Archive for the 'expectations' Category

Hayek and Rational Expectations

In this, my final, installment on Hayek and intertemporal equilibrium, I want to focus on a particular kind of intertemporal equilibrium: rational-expectations equilibrium. In his discussions of intertemporal equilibrium, Roy Radner assigns a meaning to the term “rational-expectations equilibrium” very different from the meaning normally associated with that term. Radner describes a rational-expectations equilibrium as the equilibrium that results when some agents are able to make inferences about the beliefs held by other agents when observed prices differ from what they had expected prices to be. Agents attribute the differences between observed and expected prices to information held by agents better informed than themselves, and revise their own expectations accordingly in light of the information that would have justified the observed prices.

In the early 1950s, one very rational agent, Armen Alchian, was able to figure out what chemicals were being used in making the newly developed hydrogen bomb by identifying companies whose stock prices had risen too rapidly to be explained otherwise. Alchian, who spent almost his entire career at UCLA while also moonlighting at the nearby Rand Corporation, wrote a paper for Rand in which he listed the chemicals used in making the hydrogen bomb. When people at the Defense Department heard about the paper – the Rand Corporation was started as a think tank largely funded by the Department of Defense to do research that the Defense Department was interested in – they went to Alchian, confiscated and destroyed the paper. Joseph Newhard recently wrote a paper about this episode in the Journal of Corporate Finance. Here’s the abstract:

At RAND in 1954, Armen A. Alchian conducted the world’s first event study to infer the fuel material used in the manufacturing of the newly-developed hydrogen bomb. Successfully identifying lithium as the fusion fuel using only publicly available financial data, the paper was seen as a threat to national security and was immediately confiscated and destroyed. The bomb’s construction being secret at the time but having since been partially declassified, the nuclear tests of the early 1950s provide an opportunity to observe market efficiency through the dissemination of private information as it becomes public. I replicate Alchian’s event study of capital market reactions to the Operation Castle series of nuclear detonations in the Marshall Islands, beginning with the Bravo shot on March 1, 1954 at Bikini Atoll which remains the largest nuclear detonation in US history, confirming Alchian’s results. The Operation Castle tests pioneered the use of lithium deuteride dry fuel which paved the way for the development of high yield nuclear weapons deliverable by aircraft. I find significant upward movement in the price of Lithium Corp. relative to the other corporations and to DJIA in March 1954; within three weeks of Castle Bravo the stock was up 48% before settling down to a monthly return of 28% despite secrecy, scientific uncertainty, and public confusion surrounding the test; the company saw a return of 461% for the year.

Radner also showed that the ability of some agents to infer the information on which other agents are causing prices to differ from the prices that had been expected does not necessarily lead to an equilibrium. The process of revising expectations in light of observed prices may not converge on a shared set of expectations of the future based on commonly shared knowledge.

So rather than pursue Radner’s conception of rational expectations, I will focus here on the conventional understanding of “rational expectations” in modern macroeconomics, which is that the price expectations formed by the agents in a model should be consistent with what the model itself predicts that those future prices will be. In this very restricted sense, I believe rational expectations is a very important property that any model ought to have. It simply says that a model ought to have the property that if one assumes that the agents in a model expect the equilibrium predicted by the model, then, given those expectations, the solution of the model will turn out to be the equilibrium of the model. This property is a consistency and coherence property that any model, regardless of its substantive predictions, ought to have. If a model lacks this property, there is something wrong with the model.

But there is a huge difference between saying that a model should have the property that correct expectations are self-fulfilling and saying that agents are in fact capable of predicting the equilibrium of the model. Assuming the former does not entail the latter. What kind of crazy model would have the property that correct expectations are not self-fulfilling? I mean think about: a model in which correct expectations are not self-fulfilling is a nonsense model.

But demanding that a model not spout out jibberish is very different from insisting that the agents in the model necessarily have the capacity to predict what the equilibrium of the model will be. Rational expectations in the first sense is a minimal consistency property of an economic model; rational expectations in the latter sense is an empirical assertion about the real world. You can make such an assumption if you want, but you can’t claim that it is a property of the real world. Whether it is a property of the real world is a matter of fact, not a matter of methodological fiat. But methodological fiat is what rational expectations has become in macroeconomics.

