Archive for the 'macroeconomics' Category

Methodological Arrogance

A few weeks ago, I posted a somewhat critical review of Kartik Athreya’s new book Big Ideas in Macroeconomics. In quoting a passage from chapter 4 in which Kartik defended the rational-expectations axiom on the grounds that it protects the public from economists who, if left unconstrained by the discipline of rational expectations, could use expectational assumptions to generate whatever results they wanted, I suggested that this sort of reasoning in defense of the rational-expectations axiom betrayed what I called the “methodological arrogance” of modern macroeconomics which has, to a large extent, succeeded in imposing that axiom on all macroeconomic models. In his comment responding to my criticisms, Kartik made good-natured reference in passing to my charge of “methodological arrogance,” without substantively engaging with the charge. And in a post about the early reviews of Kartik’s book, Steve Williamson, while crediting me for at least reading the book before commenting on it, registered puzzlement at what I meant by “methodological arrogance.”

Actually, I realized when writing that post that I was not being entirely clear about what “methodological arrogance” meant, but I thought that my somewhat tongue-in-cheek reference to the duty of modern macroeconomists “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” was sufficiently suggestive not to require elaboration, especially after having devoted several earlier posts to criticisms of the methodology of modern macroeconomics (e.g., here, here, and here). That was a misjudgment.

So let me try to explain what I mean by methodological arrogance, which is not the quite the same as, but is closely related to, methodological authoritarianism. I will do so by referring to the long introductory essay (“A Realist View of Logic, Physics, and History”) that Karl Popper contributed to a book The Self and Its Brain co-authored with neuroscientist John Eccles. The chief aim of the essay was to argue that the universe is not fully determined, but evolves, producing new, emergent, phenomena not originally extant in the universe, such as the higher elements, life, consciousness, language, science and all other products of human creativity, which in turn interact with the universe, in fundamentally unpredictable ways. Popper regards consciousness as a real phenomenon that cannot be reduced to or explained by purely physical causes. Though he makes only brief passing reference to the social sciences, Popper’s criticisms of reductionism are directly applicable to the microfoundations program of modern macroeconomics, and so I think it will be useful to quote what he wrote at some length.

Against the acceptance of the view of emergent evolution there is a strong intuitive prejudice. It is the intuition that, if the universe consists of atoms or elementary particles, so that all things are structures of such particles, then every event in the universe ought to be explicable, and in principle predictable, in terms of particle structure and of particle interaction.

Notice how easy it would be rephrase this statement as a statement about microfoundations:

Against the acceptance of the view that there are macroeconomic phenomena, there is a strong intuitive prejudice. It is the intuition that, if the macroeconomy consists of independent agents, so that all macroeconomic phenomena are the result of decisions made by independent agents, then every macreconomic event ought to be explicable, and in principle predictable, in terms of the decisions of individual agents and their interactions.

Popper continues:

Thus we are led to what has been called the programme of reductionism [microfoundations]. In order to discuss it I shall make use of the following Table

(12) Level of ecosystems

(11) Level of populations of metazoan and plants

(10) Level of metezoa and multicellular plants

(9) Level of tissues and organs (and of sponges?)

(8) Level of populations of unicellular organisms

(7) Level of cells and of unicellular organisms

(6) Level of organelles (and perhaps of viruses)

(5) Liquids and solids (crystals)

(4) Molecules

(3) Atoms

(2) Elementary particles

(1) Sub-elementary particles

(0) Unknown sub-sub-elementary particles?

The reductionist idea behind this table is that the events or things on each level should be explained in terms of the lower levels. . . .

This reductionist idea is interesting and important; and whenever we can explain entities and events on a higher level by those of a lower level, we can speak of a great scientific success, and can say that we have added much to our understanding of the higher level. As a research programme, reductionism is not only important, but it is part of the programme of science whose aim is to explain and to understand.

So far so good. Reductionism certainly has its place. So do microfoundations. Whenever we can take an observation and explain it in terms of its constituent elements, we have accomplished something important. We have made scientific progress.

But Popper goes on to voice a cautionary note. There may be, and probably are, strict, perhaps insuperable, limits to how far higher-level phenomena can be reduced to (explained by) lower-level phenomena.

[E]ven the often referred to reduction of chemistry to physics, important as it is, is far from complete, and very possibly incompletable. . . . [W]e are far removed indeed from being able to claim that all, or most, properties of chemical compounds can be reduced to atomic theory. . . . In fact, the five lower levels of [our] Table . . . can be used to show that we have reason to regard this kind of intuitive reduction programme as clashing with some results of modern physics.

For what [our] Table suggests may be characterized as the principle of “upward causation.” This is the principle that causation can be traced in our Table . . . . from a lower level to a higher level, but not vice versa; that what happens on a higher level can be explained in terms of the next lower level, and ultimately in terms of elementary particles and the relevant physical laws. It appears at first that the higher levels cannot act on the lower ones.

But the idea of particle-to-particle or atom-to-atom interaction has been superseded by physics itself. A diffraction grating or a crystal (belonging to level (5) of our Table . . .) is a spatially very extended complex (and periodic) structure of billions of molecules; but it interacts as a whole extended periodic structure with the photons or the particles of a beam of photons or particles. Thus we have here an important example of “downward causation“. . . . That is to say, the whole, the macro structure, may, qua whole, act upon a photon or an elementary particle or an atom. . . .

Other physical examples of downward causation – of macroscopic structures on level (5) acting upon elementary particles or photons on level (1) – are lasers, masers, and holograms. And there are also many other macro structures which are examples of downward causation: every simple arrangement of negative feedback, such as a steam engine governor, is a macroscopic structure that regulates lower level events, such as the flow of the molecules that constitute the steam. Downward causation is of course important in all tools and machines which are designed for sompe purpose. When we use a wedge, for example, we do not arrange for the action of its elementary particles, but we use a structure, relying on it ot guide the actions of its constituent elementary particles to act, in concert, so as to achieve the desired result.

Stars are undersigned, but one may look at them as undersigned “machines” for putting the atoms and elementary particles in their central region under terrific gravitational pressure, with the (undersigned) result that some atomic nuclei fuse and form the nuclei of heavier elements; an excellent example of downward causation,of the action of the whole structure upon its constituent particles.

(Stars, incidentally, are good examples of the general rule that things are processes. Also, they illustrate the mistake of distinguishing between “wholes” – which are “more than the sums of their parts” – and “mere heaps”: a star is, in a sense, a “mere” accumulation, a “mere heap” of its constituent atoms. Yet it is a process – a dynamic structure. Its stability depends upon the dynamic equilibrium between its gravitational pressure, due to its sheer bulk, and the repulsive forces between its closely packed elementary particles. If the latter are excessive, the star explodes, If they are smaller than the gravitational pressure, it collapses into a “black hole.”

The most interesting examples of downward causation are to be found in organisms and in their ecological systems, and in societies of organisms [my emphasis]. A society may continue to function even though many of its members die; but a strike in an essential industry, such as the supply of electricity, may cause great suffering to many individual people. .. . I believe that these examples make the existence of downward causation obvious; and they make the complete success of any reductionist programme at least problematic.

I was very glad when I recently found this discussion of reductionism by Popper in a book that I had not opened for maybe 40 years, because it supports an argument that I have been making on this blog against the microfoundations program in macroeconomics: that as much as macroeconomics requires microfoundations, microeconomics also requires macrofoundations. Here is how I put a little over a year ago:

In fact, the standard comparative-statics propositions of microeconomics are also based on the assumption of the existence of a unique stable general equilibrium. Those comparative-statics propositions about the signs of the derivatives of various endogenous variables (price, quantity demanded, quantity supplied, etc.) with respect to various parameters of a microeconomic model involve comparisons between equilibrium values of the relevant variables before and after the posited parametric changes. All such comparative-statics results involve a ceteris-paribus assumption, conditional on the existence of a unique stable general equilibrium which serves as the starting and ending point (after adjustment to the parameter change) of the exercise, thereby isolating the purely hypothetical effect of a parameter change. Thus, as much as macroeconomics may require microfoundations, microeconomics is no less in need of macrofoundations, i.e., the existence of a unique stable general equilibrium, absent which a comparative-statics exercise would be meaningless, because the ceteris-paribus assumption could not otherwise be maintained. To assert that macroeconomics is impossible without microfoundations is therefore to reason in a circle, the empirically relevant propositions of microeconomics being predicated on the existence of a unique stable general equilibrium. But it is precisely the putative failure of a unique stable intertemporal general equilibrium to be attained, or to serve as a powerful attractor to economic variables, that provides the rationale for the existence of a field called macroeconomics.

And more recently, I put it this way:

The microeconomic theory of price adjustment is a theory of price adjustment in a single market. It is a theory in which, implicitly, all prices and quantities, but a single price-quantity pair are in equilibrium. Equilibrium in that single market is rapidly restored by price and quantity adjustment in that single market. That is why I have said that microeconomics rests on a macroeconomic foundation, and that is why it is illusory to imagine that macroeconomics can be logically derived from microfoundations. Microfoundations, insofar as they explain how prices adjust, are themselves founded on the existence of a macroeconomic equilibrium. Founding macroeconomics on microfoundations is just a form of bootstrapping.

So I think that my criticism of the microfoundations project exactly captures the gist of Popper’s criticism of reductionism. Popper extended his criticism of a certain form of reductionism, which he called “radical materialism or radical physicalism” in later passage in the same essay that is also worth quoting:

Radical materialism or radical physicalism is certainly a selfconsistent position. Fir it is a view of the universe which, as far as we know, was adequate once; that is, before the emergence of life and consciousness. . . .

What speaks in favour of radical materialism or radical physicalism is, of course, that it offers us a simple vision of a simple universe, and this looks attractive just because, in science, we search for simple theories. However, I think that it is important that we note that there are two different ways by which we can search for simplicity. They may be called, briefly, philosophical reduction and scientific reduction. The former is characterized by an attempt to provide bold and testable theories of high explanatory power. I believe that the latter is an extremely valuable and worthwhile method; while the former is of value only if we have good reasons to assume that it corresponds to the facts about the universe.

