Why The Wall Street Journal Editorial Page is a Disgrace

In view of today’s absurdly self-righteous statement by the Wall Street Journal editorial board, I thought it would be a good idea to update one of my first posts (almost nine years ago) on this blog. Plus ca change plus c’est la meme chose; just gets worse and worse even with only occasional contributions by the estimable Mr. Stephen Moore.

Stephen Moore has the dubious honor of being a member of the editorial board of The Wall Street Journal.  He lives up (or down) to that honor by imparting his wisdom from time to time in signed columns appearing on the Journal’s editorial page. His contribution in today’s Journal (“Why Americans Hate Economics”) is noteworthy for typifying the sad decline of the Journal’s editorial page into a self-parody of obnoxious, philistine anti-intellectualism.

Mr. Moore begins by repeating a joke once told by Professor Christina Romer, formerly President Obama’s chief economist, now on the economics department at the University of California at Berkeley. The joke, not really that funny, is that there are two kinds of students:  those who hate economics and those who really hate economics.  Professor Romer apparently told the joke to explain that it’s not true. Mr. Moore repeats it to explain why he thinks it really is. Why does he? Let Mr. Moore speak for himself:  “Because too often economic theories defy common sense.” That’s it in a nutshell for Mr. Moore:  common sense — the ultimate standard of truth.

So what’s that you say, Galileo? The sun is stationary and the earth travels around it? You must be kidding! Why any child can tell you that the sun rises in the east and moves across the sky every day and then travels beneath the earth at night to reappear in the east the next morning. And you expect anyone in his right mind to believe otherwise. What? It’s the earth rotating on its axis? Are you possessed of demons? And you say that the earth is round? If the earth were round, how could anybody stand at the bottom of the earth and not fall off? Galileo, you are a raving lunatic. And you, Mr. Einstein, you say that there is something called a space-time continuum, so that time slows down as the speed one travels approaches the speed of light. My God, where could you have come up with such an idea?  By that reasoning, two people could not agree on which of two events happened first if one of them was stationary and the other traveling at half the speed of light.  Away with you, and don’t ever dare speak such nonsense again, or, by God, you shall be really, really sorry.

The point of course is not to disregard common sense–that would not be very intelligent–but to recognize that common sense isn’t enough. Sometimes things are not what they seem – the earth, Mr. Moore, is not flat – and our common sense has to be trained to correspond with a reality that can only be discerned by the intensive application of our reasoning powers, in other words, by thinking harder about what the world is really like than just accepting what common sense seems to be telling us. But once you recognize that common sense has its limitations, the snide populist sneers–the stock-in-trade of the Journal editorial page–mocking economists with degrees from elite universities in which Mr. Moore likes to indulge are exposed for what they are:  the puerile defensiveness of those unwilling to do the hard thinking required to push back the frontiers of their own ignorance.

In today’s column, Mr. Moore directs his ridicule at a number of Keynesian nostrums that I would not necessarily subscribe to, at least not without significant qualification. But Keynesian ideas are also rooted in certain common-sense notions, for example, the idea that income and expenditure are mutually interdependent, the income of one person being derived from the expenditure of another. So when Mr. Moore simply dismisses as “nonsensical” the idea that extending unemployment insurance to keep the unemployed from having to stop spending, he is in fact rejecting an idea that is no less grounded in common sense than the idea that paying people not to work discourages work. The problem is that our common sense cuts in both directions. Mr. Moore likes one and wants to ignore the other.

What we would like economists–even those unfortunate enough to have graduated from an elite university–to tell us is which effect is stronger or, perhaps, when is one effect stronger and when is the other stronger. But all that would be too complicated and messy for Mr. Moore’s–and the Journal‘s–cartoonish view of the world.

In that cartoonish view, the problem is that good old Adam Smith of “invisible hand” fame and his virtuous economic doctrines supporting free enterprise got tossed aside when the dastardly Keynes invented “macroeconomics” in the 1930s. And here is Mr. Moore’s understanding of macroeconomics.

Macroeconomics simply took basic laws of economics we know to be true for the firm or family –i.e., that demand curves are downward-sloping; that when you tax something, you get less of it; that debts have to be repaid—and turned them on their head as national policy.

Simple, isn’t it? The economics of Adam Smith (the microeconomics of firm and family) is good because it is based on common sense; the macroeconomics of Keynes is bad because it turns common sense on its head. Now I don’t know how much Mr. Moore knows about economics other than that demand curves are downward-sloping, but perhaps he has heard of, or even studied, the law of comparative advantage.

The law of comparative advantage says, in one of its formulations, that even if a country is less productive (because of, say, backward technology or a poor endowment of natural resources) than other countries in producing every single product that it produces, it would still have a lower cost of production in at least one of those products, and could profitably export that product (or those products) in international markets in sufficient amounts to pay for its imports of other products. If there is a less common-sensical notion than that in all of macroeconomics, indeed in any scientific discipline, I would like to hear about it. And trust me as a former university teacher of economics, there is no proposition in economics that students hate more or find harder to reconcile with their notions of common sense than the law of comparative advantage. Indeed, even most students who can correctly answer an exam question about comparative advantage don’t believe a word of what they wrote. The only students who actually do believe it are the ones who become economists.

But the law of comparative advantage is logically unassailable; you might as well try to disprove “two plus two equals four.” So, no, Mr. Moore, you don’t know why Americans hate economics, not unless, by Americans you mean that (one hopes small) group of individuals who happen to think exactly the same way as does the editorial board of The Wall Street Journal.

What’s Right and not so Right with Modern Monetary Theory

I am finishing up a first draft of a paper on fiat money, bitcoins and cryptocurrencies that will be included in a forthcoming volume on bitcoins and cryptocurrencies. The paper is loosely based on a number of posts that have appeared on this blog since I started blogging almost nine years ago. My first post appeared on July 5, 2011. Here are some of my posts on and fiat money, bitcoins and cryptocurrencies (this, this, this, and this). In writing the paper, it occurred to me that it might be worthwhile to include a comment on Modern Monetary Theory inasmuch as the proposition that the value of fiat money is derived from the acceptability of fiat money for discharging the tax liabilities imposed by the governments issuing those fiat moneys, which is a proposition that Modern Monetary Theorists have adopted from the chartalist school of thought associated with the work of G. F. Knapp. But there were clearly other economists before and since Knapp that have offered roughly the same explanation for the positive value of fiat money that offers no real non-monetary services to those holding such moneys. Here is the section from my draft about Modern Monetary Theory.

Although there’s a long line of prominent economic theorists who have recognized that acceptability of a fiat money for discharging tax liabilities, the proposition is now generally associated with the chartalist views of G. F. Knapp, whose views have been explicitly cited in recent works by economists associated with what is known as Modern Monetary Theory (MMT). While the capacity of fiat money to discharge tax liabilities is surely an important aspect of MMT, not all propositions associated with MMT automatically follow from that premise. Recognizing the role of the capacity of fiat money to discharge tax liabilities, Knapp juxtaposed his “state theory of money” from the metallist theory. The latter holds that the institution of money evolved from barter trade, because certain valuable commodities, especially precious metals became widely used as media of exchange, because, for whatever reason, they were readily accepted in exchange, thereby triggering the self-reinforcing network effects discussed above.[1]

However, the often bitter debates between chartalists and metallists notwithstanding, there is no necessary, or logical, inconsistency between the theories. Both theories about the origin of money could be simultaneously true, each under different historical conditions. Each theory posits an explanation for why a monetary instrument providing no direct service is readily accepted in exchange. That one explanation could be true does not entail the falsity of the other.

Taking chartalism as its theoretical foundation, MMT focuses on a set of accounting identities that are presumed to embody deep structural relationships. Because money is regarded as the creature of the state, the quantity of money is said to reflect the cumulative difference between government tax revenues and expenditures which are financed by issuing fiat money. The role of government bonds is to provide a buffer with which short-term fluctuations in the inflow of taxes (recurrently peaking at particular times of the year when tax payments become due) and government expenditures.

But the problem with MMT, shared with many other sorts of monetary theory, is that it focuses on a particular causal relationship, working through the implications of that relationship conditioned on a ceteris-paribus assumption that all other relationships are held constant and are unaffected by the changes on which the theory is focusing, regardless of whether the assumption can be maintained.

For example, MMT posits that increases in taxes are deflationary and reductions in taxes are inflationary, because an increase in taxes implies a net drain of purchasing power from the private sector to the government sector and a reduction in taxes implies an injection of purchasing power.[2] According to the MMT, the price level reflects the relationship between total spending and total available productive resources, At given current prices, some level of total spending would just suffice to ensure that all available resources are fully employed. If total spending exceeds that amount, the excess spending must cause prices to rise to absorb the extra spending.

This naïve theory of inflation captures a basic intuition about the effect of increasing the rate of spending, but it is not a complete theory of inflation, because the level of spending depends not only on how much the government spends and how much tax revenue it collects; it also depends on, among other things, whether the public is trying to add to, or to reduce, the quantity of cash balances being held. Now it’s true that an efficiently operating banking system tends to adjust the quantity of cash to the demands of the public, but the banking system also has demands for the reserves that the government, via the central bank, makes available to be held, and its demands to hold reserves may match, or fall short of, the amount that banks at any moment wish to hold.

There is an interbank system of reserves, but if the amount of reserves that the government central bank creates is systematically above the amount of reserves that banks wish to hold, the deficiency will have repercussions on total spending. MMT theorists insist that the government central bank is obligated to provide whatever quantity of reserves is demanded, but that’s because the demand of banks to hold reserves is a function of the foregone interest incurred by banks holding reserves. Given the cost of holding reserves implied by the interest-rate target established by the government central bank, the banking system will demand a corresponding quantity of reserves, and, at that interest rate, government central banks will supply all the reserves demanded. But that doesn’t mean that, in setting its target rate, the government central bank isn’t implicitly determining the quantity of reserves for the entire system, thereby exercising an independent influence on the price level or the rate of inflation that must be reconciled with the fiscal stance of the government.

A tendency toward oversimplification is hardly unique to MMT. It’s also characteristic of older schools of thought, like the metallist theory of money, the polar opposite from the MMT and the chartalist theory. The metallist theory asserts that the value of a metallic money must equal the value of the amount of the metal represented by any particular monetary unit defined in terms of that metal. Under a gold standard, for example, all monetary units represent some particular quantity of gold, and the relative values of those units correspond to the ratios of the gold represented by those units. The value of gold standard currency therefore doesn’t deviate more than trivially from the value of the amount of gold represented by the currency.

But, here again, we confront a simplification; the value of gold, or of any commodity serving as a monetary standard, isn’t independent of its monetary-standard function. The value of any commodity depends on the total demand for any and all purposes for which it is, or may be, used. If gold serves as money, either as coins actually exchanged or a reserves sitting in bank vaults, that amount of gold is withdrawn from potential non-monetary uses, so that the value of gold relative to other commodities must rise to reflect the diversion of that portion of the total stock from non-monetary uses. If the demand to hold money rises, and the additional money that must be created to meet that demand requires additional gold to be converted into monetary form, either as coins or as reserves held by banks, the additional derived demand for gold tends to increase the value of gold, and, as a result, the value of money.

