Archive for the 'expectations' Category

Nick Rowe Teaches Us a Lot about Apples and Bananas

Last week I wrote a post responding to a post by Nick Rowe about money and coordination failures. Over the weekend, Nick posted a response to my post (and to one by Brad Delong). Nick’s latest post was all about apples and bananas. It was an interesting post, though for some reason – no doubt unrelated to its form or substance – I found the post difficult to read and think about. But having now read, and I think, understood (more or less), what Nick wrote, I confess to being somewhat underwhelmed. Let me try to explain why I don’t think that Nick has adequately addressed the point that I was raising.

That point being that while coordination failures can indeed be, and frequently are, the result of a monetary disturbance, one that creates an excess demand for money, thereby leading to a contraction of spending, and thus to a reduction of output and employment, it is also possible that a coordination failure can occur independently of a monetary disturbance, at least a disturbance that could be characterized as an excess demand for money that triggers a reduction in spending, income, output, and employment.

Without evaluating his reasoning, I will just restate key elements of Nick’s model – actually two parallel models. There are apple trees and banana trees, and people like to consume both apples and bananas. Some people own apple trees, and some people own banana trees. Owners of apple trees and owners of banana trees trade apples for bananas, so that they can consume a well-balanced diet of both apples and bananas. Oh, and there’s also some gold around. People like gold, but it’s not clear why. In one version of the model, people use it as a medium of exchange, selling bananas for gold and using gold to buy apples or selling apples for gold and using gold to buy bananas. In the other version of the model, people just barter apples for bananas. Nick then proceeds to show that if trade is conducted by barter, an increase in the demand for gold, does not affect the allocation of resources, because agents continue to trade apples for bananas to achieve the desired allocation, even if the value of gold is held fixed. However, if trade is mediated by gold, the increased demand for gold, with prices held fixed, implies corresponding excess supplies of both apples and bananas, preventing the optimal reallocation of apples and bananas through trade, which Nick characterizes as a recession. However, if there is a shift in demand from bananas to apples or vice versa, with prices fixed in either model, there will be an excess demand for bananas and an excess supply of apples (or vice versa). The outcome is suboptimal because Pareto-improving trade is prevented, but there is no recession in Nick’s view because the excess supply of one real good is exactly offset by an excess demand for the other real good. Finally, Nick considers a case in which there is trade in apple trees and banana trees. An increase in the demand for fruit trees, owing to a reduced rate of time preference, causes no problems in the barter model, because there is no impediment to trading apples for bananas. However, in the money model, the reduced rate of time preference causes an increase in the amount of gold people want to hold, the foregone interest from holding more having been reduced, which prevents optimal trade with prices held fixed.

Here are the conclusions that Nick draws from his two models.

Bottom line. My conclusions.

For the second shock (a change in preferences away from apples towards bananas), we get the same reduction in the volume of trade whether we are in a barter or a monetary economy. Monetary coordination failures play no role in this sort of “recession”. But would we call that a “recession”? Well, it doesn’t look like a normal recession, because there is an excess demand for bananas.

For both the first and third shocks, we get a reduction in the volume of trade in a monetary economy, and none in the barter economy. Monetary coordination failures play a decisive role in these sorts of recessions, even though the third shock that caused the recession was not a monetary shock. It was simply an increased demand for fruit trees, because agents became more patient. And these sorts of recessions do look like recessions, because there is an excess supply of both apples and bananas.

Or, to say the same thing another way: if we want to understand a decrease in output and employment caused by structural unemployment, monetary coordination failures don’t matter, and we can ignore money. Everything else is a monetary coordination failure. Even if the original shock was not a monetary shock, that non-monetary shock can cause a recession because it causes a monetary coordination failure.

Why am I underwhelmed by Nick’s conclusions? Well, it just seems that, WADR, he is making a really trivial point. I mean in a two-good world with essentially two representative agents, there is not really that much that can go wrong. To put this model through its limited endowment of possible disturbances, and to show that only an excess demand for money implies a “recession,” doesn’t seem to me to prove a great deal. And I was tempted to say that the main thing that it proves is how minimal is the contribution to macroeconomic understanding that can be derived from a two-good, two-agent model.

But, in fact, even within a two-good, two-agent model, it turns out there is room for a coordination problem, not considered by Nick, to occur. In his very astute comment on Nick’s post, Kevin Donoghue correctly pointed out that even trade between an apple grower and a banana grower depends on the expectations of each that the other will actually have what to sell in the next period. How much each one plants depends on his expectations of how much the other will plant. If neither expects the other to plant, the output of both will fall.

Commenting on an excellent paper by Backhouse and Laidler about the promising developments in macroeconomics that were cut short because of the IS-LM revolution, I made reference to a passage quoted by Backhouse and Laidler from Bjorn Hansson about the Stockholm School. It was the Stockholm School along with Hayek who really began to think deeply about the relationship between expectations and coordination failures. Keynes also thought about that, but didn’t grasp the point as deeply as did the Swedes and the Austrians. Sorry to quote myself, but it’s already late and I’m getting tired. I think the quote explains what I think is so lacking in a lot of modern macroeconomics, and, I am sorry to say, in Nick’s discussion of apples and bananas.

Backhouse and Laidler go on to cite the Stockholm School (of which Ohlin was a leading figure) as an example of explicitly dynamic analysis.

As Bjorn Hansson (1982) has shown, this group developed an explicit method, using the idea of a succession of “unit periods,” in which each period began with agents having plans based on newly formed expectations about the outcome of executing them, and ended with the economy in some new situation that was the outcome of executing them, and ended with the economy in some new situation that was the outcome of market processes set in motion by the incompatibility of those plans, and in which expectations had been reformulated, too, in the light of experience. They applied this method to the construction of a wide variety of what they called “model sequences,” many of which involved downward spirals in economic activity at whose very heart lay rising unemployment. This is not the place to discuss the vexed question of the extent to which some of this work anticipated the Keynesian multiplier process, but it should be noted that, in IS-LM, it is the limit to which such processes move, rather than the time path they follow to get there, that is emphasized.

The Stockholm method seems to me exactly the right way to explain business-cycle downturns. In normal times, there is a rough – certainly not perfect, but good enough — correspondence of expectations among agents. That correspondence of expectations implies that the individual plans contingent on those expectations will be more or less compatible with one another. Surprises happen; here and there people are disappointed and regret past decisions, but, on the whole, they are able to adjust as needed to muddle through. There is usually enough flexibility in a system to allow most people to adjust their plans in response to unforeseen circumstances, so that the disappointment of some expectations doesn’t become contagious, causing a systemic crisis.

But when there is some sort of major shock – and it can only be a shock if it is unforeseen – the system may not be able to adjust. Instead, the disappointment of expectations becomes contagious. If my customers aren’t able to sell their products, I may not be able to sell mine. Expectations are like networks. If there is a breakdown at some point in the network, the whole network may collapse or malfunction. Because expectations and plans fit together in interlocking networks, it is possible that even a disturbance at one point in the network can cascade over an increasingly wide group of agents, leading to something like a system-wide breakdown, a financial crisis or a depression.