Indeed, the demand for simplicity in the sense of philosophical rather than scientific reduction may actually be damaging. For even in order to attempt scientific reduction, it is necessary for us to get a full grasp of the problem to be solved, and it is therefore vitally important that interesting problems are not “explained away” by philosophical analysis. If, say, more than one factor is responsible for some effect, it is important that we do not pre-empt the scientific judgment: there is always the danger that we might refuse to admit any ideas other than the ones we appear to have at hand: explaining away, or belittling the problem. The danger is increased if we try to settle the matter in advance by philosophical reduction. Philosophical reduction also makes us blind to the significance of scientific reduction.

Popper adds the following footnote about the difference between philosophic and scientific reduction.

Consider, for example, what a dogmatic philosophical reductionist of a mechanistic disposition (or even a quantum-mechanistic disposition) might have done in the face of the problem of the chemical bond. The actual reduction, so far as it goes, of the theory of the hydrogen bond to quantum mechanics is far more interesting than the philosophical assertion that such a reduction will one be achieved.

What modern macroeconomics now offers is largely an array of models simplified sufficiently so that they are solvable using the techniques of dynamic optimization. Dynamic optimization by individual agents — the microfoundations of modern macro — makes sense only in the context of an intertemporal equilibrium. But it is just the possibility that intertemporal equilibrium may not obtain that, to some of us at least, makes macroeconomics interesting and relevant. As the great Cambridge economist, Frederick Lavington, anticipating Popper in grasping the possibility of downward causation, put it so well, “the inactivity of all is the cause of the inactivity of each.”

So what do I mean by methodological arrogance? I mean an attitude that invokes microfoundations as a methodological principle — philosophical reductionism in Popper’s terminology — while dismissing non-microfounded macromodels as unscientific. To be sure, the progress of science may enable us to reformulate (and perhaps improve) explanations of certain higher-level phenomena by expressing those relationships in terms of lower-level concepts. That is what Popper calls scientific reduction. But scientific reduction is very different from rejecting, on methodological principle, any explanation not expressed in terms of more basic concepts.

And whenever macrotheory seems inconsistent with microtheory, the inconsistency poses a problem to be solved. Solving the problem will advance our understanding. But simply to reject the macrotheory on methodological principle without evidence that the microfounded theory gives a better explanation of the observed phenomena than the non-microfounded macrotheory (and especially when the evidence strongly indicates the opposite) is arrogant. Microfoundations for macroeconomics should result from progress in economic theory, not from a dubious methodological precept.

Let me quote Popper again (this time from his book Objective Knowledge) about the difference between scientific and philosophical reduction, addressing the denial by physicalists that that there is such a thing as consciousness, a denial based on their belief that all supposedly mental phenomena can and will ultimately be reduced to purely physical phenomena

[P]hilosophical speculations of a materialistic or physicalistic character are very interesting, and may even be able to point the way to a successful scientific reduction. But they should be frankly tentative theories. . . . Some physicalists do not, however, consider their theories as tentative, but as proposals to express everything in physicalist language; and they think these proposals have much in their favour because they are undoubtedly convenient: inconvenient problems such as the body-mind problem do indeed, most conveniently, disappear. So these physicalists think that there can be no doubt that these problems should be eliminated as pseudo-problems. (p. 293)

One could easily substitute “methodological speculations about macroeconomics” for “philosophical speculations of a materialistic or physicalistic character” in the first sentence. And in the third sentence one could substitute “advocates of microfounding all macroeconomic theories” for “physicalists,” “microeconomic” for “physicalist,” and “Phillips Curve” or “involuntary unemployment” for “body-mind problem.”

So, yes, I think it is arrogant to think that you can settle an argument by forcing the other side to use only those terms that you approve of.

What Does “Keynesian” Mean?

Last week Simon Wren-Lewis wrote a really interesting post on his blog trying to find the right labels with which to identify macroeconomists. Simon, rather disarmingly, starts by admitting the ultimate futility of assigning people labels; reality is just too complicated to conform to the labels that we invent to help ourselves make sense of reality. A good label can provide us with a handle with which to gain a better grasp on a messy set of observations, but it is not the reality. And if you come up with one label, I may counter with a different one. Who’s to say which label is better?

At any rate, as I read through Simon’s post I found myself alternately nodding my head in agreement and shaking my head in disagreement. So staying in the spirit of fun in which Simon wrote his post, I will provide a commentary on his labels and other pronouncements. If the comments are weighted on the side of disagreement, well, that’s what makes blogging fun, n’est-ce pas?

Simon divides academic researchers into two groups (mainstream and heterodox) and macroeconomic policy into two approaches (Keynesian and anti-Keynesian). He then offers the following comment on the meaning of the label Keynesian.

Just think about the label Keynesian. Any sensible definition would involve the words sticky prices and aggregate demand. Yet there are still some economists (generally not academics) who think Keynesian means believing fiscal rather than monetary policy should be used to stabilise demand. Fifty years ago maybe, but no longer. Even worse are non-economists who think being a Keynesian means believing in market imperfections, government intervention in general and a mixed economy. (If you do not believe this happens, look at the definition in Wikipedia.)

Well, as I pointed out in a recent post, there is nothing peculiarly Keynesian about the assumption of sticky prices, especially not as a necessary condition for an output gap and involuntary unemployment. So if Simon is going to have to work harder to justify his distinction between Keynesian and anti-Keynesian. In a comment on Simon’s blog, Nick Rowe pointed out just this problem, asking in particular why Simon could not substitute a Monetarist/anti-Monetarist dichotomy for the Keynesian/anti-Keynesian one.

The story gets more complicated in Simon’s next paragraph in which he describes his dichotomy of academic research into mainstream and heterodox.

Thanks to the microfoundations revolution in macro, mainstream macroeconomists speak the same language. I can go to a seminar that involves an RBC model with flexible prices and no involuntary unemployment and still contribute and possibly learn something. Equally an economist like John Cochrane can and does engage in meaningful discussions of New Keynesian theory (pdf).

In other words, the range of acceptable macroeconomic models has been drastically narrowed. Unless it is microfounded in a dynamic stochastic general equilibrium model, a model does not qualify as “mainstream.” This notion of microfoundation is certainly not what Edmund Phelps meant by “microeconomic foundations” when he edited his famous volume Microeconomic Foundations of Employment and Inflation Theory, which contained, among others, Alchian’s classic paper on search costs and unemployment and a paper by the then not so well-known Robert Lucas and his early collaborator Leonard Rapping. Nevertheless, in the current consensus, it is apparently the New Classicals that determine what kind of model is acceptable, while New Keynesians are allowed to make whatever adjustments, mainly sticky wages, they need to derive Keynesian policy recommendations. Anyone who doesn’t go along with this bargain is excluded from the mainstream. Simon may not be happy with this state of affairs, but he seems to have made peace with it without undue discomfort.

Now many mainstream macroeconomists, myself included, can be pretty critical of the limitations that this programme can place on economic thinking, particularly if it is taken too literally by microfoundations purists. But like it or not, that is how most macro research is done nowadays in the mainstream, and I see no sign of this changing anytime soon. (Paul Krugman discusses some reasons why here.) My own view is that I would like to see more tolerance and a greater variety of modelling approaches, but a pragmatic microfoundations macro will and should remain the major academic research paradigm.

Thus, within the mainstream, there is no basic difference in how to create a macroeconomic model. The difference is just in how to tweak the model in order to derive the desired policy implication.

When it comes to macroeconomic policy, and keeping to the different language idea, the only significant division I see is between the mainstream macro practiced by most economists, including those in most central banks, and anti-Keynesians. By anti-Keynesian I mean those who deny the potential for aggregate demand to influence output and unemployment in the short term.

So, even though New Keynesians have learned how to speak the language of New Classicals, New Keynesians can console themselves in retaining the upper hand in policy discussions. Which is why in policy terms, Simon chooses a label that is at least suggestive of a certain Keynesian primacy, the other side being defined in terms of their opposition to Keynesian policy. Half apologetically, Simon then asks: “Why do I use the term anti-Keynesian rather than, say, New Classical?” After all, it’s the New Classical model that’s being tweaked. Simon responds:

Partly because New Keynesian economics essentially just augments New Classical macroeconomics with sticky prices. But also because as far as I can see what holds anti-Keynesians together isn’t some coherent and realistic view of the world, but instead a dislike of what taking aggregate demand seriously implies.

This explanation really annoyed Steve Williamson who commented on Simon’s blog as follows:

Part of what defines a Keynesian (new or old), is that a Keynesian thinks that his or her views are “mainstream,” and that the rest of macroeconomic thought is defined relative to what Keynesians think – Keynesians reside at the center of the universe, and everything else revolves around them.

Simon goes on to explain what he means by the incoherence of the anti-Keynesian view of the world, pointing out that the Pigou Effect, which supposedly invalidated Keynes’s argument that perfect wage and price flexibility would not eventually restore full employment to an economy operating at less than full employment, has itself been shown not to be valid. And then Simon invokes that old standby Say’s Law.

Second, the evidence that prices are not flexible is so overwhelming that you need something else to drive you to ignore this evidence. Or to put it another way, you need something pretty strong for politicians or economists to make the ‘schoolboy error’ that is Says Law, which is why I think the basis of the anti-Keynesian view is essentially ideological.

Here, I think, Simon is missing something important. It was a mistake on Keynes’s part to focus on Say’s Law as the epitome of everything wrong with “classical economics.” Actually Say’s Law is a description of what happens in an economy when trading takes place at disequilibrium prices. At disequilibrium prices, potential gains from trade are left on the table. Not only are they left on the table, but the effects can be cumulative, because the failure to supply implies a further failure to demand. The Keynesian spending multiplier is the other side of the coin of the supply-side contraction envisioned by Say. Even infinite wage and price flexibility may not help an economy in which a lot of trade is occurring at disequilibrium prices.

The microeconomic theory of price adjustment is a theory of price adjustment in a single market. It is a theory in which, implicitly, all prices and quantities, but a single price-quantity pair are in equilibrium. Equilibrium in that single market is rapidly restored by price and quantity adjustment in that single market. That is why I have said that microeconomics rests on a macroeconomic foundation, and that is why it is illusory to imagine that macroeconomics can be logically derived from microfoundations. Microfoundations, insofar as they explain how prices adjust, are themselves founded on the existence of a macroeconomic equilibrium. Founding macroeconomics on microfoundations is just a form of bootstrapping.

