Archive for the 'Alchian' Category

OMG! The Age of Trump Is upon Us

UPDATE (11/11, 10:47 am EST): Clinton’s lead in the popular vote is now about 400,000 and according to David Leonhardt of the New York Times, the lead is likely to increase to as much as 2 million votes by the time all the votes are counted.

Here’s a little thought experiment for you to ponder. Suppose that the outcome of yesterday’s election had been reversed and Hillary Clinton emerged with 270+ electoral votes but trailed Donald Trump by 200,000 popular votes. What would the world be like today? What would we be hearing from Trump and his entourage about the outcome of the election? I daresay we would be hearing about “second amendment remedies” from many of the Trumpsters. I wonder how that would have played out.

(As I write this, I am hearing news reports about rowdy demonstrations in a number of locations against Trump’s election. Insofar as these demonstrations become violent, they are certainly deplorable, but nothing we have heard from Clinton and her campaign or from leaders of the Democratic Party would provide any encouragement for violent protests against the outcome of a free election.)

But enough of fantasies about an alternative universe; in the one that we happen to inhabit, the one in which Donald Trump is going to be sworn in as President of the United States in about ten weeks, we are faced with this stark reality. The American voters, in their wisdom, have elected a mountebank (OED: “A false pretender to skill or knowledge, a charlatan: a person incurring contempt or ridicule through efforts to acquire something, esp. social distinction or glamour.”), a narcissistic sociopath, as their chief executive and head of state. The success of Trump’s demagogic campaign – a campaign repackaging the repugnant themes of such successful 20th century American demagogues as Huey Long, Father Coughlin and George Wallace (not to mention not so successful ones like the deplorable Pat Buchanan) — is now being celebrated by Trump apologists and Banana Republican sycophants as evidence of his political genius in sensing and tapping into the anger and frustrations of the forgotten white working class, as if the anger and frustration of the white working class has not been the trump card that every two-bit demagogue and would-be despot of the last 150 has tried to play. Some genius.

I recently overheard a conversation between a close friend of mine who is a Trump supporter and a non-Trump supporter. My friend is white, but is not one of the poorly educated of whom Trump is so fond, holding a Ph.D. in physics, and being well read and knowledgeable about many subjects. Although he doesn’t like Trump, he is very conservative and can’t stand Clinton, so he decided to vote for Trump without any apparent internal struggle or second thoughts. One of his reasons for favoring Trump is his opposition to Obamacare, which he blames for the very large increase in premiums he has to pay for the medical insurance he gets through his employer. When it was pointed out to him that it is unlikely that the increase in his insurance premiums was caused by Obamacare, his response was that Obamacare has added to the regulations that insurance companies must comply with, so that the cost of those regulations is ultimately borne by those buying insurance, which means that his insurance premiums must have gone up because of Obamacare.

Since I wasn’t part of the conversation, I didn’t interrupt to point out that the standard arguments about the costs of regulation being ultimately borne by consumers of the regulated product don’t necessarily apply to markets like health care in which customers don’t have good information about whether suppliers are providing them with the services that they need or are instead providing unnecessary services to enrich themselves. In such markets, third-parties (i.e., insurance companies) supposedly better informed than patients about whether the services provided to patients by their doctors are really serving the patients’ interests, and are really worth the cost of providing those services, can help protect the interests of patients. Of course, the interests of insurance companies aren’t necessarily aligned very well with the interests of their policyholders either, because insurance companies may prefer not to pay for treatments that it would be in the interests of patients to receive.

So in health markets there are doctors treating ill-informed patients whose bills are being paid by insurance companies that try to monitor doctors to make sure that doctors do not provide unnecessary services and treatments to patients. But since the interests of insurance companies may be not to pay doctors to provide services that would be beneficial to patients, who is going to protect policyholders from the insurance companies? Well, um, maybe the government should be involved. Yes, but how do we know if the government is doing a good job or bad job of looking out for the interests of patients? I don’t think that we know the answer to that question. But Obamacare, aside from making medical insurance more widely available to people who need it, is an attempt to try to make insurance companies more responsive to the interests of their policyholders. Perhaps not the smartest attempt, by any means, but given the system of health care delivery that has evolved in the United States over the past three quarters of a century, it is not obviously a step in the wrong direction.

But even if Obamacare is not working well, and I have no well thought out opinion about whether it is or isn’t, the kind of simple-minded critique that my friend was making seemed to me to be genuinely cringe-worthy. Here is a Ph.D. in physics making an argument that sounded as if it were coming straight out of the mouth of Sean Hannity. OMG! The dumbing down of America is being expertly engineered by Fox News, and, boy, are they succeeding. Geniuses, that’s what they are. Geniuses!

When I took my first economics course almost a half century ago and read the greatest economics textbook ever written, University Economics by Armen Alchian and William Allen, I was blown away by their ability to show how much sloppy and muddled thinking there was about how markets work and how controls that prevent prices from allocating resources don’t eliminate destructive or wasteful competition, but rather shift competition from relatively cheap modes like offering to pay a higher price or to accept a lower price to relatively costly forms like waiting in line or lobbying a regulator to gain access to a politically determined allocation system.

I have been a fan of free markets ever since. I oppose government intervention in the economy as a default position. But the lazy thinking that once led people to assume that government regulation is the cure for all problems now leads people to assume that government regulation is the cause of all problems. What a difference half a century makes.

Susan Woodward Remembers Armen Alchian

Susan Woodward, a former colleague and co-author of the late great Armen Alchian, was kind enough to share with me an article of hers forthcoming in a special issue of the Journal of Corporate Finance dedicated to Alchian’s memory. I thank Susan and Harold Mulherin, co-editor of the Journal of Corporate Finance for allowing me to post this wonderful tribute to Alchian.

Memories of Armen

Susan Woodward

Sand Hill Econometrics

Armen Alchian approached economics with constructive eccentricity. An aspect became apparent long ago when I taught intermediate price theory, a two-quarter course. Jack Hirshleifer’s new text (Hirshleifer (1976)) was just out and his approach was the foundation of my own training, so that was an obvious choice. But also, Alchian and Allen’s University Economics (Alchian and Allen (1964)) had been usefully separated into parts, of which Exchange and Production: Competition, Coordination, and Control (Alchian and Allen (1977)), the “price theory” part, available in paperback. I used both books.

Somewhere in the second quarter we got to the topic of rent. Rent is such a difficult topic because it’s a word in everyone’s vocabulary but to which economists give a special, second meaning. To prepare a discussion, I looked up “rent” in the index of both texts. In Hirshleifer (1976), it appeared for the first time on some page like 417. In Alchian & Allen (1977), it appeared, say, on page 99, and page 102, and page 188, and pages 87-88, 336-338, and 364-365. It was peppered all through the book.

Hirshleifer approached price theory as geometry. Lay out the axioms, prove the theorems. And never introduce a new idea, especially one like “rent” that collides with standard usage, without a solid foundation. The Alchian approach is more exploratory. “Oh, here’s an idea. Let’s walk around the idea and see what it looks like from all sides. Let’s tip it over and see what’s under it and what kind of noise it makes. Let’s light a fire under it and just see what happens. Drop it ten stories.” The books were complements, not substitutes.