But the “problem” with the Stockholm method was that it was open-ended. It could offer only “a wide variety” of “model sequences,” without specifying a determinate solution. It was just this gap in the Stockholm approach that Keynes was able to fill. He provided a determinate equilibrium, “the limit to which the Stockholm model sequences would move, rather than the time path they follow to get there.” A messy, but insightful, approach to explaining the phenomenon of downward spirals in economic activity coupled with rising unemployment was cast aside in favor of the neater, simpler approach of Keynes. No wonder Ohlin sounds annoyed in his comment, quoted by Backhouse and Laidler, about Keynes. Tractability trumped insight.

Unfortunately, that is still the case today. Open-ended models of the sort that the Stockholm School tried to develop still cannot compete with the RBC and DSGE models that have displaced IS-LM and now dominate modern macroeconomics. The basic idea that modern economies form networks, and that networks have properties that are not reducible to just the nodes forming them has yet to penetrate the trained intuition of modern macroeconomists. Otherwise, how would it have been possible to imagine that a macroeconomic model could consist of a single representative agent? And just because modern macroeconomists have expanded their models to include more than a single representative agent doesn’t mean that the intellectual gap evidenced by the introduction of representative-agent models into macroeconomic discourse has been closed.

Nick Rowe on Money and Coordination Failures

Via Brad Delong, I have been reading a month-old post by Nick Rowe in which Nick argues that every coordination failure is attributable to an excess demand for money. I think money is very important, but I am afraid that Nick goes a bit overboard in attempting to attribute every failure of macroeconomic coordination to a monetary source, where “monetary” means an excess demand for money. So let me try to see where I think Nick has gotten off track, or perhaps where I have gotten off track.

His post is quite a long one – over 3000 words, all his own – so I won’t try to summarize it, but the main message is that what characterizes money economies – economies in which there is a single asset that serves as the medium of exchange – is that money is involved in almost every transaction. And when a coordination failure occurs in such an economy, there being lots of unsold good and unemployed workers, the proper way to think about what is happening is that it is hard to buy money. Another way of saying that it is hard to buy money is that there is an excess demand for money.

Nick tries to frame his discussion in terms of Walras’s Law. Walras’s Law is a property of a general-equilibrium system in which there are n goods (and services). Some of these goods are produced and sold in the current period; others exist either as gifts of nature (e.g., land and other privately owned natural resources), as legacies of past production). Walras’s Law tells us that in a competitive system in which all transactors can trade at competitive prices, it must be the case that planned sales and purchases (including asset accumulation) for each individual and for all individuals collectively must cancel out. The value of my planned purchases must equal the value of my planned sales. This is a direct implication of the assumption that prices for each good are uniform for all individuals, and the assumption that goods and services may be transferred between individuals only via market transactions (no theft or robbery). Walras’s Law holds even if there is no equilibrium, but only in the notional sense that value of planned purchases and planned sales would exactly cancel each other out. In general-equilibrium models, no trading is allowed except at the equilibrium price vector.

Walras’ Law says that if you have a $1 billion excess supply of newly-produced goods, you must have a $1 billion excess demand for something else. And that something else could be anything. It could be money, or it could be bonds, or it could be land, or it could be safe assets, or it could be….anything other than newly-produced goods. The excess demand that offsets that excess supply for newly-produced goods could pop up anywhere. Daniel Kuehn called this the “Whack-a-mole theory of business cycles”.

If Walras’ Law were right, recessions could be caused by an excess demand for unobtanium, which has zero supply, but a big demand, and the government stupidly passed a law setting a finite maximum price per kilogram for something that doesn’t even exist, thereby causing a recession and mass unemployment.

People might want to buy $1 billion of unobtanium per year, but that does not cause an excess supply of newly-produced goods. It does not cause an excess supply of anything. Because they cannot buy $1 billion of unobtanium. That excess demand for unobtanium does not affect anything anywhere in the economy. Yes, if 1 billion kgs of unobtanium were discovered, and offered for sale at $1 per kg, that would affect things. But it is the supply of unobtanium that would affect things, not the elimination of the excess demand. If instead you eliminated the excess demand by convincing people that unobtanium wasn’t worth buying, absolutely nothing would change.

An excess demand for unobtanium has absolutely zero effect on the economy. And that is true regardless of the properties of unobtanium. In particular, it makes absolutely no difference whether unobtanium is or is not a close substitute for money.

What is true for unobtanium is also true for any good for which there is excess demand. Except money. If you want to buy 10 bonds, or 10 acres of land, or 10 safe assets, but can only buy 6, because only 6 are offered for sale, those extra 4 bonds might as well be unobtanium. You want to buy 4 extra bonds, but you can’t, so you don’t. Just like you want to buy unobtanium, but you can’t, so you don’t. You can’t do anything so you don’t do anything.

Walras’ Law is wrong. Walras’ Law only works in an economy with one centralised market where all goods can be traded against each other at once. If the Walrasian auctioneer announced a finite price for unobtanium, there would be an excess demand for unobtanium and an excess supply of other goods. People would offer to sell $1 billion of some other goods to finance their offers to buy $1 billion of unobtanium. The only way the auctioneer could clear the market would be by refusing to accept offers to buy unobtanium. But in a monetary exchange economy the market for unobtanium would be a market where unobtanium trades for money. There would be an excess demand for unobtanium, matched by an equal excess supply of money, in that particular market. No other market would be affected, if people knew they could not in fact buy any unobtanium for money, even if they want to.

Now this is a really embarrassing admission to make – and right after making another embarrassing admission in my previous post – I need to stop this – but I have no idea what Nick is saying here. There is no general-equilibrium system in which there is any notional trading taking place for a non-existent good, so I have no clue what this is all about. However, even though I can’t follow Nick’s reasoning, I totally agree with him that Walras’s Law is wrong. But the reason that it’s wrong is not that it implies that recessions could be caused by an excess demand for a non-existent good; the reason is that, in the only context in which a general-equilibrium model could be relevant for macroeconomics, i.e., an incomplete-markets model (aka the Radner model) in which individual agents are forming plans based on their expectations of future prices, prices that will only be observed in future periods, Walras’s Law cannot be true unless all agents have identical and correct expectations of all future prices.

Thus, the condition for macroeconomic coordination is that all agents have correct expectations of all currently unobservable future prices. When they have correct expectations, Walras’s Law is satisfied, and all is well with the world. When they don’t, Walras’s Law does not hold. When Walras’s Law doesn’t hold, things get messy; people default on their obligations, businesses go bankrupt, workers lose their jobs.

Nick thinks it’s all about money. Money is certainly one way in which things can get messed up. The government can cause inflation, and then stop it, as happened in 1920-21 and in 1981-82. People who expected inflation to continue, and made plans based on those expectations,were very likely unable to execute their plans when inflation stopped. But there are other reasons than incorrect inflation expectations that can cause people to have incorrect expectations of future prices.

Actually, Nick admits that coordination failures can be caused by factors other than an excess demand for money, but for some reason he seems to think that every coordination failure must be associated with an excess demand for money. But that is not so. I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination. Or consider a Fisherian debt-deflation economy in which debts are denominated in terms of gold and gold is appreciating. Debtors restrict consumption not because they are trying to accumulate more cash but because their debt burden is go great, any income they earn is being transferred to their creditors. In a monetary economy suffering from debt deflation, one would certainly want to use monetary policy to alleviate the debt burden, but using monetary policy to alleviate the debt burden is different from using monetary policy to eliminate an excess demand for money. Where is the excess demand for money?