If there is widespread unemployment, it may indeed be that wages are too high, and that a reduction in wages would restore equilibrium. But there is no general presumption that unemployment will be cured by a reduction in wages. Unemployment may be the result of a more general dysfunction in which all prices are away from their equilibrium levels, in which case no adjustment of the wage would solve the problem, so that there is no presumption that the current wage exceeds the full-equilibrium wage. This, by the way, seems to me to be nothing more than a straightforward implication of the Lipsey-Lancaster theory of second best.

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.

G. L. S. Shackle and the Indeterminacy of Economics

A post by Greg Hill, which inspired a recent post of my own, and Greg’s comment on that post, have reminded me of the importance of the undeservedly neglected English economist, G. L. S. Shackle, many of whose works I read and profited from as a young economist, but which I have hardly looked at for many years. A student of Hayek’s at the London School of Economics in the 1930s, Shackle renounced his early Hayekian views and the doctoral dissertation on capital theory that he had already started writing under Hayek’s supervision, after hearing a lecture by Joan Robinson in 1935 about the new theory of income and employment that Keynes was then in the final stages of writing up to be published the following year as The General Theory of Employment, Interest and Money. When Shackle, with considerable embarrassment, had to face Hayek to inform him that he could not finish the dissertation that he had started, no longer believing in what he had written, and having been converted to Keynes’s new theory. After hearing that Shackle was planning to find a new advisor under whom to write a new dissertation on another topic, Hayek, in a gesture of extraordinary magnanimity, responded that of course Shackle was free to write on whatever topic he desired, and that he would be happy to continue to serve as Shackle’s advisor regardless of the topic Shackle chose.

Although Shackle became a Keynesian, he retained and developed a number of characteristic Hayekian ideas (possibly extending them even further than Hayek would have), especially the notion that economic fluctuations result from the incompatibility between the plans that individuals are trying to implement, an incompatibility stemming from the imperfect and inconsistent expectations about the future that individuals hold, at least some plans therefore being doomed to failure. For Shackle the conception of a general equilibrium in which all individual plans are perfectly reconciled was a purely mental construct that might be useful in specifying the necessary conditions for the harmonization of individually formulated plans, but lacking descriptive or empirical content. Not only is a general equilibrium never in fact achieved, the very conception of such a state is at odds with the nature of reality. For example, the phenomenon of surprise (and, I would add, regret) is, in Shackle’s view, a characteristic feature of economic life, but under the assumption of most economists (though not of Knight, Keynes or Hayek) that all events can be at least be forecasted in terms of their underlying probability distributions, the phenomenon of surprise cannot be understood. There are some observed events – black swans in Taleb’s terminology – that we can’t incorporate into the standard probability calculus, and are completely inconsistent with the general equilibrium paradigm.

A rational-expectations model allows for stochastic variables (e.g., will it be rainy or sunny two weeks from tomorrow), but those variables are assumed to be drawn from distributions known by the agents, who can also correctly anticipate the future prices conditional on any realization (at a precisely known future moment in time) of a random variable. Thus, all outcomes correspond to expectations conditional on all future realizations of random variables; there are no surprises and no regrets. For a model to be correct and determinate in this sense, it must have accounted fully for all the non-random factors that could affect outcomes. If any important variable(s) were left out, the predictions of the model could not be correct. In other words, unless the model is properly specified, all causal factors having been identified and accounted for, the model will not generate correct predictions for all future states and all possible realizations of random variables. And unless the agents in the model can predict prices as accurately as the fully determined model can predict them, the model will not unfold through time on an equilibrium time path. This capability of forecasting future prices contingent on the realization of all random variables affecting the actual course of the model through time, is called rational expectations, which differs from perfect foresight only in being unable to predict in advance the realizations of the random variables. But all prices conditional on those realizations are correctly expected. Which is the more demanding assumption – rational expectations or perfect foresight — is actually not entirely clear to me.

Now there are two ways to think about rational expectations — one benign and one terribly misleading. The benign way is that the assumption of rational expectations is a means of checking the internal consistency of a model. In other words, if we are trying to figure out whether a model is coherent, we can suppose that the model is the true model; if we then posit that the expectations of the agents correspond to the solution of the model – i.e., the agents expect the equilibrium outcome – the solution of the model will confirm the expectations that have been plugged into the minds of the agents of the model. This is sometimes called a fixed-point property. If the model doesn’t have this fixed-point property, then there is something wrong with the model. So the assumption of rational expectations does not necessarily involve any empirical assertion about the real world, it does not necessarily assert anything about how expectations are formed or whether they ever are rational in the sense that agents can predict the outcome of the relevant model. The assumption merely allows the model to be tested for latent inconsistencies. Equilibrium expectations being a property of equilibrium, it makes no sense for equilibrium expectations not to generate an equilibrium.

But the other way of thinking about rational expectations is as an empirical assertion about what the expectations of people actually are or how those expectations are formed. If that is how we think about rational expectations, then we are saying people always anticipate the solution of the model. And if the model is internally consistent, then the empirical assumption that agents really do have rational expectations means that we are making an empirical assumption that the economy is in fact always in equilibrium, i.e., that is moving through time along an equilibrium path. If agents in the true model expect the equilibrium of the true model, the agents must be in equilibrium. To break out of that tight circle, either expectations have to be wrong (non-rational) or the model from which people derive their expectations must be wrong.

Of course, one way to finesse this problem is to say that the model is not actually true and expectations are not fully rational, but that the assumptions are close enough to being true for the model to be a decent approximation of reality. That is a defensible response, but one either has to take that assertion on faith, or there has to be strong evidence that the real world corresponds to the predictions of the model. Rational-expectations models do reasonably well in predicting the performance of economies near full employment, but not so well in periods like the Great Depression and the Little Depression. In other words, they work pretty well when we don’t need them, and not so well when we do need them.

The relevance of the rational-expectations assumption was discussed a year and a half ago by David Levine of Washington University. Levine was an undergraduate at UCLA after I had left, and went on to get his Ph.D. from MIT. He later returned to UCLA and held the Armen Alchian chair in economics from 1997 to 2006. Along with Michele Boldrin, Levine wrote a wonderful book Aginst Intellectual Monopoly. More recently he has written a little book (Is Behavioral Economics Doomed?) defending the rationality assumption in all its various guises, a book certainly worth reading even (or especially) if one doesn’t agree with all of its conclusions. So, although I have a high regard for Levine’s capabilities as an economist, I am afraid that I have to criticize what he has to say about rational expectations. I should also add that despite my criticism of Levine’s defense of rational expectations, I think the broader point that he makes that people do learn from experience, and that public policies should not be premised on the assumption that people will not eventually figure out how those policies are working, is valid.

In particular, let’s look at a post that Levine contributed to the Huffington Post blog defending the economics profession against the accusation that the economics profession is useless as demonstrated by their failure to predict the financial crisis of 2008. To counter this charge, Levine compared economics to physics — not necessarily the strategy I would have recommended for casting economics in a favorable light, but that’s merely an aside. Just as there is an uncertainty principle in physics, which says that you cannot identify simultaneously both the location and the speed of an electron, there’s an analogous uncertainty principle in economics, which says that the forecast affects the outcome.

The uncertainty principle in economics arises from a simple fact: we are all actors in the economy and the models we use determine how we behave. If a model is discovered to be correct, then we will change our behavior to reflect our new understanding of reality — and when enough of us do so, the original model stops being correct. In this sense future human behavior must necessarily be uncertain.

Levine is certainly right that insofar as the discovery of a new model changes expectations, the model itself can change outcomes. If the model predicts a crisis, the model, if it is believed, may be what causes the crisis. Fair enough, but Levine believes that this uncertainty principle entails the rationality of expectations.

The uncertainty principle in economics leads directly to the theory of rational expectations. Just as the uncertainty principle in physics is consistent with the probabilistic predictions of quantum mechanics (there is a 20% chance this particle will appear in this location with this speed) so the uncertainty principle in economics is consistent with the probabilistic predictions of rational expectations (there is a 3% chance of a stock market crash on October 28).

This claim, if I understand it, is shocking. The equations of quantum mechanics may be able to predict the probability that a particle will appear at given location with a given speed, I am unaware of any economic model that can provide even an approximately accurate prediction of the probability that a financial crisis will occur within a given time period.

Note what rational expectations are not: they are often confused with perfect foresight — meaning we perfectly anticipate what will happen in the future. While perfect foresight is widely used by economists for studying phenomena such as long-term growth where the focus is not on uncertainty — it is not the theory used by economists for studying recessions, crises or the business cycle. The most widely used theory is called DSGE for Dynamic Stochastic General Equilibrium. Notice the word stochastic — it means random — and this theory reflects the necessary randomness brought about by the uncertainty principle.

I have already observed that the introduction of random variables into a general equilibrium is not a significant relaxation of the predictive capacities of agents — and perhaps not even a relaxation, but an enhancement of the predictive capacities of the agents. The problem with this distinction between perfect foresight and stochastic disturbances is that there is no relaxation of the requirement that all agents share the same expectations of all future prices in all possible future states of the world. The world described is a world without surprise and without regret. From the standpoint of the informational requirements imposed on agents, the distinction between perfect foresight and rational expectations is not worth discussing.

In simple language what rational expectations means is “if people believe this forecast it will be true.”

Well, I don’t know about that. If the forecast is derived from a consistent, but empirically false, model, the assumption of rational expectations will ensure that the forecast of the model coincides with what people expect. But the real world may not cooperate, producing an outcome different from what was forecast and what was rationally expected. The expectation of a correct forecast does not guarantee the truth of the forecast unless the model generating the forecast is true. Is Levine convinced that the models used by economists are sufficiently close to being true to generate valid forecasts with a frequency approaching that of the Newtonian model in forecasting, say, solar eclipses? More generally, Levine seems to be confusing the substantive content of a theory — what motivates the agents populating theory and what constrains the choices of those agents in their interactions with other agents and with nature — with an assumption about how agents form expectations. This confusion becomes palpable in the next sentence.

By contrast if a theory is not one of rational expectations it means “if people believe this forecast it will not be true.”

