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Hicks on IS-LM and Temporary Equilibrium

Published October 14, 2014 expectations , general equilibrium , intertemporal equilibrium , IS-LM , J. R. Hicks , Keynes , temporary equilibrium , wage stickiness , Walrasian equilibrium 9 Comments
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Jan, commenting on my recent post about Krugman, Minsky and IS-LM, quoted the penultimate paragraph of J. R. Hicks’s 1980 paper on IS-LM in the Journal of Post-Keynesian Economics, a brand of economics not particularly sympathetic to Hicks’s invention. Hicks explained that in the mid-1930s he had been thinking along lines similar to Keynes’s even before the General Theory was published, and had the basic idea of IS-LM in his mind even before he had read the General Theory, while also acknowledging that his enthusiasm for the IS-LM construct had waned considerably over the years.

Hicks discussed both the similarities and the differences between his model and IS-LM. But as the discussion proceeds, it becomes clear that what he is thinking of as his model is what became his model of temporary equilibrium in Value and Capital. So it really is important to understand what Hicks felt were the similarities as well as the key differences between the temporary- equilibrium model, and the IS-LM model. Here is how Hicks put it:

I recognized immediately, as soon as I read The General Theory, that my model and Keynes’ had some things in common. Both of us fixed our attention on the behavior of an economy during a period—a period that had a past, which nothing that was done during the period could alter, and a future, which during the period was unknown. Expectations of the future would nevertheless affect what happened during the period. Neither of us made any assumption about “rational expectations” ; expectations, in our models, were strictly exogenous.3 (Keynes made much more fuss over that than I did, but there is the same implication in my model also.) Subject to these data— the given equipment carried over from the past, the production possibilities within the period, the preference schedules, and the given expectations— the actual performance of the economy within the period was supposed to be determined, or determinable. It would be determined as an equilibrium performance, with respect to these data.

There was all this in common between my model and Keynes’; it was enough to make me recognize, as soon as I saw The General Theory, that his model was a relation of mine and, as such, one which I could warmly welcome. There were, however, two differences, on which (as we shall see) much depends. The more obvious difference was that mine was a flexprice model, a perfect competition model, in which all prices were flexible, while in Keynes’ the level of money wages (at least) was exogenously determined. So Keynes’ was a model that was consistent with unemployment, while mine, in his terms, was a full employment model. I shall have much to say about this difference, but I may as well note, at the start, that I do not think it matters much. I did not think, even in 1936, that it mattered much. IS-LM was in fact a translation of Keynes’ nonflexprice model into my terms. It seemed to me already that that could be done; but how it is done requires explanation.

The other difference is more fundamental; it concerns the length of the period. Keynes’ (he said) was a “short-period,” a term with connotations derived from Marshall; we shall not go far wrong if we think of it as a year. Mine was an “ultra-short-period” ; I called it a week. Much more can happen in a year than in a week; Keynes has to allow for quite a lot of things to happen. I wanted to avoid so much happening, so that my (flexprice) markets could reflect propensities (and expectations) as they are at a moment. So it was that I made my markets open only on a Monday; what actually happened during the ensuing week was not to affect them. This was a very artificial device, not (I would think now) much to be recommended. But the point of it was to exclude the things which might happen, and must disturb the markets, during a period of finite length; and this, as we shall see, is a very real trouble in Keynes. (pp. 139-40)

Hicks then explained how the specific idea of the IS-LM model came to him as a result of working on a three-good Walrasian system in which the solution could be described in terms of equilibrium in two markets, the third market necessarily being in equilibrium if the other two were in equilibrium. That’s an interesting historical tidbit, but the point that I want to discuss is what I think is Hicks’s failure to fully understand the significance of his own model, whose importance, regrettably, he consistently underestimated in later work (e.g., in Capital and Growth and in this paper).

The point that I want to focus on is in the second paragraph quoted above where Hicks says “mine [i.e. temporary equilibrium] was a flexprice model, a perfect competition model, in which all prices were flexible, while in Keynes’ the level of money wages (at least) was exogenously determined. So Keynes’ was a model that was consistent with unemployment, while mine, in his terms, was a full employment model.” This, it seems to me, is all wrong, because Hicks, is taking a very naïve and misguided view of what perfect competition and flexible prices mean. Those terms are often mistakenly assumed to meant that if prices are simply allowed to adjust freely, all  markets will clear and all resources will be utilized.

I think that is a total misconception, and the significance of the temporary-equilibrium construct is in helping us understand why an economy can operate sub-optimally with idle resources even when there is perfect competition and markets “clear.” What prevents optimality and allows resources to remain idle despite freely adjustming prices and perfect competition is that the expectations held by agents are not consistent. If expectations are not consistent, the plans based on those expectations are not consistent. If plans are not consistent, then how can one expect resources to be used optimally or even at all? Thus, for Hicks to assert, casually without explicit qualification, that his temporary-equilibrium model was a full-employment model, indicates to me that Hicks was unaware of the deeper significance of his own model.

If we take a full equilibrium as our benchmark, and look at how one of the markets in that full equilibrium clears, we can imagine the equilibrium as the intersection of a supply curve and a demand curve, whose positions in the standard price/quantity space depend on the price expectations of suppliers and of demanders. Different, i.e, inconsistent, price expectations would imply shifts in both the demand and supply curves from those corresponding to full intertemporal equilibrium. Overall, the price expectations consistent with a full intertemporal equilibrium will in some sense maximize total output and employment, so when price expectations are inconsistent with full intertemporal equilibrium, the shifts of the demand and supply curves will be such that they will intersect at points corresponding to less output and less employment than would have been the case in full intertemporal equilibrium. In fact, it is possible to imagine that expectations on the supply side and the demand side are so inconsistent that the point of intersection between the demand and supply curves corresponds to an output (and hence employment) that is way less than it would have been in full intertemporal equilibrium. The problem is not that the price in the market doesn’t allow the market to clear. Rather, given the positions of the demand and supply curves, their point of intersection implies a low output, because inconsistent price expectations are such that potentially advantageous trading opportunities are not being recognized.

So for Hicks to assert that his flexprice temporary-equilibrium model was (in Keynes’s terms) a full-employment model without noting the possibility of a significant contraction of output (and employment) in a perfectly competitive flexprice temporary-equilibrium model when there are significant inconsistencies in expectations suggests strongly that Hicks somehow did not fully comprehend what his own creation was all about. His failure to comprehend his own model also explains why he felt the need to abandon the flexprice temporary-equilibrium model in his later work for a fixprice model.

