What’s Wrong with the Price-Specie-Flow Mechanism, Part II: Friedman and Schwartz on the 1879 Resumption

Having explained in my previous post why the price-specie-flow mechanism (PSFM) is a deeply flawed mischaracterization of how the gold standard operated, I am now going to discuss two important papers by McCloskey and Zecher that go explain in detail the conceptual and especially the historical shortcomings of PSFM. The first paper (“How the Gold Standard Really Worked”) was published in the 1976 volume edited by Johnson and Frenkel, The Monetary Approach to the Balance of Payments; the second paper, (“The Success of Purchasing Power Parity: Historical Evidence and its Relevance for Macroeconomics”) was published in a 1984 NBER conference volume edited by Schwartz and Bordo, A Retrospective on the Classical Gold Standard 1821-1931. I won’t go through either paper in detail, but I do want to mention their criticisms of The Monetary History of the United States, 1867-1960, by Friedman and Schwartz and Friedman’s published response to those criticisms in the Schwartz-Bordo volume. I also want to register a mild criticism of an error of omission by McCloskey and Zecher in failing to note that, aside from the role of the balance of payments under the gold standard in equilibrating the domestic demand for money with the domestic supply of money, there is also a domestic mechanism for equilibrating the domestic demand for money with the domestic supply; it is only when the domestic mechanism does not operate that the burden for adjustment falls upon the balance of payments. I suspect that McCloskey and Zecher would not disagree that there is a domestic mechanism for equilibrating the demand for money with the supply of money, but the failure to spell out the domestic mechanism is still a shortcoming in these two otherwise splendid papers.

McCloskey and Zecher devote a section of their paper to the empirical anomalies that beset the PSFM.

If the orthodox theories of the gold standard are incorrect, it should be possible to observe signs of strain in the literature when they are applied to the experiences of the late nineteenth century. This is the case. Indeed, in the midst of their difficulties in applying the theories earlier observers have anticipated most of the elements of the alternative theory proposed here.

On the broadest level it has always been puzzling that the gold standard in its prime worked so smoothly. After all, the mechanism described by Hume, in which an initial divergence in price levels was to be corrected by flows of gold inducing a return to parity, might be expected to work fairly slowly, requiring alterations in the money supply and, more important, in expectations concerning the level and rate of change of prices which would have been difficult to achieve. The actual flows of gold in the late nineteenth century, furthermore, appear too small to play the large role assigned to them. . . . (pp. 361-62)

Later in the same section, they criticize the account given by Friedman and Schwartz of how the US formally adopted the gold standard in 1879 and its immediate aftermath, suggesting that the attempt by Friedman and Schwartz to use PSFM to interpret the events of 1879-81 was unsuccessful.

The behavior of prices in the late nineteenth century has suggested to some observers that the view that it was gold flows that were transmitting price changes from one country to another is indeed flawed. Over a short period, perhaps a year or so, the simple price-specie-flow mechanism predicts an inverse correlation in the price levels of two countries interacting with each other on the gold standard. . . . Yet, as Triffin [The Evolution of the International Monetary System, p. 4] has noted. . . even over a period as brief as a single year, what is impressive is “the overeall parallelism – rather than divergence – of price movements, expressed in the same unit of measurement, between the various trading countries maintaining a minimum degree of freedom of trade and exchange in their international transactions.

Over a longer period of time, of course, the parallelism is consistent with the theory of the price-specie-flow. In fact, one is free to assume that the lags in its mechanism are shorter than a year, attributing the close correlations among national price levels within the same year to a speedy flow of gold and a speedy price change resulting from the flow rather than to direct and rapid arbitrage. One is not free, however, to assume that there were no lags at all; in the price-specie-flow theory inflows of gold must precede increase in prices by at least the number of months necessary for the money supply to adjust to the new gold and for the increased amount of money to have an inflationary effect. The American inflation following the resumption of specie payments in January 1879 is a good example. After examining the annual statistics on gold flows and price levels for the period, Friedman and Schwartz [Monetary History of the United States, 1867-1960, p. 99] concluded that “It would be hard to find a much neater example in history of the classical gold-standard mechanism in operation.” Gold flowed in during 1879, 1880, and 1881 and American prices rose each year. Yet the monthly statistics on American gold flows and price changes tell a very different story. Changes in the Warren and Pearson wholesale price index during 1879-81 run closely parallel month by month with gold flows, rising prices corresponding to net inflows of gold. There is no tendency for prices to lag behind a gold flow and some tendency for them to lead it, suggesting not only the episode is an especially poor example of the price-specie flow theory in operation, but also that it might well be a reasonably good one of the monetary theory. (pp. 365-66)

Now let’s go back and see exactly what Friedman and Schwartz said about the episode in the Monetary History. Here is how they describe the rapid expansion starting with the resumption of convertibility on January 1, 1879:

The initial cyclical expansion from 1879 to 1882 . . . was characterized by an unusually rapid rise in the stock of money and in net national product in both current and constant prices. The stock of money rose by over 50 per cent, net national product in current prices over 35 per cent, and net national product in constant prices nearly 25 per cent. . . . (p. 96)

The initial rapid expansion reflected a combination of favorable physical and financial factors. On the physical side, the preceding contraction had been unusually protracted; once it was over, there tended to be a vigorous rebound; this is a rather typical pattern of reaction. On the financial side, the successful achievement of resumption, by itself, eased pressure on the foreign exchanges and permitted an internal price rise without external difficulties, for two reasons: first, because it eliminated the temporary demand for foreign exchange on the part of the Treasury to build up its gold reserve . . . second because it promoted a growth in U.S. balances held by foreigners and a decline in foreign balances held by U.S. residents, as confidence spread that the specie standard would be maintained and that the dollar would not depreciate again. (p. 97)

The point about financial conditions that Friedman and Schwartz are making is that, in advance of resumption, the US Treasury had been buying gold to increase reserves with which to satisfy potential demands for redemption once convertibility at the official parity was restored. The gold purchases supposedly forced the US price level to drop further (at the official price of gold, corresponding to a $4.86 dollar/sterling exchange rate) than it would have fallen if the Treasury had not been buying gold. (See quotation below from p. 99 of the Monetary History). Their reasoning is that the additional imports of gold ultimately had to be financed by a corresponding export surplus, which required depressing the US price level below the price level in the rest of the world sufficiently to cause a sufficient increase in US exports and decrease of US imports. But the premise that US exports could be increased and US imports could be decreased only by reducing the US price level relative to the rest of the world is unfounded. The incremental export surplus required only that total domestic expenditure be reduced, thereby allowing an incremental increase US exports or reduction in US imports. Reduced US spending would have been possible without any change in US prices. Friedman and Schwartz continue:

These forces were powerfully reinforced by accidents of weather that produced two successive years of bumper crops in the United States and unusually short crops elsewhere. The result was an unprecedentedly high level of exports. Exports of crude foodstuffs, in the years ending June 30, 1889 and 1881, reached levels roughly twice the average of either the preceding or the following year five years. In each year they were higher than in any preceding year, and neither figure was again exceeded until 1892. (pp. 97-98)

This is a critical point, but neither Friedman and Schwartz nor McCloskey and Zecher in their criticism seem to recognize its significance. Crop shortages in the rest of the world must have caused a substantial increase in grain and cotton prices, but Friedman and Schwartz provide no indication of the magnitudes of the price increases. At any rate, the US was then still a largely agricultural economy, so a substantial rise in agricultural prices determined in international markets would imply an increase in an index of US output prices relative to an index of British output prices reflecting both a shifting terms of trade in favor of the US and a higher share of total output accounted for by agricultural products in the US than in Britain. That shift, and the consequent increase in US versus British price levels, required no divergence between prices in the US and in Britain, and could have occurred without operation of the PSFM. Ignoring the terms-of-trade effect after drawing attention to the bumper crops in the US and crop failures elsewhere was an obvious error in the narrative provided by Friedman and Schwartz. With that in mind, let us return to their narrative.

The resulting increased demand for dollars meant that a relatively higher price level in the United States was consistent with equilibrium in the balance of payments.

Friedman and Schwartz are assuming that a demand for dollars under a fixed-exchange-rate regime can be satisfied only by through an incremental adjustment in exports and imports to induce an offsetting flow of dollars. Such a demand for dollars could also be satisfied by way of appropriate banking and credit operations requiring no change in imports and exports, but even if the demand for money is satisfied through an incremental adjustment in the trade balance, the implicit assumption that an adjustment in the trade balance requires an adjustment in relative price levels is totally unfounded; the adjustment in the trade balance can occur with no divergence in prices, such a divergence being inconsistent with the operation of international arbitrage.

Pending the rise in prices, it led to a large inflow of gold. The estimated stock of gold in the United States rose from $210 million on June 30, 1879, to $439 million on June 30, 1881.

The first sentence is difficult to understand. Having just asserted that there was a rise in US prices, why do Friedman and Schwartz now suggest that the rise in prices has not yet occurred? Presumably, the antecedent of the pronoun “it” is the demand for dollars, but why is the demand for dollars conditioned on a rise in prices? There are any number of reasons why there could have been an inflow of gold into the United States. (Presumably, higher than usual import demand could have led to a temporary drawdown of accumulated liquid assets, e.g., gold, in other countries to finance their unusually high grain imports. Moreover, the significant wealth transfer associated with a sharply improving terms of trade in favor of the US would have led to an increased demand for gold, either for real or monetary uses. More importantly, as banks increased the amount of deposits and banknotes they were supplying to the public, the demand of banks to hold gold reserves would have also increased.)

In classical gold-standard fashion, the inflow of gold helped produce an expansion in the stock of money and in prices. The implicit price index for the U.S. rose 10 per cent from 1879 to 1882 while a general index of British prices was roughly constant, so that the price level in the United States relative to that in Britain rose from 89.1 to 96.1. In classical gold-standard fashion, also, the outflow of gold from other countries produced downward pressure on their stock of money and their prices.

To say that the inflow of gold helped produce an expansion in the stock of money and in prices is simply to invoke the analytically empty story that gold reserves are lent out to the public, because the gold is sitting idle in bank vaults just waiting to be put to active use. But gold doesn’t just wind up sitting in a bank vault for no reason. Banks demand it for a purpose; either they are legally required to hold the gold or they find it more useful or rewarding to hold gold than to hold alternative assets. Banks don’t create liabilities payable in gold because they are holding gold; they hold gold because they create liabilities payable in gold; creating liabilities legally payable in gold may entail a legal obligation to hold gold reserves, or create a prudential incentive to keep some gold on hand. The throw-away references made by Friedman and Schwartz to “classical gold-standard fashion” is just meaningless chatter, and the divergence between the US and the British price indexes between 1879 and 1882 is attributable to a shift in the terms of trade of which the flow of gold from Britain to the US was the effect not the cause.

The Bank of England reserve in the Banking Department declined by nearly 40 percent from mid-1879 to mid-1881. In response, Bank rate was raised by steps from 2.5 per cent in April 1881 to 6 per cent in January 1882. The resulting effects on both prices and capital movements contributed to the cessation of the gold outflow to the U.S., and indeed, to its replacement by a subsequent inflow from the U.S. . . . (p. 98)

The only evidence about the U.S. gold stock provided by Friedman and Schwartz is an increase from $210 million to $439 million between June 30, 1879 to June 30, 1881. They juxtapose that with a decrease in the gold stock held by the Bank of England between mid-1879 and mid-1881, and an increase in Bank rate from 2.5% to 6%. Friedman and Schwartz cite Hawtrey’s Century of Bank Rate as the source for this fact (the only citation of Hawtrey in the Monetary History). But the increase in Bank rate from 2.5% did not begin till April 28, 1881, Bank rate having fluctuated between 2 and 3% from January 1878 to April 1881, two years and three months after the resumption. Discussing the fluctuations in the gold reserve of the Bank England in 1881, Hawtrey states:

The exports of gold had abated in the earlier part of the year, but set in again in August, and Bank rate was raised to 4 per cent. On the 6th of October it was put up to 5 per cent and on the 30th January, 1882, to 6.

The exports of gold had been accentuated in consequence of the crisis in Paris in January, 1882, resulting from the failure of the Union Generale. The loss of gold by export stopped almost immediately after the rise to 6 per cent. In fact the importation into the United States was ceasing, in consequence partly of the silver legislation which went far to satisfy the need for currency with silver certificates. (p. 102)

So it’s not at all clear from the narrative provided by Friedman and Schwartz to what extent the Bank of England, in raising Bank rate in 1881, was responding to the flow of gold to the United States, and they certainly do not establish that price-level changes between 1879 to 1881 reflected monetary, rather than real, forces. Here is how Friedman and Schwartz conclude their discussion of the effects of the resumption of US gold convertibility.

These gold movements and those before resumption have contrasting economic significance. As mentioned in the preceding chapter, the inflow into the U.S. before resumption was deliberately sought by the Treasury and represented an increased demand for foreign exchange. It required a surplus in the balance of payments sufficient to finance the gold inflow. The surplus could be generated only by a reduction in U.S. prices relative to foreign prices or in the price of the U.S. dollar relative to foreign currencies and was, in fact, generated by a relative reduction in U.S. prices. The gold inflow was, as it were, the active element to which the rest of the balance of payments adjusted.