I don’t what it means to say “a theory is not one of rational expectations.” Almost every economic theory depends in some way on the expectations of the agents populating the theory. There are many possible assumptions to make about how expectations are formed. Most of those assumptions about how expectations are formed allow, though they do not require, expectations to correspond to the predictions of the model. In other words, expectations can be viewed as an equilibrating variable of a model. To make a stronger assertion than that is to make an empirical claim about how closely the real world corresponds to the equilibrium state of the model. Levine goes on to make just such an assertion. Referring to a non-rational-expectations theory, he continues:

Obviously such a theory has limited usefulness. Or put differently: if there is a correct theory, eventually most people will believe it, so it must necessarily be rational expectations. Any other theory has the property that people must forever disbelieve the theory regardless of overwhelming evidence — for as soon as the theory is believed it is wrong.

It is hard to interpret what Levine is saying. What theory or class of theories is being dismissed as having limited usefulness? Presumably, all theories that are not “of rational expectations.” OK, but why is their usefulness limited? Is it that they are internally inconsistent, i.e., they lack the fixed-point property whose absence signals internal inconsistency, or is there some other deficiency? Levine seems to be conflating the two very different ways of understanding rational expectations (a test for internal inconsistency v. a substantive empirical hypothesis). Perhaps that’s why Levine feels compelled to paraphrase. But the paraphrase makes it clear that he is not distinguishing between the substantive theory and the specific expectational hypothesis. I also can’t tell whether his premise (“if there is a correct theory”) is meant to be a factual statement or a hypothetical? If it is the former, it would be nice if the correct theory were identified. If the correct theory can’t even be identified, how are people supposed to know which theory they are supposed to believe, so that they can form their expectations accordingly? Rather than an explanation for why the correct rational-expectations theory will eventually be recognized, this sounds like an explanation for why the correct theory is unknowable. Unless, of course, we assume that the rational expectations are a necessary feature of reality in which case, people have been forming expectations based on the one true model all along, and all economists are doing is trying to formalize a pre-existing process of expectations formation that already solves the problem. But the rest of his post (see part two here) makes it clear that Levine (properly) does not hold that extreme position about rational expectations.

So in the end , I find myself unable to make sense of rational expectations except as a test for the internal consistency of an economic model, and, perhaps also, as a tool for policy analysis. Just as one does not want to work with a model that is internally inconsistent, one does not want to formulate a policy based on the assumption that people will fail to understand the effects of the policy being proposed. But as a tool for understanding how economies actually work and what can go wrong, the rational-expectations assumption abstracts from precisely the key problem, the inconsistencies between the expectations held by different agents, which are an inevitable, though certainly not the only, cause of the surprise and regret that are so characteristic of real life.

Never Mistake a Change in Quantity Demanded for a Change in Demand

We are all in Scott Sumner’s debt for teaching (or reminding) us never, ever to reason from a price change. The reason is simple. You can’t just posit a price change and then start making inferences from the price change, because price changes don’t just happen spontaneously. If there’s a price change, it’s because something else has caused price to change. Maybe demand has increased; maybe supply has decreased; maybe neither supply nor demand has changed, but the market was in disequilibrium before and is in equilibrium now at the new price; maybe neither supply nor demand has changed, but the market was in equilibrium before and is in disequilibrium now. There could be other scenarios as well, but unless you specify at least one of them, you can’t reason sensibly about the implications of the price change.

There’s another important piece of advice for anyone trying to do economics: never mistake a change in quantity demanded for a change in demand. A change in demand means that the willingness of people to pay for something has changed, so that, everything else held constant, the price has to change. If for some reason, the price of something goes up, the willingness of people to pay for not having changed, then the quantity of the thing that they demand will go down. But here’s the important point: their demand for that something – their willingness to pay for it – has not gone down; the change in the amount demanded is simply a response to the increased price of that something. In other words, a change in the price of something cannot be the cause of a change in the demand for that something; it can only cause a change in the quantity demanded. A change in demand can be caused only by change in something other than price – maybe a change in wealth, or in fashion, or in taste, or in the season, or in the weather.

Why am I engaging in this bit of pedantry? Well, in a recent post, Scott responded to the following question from Dustin in the comment section to one of his posts.

An elementary question on the topic of interest rates that I’ve been unable to resolve via google:

Regarding Fed actions, I understand that reduced interest rates are thought to be expansionary because the resulting decrease in cost of capital induces greater investment. But I also understand that reduced interest rates are thought to be contractionary because the resulting decrease in opportunity cost of holding money increases demand for money.

To which Scott responded as follows:

It’s not at all clear that lower interest rates boost investment (never reason from a price change.)  And even if they did boost investment it is not at all clear that they would boost GDP.

Scott is correct to question the relationship between interest rates and investment. The relationship in the Keynesian model is based on the idea that a reduced interest rate, by reducing the rate at which expected future cash flows are discounted, increases the value of durable assets, so that the optimal size of the capital stock increases, implying a speed up in the rate of capital accumulation (investment). There are a couple of steps missing in the chain of reasoning that goes from a reduced rate of discount to a speed up in the rate of accumulation, but, in the olden days at any rate, economists have usually been willing to rely on their intuition that an increase in the size of the optimal capital stock would translate into an increased rate of capital accumulation.

Alternatively, in the Hawtreyan scheme of things, a reduced rate of interest would increase the optimal size of inventories held by traders and middlemen, causing an increase in orders to manufacturers, and a cycle of rising output and income generated by the attempt to increase inventories. Notice that in the Hawtreyan view, the reduced short-term interest is, in part, a positive supply shock (reducing the costs borne by middlemen and traders of holding inventories financed by short-term borrowing) as long as there are unused resources that can be employed if desired inventories increase in size.

That said, I’m not sure what Scott, in questioning whether a reduction in interesting rates raises investment, meant by his parenthetical remark about reasoning from a price change. Scott was asked about the effect of a Fed policy to reduce interest rates. Why is that reasoning from a price change? And furthermore, if we do posit that investment rises, why is it unclear whether GDP would rise?

Scott continues:

However it’s surprisingly hard to explain why OMPs boost NGDP using the mechanism of interest rates. Dustin is right that lower interest rates increase the demand for money.  They also reduce velocity. Higher money demand and lower velocity will, ceteris paribus, reduce NGDP.  So why does everyone think that a cut in interest rates increases NGDP?  Is it possible that Steve Williamson is right after all?

Sorry, Scott. Lower interest rates don’t increase the demand for money; lower interest rates increase the amount of money demanded. What’s the difference? If an interest-rate reduction increased the demand for money, it would mean that the demand curve had shifted, and the size of that shift would be theoretically unspecified. If that were the case, we would be comparing an unknown increase in investment on the one hand to an unknown increase in money demand on the other hand, the net effect being indeterminate. That’s the argument that Scott seems to be making.

But that’s not, repeat not, what’s going on here. What we have is an interest-rate reduction that triggers an increase investment and also in the amount of money demanded. But there is no shift in the demand curve for money, just a movement along an unchanging demand curve. That imposes a limit on the range of possibilities. What is the limit? It’s the extreme case of a demand curve for money that is perfectly elastic at the current rate of interest — in other words a liquidity trap — so that the slightest reduction in interest rates causes an unlimited increase in the amount of money demanded. But that means that the rate of interest can’t fall, so that investment can’t rise. If the demand for money is less than perfectly elastic, then the rate of interest can in fact be reduced, implying that investment, and therefore NGDP, will increase. The quantity of money demanded increases as well — velocity goes down — but not enough to prevent investment and NGDP from increasing.

So, there’s no ambiguity about the correct answer to Dustin’s question. If Steve Williamson is right, it’s because he has introduced some new analytical element not contained in the old-fashioned macroeconomic analysis. (Note that I use the term “old-fashioned” only as an identifier, not as an expression of preference in either direction.) A policy-induced reduction in the rate of interest must, under standard assumption in the old-fashioned macroeconomics, increase nominal GDP, though the size of the increase depends on specific assumptions about empirical magnitudes. I don’t disagree with Scott’s analysis in terms of the monetary base, I just don’t see a substantive difference between that analysis and the one that I just went through in terms of the interest-rate policy instrument.

Just to offer a non-controversial example, it is possible to reason through the effect of a restriction on imports in terms of a per unit tariff on imports or in terms of a numerical quota on imports. For any per unit tariff, there is a corresponding quota on imports that gives you the same solution. MMT guys often fail to see the symmetry between setting the quantity and the price of bank reserves; in this instance Scott seems to have overlooked the symmetry between the quantity and price of base money.

Microfoundations (aka Macroeconomic Reductionism) Redux

In two recent blog posts (here and here), Simon Wren-Lewis wrote sensibly about microfoundations. Though triggered by Wren-Lewis’s posts, the following comments are not intended as criticisms of him, though I think he does give microfoundations (as they are now understood) too much credit. Rather, my criticism is aimed at the way microfoundations have come to be used to restrict the kind of macroeconomic explanations and models that are up for consideration among working macroeconomists. I have written about microfoundations before on this blog (here and here)  and some, if not most, of what I am going to say may be repetitive, but obviously the misconceptions associated with what Wren-Lewis calls the “microfoundations project” are not going to be dispelled by a couple of blog posts, so a little repetitiveness may not be such a bad thing. Jim Buchanan liked to quote the following passage from Herbert Spencer’s Data of Ethics:

Hence an amount of repetition which to some will probably appear tedious. I do not, however, much regret this almost unavoidable result; for only by varied iteration can alien conceptions be forced on reluctant minds.

When the idea of providing microfoundations for macroeconomics started to catch on in the late 1960s – and probably nowhere did they catch on sooner or with more enthusiasm than at UCLA – the idea resonated, because macroeconomics, which then mainly consisted of various versions of the Keynesian model, seemed to embody certain presumptions about how markets work that contradicted the presumptions of microeconomics about how markets work. In microeconomics, the primary mechanism for achieving equilibrium is the price (actually the relative price) of whatever good is being analyzed. A full (or general) microeconomic equilibrium involves a set of prices such that each of markets (whether for final outputs or for inputs into the productive process) are in equilibrium, equilibrium meaning that every agent is able to purchase or sell as much of any output or input as desired at the equilibrium price. The set of equilibrium prices not only achieves equilibrium, the equilibrium, under some conditions, has optimal properties, because each agent, in choosing how much to buy or sell of each output or input, is presumed to be acting in a way that is optimal given the preferences of the agent and the social constraints under which the agent operates. Those optimal properties don’t always follow from microeconomic presumptions, optimality being dependent on the particular assumptions (about preferences, production and exchange technology, and property rights) adopted by the analyst in modeling an individual market or an entire system of markets.