There is, of course, a lot more to be said about all this, and Hicks’s comments concerning the choice of a length of the period are also of interest, but the clear (or so it seems to me) misunderstanding by Hicks of what is entailed by a flexprice temporary equilibrium is an important point to recognize in evaluating both Hicks’s work and his commentary on that work and its relation to Keynes.

Aggregate Demand and Coordination Failures

Published October 8, 2014 Axel Leijonfuvud , coordination failure , credit deadlock , Earl Thompson , Hawtrey , Hayek , Keynes , liquidity trap 14 Comments
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Regular readers of this blog may have noticed that I have been writing less about monetary policy and more about theory and methodology than when I started blogging a little over three years ago. Now one reason for that is that I’ve already said what I want to say about policy, and, since I get bored easily, I look for new things to write about. Another reason is that, at least in the US, the economy seems to have reached a sustainable growth path that seems likely to continue for the near to intermediate term. I think that monetary policy could be doing more to promote recovery, and I wish that it would, but unfortunately, the policy is what it is, and it will continue more or less in the way that Janet Yellen has been saying it will. Falling oil prices, because of increasing US oil output, suggest that growth may speed up slightly even as inflation stays low, possibly even falling to one percent or less. At least in the short-term, the fall in inflation does not seem like a cause for concern. A third reason for writing less about monetary policy is that I have been giving a lot of thought to what it is that I dislike about the current state of macroeconomics, and as I have been thinking about it, I have been writing about it.

In thinking about what I think is wrong with modern macroeconomics, I have been coming back again and again, though usually without explicit attribution, to an idea that was impressed upon me as an undergrad and grad student by Axel Leijonhufvud: that the main concern of macroeconomics ought to be with failures of coordination. A Swede, trained in the tradition of the Wicksellian Stockholm School, Leijonhufvud immersed himself in the study of the economics of Keynes and Keynesian economics, while also mastering the Austrian literature, and becoming an admirer of Hayek, especially Hayek’s seminal 1937 paper, “Economics and Knowledge.”

In discussing Keynes, Leijonhufvud focused on two kinds of coordination failures.

First, there is a problem in the labor market. If there is unemployment because the real wage is too high, an individual worker can’t solve the problem by offering to accept a reduced nominal wage. Suppose the price of output is $1 a unit and the wage is $10 a day, but the real wage consistent with full employment is $9 a day, meaning that producers choose to produce less output than they would produce if the real wage were lower, thus hiring fewer workers than they would if the real wage were lower than it is. If an individual worker offers to accept a wage of $9 a day, but other workers continue to hold out for $10 a day, it’s not clear that an employer would want to hire the worker who offers to work for $9 a day. If employers are not hiring additional workers because they can’t cover the cost of the additional output produced with the incremental revenue generated by the added output, the willingness of one worker to work for $9 a day is not likely to make a difference to the employer’s output and hiring decisions. It is not obvious what sequence of transactions would result in an increase in output and employment when the real wage is above the equilibrium level. There are complex feedback effects from a change, so that the net effect of making those changes in a piecemeal fashion is unpredictable, even though there is a possible full-employment equilibrium with a real wage of $9 a day. If the problem is that real wages in general are too high for full employment, the willingness of an individual worker to accept a reduced wage from a single employer does not fix the problem.

In the standard competitive model, there is a perfect market for every commodity in which every transactor is assumed to be able to buy and sell as much as he wants. But the standard competitive model has very little to say about the process by which those equilibrium prices are arrived at. And a typical worker is never faced with that kind of choice posited in the competitive model: an impersonal uniform wage at which he can decide how many hours a day or week or year he wants to work at that uniform wage. Under those circumstances, Keynes argued that the willingness of some workers to accept wage cuts in order to gain employment would not significantly increase employment, and might actually have destabilizing side-effects. Keynes tried to make this argument in the framework of an equilibrium model, though the nature of the argument, as Don Patinkin among others observed, was really better suited to a disequilibrium framework. Unfortunately, Keynes’s argument was subsequently dumbed down to a simple assertion that wages and prices are sticky (especially downward).

Second, there is an intertemporal problem, because the interest rate may be stuck at a rate too high to allow enough current investment to generate the full-employment level of spending given the current level of the money wage. In this scenario, unemployment isn’t caused by a real wage that is too high, so trying to fix it by wage adjustment would be a mistake. Since the source of the problem is the rate of interest, the way to fix the problem would be to reduce the rate of interest. But depending on the circumstances, there may be a coordination failure: bear speculators, expecting the rate of interest to rise when it falls to abnormally low levels, prevent the rate of interest from falling enough to induce enough investment to support full employment. Keynes put too much weight on bear speculators as the source of the intertemporal problem; Hawtrey’s notion of a credit deadlock would actually have been a better way to go, and nowadays, when people speak about a Keynesian liquidity trap, what they really have in mind is something closer to Hawtreyan credit deadlock than to the Keynesian liquidity trap.

Keynes surely deserves credit for identifying and explaining two possible sources of coordination failures, failures affecting the macroeconomy, because interest rates and wages, though they actually come in many different shapes and sizes, affect all markets and are true macroeconomic variables. But Keynes’s analysis of those coordination failures was far from being fully satisfactory, which is not surprising; a theoretical pioneer rarely provides a fully satisfactory analysis, leaving lots of work for successors.

But I think that Keynes’s theoretical paradigm actually did lead macroeconomics in the wrong direction, in the direction of a highly aggregated model with a single output, a bond, a medium of exchange, and a labor market, with no explicit characterization of the production technology. (I.e., is there one factor or two, and if two how is the price of the second factor determined? See, here, here, here, and here my discussion of Earl Thompson’s “A Reformulation of Macroeconomic Theory,” which I hope at some point to revisit and continue.)

Why was it the wrong direction? Because, the Keynesian model (both Keynes’s own version and the Hicksian IS-LM version of his model) ruled out the sort of coordination problems that might arise in a multi-product, multi-factor, intertemporal model in which total output depends in a meaningful way on the meshing of the interdependent plans, independently formulated by decentralized decision-makers, contingent on possibly inconsistent expectations of the future. In the over-simplified and over-aggregated Keynesian model, the essence of the coordination problem has been assumed away, leaving only a residue of the actual problem to be addressed by the model. The focus of the model is on aggregate expenditure, income, and output flows, with no attention paid to the truly daunting task of achieving sufficient coordination among the independent decision makers to allow total output and income to closely approximate the maximum sustainable output and income that the system could generate in a perfectly coordinated state, aka full intertemporal equilibrium.

