Archive for the 'Don Patinkin' Category

A Tale of Two Syntheses

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

The Neoclassical Synthesis and the Mind-Body Problem

The neoclassical synthesis that emerged in the early postwar period aimed at reconciling the macroeconomic (IS-LM) analysis derived from Keynes via Hicks and others with the neoclassical microeconomic analysis of general equilibrium derived from Walras. The macroeconomic analysis was focused on an equilibrium of income and expenditure flows while the Walrasian analysis was focused on the equilibrium between supply and demand in individual markets. The two types of analysis seemed to be incommensurate inasmuch as the conditions for equilibrium in the two analysis did not seem to match up against each other. How does an analysis focused on the equality of aggregate flows of income and expenditure get translated into an analysis focused on the equality of supply and demand in individual markets? The two languages seem to be different, so it is not obvious how a statement formulated in one language gets translated into the other. And even if a translation is possible, does the translation hold under all, or only under some, conditions? And if so, what are those conditions?

The original neoclassical synthesis did not aim to provide a definitive answer to those questions, but it was understood to assert that if the equality of income and expenditure was assured at a level consistent with full employment, one could safely assume that market forces would take care of the allocation of resources, so that markets would be cleared and the conditions of microeconomic general equilibrium satisfied, at least as a first approximation. This version of the neoclassical synthesis was obviously ad hoc and an unsatisfactory resolution of the incommensurability of the two levels of analysis. Don Patinkin sought to provide a rigorous reconciliation of the two levels of analysis in his treatise Money, Interest and Prices. But for all its virtues – and they are numerous – Patinkin’s treatise failed to bridge the gap between the two levels of analysis.

As I mentioned recently in a post on Romer and Lucas, Kenneth Arrow in a 1967 review of Samuelson’s Collected Works commented disparagingly on the neoclassical synthesis of which Samuelson was a leading proponent. The widely shared dissatisfaction expressed by Arrow motivated much of the work that soon followed on the microfoundations of macroeconomics exemplified in the famous 1970 Phelps volume. But the motivation for the search for microfoundations was then (before the rational expectations revolution) to specify the crucial deviations from the assumptions underlying the standard Walrasian general-equilibrium model that would generate actual or seeming price rigidities, which a straightforward – some might say superficial — understanding of neoclassical microeconomic theory suggested were necessary to explain why, after a macro-disturbance, equilibrium was not rapidly restored by price adjustments. Two sorts of explanations emerged from the early microfoundations literature: a) search and matching theories assuming that workers and employers must expend time and resources to find appropriate matches; b) institutional theories of efficiency wages or implicit contracts that explain why employers and workers prefer layoffs to wage cuts in response to negative demand shocks.

Forty years on, the search and matching theories do not seem capable of accounting for the magnitude of observed fluctuations in employment or the cyclical variation in layoffs, and the institutional theories are still difficult to reconcile with the standard neoclassical assumptions, remaining an ad hoc appendage to New Keynesian models that otherwise adhere to the neoclassical paradigm. Thus, although the original neoclassical synthesis in which the Keynesian income-expenditure model was seen as a pre-condition for the validity of the neoclassical model was rejected within a decade of Arrow’s dismissive comment about the neoclassical synthesis, Tom Sargent has observed in a recent review of Robert Lucas’s Collected Papers on Monetary Theory that Lucas has implicitly adopted a new version of the neoclassical synthesis dominated by an intertemporal neoclassical general-equilibrium model, but with the proviso that substantial shocks to aggregate demand and the price level are prevented by monetary policy, thereby making the neoclassical model a reasonable approximation to reality.

Ok, so you are probably asking what does all this have to do with the mind-body problem? A lot, I think in that both the neoclassical synthesis and the mind-body problem involve a disconnect between two kinds – two levels – of explanation. The neoclassical synthesis asserts some sort of connection – but a problematic one — between the explanatory apparatus – macroeconomics — used to understand the cyclical fluctuations of what we are used to think of as the aggregate economy and the explanatory apparatus – microeconomics — used to understand the constituent elements of the aggregate economy — households and firms — and how those elements are related to, and interact with, each other.