This characterization of the pre-resumption deflationary process is certainly correct insofar as refers to the necessity of a deflation in US dollar prices for the dollar to appreciate to allow convertibility into gold at the 1861 dollar price of gold and dollar/sterling exchange rate. It is not correct insofar as it suggests that beyond the deflation necessary to restore purchasing power parity, a further incremental deflation was required to finance the Treasury’s demand for foreign exchange

After resumption, on the other hand, the active element was the increased demand for dollars resulting largely from the crop situation. The gold inflow was a passive reaction which temporarily filled the gap in payments. In its absence, there would have had to be an appreciation of the dollar relative to other currencies – a solution ruled out by the fixed exchange rate under the specie standard – or a more rapid [sic! They meant “less rapid”] rise in internal U.S. prices. At the same time, the gold inflow provided the basis and stimulus for an expansion in the stock of money and thereby a rise in internal prices at home and downward pressure on the stock of money and price abroad sufficient to bring an end to the necessity for large gold inflows. (p. 99)

This explanation of the causes of gold movements is not correct. The crop situation was a real, not a monetary, disturbance. We would now say that there was a positive supply shock in the US and a negative supply shock in the rest of the world, causing the terms of trade to shift in favor of the US. The resulting gold inflow reflected an increased US demand for gold induced by rapid economic growth and the improved terms of trade and a reduced demand to hold gold elsewhere to finance a temporary excess demand for grain. The monetary demand for gold would have also increased as a result of an increasing domestic demand for money. An increased demand for money could induce an inflow of gold to be minted into coin or to be held as legally required reserves for banknotes or to be held as bank reserves for deposits. The rapid increase in output and income, fueled in part by the positive supply shock and the improving terms of trade, would normally be expected to increase the demand to hold money. If the gold inflow was the basis, or the stimulus, for an expansion of the money stock, then increases in the gold stock should have preceded increases in the money stock. But as I am going to show, Friedman himself later provided evidence showing that in this episode the money stock at first increased more rapidly than the gold stock. And just as price increases and money expansion in the US were endogenous responses to real shocks in output and the terms of trade, adjustments in the stock of money and prices abroad were not the effects of monetary disturbances but endogenous monetary adjustments to real disturbances.

Let’s now turn to the second McCloskey-Zecher paper in which they returned to the 1879 resumption of gold convertibility by the US.

In an earlier paper (1976, p. 367) we reviewed the empirical anomalies in the price-specie-flow mechanism. For instance, we argued that Milton Friedman and Anna Schwartz misapplied the mechanism to an episode in American history. The United States went back on the gold standard in January 1879 at the pre-Civil War parity. The American price level was too low for the parity, allegedly setting the mechanism in motion. Over the next three years, Friedman and Schwartz argued from annual figures, gold flowed in and the price level rose just as Hume would have had it. They conclude (1963, p. 99) that “it would be hard to find a much neater example in history of the classical gold-standard mechanism in operation.” On the contrary, however, we believe it seems much more like an example of purchasing-power parity and the monetary approach than of the Humean mechanism. In the monthly statistics (Friedman and Schwartz confined themselves to annual data), there is no tendency for price rises to follow inflows of gold, as they should in the price-specie-flow mechanism; if anything, there is a slight tendency for price rises to precede inflows of gold, as they would if arbitrage were shortcutting the mechanism and leaving Americans with higher prices directly and a higher demand for gold. Whether or not the episode is a good example of the monetary theory, it is a poor example of the price-specie-flow mechanism. (p. 126)

Milton Friedman, a discussant at the conference at which McCloskey and Zecher presented their paper, submitted his amended remarks about the paper which were published in the volume along with comments of the other discussant, Robert E. Lipsey, and a transcript of the discussion of the paper by those in attendance. Here is Friedman’s response.

[McCloskey and Zecher] quote our statement that “it would be hard to find a much neater example in history of the classical gold-standard mechanism in operation” (p. 99). Their look at that episode on the basis of monthly data is interesting and most welcome, but on closer examination it does not, contrary to their claims, contradict our interpretation of the episode. McCloskey and Zecher compare price rises to inflows of gold, concluding, “In the monthly statistics … there is no tendency for price rises to follow inflows of gold . . . ; if anything, there is a slight tendency for price rises to precede inflows of gold, as they would if arbitrage were shortcutting the mechanism.”

Their comparison is the wrong one for determining whether prices were reacting to arbitrage rather than reflecting changes in the quantity of money. For that purpose the relevant comparison is with the quantity of money. Gold flows are relevant only as a proxy for the quantity of money. (p. 159)

I don’t understand this assertion at all. Gold flows are not simply a proxy for the quantity of money, because the whole premise of the PSFM is, as he and Schwartz assert in the Monetary History, that gold flows provide the “basis and stimulus for” an increase in the quantity of money.

If we compare price rises with changes in the quantity of money directly, a very different picture emerges than McCloskey and Zecher draw (see table C2.1). Our basic estimates of the quantity of money for this period are for semiannual dates, February and August. Resumption took effect on 1 January 1879. From August 1878 to February 1879, the money supply declined a trifle, continuing a decline that had begun in 1875 in final preparation for resumption. From February 1879 to August 1879, the money supply rose sharply, according to our estimates, by 15 percent. The Warren-Pearson monthly wholesale price index fell in the first half of 1879, reflecting the earlier decline in the money stock. It started its sharp rise in September 1879, or at least seven months later than the money supply.

Again, I don’t understand Friedman’s argument. The quantity of money began to rise after the resumption. In fact, Friedman’s own data show that in the six months from February to August of 1879, the quantity of money rose by 14.8% and the gold stock by 10.6%, without any effect on the price level. Friedman asserts that the price level only started to increase in September 8 or 9 months after the resumption in January. But it seems quite plausible that the fall harvest would have been the occasion for the effects of crop failures on grain prices to begin to make themselves felt on wholesale prices. So Friedman’s own evidence undercuts his argument that the increase in the quantity of money was what was driving the increase in US prices.

As to gold, the total stock of gold, as well as gold held by the Treasury, had been rising since 1877 as part of the preparation for resumption. But it had been rising at the expense of other components of high-powered money, which actually fell slightly. However, the decline in the money stock before 1879 had been due primarily to a decline in the deposit-currency ratio and the deposit-reserve ratio. After successful resumption, both ratios rose, which enabled the stock of money to rise despite no initial increase in gold flows. The large step-up in gold inflows in the fall of 1879, to which McCloskey and Zecher call attention, was mostly absorbed in raising the fraction of high-powered money in the form of gold rather than in speeding up monetary growth.

I agree with Friedman that the rapid increase in gold flows starting the fall of 1879 probably had little to do with the increase in the US price level, that increase reflecting primarily the terms-of-trade effect of rising agricultural prices, not a divergence between prices in the US and prices elsewhere in the world.  But that does not justify Friedman’s self-confident reiteration of the conclusion reached in the Monetary History that it would be hard to find a much neater example in history of the classical gold standard mechanism in operation. On the contrary, I see no evidence at all that “the classical gold standard mechanism” aka PSFM had anything to do with the behavior of prices after the resumption.

What’s Wrong with the Price-Specie-Flow Mechanism? Part I

The tortured intellectual history of the price-specie-flow mechanism (PSFM), which received its classic exposition in an essay (“Of the Balance of Trade”) by David Hume about 275 years ago is not a history that, properly understood, provides solid grounds for optimism about the chances for progress in what we, somewhat credulously, call economic science. In brief, the price-specie-flow mechanism asserts that, under a gold or commodity standard, deviations between the price levels of those countries on the gold standard induce gold to be shipped from countries where prices are relatively high to countries where prices are relatively low, the gold flows continuing until price levels are equalized. Hence, the compound adjective “price-specie-flow,” signifying that the mechanism is set in motion by price-level differences that induce gold (specie) flows.

The PSFM is thus premised on a version of the quantity theory of money in which price levels in each country on the gold standard are determined by the quantity of money circulating in that country. In his account, Hume assumed that money consists entirely of gold, so that he could present a scenario of disturbance and re-equilibration strictly in terms of changes in the amount of gold circulating in each country. Inasmuch as Hume held a deeply hostile attitude toward banks, believing them to be essentially inflationary engines of financial disorder, subsequent interpretations of the PSFM had to struggle to formulate a more general theoretical account of international monetary adjustment to accommodate the presence of the fractional-reserve banking so detested by Hume and to devise an institutional framework that would facilitate operation of the adjustment mechanism under a fractional-reserve-banking system.

In previous posts on this blog (e.g., here, here and here) a recent article on the history of the (misconceived) distinction between rules and discretion, I’ve discussed the role played by the PSFM in one not very successful attempt at monetary reform, the English Bank Charter Act of 1844. The Bank Charter Act was intended to ensure the maintenance of monetary equilibrium by reforming the English banking system so that it would operate the way Hume described it in his account of the PSFM. However, despite the failings of the Bank Charter Act, the general confusion about monetary theory and policy that has beset economic theory for over two centuries has allowed PSFM to retain an almost canonical status, so that it continues to be widely regarded as the basic positive and normative model of how the classical gold standard operated. Using the PSFM as their normative model, monetary “experts” came up with the idea that, in countries with gold inflows, monetary authorities should reduce interest rates (i.e., lending rates to the banking system) causing monetary expansion through the banking system, and, in countries losing gold, the monetary authorities should do the opposite. These vague maxims described as the “rules of the game,” gave only directional guidance about how to respond to an increase or decrease in gold reserves, thereby avoiding the strict numerical rules, and resulting financial malfunctions, prescribed by the Bank Charter Act.

In his 1932 defense of the insane gold-accumulation policy of the Bank of France, Hayek posited an interpretation of what the rules of the game required that oddly mirrored the strict numerical rules of the Bank Charter Act, insisting that, having increased the quantity of banknotes by about as much its gold reserves had increased after restoration of the gold convertibility of the franc, the Bank of France had done all that the “rules of the game” required it to do. In fairness to Hayek, I should note that decades after his misguided defense of the Bank of France, he was sharply critical of the Bank Charter Act. At any rate, the episode indicates how indefinite the “rules of the game” actually were as a guide to policy. And, for that reason alone, it is not surprising that evidence that the rules of the game were followed during the heyday of the gold standard (roughly 1880 to 1914) is so meager. But the main reason for the lack of evidence that the rules of the game were actually followed is that the PSFM, whose implementation the rules of the game were supposed to guarantee, was a theoretically flawed misrepresentation of the international-adjustment mechanism under the gold standard.

Until my second year of graduate school (1971-72), I had accepted the PSFM as a straightforward implication of the quantity theory of money, endorsed by such luminaries as Hayek, Friedman and Jacob Viner. I had taken Axel Leijonhufvud’s graduate macro class in my first year, so in my second year I audited Earl Thompson’s graduate macro class in which he expounded his own unique approach to macroeconomics. One of the first eye-opening arguments that Thompson made was to deny that the quantity theory of money is relevant to an economy on the gold standard, the kind of economy (allowing for silver and bimetallic standards as well) that classical economics, for the most part, dealt with. It was only after the Great Depression that fiat money was widely accepted as a viable system for the long-term rather than a mere temporary wartime expedient.

What determines the price level for a gold-standard economy? Thompson’s argument was simple. The value of gold is determined relative to every other good in the economy by exactly the same forces of supply and demand that determine relative prices for every other real good. If gold is the standard, or numeraire, in terms of which all prices are quoted, then the nominal price of gold is one (the relative price of gold in terms of itself). A unit of currency is specified as a certain quantity of gold, so the price level measure in terms of the currency unit varies inversely with the value of gold. The amount of money in such an economy will correspond to the amount of gold, or, more precisely, to the amount of gold that people want to devote to monetary, as opposed to real (non-monetary), uses. But financial intermediaries (banks) will offer to exchange IOUs convertible on demand into gold for IOUs of individual agents. The IOUs of banks have the property that they are accepted in exchange, unlike the IOUs of individual agents which are not accepted in exchange (not strictly true as bills of exchange have in the past been widely accepted in exchange). Thus, the amount of money (IOUs payable on demand) issued by the banking system depends on how much money, given the value of gold, the public wants to hold; whenever people want to hold more money than they have on hand, they obtain additional money by exchanging their own IOUs – not accepted in payment — with a bank for a corresponding amount of the bank’s IOUs – which are accepted in payment.

Thus, the simple monetary theory that corresponds to a gold standard starts with a value of gold determined by real factors. Given the public’s demand to hold money, the banking system supplies whatever quantity of money is demanded by the public at a price level corresponding to the real value of gold. This monetary theory is a theory of an ideal banking system producing a competitive supply of money. It is the basic monetary paradigm of Adam Smith and a significant group of subsequent monetary theorists who formed the Banking School (and also the Free Banking School) that opposed the Currency School doctrine that provided the rationale for the Bank Charter Act. The model is highly simplified and based on assumptions that aren’t necessarily fulfilled always or even at all in the real world. The same qualification applies to all economic models, but the realism of the monetary model is certainly open to question.