This way of thinking about macroeconomics led to the merging of macroeconomics with neoclassical growth theory and to the routine and unthinking incorporation of aggregate production functions in macroeconomic models, a practice that is strictly justified only in a single-output, two-factor model in which the value of capital is independent of the rate of interest, so that the havoc-producing effects of reswitching and capital-reversal can be avoided. Eventually, these models were taken over by modern real-business-cycle theorists, who dogmatically rule out any consideration of coordination problems, while attributing all observed output and employment fluctuations to random productivity shocks. If one thinks of macroeconomics as an attempt to understand coordination failures, the RBC explanation of output and employment fluctuations is totally backwards; productivity fluctuations, like fluctuations in output and employment, are the not the results of unexplained random disturbances, they are the symptoms of coordination failures. That’s it, eureka! Solve the problem by assuming that it does not exist.

If you are thinking that this seems like an Austrian critique of the Keynesian model or the Keynesian approach, you are right; it is an Austrian critique. But it has nothing to do with stereotypical Austrian policy negativism; it is a critique of the oversimplified structure of the Keynesian model, which foreshadowed the reduction ad absurdum or modern real-business-cycle theory, which has nearly banished the idea of coordination failures from modern macroeconomics. The critique is not about the lack of a roundabout capital structure; it is about the narrow scope for inconsistencies in production and consumption plans.

I think that Leijonhufvud almost 40 years ago was getting at this point when he wrote the following paragraph near toward end of his book on Keynes.

The unclear mix of statics and dynamics [in the General Theory] would seem to be main reason for later muddles. One cannot assume that what went wrong was simply that Keynes slipped up here and there in his adaptation of standard tools, 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 from 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 simple, “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 step 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 that Keynes’. As an unhappy consequence, his far superior work on the fundamentals of the problem has not received the attention it deserves. (pp. 401-02)

I don’t think that we actually need to go back to Hayek, though “Economics and Knowledge” should certainly be read by every macroeconomist, but we do need to get a clearer understanding of the potential for breakdowns in economic activity to be caused by inconsistent expectations, especially when expectations are themselves mutually dependent and reinforcing. Because expectations are mutually interdependent, they are highly susceptible to network effects. Network effects produce tipping points, tipping points can lead to catastrophic outcomes. Just wanted to share that with you. Have a nice day.

Franklin Fisher on the Stability(?) of General Equilibrium

Published October 2, 2014 Franklin Fisher , general equilibrium , microfoundations , Walras's Law 11 Comments
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The eminent Franklin Fisher, winner of the J. B. Clark Medal in 1973, a famed econometrician and antitrust economist, who was the expert economics witness for IBM in its long battle with the U. S. Department of Justice, and was later the expert witness for the Justice Department in the antitrust case against Microsoft, currently emeritus professor professor of microeconomics at MIT, visited the FTC today to give a talk about proposals the efficient sharing of water between Israel, Palestine, and Jordan. The talk was interesting and informative, but I must admit that I was more interested in Fisher’s views on the stability of general equilibrium, the subject of a monograph he wrote for the econometric society Disequilibrium Foundations of Equilibrium Economics, a book which I have not yet read, but hope to read before very long.

However, I did find a short paper by Fisher, “The Stability of General Equilibrium – What Do We Know and Why Is It Important?” (available here) which was included in a volume General Equilibrium Analysis: A Century after Walras edited by Pacal Bridel.

Fisher’s contribution was to show that the early stability analyses of general equilibrium, despite the efforts of some of the most best economists of the mid-twentieth century, e.g, Hicks, Samuelson, Arrow and Hurwicz (all Nobel Prize winners) failed to provide a useful analysis of the question whether the general equilibrium described by Walras, whose existence was first demonstrated under very restrictive assumptions by Abraham Wald, and later under more general conditions by Arrow and Debreu, is stable or not.

Although we routinely apply comparative-statics exercises to derive what Samuelson mislabeled “meaningful theorems,” meaning refutable propositions about the directional effects of a parameter change on some observable economic variable(s), such as the effect of an excise tax on the price and quantity sold of the taxed commodity, those comparative-statics exercises are predicated on the assumption that the exercise starts from an initial position of equilibrium and that the parameter change leads, in a short period of time, to a new equilibrium. But there is no theory describing the laws of motion leading from one equilibrium to another, so the whole exercise is built on the mere assumption that a general equilibrium is sufficiently stable so that the old and the new equilibria can be usefully compared. In other words, microeconomics is predicated on macroeconomic foundations, i.e., the stability of a general equilibrium. The methodological demand for microfoundations for macroeconomics is thus a massive and transparent exercise in question begging.

In his paper on the stability of general equilibrium, Fisher observes that there are four important issues to be explored by general-equilibrium theory: existence, uniqueness, optimality, and stability. Of these he considers optimality to be the most important, as it provides a justification for a capitalistic market economy. Fisher continues:

So elegant and powerful are these results, that most economists base their conclusions upon them and work in an equilibrium framework – as they do in partial equilibrium analysis. But the justification for so doing depends on the answer to the fourth question listed above, that of stability, and a favorable answer to that is by no means assured.

It is important to understand this point which is generally ignored by economists. No matter how desirable points of competitive general equilibrium may be, that is of no consequence if they cannot be reached fairly quickly or maintained thereafter, or, as might happen when a country decides to adopt free markets, there are bad consequences on the way to equilibrium.

Milton Friedman remarked to me long ago that the study of the stability of general equilibrium is unimportant, first, because it is obvious that the economy is stable, and, second, because if it isn’t stable we are wasting our time. He should have known better. In the first place, it is not at all obvious that the actual economy is stable. Apart from the lessons of the past few years, there is the fact that prices do change all the time. Beyond this, however, is a subtler and possibly more important point. Whether or not the actual economy is stable, we largely lack a convincing theory of why that should be so. Lacking such a theory, we do not have an adequate theory of value, and there is an important lacuna in the center of microeconomic theory.

Yet economists generally behave as though this problem did not exist. Perhaps the most extreme example of this is the view of the theory of Rational Expectations that any disequilibrium disappears so fast that it can be ignored. (If the 50-dollar bill were really on the sidewalk, it would be gone already.) But this simply assumes the problem away. The pursuit of profits is a major dynamic force in the competitive economy. To only look at situations where the Invisible Hand has finished its work cannot lead to a real understanding of how that work is accomplished. (p. 35)

I would also note that Fisher confirms a proposition that I have advanced a couple of times previously, namely that Walras’s Law is not generally valid except in a full general equilibrium with either a complete set of markets or correct price expectations. Outside of general equilibrium, Walras’s Law is valid only if trading is not permitted at disequilibrium prices, i.e., Walrasian tatonnement. Here’s how Fisher puts it.

