Anti-Keynesian insurgents in the 30-year macro war made no secret about their central objective. They sought to banish from acceptable model-building the widespread use of assumptions of convenience. They particularly targeted free parameters used by Early Keynesian to introduce meaningful wage rigidity (MWR) into macro theory in order to make it more stabilization-relevant. After the New Classical victory and the establishment of micro-macro coherence as the precondition of mainstream macro debate and research dissemination, theorists committed to Keynes’s agenda that features involuntary unemployment adapted. The rebranded New Keynesians (NK) made a huge investment in time and resources in the attempt to figure out how to microfound MWR within the consensus market-centric dynamic general-equilibrium model. Success has been, at best, elusive. Many able NK theorists have become discouraged.
Revisionist NK thinking. As the most recent phase of the intermittent macro battling between coherence and stabilization-relevance was drawing toward an uneasy truce, an unhappy branch of New Keynesians mounted a more fundamental attack on the Early Keynesian research agenda, arguing that the venerable Neoclassical-Synthesis focus on MWR was mistaken. They asserted that coherent, stabilization-relevant macroeconomics is best pursued via model-building free of controversial wage rigidity. The contention is a direct challenge to the GEM Project that deserves examination. Anticipating the result, the dissident NK conclusions are badly off-base.
The strongest statement of the anti-MWR revisionism remains the 1993 Journal of Economic Perspectives article (“New and Old Keynesians”) from Bruce Greenwald and Joseph Stiglitz (hereafter G&S). G&S defined two NK camps: “…these two new Keynesian approaches have different implications for how the economy works. The first holds that the classical dichotomy breaks down, allowing monetary policy to have affects other than on the price level, because nominal prices are at least somewhat rigid throughout the economy. The second approach, however, holds that monetary policy has real effects even when wages and prices are flexible.”
G&S summarize their message: “The new Keynesian view that emphasizes price flexibility suggests an alternate and more complex perspective: first, that natural economic forces can magnify economic shocks that may seem small, and second, that existing price rigidities may reduce the magnitude of the fluctuations, as Keynes argued. Since even with perfectly flexible wages and prices, the economy could experience substantial variations in employment, they believe the single-minded focus on price and wage rigidities is misguided. And since small disturbances can give rise to large effects, there is less concern about identifying the source of the disturbance: in one case, it may be a supply shock (the oil price shocks of 1973 and 1979), in another case it may be a monetary shock (the Volcker recession).” G&S identify “incomplete contracts, and, in particular, imperfect indexing as central market failures”, as well as imperfect competition and coordination failures, as important sources of macro-shock propagation.
The GEM Project. The convenient revisionist argument is that MWR, historically a difficult concept to microfound, is not necessary in the construction of macroeconomics that is both coherent and stabilization-relevant. The Project, by contract, asserts MWR centrality in coherent, stabilization-relevant macroeconomics. A critical difference between the two arguments is that the latter invests the time and effort needed carefully define and model the concept at issue. Meaningful wage rigidity is defined by its capacity to suppress labor-price recontracting and, as a result, encompasses two components: downward nominal wage rigidity over the stationary business cycle and chronic wage rents. First and foremost, given that none of the dissident NK innovations (market imperfections or otherwise) coherently suppress recontracting, MWR uniquely microfounds involuntary job loss. The Project contends, and macro policymakers agree, that macro models that exclude layoffs cannot be stabilization-relevant. In all U.S. recessions for which data are available, forced job loss is the dominate engine of rising unemployment in recession. G&S are trying to stage Hamlet without the Prince.
The GEM Project further demonstrates the overall significance of microfounded MWR to be wide-ranging. Its downward nominal wage rigidity supports causation from nominal-demand disturbances to same-direction changes in employment and output, uniquely justifying discretionary real-side management of total spending. It also plays a critical role in the coherent modeling of job downsizing, the stagflation decade that began in the 1970s, and the two-sector growth model of Arthur Lewis. It notably refutes Keynes’s famous guess that wage rigidity may mitigate the real effects of weakened nominal demand. The purchasing capacity lost in wage cuts is more or less offset by the purchasing power lost in forced job reduction. Moreover, in the GEM Project, spending volatility is concentrated in profit-driven investment.
Rational MWR’s chronic wage rents additionally push all employees out of market equilibrium and LEV employees off the neoclassical market-supply curve, coherently repealing Keynes’s Second Classical Postulate. More generally, wage rents constrain market optimization, reconciling labor-market supply-demand disequilibrium and continuous decision-rule equilibrium. They also mandate substituting Jensen’s residual-rent factor-income distribution for the elegant textbook Wicksell-Wicksteed market-centric model, usefully reintroducing pure profit into modern, fully microfounded macroeconomics. In their rejection of MWR, G&S give up those implications and more. It seems a high cost, especially now that the GEM Project has done the hard work that they were trying to avoid.
Pulling it together. G&S err in viewing MWR and shocks propagated by nonwage factors as an either-or choice. The research agendas in no way conflict, except in setting priorities. The fundamental importance of MWR throughout highly specialized economies overwhelmingly trumps the G&S alternative agenda of searching out new coherent market imperfections.
G&S, like other NK theorists, probably abandoned MWR because of the intractability of microfounding wage rigidity in the consensus market-centric DSGE model class rather than any considered assessment of the usefulness of the concept itself. Given the success of the GEM Project, G&S need to reconsider their judgment that the path to solution of the stabilization-relevance problem runs through coherent market imperfections. The Project demonstrates that the most powerful research agenda focuses on rejecting the near universal, albeit arbitrary and nonintuitive, restriction of rational price-mediated exchange to the marketplace.
Blog Type: New Keynesian Chicago, Illinois