In his 1937 paper on intertemporal equilibrium, Hayek was very clear that correct expectations are logically implied by the concept of an equilibrium of plans extending through time. But correct expectations are not a necessary, or even descriptively valid, characteristic of reality. Hayek also conceded that we don’t even have an explanation in theory of how correct expectations come into existence. He merely alluded to the empirical observation – perhaps not the most accurate description of empirical reality in 1937 – that there is an observed general tendency for markets to move toward equilibrium, implying that over time expectations do tend to become more accurate.

It is worth pointing out that when the idea of rational expectations was introduced by John Muth in the early 1960s, he did so in the context of partial-equilibrium models in which the rational expectation in the model was the rational expectation of the equilibrium price in a paraticular market. The motivation for Muth to introduce the idea of a rational expectation was idea of a cobweb cycle in which producers simply assume that the current price will remain at whatever level currently prevails. If there is a time lag between production, as in agricultural markets between the initial application of inputs and the final yield of output, it is easy to generate an alternating sequence of boom and bust, with current high prices inducing increased output in the following period, driving prices down, thereby inducing low output and high prices in the next period and so on.

Muth argued that rational producers would not respond to price signals in a way that led to consistently mistaken expectations, but would base their price expectations on more realistic expectations of what future prices would turn out to be. In his microeconomic work on rational expectations, Muth showed that the rational-expectation assumption was a better predictor of observed prices than the assumption of static expectations underlying the traditional cobweb-cycle model. So Muth’s rational-expectations assumption was based on a realistic conjecture of how real-world agents would actually form expectations. In that sense, Muth’s assumption was consistent with Hayek’s conjecture that there is an empirical tendency for markets to move toward equilibrium.

So while Muth’s introduction of the rational-expectations hypothesis was an empirically progressive theoretical innovation, extending rational-expectations into the domain of macroeconomics has not been empirically progressive, rational expectations models having consistently failed to generate better predictions than macro-models using other expectational assumptions. Instead, a rational-expectations axiom has been imposed as part of a spurious methodological demand that all macroeconomic models be “micro-founded.” But the deeper point – a point that Hayek understood better than perhaps anyone else — is that there is a huge difference in kind between forming rational expectations about a single market price and forming rational expectations about the vector of n prices on the basis of which agents are choosing or revising their optimal intertemporal consumption and production plans.

It is one thing to assume that agents have some expert knowledge about the course of future prices in the particular markets in which they participate regularly; it is another thing entirely to assume that they have knowledge sufficient to forecast the course of all future prices and in particular to understand the subtle interactions between prices in one market and the apparently unrelated prices in another market. The former kind of knowledge is knowledge that expert traders might be expected to have; the latter kind of knowledge is knowledge that would be possessed by no one but a nearly omniscient central planner, whose existence was shown by Hayek to be a practical impossibility.

Standard macroeconomic models are typically so highly aggregated that the extreme nature of the rational-expectations assumption is effectively suppressed. To treat all output as a single good (which involves treating the single output as both a consumption good and a productive asset generating a flow of productive services) effectively imposes the assumption that the only relative price that can ever change is the wage, so that all but one future relative prices are known in advance. That assumption effectively assumes away the problem of incorrect expectations except for two variables: the future price level and the future productivity of labor (owing to the productivity shocks so beloved of Real Business Cycle theorists). Having eliminated all complexity from their models, modern macroeconomists, purporting to solve micro-founded macromodels, simply assume that there is but one or at most two variables about which agents have to form their rational expectations.

Four score years since Hayek explained how challenging the notion of intertemporal equilibrium really is and the difficulties inherent in explaining any empirical tendency toward intertempral equilibrium, modern macroeconomics has succeeded in assuming all those difficulties out of existence. Many macroeconomists feel rather proud of what modern macroeconomics has achieved. I am not quite as impressed as they are.

Hayek and Temporary Equilibrium

In my three previous posts (here, here, and here) about intertemporal equilibrium, I have been emphasizing that the defining characteristic of an intertemporal equilibrium is that agents all share the same expectations of future prices – or at least the same expectations of those future prices on which they are basing their optimizing plans – over their planning horizons. At a given moment at which agents share the same expectations of future prices, the optimizing plans of the agents are consistent, because none of the agents would have any reason to change his optimal plan as long as price expectations do not change, or are not disappointed as a result of prices turning out to be different from what they had been expected to be.