So under the ideal gold-standard model described by Thompson, what was the mechanism of international monetary adjustment? All countries on the gold standard shared a common price level, because, under competitive conditions, prices for any tradable good at any two points in space can deviate by no more than the cost of transporting that product from one point to the other. If geographic price differences are constrained by transportation costs, then the price effects of an increased quantity of gold at any location cannot be confined to prices at that location; arbitrage spreads the price effect at one location across the whole world. So the basic premise underlying the PSFM — that price differences across space resulting from any disturbance to the equilibrium distribution of gold would trigger equilibrating gold shipments to equalize prices — is untenable; price differences between any two points are always constrained by the cost of transportation between those points, whatever the geographic distribution of gold happens to be.

Aside from the theoretical point that there is a single world price level – actually it’s more correct to call it a price band reflecting the range of local price differences consistent with arbitrage — that exists under the gold standard, so that the idea that local prices vary in proportion to the local money stock is inconsistent with standard price theory, Thompson also provided an empirical refutation of the PSFM. According to the PSFM, when gold is flowing into one country and out of another, the price levels in the two countries should move in opposite directions. But the evidence shows that price-level changes in gold-standard countries were highly correlated even when gold flows were in the opposite direction. Similarly, if PSFM were correct, cyclical changes in output and employment should have been correlated with gold flows, but no such correlation between cyclical movements and gold flows is observed in the data. It was on this theoretical foundation that Thompson built a novel — except that Hawtrey and Cassel had anticipated him by about 50 years — interpretation of the Great Depression as a deflationary episode caused by a massive increase in the demand for gold between 1929 and 1933, in contrast to Milton Friedman’s narrative that explained the Great Depression in terms of massive contraction in the US money stock between 1929 and 1933.

Thompson’s ideas about the gold standard, which he had been working on for years before I encountered them, were in the air, and it wasn’t long before I encountered them in the work of Harry Johnson, Bob Mundell, Jacob Frenkel and others at the University of Chicago who were then developing what came to be known as the monetary approach to the balance of payments. Not long after leaving UCLA in 1976 for my first teaching job, I picked up a volume edited by Johnson and Frenkel with the catchy title The Monetary Approach to the Balance of Payments. I studied many of the papers in the volume, but only two made a lasting impression, the first by Johnson and Frenkel “The Monetary Approach to the Balance of Payments: Essential Concepts and Historical Origins,” and the last by McCloskey and Zecher, “How the Gold Standard Really Worked.” Reinforcing what I had learned from Thompson, the papers provided a deeper understanding of the relevant history of thought on the international-monetary-adjustment  mechanism, and the important empirical and historical evidence that contradicts the PSFM. I also owe my interest in Hawtrey to the Johnson and Frenkel paper which cites Hawtrey repeatedly for many of the basic concepts of the monetary approach, especially the existence of a single arbitrage-constrained international price level under the gold standard.

When I attended the History of Economics Society Meeting in Toronto a couple of weeks ago, I had the  pleasure of meeting Deirdre McCloskey for the first time. Anticipating that we would have a chance to chat, I reread the 1976 paper in the Johnson and Frenkel volume and a follow-up paper by McCloskey and Zecher (“The Success of Purchasing Power Parity: Historical Evidence and Its Implications for Macroeconomics“) that appeared in a volume edited by Michael Bordo and Anna Schwartz, A Retrospective on the Classical Gold Standard. We did have a chance to chat and she did attend the session at which I talked about Friedman and the gold standard, but regrettably the chat was not a long one, so I am going to try to keep the conversation going with this post, and the next one in which I will discuss the two McCloskey and Zecher papers and especially the printed comment to the later paper that Milton Friedman presented at the conference for which the paper was written. So stay tuned.

PS Here is are links to Thompson’s essential papers on monetary theory, “The Theory of Money and Income Consistent with Orthodox Value Theory” and “A Reformulation of Macroeconomic Theory” about which I have written several posts in the past. And here is a link to my paper “A Reinterpretation of Classical Monetary Theory” showing that Earl’s ideas actually captured much of what classical monetary theory was all about.

What Is This Thing Called “Currency Manipulation?”

Over the past few years, I have written a number of posts (e.g., here, here and here) posing — and trying to answer — the question: what is this strange thing called “currency manipulation?” I have to admit that I was actually moderately pleased with myself for having applied ideas developed by the eminent Australian international-trade and monetary economist Max Corden in a classic paper called “Exchange Rate Protection.” Unfortunately, my efforts don’t seem to have pleased – even minimally – Scott Sumner who, in a recent post in his Econlog blog, takes me to task for applying the term to China.

Now I get why Scott doesn’t like the term “currency manipulation.” The term is thrown around indiscriminately all the time as if its meaning were obvious. But the meaning is far from obvious. The term is also an invitation for demagogic abuse, which is another reason for being wary about using it.

A country can peg its exchange rate in terms of some other currency, or allow its exchange rate against all other currencies to float, or it can do a little of both, seeking to influence its exchange rate intermittently depending upon a variety of factors and objectives. A pegged exchange rate may be called a form of intervention (which is not — repeat not —  a synonym for “manipulation”), but if the monetary authority takes its currency peg seriously, it makes the currency peg the overriding determinant of its monetary policy. It is not the only element of its monetary policy, because the monetary authority has another policy objective that it can pursue simultaneously, namely, its holdings of foreign-exchange reserves. If the monetary authority adopts a tight monetary policy, it gains reserves, and if it adopts a loose policy it loses reserves. What constrains a monetary authority with a fixed-exchange rate in loosening policy is the amount of reserves that it is prepared to forego to maintain that exchange rate, and what constrains the monetary authority in tightening its policy is the interest income that must forego in accumulating non-interest-bearing, or low-interest-bearing, foreign-exchange reserves.

What distinguishes “currency manipulation” from mere “currency intervention?” Borrowing Max Corden’s idea of exchange-rate protection, I argued in previous posts that currency manipulation occurs when, in order to favor its tradable-goods sector (i.e., exporting and import-competing industries), a monetary authority (like the Bank of France in 1928) chooses an undervalued currency peg corresponding to a low real exchange rate, or intervenes in currency markets to reduce its nominal exchange rate, while tightening monetary policy to slow down the rise of domestic prices that normally follows a reduced nominal exchange rate. Corden points out that, as a protectionist strategy, exchange-rate protection is inferior to simply raising tariffs on imports or subsidizing exports. However, if international agreements make it difficult to raise tariffs and subsidize exports, exchange-rate protection may become the best available protectionist option.

In his post, “Nominal exchange rates, real exchange rates and protectionism,” Sumner denies that the idea of currency manipulation, and, presumably, the idea of exchange-rate protection make any sense. Here’s what Scott has to say:

The three concepts mentioned in the title of the post are completely unrelated to each other. So unrelated that the subjects ought not even be taught in the same course. The nominal exchange rate is a monetary concept. Real exchange rates belong in course on the real side of macro, perhaps including public finance. And protectionism belongs in a (micro) trade course.

The nominal exchange rate is the relative price of two monies. It’s determined by the monetary policies of the two countries in question. It plays no role in trade.

Scott often cites sticky prices as an important assumption of macroeconomics, so I don’t understand why he thinks that the nominal exchange rate has no effect on trade. If prices do not all instantaneously adjust to a change in the nominal exchange rate, changes in nominal exchange rates are also changes in real exchange rates until prices adjust fully to the new exchange rate.

Protectionism is a set of policies (such as tariffs and quotas) that drives a wedge between domestic and foreign prices. Protectionist policies reduce both imports and exports. They might also slightly affect the current account balance, but that’s a second order effect.

A protectionist policy causes resources from the non-tradable-goods sector to shift to the tradable-goods sector, favoring some domestic producers and disfavoring others, as well as favoring workers specialized to the tradable-goods sector. Whether it affects the trade balance depends on how the policy is implemented, so I agree that raising tariffs doesn’t automatically affect the trade balance. To determine whether and how the trade balance is affected, one has to make further assumptions about the distributional effects of the policy and about the budgetary and monetary policies accompanying the policy. Causation can go in either direction from real exchange rate to trade balance or from trade balance to real exchange rate.

In the following quotation, Scott ignores the relationship between the real exchange rate and the relative pricesof tradables and non-tradables. Protectionist policies, by increasing the relative price of tradables to non-tradables, shift resources from the non-tradable-goods to the tradable-goods sector. That’s the sense in which, contrary to Scott’s assertion, a low real-exchange rate makes enhances the competitiveness of one country relative to other countries. The cost of production in the domestic tradable-goods sector is reduced relative to the price of tradable goods, making the tradable-goods sector more competitive in the markets in which domestic producers compete with foreign producers. I don’t say that increasing the competitiveness of the domestic tradable-goods sector is a good idea, but it is not meaningless to talk about international competitiveness.

Real exchange rates influence the trade balance. When there is a change in either domestic saving or domestic investment, the real exchange rate must adjust to produce an equivalent change in the current account balance. A policy aimed at a bigger current account surplus is not “protectionist”, as it does not generally reduce imports and exports, nor does it drive a wedge between domestic and foreign prices. It affects the gap between imports and exports. . . .

A low real exchange rate is sometimes called a “competitive advantage”, although the concept has absolutely nothing to do with either competition or advantages. It’s simply a reflection of an imbalance between domestic saving and domestic investment. These imbalances also occur within countries, and no one ever worries about regional “deficits”. But for some odd reason at the national level they become a cause for concern. Some of this is based on the mercantilist fallacy that exports are good and imports are bad.

This is where Scott turns his attention to me.

Here’s David Glasner:

Currency manipulation has become a favorite bugbear of critics of both monetary policy and trade policy. Some claim that countries depress their exchange rates to give their exporters an unfair advantage in foreign markets and to insulate their domestic producers from foreign competition. Others claim that using monetary policy as a way to stimulate aggregate demand is necessarily a form of currency manipulation, because monetary expansion causes the currency whose supply is being expanded to depreciate against other currencies, making monetary expansion, ipso facto, a form of currency manipulation.

As I have already explained in a number of posts (e.g., here, here, and here) a theoretically respectable case can be made for the possibility that currency manipulation can be used as a form of covert protectionism without imposing either tariffs, quotas or obviously protectionist measures to favor the producers of one country against their foreign competitors.

I disagree with this. There is no theoretically respectable case for the argument that currency manipulation can be used as protectionism. But I would go much further; there is no intellectually respectable definition of currency manipulation.

Well, my only response is that I consider Max Corden to be just about the most theoretically-respectable economist alive. So let me quote at length from Corden’s essay “Macroeconomic and Industrial Policies” reprinted in his volume Protection, Growth and Trade (pp. 288-301)

There is clearly a relationship between macroeconomic policy and industrial policy on the foreign trade side. . . . The nominal exchange rate is an instrument of macroeconomic policy, while tariffs, import quotas, export subsidies and taxes and voluntary export restraints can all be regarded as instruments of industrial policy. Yet an exchange-rate change can have “industrial” effects. It therefore seems useful to clarify the relationship between exchange-rate policy and the various micro or industrial-policy instruments.

The first step is to distinguish a nominal from a real exchange-rate change and to introduce the concept of “exchange-rate protection. . . . If the exchange rate depreciates to the same extent as all costs and prices are rising (relative to costs and prices in other countries) there may be no real change at all. The nominal exchange rate is a monetary phenomenon, and it is possible that it is no more than that. A monetary authority may engineer a nominal devaluation designed to raise the domestic currency prices of exports and import-competing goods, and hence to benefit these industries. But if nominal wages quickly rise to compensate for the higher tradable-goods prices, no real effects – no rises in the absolute and relative profitability of tradable-goods industries – will remain. Monetary policy can influence the nominal-exchange rate, and possibly can even maintain it at a fixed value, but it cannot necessarily affect the real exchange rate. The real exchange rate refers to the relative price of tradable and non-tradable goods. While its absolute value is difficult to measure because of the ambiguity of the distinction between tradable and non-tradable goods, changes in it are usually – and reasonably – measured or indicated by relating changes in the nominal exchange rate to changes in some index of domestic prices or costs, or possibly to the average nominal wage level. This is sometimes called an index of competitiveness.

A nominal devaluation will devalue the real exchange rate if there is some rigidity or sluggishness either in the prices of non-tradables or in nominal wages. The nominal devaluation will then raise the prices of tradables relative to wage costs and to labour-intensive non-tradables. Thus it protects tradables. This is “exchange-rate protection”. It protects the whole group of tradables relative to non-tradables. It will tnd ot shift resources into tradables out of non-tradables and domestic demand in the opposite direction. If at the same time macroeconomic policy ensures a demand-supply balance for non-tradables – hence decreasing aggregate demand (absorption) in real terms appropriately – a balance of payments surplus (or at least a lesser deficit than before) will result. This refers to the balance of payments on current account since the concurrent fiscal and monetary policies can have varying effects on private capital inflow.

If the motive for the real devaluation was to protect tradables, then the current account surplus will be only a by-product, leading ot more accumulation of foreign exchange reserves than the country’s monetary authority really wanted. Alternatively, if the motive for the real devaluation was to build up the foreign-exchange reserves – or to stop their decline – then the protection of tradables will be the by-product.

The main point to make is that a real exchange-rate change has effects on the relative and absolute profitability of different industries, a real devaluation favouring tradables relative to non-tradables, and a real appreciation the opposite. A nominal exchange-rate change can thus serve an industrial-policy purpose, provided it can be turned into a real exchange-rate change and that the incidental effects on the balance of payments are accepted.

