In my previous post, I suggested that Stephen Williamson’s views about the incapacity of monetary policy to reduce unemployment, and his fears that monetary expansion would simply lead to higher inflation and a repeat of the bad old days the 1970s when inflation and unemployment spun out of control, follow from a theoretical presumption that the US economy is now operating (as it almost always does) in the neighborhood of equilibrium. This does not seem right to me, but it is the sort of deep theoretical assumption (e.g., like the rationality of economic agents) that is not subject to direct empirical testing. It is part of what the philosopher Imre Lakatos called the hard core of a (in this case Williamson’s) scientific research program. Whatever happens, Williamson will process the observed facts in terms of a theoretical paradigm in which prices adjust and markets clear. No other way of viewing reality makes sense, because Williamson cannot make any sense of it in terms of the theoretical paradigm or world view to which he is committed. I actually have some sympathy with that way of looking at the world, but not because I think it’s really true; it’s just the best paradigm we have at the moment. But I don’t want to follow that line of thought too far now, but who knows, maybe another time.
A good illustration of how Williamson understands his paradigm was provided by blogger J. P. Koning in his comment on my previous post copying the following quotation from a post written by Williamson a couple of years on his blog.
In other cases, as in the link you mention, there are people concerned about disequilibrium phenomena. These approaches are or were popular in Europe – I looked up Benassy and he is still hard at work. However, most of the mainstream – and here I’m including New Keynesians – sticks to equilibrium economics. New Keynesian models may have some stuck prices and wages, but those models don’t have to depart much from standard competitive equilibrium (or, if you like, competitive equilibrium with monopolistic competition). In those models, you have to determine what a firm with a stuck price produces, and that is where the big leap is. However, in terms of determining everything mathematically, it’s not a big deal. Equilibrium economics is hard enough as it is, without having to deal with the lack of discipline associated with “disequilibrium.” In equilibrium economics, particularly monetary equilibrium economics, we have all the equilibria (and more) we can handle, thanks.
I actually agree that departing from the assumption of equilibrium can involve a lack of discipline. Market clearing is a very powerful analytical tool, and to give it up without replacing it with an equally powerful analytical tool leaves us theoretically impoverished. But Williamson seems to suggest (or at least leaves ambiguous) that there is only one kind of equilibrium that can be handled theoretically, namely a fully optimal general equilibrium with perfect foresight (i.e., rational expectations) or at least with a learning process leading toward rational expectations. But there are other equilibrium concepts that preserve market clearing, but without imposing, what seems to me, the unreasonable condition of rational expectations and (near) optimality.
In particular, there is the Hicksian concept of a temporary equilibrium (inspired by Hayek’s discussion of intertemporal equilibrium) which allows for inconsistent expectations by economic agents, but assumes market clearing based on supply and demand schedules reflecting those inconsistent expectations. Nearly 40 years ago, Earl Thompson was able to deploy that equilibrium concept to derive a sub-optimal temporary equilibrium with Keynesian unemployment and a role for countercyclical monetary policy in minimizing inefficient unemployment. I have summarized and discussed Thompson’s model previously in some previous posts (here, here, here, and here), and I hope to do a few more in the future. The model is hardly the last word, but it might at least serve as a starting point for thinking seriously about the possibility that not every state of the economy is an optimal equilibrium state, but without abandoning market clearing as an analytical tool.
Uneasy Money 
David, thank you for yet another great post.
I continue to be amazed by the quality of your blog posts and I always learn I lot from reading your stuff.
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As a non-economist (I know, that’s a bad omen at the start of a comment) I have always been bothered by the insistence on equilibria in economics. Economics theorizes about a world of living organisms. Living organisms depend on a continual flow of energy–primarily from the sun–to persist.
The biosphere is clearly not at an energy equilibrium. (Ignoring global warming, we may be at more-or-less energy steady state, though.) Since economics is about entities that depend on such an energy flow, to postulate that economic analysis is grounded in equilibrium-thinking seems wrong.
It seems more appropriate to base economic analysis on principles of optimization rather than equilibrium. Economic analysis is much more like evolutionary analysis. where optimization is much more important than equilibrium. Of course we do see steady state systems in nature. (Most of nature is in a relatively steady state most of the time.) Presumably that’s because it’s a locally optimum state rather than because there is some force pushing the system toward equilibrium.