Nick invokes Hayek’s paper (“The Use of Knowledge in Society“) to explain how markets work to coordinate the decentralized plans of individual agents. Nick assumes that Hayek failed to mention money in that paper because money is so pervasive a feature of a real-world economy, that Hayek simply took its existence for granted. That’s certainly an important paper, but the more important paper in this context is Hayek’s earlier paper (“Economics and Knowledge“) in which he explained the conditions for intertemporal equilibrium in which individual plans are coordinated, and why there is simply no market mechanism to ensure that intertemporal equilibrium is achieved. Money is not mentioned in that paper either.

The Trouble with IS-LM (and its Successors)

Lately, I have been reading a paper by Roger Backhouse and David Laidler, “What Was Lost with IS-LM” (an earlier version is available here) which was part of a very interesting symposium of 11 papers on the IS-LM model published as a supplement to the 2004 volume of History of Political Economy. The main thesis of the paper is that the IS-LM model, like the General Theory of which it is a partial and imperfect distillation, aborted a number of promising developments in the rapidly developing, but still nascent, field of macroeconomics in the 1920 and 1930s, developments that just might, had they not been elbowed aside by the IS-LM model, have evolved into a more useful and relevant theory of macroeconomic fluctuations and policy than we now possess. Even though I have occasionally sparred with Scott Sumner about IS-LM – with me pushing back a bit at Scott’s attacks on IS-LM — I have a lot of sympathy for the Backhouse-Laidler thesis.

The Backhouse-Laidler paper is too long to summarize, but I will just note that there are four types of loss that they attribute to IS-LM, which are all, more or less, derivative of the static equilibrium character of Keynes’s analytic method in both the General Theory and the IS-LM construction.

1 The loss of dynamic analysis. IS-LM is a single-period model.

2 The loss of intertemporal choice and expectations. Intertemporal choice and expectations are excluded a priori in a single-period model.

3 The loss of policy regimes. In a single-period model, policy is a one-time affair. The problem of setting up a regime that leads to optimal results over time doesn’t arise.

4 The loss of intertemporal coordination failures. Another concept that is irrelevant in a one-period model.

There was one particular passage that I found especially impressive. Commenting on the lack of any systematic dynamic analysis in the GT, Backhouse and Laidler observe,

[A]lthough [Keynes] made many remarks that could be (and in some cases were later) turned into dynamic models, the emphasis of the General Theory was nevertheless on unemployment as an equilibrium phenomenon.

Dynamic accounts of how money wages might affect employment were only a little more integrated into Keynes’s formal analysis than they were later into IS-LM. Far more significant for the development in Keynes’s thought is how Keynes himself systematically neglected dynamic factors that had been discussed in previous explanations of unemployment. This was a feature of the General Theory remarked on by Bertil Ohlin (1937, 235-36):

Keynes’s theoretical system . . . is equally “old-fashioned” in the second respect which characterizes recent economic theory – namely, the attempt to break away from an explanation of economic events by means of orthodox equilibrium constructions. No other analysis of trade fluctuations in recent years – with the possible exception of the Mises-Hayek school – follows such conservative lines in this respect. In fact, Keynes is much more of an “equilibrium theorist” than such economists as Cassel and, I think, Marshall.

Backhouse and Laidler go on to cite the Stockholm School (of which Ohlin was a leading figure) as an example of explicitly dynamic analysis.

As Bjorn Hansson (1982) has shown, this group developed an explicit method, using the idea of a succession of “unit periods,” in which each period began with agents having plans based on newly formed expectations about the outcome of executing them, and ended with the economy in some new situation that was the outcome of executing them, and ended with the economy in some new situation that was the outcome of market processes set in motion by the incompatibility of those plans, and in which expectations had been reformulated, too, in the light of experience. They applied this method to the construction of a wide variety of what they called “model sequences,” many of which involved downward spirals in economic activity at whose very heart lay rising unemployment. This is not the place to discuss the vexed question of the extent to which some of this work anticipated the Keynesian multiplier process, but it should be noted that, in IS-LM, it is the limit to which such processes move, rather than the time path they follow to get there, that is emphasized.

The Stockholm method seems to me exactly the right way to explain business-cycle downturns. In normal times, there is a rough – certainly not perfect, but good enough — correspondence of expectations among agents. That correspondence of expectations implies that the individual plans contingent on those expectations will be more or less compatible with one another. Surprises happen; here and there people are disappointed and regret past decisions, but, on the whole, they are able to adjust as needed to muddle through. There is usually enough flexibility in a system to allow most people to adjust their plans in response to unforeseen circumstances, so that the disappointment of some expectations doesn’t become contagious, causing a systemic crisis.

But when there is some sort of major shock – and it can only be a shock if it is unforeseen – the system may not be able to adjust. Instead, the disappointment of expectations becomes contagious. If my customers aren’t able to sell their products, I may not be able to sell mine. Expectations are like networks. If there is a breakdown at some point in the network, the whole network may collapse or malfunction. Because expectations and plans fit together in interlocking networks, it is possible that even a disturbance at one point in the network can cascade over an increasingly wide group of agents, leading to something like a system-wide breakdown, a financial crisis or a depression.

But the “problem” with the Stockholm method was that it was open-ended. It could offer only “a wide variety” of “model sequences,” without specifying a determinate solution. It was just this gap in the Stockholm approach that Keynes was able to fill. He provided a determinate equilibrium, “the limit to which the Stockholm model sequences would move, rather than the time path they follow to get there.” A messy, but insightful, approach to explaining the phenomenon of downward spirals in economic activity coupled with rising unemployment was cast aside in favor of the neater, simpler approach of Keynes. No wonder Ohlin sounds annoyed in his comment, quoted by Backhouse and Laidler, about Keynes. Tractability trumped insight.

Unfortunately, that is still the case today. Open-ended models of the sort that the Stockholm School tried to develop still cannot compete with the RBC and DSGE models that have displaced IS-LM and now dominate modern macroeconomics. The basic idea that modern economies form networks, and that networks have properties that are not reducible to just the nodes forming them has yet to penetrate the trained intuition of modern macroeconomists. Otherwise, how would it have been possible to imagine that a macroeconomic model could consist of a single representative agent? And just because modern macroeconomists have expanded their models to include more than a single representative agent doesn’t mean that the intellectual gap evidenced by the introduction of representative-agent models into macroeconomic discourse has been closed.

A New Version of my Paper (with Paul Zimmerman) on the Hayek-Sraffa Debate Is Available on SSRN

One of the good things about having a blog (which I launched July 5, 2011) is that I get comments about what I am writing about from a lot of people that I don’t know. One of my most popular posts – it’s about the sixteenth most visited — was one I wrote, just a couple of months after starting the blog, about the Hayek-Sraffa debate on the natural rate of interest. Unlike many popular posts, to which visitors are initially drawn from very popular blogs that linked to those posts, but don’t continue to drawing a lot of visitors, this post initially had only modest popularity, but still keeps on drawing visitors.