The mind-body problem concerns the relationship between the mental – our direct experience of a conscious inner life of thoughts, emotions, memories, decisions, hopes and regrets — and the physical – matter, atoms, neurons. A basic postulate of science is that all phenomena have material causes. So the existence of conscious states that seem to us, by way of our direct experience, to be independent of material causes is also highly problematic. There are a few strategies for handling the problem. One is to assert that the mind truly is independent of the body, which is to say that consciousness is not the result of physical causes. A second is to say that mind is not independent of the body; we just don’t understand the nature of the relationship. There are two possible versions of this strategy: a) that although the nature of the relationship is unknown to us now, advances in neuroscience could reveal to us the way in which consciousness is caused by the operation of the brain; b) although our minds are somehow related to the operation of our brains, the nature of this relationship is beyond the capacity of our minds or brains to comprehend owing to considerations analogous to Godel’s incompleteness theorem (a view espoused by the philosopher Colin McGinn among others); in other words, the mind-body problem is inherently beyond human understanding. And the third strategy is to deny the existence of consciousness, because a conscious state is identical with the physical state of a brain, so that consciousness is just an epiphenomenon of a brain state; we in our naivete may think that our conscious states have a separate existence, but those states are strictly identical with corresponding brain states, so that whatever conscious state that we think we are experiencing has been entirely produced by the physical forces that determine the behavior of our brains and the configuration of its physical constituents.

The first, and probably the last, thing that one needs to understand about the third strategy is that, as explained by Colin McGinn (see e.g., here), its validity has not been demonstrated by neuroscience or by any other branch of science; it is, no less than any of the other strategies, strictly a metaphysical position. The mind-body problem is a problem precisely because science has not even come close to demonstrating how mental states are caused by, let alone that they are identical to, brain states, despite some spurious misinterpretations of research that purport to show such an identity.

Analogous to the scientific principle that all phenomena have material or physical causes, there is in economics and social science a principle called methodological individualism, which roughly states that explanations of social outcomes should be derived from theories about the conduct of individuals, not from theories about abstract social entities that exist independently of their constituent elements. The underlying motivation for methodological individualism (as opposed to political individualism with which it is related but from which it is distinct) was to counter certain ideas popular in the nineteenth and twentieth centuries asserting the existence of metaphysical social entities like “history” that are somehow distinct from yet impinge upon individual human beings, and that there are laws of history or social development from which future states of the world can be predicted, as Hegel, Marx and others tried to do. This notion gave rise to a two famous books by Popper: The Open Society and its Enemies and The Poverty of Historicism. Methodological individualism as articulated by Popper was thus primarily an attack on the attribution of special powers to determine the course of future events to abstract metaphysical or mystical entities like history or society that are supposedly things or beings in themselves distinct from the individual human beings of which they are constituted. Methodological individualism does not deny the existence of collective entities like society; it simply denies that such collective entities exist as objective facts that can be observed as such. Our apprehension of these entities must be built up from more basic elements — individuals and their plans, beliefs and expectations — that we can apprehend directly.

However, methodological individualism is not the same as reductionism; methodological individualism teaches us to look for explanations of higher-level phenomena, e.g., a pattern of social relationships like the business cycle, in terms of the basic constituents forming the pattern: households, business firms, banks, central banks and governments. It does not assert identity between the pattern of relationships and the constituent elements; it says that the pattern can be understood in terms of interactions between the elements. Thus, a methodologically individualistic explanation of the business cycle in terms of the interactions between agents – households, businesses, etc. — would be analogous to an explanation of consciousness in terms of the brain if an explanation of consciousness existed. A methodologically individualistic explanation of the business cycle would not be analogous to an assertion that consciousness exists only as an epiphenomenon of brain states. The assertion that consciousness is nothing but the epiphenomenon of a corresponding brain state is reductionist; it asserts an identity between consciousness and brain states without explaining how consciousness is caused by brain states.

In business-cycle theory, the analogue of such a reductionist assertion of identity between higher-level and lower level phenomena is the assertion that the business cycle is not the product of the interaction of individual agents, but is simply the optimal plan of a representative agent. On this account, the business cycle becomes an epiphenomenon; apparent fluctuations being nothing more than the optimal choices of the representative agent. Of course, everyone knows that the representative agent is merely a convenient modeling device in terms of which a business-cycle theorist tries to account for the observed fluctuations. But that is precisely the point. The whole exercise is a sham; the representative agent is an as-if device that does not ground business-cycle fluctuations in the conduct of individual agents and their interactions, but simply asserts an identity between those interactions and the supposed decisions of the fictitious representative agent. The optimality conditions in terms of which the model is solved completely disregard the interactions between individuals that might cause an unintended pattern of relationships between those individuals. The distinctive feature of methodological individualism is precisely the idea that the interactions between individuals can lead to unintended consequences; it is by way of those unintended consequences that a higher-level pattern might emerge from interactions among individuals. And those individual interactions are exactly what is suppressed by representative-agent models.