The problem with Keynesian macroeconomics was that it seemed to overlook, or ignore, or dismiss, or deny, the possibility that a price mechanism is operating — or could operate — to achieve equilibrium in the markets for goods and for labor services. In other words, the Keynesian model seemed to be saying that a macoreconomic equilibrium is compatible with the absence of market clearing, notwithstanding that the absence of market clearing had always been viewed as the defining characteristic of disequilibrium. Thus, from the perspective of microeconomic theory, if there is an excess supply of workers offering labor services, i.e., there are unemployed workers who would be willing to be employed at the same wage that currently employed workers are receiving, there ought to be market forces that would reduce wages to a level such that all workers willing to work at that wage could gain employment. Keynes, of course, had attempted to explain why workers could only reduce their nominal wages, not their real wages, and argued that nominal wage cuts would simply induce equivalent price reductions, leaving real wages and employment unchanged. The microeconomic reasoning on which that argument was based hinged on Keynes’s assumption that nominal wage cuts would trigger proportionate price cuts, but that assumption was not exactly convincing, if only because the percentage price cut would seem to depend not just on the percentage reduction in the nominal wage, but also on the labor intensity of the product, Keynes, habitually and inconsistently, arguing as if labor were the only factor of production while at the same time invoking the principle of diminishing marginal productivity.

At UCLA, the point of finding microfoundations was not to create a macroeconomics that would simply reflect the results and optimal properties of a full general equilibrium model. Indeed, what made UCLA approach to microeconomics distinctive was that it aimed at deriving testable implications from relaxing the usual informational and institutional assumptions (full information, zero transactions costs, fully defined and enforceable property rights) underlying conventional microeconomic theory. If the way forward in microeconomics was to move away from the extreme assumptions underlying the perfectly competitive model, then it seemed plausible that relaxing those assumptions would be fruitful in macroeconomics as well. That led Armen Alchian and others at UCLA to think of unemployment as largely a search phenomenon. For a while that approach seemed promising, and to some extent the promise was fulfilled, but many implications of a purely search-theoretic approach to unemployment don’t seem to be that well supported empirically. For example, search models suggest that in recessions, quits increase, and that workers become more likely to refuse offers of employment after the downturn than before. Neither of those implications seems to be true. A search model would suggest that workers are unemployed because they are refusing offers below their reservation wage, but in fact most workers are becoming unemployed because they are being laid off, and in recessions workers seem likely to accept offers of employment at the same wage that other workers are getting. Now it is possible to reinterpret workers’ behavior in recessions in a way that corresponds to the search-theoretic model, but the reinterpretation seems a bit of a stretch.

Even though he was an early exponent of the search theory of unemployment, Alchian greatly admired and frequently cited a 1974 paper by Donald Gordon “A Neoclassical Theory of Keynesian Unemployment,” which proposed an implicit-contract theory of employer-employee relationship. The idea was that workers make long-term commitments to their employers, and realizing their vulnerability, after having committed themselves to their employer, to exploitation by a unilateral wage cut imposed by the employer under threat of termination, expect some assurance from their employer that they will not be subjected to a unilateral demand to accept a wage cut. Such implicit understandings make it very difficult for employers, facing a reduction in demand, to force workers to accept a wage cut, because doing so would make it hard for the employer to retain those workers that are most highly valued and to attract new workers.

Gordon’s theory of implicit wage contracts has a certain similarity to Dennis Carlton’s explanation of why many suppliers don’t immediately raise prices to their steady customers. Like Gordon, Carlton posits the existence of implicit and sometimes explicit contracts in which customers commit to purchase minimum quantities or to purchase their “requirements” from a particular supplier. In return for the assurance of having a regular customer on whom the supplier can count, the supplier gives the customer assurance that he will receive his customary supply at the agreed upon price even if market conditions should change. Rather than raise the price in the event of a shortage, the supplier may feel that he is obligated to continue supplying his regular customers at the customary price, while raising the price to new or occasional customers to “market-clearing” levels. For certain kinds of supply relationships in which customer and supplier expect to continue transacting regularly over a long period of time, price is not the sole method by which allocation decisions are made.

Klein, Crawford and Alchian discussed a similar idea in their 1978 article about vertical integration as a means of avoiding or mitigating the threat of holdup when a supplier and a customer must invest in some sunk asset, e.g., a pipeline connection, for the supply relationship to be possible. The sunk investment implies that either party, under the right circumstances, could threaten to holdup the other party by threatening to withdraw from the relationship leaving the other party stuck with a useless fixed asset. Vertical integration avoids the problem by aligning the incentives of the two parties, eliminating the potential for holdup. Price rigidity can thus be viewed as a milder form of vertical integration in cases where transactors have a relatively long-term relationship and want to assure each other that they will not be taken advantage of after making a commitment (i.e., foregoing other trading opportunities) to the other party.

The search model is fairly easy to incorporate into a standard framework because search can be treated as a form of self-employment that is an alternative to accepting employment. The shape and position of the individual’s supply curve reflects his expectations about future wage offers that he will receive if he chooses not to accept employment in the current period. The more optimistic the worker’s expectation of future wages, the higher the worker’s reservation wage in the current period. The more certain the worker feels about the expected future wage, the more elastic is his supply curve in the neighborhood of the expected wage. Thus, despite its empirical shortcomings, the search model could serve as a convenient heuristic device for modeling cyclical increases in unemployment because of the unwillingness of workers to accept nominal wage cuts. From a macroeconomic modeling perspective, the incorrect or incomplete representation of the reason for the unwillingness of workers to accept wage cuts may be less important than the overall implication of the model, which is that unanticipated aggregate demand shocks can have significant and persistent effects on real output and employment. For example in his reformulation of macroeconomic theory, Earl Thompson, though he was certainly aware of Donald Gordon’s paper, relied exclusively on a search-theoretic rationale for Keynesian unemployment, and I don’t know (or can’t remember) if he had a specific objection to Gordon’s model or simply preferred to use the search-theoretic approach for pragmatic modeling reasons.

At any rate, these comments about the role of search models in modeling unemployment decisions are meant to illustrate why microfoundations could be useful for macroeconomics: by adding to the empirical content of macromodels, providing insight into the decisions or circumstances that lead workers to accept or reject employment in the aftermath of aggregate demand shocks, or why employers impose layoffs on workers rather than offer employment at reduced wages. The spectrum of such microeconomic theories of employer-employee relationships have provided us with a richer understanding of what the term “sticky wages” might actually be referring to, beyond the existence of minimum wage laws or collective bargaining contracts specifying nominal wages over a period of time for all covered employees.

In this context microfoundations meant providing a more theoretically satisfying, more micreconomically grounded explanation for a phenomenon – “sticky wages” – that seemed somehow crucial for generating the results of the Keynesian model. I don’t think that anyone would question that microfoundations in this narrow sense has been an important and useful area of research. And it is not microfoundations in this sense that is controversial. The sense in which microfoundations is controversial is whether a macroeconomic model must show that aggregate quantities that it generates can be shown to consistent with the optimizing choices of all agents in the model. In other words, the equilibrium solution of a macroeconomic model must be such that all agents are optimizing intertemporally, subject to whatever informational imperfections are specified by the model. If the model is not derived from or consistent with the solution to such an intertemporal optimization problem, the macromodel is now considered inadequate and unworthy of consideration. Here’s how Michael Woodford, a superb economist, but very much part of the stifling microfoundations consensus that has overtaken macroeconomics, put in his paper “The Convergence in Macroeconomics: Elements of the New Synthesis.”

But it is now accepted that one should know how to render one’s growth model and one’s business-cycle model consistent with one another in principle, on those occasions when it is necessary to make such connections. Similarly, microeconomic and macroeconomic analysis are no longer considered to involve fundamentally different principles, so that it should be possible to reconcile one’s views about household or firm behavior, or one’s view of the functioning of individual markets, with one’s model of the aggregate economy, when one needs to do so.

In this respect, the methodological stance of the New Classical school and the real business cycle theorists has become the mainstream. But this does not mean that the Keynesian goal of structural modeling of short-run aggregate dynamics has been abandoned. Instead, it is now understood how one can construct and analyze dynamic general-equilibrium models that incorporate a variety of types of adjustment frictions, that allow these models to provide fairly realistic representations of both shorter-run and longer-run responses to economic disturbances. In important respects, such models remain direct descendants of the Keynesian macroeconometric models of the early postwar period, though an important part of their DNA comes from neoclassical growth models as well.

Woodford argues that by incorporating various imperfections into their general equilibrium models, e.g.., imperfectly competitive output and labor markets, lags in the adjustment of wages and prices to changes in market conditions, search and matching frictions, it is possible to reconcile the existence of underutilized resources with intertemporal optimization by agents.

The insistence of monetarists, New Classicals, and early real business cycle theorists on the empirical relevance of models of perfect competitive equilibrium — a source of much controversy in past decades — is not what has now come to be generally accepted. Instead, what is important is having general-equilibrium models in the broad sense of requiring that all equations of the model be derived from mutually consistent foundations, and that the specified behavior of each economic unit make sense given the environment created by the behavior of the others. At one time, Walrasian competitive equilibrium models were the only kind of models with these features that were well understood; but this is no longer the case.

Woodford shows no recognition of the possibility of multiple equilibria, or that the evolution of an economic system and time-series data may be path-dependent, making the long-run neutrality propositions characterizing most DSGE models untenable. If the world – the data generating mechanism – is not like the world assumed by modern macroeconomics, the estimates derived from econometric models reflecting the worldview of modern macroeconomics will be inferior to estimates derived from an econometric model reflecting another, more accurate, world view. For example, if there are many possible equilibria depending on changes in expectational parameters or on the accidental deviations from an equilibrium time path, the idea of intertemporal optimization may not even be meaningful. Rather than optimize, agents may simply follow certain simple rules of thumb. But, on methodological principle, modern macroeconomics treats the estimates generated by any alternative econometric model insufficiently grounded in the microeconomic principles of intertemporal optimization as illegitimate.

Even worse from the perspective of microfoundations are the implications of something called the Sonnenchein-Mantel-Debreu Theorem, which, as I imperfectly understand it, says something like the following. Even granting the usual assumptions of the standard general equilibrium model — continuous individual demand and supply functions, homogeneity of degree zero in prices, Walras’s Law, and suitable boundary conditions on demand and supply functions, there is no guarantee that there is a unique stable equilibrium for such an economy. Thus, even apart from the dependence of equilibrium on expectations, there is no rationally expected equilibrium because there is no unique equilibrium to serve as an attractor for expectations. Thus, as I have pointed out before, as much as macroeconomics may require microfoundations, microeconomics requires macrofoundations, perhaps even more so.