This does not mean that it is an optimal form of industrial policy. . . . [P]rotection policy could be directed more precisely to the industries to be protected, avoiding the by-product effect of an undesired balance-of-payments surplus; and in any case it can be argued that defensive protection policy is unlikely to be optimal, positive adjustment policy being preferable. Nevertheless, it is not difficult to find examples of countries that have practiced exchange-rate protection, if implicitly. They have intervened in the foreign-exchange market to prevent an appreciation of the exchange rate that might otherwise have taken place – or at least, they have “leaned against the wind.” – not because they really wanted to build up foreign-exchange reserves, but because they wanted to protect their tradable-goods industries – usually mainly their export industries.

Scott again quotes me and then comments:

And the most egregious recent example of currency manipulation was undertaken by the Chinese central bank when it effectively pegged the yuan to the dollar at a fixed rate. Keeping its exchange rate fixed against the dollar was precisely the offense that the currency-manipulation police accused the Chinese of committing.

Because currency manipulation does not exist as a coherent concept, I don’t see any evidence that the Chinese did it. But if I am wrong and it does exist, then it surely refers to the real exchange rate, not the nominal rate. Thus the fact that the nominal value of the Chinese yuan was pegged for a period of time has no relevance to whether the currency was being “manipulated”. The real value of the yuan was appreciating.

One cannot conclude that an appreciating yuan means that China was not manipulating its currency. As I pointed out above, and as Corden explains, exchange-rate protection is associated with the accumulation of foreign-exchange reserves by the central bank. There is an ambiguity in interpreting the motivation of the central bank that is accumulating foreign-exchange reserves. Is it accumulating because it wants to increase the amount of reserves in its vaults, or are the increased holdings merely an unwelcome consequence of a policy being pursued for other reasons? In either case, the amount of foreign-exchange reserves a central bank is willing to hold is not unlimited. When the pile of reserves gets high enough, the policy causing accumulation may start to change, implying that the real exchange rate will start to rise.

The dollar was pegged to gold from 1879 to 1933, and yet I don’t think the US government was “manipulating” the exchange rate. And if it was, it was not by fixing the gold price peg, it would have been by depreciating the real value of the dollar via policies that increased national saving, or reduced national investment, in order to run a current account surplus. In my view it is misleading to call policies that promote national saving “currency manipulation”, and even more so to put that label on just a subset of pro-saving policies.

As in the case of the Bank of France after 1928, with a fixed exchange rate, whether a central bank is guilty of currency manipulation depends on whether the initial currency peg was chosen with a view toward creating a competitive advantage for the country’s tradable-goods sector. That was clearly an important motivation when the Bank of France chose the conversion rate between gold and the franc. I haven’t studied the choice of the dollar peg to gold in 1879.

If economists want to use the term ‘currency manipulation’, then they first need to define the term. I have not seen any definitions that make any sense.

I’m hoping that Corden’s definition works for Scott. It does for me.

The 2017 History of Economics Society Conference in Toronto

I arrived in Toronto last Thursday for the History of Economics Society Meeting at the University of Toronto (Trinity College to be exact) to give talks on Friday about two papers, one of which (“Hayek and Three Equilibrium Concepts: Sequential, Temporary and Rational Expectations”) I have been posting over the past few weeks on this blog (here, here, here, here, and here). I want to thank those of you who have posted your comments, which have been very helpful, and apologize for not responding to the more recent comments. The other paper about which I gave a talk was based on a post from three of years ago (“Real and Pseudo Gold Standards: Did Friedman Know the Difference?”) on which one of the sections of that paper was based.

Here I am talking about Friedman.

Here are the abstracts of the two papers:

“Hayek and Three Equilibrium Concepts: Sequential, Temporary, and Rational Expectations”

Almost 40 years ago, Murray Milgate (1979) drew attention to the neglected contribution of F. A. Hayek to the concept of intertemporal equilibrium, which had previously been associated with Erik Lindahl and J. R. Hicks. Milgate showed that although Lindahl had developed the concept of intertemporal equilibrium independently, Hayek’s original 1928 contribution was published before Lindahl’s and that, curiously, Hicks in Value and Capital had credited Lindahl with having developed the concept despite having been Hayek’s colleague at LSE in the early 1930s and having previously credited Hayek for the idea of intertemporal equilibrium. Aside from Milgate’s contribution, few developments of the idea of intertemporal equilibrium have adequately credited Hayek’s contribution. This paper attempts to compare three important subsequent developments of that idea with Hayek’s 1937 refinement of the key idea of his 1928 paper. In non-chronological order, the three developments of interest are: 1) Radner’s model of sequential equilibrium with incomplete markets as an alternative to the Arrow-Debreu-McKenzie model of full equilibrium with complete markets; 2) Hicks’s temporary equilibrium model, and 3) the Muth-Lucas rational expectations model. While Hayek’s 1937 treatment most closely resembles Radner’s sequential equilibrium model, which Radner, echoing Hayek, describes as an equilibrium of plans, prices, and price expectations, Hicks’s temporary equilibrium model seems to be the natural development of Hayek’s approach. The Muth-Lucas rational-expectations model, however, develops the concept of intertemporal equilibrium in a way that runs counter to the fundamental Hayekian insight about the nature of intertemporal equilibrium

“Milton Friedman and the Gold Standard”

Milton Friedman discussed the gold standard in a number of works. His two main discussions of the gold standard appear in a 1951 paper on commodity-reserve currencies and in a 1961 paper on real and pseudo gold standards. In the 1951 paper, he distinguished between a gold standard in which only gold or warehouse certificates to equivalent amounts of gold circulated as a medium of exchange and one in which mere fiduciary claims to gold also circulated as media of exchange. Friedman called the former a strict gold standard and the latter as a partial gold standard. In the later paper, he distinguished between a gold standard in which gold is used as money, and a gold standard in which the government merely fixes the price of gold, dismissing the latter as a “pseudo” gold standard. In this paper, I first discuss the origin for the real/partial distinction, an analytical error, derived from David Hume via the nineteenth-century Currency School, about the incentives of banks to overissue convertible claims to base money, which inspired the Chicago plan for 100-percent reserve banking. I then discuss the real/pseudo distinction and argue that it was primarily motivated by the ideological objective of persuading libertarian and classical-liberal supporters of the gold standard to support a fiat standard supplemented by the k-percent quantity rule that Friedman was about to propose.

And here is my concluding section from the Friedman paper:

Milton Friedman’s view of the gold standard was derived from his mentors at the University Chicago, an inheritance that, in a different context, he misleadingly described as the Chicago oral tradition. The Chicago view of the gold standard was, in turn, derived from the English Currency School of the mid-nineteenth century, which successfully promoted the enactment of the Bank Charter Act of 1844, imposing a 100-percent marginal reserve requirement on the banknotes issued by the Bank of England, and served as a model for the Chicago Plan for 100-percent-reserve banking. The Currency School, in turn, based its proposals for reform on the price-specie-flow analysis of David Hume (1742).

The pure quantity-theoretic lineage of Friedman’s views of the gold standard and the intellectual debt that he owed to the Currency School and the Bank Charter Act disposed him to view the gold standard as nothing more than a mechanism for limiting the quantity of money. If the really compelling purpose and justification of the gold standard was to provide a limitation on the capacity of a government or a monetary authority to increase the quantity of money, then there was nothing special or exceptional about the gold standard.

I have no interest in exploring the reasons why supporters of, and true believers in, the gold standard feel a strong ideological or emotional attachment to that institution, and even if I had such an interest, this would not be the place to enter into such an exploration, but I conjecture that the sources of that attachment to the gold standard go deeper than merely to provide a constraint on the power of the government to increase the quantity of money.

But from Friedman’s quantity-theoretical perspective, if the primary virtue of the gold standard was that it served to limit the ability of the government to increase the quantity of money, if another institution could perform that service, it would serve just as well as the gold standard. The lesson that Friedman took from the efforts of the Currency School to enact the Bank Charter Act was that the gold standard, on its own, did not provide a sufficient constraint on the ability of private banks to increase the quantity of money. Otherwise, the 100-percent marginal reserve requirement of the Bank Charter Act would have been unnecessary.

Now if the gold standard could not function well without additional constraints on the quantity of money, then obviously the constraint on the quantity of money that really matters is not the gold standard itself, but the 100-percent marginal reserve requirement imposed on the banking system. But if the relevant constraint on the quantity of money is the 100 percent marginal reserve requirement, then the gold standard is really just excess baggage.

That was the view of Henry Simons and the other authors of the Chicago Plan. For a long time, Friedman accepted the Chicago Plan as the best prescription for monetary stability, but at about the time that he was writing his paper on real and pseudo gold standards, Friedman was frcoming to position that a k-percent rule would be a superior alternative to the old Chicago Plan. His paper on Pseudo gold standards for the Mont Pelerin Society was his initial attempt to persuade his libertarian and classical-liberal friends and colleagues to reconsider their support for the gold standard and prepare the ground for the k-percent rule that he was about to offer. But in his ideological enthusiasm he, in effect, denied the reality of the historical gold standard.

Aside from the getting to talk about my papers, the other highlights of the HES meeting for me included the opportunity to renew a very old acquaintance with the eminent Samuel Hollander whom I met about 35 years ago at the first History of Economics Society meeting that I ever attended and making the acquaintance for the first time with the eminent Deidre McCloskey who was at both of my sessions and with the eminent E. Roy Weintraub who has been doing important research on my illustrious cousin Abraham Wald, the first one to prove the existence of a competitive equilibrium almost 20 years before Arrow, Debreu and McKenzie came up with their proofs. Doing impressive and painstaking historical research Weintraub found a paper, long thought to have been lost in which Wald, using the fixed-point theorem that Arrow, Debreu and McKenzie had independently used in their proofs, gave a more general existence proof than he had provided in his published existence proofs, clearly establishing Wald’s priority over Arrow, Debreu and McKenzie in proving the existence of general equilibrium.

HT: Rebeca Betancourt


Hayek and Rational Expectations

In this, my final, installment on Hayek and intertemporal equilibrium, I want to focus on a particular kind of intertemporal equilibrium: rational-expectations equilibrium. In his discussions of intertemporal equilibrium, Roy Radner assigns a meaning to the term “rational-expectations equilibrium” very different from the meaning normally associated with that term. Radner describes a rational-expectations equilibrium as the equilibrium that results when some agents are able to make inferences about the beliefs held by other agents when observed prices differ from what they had expected prices to be. Agents attribute the differences between observed and expected prices to information held by agents better informed than themselves, and revise their own expectations accordingly in light of the information that would have justified the observed prices.

In the early 1950s, one very rational agent, Armen Alchian, was able to figure out what chemicals were being used in making the newly developed hydrogen bomb by identifying companies whose stock prices had risen too rapidly to be explained otherwise. Alchian, who spent almost his entire career at UCLA while also moonlighting at the nearby Rand Corporation, wrote a paper for Rand in which he listed the chemicals used in making the hydrogen bomb. When people at the Defense Department heard about the paper – the Rand Corporation was started as a think tank largely funded by the Department of Defense to do research that the Defense Department was interested in – they went to Alchian, confiscated and destroyed the paper. Joseph Newhard recently wrote a paper about this episode in the Journal of Corporate Finance. Here’s the abstract:

At RAND in 1954, Armen A. Alchian conducted the world’s first event study to infer the fuel material used in the manufacturing of the newly-developed hydrogen bomb. Successfully identifying lithium as the fusion fuel using only publicly available financial data, the paper was seen as a threat to national security and was immediately confiscated and destroyed. The bomb’s construction being secret at the time but having since been partially declassified, the nuclear tests of the early 1950s provide an opportunity to observe market efficiency through the dissemination of private information as it becomes public. I replicate Alchian’s event study of capital market reactions to the Operation Castle series of nuclear detonations in the Marshall Islands, beginning with the Bravo shot on March 1, 1954 at Bikini Atoll which remains the largest nuclear detonation in US history, confirming Alchian’s results. The Operation Castle tests pioneered the use of lithium deuteride dry fuel which paved the way for the development of high yield nuclear weapons deliverable by aircraft. I find significant upward movement in the price of Lithium Corp. relative to the other corporations and to DJIA in March 1954; within three weeks of Castle Bravo the stock was up 48% before settling down to a monthly return of 28% despite secrecy, scientific uncertainty, and public confusion surrounding the test; the company saw a return of 461% for the year.

Radner also showed that the ability of some agents to infer the information on which other agents are causing prices to differ from the prices that had been expected does not necessarily lead to an equilibrium. The process of revising expectations in light of observed prices may not converge on a shared set of expectations of the future based on commonly shared knowledge.

So rather than pursue Radner’s conception of rational expectations, I will focus here on the conventional understanding of “rational expectations” in modern macroeconomics, which is that the price expectations formed by the agents in a model should be consistent with what the model itself predicts that those future prices will be. In this very restricted sense, I believe rational expectations is a very important property that any model ought to have. It simply says that a model ought to have the property that if one assumes that the agents in a model expect the equilibrium predicted by the model, then, given those expectations, the solution of the model will turn out to be the equilibrium of the model. This property is a consistency and coherence property that any model, regardless of its substantive predictions, ought to have. If a model lacks this property, there is something wrong with the model.

But there is a huge difference between saying that a model should have the property that correct expectations are self-fulfilling and saying that agents are in fact capable of predicting the equilibrium of the model. Assuming the former does not entail the latter. What kind of crazy model would have the property that correct expectations are not self-fulfilling? I mean think about: a model in which correct expectations are not self-fulfilling is a nonsense model.