While this textbook story illustrates one aspect of Armen’s thinking, the big epiphanies came working on our joint papers. Unusual for students at UCLA in that era, I didn’t have Armen as a teacher. My first year, Armen was away, and Jack Hirshleifer taught the entire first year price theory. Entranced by the finance segment of that year, the lure of finance in business school was irresistible. But fortune did not abandon me.

I came back to UCLA to teach at the dawn of personal computers. Oh they were feeble! There was a little room on the eighth floor of Bunche Hall where there were three little Compaq computers—the ones with really tiny green-on-black screens. Portable, sort of, but not like a purse. Armen and I were regulars in this word processing cave. Armen would get bored and start a conversation by asking some profound question. I’d flounder a bit and tell him I didn’t know and go back to work. But one day he asked why corporations limit liability. Whew, something to say. It is not a risk story, but about facilitating transferable shares. Limit liability, then shareholders and contracting creditors can price possible recovery, and the wealth and resources of individual shareholder are then irrelevant. When liability tries to reach beyond the firm’s assets to those of individual shareholders, shareholder wealth matters to value, and this creates reasons for inhibiting share transfers. You can limit liability and still address concern about tort creditors by having the firm carrying insurance for torts.

Armen asked “How did you figure this out?” I said, “I don’t know.” “Have you written it down?” “No, it doesn’t seem important enough, it would only be two pages.” “Oh, no, of course it is!” He was right. What I wrote at Armen’s insistence, Woodward (1985), is now in two books of readings on the modern corporation, still in print, still on reading lists, and yes it was more than two pages. The paper by Bargeron and Lehn (2015) in this volume provides empirical confirmation about the impact of limited liability on share transferability. After our conversations about limited liability, Armen never again called me “Joanne,” as in the actress, Joanne Woodward, wife of Paul Newman.

This led to many more discussions about the organization of firms. I was dismayed by the seeming mysticism of “teamwork” as discussed in the old Alchian & Demsetz paper. Does it not all boil down to moral hazard and hold-up, both aspects of information costs, and the potential for the residual claimant to manage these? Armen came to agree and that this, too, was worth writing up. So we started writing. I scribbled down my thoughts. Armen read them and said, “Well, this is right, but it will make Harold (Demsetz) mad. We can’t say it that way. We’ll say it another way.” Armen saw it as his job to bring Harold around.

As we started working on this paper (Alchian and Woodward (1987)), I asked Armen, “What journal should we be thinking of?” Armen said “Oh, don’t worry about that, something will come along”. It went to Rolf Richter’s journal because Armen admired Rolf’s efforts to promote economic analysis of institutions. There are accounts of Armen pulling accepted papers from journals in order to put them into books of readings in honor of his friends, and these stories are true. No journal impressed Armen very much. He thought that if something was good, people would find it and read it.

Soon after the first paper was circulating, Orley Ashenfelter asked Armen to write a book review of Oliver Williamson’s The Economic Institutions of Capitalism (such a brilliant title!). I got enlisted for that project too (Alchian and Woodward (1988)). Armen began writing, but I went back to reread Institutions of Capitalism. Armen gave me what he had written, and I was baffled. “Armen, this stuff isn’t in Williamson.” He asked, “Well, did he get it wrong?” I said, “No, it’s not that he got it wrong. These issues just aren’t there at all. You attribute these ideas to him, but they really come from our other paper.” And he said “Oh, well, don’t worry about that. Some historian will sort it out later. It’s a good place to promote these ideas, and they’ll get the right story eventually.” So, dear reader, now you know.

This from someone who spent his life discussing the efficiencies of private property and property rights—to basically give ideas away in order to promote them? It was a good lesson. I was just starting my ten years in the federal government. In academia, thinkers try to establish property rights in ideas. “This is mine. I thought of this. You must cite me.” In government this is not a winning strategy. Instead, you need plant an idea, then convince others that it’s their idea so they will help you.

And it was sometimes Armen’s strategy in the academic world too. Only someone who was very confident would do this. Or someone who just cared more about promoting ideas he thought were right than he cared about getting credit for them. Or someone who did not have so much respect for the refereeing process. He was so cavalier!

Armen had no use for formal models that did not teach us to look somewhere new in the known world, nor had he any patience for findings that relied on fancy econometrics. What was Armen’s idea of econometrics? Merton Miller told me. We were chatting about limited liability. Merton asked about evidence. Well, all public firms with transferable shares now have limited liability. But in private, closely-held firms, loans nearly always explicitly specify which of the owner’s personal assets are pledged against bank loans. “How do you know?” “From conversations with bankers.” Merton said said, “Ah, this sounds like UCLA econometrics! You go to Armen Alchian and you ask, ‘Armen, is this number about right?’ And Armen says, ‘Yeah, that sounds right.’ So you use that number.”

Why is Armen loved so much? It’s not just his contributions to our understanding because many great thinkers are hardly loved at all. Several things stand out. As noted above, Armen’s sense of what is important is very appealing. Ideas are important. Ideas are more important than being important. Don’t fuss over the small stuff or the small-minded stuff, just work on the ideas and get them right. Armen worked at inhibiting inefficient behavior, but never in an obvious way. He would be the first to agree that not all competition is efficient, and in particular that status competition is inefficient. Lunches and dinners with Armen never included conversations about who was getting tenure where or why various papers got in or did not get in to certain journals. He thought it just did not matter very much or deserve much attention.

Armen was intensely curious about the world and interested in things outside of himself. He was one of the least self-indulgent people that I have ever met. It cheered everybody up. Everyone was in a better mood for the often silly questions that Armen would ask about everything, such as, “Why do they use decorations in the sushi bar and not anywhere else? Is there some optimality story here?” Armen recognized his own limitations and was not afraid of them.

Armen’s views on inefficient behavior came out in an interesting way when we were working on the Williamson book review. What does the word “fair” mean? In the early 1970’s at UCLA, no one was very comfortable with “fair”. Many would even have said ‘fair’ has no meaning in economics. But then we got to pondering the car repair person in the desert (remember Los Angeles is next to a big desert), who is in a position to hold up unlucky motorists whose vehicles break down in a remote place. Why would the mechanic not hold up the motorist and charge a high price? The mechanic has the power. Information about occasional holdups would provoke inefficient avoidance of travel or taking ridiculous precautions. But from the individual perspective, why wouldn’t the mechanic engage in opportunistic behavior, on the spot? “Well,” Armen said, “probably he doesn’t do it because he was raised right.” Armen knew what “fair” meant, and was willing to take a stand on it being efficient.

For all his reputation as a conservative, Armen was very interested in Earl Thompson’s ideas about socially efficient institutions, and the useful constraints that collective action could and does impose on us. (see, for example, Thompson (1968, 1974).) He had more patience for Earl that any of Earl’s other senior colleagues except possibly Jim Buchanan. Earl could go on all evening and longer about the welfare cost of the status rat race, of militarism and how to discourage it, the brilliance of agricultural subsidies, how no one should listen to corrupt elites, and Armen would smile and nod and ponder.