Moreover, insofar as governments accumulate reserves of gold that are otherwise held idle, the decision about how much gold reserves to continue holding in relation to the monetary claims on those reserves also affects the value of gold. It’s therefore not necessarily correct to say that, under a gold standard, the value of gold determines the value of money. The strictly correct proposition is that, under a gold standard, the value of gold and the value of money must be equal. But the value of money causally affects the value of gold no less than the value of gold causally affects the value of money.

In the context of a fiat money, whose value necessarily reflects expectations of its future purchasing power, it is not only the current policies of the government and the monetary authority, but expectations about future economic conditions and about the future responses of policy-makers to those conditions that determine the value of a fiat money. A useful theory of the value of money and of the effect of monetary policy on the value of money cannot be formulated without taking the expectations of individuals into account. Rational-expectations may be a useful first step to in formulating models that explicitly take expectations into account, but their underlying suppositions of most rational-expectations models are too far-fetched – especially the assumption that all expectations converge on the “correct” probability distributions of all future prices – to provide practical insight, much less useful policy guidance (Glasner 2020).

So, in the end, all simple theories of causation, like MMT, that suggest one particular variable determines the value of another are untenable in any complex system of mutually interrelated phenomena (Hayek 1967). There are few systems in nature as complex as a modern economy; only if it were possible to write out a complete system of equations describing all those interrelationships, could we trace out the effects of increasing the income tax rate or the level of government spending on the overall price level, as MMT claims to do. But for a complex interrelated system, no direct causal relationship between any two variables to the exclusion of all the others is likely to serve as a reliable guide to policy except in special situations when it can plausibly be assumed that a ceteris-paribus assumption is likely to be even approximately true.

[1] The classic exposition of this theory of money was provided by Carl Menger (1892).


[2] In an alternate version of the tax theory of inflation, an increase in taxes increases the value of money by increasing the demand of money at the moment when tax liabilities come due. The value of money is determined by its value at those peak periods, and it is the expected value of money at those peak periods that maintains its value during non-peak periods. The problem with this version is that it presumes that the value of money is solely a function of its value in discharging tax liabilities, but money is also demanded to serve as a medium of exchange which implies an increase in value above the value it would have solely from the demand occasioned by its acceptability to discharge tax liabilities.

An Austrian Tragedy

It was hardly predictable that the New York Review of Books would take notice of Marginal Revolutionaries by Janek Wasserman, marking the susquicentenial of the publication of Carl Menger’s Grundsätze (Principles of Economics) which, along with Jevons’s Principles of Political Economy and Walras’s Elements of Pure Economics ushered in the marginal revolution upon which all of modern economics, for better or for worse, is based. The differences among the three founding fathers of modern economic theory were not insubstantial, and the Jevonian version was largely superseded by the work of his younger contemporary Alfred Marshall, so that modern neoclassical economics is built on the work of only one of the original founders, Leon Walras, Jevons’s work having left little impression on the future course of economics.

Menger’s work, however, though largely, but not totally, eclipsed by that of Marshall and Walras, did leave a more enduring imprint and a more complicated legacy than Jevons’s — not only for economics, but for political theory and philosophy, more generally. Judging from Edward Chancellor’s largely favorable review of Wasserman’s volume, one might even hope that a start might be made in reassessing that legacy, a process that could provide an opportunity for mutually beneficial interaction between long-estranged schools of thought — one dominant and one marginal — that are struggling to overcome various conceptual, analytical and philosophical problems for which no obvious solutions seem available.

In view of the failure of modern economists to anticipate the Great Recession of 2008, the worst financial shock since the 1930s, it was perhaps inevitable that the Austrian School, a once favored branch of economics that had made a specialty of booms and busts, would enjoy a revival of public interest.

The theme of Austrians as outsiders runs through Janek Wasserman’s The Marginal Revolutionaries: How Austrian Economists Fought the War of Ideas, a general history of the Austrian School from its beginnings to the present day. The title refers both to the later marginalization of the Austrian economists and to the original insight of its founding father, Carl Menger, who introduced the notion of marginal utility—namely, that economic value does not derive from the cost of inputs such as raw material or labor, as David Ricardo and later Karl Marx suggested, but from the utility an individual derives from consuming an additional amount of any good or service. Water, for instance, may be indispensable to humans, but when it is abundant, the marginal value of an extra glass of the stuff is close to zero. Diamonds are less useful than water, but a great deal rarer, and hence command a high market price. If diamonds were as common as dewdrops, however, they would be worthless.

Menger was not the first economist to ponder . . . the “paradox of value” (why useless things are worth more than essentials)—the Italian Ferdinando Galiani had gotten there more than a century earlier. His central idea of marginal utility was simultaneously developed in England by W. S. Jevons and on the Continent by Léon Walras. Menger’s originality lay in applying his theory to the entire production process, showing how the value of capital goods like factory equipment derived from the marginal value of the goods they produced. As a result, Austrian economics developed a keen interest in the allocation of capital. Furthermore, Menger and his disciples emphasized that value was inherently subjective, since it depends on what consumers are willing to pay for something; this imbued the Austrian school from the outset with a fiercely individualistic and anti-statist aspect.

Menger’s unique contribution is indeed worthy of special emphasis. He was more explicit than Jevons or Walras, and certainly more than Marshall, in explaining that the value of factors of production is derived entirely from the value of the incremental output that could be attributed (or imputed) to their services. This insight implies that cost is not an independent determinant of value, as Marshall, despite accepting the principle of marginal utility, continued to insist – famously referring to demand and supply as the two blades of the analytical scissors that determine value. The cost of production therefore turns out to be nothing but the value the output foregone when factors are used to produce one output instead of the next most highly valued alternative. Cost therefore does not determine, but is determined by, equilibrium price, which means that, in practice, costs are always subjective and conjectural. (I have made this point in an earlier post in a different context.) I will have more to say below about the importance of Menger’s specific contribution and its lasting imprint on the Austrian school.

Menger’s Principles of Economics, published in 1871, established the study of economics in Vienna—before then, no economic journals were published in Austria, and courses in economics were taught in law schools. . . .

The Austrian School was also bound together through family and social ties: [his two leading disciples, [Eugen von] Böhm-Bawerk and Friedrich von Wieser [were brothers-in-law]. [Wieser was] a close friend of the statistician Franz von Juraschek, Friedrich Hayek’s maternal grandfather. Young Austrian economists bonded on Alpine excursions and met in Böhm-Bawerk’s famous seminars (also attended by the Bolshevik Nikolai Bukharin and the German Marxist Rudolf Hilferding). Ludwig von Mises continued this tradition, holding private seminars in Vienna in the 1920s and later in New York. As Wasserman notes, the Austrian School was “a social network first and last.”

After World War I, the Habsburg Empire was dismantled by the victorious Allies. The Austrian bureaucracy shrank, and university placements became scarce. Menger, the last surviving member of the first generation of Austrian economists, died in 1921. The economic school he founded, with its emphasis on individualism and free markets, might have disappeared under the socialism of “Red Vienna.” Instead, a new generation of brilliant young economists emerged: Schumpeter, Hayek, and Mises—all of whom published best-selling works in English and remain familiar names today—along with a number of less well known but influential economists, including Oskar Morgenstern, Fritz Machlup, Alexander Gerschenkron, and Gottfried Haberler.

Two factual corrections are in order. Menger outlived Böhm-Bawerk, but not his other chief disciple von Wieser, who died in 1926, not long after supervising Hayek’s doctoral dissertation, later published in 1927, and, in 1933, translated into English and published as Monetary Theory and the Trade Cycle. Moreover, a 16-year gap separated Mises and Schumpeter, who were exact contemporaries, from Hayek (born in 1899) who was a few years older than Gerschenkron, Haberler, Machlup and Morgenstern.

All the surviving members or associates of the Austrian school wound up either in the US or Britain after World War II, and Hayek, who had taken a position in London in 1931, moved to the US in 1950, taking a position in the Committee on Social Thought at the University of Chicago after having been refused a position in the economics department. Through the intervention of wealthy sponsors, Mises obtained an academic appointment of sorts at the NYU economics department, where he succeeded in training two noteworthy disciples who wrote dissertations under his tutelage, Murray Rothbard and Israel Kirzner. (Kirzner wrote his dissertation under Mises at NYU, but Rothbard did his graduate work at Colulmbia.) Schumpeter, Haberler and Gerschenkron eventually took positions at Harvard, while Machlup (with some stops along the way) and Morgenstern made their way to Princeton. However, Hayek’s interests shifted from pure economic theory to deep philosophical questions. While Machlup and Haberler continued to work on economic theory, the Austrian influence on their work after World War II was barely recognizable. Morgenstern and Schumpeter made major contributions to economics, but did not hide their alienation from the doctrines of the Austrian School.

So there was little reason to expect that the Austrian School would survive its dispersal when the Nazis marched unopposed into Vienna in 1938. That it did survive is in no small measure due to its ideological usefulness to anti-socialist supporters who provided financial support to Hayek, enabling his appointment to the Committee on Social Thought at the University of Chicago, and Mises’s appointment at NYU, and other forms of research support to Hayek, Mises and other like-minded scholars, as well as funding the Mont Pelerin Society, an early venture in globalist networking, started by Hayek in 1947. Such support does not discredit the research to which it gave rise. That the survival of the Austrian School would probably not have been possible without the support of wealthy benefactors who anticipated that the Austrians would advance their political and economic interests does not invalidate the research thereby enabled. (In the interest of transparency, I acknowledge that I received support from such sources for two books that I wrote.)

Because Austrian School survivors other than Mises and Hayek either adapted themselves to mainstream thinking without renouncing their earlier beliefs (Haberler and Machlup) or took an entirely different direction (Morgenstern), and because the economic mainstream shifted in two directions that were most uncongenial to the Austrians: Walrasian general-equilibrium theory and Keynesian macroeconomics, the Austrian remnant, initially centered on Mises at NYU, adopted a sharply adversarial attitude toward mainstream economic doctrines.

Despite its minute numbers, the lonely remnant became a house divided against itself, Mises’s two outstanding NYU disciples, Murray Rothbard and Israel Kirzner, holding radically different conceptions of how to carry on the Austrian tradition. An extroverted radical activist, Rothbard was not content just to lead a school of economic thought, he aspired to become the leader of a fantastical anarchistic revolutionary movement to replace all established governments under a reign of private-enterprise anarcho-capitalism. Rothbard’s political radicalism, which, despite his Jewish ancestry, even included dabbling in Holocaust denialism, so alienated his mentor, that Mises terminated all contact with Rothbard for many years before his death. Kirzner, self-effacing, personally conservative, with no political or personal agenda other than the advancement of his own and his students’ scholarship, published hundreds of articles and several books filling 10 thick volumes of his collected works published by the Liberty Fund, while establishing a robust Austrian program at NYU, training many excellent scholars who found positions in respected academic and research institutions. Similar Austrian programs, established under the guidance of Kirzner’s students, were started at other institutions, most notably at George Mason University.