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David
Interesting to note that Claudio Borio of the BIS published a WP:
Click to access work395.pdf
Where he writes:
Models should deal with true monetary economies, not with real economies treated as monetary ones, as is sometimes the case. Financial contracts are set in nominal, not in real, terms. More importantly, the banking system does not simply transfer real resources, more or less efficiently, from one sector to another; it generates (nominal) purchasing power. Deposits are not endowments that precede loan formation; it is loans that create deposits. Money is not a “friction” but a necessary ingredient that improves over barter. And while the generation of purchasing power acts as oil for the economic machine, it can, in the process, open the door to instability, when combined with some of the previous elements. Working with better representations of monetary economies should help cast further light on the aggregate and sectoral distortions that arise in the real economy when credit creation becomes unanchored, poorly pinned down by loose perceptions of value and risks. Only then will it be possible to fully understand the role that monetary policy plays in the macroeconomy. And in all probability, this will require us to move away from the heavy focus on equilibrium concepts and methods to analyse business fluctuations and to rediscover the merits of disequilibrium analysis.
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David
Great, again!
One of my many unwritten posts is on price theory and equilibrium, and how the ultimate macroeconomics will have a notion of adaptive-arbitrage(heuristic)-general equilibrium for its statics. And how Keynes was trying to build that through his words.
At the moment, we hobble back and forth between
1) Rational-Utility(algorithmic) -general equilibrium (everything post Lucas)
2) Adaptive-Utility-general equilibrium (Fisher’s model, also Friedman and Tobin in parts)
3) Adaptive-utility-partial equilibrium (Samuelson)
4) Much under-appreciated, much neglected Rational-Arbitrage-General equilibrium (Fischer Black).
And once we have settled that notion of static equilibrium, we will start incorporating Schumpeter and dynamic disequilibrium, and then, perhaps, we might be close to calling macroeconomics an advanced field.
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Lars, Thank you for being such an appreciative reader and commenter.
Russ, Economic equilibrium is a tricky concept, and I periodically receive comments from non-economists who don’t understand how the term is used in economics. The term can have both static and dynamic interpretations. In almost all cases, however, the idea of equilibrium is closely related to the idea of optimization. In fact, it is hard, if not impossible, to define equilibrium in economics without assuming that individuals are optimizing, even if the collective outcome is not optimal from the standpoint of all the individuals. That is the idea of a Nash-equilibrium in game theory. Each individual is optimizing, but the result is not optimal, because they fail to take into account the fact that their decisions are mutually interdependent.
Marcus, Thanks for sharing this. It looks interesting. My own view off the top of my head is that their idea won’t catch on until they figure out how to express this in terms of some equilibrium model. But that is just my uneducated guess.
Ritwik, As I just said to Marcus, economists are just not comfortable if they can’t reason in terms of some type of optimization or equilibrium. The trick is always to figure out how to redefine the problem or recast in such a way that equilibrium methods can be deployed.
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Hi David,
In your previous post you talked about “applying monetary policy to an economy out of equilibrium”. I presume that here you’re using the temporary equilibrium concept?
In this old post you talked about a “pessimistic expectations equilibrium”. Is that also temporary equilibrium?
Temporary equilibrium is different from the disequilibrium models (Benassy et al) that Williamson mentions, right? Would it be fair to say that disequilibrium models abandon market clearing but temporary equilibrium models don’t?
Ritwik, what is the difference between rational-utility and rational-arbitrage equilibrium?
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More thoughtful blogging.
The 1970s were different from today. Then you had a more-unionized private sector, and trade was 10 percent of GDP. Arthur Burns explicitly denigrated monetary policy as a tool to fight inflation.
Today the private decor is 7 percent unionized and trade is 30 percent of GDP. Try raising your prices on anything. The Internet too makes information free, including that about prices.
The worst weakness of today’s economic profession is re-fighting the 1960s and 1970s over and over again. They want to win the last war, the one they lost.
That said, there is the reality that the Fed has wiped out $2 trillion in federal debt recently. And is now on course to wipe out $1 trillion annually. (If the Fed buys MBS, if has to sell someday, or hold to maturity, resulting in reduction in federal debt as they transfer proceeds to Treasury). Yet inflation is dead.
QE can’t last?