Armen was a happy teacher. As others attest in this issue, he brought great energy, engagement, and generosity to the classroom. He might have been dressed for golf, but he gave students his complete attention. He especially enjoyed teaching the judges in Henry Manne’s Economics & Law program. One former pupil sought him out and at dinner, brought up the Apple v. Microsoft copyright dispute. He wanted to discuss the merits of the issues. Armen said oh no, simply get the thing over with ASAP. Armen said that he was a shareholder in both companies, and consequently did not care who won, but cared very much about what resources were squandered on the battle. Though the economics of this perspective was not novel (it was aired in Texaco v Pennzoil few years earlier), Armen provided in that conversation a view that neither side had an interest in promoting in court. The reaction was: Oh! Those who followed this case might have been puzzled at the subsequent proceeding in this dispute, but those who heard the conversation at dinner were not.

And Armen was a warm and sentimental person. When I moved to Washington, I left my roller skates in the extra bedroom where I slept when I visited Armen and Pauline. These were old-fashioned skates with two wheels in the front and two in the back, Riedell boots and kryptonite wheels, bought at Rip City Skates on Santa Monica Boulevard, (which is still there in 2015! I just looked it up, the proprietor knows all the empty swimming pools within 75 miles). I would take my skates down to the beach and skate from Santa Monica to Venice and back, then go buy some cinnamon rolls at the Pioneer bakery, and bring them back to Mar Vista and Armen and Pauline and I would eat them. Armen loved this ritual. Is she back yet? When I married Bob Hall and moved back to California, Armen did not want me to take the skates away. So I didn’t.

And here is a story Armen loved: Ron Batchelder was a student at UCLA who is also a great tennis player, a professional tennis player who had to be lured out of tennis and into economics, and who has written some fine economic history and more. He played tennis with Armen regularly for many years. On one occasion before dinner Armen said to Ron, “I played really well today.” Ron said, “Yes, you did; you played quite well today.” And Armen said, “But you know what? When I play better, you play better.” And Ron smiled and shrugged his shoulders. I said, “Ron, is it true?” He shrugged again and said, “Well, a long time ago, I learned to play the customer’s game.” And of course Armen just loved that line. He re-told that story many times.

Armen’s enthusiasm for that story is a reflection of his enthusiasm for life. It was a rare enthusiasm, an extraordinary enthusiasm. We all give him credit for it and we should, because it was an act of choice; it was an act of will, a gift to us all. Armen would have never said so, though, because he was raised right.


Alchian, Armen A., William R. Allen, 1964. University Economics. Wadsworth Publishing Company, Belmont, CA.

Alchian, Armen A., William R. Allen, 1977 Exchange and Production: Competition, Coordination, and Control. Wadsworth Publishing Company, Belmont, CA., 2nd edition.

Alchian, Armen A., Woodward, Susan, 1987. “Reflections on the theory of the firm.” Journal of Institutional and Theoretical Economics. 143, 110-136.

Alchian, Armen A., Woodward, Susan, 1988. “The firm is dead: Long live the firm: A review of Oliver E. Williamson’s The Economic Institutions of Capitalism.” Journal of Economic Literature. 26, 65-79.

Bargeron, Leonce, Lehn, Kenneth, 2015. “Limited liability and share transferability: An analysis of California firms, 1920-1940.” Journal of Corporate Finance, this volume.

Hirshleifer, Jack, 1976. Price Theory and Applications. Prentice hall, Englewood Cliffs, NJ.

Thompson, Earl A., 1968. “The perfectly competitive production of public goods.” Review of Economics and Statistics. 50, 1-12.

Thompson, Earl A., 1974. “Taxation and national defense.” Journal of Political Economy. 82, 755-782.

Woodward, Susan E., 1985. “Limited liability in the theory of the firm.” Journal of Institutional and Theorectical Economics. 141, 601-611.

Microfoundations (aka Macroeconomic Reductionism) Redux

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Remembering Armen Alchian

On March 23, a memorial service celebrating the life of Armen Alchian was held at UCLA. David Henderson was there and shared some vignettes from the service.

Here is a webpage with pictures from the memorial.

Here is a tribute to Alchian by one of his finest students, Stephen N. S. Cheung. I found this passage especially moving, but follow the link and read the entire eulogy by Cheung.

Back in the old days at UCLA, it was not easy for graduate students to discuss research ideas with Alchian in person.  Most students harbored the impression that he was aloof and not very approachable.  I shared the same view initially, but discovered the contrary later.  The following is a true story.

In early 1967, after finishing the first lengthy chapter of my thesis, I received news from Hong Kong that my elder brother (who was a year older) had passed away.  Understanding that my mother must be shattered by the death of her favorite son, I thought about giving up at UCLA and returning to Hong Kong to be near her.  At that time I was already an assistant professor at the California State University at Long Beach.  I drove back to LA to tell Jack Hirshleifer the sad news and my intention to quit.  Hirshleifer thought that it would be a pity to abandon my dissertation, on which I had already made very good progress.  He then said he would discuss with other members of my thesis committee the possibility of granting me a PhD on the strength of the first long chapter alone.

That afternoon I went to see Alchian, planning to tell him what I told Hirshleifer.  Alchian obviously knew what I had in mind.  But before I had a chance to say anything, he said, “Don’t tell me anything about your personal matters.”  So I left without a word.  One day later in Long Beach, I received a letter from Alchian with a $500 check enclosed and simply two lines: “You can buy candies with this $500 or you can hire a typist to help you finish your dissertation as quickly as possible.”  This $500 was equivalent to my one month’s gross salary, so it was not a small amount.  What other alternatives did I have?  In less than two months I wrapped up my dissertation.  Alchian said it was a miracle.  In retrospect, I regret cashing that check and spending that $500.  If I had kept the check, I could now show it to my children, grandchildren, and students while telling them this proud story.  I know Armen would say, “Steve, put that check up for auction and see how much it would fare now.”

Here is another eulogy from the same website, and another eulogy from that website — in Chinese!

Here are remembrances from some of Alchian’s UCLA colleagues, including David Levine, John Riley and Harold Demsetz.

Here is the obituary about Alchian from the Los Angeles Times.

And finally (for now), here is a video clip of Alchian speaking about property rights.

Armen Alchian, The Economists’ Economist

The first time that I ever heard of Armen Alchian was when I took introductory economics at UCLA as a freshman, and his book (co-authored with his colleague William R. Allen who was probably responsible for the macro and international chapters) University Economics (the greatest economics textbook ever written) was the required text. I had only just started to get interested in economics, and was still more interested in political philosophy than in economics, but I found myself captivated by what I was reading in Alchian’s textbook, even though I didn’t find the professor teaching the course very exciting. And after 10 weeks (the University of California had switched to a quarter system) of introductory micro, I changed my major to economics. So there is no doubt that I became an economist because the textbook that I was taught from was written by Alchian.