The failure of expected prices to be fulfilled would therefore signify that the information available to agents in forming their expectations and choosing optimal plans conditional on their expectations had been superseded by newly obtained information. The arrival of new information can thus be viewed as a cause of disequilibrium as can any difference in information among agents. The relationship between information and equilibrium can be expressed as follows: differences in information or differences in how agents interpret information leads to disequilibrium, because those differences lead agents to form differing expectations of future prices.

Now the natural way to generalize the intertemporal equilibrium model is to allow for agents to have different expectations of future prices reflecting their differences in how they acquire, or in how they process, information. But if agents have different information, so that their expectations of future prices are not the same, the plans on which agents construct their subjectively optimal plans will be inconsistent and incapable of implementation without at least some revisions. But this generalization seems incompatible with the equilibrium of optimal plans, prices and price expectations described by Roy Radner, which I have identified as an updated version of Hayek’s concept of intertemporal equilibrium.

The question that I want to explore in this post is how to reconcile the absence of equilibrium of optimal plans, prices, and price expectations, with the intuitive notion of market clearing that we use to analyze asset markets and markets for current delivery. If markets for current delivery and for existing assets are in equilibrium in the sense that prices are adjusting in those markets to equate demand and supply in those markets, how can we understand the idea that  the optimizing plans that agents are seeking to implement are mutually inconsistent?

The classic attempt to explain this intermediate situation which partially is and partially is not an equilibrium, was made by J. R. Hicks in 1939 in Value and Capital when he coined the term “temporary equilibrium” to describe a situation in which current prices are adjusting to equilibrate supply and demand in current markets even though agents are basing their choices of optimal plans to implement over time on different expectations of what prices will be in the future. The divergence of the price expectations on the basis of which agents choose their optimal plans makes it inevitable that some or all of those expectations won’t be realized, and that some, or all, of those agents won’t be able to implement the optimal plans that they have chosen, without at least some revisions.

In Hayek’s early works on business-cycle theory, he argued that the correct approach to the analysis of business cycles must be analyzed as a deviation by the economy from its equilibrium path. The problem that he acknowledged with this approach was that the tools of equilibrium analysis could be used to analyze the nature of the equilibrium path of an economy, but could not easily be deployed to analyze how an economy performs once it deviates from its equilibrium path. Moreover, cyclical deviations from an equilibrium path tend not to be immediately self-correcting, but rather seem to be cumulative. Hayek attributed the tendency toward cumulative deviations from equilibrium to the lagged effects of monetary expansion which cause cumulative distortions in the capital structure of the economy that lead at first to an investment-driven expansion of output, income and employment and then later to cumulative contractions in output, income, and employment. But Hayek’s monetary analysis was never really integrated with the equilibrium analysis that he regarded as the essential foundation for a theory of business cycles, so the monetary analysis of the cycle remained largely distinct from, if not inconsistent with, the equilibrium analysis.

I would suggest that for Hayek the Hicksian temporary-equilibrium construct would have been the appropriate theoretical framework within which to formulate a monetary analysis consistent with equilibrium analysis. Although there are hints in the last part of The Pure Theory of Capital that Hayek was thinking along these lines, I don’t believe that he got very far, and he certainly gave no indication that he saw in the Hicksian method the analytical tool with which to weave the two threads of his analysis.

I will now try to explain how the temporary-equilibrium method makes it possible to understand  the conditions for a cumulative monetary disequilibrium. I make no attempt to outline a specifically Austrian or Hayekian theory of monetary disequilibrium, but perhaps others will find it worthwhile to do so.

As I mentioned in my previous post, agents understand that their price expectations may not be realized, and that their plans may have to be revised. Agents also recognize that, given the uncertainty underlying all expectations and plans, not all debt instruments (IOUs) are equally reliable. The general understanding that debt – promises to make future payments — must be evaluated and assessed makes it profitable for some agents to specialize in in debt assessment. Such specialists are known as financial intermediaries. And, as I also mentioned previously, the existence of financial intermediaries cannot be rationalized in the ADM model, because, all contracts being made in period zero, there can be no doubt that the equilibrium exchanges planned in period zero will be executed whenever and exactly as scheduled, so that everyone’s promise to pay in time zero is equally good and reliable.

