The Lucas Critique Revisited

After writing my previous post, I reread Robert Lucas’s classic article “Econometric Policy Evaluation: A Critique,” surely one of the most influential economics articles of the last half century. While the main point of the article was not entirely original, as Lucas himself acknowledged in the article, so powerful was his explanation of the point that it soon came to be known simply as the Lucas Critique. The Lucas Critique says that if a certain relationship between two economic variables has been estimated econometrically, policy makers, in formulating a policy for the future, cannot rely on that relationship to persist once a policy aiming to exploit the relationship is adopted. The motivation for the Lucas Critique was the Friedman-Phelps argument that a policy of inflation would fail to reduce the unemployment rate in the long run, because workers would eventually adjust their expectations of inflation, thereby draining inflation of any stimulative effect. By restating the Friedman-Phelps argument as the application of a more general principle, Lucas reinforced and solidified the natural-rate hypothesis, thereby establishing a key principle of modern macroeconomics.

In my previous post I argued that microeconomic relationships, e.g., demand curves and marginal rates of substitution, are, as a matter of pure theory, not independent of the state of the macroeconomy. In an interdependent economy all variables are mutually determined, so there is no warrant for saying that microrelationships are logically prior to, or even independent of, macrorelationships. If so, then the idea of microfoundations for macroeconomics is misleading, because all economic relationships are mutually interdependent; some relationships are not more basic or more fundamental than others. The kernel of truth in the idea of microfoundations is that there are certain basic principles or axioms of behavior that we don’t think an economic model should contradict, e.g., arbitrage opportunities should not be left unexploited – people should not pass up obvious opportunities, such as mutually beneficial offers of exchange, to increase their wealth or otherwise improve their state of well-being.

So I was curious to how see whether Lucas, while addressing the issue of how price expectations affected output and employment, recognized the possibility that a microeconomic relationship could be dependent on the state of the macroeconomy. For my purposes, the relevant passage occurs in section 5.3 (subtitled “Phillips Curves”) of the paper. After working out the basic theory earlier in the page, Lucas, in section 5, provided three examples of how econometric estimates of macroeconomic relationships would mislead policy makers if the effect of expectations on those relationships were not taken into account. The first two subsections treated consumption expenditures and the investment tax credit. The passage that I want to focus on consists of the first two paragraphs of subsection 5.3 (which I now quote verbatim except for minor changes in Lucas’s notation).

A third example is suggested by the recent controversy over the Phelps-Friedman hypothesis that permanent changes in the inflation rate will not alter the average rate of unemployment. Most of the major econometric models have been used in simulation experiments to test this proposition; the results are uniformly negative. Since expectations are involved in an essential way in labor and product market supply behavior, one would presumed, on the basis of the considerations raised in section 4, that these tests are beside the point. This presumption is correct, as the following example illustrates.

It will be helpful to utilize a simple, parametric model which captures the main features of the expectational view of aggregate supply – rational agents, cleared markets, incomplete information. We imagine suppliers of goods to be distributed over N distinct markets i, I = 1, . . ., N. To avoid index number problems, suppose that the same (except for location) good is traded in each market, and let y_it be the log of quantity supplied in market i in period t. Assume, further, that the supply y_it is composed of two factors

y_it = Py_it + Cy_it,

where Py_it denotes normal or permanent supply, and Cy_it cyclical or transitory supply (both again in logs). We take Py_it to be unresponsive to all but permanent relative price changes or, since the latter have been defined away by assuming a single good, simply unresponsive to price changes. Transitory supply Cy_it varies with perceived changes in the relative price of goods in i:

Cy_it = β(p_it – Ep_it),

where p_it is the log of the actual price in i at time t, and Ep_it is the log of the general (geometric average) price level in the economy as a whole, as perceived in market i.

Let’s take a moment to ponder the meaning of Lucas’s simplifying assumption that there is just one good. Relative prices (except for spatial differences in an otherwise identical good) are fixed by assumption; a disequilibrium (or suboptimal outcome) can arise only because of misperceptions of the aggregate price level. So, by explicit assumption, Lucas rules out the possibility that any microeconomic relationship depends on macroeconomic conditions. Note also that Lucas does not provide an account of the process by which market prices are established at each location, nothing being said about demand conditions. For example, if suppliers at location i perceive a price (transitorily) above the equilibrium price, and respond by (mistakenly) increasing output, thereby increasing their earnings, do those suppliers increase their demand to consume output? Suppose suppliers live and purchase at locations other than where they are supplying product, so that a supplier at location i purchases at location j, where i does not equal j. If a supplier at location i perceives an increase in price at location i, will his demand to purchase the good at location j increase as well? Will the increase in demand at location j cause an increase in the price at location j? What if there is a one-period lag between supplier receipts and their consumption demands? Lucas provides no insight into these possible ambiguities in his model.