One of the founders of the Cato Institute, which for nearly half a century has been the leading avowedly libertarian think tank in the US, Rothbard was eventually ousted by Cato, and proceeded to set up a rival think tank, the Ludwig von Mises Institute, at Auburn University, which has turned into a focal point for extreme libertarians and white nationalists to congregate, get acquainted, and strategize together.

Isolation and marginalization tend to cause a subspecies either to degenerate toward extinction, to somehow blend in with the members of the larger species, thereby losing its distinctive characteristics, or to accentuate its unique traits, enabling it to find some niche within which to survive as a distinct sub-species. Insofar as they have engaged in economic analysis rather than in various forms of political agitation and propaganda, the Rothbardian Austrians have focused on anarcho-capitalist theory and the uniquely perverse evils of fractional-reserve banking.

Rejecting the political extremism of the Rothbardians, Kirznerian Austrians differentiate themselves by analyzing what they call market processes and emphasizing the limitations on the knowledge and information possessed by actual decision-makers. They attribute this misplaced focus on equilibrium to the extravagantly unrealistic and patently false assumptions of mainstream models on the knowledge possessed by economic agents, which effectively make equilibrium the inevitable — and trivial — conclusion entailed by those extreme assumptions. In their view, the focus of mainstream models on equilibrium states with unrealistic assumptions results from a preoccupation with mathematical formalism in which mathematical tractability rather than sound economics dictates the choice of modeling assumptions.

Skepticism of the extreme assumptions about the informational endowments of agents covers a range of now routine assumptions in mainstream models, e.g., the ability of agents to form precise mathematical estimates of the probability distributions of future states of the world, implying that agents never confront decisions about which they are genuinely uncertain. Austrians also object to the routine assumption that all the information needed to determine the solution of a model is the common knowledge of the agents in the model, so that an existing equilibrium cannot be disrupted unless new information randomly and unpredictably arrives. Each agent in the model having been endowed with the capacity of a semi-omniscient central planner, solving the model for its equilibrium state becomes a trivial exercise in which the optimal choices of a single agent are taken as representative of the choices made by all of the model’s other, semi-omnicient, agents.

Although shreds of subjectivism — i.e., agents make choices based own preference orderings — are shared by all neoclassical economists, Austrian criticisms of mainstream neoclassical models are aimed at what Austrians consider to be their insufficient subjectivism. It is this fierce commitment to a robust conception of subjectivism, in which an equilibrium state of shared expectations by economic agents must be explained, not just assumed, that Chancellor properly identifies as a distinguishing feature of the Austrian School.

Menger’s original idea of marginal utility was posited on the subjective preferences of consumers. This subjectivist position was retained by subsequent generations of the school. It inspired a tradition of radical individualism, which in time made the Austrians the favorite economists of American libertarians. Subjectivism was at the heart of the Austrians’ polemical rejection of Marxism. Not only did they dismiss Marx’s labor theory of value, they argued that socialism couldn’t possibly work since it would lack the means to allocate resources efficiently.

The problem with central planning, according to Hayek, is that so much of the knowledge that people act upon is specific knowledge that individuals acquire in the course of their daily activities and life experience, knowledge that is often difficult to articulate – mere intuition and guesswork, yet more reliable than not when acted upon by people whose livelihoods depend on being able to do the right thing at the right time – much less communicate to a central planner.

Chancellor attributes Austrian mistrust of statistical aggregates or indices, like GDP and price levels, to Austrian subjectivism, which regards such magnitudes as abstractions irrelevant to the decisions of private decision-makers, except perhaps in forming expectations about the actions of government policy makers. (Of course, this exception potentially provides full subjectivist license and legitimacy for macroeconomic theorizing despite Austrian misgivings.) Observed statistical correlations between aggregate variables identified by macroeconomists are dismissed as irrelevant unless grounded in, and implied by, the purposeful choices of economic agents.

But such scruples about the use of macroeconomic aggregates and inferring causal relationships from observed correlations are hardly unique to the Austrian school. One of the most important contributions of the 20th century to the methodology of economics was an article by T. C. Koopmans, “Measurement Without Theory,” which argued that measured correlations between macroeconomic variables provide a reliable basis for business-cycle research and policy advice only if the correlations can be explained in terms of deeper theoretical or structural relationships. The Nobel Prize Committee, in awarding the 1975 Prize to Koopmans, specifically mentioned this paper in describing Koopmans’s contributions. Austrians may be more fastidious than their mainstream counterparts in rejecting macroeconomic relationships not based on microeconomic principles, but they aren’t the only ones mistrustful of mere correlations.

Chancellor cites mistrust about the use of statistical aggregates and price indices as a factor in Hayek’s disastrous policy advice warning against anti-deflationary or reflationary measures during the Great Depression.

Their distrust of price indexes brought Austrian economists into conflict with mainstream economic opinion during the 1920s. At the time, there was a general consensus among leading economists, ranging from Irving Fisher at Yale to Keynes at Cambridge, that monetary policy should aim at delivering a stable price level, and in particular seek to prevent any decline in prices (deflation). Hayek, who earlier in the decade had spent time at New York University studying monetary policy and in 1927 became the first director of the Austrian Institute for Business Cycle Research, argued that the policy of price stabilization was misguided. It was only natural, Hayek wrote, that improvements in productivity should lead to lower prices and that any resistance to this movement (sometimes described as “good deflation”) would have damaging economic consequences.

The argument that deflation stemming from economic expansion and increasing productivity is normal and desirable isn’t what led Hayek and the Austrians astray in the Great Depression; it was their failure to realize the deflation that triggered the Great Depression was a monetary phenomenon caused by a malfunctioning international gold standard. Moreover, Hayek’s own business-cycle theory explicitly stated that a neutral (stable) monetary policy ought to aim at keeping the flow of total spending and income constant in nominal terms while his policy advice of welcoming deflation meant a rapidly falling rate of total spending. Hayek’s policy advice was an inexcusable error of judgment, which, to his credit, he did acknowledge after the fact, though many, perhaps most, Austrians have refused to follow him even that far.

Considered from the vantage point of almost a century, the collapse of the Austrian School seems to have been inevitable. Hayek’s long-shot bid to establish his business-cycle theory as the dominant explanation of the Great Depression was doomed from the start by the inadequacies of the very specific version of his basic model and his disregard of the obvious implication of that model: prevent total spending from contracting. The promising young students and colleagues who had briefly gathered round him upon his arrival in England, mostly attached themselves to other mentors, leaving Hayek with only one or two immediate disciples to carry on his research program. The collapse of his research program, which he himself abandoned after completing his final work in economic theory, marked a research hiatus of almost a quarter century, with the notable exception of publications by his student, Ludwig Lachmann who, having decamped in far-away South Africa, labored in relative obscurity for most of his career.

The early clash between Keynes and Hayek, so important in the eyes of Chancellor and others, is actually overrated. Chancellor, quoting Lachmann and Nicholas Wapshott, describes it as a clash of two irreconcilable views of the economic world, and the clash that defined modern economics. In later years, Lachmann actually sought to effect a kind of reconciliation between their views. It was not a conflict of visions that undid Hayek in 1931-32, it was his misapplication of a narrowly constructed model to a problem for which it was irrelevant.

Although the marginalization of the Austrian School, after its misguided policy advice in the Great Depression and its dispersal during and after World War II, is hardly surprising, the unwillingness of mainstream economists to sort out what was useful and relevant in the teachings of the Austrian School from what is not was unfortunate not only for the Austrians. Modern economics was itself impoverished by its disregard for the complexity and interconnectedness of economic phenomena. It’s precisely the Austrian attentiveness to the complexity of economic activity — the necessity for complementary goods and factors of production to be deployed over time to satisfy individual wants – that is missing from standard economic models.

That Austrian attentiveness, pioneered by Menger himself, to the complementarity of inputs applied over the course of time undoubtedly informed Hayek’s seminal contribution to economic thought: his articulation of the idea of intertemporal equilibrium that comprehends the interdependence of the plans of independent agents and the need for them to all fit together over the course of time for equilibrium to obtain. Hayek’s articulation represented a conceptual advance over earlier versions of equilibrium analysis stemming from Walras and Pareto, and even from Irving Fisher who did pay explicit attention to intertemporal equilibrium. But in Fisher’s articulation, intertemporal consistency was described in terms of aggregate production and income, leaving unexplained the mechanisms whereby the individual plans to produce and consume particular goods over time are reconciled. Hayek’s granular exposition enabled him to attend to, and articulate, necessary but previously unspecified relationships between the current prices and expected future prices.

Moreover, neither mainstream nor Austrian economists have ever explained how prices are adjust in non-equilibrium settings. The focus of mainstream analysis has always been the determination of equilibrium prices, with the implicit understanding that “market forces” move the price toward its equilibrium value. The explanatory gap has been filled by the mainstream New Classical School which simply posits the existence of an equilibrium price vector, and, to replace an empirically untenable tâtonnement process for determining prices, posits an equally untenable rational-expectations postulate to assert that market economies typically perform as if they are in, or near the neighborhood of, equilibrium, so that apparent fluctuations in real output are viewed as optimal adjustments to unexplained random productivity shocks.

Alternatively, in New Keynesian mainstream versions, constraints on price changes prevent immediate adjustments to rationally expected equilibrium prices, leading instead to persistent reductions in output and employment following demand or supply shocks. (I note parenthetically that the assumption of rational expectations is not, as often suggested, an assumption distinct from market-clearing, because the rational expectation of all agents of a market-clearing price vector necessarily implies that the markets clear unless one posits a constraint, e.g., a binding price floor or ceiling, that prevents all mutually beneficial trades from being executed.)

Similarly, the Austrian school offers no explanation of how unconstrained price adjustments by market participants is a sufficient basis for a systemic tendency toward equilibrium. Without such an explanation, their belief that market economies have strong self-correcting properties is unfounded, because, as Hayek demonstrated in his 1937 paper, “Economics and Knowledge,” price adjustments in current markets don’t, by themselves, ensure a systemic tendency toward equilibrium values that coordinate the plans of independent economic agents unless agents’ expectations of future prices are sufficiently coincident. To take only one passage of many discussing the difficulty of explaining or accounting for a process that leads individuals toward a state of equilibrium, I offer the following as an example:

All that this condition amounts to, then, is that there must be some discernible regularity in the world which makes it possible to predict events correctly. But, while this is clearly not sufficient to prove that people will learn to foresee events correctly, the same is true to a hardly less degree even about constancy of data in an absolute sense. For any one individual, constancy of the data does in no way mean constancy of all the facts independent of himself, since, of course, only the tastes and not the actions of the other people can in this sense be assumed to be constant. As all those other people will change their decisions as they gain experience about the external facts and about other people’s actions, there is no reason why these processes of successive changes should ever come to an end. These difficulties are well known, and I mention them here only to remind you how little we actually know about the conditions under which an equilibrium will ever be reached.