For our purposes, a particular kind of financial intermediary — banks — are of primary interest. The role of a bank is to assess the quality of the IOUs offered by non-banks, and select from the IOUs offered to them those that are sufficiently reliable to be accepted by the bank. Once a prospective borrower’s IOU is accepted, the bank exchanges its own IOU for the non-bank’s IOU. No non-bank would accept a non-bank’s IOU, at least not on terms as favorable as those on which the bank offers in accepting an IOU. In return for the non-bank IOU, the bank credits the borrower with a corresponding amount of its own IOUs, which, because the bank promises to redeem its IOUs for the numeraire commodity on demand, is generally accepted at face value.

Thus, bank debt functions as a medium of exchange even as it enables non-bank agents to make current expenditures they could not have made otherwise if they can demonstrate to the bank that they are sufficiently likely to repay the loan in the future at agreed upon terms. Such borrowing and repayments are presumably similar to the borrowing and repayments that would occur in the ADM model unmediated by any financial intermediary. In assessing whether a prospective borrower will repay a loan, the bank makes two kinds of assessments. First, does the borrower have sufficient income-earning capacity to generate enough future income to make the promised repayments that the borrower would be committing himself to make? Second, should the borrower’s future income, for whatever reason, turn out to be insufficient to finance the promised repayments, does the borrower have collateral that would allow the bank to secure repayment from the collateral offered as security? In making both kinds of assessments the bank has to form an expectation about the future — the future income of the borrower and the future value of the collateral.

In a temporary-equilibrium context, the expectations of future prices held by agents are not the same, so the expectations of future prices of at least some agents will not be accurate, and some agents won’tbe able to execute their plans as intended. Agents that can’t execute their plans as intended are vulnerable if they have incurred future obligations based on their expectations of future prices that exceed their repayment capacity given the future prices that are actually realized. If they have sufficient wealth — i.e., if they have asset holdings of sufficient value — they may still be able to repay their obligations. However, in the process they may have to sell assets or reduce their own purchases, thereby reducing the income earned by other agents. Selling assets under pressure of obligations coming due is almost always associated with selling those assets at a significant loss, which is precisely why it usually preferable to finance current expenditure by borrowing funds and making repayments on a fixed schedule than to finance the expenditure by the sale of assets.

Now, in adjusting their plans when they observe that their price expectations are disappointed, agents may respond in two different ways. One type of adjustment is to increase sales or decrease purchases of particular goods and services that they had previously been planning to purchase or sell; such marginal adjustments do not fundamentally alter what agents are doing and are unlikely to seriously affect other agents. But it is also possible that disappointed expectations will cause some agents to conclude that their previous plans are no longer sustainable under the conditions in which they unexpectedly find themselves, so that they must scrap their old plans replacing them with completely new plans instead. In the latter case, the abandonment of plans that are no longer viable given disappointed expectations may cause other agents to conclude that the plans that they had expected to implement are no longer profitable and must be scrapped.

When agents whose price expectations have been disappointed respond with marginal adjustments in their existing plans rather than scrapping them and replacing them with new ones, a temporary equilibrium with disappointed expectations may still exist and that equilibrium may be reached through appropriate price adjustments in the markets for current delivery despite the divergent expectations of future prices held by agents. Operation of the price mechanism may still be able to achieve a reconciliation of revised but sub-optimal plans. The sub-optimal temporary equilibrium will be inferior to the allocation that would have resulted had agents all held correct expectations of future prices. Nevertheless, given a history of incorrect price expectations and misallocations of capital assets, labor, and other factors of production, a sub-optimal temporary equilibrium may be the best feasible outcome.