In this context, it is appropriate to remark that Walras’s Law no longer holds in its original form. Instead of the sum of the money value of all excess demands over all agents being zero, it now turned out that, at any moment of time, the same sum (including the demands for shares of firms and for money) equals the difference between the total amount of dividends that households expect to receive at that time and the amount that firms expect to pay. This difference disappears in equilibrium where expectations are correct, and the classic version of Walras’s Law then holds.

Explaining the Hegemony of New Classical Economics

Published September 30, 2014 Keynes , microfoundations , New Classicals , New Keynesians , rational expectations , wage stickiness 16 Comments
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Simon Wren-Lewis, Robert Waldmann, and Paul Krugman have all recently devoted additional space to explaining – ruefully, for the most part – how it came about that New Classical Economics took over mainstream macroeconomics just about half a century after the Keynesian Revolution. And Mark Thoma got them all started by a complaint about the sorry state of modern macroeconomics and its failure to prevent or to cure the Little Depression.

Wren-Lewis believes that the main problem with modern macro is too much of a good thing, the good thing being microfoundations. Those microfoundations, in Wren-Lewis’s rendering, filled certain gaps in the ad hoc Keynesian expenditure functions. Although the gaps were not as serious as the New Classical School believed, adding an explicit model of intertemporal expenditure plans derived from optimization conditions and rational expectations, was, in Wren-Lewis’s estimation, an improvement on the old Keynesian theory. The improvements could have been easily assimilated into the old Keynesian theory, but weren’t because New Classicals wanted to junk, not improve, the received Keynesian theory.

Wren-Lewis believes that it is actually possible for the progeny of Keynes and the progeny of Fisher to coexist harmoniously, and despite his discomfort with the anti-Keynesian bias of modern macroeconomics, he views the current macroeconomic research program as progressive. By progressive, I interpret him to mean that macroeconomics is still generating new theoretical problems to investigate, and that attempts to solve those problems are producing a stream of interesting and useful publications – interesting and useful, that is, to other economists doing macroeconomic research. Whether the problems and their solutions are useful to anyone else is perhaps not quite so clear. But even if interest in modern macroeconomics is largely confined to practitioners of modern macroeconomics, that fact alone would not conclusively show that the research program in which they are engaged is not progressive, the progressiveness of the research program requiring no more than a sufficient number of self-selecting econ grad students, and a willingness of university departments and sources of research funding to cater to the idiosyncratic tastes of modern macroeconomists.

Robert Waldmann, unsurprisingly, takes a rather less charitable view of modern macroeconomics, focusing on its failure to discover any new, previously unknown, empirical facts about macroeconomic, or to better explain known facts than do alternative models, e.g., by more accurately predicting observed macro time-series data. By that, admittedly, demanding criterion, Waldmann finds nothing progressive in the modern macroeconomics research program.

Paul Krugman weighed in by emphasizing not only the ideological agenda behind the New Classical Revolution, but the self-interest of those involved:

Well, while the explicit message of such manifestos is intellectual – this is the only valid way to do macroeconomics – there’s also an implicit message: from now on, only my students and disciples will get jobs at good schools and publish in major journals/ And that, to an important extent, is exactly what happened; Ken Rogoff wrote about the “scars of not being able to publish stick-price papers during the years of new classical repression.” As time went on and members of the clique made up an ever-growing share of senior faculty and journal editors, the clique’s dominance became self-perpetuating – and impervious to intellectual failure.

I don’t disagree that there has been intellectual repression, and that this has made professional advancement difficult for those who don’t subscribe to the reigning macroeconomic orthodoxy, but I think that the story is more complicated than Krugman suggests. The reason I say that is because I cannot believe that the top-ranking economics departments at schools like MIT, Harvard, UC Berkeley, Princeton, and Penn, and other supposed bastions of saltwater thinking have bought into the underlying New Classical ideology. Nevertheless, microfounded DSGE models have become de rigueur for any serious academic macroeconomic theorizing, not only in the Journal of Political Economy (Chicago), but in the Quarterly Journal of Economics (Harvard), the Review of Economics and Statistics (MIT), and the American Economic Review. New Keynesians, like Simon Wren-Lewis, have made their peace with the new order, and old Keynesians have been relegated to the periphery, unable to publish in the journals that matter without observing the generally accepted (even by those who don’t subscribe to New Classical ideology) conventions of proper macroeconomic discourse.

So I don’t think that Krugman’s ideology plus self-interest story fully explains how the New Classical hegemony was achieved. What I think is missing from his story is the spurious methodological requirement of microfoundations foisted on macroeconomists in the course of the 1970s. I have discussed microfoundations in a number of earlier posts (here, here, here, here, and here) so I will try, possibly in vain, not to repeat myself too much.

The importance and desirability of microfoundations were never questioned. What, after all, was the neoclassical synthesis, if not an attempt, partly successful and partly unsuccessful, to integrate monetary theory with value theory, or macroeconomics with microeconomics? But in the early 1970s the focus of attempts, notably in the 1970 Phelps volume, to provide microfoundations changed from embedding the Keynesian system in a general-equilibrium framework, as Patinkin had done, to providing an explicit microeconomic rationale for the Keynesian idea that the labor market could not be cleared via wage adjustments.

In chapter 19 of the General Theory, Keynes struggled to come up with a convincing general explanation for the failure of nominal-wage reductions to clear the labor market. Instead, he offered an assortment of seemingly ad hoc arguments about why nominal-wage adjustments would not succeed in reducing unemployment, enabling all workers willing to work at the prevailing wage to find employment at that wage. This forced Keynesians into the awkward position of relying on an argument — wages tend to be sticky, especially in the downward direction — that was not really different from one used by the “Classical Economists” excoriated by Keynes to explain high unemployment: that rigidities in the price system – often politically imposed rigidities – prevented wage and price adjustments from equilibrating demand with supply in the textbook fashion.