Stated more generally, the problem with Lucas’s example is that it seems to be designed to exclude a priori the possibility of every type of disequilibrium but one, a disequilibrium corresponding to a single type of informational imperfection. Reasoning on the basis of that narrow premise, Lucas shows that, under a given expectation of the future price level, an econometrician would find a positive correlation between the price level and output — a negatively sloped Phillips Curve. Yet, under the same assumptions, Lucas also shows that an anticipated policy to raise the rate of inflation would fail to raise output (or, by implication, increase employment). But, given his very narrow underlying assumptions, it seems plausible to doubt the robustness of Lucas’s conclusion. Proving the validity of a proposition requires more than constructing an example in which the proposition is shown to be valid. That would be like trying to prove that the sides of every triangle are equal in length by constructing a triangle whose angles are all equal to 60 degrees, and then claiming that, because the sides of that triangle are equal in length, the sides of all triangles are equal in length.

Perhaps a better model than the one Lucas posited would have been one in which the amount supplied in each market was positively correlated with the amount supplied in every other market, inasmuch as an increase (decrease) in the amount supplied in one market will tend to increase (decrease) demand in other markets. In that case, I conjecture, deviations from permanent supply would tend to be cumulative (though not necessarily permanent), implying a more complex propagation mechanism than Lucas’s simple model does. Nor is it obvious to me how the equilibrium of such a model would compare to the equilibrium in the Lucas model. It does not seem inconceivable that a model could be constructed in which equilibrium output depended on the average price level. But this is just conjecture on my part, because I haven’t tried to write out and solve such a model. Perhaps an interested reader out there will try to work it out and report back to us on the results.

PS:  Congratulations to Scott Sumner on his excellent op-ed on nominal GDP level targeting in today’s Financial Times.

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23 Responses to “The Lucas Critique Revisited”


  1. 1 Blue Aurora January 2, 2013 at 9:04 pm

    Out of curiosity David Glasner, have you read the Keynes/Tinbergen correspondence? Back in the late 1930ies to the 1940ies, Lord Keynes was engaged in a debate with Jan Tinbergen and the newly ascendant sub-field of econometrics. Some people believe that Lord Keynes was opposed to the use of mathematics in economics, but on closer inspection, this does not turn out to be the case.

    http://link.springer.com/article/10.1007%2FBF00869639

    According to Dr. Michael Emmett Brady, J.M. Keynes was basing his critique of the econometricians from points that he had made earlier in A Treatise on Probability. He makes a brief comment on the Tinbergen/Keynes debate in this article published in the International Journal of Applied Economics and Econometrics.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1920578

    For a more elaborate and scholarly treatment of the Tinbergen/Keynes debate and the history of econometrics in general, Dr. Michael Emmett Brady recommends one read Hugo A. Keuzenhampf’s Probability, Econometrics, and Truth. The Lucas Critique is really a footnote to Keynes’s criticisms of the econometricians, apparently…

  2. 2 Jan January 3, 2013 at 12:16 am

    Robert Lucas, rational expectations, and the understanding of business cycles-pofessor Lars Pålsson Syll-Malmö University

    https://larspsyll.wordpress.com/2011/05/16/robert-lucas-rational-expectations-and-the-understanding-of-business-cycles/

    Following the greatest economic depression since the 1930s, the grand old man of modern economic growth theory, Nobel laureate Robert Solow, on July 20, 2010, gave a prepared statement on “Building a Science of Economics for the Real World” for a hearing in the U. S. Congress. According to Solow modern macroeconomics has not only failed at solving present economic and financial problems, but is “bound” to fail. Building dynamically stochastic general equilibrium models (DSGE) on “assuming the economy populated by a representative agent” – consisting of “one single combination worker-owner-consumer-everything-else who plans ahead carefully and lives forever” – do not pass “the smell test: does this really make sense?” One cannot but concur in Solow’s surmise that a thoughtful person “faced with the thought that economic policy was being pursued on this basis, might reasonably wonder what planet he or she is on.”