But here’s the problem. There is no guarantee that, when prices turn out to be very different from what they were expected to be, the excess demands of agents will adjust smoothly to changes in current prices. A plan that was optimal based on the expectation that the price of widgets would be $500 a unit may well be untenable at a price of $120 a unit. When realized prices are very different from what they had been expected to be, those price changes can lead to discontinuous adjustments, violating a basic assumption — the continuity of excess demand functions — necessary to prove the existence of an equilibrium. Once output prices reach some minimum threshold, the best response for some firms may be to shut down, the excess demand for the product produced by the firm becoming discontinuous at the that threshold price. The firms shutting down operations may be unable to repay loans they had obligated themselves to repay based on their disappointed price expectations. If ownership shares in firms forced to cease production are held by households that have predicated their consumption plans on prior borrowing and current repayment obligations, the ability of those households to fulfill their obligations may be compromised once those firms stop paying out the expected profit streams. Banks holding debts incurred by firms or households that borrowers cannot service may find that their own net worth is reduced sufficiently to make the banks’ own debt unreliable, potentially causing a breakdown in the payment system. Such effects are entirely consistent with a temporary-equilibrium model if actual prices turn out to be very different from what agents had expected and upon which they had constructed their future consumption and production plans.

Sufficiently large differences between expected and actual prices in a given period may result in discontinuities in excess demand functions once prices reach critical thresholds, thereby violating the standard continuity assumptions on which the existence of general equilibrium depends under the fixed-point theorems that are the lynchpin of modern existence proofs. C. J. Bliss made such an argument in a 1983 paper (“Consistent Temporary Equilibrium” in the volume Modern Macroeconomic Theory edited by  J. P. Fitoussi) in which he also suggested, as I did above, that the divergence of individual expectations implies that agents will not typically regard the debt issued by other agents as homogeneous. Bliss therefore posited the existence of a “Financier” who would subject the borrowing plans of prospective borrowers to an evaluation process to determine if the plan underlying the prospective loan sought by a borrower was likely to generate sufficient cash flow to enable the borrower to repay the loan. The role of the Financier is to ensure that the plans that firms choose are based on roughly similar expectations of future prices so that firms will not wind up acting on price expectations that must inevitably be disappointed.

I am unsure how to understand the function that Bliss’s Financier is supposed to perform. Presumably the Financier is meant as a kind of idealized companion to the Walrasian auctioneer rather than as a representation of an actual institution, but the resemblance between what the Financier is supposed to do and what bankers actually do is close enough to make it unclear to me why Bliss chose an obviously fictitious character to weed out business plans based on implausible price expectations rather than have the role filled by more realistic characters that do what their real-world counterparts are supposed to do. Perhaps Bliss’s implicit assumption is that real-world bankers do not constrain the expectations of prospective borrowers sufficiently to suggest that their evaluation of borrowers would increase the likelihood that a temporary equilibrium actually exists so that only an idealized central authority could impose sufficient consistency on the price expectations to make the existence of a temporary equilibrium likely.

But from the perspective of positive macroeconomic and business-cycle theory, explicitly introducing banks that simultaneously provide an economy with a medium of exchange – either based on convertibility into a real commodity or into a fiat base money issued by the monetary authority – while intermediating between ultimate borrowers and ultimate lenders seems to be a promising way of modeling a dynamic economy that sometimes may — and sometimes may not — function at or near a temporary equilibrium.

We observe economies operating in the real world that sometimes appear to be functioning, from a macroeconomic perspective, reasonably well with reasonably high employment, increasing per capita output and income, and reasonable price stability. At other times, these economies do not function well at all, with high unemployment and negative growth, sometimes with high rates of inflation or with deflation. Sometimes, these economies are beset with financial crises in which there is a general crisis of solvency, and even apparently solvent firms are unable to borrow. A macroeconomic model should be able to account in some way for the diversity of observed macroeconomic experience. The temporary equilibrium paradigm seems to offer a theoretical framework capable of accounting for this diversity of experience and for explaining at least in a very general way what accounts for the difference in outcomes: the degree of congruence between the price expectations of agents. When expectations are reasonably consistent, the economy is able to function at or near a temporary equilibrium which is likely to exist. When expectations are highly divergent, a temporary equilibrium may not exist, and even if it does, the economy may not be able to find its way toward the equilibrium. Price adjustments in current markets may be incapable of restoring equilibrium inasmuch as expectations of future prices must also adjust to equilibrate the economy, there being no market mechanism by which equilibrium price expectations can be adjusted or restored.

