Microfoundations of the crisis

Posted in Economics, General Musings at 3:08 pm

Lots of interesting discussion all around regarding neoclassical economics and DSGE models (see recent blog postings by Krugman, Keen, et al).

Let’s cut to the chase:

Between November 2007 and October 2009, the unemployment rate increased from 4.7% to 10.0% and the size of the workforce shrank by almost 9 million jobs.  Many businesses closed or ran idle as sales plummeted.

What exactly caused almost 9 million jobs to be lost over a period of less than two years and output to tumble?

Did workers suddenly decide that they valued leisure over labor to a much higher degree than they previously thought and so voluntarily chose to stop working?

Did workers suddenly decide that they wanted significantly higher wages and so priced themselves out of the market?

Did real capital (plants, equipment, etc.) suddenly become less productive?

Was there some sudden change in technology that rendered production techniques LESS efficient?

Did the available physical quantity of some critical raw material suddenly plummet?

If the answer to the above five questions is “no, obviously not” then DSGE models not only failed to PREDICT the crisis, they are also incapable of EXPLAINING the crisis.

DSGE models rely on an exogenous shock to initiate a change in economic activity (downturn or upswing).  Neither a fall in house prices nor an increase in oil prices counts as exogenous, these are simply markets in action (examples of exogenous shocks here would be tornadoes destroying homes or embargoes against oil producing nations).  So where is the initial exogenous shock?

Once the initial shock (which still hasn’t been identified) occurs, DSGE models rely on various “frictions” to explain how the economy could remain in a depressed state for a period of time rather than immediately returning to a full employment equilibrium.  Sticky wages are probably the most frequent friction assumed.  Before we ask “why wages don’t fall during a recession” we should ask “why should wages fall”.  Every first year econ student is told that the price of labor (the wage rate) is determined by supply and demand and that supply is determined by the marginal disutility of labor (the work/leisure tradeoff) and demand is determined by the marginal productivity of labor.  Why should we simply assume that the “true” price of labor is suddenly lower than the market price and that the reason there’s a discrepancy is because wages are “sticky”?  What if there is no discrepancy and the market price for labor is correct (one would think this would be an economist’s first reaction)?  We are making the hidden assumption that pricing errors are the only thing that can cause a market to fail to clear.  Back to the question of supply and demand – if we are going to argue that the price of labor should be lower, we need to explain why, in terms of the marginal disutility and marginal productivity of labor.  In other words, either workers have suddenly become lazier or they have suddenly become less productive.  Which is it and why?

I would like the DSGE proponents to clearly articulate the cause of the above, without reference to money, finance, or anything else outside the framework of their models.  I want to see the “microfoundations of the crisis” if you will.