There is something suspicious about Evolution or Revolution? (2019) that is shared by the earlier entries in the academy’s annual series on macro theory after the Great Recession. Few of the contributing authors explicitly use the mainstream market-centric DSGE model class to explain evidence produced by the 2008-09 extreme instability. They know that the model they use to instruct graduate students cannot handle that really important task.
Looking for someone with confidence in mainstream macroeconomics, this post turns to Robert Hall who is known to be a bold New Keynesian. My former M.I.T. colleague is not afraid to use what he teaches to explain significant evidence. Almost by default, Hall provides insight into the capacity of rigorous New Keynesianism to make sense out of the extraordinarily damaging macro crisis, including its lead-up, contraction, and aftermath. What follows draws upon three of the prolific theorist’s relevant publications:
- “How Much Do We Understand about the Modern Recessions?” Brookings Papers on Economic Activity (2007), in which he describes the implications of the NK macro model for the evolving nature of recessions;
- “Why Does the Economy Fall to Pieces after a Financial Crisis,” Journal of Economic Perspectives (2010) that uses the mainstream NK thinking to work through the causes of the Great Recession; an In addition to his recent
- “Macroeconomics of Persistent Slumps,” Chapter 27 of the 2016 Handbook of Macroeconomics.
New Keynesian Recessions
Prior to the 2008-09 extreme instability, Hall wrote a series of papers that separated U.S. recessions into two chronological classes. He asserts a metamorphosis, largely unspecified, of cyclical downturns into their “modern” form some time after the severe 1981-82 contraction. From Hall: “In the modern U.S. economy, recessions do not begin with a burst of layoffs. Unemployment rises because jobs are hard to find, not because an unusual number of people are thrown into unemployment.” Hall’s “modern” recessions are consistent with mainstream New Keynesian theory. NK downturns that cannot accommodate neither meaningful wage rigidity (MWR) nor involuntary job loss; as a result, they must be very mild. Hall goes on to assert that familiar search/match theory, with its focus on the voluntary unemployment that occurs while workers look for “hard-to-find” jobs, provides adequate explanation of modern labor cyclicality. Hall boldly concludes that, once fully embedded in the consensus market-centric, general-equilibrium analytic framework, search/match modeling will support operational stabilization theorems.
Our capacity to assess the “modern-recessions” hypothesis is, unsurprisingly, made more robust with the expansion of the sample size from two to three. It is well-known that the addition, occurring in 2007-09, was exceptionally severe, with its outsized labor-market deterioration dominated by job losers. The six-million involuntarily lost jobs accounted for more than three-quarters of the increase in total unemployment. People who were, in Hall’s words, “thrown into unemployment” were the primary cause of the devastating jump in joblessness. The evidence rejects mainstream theorists’ claim of some policy relevance for their market-centric general-equilibrium model that cannot accommodate involuntary job loss. Recessions absent forced job loss must be unrecognizably mild.
New Keynesian Analysis of the Great Recession
Hall (2010) was one of the first of the remarkably few mainstream NK theorists who stepped up and examined the Great Recession using “a simple macro model that captures the most important features of modern models.” Playing by the market-centric New-Neoclassical-Synthesis rules of engagement, Hall emphasizes “realistic increases in financial frictions that… generate declines in real GDP and employment of the magnitude that occurred.”
From Hall: “The dominant view among macroeconomists today is that a financial crisis causes real economic activity to collapse by raising frictions.” His candidate friction for 2008-09 is measured by the jump in the spread between the Baa corporate bond and the 10-year Treasury note. The friction itself he roots in financial agency costs, featuring information asymmetries. After the Lehman bankruptcy, he claims that such costs pushed up the spread by more than four hundred basis points. Standard dynamic stochastic general equilibrium simulation tools were used to size macro implications of the higher cost of capital.
Debilitating problems plague the Hall’s capital-cost story. To begin, it is broadly understood that financial frictions, by themselves, cannot explain much cyclical behavior. From Hall: “…research generally shows that in standard neoclassical models, with normal preferences and technology and competitive markets, [financial-friction] shifts of realistic magnitude fail to deliver anything like the volatility seen in the U.S. economy.” Mainstream financial-friction models must find sufficient juice elsewhere. Hall provides the elsewhere by assuming two “… departures from the neoclassical benchmark”: (i) countercyclical pricing power and (ii) countercyclical movement of voluntary unemployment. His capacity to explain the Great Recession and its huge incidence of job separation is wholly dependent on those assumptions. He simply ignores that neither comes close to being consistent with rational behavior. He ignores that each assumption is thoroughly rejected by all of the evidence. He ignores that both assumptions are no more than a Ptolemaic convenience.