These early attempts at providing microfoundations were largely exercises in applied price theory, explaining why self-interested behavior by rational workers and employers lacking perfect information about all potential jobs and all potential workers would not result in immediate price adjustments that would enable all workers to find employment at a uniform market-clearing wage. Although these largely search-theoretic models led to a more sophisticated and nuanced understanding of labor-market dynamics than economists had previously had, the models ultimately did not provide a fully satisfactory account of cyclical unemployment. But the goal of microfoundations was to explain a certain set of phenomena in the labor market that had not been seriously investigated, in the hope that price and wage stickiness could be analyzed as an economic phenomenon rather than being arbitrarily introduced into models as an ad hoc, albeit seemingly plausible, assumption.

But instead of pursuing microfoundations as an explanatory strategy, the New Classicals chose to impose it as a methodological prerequisite. A macroeconomic model was inadmissible unless it could be explicitly and formally derived from the optimizing choices of fully rational agents. Instead of trying to enrich and potentially transform the Keynesian model with a deeper analysis and understanding of the incentives and constraints under which workers and employers make decisions, the New Classicals used microfoundations as a methodological tool by which to delegitimize Keynesian models, those models being insufficiently or improperly microfounded. Instead of using microfoundations as a method by which to make macroeconomic models conform more closely to the imperfect and limited informational resources available to actual employers deciding to hire or fire employees, and actual workers deciding to accept or reject employment opportunities, the New Classicals chose to use microfoundations as a methodological justification for the extreme unrealism of the rational-expectations assumption, portraying it as nothing more than the consistent application of the rationality postulate underlying standard neoclassical price theory.

For the New Classicals, microfoundations became a reductionist crusade. There is only one kind of economics, and it is not macroeconomics. Even the idea that there could be a conceptual distinction between micro and macroeconomics was unacceptable to Robert Lucas, just as the idea that there is, or could be, a mind not reducible to the brain is unacceptable to some deranged neuroscientists. No science, not even chemistry, has been reduced to physics. Were it ever to be accomplished, the reduction of chemistry to physics would be a great scientific achievement. Some parts of chemistry have been reduced to physics, which is a good thing, especially when doing so actually enhances our understanding of the chemical process and results in an improved, or more exact, restatement of the relevant chemical laws. But it would be absurd and preposterous simply to reject, on supposed methodological principle, those parts of chemistry that have not been reduced to physics. And how much more absurd would it be to reject higher-level sciences, like biology and ecology, for no other reason than that they have not been reduced to physics.

But reductionism is what modern macroeconomics, under the New Classical hegemony, insists on. No exceptions allowed; don’t even ask. Meekly and unreflectively, modern macroeconomics has succumbed to the absurd and arrogant methodological authoritarianism of the New Classical Revolution. What an embarrassment.

UPDATE (11:43 AM EDST): I made some minor editorial revisions to eliminate some grammatical errors and misplaced or superfluous words.

Temporary Equilibrium One More Time

Published September 23, 2014 expectations , intertemporal equilibrium , IS-LM , J. R. Hicks , Paul Krugman , rational expectations , temporary equilibrium 2 Comments
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It’s always nice to be noticed, especially by Paul Krugman. So I am not upset, but in his response to my previous post, I don’t think that Krugman quite understood what I was trying to convey. I will try to be clearer this time. It will be easiest if I just quote from his post and insert my comments or explanations.

Glasner is right to say that the Hicksian IS-LM analysis comes most directly not out of Keynes but out of Hicks’s own Value and Capital, which introduced the concept of “temporary equilibrium”.

Actually, that’s not what I was trying to say. I wasn’t making any explicit connection between Hicks’s temporary-equilibrium concept from Value and Capital and the IS-LM model that he introduced two years earlier in his paper on Keynes and the Classics. Of course that doesn’t mean that the temporary equilibrium method isn’t connected to the IS-LM model; one would need to do a more in-depth study than I have done of Hicks’s intellectual development to determine how much IS-LM was influenced by Hicks’s interest in intertemporal equilibrium and in the method of temporary equilibrium as a way of analyzing intertemporal issues.

This involves using quasi-static methods to analyze a dynamic economy, not because you don’t realize that it’s dynamic, but simply as a tool. In particular, V&C discussed at some length a temporary equilibrium in a three-sector economy, with goods, bonds, and money; that’s essentially full-employment IS-LM, which becomes the 1937 version with some price stickiness. I wrote about that a long time ago.

Now I do think that it’s fair to say that the IS-LM model was very much in the spirit of Value and Capital, in which Hicks deployed an explicit general-equilibrium model to analyze an economy at a Keynesian level of aggregation: goods, bonds, and money. But the temporary-equilibrium aspect of Value and Capital went beyond the Keynesian analysis, because the temporary equilibrium analysis was explicitly intertemporal, all agents formulating plans based on explicit future price expectations, and the inconsistency between expected prices and actual prices was explicitly noted, while in the General Theory, and in IS-LM, price expectations were kept in the background, making an appearance only in the discussion of the marginal efficiency of capital.

So is IS-LM really Keynesian? I think yes — there is a lot of temporary equilibrium in The General Theory, even if there’s other stuff too. As I wrote in the last post, one key thing that distinguished TGT from earlier business cycle theorizing was precisely that it stopped trying to tell a dynamic story — no more periods, forced saving, boom and bust, instead a focus on how economies can stay depressed. Anyway, does it matter? The real question is whether the method of temporary equilibrium is useful.

That is precisely where I think Krugman’s grasp on the concept of temporary equilibrium is slipping. Temporary equilibrium is indeed about periods, and it is explicitly dynamic. In my previous post I referred to Hicks’s discussion in Capital and Growth, about 25 years after writing Value and Capital, in which he wrote

The Temporary Equilibrium model of Value and Capital, also, is “quasi-static” [like the Keynes theory] – in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes.

As I read this passage now — and it really bothered me when I read it as I was writing my previous post — I realize that what Hicks was saying was that his desire to conform to the Keynesian paradigm led him to compromise the integrity of the temporary equilibrium model, by forcing it to be “quasi-static” when it really was essentially dynamic. The challenge has been to convert a “quasi-static” IS-LM model into something closer to the temporary-equilibrium method that Hicks introduced, but did not fully execute in Value and Capital.

What are the alternatives? One — which took over much of macro — is to do intertemporal equilibrium all the way, with consumers making lifetime consumption plans, prices set with the future rationally expected, and so on. That’s DSGE — and I think Glasner and I agree that this hasn’t worked out too well. In fact, economists who never learned temporary-equiibrium-style modeling have had a strong tendency to reinvent pre-Keynesian fallacies (cough-Say’s Law-cough), because they don’t know how to think out of the forever-equilibrium straitjacket.