Now let us compare the methodological demand for microfoundations for macroeconomics, which I would describe as a kind of macroeconomic methodological reductionism, with the reductionism of Newtonian physics. Newtonian physics reduced the Keplerian laws of planetary motion to more fundamental principles of gravitation governing the motion of all bodies celestial and terrestrial. In so doing, Newtonian physics achieved an astounding increase in explanatory power and empirical scope. What has the methodological reductionism of modern macroeconomics achieved? Reductionsim was not the source, but the result, of scientific progress. But as Carlaw and Lipsey demonstrated recently in an important paper, methodological reductionism in macroeconomics has resulted in a clear retrogression in empirical and explanatory power. Thus, methodological reductionism in macroeconomics is an antiscientific exercise in methodological authoritarianism.

My Milton Friedman Problem

In my previous post , I discussed Keynes’s perplexing and problematic criticism of the Fisher equation in chapter 11 of the General Theory, perplexing because it is difficult to understand what Keynes is trying to say in the passage, and problematic because it is not only inconsistent with Keynes’s reasoning in earlier writings in which he essentially reproduced Fisher’s argument, it is also inconsistent with Keynes’s reasoning in chapter 17 of the General Theory in his exposition of own rates of interest and their equilibrium relationship. Scott Sumner honored me with a whole post on his blog which he entitled “Glasner on Keynes and the Fisher Effect,” quite a nice little ego boost.

After paraphrasing some of what I had written in his own terminology, Scott quoted me in responding to a dismissive comment that Krugman recently made about Milton Friedman, of whom Scott tends to be highly protective. Here’s the passage I am referring to.

PPS.  Paul Krugman recently wrote the following:

Just stabilize the money supply, declared Milton Friedman, and we don’t need any of this Keynesian stuff (even though Friedman, when pressured into providing an underlying framework, basically acknowledged that he believed in IS-LM).

Actually Friedman hated IS-LM.  I don’t doubt that one could write down a set of equilibria in the money market and goods market, as a function of interest rates and real output, for almost any model.  But does this sound like a guy who “believed in” the IS-LM model as a useful way of thinking about macro policy?

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

It turns out that IS-LM curves will look very different if one moves away from the interest rate transmission mechanism of the Keynesians.  Again, here’s David:

Before closing, I will just make two side comments. First, my interpretation of Keynes’s take on the Fisher equation is similar to that of Allin Cottrell in his 1994 paper “Keynes and the Keynesians on the Fisher Effect.” Second, I would point out that the Keynesian analysis violates the standard neoclassical assumption that, in a two-factor production function, the factors are complementary, which implies that an increase in employment raises the MEC schedule. The IS curve is not downward-sloping, but upward sloping. This is point, as I have explained previously (here and here), was made a long time ago by Earl Thompson, and it has been made recently by Nick Rowe and Miles Kimball.I hope in a future post to work out in more detail the relationship between the Keynesian and the Fisherian analyses of real and nominal interest rates.

Please do.  Krugman reads Glasner’s blog, and if David keeps posting on this stuff then Krugman will eventually realize that hearing a few wisecracks from older Keynesians about various non-Keynesian traditions doesn’t make one an expert on the history of monetary thought.

I wrote a comment on Scott’s blog responding to this post in which, after thanking him for mentioning me in the same breath as Keynes and Fisher, I observed that I didn’t find Krugman’s characterization of Friedman as someone who basically believed in IS-LM as being in any way implausible.

Then, about Friedman, I don’t think he believed in IS-LM, but it’s not as if he had an alternative macromodel. He didn’t have a macromodel, so he was stuck with something like an IS-LM model by default, as was made painfully clear by his attempt to spell out his framework for monetary analysis in the early 1970s. Basically he just tinkered with the IS-LM to allow the price level to be determined, rather than leaving it undetermined as in the original Hicksian formulation. Of course in his policy analysis and historical work he was not constained by any formal macromodel, so he followed his instincts which were often reliable, but sometimes not so.

So I am afraid that my take may on Friedman may be a little closer to Krugman’s than to yours. But the real point is that IS-LM is just a framework that can be adjusted to suit the purposes of the modeler. For Friedman the important thing was to deny that that there is a liquidity trap, and introduce an explicit money-supply-money-demand relation to determine the absolute price level. It’s not just Krugman who says that, it’s also Don Patinkin and Harry Johnson. Whether Krugman knows the history of thought, I don’t know, but surely Patinkin and Johnson did.

Scott responded:

I’m afraid I strongly disagree regarding Friedman. The IS-LM “model” is much more than just the IS-LM graph, or even an assumption about the interest elasticity of money demand. For instance, suppose a shift in LM also causes IS to shift. Is that still the IS-LM model? If so, then I’d say it should be called the “IS-LM tautology” as literally anything would be possible.

When I read Friedman’s work it comes across as a sort of sustained assault on IS-LM type thinking.

To which I replied:

I think that if you look at Friedman’s responses to his critics the volume Milton Friedman’s Monetary Framework: A Debate with his Critics, he said explicitly that he didn’t think that the main differences among Keynesians and Monetarists were about theory, but about empirical estimates of the relevant elasticities. So I think that in this argument Friedman’s on my side.

And finally Scott:

This would probably be easier if you provided some examples of monetary ideas that are in conflict with IS-LM. Or indeed any ideas that are in conflict with IS-LM. I worry that people are interpreting IS-LM too broadly.

For instance, do Keynesians “believe” in MV=PY? Obviously yes. Do they think it’s useful? No.

Everyone agrees there are a set of points where the money market is in equilibrium. People don’t agree on whether easy money raises interest rates or lowers interest rates. In my view the term “believing in IS-LM” implies a belief that easy money lowers rates, which boosts investment, which boosts RGDP. (At least when not at the zero bound.) Friedman may agree that easy money boosts RGDP, but may not agree on the transmission mechanism.

People used IS-LM to argue against the Friedman and Schwartz view that tight money caused the Depression. They’d say; “How could tight money have caused the Depression? Interest rates fell sharply in 1930?”

I think that Friedman meant that economists agreed on some of the theoretical building blocks of IS-LM, but not on how the entire picture fit together.

Oddly, your critique of Keynes reminds me a lot of Friedman’s critiques of Keynes.

Actually, this was not the first time that I provoked a negative response by writing critically about Friedman. Almost a year and a half ago, I wrote a post (“Was Milton Friedman a Closet Keynesian?”) which drew some critical comments from such reliably supportive commenters as Marcus Nunes, W. Peden, and Luis Arroyo. I guess Scott must have been otherwise occupied, because I didn’t hear a word from him. Here’s what I said:

Commenting on a supremely silly and embarrassingly uninformed (no, Ms. Shlaes, A Monetary History of the United States was not Friedman’s first great work, Essays in Positive Economics, Studies in the Quantity Theory of Money, A Theory of the Consumption Function, A Program for Monetary Stability, and Capitalism and Freedom were all published before A Monetary History of the US was published) column by Amity Shlaes, accusing Ben Bernanke of betraying the teachings of Milton Friedman, teachings that Bernanke had once promised would guide the Fed for ever more, Paul Krugman turned the tables and accused Friedman of having been a crypto-Keynesian.

The truth, although nobody on the right will ever admit it, is that Friedman was basically a Keynesian — or, if you like, a Hicksian. His framework was just IS-LM coupled with an assertion that the LM curve was close enough to vertical — and money demand sufficiently stable — that steady growth in the money supply would do the job of economic stabilization. These were empirical propositions, not basic differences in analysis; and if they turn out to be wrong (as they have), monetarism dissolves back into Keynesianism.

Krugman is being unkind, but he is at least partly right.  In his famous introduction to Studies in the Quantity Theory of Money, which he called “The Quantity Theory of Money:  A Restatement,” Friedman gave the game away when he called the quantity theory of money a theory of the demand for money, an almost shockingly absurd characterization of what anyone had ever thought the quantity theory of money was.  At best one might have said that the quantity theory of money was a non-theory of the demand for money, but Friedman somehow got it into his head that he could get away with repackaging the Cambridge theory of the demand for money — the basis on which Keynes built his theory of liquidity preference — and calling that theory the quantity theory of money, while ascribing it not to Cambridge, but to a largely imaginary oral tradition at the University of Chicago.  Friedman was eventually called on this bit of scholarly legerdemain by his old friend from graduate school at Chicago Don Patinkin, and, subsequently, in an increasingly vitriolic series of essays and lectures by his then Chicago colleague Harry Johnson.  Friedman never repeated his references to the Chicago oral tradition in his later writings about the quantity theory. . . . But the simple fact is that Friedman was never able to set down a monetary or a macroeconomic model that wasn’t grounded in the conventional macroeconomics of his time.

As further evidence of Friedman’s very conventional theoretical conception of monetary theory, I could also cite Friedman’s famous (or, if you prefer, infamous) comment (often mistakenly attributed to Richard Nixon) “we are all Keynesians now” and the not so famous second half of the comment “and none of us are Keynesians anymore.” That was simply Friedman’s way of signaling his basic assent to the neoclassical synthesis which was built on the foundation of Hicksian IS-LM model augmented with a real balance effect and the assumption that prices and wages are sticky in the short run and flexible in the long run. So Friedman meant that we are all Keynesians now in the sense that the IS-LM model derived by Hicks from the General Theory was more or less universally accepted, but that none of us are Keynesians anymore in the sense that this framework was reconciled with the supposed neoclassical principle of the monetary neutrality of a unique full-employment equilibrium that can, in principle, be achieved by market forces, a principle that Keynes claimed to have disproved.

But to be fair, I should also observe that missing from Krugman’s take down of Friedman was any mention that in the original HIcksian IS-LM model, the price level was left undetermined, so that as late as 1970, most Keynesians were still in denial that inflation was a monetary phenomenon, arguing instead that inflation was essentially a cost-push phenomenon determined by the rate of increase in wages. Control of inflation was thus not primarily under the control of the central bank, but required some sort of “incomes policy” (wage-price guidelines, guideposts, controls or what have you) which opened the door for Nixon to cynically outflank his Democratic (Keynesian) opponents by coopting their proposals for price controls when he imposed a wage-price freeze (almost 42 years ago on August 15, 1971) to his everlasting shame and discredit.

