General market equilibrium (GME) has been the mainstream model for serious macroeconomic research for generations of theorists. Rooted in the late 19th-century contributions of Walras and the Continental School, its longstanding dominance has persuaded many modern economists that GME thinking is settled theory. The on-going centrality of the GME approach has been powerfully supported by its amenability to mathematic analysis. Many economists, having some math aptitude, discovered that publishable economic research had become relatively easy. Exploiting gatekeeper appreciation of mathematical analysis, young theorists found that it was no longer necessary to put in Marshallian time and effort to get to know how the economy actually works in order to have successful academic careers.
Consensus thinking, however, has always had a huge problem. Walras and his colleagues advanced marginal analysis to construct the general market equilibrium model class about the same time that the Second Industrial Revolution (SIR), enabled by the advent of large, highly specialized firms, was gaining steam. That technological jump, quickly dominating the global economy, brought with it workplaces that are restricted by costly, asymmetric employee-employer information – a well-known context for market failure. Market-centric GME modeling must ignore the existence of bureaucratic enterprises that responded to labor-market failure by moving decisions on rational labor pricing and use inside the firm. From its beginning, market-centric general-equilibrium modeling increasingly got crucial parts of the economy badly wrong. Stabilization-irrelevance was inevitable.
The twinned emergence of Walras and Second Industrial Revolution foretold a macro academy, pleased with both its growing status as advisers to stabilization authorities and the ease (and beauty) of doing publishable GME research, that must choose between explaining critical instability evidence and their elegant Walrasian analytic framework. The stakes have always been high. On one hand, consensus theory has become inseparable from mainstream human capital and professional status; on the other, effective stabilization policy can improve the well-being of millions.
Maybe not surprisingly for teachers who emphasize self-interest in rational behavior, New Keynesians have chosen to preserve their mainstream analytic framework. Most NK theorists are coy about choosing comfortable market-centric general-equilibrium modeling over stabilization-relevancy. But there are exceptions. My former MIT colleague, prominent New Keynesian Robert Hall (2007, pp.22-23) doesn’t do coy: “Sticky wages and prices are not a full explanation [for macro facts]… because they lack a deep rationalization. A sticky wage that keeps employment below a mutually desirable level creates an opportunity for a worker and an employer to make a Pareto improvement for themselves by adjusting employment upward – what matters here is the increase in employment…. The literature lacks a coherent theory of disequilibrium. Departures from equilibrium are an assertion, not a derived conclusion from fundamentals. Traditional sticky-wage … theory has a strong descriptive claim but not a strong theoretical underpinning.” Note that all references to “equilibrium” refer to the marketplace. That mainstream NK theorists assume the equivalence of market-centric and decision-rule equilibrium is almost never challenged. It is the keystone of their “settled” macro model class..
Early Keynesians, of course, made a different choice. They accepted a period of unsettled, irrational theory by assuming, not microfounding, meaningful wage rigidity that uniquely motivates causality from nominal demand disturbance to involuntary job loss and recognizable movement in employment, output, and income. They put MWR microfoundations at the top of their research agenda but badly underestimated the difficulty of the task. They ran out of time as a new generation of theorists, eager to try out their mathematical skills in the amenable market-centric general-equilibrium model class. The prevailing mood among many younger economists appeared to be that the inability to explain crucial instability facts was an acceptable price to pay for the comfort of analytic rigor.
Here’s my fundamental question. Hasn’t the trade-off, as shaky as it has always been for New Keynesians, become downright immoral with the success of the GEM Project in microfounding MWR and thereby rationally suppressing wage recontracting in the highly specialized firms spawned by the SIR. Macroeconomics that is simultaneously micro-coherent and stabilization-relevant is now readily available. The hard work has been done. The only barrier preventing widespread adoption of the generalized-exchange theory, with its uniquely effective policy advice, is the personal losses of mainstream theorists with respect to their human capital and professional status. It’s time to face facts. When weighed against the benefits of stabilization relevance, those costs are not very important.
Blog Type: New Keynesians Saint Joseph, Michigan