Yes, I agree! Rational expectations, full-equilibrium models have turned out to be a regression, not an advance. But the way I would make the point is that the temporary-equilibrium method provides a sort of a middle way to do intertemporal dynamics without presuming that consumption plans and investment plans are always optimal.

What about disequilibrium dynamics all the way? Basically, I have never seen anyone pull this off. Like the forever-equilibrium types, constant-disequilibrium theorists have a remarkable tendency to make elementary conceptual mistakes.

Again, I agree. We can’t work without some sort of equilibrium conditions, but temporary equilibrium provides a way to keep the discipline of equilibrium without assuming (nearly) full optimality.

Still, Glasner says that temporary equilibrium must involve disappointed expectations, and fails to take account of the dynamics that must result as expectations are revised.

Perhaps I was unclear, but I thought I was saying just the opposite. It’s the “quasi-static” IS-LM model, not temporary equilibrium, that fails to take account of the dynamics produced by revised expectations.

I guess I’d say two things. First, I’m not sure that this is always true. Hicks did indeed assume static expectations — the future will be like the present; but in Keynes’s vision of an economy stuck in sustained depression, such static expectations will be more or less right.

Again, I agree. There may be self-fulfilling expectations of a low-income, low-employment equilibrium. But I don’t think that that is the only explanation for such a situation, and certainly not for the downturn that can lead to such an equilibrium.

Second, those of us who use temporary equilibrium often do think in terms of dynamics as expectations adjust. In fact, you could say that the textbook story of how the short-run aggregate supply curve adjusts over time, eventually restoring full employment, is just that kind of thing. It’s not a great story, but it is the kind of dynamics Glasner wants — and it’s Econ 101 stuff.

Again, I agree. It’s not a great story, but, like it or not, the story is not a Keynesian story.

So where does this leave us? I’m not sure, but my impression is that Krugman, in his admiration for the IS-LM model, is trying too hard to identify IS-LM with the temporary-equilibrium approach, which I think represented a major conceptual advance over both the Keynesian model and the IS-LM representation of the Keynesian model. Temporary equilibrium and IS-LM are not necessarily inconsistent, but I mainly wanted to point out that the two aren’t the same, and shouldn’t be conflated.

Krugman on Minsky, IS-LM and Temporary Equilibrium

Published September 21, 2014 expectations , IS-LM , J. R. Hicks , Keynes , Paul Krugman , temporary equilibrium 13 Comments
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Catching up on my blog reading, I found this one from Paul Krugman from almost two weeks ago defending the IS-LM model against Hyman Minsky’s criticism (channeled by his student Lars Syll) that IS-LM misrepresented the message of Keynes’s General Theory. That is an old debate, and it’s a debate that will never be resolved because IS-LM is a nice way of incorporating monetary effects into the pure income-expenditure model that was the basis of Keynes’s multiplier analysis and his policy prescriptions. On the other hand, the model leaves out much of what most interesting and insightful in the General Theory — precisely the stuff that could not easily be distilled into a simple analytic model.

Here’s Krugman:

Lars Syll approvingly quotes Hyman Minsky denouncing IS-LM analysis as an “obfuscation” of Keynes; Brad DeLong disagrees. As you might guess, so do I.

There are really two questions here. The less important is whether something like IS-LM — a static, equilibrium analysis of output and employment that takes expectations and financial conditions as given — does violence to the spirit of Keynes. Why isn’t this all that important? Because Keynes was a smart guy, not a prophet. The General Theory is interesting and inspiring, but not holy writ.

It’s also a protean work that contains a lot of different ideas, not necessarily consistent with each other. Still, when I read Minsky putting into Keynes’s mouth the claim that

Only a theory that was explicitly cyclical and overtly financial was capable of being useful

I have to wonder whether he really read the book! As I read the General Theory — and I’ve read it carefully — one of Keynes’s central insights was precisely that you wanted to step back from thinking about the business cycle. Previous thinkers had focused all their energy on trying to explain booms and busts; Keynes argued that the real thing that needed explanation was the way the economy seemed to spend prolonged periods in a state of underemployment:

[I]t is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.

So Keynes started with a, yes, equilibrium model of a depressed economy. He then went on to offer thoughts about how changes in animal spirits could alter this equilibrium; but he waited until Chapter 22 (!) to sketch out a story about the business cycle, and made it clear that this was not the centerpiece of his theory. Yes, I know that he later wrote an article claiming that it was all about the instability of expectations, but the book is what changed economics, and that’s not what it says.

This all seems pretty sensible to me. Nevertheless, there is so much in the General Theory — both good and bad – that isn’t reflected in IS-LM, that to reduce the General Theory to IS-LM is a kind of misrepresentation. And to be fair, Hicks himself acknowledged that IS-LM was merely a way of representing one critical difference in the assumptions underlying the Keynesian and the “Classical” analyses of macroeconomic equilibrium.

But I would take issue with the following assertion by Krugman.

The point is that Keynes very much made use of the method of temporary equilibrium — interpreting the state of the economy in the short run as if it were a static equilibrium with a lot of stuff taken provisionally as given — as a way to clarify thought. And the larger point is that he was right to do this.

When people like me use something like IS-LM, we’re not imagining that the IS curve is fixed in position for ever after. It’s a ceteris paribus thing, just like supply and demand. Assuming short-run equilibrium in some things — in this case interest rates and output — doesn’t mean that you’ve forgotten that things change, it’s just a way to clarify your thought. And the truth is that people who try to think in terms of everything being dynamic all at once almost always end up either confused or engaging in a lot of implicit theorizing they don’t even realize they’re doing.

When I think of a temporary equilibrium, the most important – indeed the defining — characteristic of that temporary equilibrium is that expectations of at least some agents have been disappointed. The disappointment of expectations is likely to, but does not strictly require, a revision of disappointed expectations and of the plans conditioned on those expectations. The revision of expectations and plans as a result of expectations being disappointed is what gives rise to a dynamic adjustment process. But that is precisely what is excluded from – or at least not explicitly taken into account by – the IS-LM model. There is nothing in the IS-LM model that provides any direct insight into the process by which expectations are revised as a result of being disappointed. That Keynes could so easily think in terms of a depressed economy being in equilibrium suggests to me that he was missing what I regard as the key insight of the temporary-equilibrium method.