In my four years as an undergraduate at UCLA, I took three classes from Axel Leijonhufvud, two from Ben Klein, two from Bill Allen, and one each from Robert Rooney, Nicos Devletoglou, James Buchanan, Jack Hirshleifer, George Murphy, and Jean Balbach. But Alchian, who in those days was not teaching undergrads, was a looming presence. It became obvious that Alchian was the central figure in the department, the leader and the role model that everyone else looked up to. I would see him occasionally on campus, but was too shy or too much in awe of him to introduce myself to him. One incident that I particularly recall is when, in my junior year, F. A. Hayek visited UCLA in the fall and winter quarters (in the department of philosophy!) teaching an undergraduate course in the philosophy of the social sciences and a graduate seminar on the first draft of Law, Legislation and Liberty. I took Hayek’s course on the philosophy of the social sciences, and audited his graduate seminar, and I occasionally used to visit his office to ask him some questions. I once asked his advice about which graduate programs he would suggest that I apply to. He mentioned two schools, Chicago, of course, and Princeton where his friends Fritz Machlup and Jacob Viner were still teaching, before asking, “but why would you think of going to graduate school anywhere else than UCLA? You will get the best training in economics in the world from Alchian, Hirshleifer and Leijonhufvud.” And so it was, I applied to, and was accepted at, Chicago, but stayed at UCLA.

As a first year graduate student, I took the (three-quarter) microeconomics sequence from Jack Hirshleifer (who in the scholarly hierarachy at UCLA ranked only slightly below Alchian) and the two-quarter macroeconomics sequence from Leijonhufvud. Hirshleifer taught a great course. He was totally prepared, very organized and his lectures were always clear and easy to follow. To do well, you had to sit back listen, review the lecture notes, read through the reading assignments, and do the homework problems. For me at least, with the benefit of four years of UCLA undergraduate training, it was a breeze.

Great as Hirshleifer was as a teacher, I still felt that I was missing out by not having been taught by Alchian. Perhaps Alchian felt that the students who took the microeconomics sequence from Hirshleifer should get some training from him as well, so the next year he taught a graduate seminar in topics in price theory, to give us an opportunity to learn from him how to do economics. You could also see how Alchian operated if you went to a workshop or lecture by a visiting scholar, when Alchian would start to ask questions. He would smile, put his head on his forehead, and say something like, “I just don’t understand that,” and force whoever it was to try to explain the logic by which he had arrived at some conclusion. And Alchian would just keep smiling, explain what the problem was with the answer he got, and ask more questions. Alchian didn’t shout or rant or rave, but if Alchian was questioning you, you were not in a very comfortable position.

So I was more than a bit apprehensive going into Alchian’s seminar. There were all kinds of stories told by graduate students about how tough Alchian could be on his students if they weren’t able to respond adequately when subjected to his questioning in the Socratic style. But the seminar could not have been more enjoyable. There was give and take, but I don’t remember seeing any blood spilled. Perhaps by the time I got to his seminar, Alchian, then about 57, had mellowed a bit, or, maybe, because we had all gone through the graduate microeconomics sequence, he felt that we didn’t require such an intense learning environment. At any rate, the seminar, which met twice a week for an hour and a quarter for 10 weeks, usually involved Alchian picking a story from the newspaper and asking us how to analyze the economics underlying the story. Armed with nothing but a chalkboard and piece of chalk, Alchian would lead us relatively painlessly from confusion to clarity, from obscurity to enlightenment. The key concepts with which to approach any problem were to understand the choices available to those involved, to define the relevant costs, and to understand the constraints under which choices are made, the constraints being determined largely by the delimitation of the property rights under which the resources can be used or exchanged, or, to be more precise, the property rights to use those resources can be exchanged.

Ultimately, the lesson that I learned from Alchian is that, at its best, economic theory is a tool for solving actual real problems, and the nature of the problem ought to dictate the way in which the theory (verbal, numerical, graphical, higher mathematical) is deployed, not the other way around. The goal is not to reach any particular conclusion, but to apply the tools in the best and most authentic way that they can be applied. Alchian did not wear his politics on his sleeve, though it wasn’t too hard to figure out that he was politically conservative with libertarian tendencies. But you never got the feeling that his politics dictated his economic analysis. In many respects, Alchian’s closest disciple was Earl Thompson, who studied under Alchian as an undergraduate, and then, after playing minor-league baseball for a couple of years, going to Harvard for graduate school, eventually coming back to UCLA as an assistant professor where he remained for his entire career. Earl, discarding his youthful libertarianism early on, developed many completely original, often eccentric, theories about the optimality of all kinds of government interventions – even protectionism – opposed by most economists, but Alchian took them all in stride. Mere policy disagreements never affected their close personal bond, and Alchian wrote the forward to Earl’s book with Charles Hickson, Ideology and the Evolution of Vital Economics Institutions. If Alchian was friendly with and an admirer of Milton Friedman, he just as friendly with, and just as admiring of, Paul Samuelson and Kenneth Arrow, with whom he collaborated on several projects in the 1950s when they consulted for the Rand Corporation. Alchian cared less about the policy conclusion than he did about the quality of the underlying economic analysis.

As I have pointed out on several prior occasions, it is simply scandalous that Alchian was not awarded the Noble Prize. His published output was not as voluminous as that of some other luminaries, but there is a remarkably high proportion of classics among his publications. So many important ideas came from him, especially thinking about economic competition as an evolutionary process, the distinction between the functional relationship between cost and volume of output and cost and rate of output, the effect of incomplete information on economic action, the economics of property rights, the effects of inflation on economic activity. (Two volumes of his Collected Works, a must for anyone really serious about economics, contain a number of previously unpublished or hard to find papers, and are available here.) Perhaps in the future I will discuss some of my favorites among his articles.

Although Alchian did not win the Nobel Prize, in 1990 the Nobel Prize was awarded to Harry Markowitz, Merton Miller, and William F. Sharpe for their work on financial economics. Sharp, went to UCLA, writing his Ph.D. dissertation on securities prices under Alchian, and worked at the Rand Corporation in the 1950s and 1960s with Markowitz.  Here’s what Sharpe wrote about Alchian:

Armen Alchian, a professor of economics, was my role model at UCLA. He taught his students to question everything; to always begin an analysis with first principles; to concentrate on essential elements and abstract from secondary ones; and to play devil’s advocate with one’s own ideas. In his classes we were able to watch a first-rate mind work on a host of fascinating problems. I have attempted to emulate his approach to research ever since.

And if you go to the Amazon page for University Economics and look at the comments you will see a comment from none other than Harry Markowitz:

I am about to order this book. I have just read its quite favorable reviews, and I am not a bit surprised at their being impressed by Armen Alchian’s writings. I was a colleague of Armen’s, at the Rand Corporation “think tank,” during the 1950s, and hold no economist in higher regard. When I sat down at my keyboard just now it was to find out what happened to Armen’s works. One Google response was someone saying that Armen should get a Nobel Prize. I concur. My own Nobel Prize in Economics was awarded in 1990 along with the prize for Wm. Sharpe. I see in Wikipedia that Armen “influenced” Bill, and that Armen is still alive and is 96 years old. I’ll see if I can contact him, but first I’ll buy this book.