In this theoretical muddle, Keynesian economics and the neoclassical synthesis were abandoned, because the key proposition of Keynesian economics was supposedly the tendency of a modern economy toward an equilibrium with involuntary unemployment while the neoclassical synthesis rejected that proposition, so that the supposed synthesis was no more than an agreement to disagree. That divided house could not stand. The inability of Keynesian economists such as Hicks, Modigliani, Samuelson and Patinkin to find a satisfactory (at least in terms of a preferred Walrasian general-equilibrium model) rationalization for Keynes’s conclusion that an economy would likely become stuck in an equilibrium with involuntary unemployment led to the breakdown of the neoclassical synthesis and the displacement of Keynesianism as the dominant macroeconomic paradigm.

But perhaps the way out of the muddle is to abandon the idea that a systemic tendency toward equilibrium is a property of an economic system, and, instead, to recognize that equilibrium is, as Hayek suggested, a contingent, not a necessary, property of a complex economy. Ludwig Lachmann, cited by Chancellor for his remark that the early theoretical clash between Hayek and Keynes was a conflict of visions, eventually realized that in an important sense both Hayek and Keynes shared a similar subjectivist conception of the crucial role of individual expectations of the future in explaining the stability or instability of market economies. And despite the efforts of New Classical economists to establish rational expectations as an axiomatic equilibrating property of market economies, that notion rests on nothing more than arbitrary methodological fiat.

Chancellor concludes by suggesting that Wasserman’s characterization of the Austrians as marginalized is not entirely accurate inasmuch as “the Austrians’ view of the economy as a complex, evolving system continues to inspire new research.” Indeed, if economics is ever to find a way out of its current state of confusion, following Lachmann in his quest for a synthesis of sorts between Keynes and Hayek might just be a good place to start from.

A Tale of Two Syntheses

I recently finished reading a slender, but weighty, collection of essays, Microfoundtions Reconsidered: The Relationship of Micro and Macroeconomics in Historical Perspective, edited by Pedro Duarte and Gilberto Lima; it contains in addition to a brief introductory essay by the editors, and contributions by Kevin Hoover, Robert Leonard, Wade Hands, Phil Mirowski, Michel De Vroey, and Pedro Duarte. The volume is both informative and stimulating, helping me to crystalize ideas about which I have been ruminating and writing for a long time, but especially in some of my more recent posts (e.g., here, here, and here) and my recent paper “Hayek, Hicks, Radner and Four Equilibrium Concepts.”

Hoover’s essay provides a historical account of the microfoundations, making clear that the search for microfoundations long preceded the Lucasian microfoundations movement of the 1970s and 1980s that would revolutionize macroeconomics in the late 1980s and early 1990s. I have been writing about the differences between varieties of microfoundations for quite a while (here and here), and Hoover provides valuable detail about early discussions of microfoundations and about their relationship to the now regnant Lucasian microfoundations dogma. But for my purposes here, Hoover’s key contribution is his deconstruction of the concept of microfoundations, showing that the idea of microfoundations depends crucially on the notion that agents in a macroeconomic model be explicit optimizers, meaning that they maximize an explicit function subject to explicit constraints.

What Hoover clarifies is vacuity of the Lucasian optimization dogma. Until Lucas, optimization by agents had been merely a necessary condition for a model to be microfounded. But there was also another condition: that the optimizing choices of agents be mutually consistent. Establishing that the optimizing choices of agents are mutually consistent is not necessarily easy or even possible, so often the consistency of optimizing plans can only be suggested by some sort of heuristic argument. But Lucas and his cohorts, followed by their acolytes, unable to explain, even informally or heuristically, how the optimizing choices of individual agents are rendered mutually consistent, instead resorted to question-begging and question-dodging techniques to avoid addressing the consistency issue, of which one — the most egregious, but not the only — is the representative agent. In so doing, Lucas et al. transformed the optimization problem from the coordination of multiple independent choices into the optimal plan of a single decision maker. Heckuva job!

The second essay by Robert Leonard, though not directly addressing the question of microfoundations, helps clarify and underscore the misrepresentation perpetrated by the Lucasian microfoundational dogma in disregarding and evading the need to describe a mechanism whereby the optimal choices of individual agents are, or could be, reconciled. Leonard focuses on a particular economist, Oskar Morgenstern, who began his career in Vienna as a not untypical adherent of the Austrian school of economics, a member of the Mises seminar and successor of F. A. Hayek as director of the Austrian Institute for Business Cycle Research upon Hayek’s 1931 departure to take a position at the London School of Economics. However, Morgenstern soon began to question the economic orthodoxy of neoclassical economic theory and its emphasis on the tendency of economic forces to reach a state of equilibrium.

In his famous early critique of the foundations of equilibrium theory, Morgenstern tried to show that the concept of perfect foresight, upon which, he alleged, the concept of equilibrium rests, is incoherent. To do so, Morgenstern used the example of the Holmes-Moriarity interaction in which Holmes and Moriarty are caught in a dilemma in which neither can predict whether the other will get off or stay on the train on which they are both passengers, because the optimal choice of each depends on the choice of the other. The unresolvable conflict between Holmes and Moriarty, in Morgenstern’s view, showed that the incoherence of the idea of perfect foresight.

As his disillusionment with orthodox economic theory deepened, Morgenstern became increasingly interested in the potential of mathematics to serve as a tool of economic analysis. Through his acquaintance with the mathematician Karl Menger, the son of Carl Menger, founder of the Austrian School of economics. Morgenstern became close to Menger’s student, Abraham Wald, a pure mathematician of exceptional ability, who, to support himself, was working on statistical and mathematical problems for the Austrian Institute for Business Cycle Resarch, and tutoring Morgenstern in mathematics and its applications to economic theory. Wald, himself, went on to make seminal contributions to mathematical economics and statistical analysis.

Moregenstern also became acquainted with another student of Menger, John von Neumnn, with an interest in applying advanced mathematics to economic theory. Von Neumann and Morgenstern would later collaborate in writing The Theory of Games and Economic Behavior, as a result of which Morgenstern came to reconsider his early view of the Holmes-Moriarty paradox inasmuch as it could be shown that an equilibrium solution of their interaction could be found if payoffs to their joint choices were specified, thereby enabling Holmes and Moriarty to choose optimal probablistic strategies.

I don’t think that the game-theoretic solution to the Holmes Moriarty game is as straightforward as Morgenstern eventually agreed, but the critical point in the microfoundations discussion is that the mathematical solution to the Holmes-Moriarty paradox acknowledges the necessity for the choices made by two or more agents in an economic or game-theoretic equilibrium to be reconciled – i.e., rendered mutually consistent — in equilibrium. Under Lucasian microfoundations dogma, the problem is either annihilated by positing an optimizing representative agent having no need to coordinate his decision with other agents (I leave the question who, in the Holmes-Moriarty interaction, is the representative agent as an exercise for the reader) or it is assumed away by positing the existence of a magical equilibrium with no explanation of how the mutually consistent choices are arrived at.

The third essay (“The Rise and Fall of Walrasian Economics: The Keynes Effect”) by Wade Hands considers the first of the two syntheses – the neoclassical synthesis — that are alluded to in the title of this post. Hands gives a learned account of the mutually reinforcing co-development of Walrasian general equilibrium theory and Keynesian economics in the 25 years or so following World War II. Although Hands agrees that there is no necessary connection between Walrasian GE theory and Keynesian theory, he argues that there was enough common ground between Keynesians and Walrasians, as famously explained by Hicks in summarizing Keynesian theory by way of his IS-LM model, to allow the two disparate research programs to nourish each other in a kind of symbiotic relationship as the two research programs came to dominate postwar economics.

The task for Keynesian macroeconomists following the lead of Samuelson, Solow and Modigliani at MIT, Alvin Hansen at Harvard and James Tobin at Yale was to elaborate the Hicksian IS-LM approach by embedding it in a more general Walrasian framework. In so doing, they helped to shape a research agenda for Walrasian general-equilibrium theorists working out the details of the newly developed Arrow-Debreu model, deriving conditions for the uniqueness and stability of the equilibrium of that model. The neoclassical synthesis followed from those efforts, achieving an uneasy reconciliation between Walrasian general equilibrium theory and Keynesian theory. It received its most complete articulation in the impressive treatise of Don Patinkin which attempted to derive or at least evaluate key Keyensian propositions in the context of a full general equilibrium model. At an even higher level of theoretical sophistication, the 1971 summation of general equilibrium theory by Arrow and Hahn, gave disproportionate attention to Keynesian ideas which were presented and analyzed using the tools of state-of-the art Walrasian analysis.

Hands sums up the coexistence of Walrasian and Keynesian ideas in the Arrow-Hahn volume as follows:

Arrow and Hahn’s General Competitive Analysis – the canonical summary of the literature – dedicated far more pages to stability than to any other topic. The book had fourteen chapters (and a number of mathematical appendices); there was one chapter on consumer choice, one chapter on production theory, and one chapter on existence [of equilibrium], but there were three chapters on stability analysis, (two on the traditional tatonnement and one on alternative ways of modeling general equilibrium dynamics). Add to this the fact that there was an important chapter on “The Keynesian Model’; and it becomes clear how important stability analysis and its connection to Keynesian economics was for Walrasian microeconomics during this period. The purpose of this section has been to show that that would not have been the case if the Walrasian economics of the day had not been a product of co-evolution with Keynesian economic theory. (p. 108)

What seems most unfortunate about the neoclassical synthesis is that it elevated and reinforced the least relevant and least fruitful features of both the Walrasian and the Keynesian research programs. The Hicksian IS-LM setup abstracted from the dynamic and forward-looking aspects of Keynesian theory, modeling a static one-period model, not easily deployed as a tool of dynamic analysis. Walrasian GE analysis, which, following the pathbreaking GE existence proofs of Arrow and Debreu, then proceeded to a disappointing search for the conditions for a unique and stable general equilibrium.

It was Paul Samuelson who, building on Hicks’s pioneering foray into stability analysis, argued that the stability question could be answered by investigating whether a system of Lyapounov differential equations could describe market price adjustments as functions of market excess demands that would converge on an equilibrium price vector. But Samuelson’s approach to establishing stability required the mechanism of a fictional tatonnement process. Even with that unsatisfactory assumption, the stability results were disappointing.

Although for Walrasian theorists the results hardly repaid the effort expended, for those Keynesians who interpreted Keynes as an instability theorist, the weak Walrasian stability results might have been viewed as encouraging. But that was not any easy route to take either, because Keynes had also argued that a persistent unemployment equilibrium might be the norm.

It’s also hard to understand how the stability of equilibrium in an imaginary tatonnement process could ever have been considered relevant to the operation of an actual economy in real time – a leap of faith almost as extraordinary as imagining an economy represented by a single agent. Any conventional comparative-statics exercise – the bread and butter of microeconomic analysis – involves comparing two equilibria, corresponding to a specified parametric change in the conditions of the economy. The comparison presumes that, starting from an equilibrium position, the parametric change leads from an initial to a new equilibrium. If the economy isn’t stable, a disturbance causing an economy to depart from an initial equilibrium need not result in an adjustment to a new equilibrium comparable to the old one.

If conventional comparative statics hinges on an implicit stability assumption, it’s hard to see how a stability analysis of tatonnement has any bearing on the comparative-statics routinely relied upon by economists. No actual economy ever adjusts to a parametric change by way of tatonnement. Whether a parametric change displacing an economy from its equilibrium time path would lead the economy toward another equilibrium time path is another interesting and relevant question, but it’s difficult to see what insight would be gained by proving the stability of equilibrium under a tatonnement process.