But demanding that a model not spout out jibberish is very different from insisting that the agents in the model necessarily have the capacity to predict what the equilibrium of the model will be. Rational expectations in the first sense is a minimal consistency property of an economic model; rational expectations in the latter sense is an empirical assertion about the real world. You can make such an assumption if you want, but you can’t claim that it is a property of the real world. Whether it is a property of the real world is a matter of fact, not a matter of methodological fiat. But methodological fiat is what rational expectations has become in macroeconomics.

In his 1937 paper on intertemporal equilibrium, Hayek was very clear that correct expectations are logically implied by the concept of an equilibrium of plans extending through time. But correct expectations are not a necessary, or even descriptively valid, characteristic of reality. Hayek also conceded that we don’t even have an explanation in theory of how correct expectations come into existence. He merely alluded to the empirical observation – perhaps not the most accurate description of empirical reality in 1937 – that there is an observed general tendency for markets to move toward equilibrium, implying that over time expectations do tend to become more accurate.

It is worth pointing out that when the idea of rational expectations was introduced by John Muth in the early 1960s, he did so in the context of partial-equilibrium models in which the rational expectation in the model was the rational expectation of the equilibrium price in a paraticular market. The motivation for Muth to introduce the idea of a rational expectation was idea of a cobweb cycle in which producers simply assume that the current price will remain at whatever level currently prevails. If there is a time lag between production, as in agricultural markets between the initial application of inputs and the final yield of output, it is easy to generate an alternating sequence of boom and bust, with current high prices inducing increased output in the following period, driving prices down, thereby inducing low output and high prices in the next period and so on.

Muth argued that rational producers would not respond to price signals in a way that led to consistently mistaken expectations, but would base their price expectations on more realistic expectations of what future prices would turn out to be. In his microeconomic work on rational expectations, Muth showed that the rational-expectation assumption was a better predictor of observed prices than the assumption of static expectations underlying the traditional cobweb-cycle model. So Muth’s rational-expectations assumption was based on a realistic conjecture of how real-world agents would actually form expectations. In that sense, Muth’s assumption was consistent with Hayek’s conjecture that there is an empirical tendency for markets to move toward equilibrium.

So while Muth’s introduction of the rational-expectations hypothesis was an empirically progressive theoretical innovation, extending rational-expectations into the domain of macroeconomics has not been empirically progressive, rational expectations models having consistently failed to generate better predictions than macro-models using other expectational assumptions. Instead, a rational-expectations axiom has been imposed as part of a spurious methodological demand that all macroeconomic models be “micro-founded.” But the deeper point – a point that Hayek understood better than perhaps anyone else — is that there is a huge difference in kind between forming rational expectations about a single market price and forming rational expectations about the vector of n prices on the basis of which agents are choosing or revising their optimal intertemporal consumption and production plans.

It is one thing to assume that agents have some expert knowledge about the course of future prices in the particular markets in which they participate regularly; it is another thing entirely to assume that they have knowledge sufficient to forecast the course of all future prices and in particular to understand the subtle interactions between prices in one market and the apparently unrelated prices in another market. The former kind of knowledge is knowledge that expert traders might be expected to have; the latter kind of knowledge is knowledge that would be possessed by no one but a nearly omniscient central planner, whose existence was shown by Hayek to be a practical impossibility.

Standard macroeconomic models are typically so highly aggregated that the extreme nature of the rational-expectations assumption is effectively suppressed. To treat all output as a single good (which involves treating the single output as both a consumption good and a productive asset generating a flow of productive services) effectively imposes the assumption that the only relative price that can ever change is the wage, so that all but one future relative prices are known in advance. That assumption effectively assumes away the problem of incorrect expectations except for two variables: the future price level and the future productivity of labor (owing to the productivity shocks so beloved of Real Business Cycle theorists). Having eliminated all complexity from their models, modern macroeconomists, purporting to solve micro-founded macromodels, simply assume that there is but one or at most two variables about which agents have to form their rational expectations.

Four score years since Hayek explained how challenging the notion of intertemporal equilibrium really is and the difficulties inherent in explaining any empirical tendency toward intertempral equilibrium, modern macroeconomics has succeeded in assuming all those difficulties out of existence. Many macroeconomists feel rather proud of what modern macroeconomics has achieved. I am not quite as impressed as they are.

Hayek and Temporary Equilibrium

In my three previous posts (here, here, and here) about intertemporal equilibrium, I have been emphasizing that the defining characteristic of an intertemporal equilibrium is that agents all share the same expectations of future prices – or at least the same expectations of those future prices on which they are basing their optimizing plans – over their planning horizons. At a given moment at which agents share the same expectations of future prices, the optimizing plans of the agents are consistent, because none of the agents would have any reason to change his optimal plan as long as price expectations do not change, or are not disappointed as a result of prices turning out to be different from what they had been expected to be.

The failure of expected prices to be fulfilled would therefore signify that the information available to agents in forming their expectations and choosing optimal plans conditional on their expectations had been superseded by newly obtained information. The arrival of new information can thus be viewed as a cause of disequilibrium as can any difference in information among agents. The relationship between information and equilibrium can be expressed as follows: differences in information or differences in how agents interpret information leads to disequilibrium, because those differences lead agents to form differing expectations of future prices.

Now the natural way to generalize the intertemporal equilibrium model is to allow for agents to have different expectations of future prices reflecting their differences in how they acquire, or in how they process, information. But if agents have different information, so that their expectations of future prices are not the same, the plans on which agents construct their subjectively optimal plans will be inconsistent and incapable of implementation without at least some revisions. But this generalization seems incompatible with the equilibrium of optimal plans, prices and price expectations described by Roy Radner, which I have identified as an updated version of Hayek’s concept of intertemporal equilibrium.

The question that I want to explore in this post is how to reconcile the absence of equilibrium of optimal plans, prices, and price expectations, with the intuitive notion of market clearing that we use to analyze asset markets and markets for current delivery. If markets for current delivery and for existing assets are in equilibrium in the sense that prices are adjusting in those markets to equate demand and supply in those markets, how can we understand the idea that  the optimizing plans that agents are seeking to implement are mutually inconsistent?

The classic attempt to explain this intermediate situation which partially is and partially is not an equilibrium, was made by J. R. Hicks in 1939 in Value and Capital when he coined the term “temporary equilibrium” to describe a situation in which current prices are adjusting to equilibrate supply and demand in current markets even though agents are basing their choices of optimal plans to implement over time on different expectations of what prices will be in the future. The divergence of the price expectations on the basis of which agents choose their optimal plans makes it inevitable that some or all of those expectations won’t be realized, and that some, or all, of those agents won’t be able to implement the optimal plans that they have chosen, without at least some revisions.

In Hayek’s early works on business-cycle theory, he argued that the correct approach to the analysis of business cycles must be analyzed as a deviation by the economy from its equilibrium path. The problem that he acknowledged with this approach was that the tools of equilibrium analysis could be used to analyze the nature of the equilibrium path of an economy, but could not easily be deployed to analyze how an economy performs once it deviates from its equilibrium path. Moreover, cyclical deviations from an equilibrium path tend not to be immediately self-correcting, but rather seem to be cumulative. Hayek attributed the tendency toward cumulative deviations from equilibrium to the lagged effects of monetary expansion which cause cumulative distortions in the capital structure of the economy that lead at first to an investment-driven expansion of output, income and employment and then later to cumulative contractions in output, income, and employment. But Hayek’s monetary analysis was never really integrated with the equilibrium analysis that he regarded as the essential foundation for a theory of business cycles, so the monetary analysis of the cycle remained largely distinct from, if not inconsistent with, the equilibrium analysis.

I would suggest that for Hayek the Hicksian temporary-equilibrium construct would have been the appropriate theoretical framework within which to formulate a monetary analysis consistent with equilibrium analysis. Although there are hints in the last part of The Pure Theory of Capital that Hayek was thinking along these lines, I don’t believe that he got very far, and he certainly gave no indication that he saw in the Hicksian method the analytical tool with which to weave the two threads of his analysis.

I will now try to explain how the temporary-equilibrium method makes it possible to understand  the conditions for a cumulative monetary disequilibrium. I make no attempt to outline a specifically Austrian or Hayekian theory of monetary disequilibrium, but perhaps others will find it worthwhile to do so.

As I mentioned in my previous post, agents understand that their price expectations may not be realized, and that their plans may have to be revised. Agents also recognize that, given the uncertainty underlying all expectations and plans, not all debt instruments (IOUs) are equally reliable. The general understanding that debt – promises to make future payments — must be evaluated and assessed makes it profitable for some agents to specialize in in debt assessment. Such specialists are known as financial intermediaries. And, as I also mentioned previously, the existence of financial intermediaries cannot be rationalized in the ADM model, because, all contracts being made in period zero, there can be no doubt that the equilibrium exchanges planned in period zero will be executed whenever and exactly as scheduled, so that everyone’s promise to pay in time zero is equally good and reliable.

For our purposes, a particular kind of financial intermediary — banks — are of primary interest. The role of a bank is to assess the quality of the IOUs offered by non-banks, and select from the IOUs offered to them those that are sufficiently reliable to be accepted by the bank. Once a prospective borrower’s IOU is accepted, the bank exchanges its own IOU for the non-bank’s IOU. No non-bank would accept a non-bank’s IOU, at least not on terms as favorable as those on which the bank offers in accepting an IOU. In return for the non-bank IOU, the bank credits the borrower with a corresponding amount of its own IOUs, which, because the bank promises to redeem its IOUs for the numeraire commodity on demand, is generally accepted at face value.

Thus, bank debt functions as a medium of exchange even as it enables non-bank agents to make current expenditures they could not have made otherwise if they can demonstrate to the bank that they are sufficiently likely to repay the loan in the future at agreed upon terms. Such borrowing and repayments are presumably similar to the borrowing and repayments that would occur in the ADM model unmediated by any financial intermediary. In assessing whether a prospective borrower will repay a loan, the bank makes two kinds of assessments. First, does the borrower have sufficient income-earning capacity to generate enough future income to make the promised repayments that the borrower would be committing himself to make? Second, should the borrower’s future income, for whatever reason, turn out to be insufficient to finance the promised repayments, does the borrower have collateral that would allow the bank to secure repayment from the collateral offered as security? In making both kinds of assessments the bank has to form an expectation about the future — the future income of the borrower and the future value of the collateral.

In a temporary-equilibrium context, the expectations of future prices held by agents are not the same, so the expectations of future prices of at least some agents will not be accurate, and some agents won’tbe able to execute their plans as intended. Agents that can’t execute their plans as intended are vulnerable if they have incurred future obligations based on their expectations of future prices that exceed their repayment capacity given the future prices that are actually realized. If they have sufficient wealth — i.e., if they have asset holdings of sufficient value — they may still be able to repay their obligations. However, in the process they may have to sell assets or reduce their own purchases, thereby reducing the income earned by other agents. Selling assets under pressure of obligations coming due is almost always associated with selling those assets at a significant loss, which is precisely why it usually preferable to finance current expenditure by borrowing funds and making repayments on a fixed schedule than to finance the expenditure by the sale of assets.

Now, in adjusting their plans when they observe that their price expectations are disappointed, agents may respond in two different ways. One type of adjustment is to increase sales or decrease purchases of particular goods and services that they had previously been planning to purchase or sell; such marginal adjustments do not fundamentally alter what agents are doing and are unlikely to seriously affect other agents. But it is also possible that disappointed expectations will cause some agents to conclude that their previous plans are no longer sustainable under the conditions in which they unexpectedly find themselves, so that they must scrap their old plans replacing them with completely new plans instead. In the latter case, the abandonment of plans that are no longer viable given disappointed expectations may cause other agents to conclude that the plans that they had expected to implement are no longer profitable and must be scrapped.

When agents whose price expectations have been disappointed respond with marginal adjustments in their existing plans rather than scrapping them and replacing them with new ones, a temporary equilibrium with disappointed expectations may still exist and that equilibrium may be reached through appropriate price adjustments in the markets for current delivery despite the divergent expectations of future prices held by agents. Operation of the price mechanism may still be able to achieve a reconciliation of revised but sub-optimal plans. The sub-optimal temporary equilibrium will be inferior to the allocation that would have resulted had agents all held correct expectations of future prices. Nevertheless, given a history of incorrect price expectations and misallocations of capital assets, labor, and other factors of production, a sub-optimal temporary equilibrium may be the best feasible outcome.

But here’s the problem. There is no guarantee that, when prices turn out to be very different from what they were expected to be, the excess demands of agents will adjust smoothly to changes in current prices. A plan that was optimal based on the expectation that the price of widgets would be $500 a unit may well be untenable at a price of $120 a unit. When realized prices are very different from what they had been expected to be, those price changes can lead to discontinuous adjustments, violating a basic assumption — the continuity of excess demand functions — necessary to prove the existence of an equilibrium. Once output prices reach some minimum threshold, the best response for some firms may be to shut down, the excess demand for the product produced by the firm becoming discontinuous at the that threshold price. The firms shutting down operations may be unable to repay loans they had obligated themselves to repay based on their disappointed price expectations. If ownership shares in firms forced to cease production are held by households that have predicated their consumption plans on prior borrowing and current repayment obligations, the ability of those households to fulfill their obligations may be compromised once those firms stop paying out the expected profit streams. Banks holding debts incurred by firms or households that borrowers cannot service may find that their own net worth is reduced sufficiently to make the banks’ own debt unreliable, potentially causing a breakdown in the payment system. Such effects are entirely consistent with a temporary-equilibrium model if actual prices turn out to be very different from what agents had expected and upon which they had constructed their future consumption and production plans.