I will always remember Alchian’s air of amused, philosophical detachment, occasionally bemused (though, perhaps only apparently so, as he tried to guide his students and colleagues with question to figure out a point that he already grasped), always curious, always eager for the intellectual challenge of discovery and problem solving. Has there ever been a greater teacher of economics than Alchian? Perhaps, but I don’t know who. I close with one more quotation, this one from Axel Leijonhufvud written about Alchian 25 years ago.  It still rings true.

[Alchian’s] unique brand of price theory is what gave UCLA Economics its own intellectual profile and achieved for us international recognition as an independent school of some importance—as a group of scholars who did not always take their leads from MIT, Chicago or wherever. When I came here (in 1964) the Department had Armen’s intellectual stamp on it (and he remained the obvious leader until just a couple of years ago ….). Even people outside Armen’s fields, like myself, learned to do Armen’s brand of economic analysis and a strong esprit de corps among both faculty and graduate students sprang from the consciousness that this ‘New Institutional Economics’ was one of the waves of the future and that we, at UCLA, were surfing it way ahead of the rest. But Armen’s true importance to the UCLA school did not stem just from the new ideas he taught or the outwardly recognized “brandname” that he created for us. For many of his young colleagues he embodied qualities of mind and character that seemed the more important to seek to emulate the more closely you got to know him.

My Paper (co-authored with Paul Zimmerman) on Hayek and Sraffa

I have just uploaded to the SSRN website a new draft of the paper (co-authored with Paul Zimmerman) on Hayek and Sraffa and the natural rate of interest, presented last June at the History of Economics Society conference at Brock University. The paper evolved from an early post on this blog in September 2011. I also wrote about the Hayek-Sraffa controversy in a post in June 2012 just after the HES conference.

One interesting wrinkle that occurred to me just as I was making revisions in the paper this week is that Keynes’s treatment of own rates in chapter 17 of the General Theory, which was in an important sense inspired by Sraffa, but, in my view, came to a very different conclusion from Sraffa’s, was actually nothing more than a generalization of Irving Fisher’s analysis of the real and nominal rates of interest, first presented in Fisher’s 1896 book Appreciation and Interest. In his Tract on Monetary Reform, Keynes extended Fisher’s analysis into his theory of covered interest rate arbitrage. What is really surprising is that, despite his reliance on Fisher’s analysis in the Tract and also in the Treatise on Money, Keynes sharply criticized Fisher’s analysis of the nominal and real rates of interest in chapter 13 of the General Theory. (I discussed that difficult passage in the General Theory in this post).  That is certainly surprising. But what is astonishing to me is that, after trashing Fisher in chapter 13 of the GT, Keynes goes back to Fisher in chapter 17, giving a generalized restatement of Fisher’s analysis in his discussion of own rates. Am I the first person to have noticed Keynes’s schizophrenic treatment of Fisher in the General Theory?

PS: My revered teacher, the great Armen Alchian passed away yesterday at the age of 98. There have been many tributes to him, such as this one by David Henderson, also a student of Alchian’s, in the Wall Street Journal. I have written about Alchian in the past (here, here, here, here, and here), and I hope to write about Alchian again in the near future. There was none like him; he will be missed terribly.

W. H. Hutt on Say’s Law and the Keynesian Multiplier

In a post a few months ago, I referred to W. H. Hutt as an “unjustly underrated” and “all but forgotten economist” and “as an admirable human being,” who wrote an important book in 1939, The Theory of Idle Resources, seeking to counter Keynes’s theory of involuntary unemployment. In responding to a comment on a more recent post, I pointed out that Armen Alchian relied on one of Hutt’s explanations for unemployment to provide a microeconomic basis for Keynes’s rather convoluted definition of involuntary unemployment, so that Hutt unintentionally provided support for the very Keynesian theory that he was tried to disprove. In this post, I want to explore Hutt’s very important and valuable book ARehabilitation of Say’s Law, even though, following Alchian, I would interpret what Hutt wrote in a way that is at least potentially supportive of Keynes, while also showing that Hutt’s understanding of Say’s Law allows us to view Says Law and the Keynesian multiplier as two (almost?) identical ways of describing the same phenomenon.

But before I discuss Hutt’s understanding of Say’s Law, a few words about why I think Hutt was an admirable human being are in order. Born in 1899 into a working class English family (his father was a printer), Hutt attended the London School of Economics in the early 1920s, coming under the influence of Edwin Cannan, whose writings Hutt often referred to. After gaining his bachelor’s degree, Hutt, though working full-time, continued taking courses at LSE, even publishing several articles before taking a position at the University of Capetown in 1930, despite having no advanced degree in economics. Hutt remained in South Africa until the late 1960s or early 1970s, becoming an outspoken critic of legal discrimination against non-whites and later of the apartheid regime instituted in 1948. In his book, The Economics of the Colour Bar, Hutt traced the racial policies of the South African regime not just to white racism, but to the interest of white labor unions in excluding competition by non-whites. Hutt’s hostility to labor unions for their exclusionary and protectionist policies was evident in much of his work, beginning at least with his Theory of Collective Bargaining, his Strike-Threat System, and his many critiques of Keynesian economics. However, he was opposed not to labor unions as such, just to the legal recognition of the right of some workers to coerce others into a collusive agreement to withhold their services unless their joint demand for a stipulated money wage was acceded to by employers, a right that in most other contexts would be both legally and morally unacceptable. Whether or not Hutt took his moral opposition to collective bargaining to extremes, he certainly was not motivated by any venal motives. Certainly his public opposition to apartheid, inviting retribution by the South African regime, was totally disinterested, and his opposition to collective bargaining was no less sincere, even If less widely admired, than his opposition to apartheid, and no more motivated by any expectation of personal gain.

In the General Theory, launching an attack on what he carelessly called “classical economics,” Keynes devoted special attention to the doctrine he described as Say’s Law, a doctrine that had been extensively and inconclusively debated in the nineteenth century after Say formulated what he had called the Law of the Markets in his Treatise on Political Economy in 1803. The exact meaning of the Law of the Markets was never entirely clear, so that, in arguing about Say’s Law, one can never be quite sure that one knows what one is talking about. At any rate, Keynes paraphrased Say’s Law in the following way: supply creates its own demand. In other words, “if you make it, they will buy it, or at least buy something else, because the capacity to demand is derived from the capacity to supply.”

Here is Keynes at p. 18 of the General Theory:

From the time of Say and Ricardo the classical economists have taught that supply creates its own demand; — meaning by this in some significant, but not clearly defined, sense that the whole of the costs of production must necessarily be spent in the aggregate, directly or indirectly, on purchasing the product.

In J. S. Mill’s Principles of Political Economy the doctrine is expressly set forth:

What constitutes the means of payment for commodities. Each person’s means of paying for the productions of other people consist of those which he himself possesses. All sellers are inevitably, and by the meaning of the word, buyers. Could we suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply; everybody would be able to buy twice as much, because every one would have twice as much to offer in exchange.