Moreover, there is a distinct question about the endogenous stability of an economy: are there endogenous tendencies within an economy that lead it away from its equilibrium time path. But questions of endogenous stability can only be posed in a dynamic, rather than a static, model. While extending the Walrasian model to include an infinity of time periods, Arrow and Debreu telescoped determination of the intertemporal-equilibrium price vector into a preliminary time period before time, production, exchange and consumption begin. So, even in the formally intertemporal Arrow-Debreu model, the equilibrium price vector, once determined, is fixed and not subject to revision. Standard stability analysis was concerned with the response over time to changing circumstances only insofar as changes are foreseen at time zero, before time begins, so that they can be and are taken fully into account when the equilibrium price vector is determined.

Though not entirely uninteresting, the intertemporal analysis had little relevance to the stability of an actual economy operating in real time. Thus, neither the standard Keyensian (IS-LM) model nor the standard Walrasian Arrow-Debreu model provided an intertemporal framework within which to address the dynamic stability that Keynes (and contemporaries like Hayek, Myrdal, Lindahl and Hicks) had developed in the 1930s. In particular, Hicks’s analytical device of temporary equilibrium might have facilitated such an analysis. But, having introduced his IS-LM model two years before publishing his temporary equilibrium analysis in Value and Capital, Hicks concentrated his attention primarily on Keynesian analysis and did not return to the temporary equilibrium model until 1965 in Capital and Growth. And it was IS-LM that became, for a generation or two, the preferred analytical framework for macroeconomic analysis, while temproary equilibrium remained overlooked until the 1970s just as the neoclassical synthesis started coming apart.

The fourth essay by Phil Mirowski investigates the role of the Cowles Commission, based at the University of Chicago from 1939 to 1955, in undermining Keynesian macroeconomics. While Hands argues that Walrasians and Keynesians came together in a non-hostile spirit of tacit cooperation, Mirowski believes that owing to their Walrasian sympathies, the Cowles Committee had an implicit anti-Keynesian orientation and was therefore at best unsympathetic if not overtly hostile to Keynesian theorizing, which was incompatible the Walrasian optimization paradigm endorsed by the Cowles economists. (Another layer of unexplored complexity is the tension between the Walrasianism of the Cowles economists and the Marshallianism of the Chicago School economists, especially Knight and Friedman, which made Chicago an inhospitable home for the Cowles Commission and led to its eventual departure to Yale.)

Whatever differences, both the Mirowski and the Hands essays support the conclusion that the uneasy relationship between Walrasianism and Keynesianism was inherently problematic and unltimately unsustainable. But to me the tragedy is that before the fall, in the 1950s and 1960s, when the neoclassical synthesis bestrode economics like a colossus, the static orientation of both the Walrasian and the Keynesian research programs combined to distract economists from a more promising research program. Such a program, instead of treating expectations either as parametric constants or as merely adaptive, based on an assumed distributed lag function, might have considered whether expectations could perform a potentially equilibrating role in a general equilibrium model.

The equilibrating role of expectations, though implicit in various contributions by Hayek, Myrdal, Lindahl, Irving Fisher, and even Keynes, is contingent so that equilibrium is not inevitable, only a possibility. Instead, the introduction of expectations as an equilibrating variable did not occur until the mid-1970s when Robert Lucas, Tom Sargent and Neil Wallace, borrowing from John Muth’s work in applied microeconomics, introduced the idea of rational expectations into macroeconomics. But in introducing rational expectations, Lucas et al. made rational expectations not the condition of a contingent equilibrium but an indisputable postulate guaranteeing the realization of equilibrium without offering any theoretical account of a mechanism whereby the rationality of expectations is achieved.

The fifth essay by Michel DeVroey (“Microfoundations: a decisive dividing line between Keynesian and new classical macroeconomics?”) is a philosophically sophisticated analysis of Lucasian microfoundations methodological principles. DeVroey begins by crediting Lucas with the revolution in macroeconomics that displaced a Keynesian orthodoxy already discredited in the eyes of many economists after its failure to account for simultaneously rising inflation and unemployment.

The apparent theoretical disorder characterizing the Keynesian orthodoxy and its Monetarist opposition left a void for Lucas to fill by providing a seemingly rigorous microfounded alternative to the confused state of macroeconomics. And microfoundations became the methodological weapon by which Lucas and his associates and followers imposed an iron discipline on the unruly community of macroeconomists. “In Lucas’s eyes,” DeVroey aptly writes,“ the mere intention to produce a theory of involuntary unemployment constitutes an infringement of the equilibrium discipline.” Showing that his description of Lucas is hardly overstated, DeVroey quotes from the famous 1978 joint declaration of war issued by Lucas and Sargent against Keynesian macroeconomics:

After freeing himself of the straightjacket (or discipline) imposed by the classical postulates, Keynes described a model in which rules of thumb, such as the consumption function and liquidity preference schedule, took the place of decision functions that a classical economist would insist be derived from the theory of choice. And rather than require that wages and prices be determined by the postulate that markets clear – which for the labor market seemed patently contradicted by the severity of business depressions – Keynes took as an unexamined postulate that money wages are sticky, meaning that they are set at a level or by a process that could be taken as uninfluenced by the macroeconomic forces he proposed to analyze.

Echoing Keynes’s famous description of the sway of Ricardian doctrines over England in the nineteenth century, DeVroey remarks that the microfoundations requirement “conquered macroeconomics as quickly and thoroughly as the Holy Inquisition conquered Spain,” noting, even more tellingly, that the conquest was achieved without providing any justification. Ricardo had, at least, provided a substantive analysis that could be debated; Lucas offered only an undisputable methodological imperative about the sole acceptable mode of macroeconomic reasoning. Just as optimization is a necessary component of the equilibrium discipline that had to be ruthlessly imposed on pain of excommunication from the macroeconomic community, so, too, did the correlate principle of market-clearing. To deviate from the market-clearing postulate was ipso facto evidence of an impure and heretical state of mind. DeVroey further quotes from the war declaration of Lucas and Sargent.

Cleared markets is simply a principle, not verifiable by direct observation, which may or may not be useful in constructing successful hypotheses about the behavior of these [time] series.

What was only implicit in the war declaration became evident later after right-thinking was enforced, and woe unto him that dared deviate from the right way of thinking.

But, as DeVroey skillfully shows, what is most remarkable is that, having declared market clearing an indisputable methodological principle, Lucas, contrary to his own demand for theoretical discipline, used the market-clearing postulate to free himself from the very equilibrium discipline he claimed to be imposing. How did the market-clearing postulate liberate Lucas from equilibrium discipline? To show how the sleight-of-hand was accomplished, DeVroey, in an argument parallel to that of Hoover in chapter one and that suggested by Leonard in chapter two, contrasts Lucas’s conception of microfoundations with a different microfoundations conception espoused by Hayek and Patinkin. Unlike Lucas, Hayek and Patinkin recognized that the optimization of individual economic agents is conditional on the optimization of other agents. Lucas assumes that if all agents optimize, then their individual optimization ensures that a social optimum is achieved, the whole being the sum of its parts. But that assumption ignores that the choices made interacting agents are themelves interdependent.

To capture the distinction between independent and interdependent optimization, DeVroey distinguishes between optimal plans and optimal behavior. Behavior is optimal only if an optimal plan can be executed. All agents can optimize individually in making their plans, but the optimality of their behavior depends on their capacity to carry those plans out. And the capacity of each to carry out his plan is contingent on the optimal choices of all other agents.

Optimizing plans refers to agents’ intentions before the opening of trading, the solution to the choice-theoretical problem with which they are faced. Optimizing behavior refers to what is observable after trading has started. Thus optimal behavior implies that the optimal plan has been realized. . . . [O]ptmizing plans and optimizing behavior need to be logically separated – there is a difference between finding a solution to a choice problem and implementing the solution. In contrast, whenever optimizing behavior is the sole concept used, the possibility of there being a difference between them is discarded by definition. This is the standpoint takenby Lucas and Sargent. Once it is adopted, it becomes misleading to claim . . .that the microfoundations requirement is based on two criteria, optimizing behavior and market clearing. A single criterion is needed, and it is irrelevant whether this is called generalized optimizing behavior or market clearing. (De Vroey, p. 176)

Each agent is free to optimize his plan, but no agent can execute his optimal plan unless the plan coincides with the complementary plans of other agents. So, the execution of an optimal plan is not within the unilateral control of an agent formulating his own plan. One can readily assume that agents optimize their plans, but one cannot just assume that those plans can be executed as planned. The optimality of interdependent plans is not self-evident; it is a proposition that must be demonstrated. Assuming that agents optimize, Lucas simply asserts that, because agents optimize, markets must clear.

That is a remarkable non-sequitur. And from that non-sequitur, Lucas jumps to a further non-sequitur: that an optimizing representative agent is all that’s required for a macroeconomic model. The logical straightjacket (or discipline) of demonstrating that interdependent optimal plans are consistent is thus discarded (or trampled upon). Lucas’s insistence on a market-clearing principle turns out to be subterfuge by which the pretense of its upholding conceals its violation in practice.

My own view is that the assumption that agents formulate optimizing plans cannot be maintained without further analysis unless the agents are operating in isolation. If the agents interacting with each other, the assumption that they optimize requires a theory of their interaction. If the focus is on equilibrium interactions, then one can have a theory of equilibrium, but then the possibility of non-equilibrium states must also be acknowledged.

That is what John Nash did in developing his equilibrium theory of positive-sum games. He defined conditions for the existence of equilibrium, but he offered no theory of how equilibrium is achieved. Lacking such a theory, he acknowledged that non-equilibrium solutions might occur, e.g., in some variant of the Holmes-Moriarty game. To simply assert that because interdependent agents try to optimize, they must, as a matter of principle, succeed in optimizing is to engage in question-begging on a truly grand scale. To insist, as a matter of methodological principle, that everyone else must also engage in question-begging on equally grand scale is what I have previously called methodological arrogance, though an even harsher description might be appropriate.

In the sixth essay (“Not Going Away: Microfoundations in the making of a new consensus in macroeconomics”), Pedro Duarte considers the current state of apparent macroeconomic consensus in the wake of the sweeping triumph of the Lucasian micorfoundtions methodological imperative. In its current state, mainstream macroeconomists from a variety of backgrounds have reconciled themselves and adjusted to the methodological absolutism Lucas and his associates and followers have imposed on macroeconomic theorizing. Leading proponents of the current consensus are pleased to announce, in unseemly self-satisfaction, that macroeconomics is now – but presumably not previously – “firmly grounded in the principles of economic [presumably neoclassical] theory.” But the underlying conception of neoclassical economic theory motivating such a statement is almost laughably narrow, and, as I have just shown, strictly false even if, for argument’s sake, that narrow conception is accepted.