Of course, there are those who argue, perhaps most notably Roger Farmer, that economies have multiple equilibria, each with different levels of output and employment corresponding to different expectational parameters. That seems to me a more Keynesian approach, an approach recognizing that expectations can be self-fulfilling, than the temporary-equilibrium approach in which the focus is on mistaken and conflicting expectations, not their self-fulfillment.

Now to be fair, I have to admit that Hicks, himself, who introduced the temporary-equilibrium approach in Value and Capital (1939) later (1965) suggested in Capital and Growth (p. 65) that both the Keynes in the General Theory and the temporary-equilibrium approach of Value and Capital were “quasi-static.” The analysis of the General Theory “is not the analysis of a process; no means has been provided by which we can pass from one Keynesian period to the next. . . . The Temporary Equilibrium model of Value and Capital, also, is quasi-static in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes.

Despite Hicks’s identification of the temporary-equilibrium method with Keynes’s method in the General Theory, I think that Hicks was overly modest in assessing his own contribution in Value and Capital, failing to appreciate the full significance of the method he had introduced. Which, I suppose, just goes to show that you can’t assume that the person who invents a concept or an idea is necessarily the one who has the best, or most comprehensive, understanding of what the concept means of what its significance is.

Nick Rowe Teaches Us a Lot about Apples and Bananas

Published September 17, 2014 coordination failure , expectations , networks , Nick Rowe 13 Comments
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Last week I wrote a post responding to a post by Nick Rowe about money and coordination failures. Over the weekend, Nick posted a response to my post (and to one by Brad Delong). Nick’s latest post was all about apples and bananas. It was an interesting post, though for some reason – no doubt unrelated to its form or substance – I found the post difficult to read and think about. But having now read, and I think, understood (more or less), what Nick wrote, I confess to being somewhat underwhelmed. Let me try to explain why I don’t think that Nick has adequately addressed the point that I was raising.

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

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

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

Bottom line. My conclusions.

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

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

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

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

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

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

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

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

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

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

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

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

Responding to Scott Sumner

Published September 14, 2014 coordination failure , Nick Rowe , Scott Sumner 12 Comments
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Scott Sumner cites this passage from my previous post about coordination failures.

I can envision a pure barter economy with incorrect price expectations in which individual plans are in a state of discoordination. Or consider a Fisherian debt-deflation economy in which debts are denominated in terms of gold and gold is appreciating. Debtors restrict consumption not because they are trying to accumulate more cash but because their debt burden is so great, any income they earn is being transferred to their creditors. In a monetary economy suffering from debt deflation, one would certainly want to use monetary policy to alleviate the debt burden, but using monetary policy to alleviate the debt burden is different from using monetary policy to eliminate an excess demand for money. Where is the excess demand for money?

Evidently, Scott doesn’t quite find my argument that coordination failures are possible, even without an excess demand for money, persuasive. So he puts the following question to me.

Why is it different from alleviating an excess demand for money?

I suppose that my response is this is: I am not sure what the question means. Does Scott mean to say that he does not accept that in my examples there really is no excess demand for money? Or does he mean that the effects of the coordination failure are no different from what they would be if there were an excess demand for money, any deflationary problem being treatable by increasing the quantity of money, thereby creating an excess supply of money. If Scott’s question is the latter, then he might be saying that the two cases are observationally equivalent, so that my distinction between a coordination failure with an excess demand for money and a coordination failure without an excess demand for money is really not a difference worth making a fuss about. The first question raises an analytical issue; the second a pragmatic issue.

Scott continues:

As far as I know the demand for money is usually defined as either M/P or the Cambridge K.  In either case, a debt crisis might raise the demand for money, and cause a recession if the supply of money is fixed.  Or the Fed could adjust the supply of money to offset the change in the demand for money, and this would prevent any change in AD, P, and NGDP.

I don’t know what Scott means when he says that the demand for money is usually defined as M/P. M/P is a number of units of currency. The demand for money is some functional relationship between desired holdings of money and a list of variables that influence those desired holdings. To say that the demand for money is defined as M/P is to assert an identity between the amount of money demanded and the amount in existence which rules out an excess demand for money by definition, so now I am really confused. The Cambridge k expresses the demand for money in terms of a desired relationship between the amount of money held and nominal income. But again, I can’t tell whether Scott is thinking of k as a functional relationship that depends on a list of variables or as a definition in which case the existence of an excess demand for money is ruled out by definition. So I am still confused.

I agree that a debt crisis could raise the demand for money, but in my example, it is entirely plausible that, on balance, the demand for money to hold went down because debtors would have to use all their resources to pay the interest owed on their debts.

I don’t disagree that the Fed could engage in a monetary policy that would alleviate the debt burden, but the problem they would be addressing would not be an excess demand for money; the problem being addressed would be the debt burden. but under a gold clause inflation wouldn’t help because creditors would be protected from inflation by the requirement that they be repaid in terms of a constant gold value.

Scott concludes:

Perhaps David sees the debt crisis working through supply-side channels—causing a recession despite no change in NGDP.  That’s possible, but it’s not at all clear to me that this is what David has in mind.

The case I had in mind may or may not be associated with a change in NGDP, but any change in NGDP was not induced by an excess demand for money; it was induced by an increase in the value of gold when debts were denominated, as they were under the gold clause, in terms of gold.

I hope that this helps.

PS I see that Nick Rowe has a new post responding to my previous post. I have not yet read it. But it is near the top of my required reading list, so I hope to have a response for him in the next day or two.

Nick Rowe on Money and Coordination Failures

Published September 11, 2014 expectations , Hayek , Nick Rowe , Radner model 19 Comments
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Via Brad Delong, I have been reading a month-old post by Nick Rowe in which Nick argues that every coordination failure is attributable to an excess demand for money. I think money is very important, but I am afraid that Nick goes a bit overboard in attempting to attribute every failure of macroeconomic coordination to a monetary source, where “monetary” means an excess demand for money. So let me try to see where I think Nick has gotten off track, or perhaps where I have gotten off track.

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

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

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

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

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

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

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

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

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

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

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

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

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

Explaining Post-Traumatic-Inflation Stress Disorder

Published September 9, 2014 gold standard , inflation , Paul Krugman , Steve Waldman 22 Comments
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Paul Krugman and Steve Waldman having been puzzling of late about why inflation is so viscerally opposed by the dreaded one percent (even more so by the ultra-dreaded 0.01 percent). Here’s how Krugman phrased the conundrum.

One thought I’ve had and written about is that the one percent (or actually the 0.01 percent) like hard money because they’re rentiers. But you can argue that this is foolish — that they have much more to gain from asset appreciation than they have to lose from the small chance of runaway inflation. . . .