So the notion that any analysis premised on a representative agent provides microfoundations for macroeconomic theory seems to be a travesty built on a total misunderstanding of the principle of methodological individualism that it purports to affirm.

Sumner Sticks with Friedman

Scott Sumner won’t let go. Scott had another post today trying to show that the Cambridge Theory of the demand for money was already in place before Keynes arrived on the scene. He quotes from Hicks’s classic article “Mr. Keynes and the Classics” to dispute the quotation from another classic article by Hicks, “A Suggestions for Simplifying the Theory of Money,” which I presented in a post last week, demonstrating that Hicks credited Keynes with an important contribution to the demand for money that went beyond what Pigou, and even Lavington, had provided in their discussions of the demand for money.

In this battle of dueling quotations, I will now call upon Mark Blaug, perhaps the greatest historian of economics since Schumpeter, who in his book Economic Theory in Retrospect devotes an entire chapter (15) to the neoclassical theory of money, interest and prices. I quote from pp. 636-37 (4th edition).

Marshall and his followers went some way to move the theory of the demand for money in the direction of ordinary demand analysis, first, by relating money to net output or national income rather than the broader category of total transactions, and, second, by shifting from money’s rate of turnover to the proportion of annual income that the public wishes to hold in the form of money. In purely formal terms, there I nothing to choose between the Fisherian transaction approach and the Cambridge cash-balance approach, but the Cambridge formulation held out the potential of a genuine portfolio theory of the demand for money, which potential, however, was never fully exploited. . . .

The Cambridge formulation implies a demand for money equation, D_m = kPY, which contains no variable to represent the opportunity costs of holding cash, namely the rate of interest or the yield of alternative non-money assets, analogous to the relative price arguments of ordinary demand functions.
Yet a straight-forward application of utility-maximizing principles would have suggested that a rise in interest rates is likely to induce a fall in k as people strive to substitute interest-earning assets for passive money balances in their asset portfolios. Similarly, a fall in interest rates, by lowering the opportunity cost of holding money, is likely to cause a rise in k. Strangely enough, however, the Cambridge monetary theory never explicitly recognized the functional dependence of k on either the rate of interest or the rate on all non-monetary assets. After constructing a framework highly suggestive of a study of all the factors influencing cash-holding decisions, the Cambridge writers tended to lapse back to a list of the determinants of k that differed in no important respects from the list of institutional factors that Fisher had cited in his discussion of V. One can find references in Marshall, Pigou and particularly Lavington to a representative individual striking a balance between the costs of cash holdings in terms of interest foregone (minus the brokerage costs that would have been incurred by the movement into stocks and bonds) and their returns in terms of convenience and security against default but such passages were never systematically integrated with the cash-balance equation. As late as 1923, we find the young Keynes in A Tract on Monetary Reform interpreting k as a stable constant, representing an invariant link in the transmission mechanism connecting money to prices. If only Keynes at that date had read Wicksell instead of Marshall, he might have arrived at a money demand function that incorporates variations in the interest rate years before The General Theory (1936).

Moving to pp. 645-46, we find the following under the heading “The Demand for Money after Keynes.”

In giving explicit consideration to the yields on assets that compete with money, Keynes became one of the founders of the portfolio balance approach to monetary analysis. However, it is Hicks rather than Keynes who ought to be regarded as the founder of the view that the demand for money is simply an aspect of the problem of choosing an optimum portfolio of assets. In a remarkable paper published a year before the appearance of the General Theory, modestly entitled “A Suggestion for Simplifying the Theory of Money,” Hicks argued that money held at least partly as a store of value must be considered a type of capital asset. Hence the demand for money equation must include total wealth and expected rates of return on non-monetary assets as explanatory variables. Because individuals can choose to hold their entire wealth portfolios in the form of cash, the wealth variable represents the budget constraint on money holdings. The yield variables, on the other hand, represent both the opportunity costs of holding money and the substitutions effects of changes in relative rates of return. Individuals optimize their portfolio balances by comparing these yields with the imputed yield in terms of convenience and security of holding money. By these means, Hicks in effect treated the demand for money as a problem of balance sheet equilibrium analyzed along the same lines as those employed in ordinary demand theory.