That post also led to a collaboration between me and my FTC colleague Paul Zimmerman on a paper “The Sraffa-Hayek Debate on the Natural Rate of Interest” which I presented two years ago at the History of Economics Society conference. We have now finished our revisions of the version we wrote for the conference, and I have just posted the new version on SSRN and will be submitting it for publication later this week.

Here’s the abstract posted on the SSRN site:

Hayek’s Prices and Production, based on his hugely successful lectures at LSE in 1931, was the first English presentation of Austrian business-cycle theory, and established Hayek as a leading business-cycle theorist. Sraffa’s 1932 review of Prices and Production seems to have been instrumental in turning opinion against Hayek and the Austrian theory. A key element of Sraffa’s attack was that Hayek’s idea of a natural rate of interest, reflecting underlying real relationships, undisturbed by monetary factors, was, even from Hayek’s own perspective, incoherent, because, without money, there is a multiplicity of own rates, none of which can be uniquely identified as the natural rate of interest. Although Hayek’s response failed to counter Sraffa’s argument, Ludwig Lachmann later observed that Keynes’s treatment of own rates in Chapter 17 of the General Theory (itself a generalization of Fisher’s (1896) distinction between the real and nominal rates of interest) undercut Sraffa’s criticism. Own rates, Keynes showed, cannot deviate from each other by more than expected price appreciation plus the cost of storage and the commodity service flow, so that anticipated asset yields are equalized in intertemporal equilibrium. Thus, on Keynes’s analysis in the General Theory, the natural rate of interest is indeed well-defined. However, Keynes’s revision of Sraffa’s own-rate analysis provides only a partial rehabilitation of Hayek’s natural rate. There being no unique price level or rate of inflation in a barter system, no unique money natural rate of interest can be specified. Hayek implicitly was reasoning in terms of a constant nominal value of GDP, but barter relationships cannot identify any path for nominal GDP, let alone a constant one, as uniquely compatible with intertemporal equilibrium.

Aside from clarifying the conceptual basis of the natural-rate analysis and its relationship to Sraffa’s own-rate analysis, the paper also highlights the connection (usually overlooked but mentioned by Harald Hagemann in his 2008 article on the own rate of interest for the International Encyclopedia of the Social Sciences) between the own-rate analysis, in either its Sraffian or Keynesian versions, and Fisher’s early distinction between the real and nominal rates of interest. The conceptual identity between Fisher’s real and nominal distinction and Keynes’s own-rate analysis in the General Theory only magnifies the mystery associated with Keynes’s attack in chapter 13 of the General Theory on Fisher’s distinction between the real and the nominal rates of interest.

I also feel that the following discussion of Hayek’s role in developing the concept of intertemporal equilibrium, though tangential to the main topic of the paper, makes an important point about how to think about intertemporal equilibrium.

Perhaps the key analytical concept developed by Hayek in his early work on monetary theory and business cycles was the idea of an intertemporal equilibrium. Before Hayek, the idea of equilibrium had been reserved for a static, unchanging, state in which economic agents continue doing what they have been doing. Equilibrium is the end state in which all adjustments to a set of initial conditions have been fully worked out. Hayek attempted to generalize this narrow equilibrium concept to make it applicable to the study of economic fluctuations – business cycles – in which he was engaged. Hayek chose to formulate a generalized equilibrium concept. He did not do so, as many have done, by simply adding a steady-state rate of growth to factor supplies and technology. Nor did Hayek define equilibrium in terms of any objective or measurable magnitudes. Rather, Hayek defined equilibrium as the mutual consistency of the independent plans of individual economic agents.

The potential consistency of such plans may be conceived of even if economic magnitudes do not remain constant or grow at a constant rate. Even if the magnitudes fluctuate, equilibrium is conceivable if the fluctuations are correctly foreseen. Correct foresight is not the same as perfect foresight. Perfect foresight is necessarily correct; correct foresight is only contingently correct. All that is necessary for equilibrium is that fluctuations (as reflected in future prices) be foreseen. It is not even necessary, as Hayek (1937) pointed out, that future price changes be foreseen correctly, provided that individual agents agree in their anticipations of future prices. If all agents agree in their expectations of future prices, then the individual plans formulated on the basis of those anticipations are, at least momentarily, equilibrium plans, conditional on the realization of those expectations, because the realization of those expectations would allow the plans formulated on the basis of those expectations to be executed without need for revision. What is required for intertemporal equilibrium is therefore a contingently correct anticipation by future agents of future prices, a contingent anticipation not the result of perfect foresight, but of contingently, even fortuitously, correct foresight. The seminal statement of this concept was given by Hayek in his classic 1937 paper, and the idea was restated by J. R. Hicks (1939), with no mention of Hayek, two years later in Value and Capital.

I made the following comment in a footnote to the penultimate sentence of the quotation:

By defining correct foresight as a contingent outcome rather than as an essential property of economic agents, Hayek elegantly avoided the problems that confounded Oskar Morgenstern ([1935] 1976) in his discussion of the meaning of equilibrium.

I look forward to reading your comments.

Monetary Theory on the Neo-Fisherite Edge

The week before last, Noah Smith wrote a post “The Neo-Fisherite Rebellion” discussing, rather sympathetically I thought, the contrarian school of monetary thought emerging from the Great American Heartland, according to which, notwithstanding everything monetary economists since Henry Thornton have taught, high interest rates are inflationary and low interest rates deflationary. This view of the relationship between interest rates and inflation was advanced (but later retracted) by Narayana Kocherlakota, President of the Minneapolis Fed in a 2010 lecture, and was embraced and expounded with increased steadfastness by Stephen Williamson of Washington University in St. Louis and the St. Louis Fed in at least one working paper and in a series of posts over the past five or six months (e.g. here, here and here). And John Cochrane of the University of Chicago has picked up on the idea as well in two recent blog posts (here and here). Others seem to be joining the upstart school as well.

The new argument seems simple: given the Fisher equation, in which the nominal interest rate equals the real interest rate plus the (expected) rate of inflation, a central bank can meet its inflation target by setting a fixed nominal interest rate target consistent with its inflation target and keeping it there. Once the central bank sets its target, the long-run neutrality of money, implying that the real interest rate is independent of the nominal targets set by the central bank, ensures that inflation expectations must converge on rates consistent with the nominal interest rate target and the independently determined real interest rate (i.e., the real yield curve), so that the actual and expected rates of inflation adjust to ensure that the Fisher equation is satisfied. If the promise of the central bank to maintain a particular nominal rate over time is believed, the promise will induce a rate of inflation consistent with the nominal interest-rate target and the exogenous real rate.

The novelty of this way of thinking about monetary policy is that monetary theorists have generally assumed that the actual adjustment of the price level or inflation rate depends on whether the target interest rate is greater or less than the real rate plus the expected rate. When the target rate is greater than the real rate plus expected inflation, inflation goes down, and when it is less than the real rate plus expected inflation, inflation goes up. In the conventional treatment, the expected rate of inflation is momentarily fixed, and the (expected) real rate variable. In the Neo-Fisherite school, the (expected) real rate is fixed, and the expected inflation rate is variable. (Just as an aside, I would observe that the idea that expectations about the real rate of interest and the inflation rate cannot occur simultaneously in the short run is not derived from the limited cognitive capacity of economic agents; it can only be derived from the limited intellectual capacity of economic theorists.)