Then, again at p. 26, Keynes restates Say’s Law in his own terminology:

In the previous chapter we have given a definition of full employment in terms of the behavior of labour. An alternative, though equivalent, criterion is that at which we have now arrived, namely, a situation in which aggregate employment is inelastic in response to an increase in effective demand for its output. Thus Say’s Law, that the aggregate demand price of output as a whole is equal ot its aggregate supply price for all volumes of output [“could we suddenly double the productive powers of the country . . . we should . . . double the purchasing power”], is equivalent the proposition that there is no obstacle to full employment. If, however, this is not the true law relating the aggregate demand and supply functions, there is a vitally important chapter of economic theory which remains to be written and without which all discussions concerning the volume of aggregate employment are futile.

Keynes restated the same point in terms of his doctrine that macroeconomic equilibrium, the condition for which being that savings equal investment, could occur at a level of output and income corresponding to less than full employment. How could this happen? Keynes believed that if the amount that households desired to save at the full employment level of income were greater than the amount that businesses would invest at that income level, expenditure and income would decline until desired (and actual) savings equaled investment. If Say’s Law held, then whatever households chose not to spend would get transformed into investment by business, but Keynes denied that there was any mechanism by which this transformation would occur. Keynes proposed his theory of liquidity preference to explain why savings by households would not necessarily find their way into increased investment by businesses, liquidity preference preventing the rate of interest from adjusting to induce as much investment as required to generate the full-employment level of output and income.

Now the challenge for Keynes was to explain why, if there is less than full employment, wages would not fall to induce businesses to hire the unemployed workers. From Keynes’s point of view it wasn’t enough to assert that wages are sticky, because a classical believer in Say’s Law could have given that answer just as well.  If you prevent prices from adjusting, the result will be a disequilibrium.  From Keynes’s standpoint, positing price or wage inflexibility was not an acceptable explanation for unemployment.  So Keynes had to argue that, even if wages were perfectly flexible, falling wages would not induce an increase in employment. That was the point of Keynes’s definition of involuntary unemployment as a situation in which an increased price level, but not a fall in money wages, would increase employment. It was in chapter 19 of the General Theory that Keynes provided his explanation for why falling money wages would not induce an increase in output and employment.

Hutt’s insight was to interpret Say’s Law differently from the way in which most previous writers, including Keynes, had interpreted it, by focusing on “supply failures” rather than “demand failures” as the cause of total output and income falling short of the full-employment level. Every failure of supply, in other words every failure to achieve market equilibrium, means that the total effective supply in that market is less than it would have been had the market cleared. So a failure of supply (a failure to reach the maximum output of a particular product or service, given the outputs of all other products and services) implies a restriction of demand, because all the factors engaged in producing the product whose effective supply is less than its market-clearing level are generating less demand for other products than if they were producing the market-clearing level of output for that product. Similarly, if workers don’t accept employment at market-clearing wages, their failure to supply involves a failure to demand other products. Thus, failures to supply can be cumulative, because any failure of supply induces corresponding failures of demand, which, unless there are further pricing adjustments to clear other affected markets, trigger further failures of demand. And clearly the price adjustments required to clear any given market will be greater when other markets are not clearing than when those other markets are clearing.

So, with this interpretation, Hutt was able to deploy Say’s Law in a way that sheds important light on the cumulative processes of contraction and expansion characterizing business-cycle downturns and recoveries. In his modesty, Hutt disclaimed originality in using Say’s Law as a key to understanding those cumulative processes, citing various isolated statements by older economists (in particular a remark of the Cambridge economist Frederick Lavington in his 1921 book The Trade Cycle: “The inactivity of all is the cause of the inactivity of each”) that vaguely suggest, but don’t spell out, the process that Hutt describes in meticulous detail. If Hutt’s analysis was anticipated in any important way, it was by Clower and Leijonhufvud in their paper “Say’s Principle, What it Means and Doesn’t Mean,” (reprinted here and here), which introduced a somewhat artificial distinction between Say’s Law, as Keynes conceived of it, and Say’s Principle, which is closer to how Hutt thought about it.  But to Clower and Leijonhufvud, Say’s Principle was an essential part of the explanation of the Keynesian multiplier.  The connection between them is simple, effective supply is identical to effective demand because every purchase is also a sale.  A cumulative process can be viewed as either a supply-side process (Say’s Law) or a demand-side process (the Keynesian multiplier), but they are really just two sides of the same coin.

So if you have followed me this far, you may be asking yourself, did Hutt really rehabilitate Say’s Law, as he claimed to have done? And if so, did he refute Keynes, as he also claimed to have done? My answer to the first question is a qualified yes. And my answer to the second question is a qualified no. I will not try to justify my qualification to my answer to the first question, except to note that the qualification depends on the assumptions made about how money is supplied in the relevant model of the economy. In a model in which money is endogenously supplied by private banks, Say’s Law holds; in a model in which the supply of money is fixed exogenously, Say’s Law does not hold. For more on this, see my paper, “A Reinterpretation of Classical Monetary Theory,” or my book Free Banking and Monetary Reform (pp. 62-66).

But if Hutt was right about Say’s Law, how can Keynes be right that cutting money wages is not a good way (but in Hutt’s view the best way) to cure a depression that is itself caused by the mispricing of assets and factors of production? The answer is that, for all the care Hutt exercised in working out his analysis, he was careless in making explicit his assumptions about the expectations of workers about future wages (i.e., the wages at which they would be able to gain employment). The key point is that if workers expect to be able to find employment at higher wages than they will in fact be offered, the aggregate supply curve of labor will intersect the aggregate demand curve for labor at a wage rate that is higher, and a quantity that is lower, than would be the case in an equilibrium in which workers’ expectations about future wages were correct. From the point of view of Hutt, there is a supply failure because the aggregate supply of labor is less than the hypothetical equilibrium supply under correct wage expectations. But there is no restriction on market pricing, just incorrect expectations of future wages. Expectations need not be rigid, but in a cumulative process, wage expectations may not adjust as fast as wages are falling. Though Keynes, himself, did not discuss the possibility explicitly, it is also possible that there could be multiple equilibria corresponding to different sets of expectations (e.g., optimistic or pessimistic). If the economy settles into a pessimistic equilibrium, unemployment could stabilize at levels that are permanently higher than those that would have prevailed under an optimistic set of expectations. Perhaps we are now stuck in (or approaching) such a pessimistic equilibrium.

Be that as it may, Hutt simply assumes that allowing all prices to be determined freely in unfettered markets must result in the quick restoration of a full-employment equilibrium. This is a reasonable position to take, but there is no way of proving it logically. Proofs that free-market adjustment leads to an equilibrium are based on some sort of tatonnement or recontracting process in which trading does not occur at disequilibrium prices. In the real world, there is no restriction on trading at disequilibrium process, so there is no logical argument that shows that the Say’s Law dynamic described by Hutt cannot go on indefinitely without reaching equilibrium. F. A. Hayek, himself, explained this point in his classic 1937 paper “Economics and Knowledge.”