Scott asked me to list some monetary ideas that I believe are in conflict with IS-LM. I have done so in my earlier posts (here, here, here and here) on Earl Thompson’s paper “A Reformulation of Macroeconomic Theory” (not that I am totally satisfied with Thompson’s model either, but that’s a topic for another post). Three of the main messages from Thompson’s work are that IS-LM mischaracterizes the monetary sector, because in a modern monetary economy the money supply is endogenous, not exogenous as Keynes and Friedman assumed. Second, the IS curve (or something corresponding to it) is not negatively sloped as Keynesians generally assume, but upward-sloping. I don’t think Friedman ever said a word about an upward-sloping IS curve. Third, the IS-LM model is essentially a one-period model which makes it difficult to carry out a dynamic analysis that incorporates expectations into that framework. Analysis of inflation, expectations, and the distinction between nominal and real interest rates requires a richer model than the HIcksian IS-LM apparatus. But Friedman didn’t scrap IS-LM, he expanded it to accommodate expectations, inflation, and the distinction between real and nominal interest rates.

Scott’s complaint about IS-LM seems to be that it implies that easy money reduces interest rates and that tight money raises rates, but, in reality, it’s the opposite. But I don’t think that you need a macro-model to understand that low inflation implies low interest rates and that high inflation implies high interest rates. There is nothing in IS-LM that contradicts that insight; it just requires augmenting the model with a term for expectations. But there’s nothing in the model that prevents you from seeing the distinction between real and nominal interest rates. Similarly, there is nothing in MV = PY that prevented Friedman from seeing that increasing the quantity of money by 3% a year was not likely to stabilize the economy. If you are committed to a particular result, you can always torture a model in such a way that the desired result can be deduced from it. Friedman did it to MV = PY to get his 3% rule; Keynesians (or some of them) did it to IS-LM to argue that low interest rates always indicate easy money (and it’s not only Keynesians who do that, as Scott knows only too well). So what? Those are examples of the universal tendency to forget that there is an identification problem. I blame the modeler, not the model.

OK, so why am I not a fan of Friedman’s? Here are some reasons. But before I list them, I will state for the record that he was a great economist, and deserved the professional accolades that he received in his long and amazingly productive career. I just don’t think that he was that great a monetary theorist, but his accomplishments far exceeded his contributions to monetary theory. The accomplishments mainly stemmed from his great understanding of price theory, and his skill in applying it to economic problems, and his great skill as a mathematical statistician.

1 His knowledge of the history of monetary theory was very inadequate. He had an inordinately high opinion of Lloyd Mints’s History of Banking Theory which was obsessed with proving that the real bills doctrine was a fallacy, uncritically adopting its pro-currency-school and anti-banking-school bias.

2 He covered up his lack of knowledge of the history of monetary theory by inventing a non-existent Chicago oral tradition and using it as a disguise for his repackaging the Cambridge theory of the demand for money and aspects of the Keynesian theory of liquidity preference as the quantity theory of money, while deliberately obfuscating the role of the interest rate as the opportunity cost of holding money.

3 His theory of international monetary adjustment was a naïve version of the Humean Price-Specie-Flow mechanism, ignoring the tendency of commodity arbitrage to equalize price levels under the gold standard even without gold shipments, thereby misinterpreting the significance of gold shipments under the gold standard.

4 In trying to find a respectable alternative to Keynesian theory, he completely ignored all pre-Keynesian monetary theories other than what he regarded as the discredited Austrian theory, overlooking or suppressing the fact that Hawtrey and Cassel had 40 years before he published the Monetary History of the United States provided (before the fact) a monetary explanation for the Great Depression, which he claimed to have discovered. And in every important respect, Friedman’s explanation was inferior to and retrogression from Hawtrey and Cassel explanation.

5 For example, his theory provided no explanation for the beginning of the downturn in 1929, treating it as if it were simply routine business-cycle downturn, while ignoring the international dimensions, and especially the critical role played by the insane Bank of France.

6 His 3% rule was predicated on the implicit assumption that the demand for money (or velocity of circulation) is highly stable, a proposition for which there was, at best, weak empirical support. Moreover, it was completely at variance with experience during the nineteenth century when the model for his 3% rule — Peel’s Bank Charter Act of 1844 — had to be suspended three times in the next 22 years as a result of financial crises largely induced, as Walter Bagehot explained, by the restriction on creation of banknotes imposed by the Bank Charter Act. However, despite its obvious shortcomings, the 3% rule did serve as an ideological shield with which Friedman could defend his libertarian credentials against criticism for his opposition to the gold standard (so beloved of libertarians) and to free banking (the theory of which Friedman did not comprehend until late in his career).

7 Despite his professed libertarianism, he was an intellectual bully who abused underlings (students and junior professors) who dared to disagree with him, as documented in Perry Mehrling’s biography of Fischer Black, and confirmed to me by others who attended his lectures. Black was made so uncomfortable by Friedman that Black fled Chicago to seek refuge among the Keynesians at MIT.

The State We’re In

Last week, Paul Krugman, set off by this blog post, complained about the current state macroeconomics. Apparently, Krugman feels that if saltwater economists like himself were willing to accommodate the intertemporal-maximization paradigm developed by the freshwater economists, the freshwater economists ought to have reciprocated by acknowledging some role for countercyclical policy. Seeing little evidence of accommodation on the part of the freshwater economists, Krugman, evidently feeling betrayed, came to this rather harsh conclusion:

The state of macro is, in fact, rotten, and will remain so until the cult that has taken over half the field is somehow dislodged.

Besides engaging in a pretty personal attack on his fellow economists, Krugman did not present a very flattering picture of economics as a scientific discipline. What Krugman describes seems less like a search for truth than a cynical bargaining game, in which Krugman feels that his (saltwater) side, after making good faith offers of cooperation and accommodation that were seemingly accepted by the other (freshwater) side, was somehow misled into making concessions that undermined his side’s strategic position. What I found interesting was that Krugman seemed unaware that his account of the interaction between saltwater and freshwater economists was not much more flattering to the former than the latter.

Krugman’s diatribe gave Stephen Williamson an opportunity to scorn and scold Krugman for a crass misunderstanding of the progress of science. According to Williamson, modern macroeconomics has passed by out-of-touch old-timers like Krugman. Among modern macroeconomists, Williamson observes, the freshwater-saltwater distinction is no longer meaningful or relevant. Everyone is now, more or less, on the same page; differences are worked out collegially in seminars, workshops, conferences and in the top academic journals without the rancor and disrespect in which Krugman indulges himself. If you are lucky (and hard-working) enough to be part of it, macroeconomics is a great place to be. One can almost visualize the condescension and the pity oozing from Williamson’s pores for those not part of the charmed circle.

Commenting on this exchange, Noah Smith generally agreed with Williamson that modern macroeconomics is not a discipline divided against itself; the intetermporal maximizers are clearly dominant. But Noah allows himself to wonder whether this is really any cause for celebration – celebration, at any rate, by those not in the charmed circle.

So macro has not yet discovered what causes recessions, nor come anywhere close to reaching a consensus on how (or even if) we should fight them. . . .

Given this state of affairs, can we conclude that the state of macro is good? Is a field successful as long as its members aren’t divided into warring camps? Or should we require a science to give us actual answers? And if we conclude that a science isn’t giving us actual answers, what do we, the people outside the field, do? Do we demand that the people currently working in the field start producing results pronto, threatening to replace them with people who are currently relegated to the fringe? Do we keep supporting the field with money and acclaim, in the hope that we’re currently only in an interim stage, and that real answers will emerge soon enough? Do we simply conclude that the field isn’t as fruitful an area of inquiry as we thought, and quietly defund it?

All of this seems to me to be a side issue. Who cares if macroeconomists like each other or hate each other? Whether they get along or not, whether they treat each other nicely or not, is really of no great import. For example, it was largely at Milton Friedman’s urging that Harry Johnson was hired to be the resident Keynesian at Chicago. But almost as soon as Johnson arrived, he and Friedman were getting into rather unpleasant personal exchanges and arguments. And even though Johnson underwent a metamorphosis from mildly left-wing Keynesianism to moderately conservative monetarism during his nearly two decades at Chicago, his personal and professional relationship with Friedman got progressively worse. And all of that nastiness was happening while both Friedman and Johnson were becoming dominant figures in the economics profession. So what does the level of collegiality and absence of personal discord have to do with the state of a scientific or academic discipline? Not all that much, I would venture to say.

So when Scott Sumner says:

while Krugman might seem pessimistic about the state of macro, he’s a Pollyanna compared to me. I see the field of macro as being completely adrift

I agree totally. But I diagnose the problem with macro a bit differently from how Scott does. He is chiefly concerned with getting policy right, which is certainly important, inasmuch as policy, since early 2008, has, for the most part, been disastrously wrong. One did not need a theoretically sophisticated model to see that the FOMC, out of misplaced concern that inflation expectations were becoming unanchored, kept money way too tight in 2008 in the face of rising food and energy prices, even as the economy was rapidly contracting in the second and third quarters. And in the wake of the contraction in the second and third quarters and a frightening collapse and panic in the fourth quarter, it did not take a sophisticated model to understand that rapid monetary expansion was called for. That’s why Scott writes the following:

All we really know is what Milton Friedman knew, with his partial equilibrium approach. Monetary policy drives nominal variables.  And cyclical fluctuations caused by nominal shocks seem sub-optimal.  Beyond that it’s all conjecture.

Ahem, and Marshall and Wicksell and Cassel and Fisher and Keynes and Hawtrey and Robertson and Hayek and at least 25 others that I could easily name. But it’s interesting to note that, despite his Marshallian (anti-Walrasian) proclivities, it was Friedman himself who started modern macroeconomics down the fruitless path it has been following for the last 40 years when he introduced the concept of the natural rate of unemployment in his famous 1968 AEA Presidential lecture on the role of monetary policy. Friedman defined the natural rate of unemployment as:

the level [of unemployment] that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the costs of gathering information about job vacancies, and labor availabilities, the costs of mobility, and so on.