The heretical views expressed by Williamson and Cochrane and earlier by Kocherlakota have understandably elicited scorn and derision from conventional monetary theorists, whether Keynesian, New Keynesian, Monetarist or Market Monetarist. (Williamson having appropriated for himself the New Monetarist label, I regrettably could not preserve an appropriate symmetry in my list of labels for monetary theorists.) As a matter of fact, I wrote a post last December challenging Williamson’s reasoning in arguing that QE had caused a decline in inflation, though in his initial foray into uncharted territory, Williamson was actually making a narrower argument than the more general thesis that he has more recently expounded.

Although deep down, I have no great sympathy for Williamson’s argument, the counterarguments I have seen leave me feeling a bit, shall we say, underwhelmed. That’s not to say that I am becoming a convert to New Monetarism, but I am feeling that we have reached a point at which certain underlying gaps in monetary theory can’t be concealed any longer. To explain what I mean by that remark, let me start by reviewing the historical context in which the ruling doctrine governing central-bank operations via adjustments in the central-bank lending rate evolved. The primary (though historically not the first) source of the doctrine is Henry Thornton in his classic volume The Nature and Effects of the Paper Credit of Great Britain.

Even though Thornton focused on the policy of the Bank of England during the Napoleonic Wars, when Bank of England notes, not gold, were legal tender, his discussion was still in the context of a monetary system in which paper money was generally convertible into either gold or silver. Inconvertible banknotes – aka fiat money — were the exception not the rule. Gold and silver were what Nick Rowe would call alpha money. All other moneys were evaluated in terms of gold and silver, not in terms of a general price level (not yet a widely accepted concept). Even though Bank of England notes became an alternative alpha money during the restriction period of inconvertibility, that situation was generally viewed as temporary, the restoration of convertibility being expected after the war. The value of the paper pound was tracked by the sterling price of gold on the Hamburg exchange. Thus, Ricardo’s first published work was entitled The High Price of Bullion, in which he blamed the high sterling price of bullion at Hamburg on an overissue of banknotes by the Bank of England.

But to get back to Thornton, who was far more concerned with the mechanics of monetary policy than Ricardo, his great contribution was to show that the Bank of England could control the amount of lending (and money creation) by adjusting the interest rate charged to borrowers. If banknotes were depreciating relative to gold, the Bank of England could increase the value of their notes by raising the rate of interest charged on loans.

The point is that if you are a central banker and are trying to target the exchange rate of your currency with respect to an alpha currency, you can do so by adjusting the interest rate that you charge borrowers. Raising the interest rate will cause the exchange value of your currency to rise and reducing the interest rate will cause the exchange value to fall. And if you are operating under strict convertibility, so that you are committed to keep the exchange rate between your currency and an alpha currency at a specified par value, raising that interest rate will cause you to accumulate reserves payable in terms of the alpha currency, and reducing that interest rate will cause you to emit reserves payable in terms of the alpha currency.

So the idea that an increase in the central-bank interest rate tends to increase the exchange value of its currency, or, under a fixed-exchange rate regime, an increase in the foreign exchange reserves of the bank, has a history at least two centuries old, though the doctrine has not exactly been free of misunderstanding or confusion in the course of those two centuries. One of those misunderstandings was about the effect of a change in the central-bank interest rate, under a fixed-exchange rate regime. In fact, as long as the central bank is maintaining a fixed exchange rate between its currency and an alpha currency, changes in the central-bank interest rate don’t affect (at least as a first approximation) either the domestic money supply or the domestic price level; all that changes in the central-bank interest rate can accomplish is to change the bank’s holdings of alpha-currency reserves.

It seems to me that this long well-documented historical association between changes in the central-bank interest rates and the exchange value of currencies and the level of private spending is the basis for the widespread theoretical presumption that raising the central-bank interest rate target is deflationary and reducing it is inflationary. However, the old central-bank doctrine of the Bank Rate was conceived in a world in which gold and silver were the alpha moneys, and central banks – even central banks operating with inconvertible currencies – were beta banks, because the value of a central-bank currency was still reckoned, like the value of inconvertible Bank of England notes in the Napoleonic Wars, in terms of gold and silver.

In the Neo-Fisherite world, central banks rarely peg exchange rates against each other, and there is no longer any outside standard of value to which central banks even nominally commit themselves. In a world without the metallic standard of value in which the conventional theory of central banking developed, do the propositions about the effects of central-bank interest-rate setting still obtain? I am not so sure that they do, not with the analytical tools that we normally deploy when thinking about the effects of central-bank policies. Why not? Because, in a Neo-Fisherite world in which all central banks are alpha banks, I am not so sure that we really know what determines the value of this thing called fiat money. And if we don’t really know what determines the value of a fiat money, how can we really be sure that interest-rate policy works the same way in a Neo-Fisherite world that it used to work when the value of money was determined in relation to a metallic standard? (Just to avoid misunderstanding, I am not – repeat NOT — arguing for restoring the gold standard.)

Why do I say that we don’t know what determines the value of fiat money in a Neo-Fisherite world? Well, consider this. Almost three weeks ago I wrote a post in which I suggested that Bitcoins could be a massive bubble. My explanation for why Bitcoins could be a bubble is that they provide no real (i.e., non-monetary) service, so that their value is totally contingent on, and derived from (or so it seems to me, though I admit that my understanding of Bitcoins is partial and imperfect), the expectation of a positive future resale value. However, it seems certain that the resale value of Bitcoins must eventually fall to zero, so that backward induction implies that Bitcoins, inasmuch as they provide no real service, cannot retain a positive value in the present. On this reasoning, any observed value of a Bitcoin seems inexplicable except as an irrational bubble phenomenon.

Most of the comments I received about that post challenged the relevance of the backward-induction argument. The challenges were mainly of two types: a) the end state, when everyone will certainly stop accepting a Bitcoin in exchange, is very, very far into the future and its date is unknown, and b) the backward-induction argument applies equally to every fiat currency, so my own reasoning, according to my critics, implies that the value of every fiat currency is just as much a bubble phenomenon as the value of a Bitcoin.

My response to the first objection is that even if the strict logic of the backward-induction argument is inconclusive, because of the long and uncertain duration of the time elapse between now and the end state, the argument nevertheless suggests that the value of a Bitcoin is potentially very unsteady and vulnerable to sudden collapse. Those are not generally thought to be desirable attributes in a medium of exchange.

My response to the second objection is that fiat currencies are actually quite different from Bitcoins, because fiat currencies are accepted by governments in discharging the tax liabilities due to them. The discharge of a tax liability is a real (i.e. non-monetary) service, creating a distinct non-monetary demand for fiat currencies, thereby ensuring that fiat currencies retain value, even apart from being accepted as a medium of exchange.