    Although the “representative agent model” is one of the main reasons for the deficiencies in modern (macro)economic theory, it is far from the only modeling assumption that does not pass the smell test. In fact in this essay it will be argued that modern orthodox (neoclassical) economic theory in general does not pass the smell test at all.

    The recent economic crisis and the fact that orthodox economic theory has had next to nothing to contribute in understanding it, shows that neoclassical economics – in Lakatosian terms – is a degenerative research program in dire need of replacement.

    To get a more particularized and precise picture of what neoclassical economic theory is today, it is indispensible to complement the perhaps rather “top-down” approaches often used with a more “bottom-up” approach. To that end I will below present – with emphasis on the chosen model-building strategy – a paradigmatic example, Robert Lucas business cycles theory, to exemplify and diagnose neoclassical economic theory as practiced nowadays.

    Neoclassical economic theory today is in the story-telling business whereby economic theorists create make-believe analogue models of the target system – usually conceived as the real economic system. This modeling activity is considered useful and essential. Since fully-fledged experiments on a societal scale as a rule are prohibitively expensive, ethically indefensible or unmanageable, economic theorists have to substitute experimenting with something else. To understand and explain relations between different entities in the real economy the predominant strategy is to build models and make things happen in these “analogue-economy models” rather than engineering things happening in real economies.

    In business cycles theory these models are constructed with the purpose of showing that changes in the supply of money “have the capacity to induce depressions or booms” [Lucas 1988:3] not just in these models, but also in real economies. To do so economists are supposed to imagine subjecting their models to some kind of “operational experiment” and “a variety of reactions”. “In general, I believe that one who claims to understand the principles of flight can reasonably be expected to be able to make a flying machine, and that understanding business cycles means the ability to make them too, in roughly the same sense” [Lucas 1981:8]. To Lucas models are the laboratories of economic theories, and after having made a simulacrum-depression Lucas hopes we find it “convincing on its own terms – that what I said would happen in the [model] as a result of my manipulation would in fact happen” [Lucas 1988:4]. The clarity with which the effects are seen is considered “the key advantage of operating in simplified, fictional worlds” [Lucas 1988:5].

    On the flipside lies the fact that “we are not really interested in understanding and preventing depressions in hypothetical [models]. We are interested in our own, vastly more complicated society” [Lucas 1988:5]. But how do we bridge the gulf between model and “target system”? According to Lucas we have to be willing to “argue by analogy from what we know about one situation to what we would like to know about another, quite different situation” [Lucas 1988:5]. Progress lies in the pursuit of the ambition to “tell better and better stories” [Lucas 1988:5], simply because that is what economists do.

    “We are storytellers, operating much of the time in worlds of make believe. We do not find that the realm of imagination and ideas is an alternative to, or retreat from, practical reality. On the contrary, it is the only way we have found to think seriously about reality. In a way, there is nothing more to this method than maintaining the conviction … that imagination and ideas matter … there is no practical alternative” [Lucas 1988:6].

    Lucas has applied this mode of theorizing by constructing “make-believe economic systems” to the age-old question of what causes and constitutes business cycles. According to Lucas the standard for what that means is that one “exhibits understanding of business cycles by constructing a model in the most literal sense: a fully articulated artificial economy, which behaves through time so as to imitate closely the time series behavior of actual economies” [Lucas 1981:219].

    To Lucas business cycles is an inherently systemic phenomenon basically characterized by conditional co-variations of different time series. The vision is “the possibility of a unified explanation of business cycles, grounded in the general laws governing market economies, rather than in political or institutional characteristics specific to particular countries or periods” [Lucas 1981:218]. To be able to sustain this view and adopt his “equilibrium approach” he has to define the object of study in a very constrained way. Lucas asserts, e.g., that if one wants to get numerical answers “one needs an explicit, equilibrium account of the business cycles” [Lucas 1981:222]. But his arguments for why it necessarily has to be an equilibrium is not very convincing, but rather confirms Hausman’s view [2001:320] that faced with the problem of explaining adjustments to changes, economists “have become complacent about this inadequacy – they have become willing prisoners of the limitations of their theories.” The main restriction is that Lucas only deals with purportedly invariable regularities “common to all decentralized market economies” [Lucas 1981:218]. Adopting this definition he can treat business cycles as all alike “with respect to the qualitative behavior of the co-movements among series” [1981:218]. As noted by Hoover [1988:187]:

    Lucas’s point is not that all estimated macroeconomic relations are necessarily not invariant. It is rather that, in order to obtain an invariant relation, one must derive the functional form to be estimated from the underlying choices of individual agents. Lucas supposes that this means that one must derive aggregate relations from individual optimization problems taking only tastes and technology as given.

