This post digs more deeply into the New Keynesian market-centric general-equilibrium model class that has occupied the macro mainstream for a generation. It begins with a contribution that ranks among the greatest in the history of economics. In it, Arrow and Debreu (1954) identified the assumptions needed for rational-behavior general market equilibrium to exist. Conditions that assure the mainstream system of excess-demand equations has a market-clearing solution include (a) the absence of increasing returns; (b) the absence of joint products or externalities in production or consumption; (c) universal price quoting (implying the existence of forward markets for all final goods and services); (d) universal price taking (implying the absence of pricing power in all product and factor markets); and (e) gross substitutability of all goods (implying that an increase in the price of one good always produces a positive excess demand for at least one other good). Stability and uniqueness, each even more problematic than existence for NK modelers, have eluded formal proof of existence.
Arrow never argued that their requirements actually characterize modern economies. He saw them as necessary conditions, not axioms from which operational theorems can be derived. Yet, as the general-market-equilibrium model class has been inexorably pushed forward as the proper framework for policy-useful macro analysis, the conditions have morphed into shadow axioms. Overt GME limitations on the capacity to explain labor pricing and use are instructively illustrated by the universal price-taking and price-quoting that require that all goods and services be priced in competitive markets, a restriction incorporated into the ubiquitous search/match model that has been widely accepted as stabilization relevant. It is, however, broadly understood by practitioners that worker cooperative input on the job, in the context of inherently costly, asymmetric workplace information, cannot be adequately observed, priced, or exchanged in the marketplace. Labor hours, which markets can measure and exchange, are an acceptable proxy for cooperative input (Έ) only if employee OJB is cost-effectively monitored (Źj=Źɱj) or otherwise effectively managed. By definition, mainstream GME theory has no capacity to model the generalized (market and workplace) exchange that developed in the aftermath of the Second Industrial Revolution.
The point is important. Market-centric general-equilibrium thinking is inadequate to the task of stabilization-relevant modeling of optimizing exchange in modern, specialized economies. Imagine that Debreu’s (1959) research program to motivate GME modeling with somewhat intuitive assumptions (e.g., endowing commodities with delivery dates, location, and a context of relevant random events) had been tractably realized. The core model’s fundamental limitation (i.e., its restriction of exchange to the marketplace) still confines it to being no more than a special case of the GEM Project’s macro analysis as well as a deeply misleading description of stabilization-relevant macrodynamic behavior. Moreover, in a great irony, it has become clear that clinging to the familiarity and comfort of GME thinking itself threatens the mainstream status of the formal economic method rooted in optimization and equilibrium.
A second point is even more important. GEM Project macroeconomics rooted in the generalization of optimizing exchange from the marketplace to workplaces intuitively restricted by costly, asymmetric employer-employee information is much more powerful than the go-to GME model class. The two-venue macro theory is consistent with the formal economic method, enables microfounded meaningful wage rigidity, uniquely produces rational involuntary job loss in response to adverse nominal demand disturbances, rationally produces chronic wage rents, and requires none of the restrictive assumptions required by market-centric general-equilibrium modeling cited above. Those are big claims. For elaboration, spend some time with the website’s e-book, beginning with Chapter 5. It is interesting reading.
Blog Type: Wonkish Chicago, Illinois