That, at any rate, is my view, which I first heard from Earl Thompson (see his unpublished paper, “A Reformulation of Macroeconomic Theory” pp. 23-25 for a derivation of the value of fiat money when tax liability is a fixed proportion of income). Some other pretty good economists have also held that view, like Abba Lerner, P. H. Wicksteed, and Adam Smith. Georg Friedrich Knapp also held that view, and, in his day, he was certainly well known, but I am unable to pass judgment on whether he was or wasn’t a good economist. But I do know that his views about money were famously misrepresented and caricatured by Ludwig von Mises. However, there are other good economists (Hal Varian for one), apparently unaware of, or untroubled by, the backward induction argument, who don’t think that acceptability in discharging tax liability is required to explain the value of fiat money.

Nor do I think that Thompson’s tax-acceptability theory of the value of money can stand entirely on its own, because it implies a kind of saw-tooth time profile of the price level, so that a fiat currency, earning no liquidity premium, would actually be appreciating between peak tax collection dates, and depreciating immediately following those dates, a pattern not obviously consistent with observed price data, though I do recall that Thompson used to claim that there is a lot of evidence that prices fall just before peak tax-collection dates. I don’t think that anyone has ever tried to combine the tax-acceptability theory with the empirical premise that currency (or base money) does in fact provide significant liquidity services. That, it seems to me, would be a worthwhile endeavor for any eager young researcher to undertake.

What does all of this have to do with the Neo-Fisherite Rebellion? Well, if we don’t have a satisfactory theory of the value of fiat money at hand, which is what another very smart economist Fischer Black – who, to my knowledge never mentioned the tax-liability theory — thought, then the only explanation of the value of fiat money is that, like the value of a Bitcoin, it is whatever people expect it to be. And the rate of inflation is equally inexplicable, being just whatever it is expected to be. So in a Neo-Fisherite world, if the central bank announces that it is reducing its interest-rate target, the effect of the announcement depends entirely on what “the market” reads into the announcement. And that is exactly what Fischer Black believed. See his paper “Active and Passive Monetary Policy in a Neoclassical Model.”

I don’t say that Williamson and his Neo-Fisherite colleagues are correct. Nor have they, to my knowledge, related their arguments to Fischer Black’s work. What I do say (indeed this is a problem I raised almost three years ago in one of my first posts on this blog) is that existing monetary theories of the price level are unable to rule out his result, because the behavior of the price level and inflation seems to depend, more than anything else, on expectations. And it is far from clear to me that there are any fundamentals in which these expectations can be grounded. If you impose the rational expectations assumption, which is almost certainly wrong empirically, maybe you can argue that the central bank provides a focal point for expectations to converge on. The problem, of course, is that in the real world, expectations are all over the place, there being no fundamentals to force the convergence of expectations to a stable equilibrium value.

In other words, it’s just a mess, a bloody mess, and I do not like it, not one little bit.

Paul Krugman and Roger Farmer on Sticky Wages

I was pleasantly surprised last Friday to see that Paul Krugman took favorable notice of my post about sticky wages, but also registering some disagreement.

[Glasner] is partially right in suggesting that there has been a bit of a role reversal regarding the role of sticky wages in recessions: Keynes asserted that wage flexibility would not help, but Keynes’s self-proclaimed heirs ended up putting downward nominal wage rigidity at the core of their analysis. By the way, this didn’t start with the New Keynesians; way back in the 1940s Franco Modigliani had already taught us to think that everything depended on M/w, the ratio of the money supply to the wage rate.

That said, wage stickiness plays a bigger role in The General Theory — and in modern discussions that are consistent with what Keynes said — than Glasner indicates.

To document his assertion about Keynes, Krugman quotes a passage from the General Theory in which Keynes seems to suggest that in the nineteenth century inflexible wages were partially compensated for by price level movements. One might quibble with Krugman’s interpretation, but the payoff doesn’t seem worth the effort.

But I will quibble with the next paragraph in Krugman’s post.

But there’s another point: even if you don’t think wage flexibility would help in our current situation (and like Keynes, I think it wouldn’t), Keynesians still need a sticky-wage story to make the facts consistent with involuntary unemployment. For if wages were flexible, an excess supply of labor should be reflected in ever-falling wages. If you want to say that we have lots of willing workers unable to find jobs — as opposed to moochers not really seeking work because they’re cradled in Paul Ryan’s hammock — you have to have a story about why wages aren’t falling.

Not that I really disagree with Krugman that the behavior of wages since the 2008 downturn is consistent with some stickiness in wages. Nevertheless, it is still not necessarily the case that, if wages were flexible, an excess supply of labor would lead to ever-falling wages. In a search model of unemployment, if workers are expecting wages to rise every year at a 3% rate, and instead wages rise at only a 1% rate, the model predicts that unemployment will rise, and will continue to rise (or at least not return to the natural rate) as long as observed wages did not increase as fast as workers were expecting wages to rise. Presumably over time, wage expectations would adjust to a new lower rate of increase, but there is no guarantee that the transition would be speedy.

Krugman concludes:

So sticky wages are an important part of both old and new Keynesian analysis, not because wage cuts would help us, but simply to make sense of what we see.

My own view is actually a bit more guarded. I think that “sticky wages” is simply a name that we apply to a problematic phenomenon for ehich we still haven’t found a really satisfactory explanation for. Search models, for all their theoretical elegance, simply can’t explain the observed process by which unemployment rises during recessions, i.e., by layoffs and a lack of job openings rather than an increase in quits and refused offers, as search models imply. The suggestion in my earlier post was intended to offer a possible basis of understanding what the phrase “sticky wages” is actually describing.

Roger Farmer, a long-time and renowned UCLA economist, also commented on my post on his new blog. Welcome to the blogosphere, Roger.

Roger has a different take on the sticky-wage phenomenon. Roger argues, as did some of the commenters to my post, that wages are not sticky. To document this assertion, Roger presents a diagram showing that the decline of nominal wages closely tracked that of prices for the first six years of the Great Depression. From this evidence Roger concludes that nominal wage rigidity is not the cause of rising unemployment during the Great Depression, and presumably, not the cause of rising unemployment in the Little Depression.

farmer_sticky_wagesInstead, Roger argues, the rise in unemployment was caused by an outbreak of self-fulfilling pessimism. Roger believes that there are many alternative equilibria and which equilibrium (actually equilibrium time path) we reach depends on what our expectations are. Roger also believes that our expectations are rational, so that we get what we expect, as he succinctly phrases it “beliefs are fundamental.” I have a lot of sympathy for this way of looking at the economy. In fact one of the early posts on this blog was entitled “Expectations are Fundamental.” But as I have explained in other posts, I am not so sure that expectations are rational in any useful sense, because I think that individual expectations diverge. I don’t think that there is a single way of looking at reality. If there are many potential equilibria, why should everyone expect the same equilibrium. I can be an optimist, and you can be a pessimist. If we agreed, we would be right, but if we disagree, we will both be wrong. What economic mechanism is there to reconcile our expectations? In a world in which expectations diverge — a world of temporary equilibrium — there can be cumulative output reductions that get propagated across the economy as each sector fails to produce its maximum potential output, thereby reducing the demand for the output of other sectors to which it is linked. That’s what happens when there is trading at prices that don’t correspond to the full optimum equilibrium solution.