    Postulating invariance paves the way for treating various economic entities as stationary stochastic processes (a standard assumption in most modern probabilistic econometric approaches) and the possible application of “economic equilibrium theory.” The result is that Lucas business cycle is a rather watered-down version of what is usually connoted when speaking of business cycles.

    Based on the postulates of “self-interest” and “market clearing” Lucas has repeatedly stated that a pure equilibrium method is a necessary intelligibility condition and that disequilibria are somehow “arbitrary” and “unintelligible” [Lucas 1981:225]. Although this might (arguably) be requirements put on models, these requirements are irrelevant and totally without justification vis-à-vis the real world target system. Why should involuntary unemployment, for example, be considered an unintelligible disequilibrium concept? Given the lack of success of these models when empirically applied, what is unintelligible, is rather to pursue in this reinterpretation of the ups and downs in business cycles and labour markets as equilibria. To Keynes involuntary unemployment is not equatable to actors on the labour market becoming irrational non-optimizers. It is basically a reduction in the range of working-options open to workers, regardless of any volitional optimality choices made on their part. Involuntary unemployment is excess supply of labour. That unemployed in Lucas business cycles models only can be conceived of as having chosen leisure over work is not a substantive argument about real world unemployment.

    “The point at issue [is] whether the concept of involuntary unemployment actually delineates circumstances of economic importance … If the worker’s reservation wage is higher than all offer wages, then he is unemployed. This is his preference given his options. For the new classicals, the unemployed have placed and lost a bet. It is sad perhaps, but optimal” [Hoover 1988:59].

    Sometimes workers are not employed. That is a real phenomenon and not a “theoretical construct … the task of modern theoretical economics to ‘explain’” [Lucas 1981:243].

    All economic theories have to somehow deal with the daunting question of uncertainty and risk. It is “absolutely crucial for understanding business cycles” [Lucas 1981:223]. To be able to practice economics at all, “we need some way … of understanding which decision problem agents are solving” [Lucas 1981:223]. Lucas – in search of a “technical model-building principle” [Lucas 1981:1] – adapts the rational expectations view, according to which agents’ subjective probabilities are identified “with observed frequencies of the events to be forecast” are coincident with “true” probabilities. This hypothesis [Lucas 1981:224]

    “will most likely be useful in situations in which the probabilities of interest concern a fairly well defined recurrent event, situations of ‘risk’ [where] behavior may be explainable in terms of economic theory … In cases of uncertainty, economic reasoning will be of no value … Insofar as business cycles can be viewed as repeated instances of essentially similar events, it will be reasonable to treat agents as reacting to cyclical changes as ‘risk’, or to assume their expectations are rational, that they have fairly stable arrangements for collecting and processing information, and that they utilize this information in forecasting the future in a stable way, free of systemic and easily correctable biases.””

    To me this seems much like putting the cart before the horse. Instead of adapting the model to the object – which from both ontological and epistemological considerations seem the natural thing to do – Lucas proceeds in the opposite way and chooses to define his object and construct a model solely to suit own methodological and theoretical preferences. All those – interesting and important – features of business cycles that have anything to do with model-theoretical openness, and a fortiori not possible to squeeze into the closure of the model, are excluded. One might rightly ask what is left of that we in a common sense meaning refer to as business cycles. Einstein’s dictum – “everything should be made as simple as possible but not simpler” falls to mind. Lucas – and neoclassical economics at large – does not heed the implied apt warning.

    The development of macro-econometrics has according to Lucas supplied economists with “detailed, quantitatively accurate replicas of the actual economy” thereby enabling us to treat policy recommendations “as though they had been experimentally tested” [Lucas 1981:220]. But if the goal of theory is to be able to make accurate forecasts this “ability of a model to imitate actual behavior” does not give much leverage. What is required is “invariance of the structure of the model under policy variations”. Parametric invariance in an economic model cannot be taken for granted, “but it seems reasonable to hope that neither tastes nor technology vary systematically” [Lucas 1981:220].