Maybe. Japan went to zero bound, tried QE 2001-6, and suffered no inflation, quite the opposite. Still deflation.
If we get trapped in zero bound—I think likely, given Fed timidity and the Japan model—then QE moves beyond default, and become a conventional policy.
This suggests the Fed should be moved into the Treasury. It will be generating trillions in revenues for the US government. A Treasury function.
Globally, we see sovereign yields heading towards zero. Zero bound all the time everywhere.
The next task for the economics profession is not wringing your hands over inflation, but what to do when the economy has slipped on the ice, and is in zero bound.That might be globally soon, thanks to central banker fixations on inflation.
Deficit spending does not work, see Japan. Certainly not if passive tightening is the rule.
And at zero bound, a central bank passively tightens, unless it conducts serious and sustained QE programs.
The stairway to heaven is the the joy of monetizing debt with only positive effects.
I know this is sacrilege, blasphemy to many.
But explain Japan. Explain the USA since the Fed started QE. We are seeing the lowest readings on the Cleveland Fed Index of Inflationary Expectations ever. After $2 trillion in QE. Monetizing dedt has not led to inflation. It has deleveraged the American taxpayer.
The Fed should be targeting 2 percent inflation–as a floor. Seriously.
So should the ECB and Japan. See the chart on sovereign yields. The world is headed to zero bound while central banker pompously pettifog about inflation.
And so far, no one has devised a real world lift-off from the zero bound.
That is where the danger lies.
Stephen Williamson is not advising us on how to escape zero bound. He seems to advocating the Japan approach.
I advocate we print (digitize0 money by the trillions. I want the bar full of big tippers, the auto lots crammed with buyers, the housing market booming.
Then tell me about fighting inflation.
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David, Thanks for replying to my comment. I’m not quite convinced, though. As I understand the economic sense of equilibrium, it is a true equilibrium. Like the Nash equilibrium, there is no way the state can be improved for any participant. In other words, there is no potential left unused. (Or if there is, the system is at a local minimum and can’t get to the global minimum through natural means.) That’s similar to saying that the system is in a minimum energy state. The fact that it gets there because the participants are each optimizing their value isn’t the point. It is still in a minimum energy state.
But a system that is based on an energy flow doesn’t have a minimal energy state because it keeps receiving new energy. All it can optimize is the rate at which it uses the energy flow.
This seems to me like an important distinction. I would have thought that the physicists-turned-economists would have said something about it — and perhaps they have. But I haven’t run across it.
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Good stuff, esp. on Williamson
Your write, “Market clearing is a very powerful analytical tool, and to give it up without replacing it with an equally powerful analytical tool leaves us theoretically impoverished.”
It seems to me this argument is not good science. Aren’t you are saying that “we are using something which is wrong because we don’t know what we should be using.”
It seems to me that good science would require one to stop using a failed analytic tool
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J P Koning
The arbitrage vs utility distinction is essentially about what kind of maximizing behaviour do we infuse our economic agents with. The arbitrage argument is about not leaving money on the table, it’s about a heuristic, procedural rationality as Leijonhufvud puts it. It is the hall-mark of Marshallian micro, that gets papered over when we start using utility curves and conceptualize rationality as ex-ante, algorithmic optimization.
But even beyond Marshall, it is also the mode of thinking that comes most naturally to someone who approaches macroeconomic questions from the perspective of finance, rather than consumption.
Thus Fischer Black, while going to the extent of arguing that ALL macroeconomic phenomena could be seen as in equilibrium, also conceptualized this equilibrium as a no-arbitrage equilibrium, rather than a optimally-consistent plans one.
Rational-utility equilibrium is Lucas. Rational-arbitrage equilibrium is Black. I have no doubt whose side I am on.
Friedman & Samuelson are said to have preserved elements of Marshallian price theory in their Walrasian overtures, but I contend that this was limited to adaptive expectations. In their commitment to utility theory, they were firmly Walrasian.
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JP, In principle, a “pessimistic expectations equilibrium” could be a full equilibrium, but in reality, as opposed to theory, there is never a full equilibrium, so it’s hard to say whether the pessimistic expectations equilibrium Is either a full equilibrium or a temporary equilibrium. Sorry, if I seem to be dodging your question, but it’s the best I can come up with at the moment.