So I agree with Roger in part, but I think that the coordination problem is (at least potentially) more serious than he imagines.

Big Ideas in Macroeconomics: A Review

Steve Williamson recently plugged a new book by Kartik Athreya (Big Ideas in Macroeconomics), an economist at the Federal Reserve Bank of Richmond, which tries to explain in relatively non-technical terms what modern macroeconomics is all about. I will acknowledge that my graduate training in macroeconomics predated the rise of modern macro, and I am not fluent in the language of modern macro, though I am trying to fill in the gaps. And this book is a good place to start. I found Athreya’s book a good overview of the field, explaining the fundamental ideas and how they fit together.

Big Ideas in Macroeconomics is a moderately big book, 415 pages, covering a very wide range of topics. It is noteworthy, I think, that despite its size, there is so little overlap between the topics covered in this book, and those covered in more traditional, perhaps old-fashioned, books on macroeconomics. The index contains not a single entry on the price level, inflation, deflation, money, interest, total output, employment or unemployment. Which is not to say that none of those concepts are ever mentioned or discussed, just that they are not treated, as they are in traditional macroeconomics books, as the principal objects of macroeconomic inquiry. The conduct of monetary or fiscal policy to achieve some explicit macroeconomic objective is never discussed. In contrast, there are repeated references to Walrasian equilibrium, the Arrow-Debreu-McKenzie model, the Radner model, Nash-equilibria, Pareto optimality, the first and second Welfare theorems. It’s a new world.

The first two chapters present a fairly detailed description of the idea of Walrasian general equilibrium and its modern incarnation in the canonical Arrow-Debreu-McKenzie (ADM) model.The ADM model describes an economy of utility-maximizing households and profit-maximizing firms engaged in the production and consumption of commodities through time and space. There are markets for commodities dated by time period, specified by location and classified by foreseeable contingent states of the world, so that the same physical commodity corresponds to many separate commodities, each corresponding to different time periods and locations and to contingent states of the world. Prices for such physically identical commodities are not necessarily uniform across times, locations or contingent states.The demand for road salt to de-ice roads depends on whether conditions, which depend on time and location and on states of the world. For each different possible weather contingency, there would be a distinct market for road salt for each location and time period.

The ADM model is solved once for all time periods and all states of the world. Under appropriate conditions, there is one (and possibly more than one) intertemporal equilibrium, all trades being executed in advance, with all deliveries subsequently being carried out, as time an contingencies unfold, in accordance with the terms of the original contracts.

Given the existence of an equilibrium, i.e., a set of prices subject to which all agents are individually optimizing, and all markets are clearing, there are two classical welfare theorems stating that any such equilibrium involves a Pareto-optimal allocation and any Pareto-optimal allocation could be supported by an equilibrium set of prices corresponding to a suitably chosen set of initial endowments. For these optimality results to obtain, it is necessary that markets be complete in the sense that there is a market for each commodity in each time period and contingent state of the world. Without a complete set of markets in this sense, the Pareto-optimality of the Walrasian equilibrium cannot be proved.

Readers may wonder about the process by which an equilibrium price vector would actually be found through some trading process. Athreya invokes the fiction of a Walrasian clearinghouse in which all agents (truthfully) register their notional demands and supplies at alternative price vectors. Based on these responses the clearinghouse is able to determine, by a process of trial and error, the equilibrium price vector. Since the Walrasian clearinghouse presumes that no trading occurs except at an equilibrium price vector, there can be no assurance that an equilibrium price vector would ever be arrived at under an actual trading process in which trading occurs at disequilibrium prices. Moreover, as Clower and Leijonhufvud showed over 40 years ago (“Say’s Principle: What it Means and What it Doesn’t Mean”), trading at disequilibrium prices may cause cumulative contractions of aggregate demand because the total volume of trade at a disequilibrium price will always be less than the volume of trade at an equilibrium price, the volume of trade being constrained by the lesser of quantity supplied and quantity demanded.

In the view of modern macroeconomics, then, Walrasian general equilibrium, as characterized by the ADM model, is the basic and overarching paradigm of macroeconomic analysis. To be sure, modern macroeconomics tries to go beyond the highly restrictive assumptions of the ADM model, but it is not clear whether the concessions made by modern macroeconomics to the real world go very far in enhancing the realism of the basic model.

Chapter 3, contains some interesting reflections on the importance of efficiency (Pareto-optimality) as a policy objective and on the trade-offs between efficiency and equity and between ex-ante and ex-post efficiency. But these topics are on the periphery of macroeconomics, so I will offer no comment here.

In chapter 4, Athreya turns to some common criticisms of modern macroeconomics: that it is too highly aggregated, too wedded to the rationality assumption, too focused on equilibrium steady states, and too highly mathematical. Athreya correctly points out that older macroeconomic models were also highly aggregated, so that if aggregation is a problem it is not unique to modern macroeconomics. That’s a fair point, but skirts some thorny issues. As Athreya acknowledges in chapter 5, an important issue separating certain older macroeconomic traditions (both Keynesian and Austrian among others) is the idea that macroeconomic dysfunction is a manifestation of coordination failure. It is a property – a remarkable property – of Walrasian general equilibrium that it achieves perfect (i.e., Pareto-optimal) coordination of disparate, self-interested, competitive individual agents, fully reconciling their plans in a way that might have been achieved by an omniscient and benevolent central planner. Walrasian general equilibrium fully solves the coordination problem. Insofar as important results of modern macroeconomics depend on the assumption that a real-life economy can be realistically characterized as a Walrasian equilibrium, modern macroeconomics is assuming that coordination failures are irrelevant to macroeconomics. It is only after coordination failures have been excluded from the purview of macroeconomics that it became legitimate (for the sake of mathematical tractability) to deploy representative-agent models in macroeconomics, a coordination failure being tantamount, in the context of a representative agent model, to a form of irrationality on the part of the representative agent. Athreya characterizes choices about the level of aggregation as a trade-off between realism and tractability, but it seems to me that, rather than making a trade-off between realism and tractability, modern macroeconomics has simply made an a priori decision that coordination problems are not a relevant macroeconomic concern.

A similar argument applies to Athreya’s defense of rational expectations and the use of equilibrium in modern macroeconomic models. I would not deny that there are good reasons to adopt rational expectations and full equilibrium in some modeling situations, depending on the problem that theorist is trying to address. The question is whether it can be appropriate to deviate from the assumption of a full rational-expectations equilibrium for the purposes of modeling fluctuations over the course of a business cycle, especially a deep cyclical downturn. In particular, the idea of a Hicksian temporary equilibrium in which agents hold divergent expectations about future prices, but markets clear period by period given those divergent expectations, seems to offer (as in, e.g., Thompson’s “Reformulation of Macroeconomic Theory“) more realism and richer empirical content than modern macromodels of rational expectations.

Athreya offers the following explanation and defense of rational expectations:

[Rational expectations] purports to explain the expectations people actually have about the relevant items in their own futures. It does so by asking that their expectations lead to economy-wide outcomes that do not contradict their views. By imposing the requirement that expectations not be systematically contradicted by outcomes, economists keep an unobservable object from becoming a source of “free parameters” through which we can cheaply claim to have “explained” some phenomenon. In other words, in rational-expectations models, expectations are part of what is solved for, and so they are not left to the discretion of the modeler to impose willy-nilly. In so doing, the assumption of rational expectations protects the public from economists.