    The model should enable us to posit contrafactual questions about what would happen if some variable was to change in a specific way. Hence the assumption of structural invariance, that purportedly enables the theoretical economist to do just that. But does it? Lucas appeals to “reasonable hope”, a rather weak justification for a modeler to apply such a far-reaching assumption. To warrant it one would expect an argumentation that this assumption – whether we conceive of it as part of a strategy of “isolation”, “idealization” or “successive approximation” – really establishes a useful relation that we can export or bridge to the target system, the “actual economy.” That argumentation is neither in Lucas, nor – to my knowledge – in the succeeding neoclassical refinements of his “necessarily artificial, abstract, patently ‘unreal’” analogue economies [Lucas 1981:271]. At most we get what Lucas himself calls “inappropriately maligned” casual empiricism in the form of “the method of keeping one’s eyes open.” That is far from sufficient to warrant any credibility in a model pretending to explain the complex and difficult recurrent phenomena we call business cycles. To provide an empirical “illustration” or a “story” to back up your model do not suffice. There are simply too many competing illustrations and stories that could be exhibited or told.

    As Lucas has to admit – complaining about the less than ideal contact between theoretical economics and econometrics – even though the “stories” are (purportedly) getting better and better, “the necessary interaction between theory and fact tends not to take place” [Lucas 1981:11].

    The basic assumption of this “precise and rigorous” model therefore cannot be considered anything else than an unsubstantiated conjecture as long as it is not supported by evidence from outside the theory or model. To my knowledge no in any way decisive empirical evidence have been presented. This is the more tantalizing since Lucas himself stresses that the presumption “seems a sound one to me, but it must be defended on empirical, not logical grounds” [Lucas 1981:12].

    And applying a “Lucas critique” on Lucas own model, it is obvious that it too fails. Changing “policy rules” cannot just be presumed not to influence investment and consumption behavior and a fortiori technology, thereby contradicting the invariance assumption. Technology and tastes cannot live up to the status of an economy’s deep and structurally stable Holy Grail. They too are part and parcel of an ever-changing and open economy. Lucas hope of being able to model the economy as “a FORTRAN program” and “gain some confidence that the component parts of the program are in some sense reliable prior to running it” [Lucas 1981:288] therefore seems – from an ontological point of view – totally misdirected. The failure in the attempt to anchor the analysis in the alleged stable deep parameters “tastes” and “technology” shows that if you neglect ontological considerations pertaining to the target system, ultimately reality kicks back when at last questions of bridging and exportation of model exercises are laid on the table. No matter how precise and rigorous the analysis is, and no matter how hard one tries to cast the argument in “modern mathematical form” [Lucas 1981:7] they do not push science forwards one millimeter if they do not stand the acid test of relevance to the target. No matter how clear, precise, rigorous or certain the inferences delivered inside these models are, they do not per se say anything about external validity.

    Formalistic deductive “Glasperlenspiel” can be very impressive and seductive. But in the realm of science it ought to be considered of little or no value to simply make claims about the model and lose sight of the other part of the model-target dyad.

    Neoclassical economics has since long given up on the real world and contents itself with proving things about thought up worlds. Empirical evidence only plays a minor role in economic theory, where models largely function as a substitute for empirical evidence. But “facts kick”, as Gunnar Myrdal used to say. Hopefully humbled by the manifest failure of its theoretical pretences, the one-sided, almost religious, insistence on mathematical-deductivist modeling as the only scientific activity worthy of pursuing in economics will give way to methodological pluralism based on ontological considerations rather than formalistic tractability.

    If not, we will have to keep on wondering – with Robert Solow – what planet the economic theoretician is on.

    References
    Hausman, Daniel (1997), Why Does Evidence Matter So Little To Economic Theory? In Dalla Chiara et al (eds.), Structures and Norms in Science (pp 395-407). Dordrecht: Reidel.

    -(2001), Explanation and Diagnosis in Economics. Revue Internationale De Philosophie 55:311-326.

    Hoover, Kevin (1988), The New Classical Macroeconomics. Oxford: Basil Blackwell.

    – (2002), Econometrics and reality. In U. Mäki (ed.), Fact and fiction in economics (pp. 152-177). Cambridge: Cambridge University Press.