It was Milton Friedman who carried this Hicksian analysis of money as a capital asset to its logical conclusion. In a 1956 essay, he set out a precise and complete specification of the relevant constraints and opportunity cost variable entering a household’s money demand function. His independent variable included wealth or permanent income – the present value of expected future receipts from all sources, whether personal earning or the income from real property and financial assets – the ratio of human to non-human wealth, expected rates of return on stocks, bonds and real assets, the nominal interest rate, the actual price level, and, finally, the expected percentage change in the price level. Like Hicks, Friedman specified wealth as the appropriate budget constraint but his concept of wealth was much broader than that adopted by Hicks. Whereas Keynes had viewed bonds as the only asset competing with cash, Friedman regarded all types of wealth as potential substitutes for cash holdings in an individual’s balance sheet; thus, instead of a single interest variable in the Keynesian liquidity preference equation, we get a whole list of relative yield variables in Friedman. An additional novel feature, entirely original with Friedman, is the inclusion of the expected rate of change in P as a measure of the anticipated rate of depreciation in the purchasing power of cash balances.

This formulation of the money demand function was offered in a paper entitled “The Quantity Theory of Money: A Restatement.” Friedman claimed not only that the quantity theory of money had always been a theory about the demand for money but also that his reformulation corresponded closely to what some of the great Chicago monetary economists, such as H.C. Simons and L. W. Mints, had always meant by the quantity theory. It is clear, however, from our earlier discussion that the quantity theory of money, while embodying an implicit conception of the demand for money, had always stood first and foremost for a theory of the determination of prices and nominal income; it contained much more than a particular theory of the demand for money.

Finally, Blaug remarks in his “notes for further reading” at the end of chapter 15,

In an influential essay, “The Quantity Theory of Money – A Restatement,” . . . M. Friedman claimed that his restatement was nothing more than the University of Chicago “oral” tradition. That claim was effectively destroyed by D. Patinkin, “The Chicago Tradition, the Quantity Theory, and Friedman, JMCB, 1969 .

Well, just a couple of quick comments on Blaug. I don’t entirely agree with everything he says about Cambridge monetary theory, and about the relative importance of Hicks and Keynes in advancing the theory of the demand for money. Cambridge economists may have been a bit more aware that the demand for money was a function of the rate of interest than he admits, and I think Keynes in chapter 17, definitely formulated a theory of the demand for money in a portfolio balance context, so I think that Friedman was indebted to both Hicks and Keynes for his theory of the demand for money.

As for Scott Sumner’s quotation from Hicks’s Mr. Keynes and the Classics, I think the point of that paper was not so much the theory of the demand for money, which had already been addressed in the 1935 paper from which I quoted, as to sketch out a way of generalizing the argument of the General Theory to encompass both the liquidity trap and the non-liquidity trap cases within a single graph. From the standpoint of the IS-LM diagram, the distinctive Keynesian contribution was the case of absolute liquidity preference, that doesn’t mean that Hicks meant that nothing had been added to the theory of the demand for money since Lavington. If that were the case, Hicks would have been denying that his 1935 paper had made any contribution. I don’t think that’s what he meant to suggest.

To sum up: 1) there was no Chicago oral tradition of the demand for money; 2) Friedman’s restatement of the quantity theory owed more to Keynes (and Hicks) than he admitted; 3) Friedman adapted the Cambridge/Keynes/Hicks theory of the demand for money in novel ways that allowed him to develop an analysis of price level changes that was more straightforward than was possible in the IS-LM model, thereby de-emphasizing the link between money and interest rates, which had been a such a prominent feature of the Keynesian models. That of course is a point that Scott Sumner likes to stress. In an upcoming post, I will comment on the fact that it was not just Keynesian models which stressed the link between money and interest rates. Pre-Keynesian monetary models also stressed the connection between easy money and low interest rates and dear money and high interest rates. Friedman’s argument was thus an innovation not only relative to Keynesian models but to orthodox monetary models. What accounts for this innovation?


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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