This, I think, is the insight underlying Axel Leijonhufvud’s idea of a corridor within which an economy tends to stay close to an equilibrium path. However if the economy drifts or is shocked away from its equilibrium time path, the stabilizing forces that tend to keep an economy within the corridor cease to operate at all or operate only weakly, so that the tendency for the economy to revert back to its equilibrium time path is either absent or disappointingly weak.

The temporary-equilibrium method, it seems to me, might have been a path that Hayek could have successfully taken in pursuing the goal he had set for himself early in his career: to reconcile equilibrium-analysis with a theory of business cycles. Why he ultimately chose not to take this path is a question that, for now at least, I will leave to others to try to answer.

Roy Radner and the Equilibrium of Plans, Prices and Price Expectations

In this post I want to discuss Roy Radner’s treatment of an equilibrium of plans, prices, and price expectations (EPPPE) and its relationship to Hayek’s conception of intertemporal equilibrium, of which Radner’s treatment is a technically more sophisticated version. Although I seen no evidence that Radner was directly influenced by Hayek’s work, I consider Radner’s conception of EPPPE to be a version of Hayek’s conception of intertemporal equilibrium, because it captures essential properties of Hayek’s conception of intertemporal equilibrium as a situation in which agents independently formulate their own optimizing plans based on the prices that they actually observe – their common knowledge – and on the future prices that they expect to observe over the course of their planning horizons. While currently observed prices are common knowledge – not necessarily a factual description of economic reality but not an entirely unreasonable simplifying assumption – the prices that individual agents expect to observe in the future are subjective knowledge based on whatever common or private knowledge individuals may have and whatever methods they may be using to form their expectations of the prices that will be observed in the future. An intertemporal equilibrium refers to a set of decentralized plans that are both a) optimal from the standpoint of every agent’s own objectives given their common knowledge of current prices and their subjective expectations of future prices and b) mutually consistent.

If an agent has chosen an optimal plan given current and expected future prices, that plan will not be changed unless the agent acquires new information that renders the existing plan sub-optimal relative to the new information. Otherwise, there would be no reason for the agent to deviate from an optimal plan. The new information that could cause an agent to change a formerly optimal plan would either affect the preferences of the agent, the technology available to the agent, or would somehow be reflected in current prices or in expected future prices. But it seems improbable that there could be a change in preferences or technology would not also be reflected in current or expected future prices. So absent a change in current or expected future prices, there would seem to be almost no likelihood that an agent would deviate from a plan that was optimal given current prices and the future prices expected by the agent.

The mutual consistency of the optimizing plans of independent agents therefore turns out to be equivalent to the condition that all agents observe the same current prices – their common knowledge – and have exactly the same forecasts of the future prices upon which they have relied in choosing their optimal plans. Even should their forecasts of future prices turn out to be wrong, at the moment before their forecasts of future prices were changed or disproved by observation, their plans were still mutually consistent relative to the information on which their plans had been chosen. The failure of the equilibrium to be maintained could be attributed to a change in information that meant that the formerly optimal plans were no longer optimal given the newly acquired information. But until the new information became available, the mutual consistency of optimal plans at that (fleeting) moment signified an equilibrium state. Thus, the defining characteristic of an intertemporal equilibrium in which current prices are common knowledge is that all agents share the same expectations of the future prices on which their optimal plans have been based.

There are fundamental differences between the Arrow-Debreu-McKenzie (ADM) equilibrium and the EPPPE. One difference worth mentioning is that, under the standard assumptions of the ADM model, the equilibrium is Pareto-optimal, and any Pareto-optimum allocation, by a suitable redistribution of initial endowments, could be achieved as a general equilibrium (two welfare theorems). These results do not generally hold for EPPPE, because, in contrast to the ADM model, it is possible for agents in EPPPE to acquire additional information over time, not only passively, but by investing resources in the production of information. Investing resources in the production of information can cause inefficiency in two ways: first, by creating non-convexities (owing to start-up costs in information gathering activities) that are inconsistent with the uniform competitive prices characteristic of the ADM equilibrium, and second, by creating incentives to devote resources to produce information whose value is derived from profits in trading with less well-informed agents. The latter source of inefficiency was discovered by Jack Hirshleifer in his classic 1971 paper, which I have written about in several previous posts (here, here, here, and here).