Sufficiently large differences between expected and actual prices in a given period may result in discontinuities in excess demand functions once prices reach critical thresholds, thereby violating the standard continuity assumptions on which the existence of general equilibrium depends under the fixed-point theorems that are the lynchpin of modern existence proofs. C. J. Bliss made such an argument in a 1983 paper (“Consistent Temporary Equilibrium” in the volume Modern Macroeconomic Theory edited by  J. P. Fitoussi) in which he also suggested, as I did above, that the divergence of individual expectations implies that agents will not typically regard the debt issued by other agents as homogeneous. Bliss therefore posited the existence of a “Financier” who would subject the borrowing plans of prospective borrowers to an evaluation process to determine if the plan underlying the prospective loan sought by a borrower was likely to generate sufficient cash flow to enable the borrower to repay the loan. The role of the Financier is to ensure that the plans that firms choose are based on roughly similar expectations of future prices so that firms will not wind up acting on price expectations that must inevitably be disappointed.

I am unsure how to understand the function that Bliss’s Financier is supposed to perform. Presumably the Financier is meant as a kind of idealized companion to the Walrasian auctioneer rather than as a representation of an actual institution, but the resemblance between what the Financier is supposed to do and what bankers actually do is close enough to make it unclear to me why Bliss chose an obviously fictitious character to weed out business plans based on implausible price expectations rather than have the role filled by more realistic characters that do what their real-world counterparts are supposed to do. Perhaps Bliss’s implicit assumption is that real-world bankers do not constrain the expectations of prospective borrowers sufficiently to suggest that their evaluation of borrowers would increase the likelihood that a temporary equilibrium actually exists so that only an idealized central authority could impose sufficient consistency on the price expectations to make the existence of a temporary equilibrium likely.

But from the perspective of positive macroeconomic and business-cycle theory, explicitly introducing banks that simultaneously provide an economy with a medium of exchange – either based on convertibility into a real commodity or into a fiat base money issued by the monetary authority – while intermediating between ultimate borrowers and ultimate lenders seems to be a promising way of modeling a dynamic economy that sometimes may — and sometimes may not — function at or near a temporary equilibrium.

We observe economies operating in the real world that sometimes appear to be functioning, from a macroeconomic perspective, reasonably well with reasonably high employment, increasing per capita output and income, and reasonable price stability. At other times, these economies do not function well at all, with high unemployment and negative growth, sometimes with high rates of inflation or with deflation. Sometimes, these economies are beset with financial crises in which there is a general crisis of solvency, and even apparently solvent firms are unable to borrow. A macroeconomic model should be able to account in some way for the diversity of observed macroeconomic experience. The temporary equilibrium paradigm seems to offer a theoretical framework capable of accounting for this diversity of experience and for explaining at least in a very general way what accounts for the difference in outcomes: the degree of congruence between the price expectations of agents. When expectations are reasonably consistent, the economy is able to function at or near a temporary equilibrium which is likely to exist. When expectations are highly divergent, a temporary equilibrium may not exist, and even if it does, the economy may not be able to find its way toward the equilibrium. Price adjustments in current markets may be incapable of restoring equilibrium inasmuch as expectations of future prices must also adjust to equilibrate the economy, there being no market mechanism by which equilibrium price expectations can be adjusted or restored.

This, I think, is the insight underlying Axel Leijonhufvud’s idea of a corridor within which an economy tends to stay close to an equilibrium path. However if the economy drifts or is shocked away from its equilibrium time path, the stabilizing forces that tend to keep an economy within the corridor cease to operate at all or operate only weakly, so that the tendency for the economy to revert back to its equilibrium time path is either absent or disappointingly weak.

The temporary-equilibrium method, it seems to me, might have been a path that Hayek could have successfully taken in pursuing the goal he had set for himself early in his career: to reconcile equilibrium-analysis with a theory of business cycles. Why he ultimately chose not to take this path is a question that, for now at least, I will leave to others to try to answer.

Roy Radner and the Equilibrium of Plans, Prices and Price Expectations

In this post I want to discuss Roy Radner’s treatment of an equilibrium of plans, prices, and price expectations (EPPPE) and its relationship to Hayek’s conception of intertemporal equilibrium, of which Radner’s treatment is a technically more sophisticated version. Although I seen no evidence that Radner was directly influenced by Hayek’s work, I consider Radner’s conception of EPPPE to be a version of Hayek’s conception of intertemporal equilibrium, because it captures essential properties of Hayek’s conception of intertemporal equilibrium as a situation in which agents independently formulate their own optimizing plans based on the prices that they actually observe – their common knowledge – and on the future prices that they expect to observe over the course of their planning horizons. While currently observed prices are common knowledge – not necessarily a factual description of economic reality but not an entirely unreasonable simplifying assumption – the prices that individual agents expect to observe in the future are subjective knowledge based on whatever common or private knowledge individuals may have and whatever methods they may be using to form their expectations of the prices that will be observed in the future. An intertemporal equilibrium refers to a set of decentralized plans that are both a) optimal from the standpoint of every agent’s own objectives given their common knowledge of current prices and their subjective expectations of future prices and b) mutually consistent.

If an agent has chosen an optimal plan given current and expected future prices, that plan will not be changed unless the agent acquires new information that renders the existing plan sub-optimal relative to the new information. Otherwise, there would be no reason for the agent to deviate from an optimal plan. The new information that could cause an agent to change a formerly optimal plan would either affect the preferences of the agent, the technology available to the agent, or would somehow be reflected in current prices or in expected future prices. But it seems improbable that there could be a change in preferences or technology would not also be reflected in current or expected future prices. So absent a change in current or expected future prices, there would seem to be almost no likelihood that an agent would deviate from a plan that was optimal given current prices and the future prices expected by the agent.

The mutual consistency of the optimizing plans of independent agents therefore turns out to be equivalent to the condition that all agents observe the same current prices – their common knowledge – and have exactly the same forecasts of the future prices upon which they have relied in choosing their optimal plans. Even should their forecasts of future prices turn out to be wrong, at the moment before their forecasts of future prices were changed or disproved by observation, their plans were still mutually consistent relative to the information on which their plans had been chosen. The failure of the equilibrium to be maintained could be attributed to a change in information that meant that the formerly optimal plans were no longer optimal given the newly acquired information. But until the new information became available, the mutual consistency of optimal plans at that (fleeting) moment signified an equilibrium state. Thus, the defining characteristic of an intertemporal equilibrium in which current prices are common knowledge is that all agents share the same expectations of the future prices on which their optimal plans have been based.

There are fundamental differences between the Arrow-Debreu-McKenzie (ADM) equilibrium and the EPPPE. One difference worth mentioning is that, under the standard assumptions of the ADM model, the equilibrium is Pareto-optimal, and any Pareto-optimum allocation, by a suitable redistribution of initial endowments, could be achieved as a general equilibrium (two welfare theorems). These results do not generally hold for EPPPE, because, in contrast to the ADM model, it is possible for agents in EPPPE to acquire additional information over time, not only passively, but by investing resources in the production of information. Investing resources in the production of information can cause inefficiency in two ways: first, by creating non-convexities (owing to start-up costs in information gathering activities) that are inconsistent with the uniform competitive prices characteristic of the ADM equilibrium, and second, by creating incentives to devote resources to produce information whose value is derived from profits in trading with less well-informed agents. The latter source of inefficiency was discovered by Jack Hirshleifer in his classic 1971 paper, which I have written about in several previous posts (here, here, here, and here).

But the important feature of Radner’s EPPPE that I want to emphasize here — and what radically distinguishes it from the ADM equilibrium — is its fragility. Unlike the ADM equilibrium which is established once and forever at time zero of a model in which all production and consumption starts in period one, the EPPPE, even if it ever exists, is momentary, and is subject to unraveling whenever there is a change in the underlying information upon which current prices and expected future prices depend, and upon which agents, in choosing their optimal plans, rely. Time is not just, as it is in the ADM model, an appendage to the EPPPE, and, as a result, EPPPE can account for many phenomena, practices, and institutions that are left out of the ADM model.

The two differences that are most relevant in this context are the existence of stock markets in which shares of firms are traded based on expectations of the future net income streams associated with those firms, and the existence of a medium of exchange supplied by private financial intermediaries known as banks. In the ADM model in which all transactions are executed in time zero, in advance of all the actual consumption and production activities determined by those transactions, there would be no reason to hold, or to supply, a medium of exchange. The ADM equilibrium allows for agents to borrow or lend at equilibrium interest rates to optimize the time profiles of their consumption relative to their endowments and the time profiles of their earnings. Since all such transactions are consummated in time zero, and since, through some undefined process, the complete solvency and the integrity of all parties to all transactions is ascertained in time zero, the probability of a default on any loan contracted at time zero is zero. As a result, each agent faces a single intertemporal budget constraint at time zero over all periods from 1 to n. Walras’s Law therefore holds across all time periods for this intertemporal budget constraint, each agent transacting at the same prices in each period as every other agent does.

Once an equilibrium price vector is established in time zero, each agent knows that his optimal plan based on that price vector (which is the common knowledge of all agents) will be executed over time exactly as determined in time zero. There is no reason for any exchange of ownership shares in firms, the future income streams from each firm being known in advance.

The ADM equilibrium is a model of an economic process very different from Radner’s EPPPE, because in EPPPE, agents have no reason to assume that their current plans, even if they are momentarily both optimal and mutually consistent with the plans of all other agents, will remain optimal and consistent with the plans of all other agents. New information can arrive or be produced that will necessitate a revision in plans. Because even equilibrium plans are subject to revision, agents must take into account the solvency and credit worthiness of counterparties with whom they enter into transactions. The potentially imperfect credit-worthiness of at least some agents enables certain financial intermediaries (aka banks) to provide a service by offering to exchange their debt, which is widely considered to be more credit-worthy than the debt of ordinary agents, to agents seeking to borrow to finance purchases of either consumption or investment goods. Many agents seeking to borrow therefore prefer exchanging their debt for bank debt, bank debt being acceptable by other agents at face value. In addition, because the acquisition of new information is possible, there is a reason for agents to engage in speculative trades of commodities or assets. Such assets include ownership shares of firms, and agents may revise their valuations of those firms as they revise their expectations about future prices and their expectations about the revised plans of those firms in response to newly acquired information.

I will discuss the special role of banks at greater length in my next post on temporary equilibrium. But for now, I just want to underscore a key point: in the EPPE, unless all agents have the same expectations of future prices, Walras’s Law need not hold. The proof that Walras’s holds depends on the assumption that individual plans to buy and sell are based on the assumption that every agent buys or sells each commodity at the same price that every other transactor buys  or sells that commodity. But in the intertemporal context, in which only current, not future prices, are observed, plans for current and future prices are made based on expectations about future prices. If agents don’t share the same expectations about future prices, agents making plans for future purchases based on overly optimistic expectations about the prices at which they will be able to sell, may make commitments to buy in the future (or commitment to repay loans to finance purchases in the present) that they will be unable to discharge. Reneging on commitments to buy in the future or to repay obligations incurred in the present may rule out the existence of even a temporary equilibrium in the future.

Finally, let me add a word about Radner’s terminology. In his 1987 entry on “Uncertainty and General Equilibrium” for the New Palgrave Dictionary of Economics, (Here is a link to the revised version on line), Radner writes:

A trader’s expectations concern both future environmental events and future prices. Regarding expectations about future environmental events, there is no conceptual problem. According to the Expected Utility Hypothesis, each trader is characterized by a subjective probability measure on the set of complete histories of the environment. Since, by definition, the evolution of the environment is exogenous, a trader’s conditional probability of a future event, given the information to date, is well defined.

It is not so obvious how to proceed with regard to trader’s expectations about future prices. I shall contrast two possible approaches. In the first, which I shall call the perfect foresight approach, let us assume that the behaviour of traders is such as to determine, for each complete history of the environment, a unique corresponding sequence of price system[s]. . .

Thus, the perfect foresight approach implies that, in equilibrium, traders have common price expectation functions. These price expectation functions indicate, for each date-event pair, what the equilibrium price system would be in the corresponding market at that date event pair. . . . [I]t follows that, in equilibrium the traders would have strategies (plans) such that if these strategies were carried out, the markets would be cleared at each date-event pair. Call such plans consistent. A set of common price expectations and corresponding consistent plans is called an equilibrium of plans, prices, and price expectations.

My only problem with Radner’s formulation here is that he is defining his equilibrium concept in terms of the intrinsic capacity of the traders to predict prices rather the simple fact that traders form correct expectations. For purposes of the formal definition of EPPE, it is irrelevant whether traders predictions of future prices are correct because they are endowed with the correct model of the economy or because they are all lucky and randomly have happened simultaneously to form the same expectations of future prices. Radner also formulates an alternative version of his perfect-foresight approach in which agents don’t all share the same information. In such cases, it becomes possible for traders to make inferences about the environment by observing prices differ from what they had expected.