Duarte provides an informative historical account of the process whereby most mainstream Keynesians and former old-line Monetarists, who had, in fact, adopted much of the underlying Keynesian theoretical framework themselves, became reconciled to the non-negotiable methodological microfoundational demands upon which Lucas and his New Classical followers and Real-Business-Cycle fellow-travelers insisted. While Lucas was willing to tolerate differences of opinion about the importance of monetary factors in accounting for business-cycle fluctuations in real output and employment, and even willing to countenance a role for countercyclical monetary policy, such differences of opinion could be tolerated only if they could be derived from an acceptable microfounded model in which the agent(s) form rational expectations. If New Keynesians were able to produce results rationalizing countercyclical policies in such microfounded models with rational expectations, Lucas was satisfied. Presumably, Lucas felt the price of conceding the theoretical legitimacy of countercyclical policy was worth paying in order to achieve methodological hegemony over macroeconomic theory.

And no doubt, for Lucas, the price was worth paying, because it led to what Marvin Goodfriend and Robert King called the New Neoclassical Synthesis in their 1997 article ushering in the new era of good feelings, a synthesis based on “the systematic application of intertemporal optimization and rational expectations” while embodying “the insights of monetarists . . . regarding the theory and practice of monetary policy.”

While the first synthesis brought about a convergence of sorts between the disparate Walrasian and Keynesian theoretical frameworks, the convergence proved unstable because the inherent theoretical weaknesses of both paradigms were unable to withstand criticisms of the theoretical apparatus and of the policy recommendations emerging from that synthesis, particularly an inability to provide a straightforward analysis of inflation when it became a serious policy problem in the late 1960s and 1970s. But neither the Keynesian nor the Walrasian paradigms were developing in a way that addressed the points of most serious weakness.

On the Keynesian side, the defects included the static nature of the workhorse IS-LM model, the absence of a market for real capital and of a market for endogenous money. On the Walrasian side, the defects were the lack of any theory of actual price determination or of dynamic adjustment. The Hicksian temporary equilibrium paradigm might have provided a viable way forward, and for a very different kind of synthesis, but not even Hicks himself realized the potential of his own creation.

While the first synthesis was a product of convenience and misplaced optimism, the second synthesis is a product of methodological hubris and misplaced complacency derived from an elementary misunderstanding of the distinction between optimization by a single agent and the simultaneous optimization of two or more independent, yet interdependent, agents. The equilibrium of each is the result of the equilibrium of all, and a theory of optimization involving two or more agents requires a theory of how two or more interdependent agents can optimize simultaneously. The New neoclassical synthesis rests on the demand for a macroeconomic theory of individual optimization that refuses even to ask, let along provide an answer to, the question whether the optimization that it demands is actually achieved in practice or what happens if it is not. This is not a synthesis that will last, or that deserves to. And the sooner it collapses, the better off macroeconomics will be.

What the answer is I don’t know, but if I had to offer a suggestion, the one offered by my teacher Axel Leijonhufvud towards the end of his great book, written more than half a century ago, strikes me as not bad at all:

One cannot assume that what went wrong was simply that Keynes slipped up here and there in his adaptation of standard tool, and that consequently, if we go back and tinker a little more with the Marshallian toolbox his purposes will be realized. What is required, I believe, is a systematic investigation, form the standpoint of the information problems stressed in this study, of what elements of the static theory of resource allocation can without further ado be utilized in the analysis of dynamic and historical systems. This, of course, would be merely a first-step: the gap yawns very wide between the systematic and rigorous modern analysis of the stability of “featureless,” pure exchange systems and Keynes’ inspired sketch of the income-constrained process in a monetary-exchange-cum-production system. But even for such a first step, the prescription cannot be to “go back to Keynes.” If one must retrace some steps of past developments in order to get on the right track—and that is probably advisable—my own preference is to go back to Hayek. Hayek’s Gestalt-conception of what happens during business cycles, it has been generally agreed, was much less sound than Keynes’. As an unhappy consequence, his far superior work on the fundamentals of the problem has not received the attention it deserves. (p. 401)

I agree with all that, but would also recommend Roy Radner’s development of an alternative to the Arrow-Debreu version of Walrasian general equilibrium theory that can accommodate Hicksian temporary equilibrium, and Hawtrey’s important contributions to our understanding of monetary theory and the role and potential instability of endogenous bank money. On top of that, Franklin Fisher in his important work, The Disequilibrium Foundations of Equilibrium Economics, has given us further valuable guidance in how to improve the current sorry state of macroeconomics.


Filling the Arrow Explanatory Gap

The following (with some minor revisions) is a Twitter thread I posted yesterday. Unfortunately, because it was my first attempt at threading the thread wound up being split into three sub-threads and rather than try to reconnect them all, I will just post the complete thread here as a blogpost.

1. Here’s an outline of an unwritten paper developing some ideas from my paper “Hayek Hicks Radner and Four Equilibrium Concepts” (see here for an earlier ungated version) and some from previous blog posts, in particular Phillips Curve Musings

2. Standard supply-demand analysis is a form of partial-equilibrium (PE) analysis, which means that it is contingent on a ceteris paribus (CP) assumption, an assumption largely incompatible with realistic dynamic macroeconomic analysis.

3. Macroeconomic analysis is necessarily situated a in general-equilibrium (GE) context that precludes any CP assumption, because there are no variables that are held constant in GE analysis.

4. In the General Theory, Keynes criticized the argument based on supply-demand analysis that cutting nominal wages would cure unemployment. Instead, despite his Marshallian training (upbringing) in PE analysis, Keynes argued that PE (AKA supply-demand) analysis is unsuited for understanding the problem of aggregate (involuntary) unemployment.

5. The comparative-statics method described by Samuelson in the Foundations of Econ Analysis formalized PE analysis under the maintained assumption that a unique GE obtains and deriving a “meaningful theorem” from the 1st- and 2nd-order conditions for a local optimum.

6. PE analysis, as formalized by Samuelson, is conditioned on the assumption that GE obtains. It is focused on the effect of changing a single parameter in a single market small enough for the effects on other markets of the parameter change to be made negligible.

7. Thus, PE analysis, the essence of micro-economics is predicated on the macrofoundation that all, but one, markets are in equilibrium.

8. Samuelson’s meaningful theorems were a misnomer reflecting mid-20th-century operationalism. They can now be understood as empirically refutable propositions implied by theorems augmented with a CP assumption that interactions b/w markets are small enough to be neglected.

9. If a PE model is appropriately specified, and if the market under consideration is small or only minimally related to other markets, then differences between predictions and observations will be statistically insignificant.

10. So PE analysis uses comparative-statics to compare two alternative general equilibria that differ only in respect of a small parameter change.

11. The difference allows an inference about the causal effect of a small change in that parameter, but says nothing about how an economy would actually adjust to a parameter change.

12. PE analysis is conditioned on the CP assumption that the analyzed market and the parameter change are small enough to allow any interaction between the parameter change and markets other than the market under consideration to be disregarded.

13. However, the process whereby one equilibrium transitions to another is left undetermined; the difference between the two equilibria with and without the parameter change is computed but no account of an adjustment process leading from one equilibrium to the other is provided.

14. Hence, the term “comparative statics.”

15. The only suggestion of an adjustment process is an assumption that the price-adjustment in any market is an increasing function of excess demand in the market.

16. In his seminal account of GE, Walras posited the device of an auctioneer who announces prices–one for each market–computes desired purchases and sales at those prices, and sets, under an adjustment algorithm, new prices at which desired purchases and sales are recomputed.

17. The process continues until a set of equilibrium prices is found at which excess demands in all markets are zero. In Walras’s heuristic account of what he called the tatonnement process, trading is allowed only after the equilibrium price vector is found by the auctioneer.

18. Walras and his successors assumed, but did not prove, that, if an equilibrium price vector exists, the tatonnement process would eventually, through trial and error, converge on that price vector.

19. However, contributions by Sonnenschein, Mantel and Debreu (hereinafter referred to as the SMD Theorem) show that no price-adjustment rule necessarily converges on a unique equilibrium price vector even if one exists.

20. The possibility that there are multiple equilibria with distinct equilibrium price vectors may or may not be worth explicit attention, but for purposes of this discussion, I confine myself to the case in which a unique equilibrium exists.

21. The SMD Theorem underscores the lack of any explanatory account of a mechanism whereby changes in market prices, responding to excess demands or supplies, guide a decentralized system of competitive markets toward an equilibrium state, even if a unique equilibrium exists.

22. The Walrasian tatonnement process has been replaced by the Arrow-Debreu-McKenzie (ADM) model in an economy of infinite duration consisting of an infinite number of generations of agents with given resources and technology.

23. The equilibrium of the model involves all agents populating the economy over all time periods meeting before trading starts, and, based on initial endowments and common knowledge, making plans given an announced equilibrium price vector for all time in all markets.

24. Uncertainty is accommodated by the mechanism of contingent trading in alternative states of the world. Given assumptions about technology and preferences, the ADM equilibrium determines the set prices for all contingent states of the world in all time periods.

25. Given equilibrium prices, all agents enter into optimal transactions in advance, conditioned on those prices. Time unfolds according to the equilibrium set of plans and associated transactions agreed upon at the outset and executed without fail over the course of time.

26. At the ADM equilibrium price vector all agents can execute their chosen optimal transactions at those prices in all markets (certain or contingent) in all time periods. In other words, at that price vector, excess demands in all markets with positive prices are zero.

27. The ADM model makes no pretense of identifying a process that discovers the equilibrium price vector. All that can be said about that price vector is that if it exists and trading occurs at equilibrium prices, then excess demands will be zero if prices are positive.

28. Arrow himself drew attention to the gap in the ADM model, writing in 1959:

29. In addition to the explanatory gap identified by Arrow, another shortcoming of the ADM model was discussed by Radner: the dependence of the ADM model on a complete set of forward and state-contingent markets at time zero when equilibrium prices are determined.

30. Not only is the complete-market assumption a backdoor reintroduction of perfect foresight, it excludes many features of the greatest interest in modern market economies: the existence of money, stock markets, and money-crating commercial banks.

31. Radner showed that for full equilibrium to obtain, not only must excess demands in current markets be zero, but whenever current markets and current prices for future delivery are missing, agents must correctly expect those future prices.

32. But there is no plausible account of an equilibrating mechanism whereby price expectations become consistent with GE. Although PE analysis suggests that price adjustments do clear markets, no analogous analysis explains how future price expectations are equilibrated.

33. But if both price expectations and actual prices must be equilibrated for GE to obtain, the notion that “market-clearing” price adjustments are sufficient to achieve macroeconomic “equilibrium” is untenable.

34. Nevertheless, the idea that individual price expectations are rational (correct), so that, except for random shocks, continuous equilibrium is maintained, became the bedrock for New Classical macroeconomics and its New Keynesian and real-business cycle offshoots.

35. Macroeconomic theory has become a theory of dynamic intertemporal optimization subject to stochastic disturbances and market frictions that prevent or delay optimal adjustment to the disturbances, potentially allowing scope for countercyclical monetary or fiscal policies.