This defense of rational expectations plainly belies betrays the methodological arrogance of modern macroeconomics. I am all in favor of solving a model for equilibrium expectations, but solving for equilibrium expectations is certainly not the same as insisting that the only interesting or relevant result of a model is the one generated by the assumption of full equilibrium under rational expectations. (Again see Thompson’s “Reformulation of Macroeconomic Theory” as well as the classic paper by Foley and Sidrauski, and this post by Rajiv Sethi on his blog.) It may be relevant and useful to look at a model and examine its properties in a state in which agents hold inconsistent expectations about future prices; the temporary equilibrium existing at a point in time does not correspond to a steady state. Why is such an equilibrium uninteresting and uninformative about what happens in a business cycle? But evidently modern macroeconomists such as Athreya consider it their duty to ban such models from polite discourse — certainly from the leading economics journals — lest the public be tainted by economists who might otherwise dare to abuse their models by making illicit assumptions about expectations formation and equilibrium concepts.

Chapter 5 is the most important chapter of the book. It is in this chapter that Athreya examines in more detail the kinds of adjustments that modern macroeconomists make in the Walrasian/ADM paradigm to accommodate the incompleteness of markets and the imperfections of expectation formation that limit the empirical relevance of the full ADM model as a macroeconomic paradigm. To do so, Athreya starts by explaining how the Radner model in which a less than the full complement of Arrow-Debreu contingent-laims markets is available. In the Radner model, unlike the ADM model, trading takes place through time for those markets that actually exist, so that the full Walrasian equilibrium exists only if agents are able to form correct expectations about future prices. And even if the full Walrasian equilibrium exists, in the absence of a complete set of Arrow-Debreu markets, the classical welfare theorems may not obtain.

To Athreya, these limitations on the Radner version of the Walrasian model seem manageable. After all, if no one really knows how to improve on the equilibrium of the Radner model, the potential existence of Pareto improvements to the Radner equilibrium is not necessarily that big a deal. Athreya expands on the discussion of the Radner model by introducing the neoclassical growth model in both its deterministic and stochastic versions, all the elements of the dynamic stochastic general equilibrium (DSGE) model that characterizes modern macroeconomics now being in place. Athreya closes out the chapter with additional discussions of the role of further modifications to the basic Walrasian paradigm, particularly search models and overlapping-generations models.

I found the discussion in chapter 5 highly informative and useful, but it doesn’t seem to me that Athreya faces up to the limitations of the Radner model or to the implied disconnect between the Walraisan paradigm and macroeconomic analysis. A full Walrasian equilibrium exists in the Radner model only if all agents correctly anticipate future prices. If they don’t correctly anticipate future prices, then we are in the world of Hicksian temporary equilibrium. But in that world, the kind of coordination failures that Athreya so casually dismisses seem all too likely to occur. In a world of temporary equilibrium, there is no guarantee that intertemporal budget constraints will be effective, because those budget constraint reflect expected, not actual, future prices, and, in temporary equilibrium, expected prices are not the same for all transactors. Budget constraints are not binding in a world in which trading takes place through time based on possibly incorrect expectations of future prices. Not only does this mean that all the standard equilibrium and optimality conditions of Walrasian theory are violated, but that defaults on IOUs and, thus, financial-market breakdowns, are entirely possible.

In a key passage in chapter 5, Athreya dismisses coordination-failure explanations, invidiously characterized as Keynesian, for inefficient declines in output and employment. While acknowledging that such fluctuations could, in theory, be caused by “self-fulfilling pessimism or fear,” Athreya invokes the benchmark Radner trading arrangement of the ADM model. “In the Radner economy, Athreya writes, “households and firms have correct expectations for the spot market prices one period hence.” The justification for that expectational assumption, which seems indistinguishable from the assumption of a full, rational-expectations equilibrium, is left unstated. Athreya continues:

Granting that they indeed have such expectations, we can now ask about the extent to which, in a modern economy, we can have outcomes that are extremely sensitive to them. In particular, is it the case that under fairly plausible conditions, “optimism” and “pessimism” can be self-fulfilling in ways that make everyone (or nearly everyone) better off in the former than the latter?

Athreya argues that this is possible only if the aggregate production function of the economy is characterized by increasing returns to scale, so that productivity increases as output rises.

[W]hat I have in mind is that the structure of the economy must be such that when, for example, all households suddenly defer consumption spending (and save instead), interest rates do not adjust rapidly to forestall such a fall in spending by encouraging firms to invest.

Notice that Athreya makes no distinction between a reduction in consumption in which people shift into long-term real or financial assets and one in which people shift into holding cash. The two cases are hardly identical, but Athreya has nothing to say about the demand for money and its role in macroeconomics.

If they did, under what I will later describe as a “standard” production side for the economy, wages would, barring any countervailing forces, promptly rise (as the capital stock rises and makes workers more productive). In turn, output would not fall in response to pessimism.

What Athreya is saying is that if we assume that there is a reduction in the time preference of households, causing them to defer present consumption in order to increase their future consumption, the shift in time preference should be reflected in a rise in asset prices, causing an increase in the production of durable assets, and leading to an increase in wages insofar as the increase in the stock of fixed capital implies an increase in the marginal product of labor. Thus, if all the consequences of increased thrift are foreseen at the moment that current demand for output falls, there would be a smooth transition from the previous steady state corresponding to a high rate of time preference to the new steady state corresponding to a low rate of time preference.

Fine. If you assume that the economy always remains in full equilibrium, even in the transition from one steady state to another, because everyone has rational expectations, you will avoid a lot of unpleasantness. But what if entrepreneurial expectations do not change instantaneously, and the reduction in current demand for output corresponding to reduced spending on consumption causes entrepreneurs to reduce, not increase, their demand for capital equipment? If, after the shift in time preference, total spending actually falls, there may be a chain of disappointments in expectations, and a series of defaults on IOUs, culminating in a financial crisis. Pessimism may indeed be self-fulfilling. But Athreya has a just-so story to tell, and he seems satisfied that there is no other story to be told. Others may not be so easily satisfied, especially when his just-so story depends on a) the rational expectations assumption that many smart people have a hard time accepting as even remotely plausible, and b) the assumption that no trading takes place at disequilibrium prices. Athreya continues:

Thus, at least within the context of models in which households and firms are not routinely incorrect about the future, multiple self-fulfilling outcomes require particular features of the production side of the economy to prevail.

Actually what Athreya should have said is: “within the context of models in which households and firms always predict future prices correctly.”

In chapter 6, Athreya discusses how modern macroeconomics can and has contributed to the understanding of the financial crisis of 2007-08 and the subsequent downturn and anemic recovery. There is a lot of very useful information and discussion of various issues, especially in connection with banking and financial markets. But further comment at this point would be largely repetitive.

Anyway, despite my obvious and strong disagreements with much of what I read, I learned a lot from Athreya’s well-written and stimulating book, and I actually enjoyed reading it.


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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