The situation in which traders enter the market with different non-price information presents an opportunity for agents to learn about the environment from prices, since current prices reflect, in a possibly complicated manner, the non-price information signals received by the various agents. To take an extreme example, the “inside information” of a trader in a securities market may lead him to bid up the price to a level higher than it otherwise would have been. . . . [A]n astute market observer might be able to infer that an insider has obtained some favourable information, just by careful observation of the price movement.

The ability to infer non-price information from otherwise inexplicable movements in prices leads Radner to define a concept of rational expectations equilibrium.

[E]conomic agents have the opportunity to revise their individual models in the light of observations and published data. Hence, there is a feedback from the true relationship to the individual models. An equilibrium of this system, in which the individual models are identical with the true model, is called a rational expectations equilibrium. This concept of equilibrium is more subtle, of course, that the ordinary concept of equilibrium of supply and demand. In a rational expectations equilibrium, not only are prices determined so as to equate supply and demand, but individual economic agents correctly perceive the true relationship between the non-price information received by the market participants and the resulting equilibrium market prices.

Though this discussion is very interesting from several theoretical angles, as an explanation of what is entailed by an economic equilibrium, it misses the key point, which is the one that Hayek identified in his 1928 and (especially) 1937 articles mentioned in my previous posts. An equilibrium corresponds to a situation in which all agents have identical expectations of the future prices upon which they are making optimal plans given the commonly observed current prices and the expected future prices. If all agents are indeed formulating optimal plans based on the information that they have at that moment, their plans will be mutually consistent and will be executable simultaneously without revision as long as the state of their knowledge at that instant does not change. How it happened that they arrived at identical expectations — by luck chance or supernatural powers of foresight — is irrelevant to that definition of equilibrium. Radner does acknowledge that, under the perfect-foresight approach, he is endowing economic agents with a wildly unrealistic powers of imagination and computational capacity, but from his exposition, I am unable to decide whether he grasped the subtle but crucial point about the irrelevance of an assumption about the capacities of agents to the definition of EPPPE.

Although it is capable of describing a richer set of institutions and behavior than is the Arrow-Debreu model, the perfect-foresight approach is contrary to the spirit of much of competitive market theory in that it postulates that individual traders must be able to forecast, in some sense, the equilibrium prices that will prevail in the future under all alternative states of the environment. . . .[T]his approach . . . seems to require of the traders a capacity for imagination and computation far beyond what is realistic. . . .

These last considerations lead us in a different direction, which I shall call the bounded rationality approach. . . . An example of the bounded-rationality approach is the theory of temporary equilibrium.

By eschewing any claims about the rationality of the agents or their computational powers, one can simply talk about whether agents do or do not have identical expectations of future prices and what the implications of those assumptions are. When expectations do agree, there is at least a momentary equilibrium of plans, prices and price expectations. When they don’t agree, the question becomes whether even a temporary equilibrium exists and what kind of dynamic process is implied by the divergence of expectations. That it seems to me would be a fruitful way forward for macroeconomics to follow. In my next post, I will discuss some of the characteristics and implications of a temporary-equilibrium approach to macroeconomics.


Correct Foresight, Perfect Foresight, and Intertemporal Equilibrium

In my previous post, I discussed Hayek’s path-breaking insight into the meaning of intertemporal equilibrium. His breakthrough was to see that an equilibrium can be understood not as a stationary state in which nothing changes, but as a state in which decentralized plans are both optimal from the point of view of the individuals formulating the plans and mutually consistent, so that the individually optimal plans, at least potentially, could be simultaneously executed. In the simple one-period model, the plans of individuals extending over a single-period time horizon are constrained by the necessary equality for each agent between the value of all planned purchases and the value of all planned sales in that period. A single-period or stationary equilibrium, if it exists, is characterized by a set of prices such that the optimal plans corresponding to that set of prices such that total amount demanded for each product equals the total amount supplied for each product. Thus, an equilibrium price vector has the property that every individual is choosing optimally based on the choice criteria and the constraints governing the decisions for each individual and that those individually optimal choices are mutually consistent, that mutual consistency being manifested in the equality of the total amount demanded and the total amount supplied of each product in that single period.

The problem posed by the concept of intertemporal equilibrium is how to generalize the single-period notion of an equilibrium as a vector of all the observed prices of goods and services actually traded in that single period into a multi-period concept in which the prices on which optimal choices depend include both the actual prices of goods traded in the current period as well as the prices of goods and services that agents plan to buy or sell only in some future time period. In an intertemporal context, the prices on the basis of which optimal plans are chosen cannot be just those prices at which transactions are being executed in the current period; the relevant set of prices must also include those prices at which transactions already being planned in the current period will be executed. Because even choices about transactions today may depend on the prices at which future transactions will take place, future prices can affect not only future demands and supplies they can also affect current demands and supplies.

But because prices in future periods are typically not observable by individuals in the present, it is not observed — but expected — future prices on the basis of which individual agents are making the optimal choices reflected in their intertemporal plans. And insofar as optimal plans depend on expected future prices, those optimal plans can be mutually consistent only if they are based on the same expected future prices, because if their choices are based on different expected future prices, then it is not possible that all expectations are realized. If the expectations of at least one agent, and probably of many agents, will be disappointed, implying that the plans of at least one and probably of many agents will not be optimized and will have to be revised.

The recognition that the mutual consistency of optimal plans requires individuals to accurately foresee the future prices upon which their optimal choices are based suggested that individual agents must be endowed with remarkable capacities to foresee the future. To assume that all individual agents would be endowed with the extraordinary ability to foresee correctly all the future prices relevant to their optimal choices about their intertemporal plans seemed an exceedingly unrealistic assumption on which to premise an economic model.

This dismissive attitude toward the concept of intertemporal equilibrium and the seemingly related assumption of “perfect foresight” necessary for an intertemporal equilibrium to exist was stridently expressed by Oskar Morgenstern in his famous 1935 article “Perfect Foresight and Economic Equilibrium.”

The impossibly high claims which are attributed to the intellectual efficiency of the economic subject immediately indicate that there are included in this equilibrium system not ordinary men, but rather, at least to one another, exactly equal demi-gods, in case the claim of complete foresight is fulfilled. If this is the case, there is, of course, nothing more to be done. If “full” or “perfect” foresight is to provide the basis of the theory of equilibrium in the strictly specified sense, and in the meaning obviously intended by the economic authors, then, a completely meaningless assumption is being considered. If limitations are introduced in such a way that the perfection of foresight is not reached, then these limitations are to be stated very precisely. They would have to be so narrowly drawn that the fundamental aim of producing ostensibly full rationality of the system by means of high, de facto unlimited, foresight, would be lost. For the theoretical economist, there is no way out of this dilemma. ln this discussion, “full” and “perfect” foresight are not only used synonymously, but both are employed, moreover, in the essentialIy more exact sense of limitlessness. This expression would have to be preferred because with the words “perfect” or “imperfect”, there arise superficial valuations which play no role here at all.

Morgenstern then went on to make an even more powerful attack on the idea of perfect foresight: that the idea is itself self-contradictory. Interestingly, he did so by positing an example that would figure in Morgenstern’s later development of game theory with his collaborator John von Neumann (and, as we now know, with his research assistant who in fact was his mathematical guide and mentor, Abraham Wald, fcredited as a co-author of The Theory of Games and Economic Behavior).

Sherlock Holmes, pursued by his opponent, Moriarity, leaves London for Dover. The train stops at a station on the way, and he alights there rather than traveling on to Dover. He has seen Moriarity at the railway station, recognizes that he is very clever and expects that Moriarity will take a faster special train in order to catch him in Dover. Holmes’ anticipation turns out to be correct. But what if Moriarity had been still more clever, had estimated Holmes’ mental abilities better and had foreseen his actions accordingly? Then, obviously, he would have traveled to the intermediate station. Holmes, again, would have had to calculate that, and he himself would have decided to go on to Dover. Whereupon, Moriarity would again have “reacted” differently. Because of so much thinking they might not have been able to act at all or the intellectually weaker of the two would have surrendered to the other in the Victoria Station, since the whole flight would have become unnecessary. Examples of this kind can be drawn from everywhere. However, chess, strategy, etc. presuppose expert knowledge, which encumbers the example unnecessarily.

One may be easily convinced that here lies an insoluble paradox. And the situation is not improved, but, rather, greatly aggravated if we assume that more than two individuals-as, for example, is the case with exchange-are brought together into a position, which would correspond to the one brought forward here. Always, there is exhibited an endless chain of reciprocally conjectural reactions and counter-reactions. This chain can never be broken by an act of knowledge but always only through an arbitrary act-a resolution. This resolution, again, would have to be foreseen by the two or more persons concerned. The paradox still remains no matter how one attempts to twist or turn things around. Unlimited foresight and economic equilibrium are thus irreconcilable with one another. But can equilibrium really take place with a faulty, heterogeneous foresight, however, it may be disposed? This is the question which arises at once when an answer is sought. One can even say this: has foresight been truly introduced at all into the consideration of equilibrium, or, rather, does not the theorem of equilibrium generally stand in no proven connection with the assumptions about foresight, so that a false assumption is being considered?

As Carlo Zappia has shown, it was probably Morgenstern’s attack on the notion of intertemporal equilibrium and perfect foresight that led Hayek to his classic restatement of the idea in his 1937 paper “Economics and Knowledge.” The point that Hayek clarified in his 1937 version, but had not been clear in his earlier expositions of the concept, is that correct foresight is not an assumption from which the existence of an intertemporal equilibrium can be causally deduced; there is no assertion that a state of equilibrium is the result of correct foresight. Rather, correct foresight is the characteristic that defines what is meant when the term “intertemporal equilibrium” is used in economic theory. Morgenstern’s conceptual error was to mistake a tautological statement about what would have to be true if an intertemporal equilibrium were to obtain for a causal statement about what conditions would bring an intertemporal equilibrium into existence.

The idea of correct foresight does not attribute any special powers to the economic agents who might under hypothetical circumstances possess correct expectations of future prices. The term is not meant to be a description of an actual state of affairs, but a description of what would have to be true for a state of affairs to be an equilibrium state of affairs.

As an aside, I would simply mention that many years ago when I met Hayek and had the opportunity to ask him about his 1937 paper and his role in developing the concept of intertemporal equilibrium, he brought my attention to his 1928 paper in which he first described an intertemporal equilibrium as state of affairs in which agents had correct expectations about future prices. My recollection of that conversation is unfortunately rather vague, but I do remember that he expressed some regret for not having had the paper translated into English, which would have established his priority in articulating the intertemporal equilibrium concept. My recollection is that the reason he gave for not having had the paper translated into English was that there was something about the paper about which he felt dissatisfied, but I can no longer remember what it was that he said he was dissatisfied with. However, I would now be inclined to conjecture that he was dissatisfied with not having disambiguated, as he did in the 1937 paper, between correct foresight as a defining characteristic of what intertemporal equilibrium means versus perfect foresight as the cause that brings intertemporal equilibruim into existence.

It is also interesting to note that the subsequent development of game theory in which Morgenstern played a not insubstantial role, shows that under a probabilistic interpretation of the interaction between Holmes and Moriarity, there could be an optimal mixed strategy that would provide an equilibrium solution of repeated Holmes-Moriarity interactions. But if the interaction is treated as a single non-repeatable event with no mixed strategy available to either party, the correct interpretation of the interaction is certainly that there is no equilibrium solution to the interaction. If there is no equilibrium solution, then it is precisely the absence of an equilibrium solution that implies the impossibility of correct foresight, correct foresight and the existence of an equilibrium being logically equivalent concepts.

A Draft of my Paper on Rules versus Discretion Is Now Available on SSRN

My paper “Rules versus Discretion in Monetary Policy Historically Contemplated” which I spoke about last September at the Mercatus Center Conference on rules for a post-crisis world has been accepted by the Journal of Macroeconomics. I posted a draft of the concluding section of the paper on this blog several weeks ago. An abstract, and a complete draft, of the paper are available on the journal website, but only the abstract is ungated.

I have posted a draft of the paper on SSRN where it may now be downloaded. Here is the abstract of the paper.

Monetary-policy rules are attempts to cope with the implications of having a medium of exchange whose value exceeds its cost of production. Two classes of monetary rules can be identified: (1) price rules that target the value of money in terms of a real commodity, e.g., gold, or in terms of some index of prices, and (2) quantity rules that target the quantity of money in circulation. Historically, price rules, e.g. the gold standard, have predominated, but the Bank Charter Act of 1844 imposed a quantity rule as an adjunct to the gold standard, because the gold standard had performed unsatisfactorily after being restored in Britain at the close of the Napoleonic Wars. A quantity rule was not proposed independently of a price rule until Henry Simons proposed a constant money supply consisting of government-issued fiat currency and deposits issued by banks operating on a 100-percent reserve basis. Simons argued that such a plan would be ideal if it could be implemented because it would deprive the monetary authority of any discretionary decision-making power. Nevertheless, Simons concluded that such a plan was impractical and supported a price rule to stabilized the price level. Simons’s student Milton Friedman revived Simons’s argument against discretion and modified Simons plan for 100-percent reserve banking and a constant money supply into his k-percent rule for monetary growth. This paper examines the doctrinal and ideological origins and background that lay behind the rules versus discretion distinction.

