The GEM Project reconstructs macroeconomic theory to be simultaneously micro-coherent and stabilization-relevant. It is a powerful guide to policymaking capable of containing welfare losses that periodically result from the demand propagation of macro shocks. In this post, generalized-exchange analysis identifies three important lessons for stabilization-policy design.
First lesson. Disturbances in aggregate nominal demand are the essential feature of economic instability. The GEM Project restores the centrality of total spending in modern rigorous thinking by microfounding meaningful wage rigidity and associated product-price stickiness. The restoration uniquely motivates the nominal-real nexus that must be at the core of stabilization-relevant macroeconomics. The academy at last has a model, rooted in optimization and general equilibrium, that produces causation from adverse nominal spending disturbances to involuntary job loss and recognizable movement in total employment, output, and income. The innovation enabling stabilization relevance is the intuitive generalization of rational exchange from the marketplace to workplaces restricted by asymmetric employee-employer information.
In the GEM Project, effective preparation for containing welfare loss associated with aggregate instability, ranging from significant to disastrous, must focus on the authorities’ capacity to manage aggregate demand. The policymakers’ discretionary toolkit, especially interventions that take full advantage of the Federal Reserve’s balance sheet, must be made as powerful as possible.
Second lesson. Modern, highly specialized economies are complex, vulnerable to macro shocks that produce a dizzying variety of market failure. Stabilization authorities must have the latitude to pick and choose, depending on the circumstances, what macro objective to pursue. Their immediate choice will almost always be between high trend employment/output and low trend product-price inflation.
Perhaps the most damaging policy advice, persisting for a generation, from mainstream macro theorists has been their concerted effort to convince authorities to make inflation control always their dominant objective. Why? Such a nominal focus is consistent with the market-centric, general-equilibrium theory that dominates the macro academy. The problem, however, is that the mainstream model is deeply flawed. Most consequentially, it has never squared with the most important evidence. (It is a mission of the GEM Blog to never stop hammering home that consensus market-centric general-equilibrium modeling does not accommodate involuntary job loss.) Do the mainstream macroeconomists who continue to assert the primacy of the inflation objective really believe that Ben Bernanke and the Fed should have relied on the contemporaneous behavior of inflation to guide the urgency and size of their effort to halt and reverse the contraction of total spending in 2008-09? Assigning primacy to the inflation objective would have been, by far, the worst mistake in the history of stabilization policy. Bernanke was too smart and too skeptical of modern macroeconomics to make it.
Third lesson. The last of the big three policymaking lessons from the generalization of rational exchange concerns whether real and nominal stabilization objectives should be coequal. Given its rational suppression of wage recontracting and the consequent causal relation from adverse total-spending disturbances to forced job loss and recognizably-sized movement in output, employment, and income, the GEM Project has reasserted the early Keynesian emphasis on the macrodynamics of aggregate demand. The generalization of exchange has been used to introduce rational investor/lender confidence in a powerful model of acute instability, the class of contracting aggregate demand that is resistant to the normal responses effective in garden-variety recessions (automatic fiscal stabilizers and reductions in short-term interest rates). It has been demonstrated that the central impetus to an unchecked collapse in total spending is the loss investor/lender credibility in the capacity of stabilization authorities to deliver on their high trend employment/ output objective. That real-side credibility became shaky in 2008-09, causing investors/ lenders to pause in their acquisition of assets, feeding the gathering collapse in demand. Bernanke avoided the unimaginable cost of a 21st-century depression by implementing extraordinarily aggressive, buyer-of-last-resort policies that reestablished the Fed’s real-side credibility. Had the Fed’s inventory of demand-management tools been significantly more powerful, the cost of the Great Recession would have been correspondingly smaller. Had they been significantly less powerful, the Great Recession would have been a depression.
Unmatched huge costs of modern depressions make the maintenance of stabilization authorities’ trend real-side credibility more important than nominal (inflation) credibility. The practical conclusion is that economic research on the Fed’s toolkit targeting high trend employment and political capital used to ratify those tools should get priority over its trend-inflation counterpart. With respect to stabilization policy implementation, circumstances that challenge real and nominal trend commitments differ sufficiently to make choosing between them something that can be typically avoided. But, if the choice somehow becomes inevitable, maintaining real-side credibility is the clear choice. Finally, closer to home, mainstream macro theorists must escape the Ptolemaic grip of putting reputation above public welfare and stop peddling really bad policymaking advice.
Blog Type: New Keynesians Chicago, Illinois