    – (2008), “Idealizing Reduction: The Microfoundations of Macroeconomics. Manuscript, 27 May 2008. (forthcoming in Erkenntnis)

    Lucas, Robert (1981), Studies in Business-Cycle Theory. Oxford: Basil Blackwell.

    – (1986), Adaptive Behavior and Economic Theory. In Hogarth, Robin & Reder, Melvin (eds) Rational Choice (pp. 217-242). Chicago: The University of Chicago Press.

    – (1988), What Economists Do. http://home.uchicago.edu/~vlima/courses/econ203/fall01/Lucas_wedo.pdf

    Solow, Robert (2010), Building a Science of Economics for the Real World, House Committee on Science and Technology Subcommittee on Investigations and Oversight.

  3. 3 Nick Rowe January 3, 2013 at 3:17 am

    David: “Perhaps a better model than the one Lucas posited would have been one in which the amount supplied in each market was positively correlated with the amount supplied in every other market, inasmuch as an increase (decrease) in the amount supplied in one market will tend to increase (decrease) demand in other markets.”

    The standard New Keynesian model has that feature (provided we interpret the word “supply” loosely, since imperfectly competitive firms do not have supply curves strictly speaking).

    Here’s the way I think about it:

    The representative individual firm has a marginal revenue function MR(y,Y) and marginal cost function MC(y,Y), where y is the individual firm’s output and Y is average aggregate output per firm. (In symmetric equilibrium y=Y.)

    Holding Y constant, we can draw a downward-sloping MR curve and an MC curve that may either slope up, down, or sideways, depending on technology, but we know that the MR curve must cut the MC curve from above to satisfy the second order conditions for a maximum.

    Holding y constant, MR will almost certainly be an increasing function of Y (because if all other firms increase output, income will increase too, which will increase demand for our firm’s output). MC will also be an increasing function of Y, (because if all other firms increase output they will increase employment and bid up real wages which increases our firm’s marginal cost). The first (MR) effect causes positive feedback, and the second (MC) effect causes negative feedback.

    Putting both those effects together, we want to know what happens to MR and MC when our firm and all the other firms increase y and Y by the same amount. We want to know the slopes of the loci MR(Y,Y) and MC(Y,Y). If the MR locus cuts the MC locus once only, and from above, we get a unique stable equilibrium. (If we start in equilibrium where MR(Y,Y)=MC(Y,Y), then hold all prices temporarily fixed, then increase AD, by loosening monetary policy, so that all firms increase output to Y’, then each individual firm will find that MR(Y’,Y’) < MC(Y',Y'), so each firm will want to raise its relative price and reduce its relative output).

    The standard NK model assumes a constant elasticity of demand E, so that the MR(Y,Y) locus is horizontal at 1-1/E. And assumes an upward-sloping MC(Y,Y) locus because of the upward-sloping labour supply curve. So you get a unique stable macro equilibrium in which money is LR neutral. You get either positive or negative feedback, depending on the elasticity of labour supply.

    If you "rigged" the assumptions you could build a NK model with a positive feedback greater than one, so the MR(Y,Y) locus would cut the MC(Y,Y) locus from below, or more than once, giving you multiple equilibria, where money could have permanent effects, by flipping the economy from a low to a high equilibrium.

    You would need to assume: demand is a lot more elastic in a boom than in a slump (so MR(Y,Y) locus slopes up); a very elastic labour supply curve, and strongly increasing returns to scale (to make the MC(Y,Y) locus fairly flat).

    I have played around with models like this. The stumbling block, empirically, is the labour supply curve (or whatever replaces it). It's hard to think up good reasons to make it flat enough to get a flattish MC(Y,Y) locus. The same problem that RBC models face.

  4. 5 Nick Rowe January 3, 2013 at 4:00 am

    Bottom line:

    You always get positive feedback on the demand side (except for firms producing inferior goods).

    You get negative feedback on the supply side, given scarce resources that are rival between firms.

    So total feedback could be either positive or negative.

    But to overturn LR monetary neutrality by this route, you need more than net positive feedback. You need net positive feedback greater than one (at least locally). That can be built into a model, but I have doubts about its plausibility

  5. 6 Luis January 3, 2013 at 9:01 am

    Really brillant, David.