Aside from the peculiar verb choice in describing the solution of an unknown variable contained in a system of equations, what is noteworthy about his definition is that Friedman was explicitly adopting a conception of an intertemporal general equilibrium as the unique and stable solution of that system of equations, and, whether he intended to or not, appeared to be suggesting that such a concept was operationally useful as a policy benchmark. Thus, despite Friedman’s own deep skepticism about the usefulness and relevance of general-equilibrium analysis, Friedman, for whatever reasons, chose to present his natural-rate argument in the language (however stilted on his part) of the Walrasian general-equilibrium theory for which he had little use and even less sympathy.

Inspired by the powerful policy conclusions that followed from the natural-rate hypothesis, Friedman’s direct and indirect followers, most notably Robert Lucas, used that analysis to transform macroeconomics, reducing macroeconomics to the manipulation of a simplified intertemporal general-equilibrium system. Under the assumption that all economic agents could correctly forecast all future prices (aka rational expectations), all agents could be viewed as intertemporal optimizers, any observed unemployment reflecting the optimizing choices of individuals to consume leisure or to engage in non-market production. I find it inconceivable that Friedman could have been pleased with the direction taken by the economics profession at large, and especially by his own department when he departed Chicago in 1977. This is pure conjecture on my part, but Friedman’s departure upon reaching retirement age might have had something to do with his own lack of sympathy with the direction that his own department had, under Lucas’s leadership, already taken. The problem was not so much with policy, but with the whole conception of what constitutes macroeconomic analysis.

The paper by Carlaw and Lipsey, which I referenced in my previous post, provides just one of many possible lines of attack against what modern macroeconomics has become. Without in any way suggesting that their criticisms are not weighty and serious, I would just point out that there really is no basis at all for assuming that the economy can be appropriately modeled as being in a continuous, or nearly continuous, state of general equilibrium. In the absence of a complete set of markets, the Arrow-Debreu conditions for the existence of a full intertemporal equilibrium are not satisfied, and there is no market mechanism that leads, even in principle, to a general equilibrium. The rational-expectations assumption is simply a deus-ex-machina method by which to solve a simplified model, a method with no real-world counterpart. And the suggestion that rational expectations is no more than the extension, let alone a logical consequence, of the standard rationality assumptions of basic economic theory is transparently bogus. Nor is there any basis for assuming that, if a general equilibrium does exist, it is unique, and that if it is unique, it is necessarily stable. In particular, in an economy with an incomplete (in the Arrow-Debreu sense) set of markets, an equilibrium may very much depend on the expectations of agents, expectations potentially even being self-fulfilling. We actually know that in many markets, especially those characterized by network effects, equilibria are expectation-dependent. Self-fulfilling expectations may thus be a characteristic property of modern economies, but they do not necessarily produce equilibrium.

An especially pretentious conceit of the modern macroeconomics of the last 40 years is that the extreme assumptions on which it rests are the essential microfoundations without which macroeconomics lacks any scientific standing. That’s preposterous. Perfect foresight and rational expectations are assumptions required for finding the solution to a system of equations describing a general equilibrium. They are not essential properties of a system consistent with the basic rationality propositions of microeconomics. To insist that a macroeconomic theory must correspond to the extreme assumptions necessary to prove the existence of a unique stable general equilibrium is to guarantee in advance the sterility and uselessness of that theory, because the entire field of study called macroeconomics is the result of long historical experience strongly suggesting that persistent, even cumulative, deviations from general equilibrium have been routine features of economic life since at least the early 19th century. That modern macroeconomics can tell a story in which apparently large deviations from general equilibrium are not really what they seem is not evidence that such deviations don’t exist; it merely shows that modern macroeconomics has constructed a language that allows the observed data to be classified in terms consistent with a theoretical paradigm that does not allow for lapses from equilibrium. That modern macroeconomics has constructed such a language is no reason why anyone not already committed to its underlying assumptions should feel compelled to accept its validity.

In fact, the standard comparative-statics propositions of microeconomics are also based on the assumption of the existence of a unique stable general equilibrium. Those comparative-statics propositions about the signs of the derivatives of various endogenous variables (price, quantity demanded, quantity supplied, etc.) with respect to various parameters of a microeconomic model involve comparisons between equilibrium values of the relevant variables before and after the posited parametric changes. All such comparative-statics results involve a ceteris-paribus assumption, conditional on the existence of a unique stable general equilibrium which serves as the starting and ending point (after adjustment to the parameter change) of the exercise, thereby isolating the purely hypothetical effect of a parameter change. Thus, as much as macroeconomics may require microfoundations, microeconomics is no less in need of macrofoundations, i.e., the existence of a unique stable general equilibrium, absent which a comparative-statics exercise would be meaningless, because the ceteris-paribus assumption could not otherwise be maintained. To assert that macroeconomics is impossible without microfoundations is therefore to reason in a circle, the empirically relevant propositions of microeconomics being predicated on the existence of a unique stable general equilibrium. But it is precisely the putative failure of a unique stable intertemporal general equilibrium to be attained, or to serve as a powerful attractor to economic variables, that provides the rationale for the existence of a field called macroeconomics.

So I certainly agree with Krugman that the present state of macroeconomics is pretty dismal. However, his own admitted willingness (and that of his New Keynesian colleagues) to adopt a theoretical paradigm that assumes the perpetual, or near-perpetual, existence of a unique stable intertemporal equilibrium, or at most admits the possibility of a very small set of deviations from such an equilibrium, means that, by his own admission, Krugman and his saltwater colleagues also bear a share of the responsibility for the very state of macroeconomics that Krugman now deplores.

Carlaw and Lipsey on Whether History Matters

About six months ago,  I mentioned a forthcoming paper by Kenneth Carlaw and Richard Lipsey, “Does history matter? Empirical analysis  of evolutionary versus stationary equilibrium views of the economy.”  The paper was recently published in the Journal of Evolutionary Economics.  The empirical analysis undertaken by Carlaw and Lipsey undermines many widely accepted propositions of modern macroeconomics, and is thus especially timely after the recent flurry of posts on the current state of macroecoomics by Krugman, Williamson, Smith, Delong, Sumner, et al., a topic about which I may have a word or two to say anon.  Here is the abstract of the Carlaw and Lipsey paper.

The evolutionary vision in which history matters is of an evolving economy driven by bursts of technological change initiated by agents facing uncertainty and producing long term, path-dependent growth and shorter-term, non-random investment cycles. The alternative vision in which history does not matter is of a stationary, ergodic process driven by rational agents facing risk and producing stable trend growth and shorter term cycles caused by random disturbances. We use Carlaw and Lipsey’s simulation model of non-stationary, sustained growth driven by endogenous, path-dependent technological change under uncertainty to generate artificial macro data. We match these data to the New Classical stylized growth facts. The raw simulation data pass standard tests for trend and difference stationarity, exhibiting unit roots and cointegrating processes of order one. Thus, contrary to current belief, these tests do not establish that the real data are generated by a stationary process. Real data are then used to estimate time-varying NAIRU’s for six OECD countries. The estimates are shown to be highly sensitive to the time period over which they are made. They also fail to show any relation between the unemployment gap, actual unemployment minus estimated NAIRU and the acceleration of inflation. Thus there is no tendency for inflation to behave as required by the New Keynesian and earlier New Classical theory. We conclude by rejecting the existence of a well-defined a short-run, negatively sloped Philips curve, a NAIRU, a unique general equilibrium, short and long-run, a vertical long-run Phillips curve, and the long-run neutrality of money.

UPDATE:  In addition to the abstract, I think it would be worthwhile to quote the three introductory paragraphs from Carlaw and Lipsey.

Economists face two conflicting visions of the market economy, visions that reflect two distinct paradigms, the Newtonian and the Darwinian. In the former, the behaviour of the economy is seen as the result of an equilibrium reached by the operation of opposing forces – such as market demanders and suppliers or competing oligopolists – that operate in markets characterised by negative feedback that returns the economy to its static equilibrium or its stationary equilibrium growth path. In the latter, the behaviour of the economy is seen as the result of many different forces – especially technological changes – that evolve endogenously over time, that are subject to many exogenous shocks, and that often operate in markets subject to positive feedback and in which agents operate under conditions of genuine uncertainty.
One major characteristic that distinguishes the two visions is stationarity for the Newtonian and non-stationarity for the Darwinian. In the stationary equilibrium of a static general equilibrium model and the equilibrium growth path of a Solow-type or endogenous growth model, the path by which the equilibrium is reached has no effect on the equilibrium values themselves. In short, history does not matter. In contrast, an important characteristic of the Darwinian vision is path dependency: what happens now has important implications for what will happen in the future. In short, history does matter.
In this paper, we consider, and cast doubts on, the stationarity properties of models in the Newtonian tradition. These doubts, if sustained, have important implications for understanding virtually all aspects of macroeconomics, including of long term economic growth, shorter term business cycles, and stabilisation policy.
UPDATE (12/28/12):  I received an email from Richard Lipsey about this post.  He attached two footnotes (1 and 5) from his article with Carlaw, which he thinks are relevant to some of the issues raised in comments to this post.  Footnote 1 explains their use of “Darwinian” to describe their path-dependent approach to economic modeling; footnote 5 observes that the analysis of many microeconomic problems and short-run macro-policy analysis may be amenable to the static-equilibrium method.

1 The use of the terms Darwinian and Newtonian here is meant to highlight the significant difference in equilibrium concept employed in the two groups of theories that we contrast, the evolutionary and what we call equilibrium with deviations (EWD) theories. Not all evolutionary theories, including the one employed here, are strictly speaking Darwinian in the sense that they embody replication and selection. We use the term, Darwinian to highlight the critical equilibrium concept of a path dependent, non-ergodic, historical process employed in Darwinian and evolutionary theories and to draw the contrast between that and the negative feedback, usually unique, ergodic equilibrium concept employed in Newtonian and EWD theories.

 5 Most evolutionary economists accept that for many issues in micro economics, comparative static equilibrium models are useful. Also, there is nothing incompatible between the evolutionary world view and the use of Keynesian models – of which IS-LM closed by an expectations-augmented Phillips curve is the prototype – to study such short run phenomenon as stagflation and the impact effects of monetary and fiscal policy shocks. Problems arise, however, when such analyses are applied to situations in which technology is changing endogenously over time periods that are relevant to the issues being studied. Depending on the issue at hand, this might be as short as a few months.


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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