36. Given incomplete markets, the assumption of nearly continuous intertemporal equilibrium implies that agents correctly foresee future prices except when random shocks occur, whereupon agents revise expectations in line with the new information communicated by the shocks.
37. Modern macroeconomics replaced the Walrasian auctioneer with agents able to forecast the time path of all prices indefinitely into the future, except for intermittent unforeseen shocks that require agents to optimally their revise previous forecasts.
38. When new information or random events, requiring revision of previous expectations, occur, the new information becomes common knowledge and is processed and interpreted in the same way by all agents. Agents with rational expectations always share the same expectations.
39. So in modern macro, Arrow’s explanatory gap is filled by assuming that all agents, given their common knowledge, correctly anticipate current and future equilibrium prices subject to unpredictable forecast errors that change their expectations of future prices to change.
40. Equilibrium prices aren’t determined by an economic process or idealized market interactions of Walrasian tatonnement. Equilibrium prices are anticipated by agents, except after random changes in common knowledge. Semi-omniscient agents replace the Walrasian auctioneer.
41. Modern macro assumes that agents’ common knowledge enables them to form expectations that, until superseded by new knowledge, will be validated. The assumption is wrong, and the mistake is deeper than just the unrealism of perfect competition singled out by Arrow.
42. Assuming perfect competition, like assuming zero friction in physics, may be a reasonable simplification for some problems in economics, because the simplification renders an otherwise intractable problem tractable.
43. But to assume that agents’ common knowledge enables them to forecast future prices correctly transforms a model of decentralized decision-making into a model of central planning with each agent possessing the knowledge only possessed by an omniscient central planner.
44. The rational-expectations assumption fills Arrow’s explanatory gap, but in a deeply unsatisfactory way. A better approach to filling the gap would be to acknowledge that agents have private knowledge (and theories) that they rely on in forming their expectations.
45. Agents’ expectations are – at least potentially, if not inevitably – inconsistent. Because expectations differ, it’s the expectations of market specialists, who are better-informed than non-specialists, that determine the prices at which most transactions occur.
46. Because price expectations differ even among specialists, prices, even in competitive markets, need not be uniform, so that observed price differences reflect expectational differences among specialists.
47. When market specialists have similar expectations about future prices, current prices will converge on the common expectation, with arbitrage tending to force transactions prices to converge toward notwithstanding the existence of expectational differences.
48. However, the knowledge advantage of market specialists over non-specialists is largely limited to their knowledge of the workings of, at most, a small number of related markets.
49. The perspective of specialists whose expectations govern the actual transactions prices in most markets is almost always a PE perspective from which potentially relevant developments in other markets and in macroeconomic conditions are largely excluded.
50. The interrelationships between markets that, according to the SMD theorem, preclude any price-adjustment algorithm, from converging on the equilibrium price vector may also preclude market specialists from converging, even roughly, on the equilibrium price vector.
51. A strict equilibrium approach to business cycles, either real-business cycle or New Keynesian, requires outlandish assumptions about agents’ common knowledge and their capacity to anticipate the future prices upon which optimal production and consumption plans are based.
52. It is hard to imagine how, without those outlandish assumptions, the theoretical superstructure of real-business cycle theory, New Keynesian theory, or any other version of New Classical economics founded on the rational-expectations postulate can be salvaged.
53. The dominance of an untenable macroeconomic paradigm has tragically led modern macroeconomics into a theoretical dead end.

The Equilibrium of Each Is the Result of the Equilibrium of All, or, the Rational Expectation of Each is the Result of the Rational Expectation of All

A few weeks ago, I wrote a post whose title (“The Idleness of Each Is the Result of the Idleness of All”) was taken from the marvelous remark of the great, but sadly forgotten, Cambridge economist Frederick Lavington’s book The Trade Cycle. Lavington was born two years after Ralph Hawtrey and two years before John Maynard Keynes. The brilliant insight expressed so eloquently by Lavington is that the inability of some those unemployed to find employment may not be the result of a voluntary decision made by an individual worker any more than the inability of a driver stuck in a traffic jam to drive at the speed he wants to drive at is a voluntary decision. The circumstances in which an unemployed worker finds himself may be such that he or she has no practical alternative other than to remain unemployed.

In this post I merely want to express the same idea from two different vantage points. In any economic model, the equilibrium decision of any agent in the model is conditional on a corresponding set of equilibrium decisions taken by all other agents in the model. Unless all other agents are making optimal choices, the equilibrium (optimal) choice of any individual agent is neither feasible nor optimal, because the optimality of any decision is conditional on the decisions taken by all other agents. Only if the optimal decisions of each are mutually consistent are they individually optimal. (Individual optimality does not necessarily result in overall optimality owing to interdependencies (aka externalities) among the individuals). My ability to buy as much as I want to, and to sell as much as I want to, at market-clearing prices is contingent on everyone else being able to buy and sell as much as I and they want to at those same prices.

Now let’s take the argument a step further. Suppose the equilibrium decisions involve making purchases and sales in both the present and the future, according to current expectations of what future conditions will be like. If you are running a business, how much inputs you buy today to turn into output to be sold tomorrow will depend on the price at which you expect to be able to sell the output produced tomorrow. If decisions to purchase and sell today depend not only on current prices but also on expected future prices, then your optimal decisions now about how much to buy and sell now will depend on your expectations of buying and selling prices in the future. For an equilibrium in which everyone can execute his or her plans (as originally formulated) to exist, each person must have rational expectations about what future prices will be, and such rational expectations are possible only when those expectations are mutually consistent. In game-theoretical terms, a Nash equilibrium obtains only when all the individual expectations on which decisions are conditional converge.

Here is how Tom Schelling explained the idea of rational – i.e., convergent – expectations in a classic discussion of cooperative games.

One may or may not agree with any particular hypothesis as to how a bargainer’s expectations are formed either in the bargaining process or before it and either by the bargaining itself or by other forces. But it does seem clear that the outcome of a bargaining process is to be described most immediately, most straightforwardly, and most empirically, in terms of some phenomenon of stable and convergent expectations. Whether one agrees explicitly to a bargain, or agrees tacitly, or accepts by default, he must if he has his wits about him, expect that he could do no better and recognize that the other party must reciprocate the feeling. Thus, the fact of an outcome, which is simply a coordinated choice, should be analytically characterized by the notion of convergent expectations.

The intuitive formulation, or even a careful formulation in psychological terms, of what it is that a rational player expects in relation to another rational player in the “pure” bargaining game, poses a problem in sheer scientific description. Both players, being rational, must recognize that the only kind of “rational” expectation they can have is a fully shared expectation of an outcome. It is not quite accurate – as a description of a psychological phenomenon – to say that one expects the second to concede something; the second’s readiness to concede or to accept is only an expression of what he expects the first to accept or to concede, which in turn is what he expects the first to expect the second to expect the first to expect, and so on. To avoid an “ad infinitum” in the description process, we have to say that both sense a shared expectation of an outcome; one’s expectation is a belief that both identify the outcome as being indicated by the situation, hence as virtually inevitable. Both players, in effect, accept a common authority – the power of the game to dictate its own solution through their intellectual capacity to perceive it – and what they “expect” is that they both perceive the same solution.

If expectations of everyone do not converge — individuals having conflicting expectations about what will happen — then the expectations of none of the individuals can be rational. Even if one individual correctly anticipates the outcome, from the point of view of the disequilibrium system as a whole, the correct expectations are not rational because those expectations are inconsistent with equilibrium of the entire system. A change in the expectations of any other individual would imply that future prices would change from what had been expected. Only equilibrium expectations can be considered rational, and equilibrium expectations are a set of individual expectations that are convergent.

My Paper “Hayek, Deflation, Gold, and Nihilism” Is now Available on SSRN

I contributed a chapter entitled “Hayek, Deflation, Gold and Nihilism” to volume 13 of Hayek: A Collaborative Biography edited by Robert Leeson and published in 2018 by Palgrave Macmillan.

I have posted a preliminary draft of that chapter on SSRN. Here is the abstract.

In Hayek’s early writings on business cycle theory and the Great Depression he argued that business cycle downturns including the steep downturn of 1929-31 were caused by unsustainable elongations of capital structure of the economy resulting from bank-financed investment in excess of voluntary saving. Because monetary expansion was the cause of the crisis, Hayek argued that monetary expansion was an inappropriate remedy to cure the deflation and high unemployment caused by the crisis. He therefore recommended allowing the Depression to take its course until the distortions that led to the downturn could be corrected by market forces. However, this view of the Depression was at odds with Hayek’s own neutral money criterion which implied that prices should fall during expansions and rise during contractions so that nominal spending would remain more or less constant over the cycle. Although Hayek strongly favored allowing prices to fall in the expansion, he did not follow the logic of his own theory in favoring generally increasing prices during the contraction. This paper explores the reasons for Hayek’s reluctance to follow the logic of his own theory in his early policy recommendations. The key factors responsible for his early policy recommendations seem to be his attachment to the gold standard and the seeming necessity for countries to accept deflation to maintain convertibility and his hope or expectation that deflation would overwhelm the price rigidities that he believed were obstructing the price mechanism from speeding a recovery. By 1935 Hayek’s attachment to the gold standard was starting to weaken, and in later years he openly acknowledged that he had been mistaken not to favor policy measures, including monetary expansion, designed to stabilize total spending.

“The Idleness of Each Is the Result of the Idleness of All”

Everyone is fretting about how severe the downturn that is now starting and causing the worst plunge in the stock market since the 1929 crash is going to be. Much of the discussion has turned on whether the cause of the downturn is a supply shock or a demand shock. Some, perhaps many, seem to think that if the shock is a supply, rather than a demand, shock, then there is no role for a countercyclical policy response designed to increase demand. In other words, if the downturn is caused by people getting sick from a highly contagious virus, making it dangerous for people to gather together to work, then output will necessarily fall. Because the cutback in the supply of labor necessarily will cause a reduction in output, trying to counteract supply shock by increasing demand, as if an increase in demand could prevent the reduction of output associated with a reduced labor force after the onset of the virus, seems like an exercise in futility.

The problem with that reasoning is that reductions in supply are themselves effectively reductions in demand. The follow-on reductions in demand constitute a secondary contractionary shock on top of the primary supply shock, thereby setting in motion a cumulative process of further reductions in supply and demand. From that aggregate perspective, whether the initial contractionary shock is a shock to supply or to demand is of less importance than ensuring that the cumulative process is short-circuited by placing a floor under aggregate demand (total spending) so that the contraction caused by the initial supply shock does not become self-amplifying.

The interconnectedness of the entire economy, and the inability of any individual to avoid the consequences of a social or economic breakdown by making different (better) choices — e.g., accepting a cut in wages to retain employment — was recognized by the most orthodox of all Cambridge University economists, Frederick Lavington, in his short book The Trade Cycle published in 1922 in the wake of the horrendous 1921-22 depression from which the profound observation that serves as the title of this post is taken.

It’s now 60 years since John Nash defined an equilibrium as a situation in which “each player’s mixed strategy maximizes his payoff if the strategies of the others are held fixed. Thus each player’s strategy is optimal against those of the others.” If the expectations of other agents on which other agents are conditioning their strategies (plans) are sufficiently pessimistic, then an unemployed worker may not be able to find employment at any wage, even if it is only a small fraction of the wage earned when last employed. That situation is not the result of a diminution in the productivity of the worker, but of the worsening expectations underlying the strategies (plans) of other agents.