In the light of our analysis of the meaning of a state of equilibrium it should be easy to say what is the real content of the assertion that a tendency toward equilibrium exists. It can hardly mean anything but that, under certain conditions, the knowledge and intentions of the different members of society are supposed to come more and more into agreement or, to put the same thing in less general and less exact but more concrete terms, that the expectations of the people and particularly of the entrepreneurs will become more and more correct. In this form the assertion of the existence of a tendency toward equilibrium is clearly an empirical proposition, that is, an assertion about what happens in the real world which ought, at least in principle, to be capable of verification. And it gives our somewhat abstract statement a rather plausible common-sense meaning. The only trouble is that we are still pretty much in the dark about (a) the conditionsunder which this tendency is supposed to exist and (b) the nature of the process by which individual knowledge is changed.

In the usual presentations of equilibrium analysis it is generally made to appear as if these questions of how the equilibrium comes about were solved. But, if we look closer, it soon becomes evident that these apparent demonstrations amount to no more than the apparent proof of what is already assumed[11] . The device generally adopted for this purpose is the assumption of a perfect market where every event becomes known instantaneously to every member. It is necessary to remember here that the perfect market which is required to satisfy the assumptions of equilibrium analysis must not be confined to the particular markets of all the individual commodities; the whole economic system must be assumed to be one perfect market in which everybody knows everything. The assumption of a perfect market, then, means nothing less than that all the members of the community even if they are not supposed to be strictly omniscient, are at least supposed to know automatically all that is relevant for their decisions. It seems that that skeleton in our cupboard, the “economic man,” whom we have exorcised with prayer and fasting, has returned through the back door in the form of a quasi-omniscient individual.

Money Wages and Money Illusion

A couple of weeks ago, in the first of three posts about Armen Alchian’s discussion of the microeconomic underpinnings for Keynesian involuntary unemployment, I quoted the following passage from a footnote in Alchian’s classic paper, “Information Costs, Pricing, and Resource Unemployment.”

[C]onsider the following question: Why would a cut in money wages provoke a different response than if the price level rose relative to wages – when both would amount to the same change in relative prices, but differ only in the money price level? Almost everyone thought Keynes presumed a money wage illusion. However, an answer more respectful of Keynes is available. The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen. A cut only in one’s present job is revealed. The money versus real wage distinction is not the relevant comparison; the wage in the present job versus the wage in all other jobs is the relevant comparison. This rationalizes Keynes’ definition of involuntary unemployment in terms of price-level changes. If wages were cut everywhere else, and if employees knew it, they would not choose unemployment – but they would if they believed wages were cut just in their current job. When one employer cuts wages, this does not signify cuts elsewhere. His employees rightly think wages are not reduced elsewhere. On the other hand, with a rise in the price level, employees have less reason to think their current real wages are lower than they are elsewhere. So they do not immediately refuse a lower real wage induced by a higher price level, whereas they would refuse an equal money wage cut in their present job. It is the revelation of information about prospects elsewhere that makes the difference.

Saturos made the following comment on that post:

“The price level rise conveys different information: Money wages everywhere have fallen relative to prices. On the other hand, a cut in one’s own wage money wage does not imply options elsewhere have fallen.”

But that is money illusion. If my money wage rises by less than inflation, that says nothing about whether other money wages have risen by less than inflation. There is no explanation for a separate behavioral response to a cut in one’s observed real wage through nominal wages or prices – unless workers are observing their nominal wages instead of their real wages, i.e. money illusion.

I gave only a cursory response to Saturos’s comment, though I did come back to it in the third of my series of posts on Alchian’s discussion of Keynesian unemployment. But my focus was primarily on Alchian’s discussion of the validity of the inflation-induced-wage-lag hypothesis, a hypothesis disputed by Alchian and attributed by him to Keynes. I discussed my own reservations about Alchian’s position on the wage lag in that post, but here I want to go back and discuss Saturos’s objection directly. My claim is that there is a difference between the assumption that workers observe only nominal, not real, wages, in the process of making decisions about whether to accept or reject wage offers and the assumption of money illusion.

Here is how to think about the difference. In any period, some workers are searching for employment, and presumably they (or at least some of them) can search more efficiently (i.e., collect more wage offers) while unemployed than employed.  In obtaining wage offers, workers can only observe a nominal wage offer for their services; they can’t observe a real wage, because it is too costly and time-consuming for any individual to collect observations for all the goods and services that enter into a reasonably comprehensive price index, and then compute a price level from those price observations. However, based on experience and other sources of information, workers, like other economic agents, form expectations about what prices they will observe (i.e., the prices that will clear markets). In any period, workers’ wage expectations are determined, in part, by their expectations of movements in the general price level. The higher the expected rate of inflation, the higher the expected wage. The absence of money illusion means that workers change their expectations of wage offers (given expectations about changes in real wages) in line with their expectations of inflation. However, within any period, workers’ expectations are fixed. (Actually, the period can be defined as the length of time during which expectations are held fixed.) This is simply the temporary-equilibrium construct introduced by Hicks in Value and Capital and again in Capital and Growth.

With expectations fixed during a given period, workers, observing wage offers, either accept or reject those offers by comparing a given nominal nominal wage offer with the nominal reservation wage settled upon at the beginning of the period, a reservation wage conditional on the expectation of inflation for that period formed at the beginning of the period. Thus, the distinction made by Alchian between the information conveyed by a nominal-wage cut at a constant price level versus the information conveyed by a constant money wage at an unexpectedly high price level is perfectly valid, and entails no money illusion. The only assumption is that, over some finite period of time, inflation or price-level expectations are held constant instead of being revised continuously and instantaneously. Another way of saying this is that the actual rate of inflation does not always equal the expected rate of inflation. But to repeat, there is no assumption of money illusion. I am pretty sure that I heard Earl Thompson explain this in his graduate macrotheory class at UCLA around 1972-73, but I had to work through the argument again for myself before remembering that I had heard it all from Earl about 40 years earlier.

Alchian on Money Illusion and the Wage-Price Lag During Inflation

At the end of my post a couple of days ago, I observed that the last two sentences of the footnote that I reproduced from Alchian’s “Information Costs, Pricing, and Resource Unemployment,” required a lot of unpacking. So let’s come back to it and try to figure out what Alchian meant. The point of the footnote was to say that Keynes’s opaque definition of involuntary unemployment rested on a distinction between the information conveyed to workers by an increase in the price level, their money wage held constant, and the information conveyed to them by a reduction in their money wage, with the price level held constant. An increase in the price level with constant money wages conveys no information to workers about any change in their alternatives. Employed workers are not induced by an increase in prices to quit their current jobs in the expectation of finding higher paying jobs, and unemployed workers are not induced to refuse an offer from a prospective employer, as they would be if the employer cut the money wages at which he was willing pay his current employees or to hire new ones. That subtle difference in the information conveyed by a cut in real wages effected by rising prices versus the information conveyed by a cut in real wages effected by a cut in money wages, Alchian explained, is the reason that Keynes made his definition of involuntary unemployment contingent on the differing responses of workers to a reduced real wage resulting from a rising price level and from a falling money wage.

Here is where the plot thickens, because Alchian adds the following comment.

