into the shadows of modern business-cycle research. By default, search-match-bargaining analysis and its voluntary unemployment today occupy center stage; and inflation becomes the star of the stabilization show.
Acute Instability Macrodynamics
Demand disturbances. The GEM Project bimodally separates nominal spending disturbances. Stationary demand disturbances (SDD) reflect the contained, temporary weakening of total spending associated with garden-variety recessions. Nonstationary demand disturbances (NND) are much more exciting, reflecting unchecked spending collapses associated with acute instability that overwhelms automatic stabilizers and Fed purchase of short-term Treasury debt. (Chapter 10) NDD critically differs from SDD by introducing uncertainty into investor/lender perceptions of the credibility of stabilization-authorities’ trend real-side objective. As noted, damaged Ƈ induces investors and lenders to become inactive, awaiting a credible reversal in collapsing total demand. The economy experiences a breakdown in its capacity to recycle saving into spending, the market failure that Bernanke (1984) indentified as central to 1930s depression macrodynamics. (Chapter 6)
Investment outlays. In modeling NDD, the GEM Project focuses on investment outlays, the most volatile component of total spending. The basic model is:
I(t)=ƒ(Ƈ(t)И(t), (1-Ƈ(t))₡(t)), such that ΔI/ΔИ>0, ΔI/Δ₡>0, 0<Ƈ<1,
where I denotes nominal investment outlays on capital goods, construction, and software at time t; И represents discounted, inflation-adjusted expectations of future profits rooted in economic fundamentals; ₡ denotes investor confidence, the Project’s version of Keynes’s animal spirits; and Ƈ calibrates investor perceptions of the trend real-side credibility of stabilization authorities.
Ƈ critically mediates the relative influence of economic fundamentals and self-referential confidence in investment spending. When credibility is high, investors’ macro expectations are governed by generally agreed-upon probabilities; and investment spending is almost wholly driven by profit fundamentals. As credibility erodes, however, the average investor becomes more uncertain, causing rational inaction and investment spending to be increasingly driven by faltering confidence. (For more on the modeling of self-referential confidence, see Chapter 6.)
In late 2008 and early 2009, Ƈ played a central role in the brewing spending collapse. Investors and lenders clearly became uncertain about the reliability of trend real-side stabilization goals, becoming rationally inactive and thereby pushing asset prices and total demand into downward spirals. The practical macro issue was the authorities’ capacity and will to reverse rapidly contracting total spending and hemorrhaging job loss.
Consider the counter-factual case. If investors/lenders in 2008-09 had been confident with respect to the Fed’s capacity and will to sustain trend aggregate demand in the face of the financial disruption associated with subprime and exotic residential-mortgage default, private-sector decision-making would have continued to be rooted in profit-seeking guided by economic fundamentals. There would have been no 50% collapse in equity prices, and, most critically, no sharp contraction in total spending, employment, and output.
Flawed Mainstream Thinking
Here’s the embarrassing fact. Mainstream macroeconomists have long advised central banks to emphasize nominal, not real, targeting. In his 2003 New Keynesian bible, Michael Woodford is illustrative: “… because of the difficulty involved in measuring the efficient level of economic activity in real time – depending as this does on variations in production costs, consumption needs, and investment opportunities – it may well be more convenient for a central bank to concern itself with monitoring the stability of prices.” (p.13) Elsewhere in Interest and Prices, inflation primacy is asserted more forcefully, notably when Woodford argues that Phillips-curve relations have mistakenly been thought to imply that “monetary policy should be used to achieve output or employment goals, rather than giving priority to price stability. The present study argues instead for a different view of the proper goals of monetary policy. Its use to stabilize an appropriately defined price index is in fact an important end toward which efforts should be directed – at least to a first approximation, it should be the primary aim of monetary policy.” (p.4)
This is the second in a series of essays on stabilization policymaking as informed by the GEM Project. It rejects, as damaging nonsense, the modern deemphasis of the trend real-side objective of stabilization authorities. Generalized-exchange macroeconomics demonstrates that trend full employment is at least as important as trend low inflation in the macro management of economic welfare.
Blog Type: Wonkish Chicago, Illinois