To call unemployment “voluntary” under such circumstances is like calling the reduced speed of drivers in a traffic jam “voluntary.” To suppose that the intersection of a supply-demand diagram provides a relevant analysis of the problem of unemployment under circumstances in which there are massive layoffs of workers from their jobs is absurd. Nevertheless, modern macroeconomics for the most part proceeds as if the possibility of an inefficient Nash equilibrium is irrelevant to the problems with which it is concerned.

There are only two ways to prevent that cumulative decline from taking hold. The first is to ensure that there is an immediate readjustment of all relative prices to a new equilibrium at which all agents are able to simultaneously formulate and execute optimal plans by buying and selling at market-clearing equilibrium prices. Such an immediate readjustment of relative prices to a new equilibrium price vector is, for a multitude of reasons which I have described in my recent paper “Hayek, Hicks, Radner and Four Equilibrium Concepts,” an extremely implausible outcome.

If an immediate adjustment to an unexpected supply shock that would return a complex economy back to the neighborhood of equilibrium is not even remotely likely, then the only way to ensure against a cumulative decline of aggregate output and employment is to prevent total spending from declining. And if total spending is kept from declining in the face of a decline in total output due to a supply shock, then it follows, as a matter of simple arithmetic, that the prices at which the reduced output will be sold are going to be correspondingly higher than they would have been had output not fallen.

In the face of an adverse supply shock, a spell of inflation lasting as long as the downturn is therefore to be welcomed as benign and salutary, not resisted as evil and destructive. The time for a decline in, or reversal of, inflation ought to be postpone till the recovery is under way.

Noah Smith Gives Elizabeth Warren’s Economic Patriotism Plan Two Cheers; I Give it a Bit Less

Update 2/25/20 4:41pm EST: I wrote this post many months ago; I actually don’t remember where or when, but never posted it. I don’t remember why I didn’t post it. I don’t even know how it got posted, because, having long forgotten about it, I certainly wasn’t trying to post it. I was just searching for another old and published post of mine that I wanted to look at. But since it’s seen the light of day, I guess I will just leave it out there for whoever is interested.

Elizabeth Warren issued another one of her policy documents, this one a plan for advancing what she calls “economic patriotism,” a term that certainly doesn’t resonate in my own ears. But to each his own. Noah Smith lost no time publishing his own analysis of Warren’s proposals, no doubt after giving it a careful reading and a lot of careful thought.

Being less diligent than Noah, I haven’t actually read Warren’s policy proposals, but I did read Noah’s analysis of Warren’s proposals, and  here are some quick reactions to Noah and indirectly to Senator Warren.

It’s safe to say that the postwar free-trade consensus in Washington has crumbled. The main agent of its destruction was President Donald Trump, who fulfilled his campaign promises by canceling free-trade deals and launching trade wars with almost every country with which the U.S. does business. But the turn against free trade is bipartisan — socialist presidential candidate Bernie Sanders also promised to pull out of some international deals, and some prominent Democrats have backed Trump’s tariffs against China.

Now Senator and 2020 presidential candidate Elizabeth Warren has released a trade plan that goes squarely against the old consensus. Warren’s “A Plan For Economic Patriotism” would seek to revive U.S. industry in a number of ways — some of them smart, some of them problematic. The plan would leverage government-funded research and development to boost industry — a very good but hardly novel idea — and promote manufacturing (Warren also released a companion proposal specifically about manufacturing). The plan also would aggressively promote U.S. exports.

Although the purpose of the plan may be to triangulate Trump on trade, doing more to promote exports is probably a good idea in its own right. There is a growing body of evidence that nudging developing-country manufacturers to export increases their productivity, and some studies suggest that the phenomenon extends to rich countries like the U.S. This makes sense — when a company starts competing in international markets, it must up its game against global competition, improving efficiency, developing new products and so on.  But the U.S. domestic market is so large that American companies are often tempted to ignore the outside world; export promotion would fight this corrosive complacency.

I am inclined to favor free trade, but as I have observed before, the standard case for unilateral free trade is based on a number of implicit welfare assumptions that are not necessarily true and may leave out important considerations that are relevant to an appropriate analysis of trade policy. If we are trying to promote high employment then the best way of doing that is not by raising the price of imports which mainly benefits the owners of specialized domestic capital used in import-competing industries. It would be better to subsidize employment in industries that produce exports encouraging their expansion.

Then there’s the trade deficit. Countries can’t all run trade surpluses at each other’s expense, and attempts to do so can easily degenerate into a game of beggar-thy-neighbor. If a country runs trade deficits in order to fuel a temporary investment boom, which can help growth. But for more than two decades now, the U.S. has run substantial trade deficits even as investment’s share of the economy has fallen:

That suggests that U.S. consumers are consistently living beyond their means, which seems unsustainable. Increasing exports, rather than trying to cut imports as Trump has done, is a smart way to try to make U.S. consumption levels more sustainable.

The problem is how exactly to do it. Warren would dramatically expand the Export-Import bank’s activities, and direct more of its loans to smaller companies instead of big ones — a great idea that I have called for in the past. Warren would also consolidate the vast array of federal government agencies responsible for industrial policy into a single Department of Economic Development — another smart move.

I’m not following Noah’s reasoning. If the trade deficit is, as Noah correctly suggests, a reflection of a low US saving rate compared to saving in other countries, how will subsidizing exports raise the US propensity to save. Increasing the exports of some products will not induce Americans to increase their saving rate. If aggregate US saving doesn’t increase, the size of the trade deficit will not change; only the composition of that deficit will change.

A less savory tool is Warren’s proposal to have the federal government buy only American-made goods — a protectionist move that would do nothing to promote exports and would simply raise costs for the infrastructure that U.S. manufacturers need to be competitive. Warren should discard this piece of the plan.


More actively managing our currency value to promote exports and domestic manufacturing…We should consider a number of tools and work with other countries harmed by currency misalignment to produce a currency value that’s better for our workers and our industries.

The dollar now functions as the world’s so-called reserve currency — other countries hold dollar assets as buffers against capital outflows, and many internationally traded commodities are priced in dollars. This increases global demand for dollars, which pushes up their value against other currencies. That makes it easier for Americans to borrow, but harder for them to export.

It’s hard to see how Warren’s plan would change that state of affairs. Currency intervention would probably come from the Federal Reserve; if the Fed prints dollars, it puts downward pressure on the dollar. But because the U.S. doesn’t have the same control over its financial system that China does, creating all those dollars would risk inflation.  The difficulty of maintaining an independent monetary policy while also targeting exchange rates is a well-known dilemma in international economics.

Precisely. Noah seems to referencing a policy of exchange-rate protection, which I have written about many times already on this blog, based on the classic article on the subject of the eminent Max Corden. The upshot of Corden’s article was that exchange-rate protection can only work if the monetary authority simultaneously intervenes to reduce the value of its currency in the foreign-exchange market by selling its currency in exchange for foreign currencies and tightens its domestic monetary policy. Exchange-rate intervention means increasing the quantity of the domestic currency, thereby causing domestic prices to rise. If domestic prices rise along with the depreciation of the exchange rate of the domestic currency, exporters gain no advantage. If exports are to be promoted by exchange-rate intervention, the monetary authority must either reduce the domestic quantity of money or increase the demand for it (usually by increasing reserve requirements for the banking system) while the exchange rate is depreciated, creating an excess domestic demand for money. If the domestic economy is chronically short of cash, the only way for cash balances to be increased is through reduced expenditure which means that imports will decrease and exports will increase as a result of reduced domestic expenditure. That doesn’t sound like the sort of strategy for currency manipulation to reduce the real effective exchange rate that Senator Warren would be inclined to support

As an alternative, the U.S. could try to stop other countries from holding U.S. dollar reserves and pricing commodities in dollars, thus forfeiting the dollar’s role as the global reserve currency. But this could destabilize the global financial system in ways that are poorly understood, and thus would be a risky move.

In the end, the best approach on the currency may simply be to put pressure on countries that intervene to reduce the value of their own currencies against the dollar. The problem is that China is by far the biggest of these — although it hasn’t had to intervene to hold down the yuan in recent years, its capital controls and currency management policies are still in place, limiting the potential for yuan appreciation. If other countries allow their own currencies to appreciate against the dollar, they’ll be putting themselves in an uncompetitive position relative to China.

Thus, the issues of economic patriotism, export promotion and currency revaluation will ultimately come back to China. Until and unless that giant country gives up its strategy of promoting manufactured exports to the U.S., it will be an uphill battle to correct the U.S.’s imbalances or revive its export competitiveness. A President Warren would be smarter than a President Trump on trade, but she would find herself confronting much the same challenges.

While China probably was a currency manipulator in the early years of this century, as reflected China’s rapid accumulation of foreign exchange, the pace of foreign exchange accumulation has since tapered off. China could be pressured to disgorge some of its enormous foreign-exchange holdings, which would require China to buy more foreign assets or increase imports from abroad. How that could be done is not exactly obvious, but the most likely way to achieve that result would be for the US to aim for a higher rate of inflation thereby increasing the cost to China and other holders of US foreign exchange of holding low-yielding US financial assets. Whether President Warren would find such a policy approach to her liking is far from obvious.

My Paper “Hayek, Hicks, Radner and Four Equilibrium Concepts” Is Now Available Online.

The paper, forthcoming in The Review of Austrian Economics, can be read online.

Here is the abstract:

Hayek was among the first to realize that for intertemporal equilibrium to obtain all agents must have correct expectations of future prices. Before comparing four categories of intertemporal, the paper explains Hayek’s distinction between correct expectations and perfect foresight. The four equilibrium concepts considered are: (1) Perfect foresight equilibrium of which the Arrow-Debreu-McKenzie (ADM) model of equilibrium with complete markets is an alternative version, (2) Radner’s sequential equilibrium with incomplete markets, (3) Hicks’s temporary equilibrium, as extended by Bliss; (4) the Muth rational-expectations equilibrium as extended by Lucas into macroeconomics. While Hayek’s understanding closely resembles Radner’s sequential equilibrium, described by Radner as an equilibrium of plans, prices, and price expectations, Hicks’s temporary equilibrium seems to have been the natural extension of Hayek’s approach. The now dominant Lucas rational-expectations equilibrium misconceives intertemporal equilibrium, suppressing Hayek’s insights thereby retreating to a sterile perfect-foresight equilibrium.

And here is my concluding paragraph:

Four score and three years after Hayek explained how challenging the subtleties of the notion of intertemporal equilibrium and the elusiveness of any theoretical account of an empirical tendency toward intertemporal equilibrium, modern macroeconomics has now built a formidable theoretical apparatus founded on a methodological principle that rejects all the concerns that Hayek found so vexing denies that all those difficulties even exist. Many macroeconomists feel proud of what modern macroeconomics has achieved, but there is reason to think that the path trod by Hayek, Hicks and Radner could have led macroeconomics in a more fruitful direction than the one on which it has been led by Lucas and his associates.

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.


Enter your email address to follow this blog and receive notifications of new posts by email.

Join 2,567 other followers

Follow Uneasy Money on WordPress.com