  6. 7 Roman P. January 3, 2013 at 11:20 am

    David,

    What axioms should economics use, in your opinion? What do you think of the Paul Davidson’s list (three axioms he often repeats):
    1) Non-ergodicity (the world is ontologically uncertain)
    2) Non-neutral money
    3) No gross substitution

    Personally, I dislike your example of arbitrage. It is true that a person *on average* will not pass profitable opportunities known to him, but just assuming this as an axiom opens the way to concluding that all opportunities in an economy are exploited, which is obviously untrue.

  7. 8 David Glasner January 3, 2013 at 7:44 pm

    Blue Aurora, I have seen references to the correspondence and perhaps even some quotations. I think that a long time ago I once actually quoted some remark of Keynes about econometric estimation in something that I wrote about econometrics for attorneys that I was working concerning the work of an econometrician who presented some econometric findings to the FTC on behalf of a client. But I can’t actually recall the quotation. Thanks for your citations to the work of Brady and Keuzenhampf.

    Jan, I remember Solow’s testimony, and was very impressed by it. But Stephen Williamson dismissed the criticism as merely evidence that Solow was not up to date on the current state of macroeconomics, because more recent versions of DSGE models were no longer being constructed as representative agent models. I agree with Solow that representative agent models are a travesty. Whether the most up-to-date DSGE models have evolved beyond representative agent models I don’t know, but as long as DSGE models are treated as versions of Arrow-Debreu GE models with a unique and stable equilibrium, I can’t take them seriously.

    Nick, Many thanks for responding to my request. How prescient of you to have figured it all out and posted it on your blog before I even posed the question. Very impressive! What I don’t get is why the existence of multiple equilibria is not sufficient to demonstrate that money may not be neutral in the long run.

    Luis, Thanks so much.

    Roman P., I don’t have a definitive list of axioms. I think it depends on the problem and the modeling strategy. It also depends on the results generated by alternative models and how well the results of the models can account for the observed data. I am OK with Davidson’s first and second axioms, though under certain fairly extreme conditions money is neutral, so I don’t know if I would make it an axiom. I don’t immediately see why no gross substitution is a big deal. There is a difference between an arbitrage opportunity and a more subtle profit opportunity, but again it is a matter of degree. That’s why I am suspicious of axiomitizing economics.

  8. 9 Blue Aurora January 3, 2013 at 8:48 pm

    You’re welcome, David Glasner. BTW, I misspelled the surname of the author of Probability, Econometrics, and Truth. It’s “Keuzenkamp”, NOT “Keuzenhampf”! And just for the record, you can acquire a copy of the book on Amazon.com.

  9. 10 Greg Ransom January 3, 2013 at 10:37 pm

    There is nothing more embarrassing to the pretensions of economic professors than the history of economic ideas, ie a examination of the genealogy of their unreflective presuppositions.

  10. 11 Roman P. January 3, 2013 at 11:34 pm

    David,

    “No gross substitution” in Davidson’s case means simply that liquidity is special: for an individual, it has almost zero elasticity of production and almost zero elasticity of substitution with illiquid assets. I.e. it is hard to get and the demand for it can’t be readily fulfilled by other goods. I understand from his writings that he links this special property of money with the breaking of Say’s Law and the absence of universally downward slopping demand curves, but I’m probably misrepresenting his works somehow.

  11. 12 Nick Rowe January 4, 2013 at 1:30 pm

    David: ” What I don’t get is why the existence of multiple equilibria is not sufficient to demonstrate that money may not be neutral in the long run.”

    I wasn’t clear. In my view, if there are multiple equilibria, you have a good prime facie case for longish run non-neutrality of money. But it’s hard to get multiple equilibria from this particular channel.

  12. 13 Becky Hargrove January 5, 2013 at 1:24 pm

    This was a great post and I’ve scribbled notes for a couple of days…will at least share a few thoughts: suppose there are three equilibria with different characteristics, potential perimeters and degrees of neutrality. First, the production equilibrium which makes the most monetary sense in terms of neutrality and endogenous (or global) characteristics and fair to say the point from which many transmissions flow (alonside the Fed, of course there is transmission from insurance for services). Here lies the definition of unemployment which makes the most sense. The production equilibrium is the mobile and physical good whose main scarcity lies in specific, replacable materials.