You are right that as I am using the terms (which is really how Hicks defined them in Value and Capital), a temporary involves market clearing, but that doesn’t exclude the possibility that many resources are idle because of incorrect, overoptimistic, expectations. It is incorrect expectations, not the absence of market clearing, that induces the withholding of resources from current employment. Such withholding can have cumulative contractionary effects via the operation of Say’s Law, failure to supply causing demand to fall.
Benjamin, We are both inflationists, but I think that there is a time and place for everything. Perpetual inflation is not necessarily always the answer, even though temporary inflation is the answer for now..
Russ, You are talking about a pareto-optimal equilibrium. Pareto optimality is a property of full equilibrium under a very restrictive set of assumptions, even more restrictive than those required for the existence of a full equilibrium. A Nash equilibrium need not be Pareto-optimal. Think of the Prisoner’s dilemma. Optimizing independently, each prisoner makes a choice that leads to a jointly sub-optimal result. To get Pareto-optimality there has to be some form of communication between the two prisoners so that they don’t narrowly pursue their self-interest.
anonfromDetroit, Good science requires using the best available tool. You don’t give up an imperfect tool until you find something that works better. You can’t let the best be the enemy of the good. Physicists knew that there were problems with Newtonian mechanics before Einstein came along, but they didn’t abandon (and for many questions continue to use) Newtonian physics until Einstein showed that he had a better theory than Newton.
Ritwik, I like your conceptualization of the difference between Black and Lucas. I also prefer Black. Have you tried it out on Perry Mehrling?
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David
It seems to me that Richard Feynman would not agree with you. Newtonian physics is not “wrong,” it is limited. Newtonian physics makes accurate predictions and is used today because it is accurate.
In contrast, “market clearing” is not subject to experiment and does not forecast. It is nothing more than, at best, a thought experiment.
It seems to me that your piece
Well let me approach it this way. We can run lots of experiments that show that markets do not clear. Or, as Feynman permits since science can be based on observation or experience, we can simply observe and see that markets do not clear. So the proposition is wrong.
Now, a rigorous application of Feynman would result in a lot “smaller” economics, but isn’t that what we need?
In sum, my argument is that we need to reduce economics down to what is a science, and label the rest speculation and conjecture.
Now, a great consequence and benefit of this would be that economics would be built on the true fact that markets are irrational and do not tend toward equilibrium.
In sum, doesn’t the truth about irrationality and equilibrium put economics in the position that Einstein found himself when confronted with Quantum Mechanics?
Isn’t time to own up to the truth that God “plays dice,” with the economy?
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David, thanks for your response. I detect some W.H. Hutt in your response, especially in the word “withholdings”. When people are withholding, the market still clears because these people are demanding their own product, right?
Ritwik, I do tend to see things from the perspective of finance, rather than consumption. I remember this Perry Merhling quote which I like quite a bit. This seems to be what you are talking about with respect to an arbitrage equilibrium?
“Most significant, Black seems to have taken his overall vision of the economy from Fisher. Fisher’s accounting system presents a unified picture of the economy as a stock of wealth moving through time, throwing off a flow of services as it goes. In Fisher’s formulation all wealth is capital, not just machines and buildings, but also land and even human beings. …All produce a stream of income (services) so all are capital, and their income discounted back to the present is their capital value. Similarly, at the highest level of abstraction, there is no distinction between the traditional categories of wages, profit, and rent. All are incomes thrown off by capital, hence all are forms of the more general category of interest, which is the rate at which income flows from wealth.”
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David-
I did say, after the bars are full of big tippers, the car lots are short on product and the housing market is booming, and people can get jobs if they look, then talk to me about fighting inflation.
But moderate inflation forever (4 percent) is probably very livable.
China’s central bank targets four percent inflation, Seems to work.
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David
Thanks. No, I haven’t run it by Perry Mehrling, Perhaps I should!
JP Koning
I remember that quote as well. It completes the ‘finance-view’ of the world, but it isn’t necessarily what I was talking about with regard to arbitrage vs utility, which is more about how we perceive economic agents to be acting in their self interest. Utility maximization is a ‘constrained optimization’ problem for which we need to know preference sets, discount factors etc. while eliminating arbitrage is about following simple heuristics that don’t obviously leave money on the table.