But maybe the 1% doesn’t make the connection?

Steve Waldman, however, doesn’t take the one percent — and certainly not the 0.01 percent — for the misguided dunces that Krugman suggests they are. Waldman sees them as the cunning, calculating villains that we all (notwithstanding his politically correct disclaimer that the rich aren’t bad people) know they really are.

Soft money types — I’ve heard the sentiment from Scott Sumner, Brad DeLong, Kevin Drum, and now Paul Krugman — really want to see the bias towards hard money and fiscal austerity as some kind of mistake. I wish that were true. It just isn’t. Aggregate wealth is held by risk averse individuals who don’t individually experience aggregate outcomes. Prospective outcomes have to be extremely good and nearly certain to offset the insecurity soft money policy induces among individuals at the top of the distribution, people who have much more to lose than they are likely to gain.

That’s all very interesting. Are the rich opposed to inflation because they are stupid, or because they are clever? Krugman thinks it’s the former, Waldman the latter. And I agree; it is a puzzle.

But what about the poor and the middle class? Has anyone seen any demonstrations lately by the 99 percent demanding that the Fed increase its inflation target? Did even one Democrat in the Senate – not even that self-proclaimed socialist Bernie Sanders — threaten to vote against confirmation of Janet Yellen unless she promised to raise the Fed’s inflation target? Well, maybe that just shows that the Democrats are as beholden to the one percent as the Republicans, but I suspect that the real reason is because the 99 percent hate inflation just as much as the one percent do. I mean, don’t the 99 percent realize that inflation would increase total output and employment, thereby benefitting ordinary workers generally?

Oh, you say, workers must be afraid that inflation would reduce their real wages. That’s a widely believed factoid about inflation — that inflation is biased against workers, because wages adjust more slowly than other prices to changes in demand. Well, that factoid is not necessarily true, either in theory or in practice. That doesn’t mean that inflation might not be associated with reduced real wages, but if it is, it would mean that inflation is facilitating a market adjustment in real wages that would tend to increase total output and total employment, thereby increasing aggregate wages paid to workers. That is just the sort of tradeoff between a prospective upside from growth-inducing inflation and a perceived downside from inflation redistribution. In other words, the attitudes of the one percent and of the 99 percent toward inflation don’t seem all that different.

And aside from the potential direct output-expanding effect of inflation, there is also the redistributional effect from creditors to debtors. A lot of underwater homeowners could have sold their homes if a 10- or 20-percent increase in the overall price level had kept nominal home prices from falling below nominal mortgage indebtedness. Inflation would have been the simplest and easiest way to avoid a foreclosure crisis and getting stuck in a balance-sheet recession. Why weren’t underwater homeowners out their clamoring for some inflationary relief?

I have not done a historical study, but I cannot think of any successful political movement or campaign that has ever been carried out on a platform of increasing inflation. Even FDR, who saved the country from ruin by taking the US off the gold standard in 1933, did not say that he would do so when running for office.

Nor has anyone ever stated the case against inflation more eloquently than John Maynard Keynes, hardly a spokesman for the interests of rentiers.

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,” who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose. (Economic Consequences of the Peace)

One might say that when Keynes wrote this he was still very much of an orthodox Marshallian economist, who only later outgrew his orthodox prejudices when he finally saw the light and wrote the General Theory. But Keynes was actually quite explicit in the General Theory that he favored a monetary policy aiming at price-level stabilization. If Keynes favored inflation it was only in the context of counteracting a massive deflation. Similarly, Ralph Hawtrey, who famously likened opposition to monetary stimulus, out of fear of inflation, during the Great Depression to crying “fire, fire” during Noah’s Flood, favored a monetary regime aiming at stable money wages, a regime that over the long term would generate a gradually falling output price level. So I fail to see why anyone should be surprised that a pro-inflationary policy would be a tough sell even when unemployment is high.

But, in thinking about all this, I believe it may help to distinguish between two types of post-traumatic-inflation stress disorder. One is a kind of instinctual aversion to inflation, which I think is widely shared by people from all kinds of backgrounds, beliefs, and economic status. After arguing and pleading for higher inflation for over three years on this blog, I am a little bit embarrassed to make this admission, but I suffer from this type of post-traumatic-inflation stress disorder myself. I know that it’s weird, but every month when the CPI is announced, and the monthly change is less than 2%, I just get a warm fuzzy feeling inside of me. I know (or at least believe) that people will suffer because inflation is not higher than a measly 2%, but I can’t help getting that feeling of comfort and well-being when I hear that inflation is low. That just seems to be the natural order of things. And I don’t think that I am the only one who feels that way, though I probably suffer more guilt than most for not being able to suppress the feeling.

But there is another kind of post-traumatic-inflation stress disorder. This is a purely intellectual disorder brought on by excessive exposure to extreme libertarian dogmas associated with pop-Austrianism and reading too many (i.e., more than zero) novels by Ayn Rand. Unfortunately, one of the two major political parties seems to have been captured this group of ideologues, and anti-inflationary dogma has become an article of faith rather than a mere disposition. It is one thing to have a disposition or a bias in favor of low inflation; it is altogether different to make anti-inflationism a moral or ideological crusade. I think most people, whether they are in the one percent or the 99 percent are biased in favor of low inflation, but most of them don’t oppose inflation as a moral or ideological imperative. Now it’s true that that the attachment of a great many people to the gold standard before World War I was akin to a moral precept, but at least since the collapse of the gold standard in the Great Depression, most people no longer think about inflation in moral and ideological terms.

Before anti-inflationism became a moral crusade, it was possible for people like Richard Nixon and Ronald Reagan, who were disposed to favor low inflation, to accommodate themselves fairly easily to an annual rate of inflation of 4 percent. Indeed, it was largely because of pressure from Democrats to fight inflation by wage and price controls that Nixon did the unthinkable and imposed wage and price controls on August 15, 1971. Reagan, who had no interest in repeating that colossal blunder, instead fought against Paul Volcker’s desire to bring inflation down below 4 percent for most of his two terms. Of course, one doesn’t know to what extent the current moral and ideological crusade against inflation would survive an accession to power by a Republican administration. It is always easier to proclaim one’s ideological principles when one doesn’t have any responsibility to implement them. But given the current ideological commitment to anti-inflationism, there was never any chance for a pragmatic accommodation that might have used increased inflation as a means of alleviating economic distress.

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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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