    The second equilibrium, (land and housing) was made “mobile” through the use of titles but has since become less mobile in practice through actual scarcity and cultural definition (family law), and is therefore somewhat exogenous to overall equilibrium in terms of balanced wealth flow options. Actual geographic scarcities also lend a non-neutral aspect to this group, even as overreach in zoning definition gets scaled back. Land use can be made more money neutral, flexible and endogenous by optimizing settings without (highly) specific geographic advantages.

    Third equilibrium, services, are mobile and endogenous where technology allows them to be global, but somewhat exogenous to global definition when actual use may compel them to remain either local or undefined. Services are the non physical good, thus rely upon wealth transmission in order to take place in monetary terms (time use cannot be “stored” unless it is unequal). Services are also what has created the illusion that production has slowed, as they become a larger part of economic activity. A growing number of them also take place outside the monetary spectrum, albeit in mostly undefined terms. Three kinds of “unpaid” services: group and individual projects assisted by technology, DIY shifted to customers for savings in institutional time, and of course cultural or familal expectation.

  13. 14 David Glasner January 7, 2013 at 2:19 pm

    Blue Aurora, Thanks for the correction and the link. It looks like a very fine book.

    Greg, If a discipline is worth studying, it seems to me that so is its history. Unfortunately, in these enlightened times, the study of the history of economics is no longer considered a worthy undertaking for a professional economist, and fewer and fewer departments are even bothering to teach anything about the history of economics. A pity.

    Roman P., I see that Bob Dimand discusses this in a recent paper in the Journal of Post Keynesian Economics. http://ideas.repec.org/a/mes/postke/v32y2009i1p59-72.html

    Here’s the abstract:

    “Paul Davidson’s admirable and concise new introduction to Keynes the person and to the ideas of Keynes emphasizes Keynes’s demonstration that even a competitive economy with freely flexible wages and prices may lack an adjustment mechanism to automatically restore full employment without active government stabilization policy. This paper underlines Davidson’s critique of the neutral money axiom of neoclassicals economics by showing that money cannot be both neutral and superneutral, uses student notes on Keynes’s lectures to extend Davidson’s account of how IS-LM came to be accepted as a representation of Keynes, and questions Davidson’s claim that the existence of equilibrium in neoclassical economics depends on assuming that all goods are gross substitutes.”

    Nick, You said:

    “In my view, if there are multiple equilibria, you have a good prime facie case for longish run non-neutrality of money. But it’s hard to get multiple equilibria from this particular channel.”

    Unless you assume that there is only one output, why is it a stretch to imagine that an imperfectly competitive equilibrium is not unique. It seems to me that if the output of every firm depends on the shape of the demand curve for its output, and there are a lot of degrees of freedom in solving for a new equilibrium. On the other hand, I guess there is also a possibility that an increase in demand would reduce rather than increase demand elasticities causing output to contract not expand. But I really don’t know much about general equilibrium under imperfect competition.

    Becky, Thanks for your kind words and for taking the trouble to share your thoughts about different equilibrium concepts.

  14. 15 Roman P. January 7, 2013 at 11:11 pm

    David,

    Thanks for the link, the paper was enlightening. Sometimes I wish I had enough time to read all of the issues of JPKE, but as it is I’m only able to read a few of the more standing out papers.

    The issue of the gross substitution is pretty obscure; and I wonder if even prof. Davidson himself has adjusted his position after accepting Dimand’s paper into his own journal.

  15. 16 Blue Aurora January 8, 2013 at 2:20 am

    Regarding ergodicity and non-ergodicity in the economy, Paul Davidson has been criticised on this matter before…apparently, Paul Davidson may not quite understand how ergodicity and non-ergodicity actually works.

    http://www.amazon.com/review/R1L90S6XLQLFTG

    http://www.amazon.com/review/R32PPK2MQ5SQUG

  16. 17 David Glasner January 10, 2013 at 6:19 pm

    Roman P., You’re welcome. There’s a lot of good stuff out there waiting to be read.

    Blue Aurora, I am sorry, but I am not competent to weigh in on the debate between Michael Brady and Paul Davidson on ergodicity.


  1. 1 Economist's View: Links for 01-03-2013 Trackback on January 3, 2013 at 12:06 am
  2. 2 Remarkable! — shareholdersunite.com Trackback on January 4, 2013 at 6:43 am
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  6. 6 The Microfoundations Wars Continue | Uneasy Money Trackback on January 2, 2014 at 7:54 pm

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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