In the most recent update of the Handbook of Monetary Economics, Mankiw and Reis (2010, p.222) begin their review of macro theory on the wrong foot. They follow standard practice by framing of the fundamental question of why money matters in a way that restricts, and ultimately defeats, an adequate answer: “Since the birth of business cycle theory, economists have struggled with one overarching question: What is the nature of the market imperfection, if any, that causes the economy to deviate in the short run from full employment and the optimal allocation of resources? Or, to put the question more concretely and more prosaically in terms of undergraduate macroeconomics: What friction causes the short-run aggregate supply curve to be upward sloping rather than vertical, giving a role to aggregate demand in explaining economic fluctuations?”
An adequate answer to why money matters turns out to be inconsistent with modern theorists’ consensus assumption, illustrated by Mankiw-Reis, that optimizing exchange occurs wholly in the marketplace. That universal, unexamined, and ultimately untenable belief implies that the channel through which nominal disturbances induce deviations from full employment must be motivated by one or more micro-coherent market frictions. Candidate frictions problematically confront, and are always overwhelmed by, rational employer offers to cut wages in lieu of job loss. If the reduction does not violate employee opportunity costs, it is rationally accepted. If it does violate opportunity costs, the worker quits; and the job separation is voluntary.
Wage recontracting provides a stonewall friction-augmented general-market-equilibrium (FGME) line of defense against the failure to realize gains from trade and cannot be ignored in mainstream neoclassical modeling. Yet, it has become clear that recontracting, and consequently micro-coherence, must be ignored if market-centric thinking is to be stabilization relevant. That conundrum plagues formal modeling throughout the Handbook of Monetary Economics (2010). Meaningful wage rigidity (MWR) is necessary for the existence of involuntary job loss but cannot itself exist in FGME thinking. New Keynesian response to that macro muddle has been to construct and use models that push aside the rational treatment of wages. The discomfiting, ostrich-like strategy obscures, but cannot eliminate, the conundrum and its debilitating effects on modern efforts to derive operational stabilization theorems.
Illustrative is a paper in the collection by Jordi Gali (2010), in which he is burdened with a topic (monetary policy and unemployment) that affords little place to hide. He provides the only modeling of nominal wage rigidity in the fifteen hundred pages of the Handbook. His FGME treatment amounts to little more than drawing attention to the bit of cyclical behavior squeezed out of voluntary joblessness by Search/Match theorists (featured last week) and positing implausible restrictions, usually of the Calvo (1983) variety, on the incidence of wage recontracting. It does not surprise that Gali’s analysis cannot accommodate involuntary job loss, implying his endogenous cyclicality must be sufficiently mild never to generate forced unemployment. Nor does he confront the academy’s requirement (in part to weed out convenient implausibilities) that continuous-equilibrium modeling rationally derive its significant restrictions from model primitives. His policy-relevancy results from free parameters that ultimately differ little from those that got Early Keynesians banished. I recognize that my unflattering assessment largely results from Gali having done his job. His inattention to the most critical issues of labor pricing accurately portrays the low status of wage rigidities, once recognized as the lynchpin of macro theory, in the modern academy.
The Serious Alternative
The alternative to ignoring the most pressing problems in monetary theory is to get serious about modeling meaningful wage rigidity. It should be encouraging that the necessary content of any careful effort has been understood by practitioners for a long time. During the century and a half since the Second Industrial Revolution, rational workplace exchange has suppressed wage recontracting for an increasing share of the global labor force. MWR, formally derived, implies for workplaces restricted by costly, asymmetric information labor-market opportunity costs are chronically and variably below labor’s marginal value product. Chronic continuous-equilibrium wage rents have pushed workers off their notional market-supply schedule, thwarting optimization at the leisure-consumption margin. In complex bureaucratic workplaces, employees instead optimize their discretionary on-the-job behavior with respect to axiomatic preferences. Some recognition of such conduct is today being forced into mainstream macro theory by behavioral economists.
MWR uniquely microfounds the macro channel that, when combined with sufficiently adverse shifts in nominal demand, induces recognizable recession-sized increases in involuntary job loss. Stepping back, it is easily seen that an important generalized-exchange innovation, relative to NK practice, is its insistence preferences and technological constraints that are truly axiomatic. Taking that central tenet of formal modeling seriously would enable mainstream theorists to identify wage recontracting as the overarching problem in modern stabilization-relevant monetary modeling. Mainstream economists must understand that the reconstruction of labor supply to accommodate workplace exchange and its rational suppression of labor-price recontracting is rooted in rational behavior. Rational choice powerfully organizes the model coherence that, along with stabilization-relevance, has been promised and delivered in the GEM Project.
So why haven’t the best and brightest of macro theorists rushed to incorporate information-challenged workplaces into their modeling? Perhaps the impact of the second venue of rational exchange on their human capital, their reputations, and their satisfaction with how well they have prepared their students has hobbled their rush to superior modeling.
Blog Type: New Keynesians Saint Joseph, Michigan