And this is perfectly consistent with Keynes’s definition of [involuntary] unemployment, and it is also consistent with his entire theory of market adjustment processes . . . , since he believed wages lagged behind nonwage prices – an unproved and probably false belief (R. A. Kessel and A. A. Alchian, “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices,” Amer. Econ. Rev. 50 [March 1960]:43-66). Without this belief a general price-level rise is indeed general; it includes wages, and as such there is no reason to believe a price-level rise is equivalent in real terms to a money-wage cut in a particular job.

So, according to Alchian, Keynes’s assumption that the information extracted by workers from a price-level increase is not the same as the information extracted from a nominal wage cut depends on the existence of a lag in the adjustment of wages to an inflationary disturbance. Keynes believed that during periods of inflation, output prices rise before, and rise faster than, wages rise, at least in the early stages of inflation. But if prices and wages rise simultaneously and at the same rate during inflation, then there would be no basis for workers to draw different inferences about their employment opportunities from observing price increases as opposed to observing a nominal wage cut. Alchian believes that the assumption that there is a wage-lag during inflation is both theoretically problematic, and empirically suspect, relying on several important papers that he co-authored with Reuben Kessel that found little support for the existence of such a lag in the historical data on wages and prices.

I have two problems with Alchian’s caveat about the existence of a wage-price lag.

First, Alchian’s premise (with which I agree totally) in the article from which I am quoting is that lack of information about the characteristics of goods being sold and about the characteristics of sellers or buyers (when the transaction involves a continuing relationship between the transactors) and about the prices and characteristics of alternatives induces costly search activities, the holding of inventories, and even rationing or queuing, as alternatives to immediate price adjustments as a response to fluctuations in demand or supply. The speed of price adjustment is thus an economically determined phenomenon, the speed depending on, among other things, the particular characteristics of the good or service being sold and the ease of collecting information about the good and service. For example, highly standardized commodities about which information is readily available tend to have more rapidly adjusting prices than those of idiosyncratic goods and services requiring intensive information gathering by transactors before they can come to terms on a transaction. If employment transactions typically involve a more intensive information gathering process about the characteristics of workers and employers than most other goods and services, then Alchian’s own argument suggests that there should be a lag in wage adjustment relative to the prices of most other goods. An inflation, on Alchian’s reasoning, ought to induce an initial response in the prices of the more standardized commodities with price adjustments in less standardized, more informationally complex, markets, like labor markets, coming later. So I don’t understand Alchian’s theoretical basis for questioning the existence of a wage lag.

Second, my memory is a bit hazy, and I will need to check his article on the wage lag, but I do believe that Alchian pointed out that there is a problem of interpretation in evaluating evidence on the wage lag, because inflation may occur concurrently, but independently, with another change that reduces the demand for labor and causes the real wage to fall. So if one starts, as did Keynes in his discussion of involuntary unemployment, from the premise that a recession is associated with a fall in the real demand for labor that requires a reduction in the real wage to restore full employment, then it is not clear to me why it would be rational for a worker to increase his reservation wage immediately upon observing that output prices are increasing. Workers will typically have some expectation about how rapidly the wage at which they can find employment will rise; this expectation is clearly related to their expectation of how fast prices will rise. If workers observe that prices are rising faster than they expected prices to rise, while their wage is not rising any faster than expected, there is uncertainty about whether their wage opportunities in general have fallen or whether the wage from their current employer has fallen relative to other opportunities. Saturos, in a comment on Tuesday’s post, argued that the two scenarios are indeed symmetrical and that to suggest otherwise is indeed an instance of money illusion. The argument is well taken, but I think that at least in transitional situations (when it seems to me theory supports the existence of a wage lag) and in which workers have some evidence of deteriorating macroeconomic conditions, there is a basis, independent of money illusion, for the Keynesian distinction about the informational content of a real wage cut resulting from a price level increase versus a real wage cut resulting from a cut in money wages.  But I am not sure that this is the last word on the subject.

Alchian on Why Wages Adjust Slowly and Why It Matters

In my previous post, I reproduced a footnote from Armen Alchian’s classic article “Information Costs, Pricing and Resource Unemployment,” a footnote explaining the theoretical basis for Keynes’s somewhat tortured definition of involuntary unemployment. In this post, I offer another excerpt from Alchian’s article, elaborating on the microeconomic rationale for “slow” adjustments in wages. In an upcoming post, I will try to tie some threads together and discuss the issue of whether there might be, contrary to Alchian’s belief, a theoretical basis for wages to lag behind other prices, ata least during the initial stages of inflation. Herewith are the first four paragraphs of section II (Labor Markets) of Alchian’s paper.

Though most analyses of unemployment rely on wage conventions, restriction, and controls to retard wage adjustments above market-clearing levels, [J. R.] Hicks and [W. H.] Hutt penetrated deeper. Hicks suggested a solution consistent with conventional exchange theory. He stated that “knowledge of opportunities is imperfect” and that the time required to obtain that knowledge leads to unemployment and a delayed effect on wages. [fn. J. R. Hicks, The Theory of Wages, 2d ed. (London, 1963), 45, 58. And headed another type – “the unemployment of the man who gives up his job to look for a better.”] It is precisely this enhanced significance that this paper seeks to develop, and which Hicks ignored when he immediately turned to different factors – unions and wage regulations, placing major blame on both for England’s heavy unemployment in the 1920s and 30s.

We digress to note that Keynes, in using a quantity-, instead of a price-, adjustment theory of exchange, merely postulated a “slow” reacting price without showing that slow price responses were consistent with utility or wealth-maximizing behavior in open, unconstrained markets. Keynes’s analysis was altered in the subsequent income-expenditure models where reliance was placed on “conventional” or “noncompetitive” wage rates. Modern “income-expenditure” theorists assumed “institutionally” or “irrationally” inflexible wages resulting from unions, money illusions, regulations, or factors allegedly idiosyncratic to labor. Keynes did not assume inflexibility for only wages. His theory rested on a more general scope of price inflexibility. [fn. For a thorough exposition and justification of these remarks on Keynes, see A. Leijonhufvud, On Keynesian Economics and the Economics of Keynes (Oxford, 1968).] The present paper may in part be viewed as an attempt to “justify” Keynes’s presumption about price response to disturbances in demand.

In 1939 W. H. Hutt exposed many of the fallacious interpretations of idleness and unemployment. Hutt applied the analysis suggested by Hicks but later ignored it when discussing Keynes’s analysis of involuntary unemployment and policies to alleviate it. [fn. W. H. Hutt, The Theory of Idle Resources (London, 1939), 165-69.] This is unfortunate, because Hutt’s analysis seems to be capable of explaining and accounting for a substantial portion of that unemployment.

If we follow the lead of Hicks and Hutt and develop the implications of “frictional” unemployment for both human and nonhuman goods, we can perceive conditions that will imply massive “frictional” unemployment and depressions in open, unrestricted, competitive markets with rational, utility maximizing, individual behavior.

So Alchian is telling us that it is at least possible to conceive of conditions in which massive unemployment and depressions are consistent with “open, unrestricted, competitive markets with rational, utility maximizing, individual behavior.” And presumably would be more going on in such periods of massive unemployment than the efficient substitution of leisure for work in periods of relatively low marginal labor productivity.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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