I suppose the best I can do is leave you with these two papers from Leijonhufvud :
Click to access paperel.pdf
http://www.libertarianismo.org/livros/sgpeotmpaase.pdf#page=19
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anonfromDetroit, I am not sure that your distinction is significant. Very few if any propositions in economics are subject to experiment. I have no patience for criticisms of the scientific status of economics when it is simply not possible to subject the propositions of economics to the sort of empirical tests that physicists to which the propositions of physics can be subjected. Empirical tests in economics are always indirect and they always implicate a number of maintained hypotheses as well as the hypothesis ostensibly being tested, so there is always wiggle room in how to respond to a test that doesn’t corroborate a given hypothesis. That is also true in physics, by the way, but usually the distinction between the maintained hypothesis and the tested hypothesis is clearer. So you might as well condemn human beings for not being able to fly or live under water as criticize economics for being unscientific. Economics has to do the best it can with the data at its disposable which is very messy and complicated and not always very reliable. You say that we can run lots of experiments that show that markets do not clear. I say we had thousands of years of experiments that showed that the earth was stationary. Those experiments weren’t refuted they were reinterpreted in the light of a different theory. Every observation must be interpreted in the light of a theory. Alternative theories can make the same observations and interpret them in completely different ways. One has to have a whole constellation of observations and assess which theory does a better job of explaining the totality of relevant (from the standpoint of the theory) observations. It seems to me you are advocating a kind of economic behaviorism. Behaviorism seems to have failed in psychology. It would be a vastly greater failure in economics. On the other hand I do very much agree that uncertainty is an integral part of economics and theories that attempt to eliminate it, like modern real business cycle theories and their New Keynesian variants are very close to being a complete waste of time.
JP, Yes, I am a fan of Hutt, though he clearly went overboard in his anti-Keynesian bias. Withholding is not inconsistent with market clearing, when it is done based on expectations of future prices that make it worthwhile (given the expectation) not to supply in the present. Whether withholding based on the exercise of market power is consistent with market clearing is a matter of definition, but I would be inclined to say that it is as well.
Benjamin, I am sure that perpetual 4% inflation is livable. Whether it is optimal is a different question. Where does it say that Chinese central bank is targeting 4% inflation?
Ritwik, Yes you should, and thanks for the links.
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David
So that we can continue to exchange thoughts lets just say that I don’t accept that we had thousands of years of experiments showing the earth was stationary and leave it at that.
My POV on what would be best for economics is that it forget macro for the time being, as there is no science there.
Contrary to your assertion, it seems to me that there are lots of experiments which economics could run which would lead to real insights in macro. For example, we could test different methods of bank regulation, especially the terms and conditions on which loans are made. We could test the regulation of securities. We could end the zero sum game of states competing, a zero sum game, with taxes, tax credits, etc.
As for behavorial, we could help ourselves a lot by studying behavior. For example, true entrepreneurs hate risk. They do everything possible to minimize risk. If we reduce risk, can we get more entrepreneurs?
Anyway, good comments on SW, again
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Ritwik, thanks for the links. David, thanks for your response. Good conversation, all.
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anonfromDetroit, The experiments that you propose would not doubt be worthwhile from a lot of different perspectives, but they have almost nothing in common with what we usually think of as scientific experiments which are designed to isolate the effect of a single causal factor under carefully controlled conditions. Seeing what happens when you try a lot of different types of regulation simply increases the number of degrees of freedom, making it more, not less, difficult to identify a stable relationship between observed variables. The problem with social science is that there are too many degrees of freedom (and they keep increasing). We will never generate enough data points to overcome all those degrees of freedom. Occasionally we get lucky, and can find a stable empirical relationship, but that’s the exception, not the rule.
JP, You’re welcome, and thanks, as always, for your astute comments and questions.
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Anonfromdetroit and David Glasner
I wonder if you have read and Stephen Jay Gould? Anon – I think you might like him. David – you may be very challenged. Stephen was a biological scientist, in what he called the historical sciences (I think I recall the phrase right). I find it very interesting but guess that he would rapidly understand the questions of dynamics, path, structure, and the exogenous that economics continues to confront and that Carlaw and Lipsey also raise.
I’m reading the Borio working paper. It opens the door that I hope you David, won’t shut. You seem to have a very narrow view of what economists prefer I.e. an equilibrium. There are many that Bario, and Schumpeter (even more so) in his History of Economic Analysis, refer to.
Best wishes,
Jim
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