From the perspective of stabilization authorities, the most objectionable aspect of Hall’s analysis is the broad range of critical facts that are shoved under the rug. Most notably, he characteristically provides little role for the contraction in nominal demand that occurred in the Great Recession. In generalized-exchange theory, almost all of the effects on real activity in the 2008-09 financial crisis result from the real shock’s propagation by weakening total spending interacting with MWR. Direct costs from increased financial frictions are recognized to be relatively negligible.
As noted above, Hall’s model class provides no room for, and no mention of, the six million involuntary layoffs, which accounted for most of the higher unemployment that practitioners understand to have resulted from collapsing demand. Hall can make no distinction between nonstationary and stationary demand disturbances. He must pretend, counterfactually, that the former does not exist. The real-side credibility of stabilization authorities also has no place in his mainstream analysis. Even in the extreme 2008-09 instability, Hall must assume that interest rates exert the primary influence on investment outlays, despite investors making no secret about paying most attention to uncertain expectations of profit and product demand.
Further indicative of a hopelessly flawed model, Hall achieves his realistic 16% and 23% reductions in real consumption and output by positing a 40% cut in real wages as well as the destruction of half of the existing capital stock, wildly out-of-bounds calibrations that everybody knows did not come close to occurring. When did assumptions, conveniently tailored to yield specific results, that impose preposterous restrictions on other critical variables become acceptable in stabilization model-building? Answer: When theorists and the editors who publish them became captive to the need to defend at all costs their consensus market-centric, general-equilibrium model. Also telling is Hall’s concession that his mainstream theory “… cannot explain why GDP and employment failed to recover once the financial crisis subsided – the model implies a recovery as soon as financial frictions return to normal.” Despite huge problems, Hall concludes that modeling provides a promising, albeit “highly stylized”, explanation of the Great Recession.
New Keynesian Analysis of Recession Persistence
In his “Macroeconomics of Persistent Slumps,” Chapter 27 of the 2016 Handbook of Macroeconomics, Hall summarizes the market-centric continuous general-equilibrium analysis of persistent excess capacity in the aftermath of recessions. He quickly goes off-track by confining attention to real factors, fatally ignoring the role aggregate nominal demand in the sluggish recovery. He is also inattentive to, along with the unusually long persistence of excess capacity, the facts that the Great Recession was unusually fast developing, unusually deep, accompanied by an unusually large drop in market asset prices, and unusually costly. Examination of those aspects of the Great Recession may not rise to the standard of importance required for inclusion in the 2016 Handbook but are by any reasonable standard too important to ignore.
From Hall: “In modern economies, sharp increases in unemployment from major adverse shocks result in long periods of abnormal unemployment and low output. This chapter investigates the processes that account for these persistent slumps. The data are from the economy of the United States, and the discussion emphasizes the financial crisis of 2008 and the ensuing slump. The framework starts by discerning driving forces set in motion by the initial shock. These are higher discounts applied by decision makers (possibly related to a loss of confidence), withdrawal of potential workers from the labor market, diminished productivity growth, higher markups in product markets, and spending declines resulting from tighter lending standards at financial institutions. The next step is to study how driving forces influence general equilibrium, both at the time of the initial shock and later as its effects persist. Some of the effects propagate the effects of the shock— they contribute to poor performance even after the driving force itself has subsided. Depletion of the capital stock is the most important of these propagation mechanisms. I use a medium-frequency dynamic equilibrium model to gain some notions of the magnitudes of responses and propagation.” Enough said.
Now we know what mainstream NK theorists are afraid of. They know that their consensus market-centric general-equilibrium theory is stunningly wrong about the 2008-09 extreme instability. That’s why there is so little use of DSGE analysis, otherwise peddled as settled theory, to explain the important evidence produced by the Great Recession. Unexplained evidence centrally includes 6 million involuntarily lost jobs, which would seemingly be hard to miss. But paying attention to what was once the focus of Keynesian analysis would draw attention to the egregious NK error that recessions must be mild. What other conclusion is there if the model restricts recessions from triggering forced layoffs. There is very little harm that voluntary job quits and market frictions associated with job search/matching can do. It is silly to believe otherwise.
Blog Type: New Keynesians Chicago, Illinois