Hayek and Intertemporal Equilibrium

I am starting to write a paper on Hayek and intertemporal equilibrium, and as I write it over the next couple of weeks, I am going to post sections of it on this blog. Comments from readers will be even more welcome than usual, and I will do my utmost to reply to comments, a goal that, I am sorry to say, I have not been living up to in my recent posts.

The idea of equilibrium is an essential concept in economics. It is an essential concept in other sciences as well, its meaning in economics is not the same as in other disciplines. The concept having originally been borrowed from physics, the meaning originally attached to it by economists corresponded to the notion of a system at rest, and it took a long time for economists to see that viewing an economy as a system at rest was not the only, or even the most useful, way of applying the equilibrium concept to economic phenomena.

What would it mean for an economic system to be at rest? The obvious answer was to say that prices and quantities would not change. If supply equals demand in every market, and if there no exogenous change introduced into the system, e.g., in population, technology, tastes, etc., it would seem that would be no reason for the prices paid and quantities produced to change in that system. But that view of an economic system was a very restrictive one, because such a large share of economic activity – savings and investment — is predicated on the assumption and expectation of change.

The model of a stationary economy at rest in which all economic activity simply repeats what has already happened before did not seem very satisfying or informative, but that was the view of equilibrium that originally took hold in economics. The idea of a stationary timeless equilibrium can be traced back to the classical economists, especially Ricardo and Mill who wrote about the long-run tendency of an economic system toward a stationary state. But it was the introduction by Jevons, Menger, Walras and their followers of the idea of optimizing decisions by rational consumers and producers that provided the key insight for a more robust and fruitful version of the equilibrium concept.

If each economic agent (household or business firm) is viewed as making optimal choices based on some scale of preferences subject to limitations or constraints imposed by their capacities, endowments, technology and the legal system, then the equilibrium of an economy must describe a state in which each agent, given his own subjective ranking of the feasible alternatives, is making a optimal decision, and those optimal decisions are consistent with those of all other agents. The optimal decisions of each agent must simultaneously be optimal from the point of view of that agent while also being consistent, or compatible, with the optimal decisions of every other agent. In other words, the decisions of all buyers of how much to purchase must be consistent with the decisions of all sellers of how much to sell.

The idea of an equilibrium as a set of independently conceived, mutually consistent optimal plans was latent in the earlier notions of equilibrium, but it could not be articulated until a concept of optimality had been defined. That concept was utility maximization and it was further extended to include the ideas of cost minimization and profit maximization. Once the idea of an optimal plan was worked out, the necessary conditions for the mutual consistency of optimal plans could be articulated as the necessary conditions for a general economic equilibrium. Once equilibrium was defined as the consistency of optimal plans, the path was clear to define an intertemporal equilibrium as the consistency of optimal plans extending over time. Because current goods and services and otherwise identical goods and services in the future could be treated as economically distinct goods and services, defining the conditions for an intertemporal equilibrium was formally almost equivalent to defining the conditions for a static, stationary equilibrium. Just as the conditions for a static equilibrium could be stated in terms of equalities between marginal rates of substitution of goods in consumption and in production to their corresponding price ratios, an intertemporal equilibrium could be stated in terms of equalities between the marginal rates of intertemporal substitution in consumption and in production and their corresponding intertemporal price ratios.

The only formal adjustment required in the necessary conditions for static equilibrium to be extended to intertemporal equilibrium was to recognize that, inasmuch as future prices (typically) are unobservable, and hence unknown to economic agents, the intertemporal price ratios cannot be ratios between actual current prices and actual future prices, but, instead, ratios between current prices and expected future prices. From this it followed that for optimal plans to be mutually consistent, all economic agents must have the same expectations of the future prices in terms of which their plans were optimized.

The concept of an intertemporal equilibrium was first presented in English by F. A. Hayek in his 1937 article “Economics and Knowledge.” But it was through J. R. Hicks’s Value and Capital published two years later in 1939 that the concept became more widely known and understood. In explaining and applying the concept of intertemporal equilibrium and introducing the derivative concept of a temporary equilibrium in which current markets clear, but individual expectations of future prices are not the same, Hicks did not claim originality, but instead of crediting Hayek for the concept, or even mentioning Hayek’s 1937 paper, Hicks credited the Swedish economist Erik Lindahl, who had published articles in the early 1930s in which he had articulated the concept. But although Lindahl had published his important work on intertemporal equilibrium before Hayek’s 1937 article, Hayek had already explained the concept in a 1928 article “Das intertemporale Gleichgewichtasystem der Priese und die Bewegungen des ‘Geltwertes.'” (English translation: “Intertemporal price equilibrium and movements in the value of money.“)

Having been a junior colleague of Hayek’s in the early 1930s when Hayek arrived at the London School of Economics, and having come very much under Hayek’s influence for a few years before moving in a different theoretical direction in the mid-1930s, Hicks was certainly aware of Hayek’s work on intertemporal equilibrium, so it has long been a puzzle to me why Hicks did not credit Hayek along with Lindahl for having developed the concept of intertemporal equilibrium. It might be worth pursuing that question, but I mention it now only as an aside, in the hope that someone else might find it interesting and worthwhile to try to find a solution to that puzzle. As a further aside, I will mention that Murray Milgate in a 1979 article “On the Origin of the Notion of ‘Intertemporal Equilibrium’” has previously tried to redress the failure to credit Hayek’s role in introducing the concept of intertemporal equilibrium into economic theory.

What I am going to discuss in here and in future posts are three distinct ways in which the concept of intertemporal equilibrium has been developed since Hayek’s early work – his 1928 and 1937 articles but also his 1941 discussion of intertemporal equilibrium in The Pure Theory of Capital. Of course, the best known development of the concept of intertemporal equilibrium is the Arrow-Debreu-McKenzie (ADM) general-equilibrium model. But although it can be thought of as a model of intertemporal equilibrium, the ADM model is set up in such a way that all economic decisions are taken before the clock even starts ticking; the transactions that are executed once the clock does start simply follow a pre-determined script. In the ADM model, the passage of time is a triviality, merely a way of recording the sequential order of the predetermined production and consumption activities. This feat is accomplished by assuming that all agents are present at time zero with their property endowments in hand and capable of transacting – but conditional on the determination of an equilibrium price vector that allows all optimal plans to be simultaneously executed over the entire duration of the model — in a complete set of markets (including state-contingent markets covering the entire range of contingent events that will unfold in the course of time whose outcomes could affect the wealth or well-being of any agent with the probabilities associated with every contingent event known in advance).

Just as identical goods in different physical locations or different time periods can be distinguished as different commodities that cn be purchased at different prices for delivery at specific times and places, identical goods can be distinguished under different states of the world (ice cream on July 4, 2017 in Washington DC at 2pm only if the temperature is greater than 90 degrees). Given the complete set of state-contingent markets and the known probabilities of the contingent events, an equilibrium price vector for the complete set of markets would give rise to optimal trades reallocating the risks associated with future contingent events and to an optimal allocation of resources over time. Although the ADM model is an intertemporal model only in a limited sense, it does provide an ideal benchmark describing the characteristics of a set of mutually consistent optimal plans.

The seminal work of Roy Radner in relaxing some of the extreme assumptions of the ADM model puts Hayek’s contribution to the understanding of the necessary conditions for an intertemporal equilibrium into proper perspective. At an informal level, Hayek was addressing the same kinds of problems that Radner analyzed with far more powerful analytical tools than were available to Hayek. But the were both concerned with a common problem: under what conditions could an economy with an incomplete set of markets be said to be in a state of intertemporal equilibrium? In an economy lacking the full set of forward and state contingent markets describing the ADM model, intertemporal equilibrium cannot predetermined before trading even begins, but must, if such an equilibrium obtains, unfold through the passage of time. Outcomes might be expected, but they would not be predetermined in advance. Echoing Hayek, though to my knowledge he does not refer to Hayek in his work, Radner describes his intertemporal equilibrium under uncertainty as an equilibrium of plans, prices, and price expectations. Even if it exists, the Radner equilibrium is not the same as the ADM equilibrium, because without a full set of markets, agents can’t fully hedge against, or insure, all the risks to which they are exposed. The distinction between ex ante and ex post is not eliminated in the Radner equilibrium, though it is eliminated in the ADM equilibrium.

Additionally, because all trades in the ADM model have been executed before “time” begins, it seems impossible to rationalize holding any asset whose only use is to serve as a medium of exchange. In his early writings on business cycles, e.g., Monetary Theory and the Trade Cycle, Hayek questioned whether it would be possible to rationalize the holding of money in the context of a model of full equilibrium, suggesting that monetary exchange, by severing the link between aggregate supply and aggregate demand characteristic of a barter economy as described by Say’s Law, was the source of systematic deviations from the intertemporal equilibrium corresponding to the solution of a system of Walrasian equations. Hayek suggested that progress in analyzing economic fluctuations would be possible only if the Walrasian equilibrium method could be somehow be extended to accommodate the existence of money, uncertainty, and other characteristics of the real world while maintaining the analytical discipline imposed by the equilibrium method and the optimization principle. It proved to be a task requiring resources that were beyond those at Hayek’s, or probably anyone else’s, disposal at the time. But it would be wrong to fault Hayek for having had to insight to perceive and frame a problem that was beyond his capacity to solve. What he may be criticized for is mistakenly believing that he he had in fact grasped the general outlines of a solution when in fact he had only perceived some aspects of the solution and offering seriously inappropriate policy recommendations based on that seriously incomplete understanding.

In Value and Capital, Hicks also expressed doubts whether it would be possible to analyze the economic fluctuations characterizing the business cycle using a model of pure intertemporal equilibrium. He proposed an alternative approach for analyzing fluctuations which he called the method of temporary equilibrium. The essence of the temporary-equilibrium method is to analyze the behavior of an economy under the assumption that all markets for current delivery clear (in some not entirely clear sense of the term “clear”) while understanding that demand and supply in current markets depend not only on current prices but also upon expected future prices, and that the failure of current prices to equal what they had been expected to be is a potential cause for the plans that economic agents are trying to execute to be modified and possibly abandoned. In the Pure Theory of Capital, Hayek discussed Hicks’s temporary-equilibrium method a possible method of achieving the modification in the Walrasian method that he himself had proposed in Monetary Theory and the Trade Cycle. But after a brief critical discussion of the method, he dismissed it for reasons that remain obscure. Hayek’s rejection of the temporary-equilibrium method seems in retrospect to have been one of Hayek’s worst theoretical — or perhaps, meta-theoretical — blunders.

Decades later, C. J. Bliss developed the concept of temporary equilibrium to show that temporary equilibrium method can rationalize both holding an asset purely for its services as a medium of exchange and the existence of financial intermediaries (private banks) that supply financial assets held exclusively to serve as a medium of exchange. In such a temporary-equilibrium model with financial intermediaries, it seems possible to model not only the existence of private suppliers of a medium of exchange, but also the conditions – in a very general sense — under which the system of financial intermediaries breaks down. The key variable of course is vectors of expected prices subject to which the plans of individual households, business firms, and financial intermediaries are optimized. The critical point that emerges from Bliss’s analysis is that there are sets of expected prices, which if held by agents, are inconsistent with the existence of even a temporary equilibrium. Thus price flexibility in current market cannot, in principle, result in even a temporary equilibrium, because there is no price vector of current price in markets for present delivery that solves the temporary-equilibrium system. Even perfect price flexibility doesn’t lead to equilibrium if the equilibrium does not exist. And the equilibrium cannot exist if price expectations are in some sense “too far out of whack.”

Expected prices are thus, necessarily, equilibrating variables. But there is no economic mechanism that tends to cause the adjustment of expected prices so that they are consistent with the existence of even a temporary equilibrium, much less a full equilibrium.

Unfortunately, modern macroeconomics continues to neglect the temporary-equilibrium method; instead macroeconomists have for the most part insisted on the adoption of the rational-expectations hypothesis, a hypothesis that elevates question-begging to the status of a fundamental axiom of rationality. The crucial error in the rational-expectations hypothesis was to misunderstand the role of the comparative-statics method developed by Samuelson in The Foundations of Economic Analysis. The role of the comparative-statics method is to isolate the pure theoretical effect of a parameter change under a ceteris-paribus assumption. Such an effect could be derived only by comparing two equilibria under the assumption of a locally unique and stable equilibrium before and after the parameter change. But the method of comparative statics is completely inappropriate to most macroeconomic problems which are precisely concerned with the failure of the economy to achieve, or even to approximate, the unique and stable equilibrium state posited by the comparative-statics method.

Moreover, the original empirical application of the rational-expectations hypothesis by Muth was in the context of the behavior of a single market in which the market was dominated by well-informed specialists who could be presumed to have well-founded expectations of future prices conditional on a relatively stable economic environment. Under conditions of macroeconomic instability, there is good reason to doubt that the accumulated knowledge and experience of market participants would enable agents to form accurate expectations of the future course of prices even in those markets about which they expert knowledge. Insofar as the rational expectations hypothesis has any claim to empirical relevance it is only in the context of stable market situations that can be assumed to be already operating in the neighborhood of an equilibrium. For the kinds of problems that macroeconomists are really trying to answer that assumption is neither relevant nor appropriate.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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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