But the important feature of Radner’s EPPPE that I want to emphasize here — and what radically distinguishes it from the ADM equilibrium — is its fragility. Unlike the ADM equilibrium which is established once and forever at time zero of a model in which all production and consumption starts in period one, the EPPPE, even if it ever exists, is momentary, and is subject to unraveling whenever there is a change in the underlying information upon which current prices and expected future prices depend, and upon which agents, in choosing their optimal plans, rely. Time is not just, as it is in the ADM model, an appendage to the EPPPE, and, as a result, EPPPE can account for many phenomena, practices, and institutions that are left out of the ADM model.

The two differences that are most relevant in this context are the existence of stock markets in which shares of firms are traded based on expectations of the future net income streams associated with those firms, and the existence of a medium of exchange supplied by private financial intermediaries known as banks. In the ADM model in which all transactions are executed in time zero, in advance of all the actual consumption and production activities determined by those transactions, there would be no reason to hold, or to supply, a medium of exchange. The ADM equilibrium allows for agents to borrow or lend at equilibrium interest rates to optimize the time profiles of their consumption relative to their endowments and the time profiles of their earnings. Since all such transactions are consummated in time zero, and since, through some undefined process, the complete solvency and the integrity of all parties to all transactions is ascertained in time zero, the probability of a default on any loan contracted at time zero is zero. As a result, each agent faces a single intertemporal budget constraint at time zero over all periods from 1 to n. Walras’s Law therefore holds across all time periods for this intertemporal budget constraint, each agent transacting at the same prices in each period as every other agent does.

Once an equilibrium price vector is established in time zero, each agent knows that his optimal plan based on that price vector (which is the common knowledge of all agents) will be executed over time exactly as determined in time zero. There is no reason for any exchange of ownership shares in firms, the future income streams from each firm being known in advance.

The ADM equilibrium is a model of an economic process very different from Radner’s EPPPE, because in EPPPE, agents have no reason to assume that their current plans, even if they are momentarily both optimal and mutually consistent with the plans of all other agents, will remain optimal and consistent with the plans of all other agents. New information can arrive or be produced that will necessitate a revision in plans. Because even equilibrium plans are subject to revision, agents must take into account the solvency and credit worthiness of counterparties with whom they enter into transactions. The potentially imperfect credit-worthiness of at least some agents enables certain financial intermediaries (aka banks) to provide a service by offering to exchange their debt, which is widely considered to be more credit-worthy than the debt of ordinary agents, to agents seeking to borrow to finance purchases of either consumption or investment goods. Many agents seeking to borrow therefore prefer exchanging their debt for bank debt, bank debt being acceptable by other agents at face value. In addition, because the acquisition of new information is possible, there is a reason for agents to engage in speculative trades of commodities or assets. Such assets include ownership shares of firms, and agents may revise their valuations of those firms as they revise their expectations about future prices and their expectations about the revised plans of those firms in response to newly acquired information.

I will discuss the special role of banks at greater length in my next post on temporary equilibrium. But for now, I just want to underscore a key point: in the EPPE, unless all agents have the same expectations of future prices, Walras’s Law need not hold. The proof that Walras’s holds depends on the assumption that individual plans to buy and sell are based on the assumption that every agent buys or sells each commodity at the same price that every other transactor buys  or sells that commodity. But in the intertemporal context, in which only current, not future prices, are observed, plans for current and future prices are made based on expectations about future prices. If agents don’t share the same expectations about future prices, agents making plans for future purchases based on overly optimistic expectations about the prices at which they will be able to sell, may make commitments to buy in the future (or commitment to repay loans to finance purchases in the present) that they will be unable to discharge. Reneging on commitments to buy in the future or to repay obligations incurred in the present may rule out the existence of even a temporary equilibrium in the future.

Finally, let me add a word about Radner’s terminology. In his 1987 entry on “Uncertainty and General Equilibrium” for the New Palgrave Dictionary of Economics, (Here is a link to the revised version on line), Radner writes:

A trader’s expectations concern both future environmental events and future prices. Regarding expectations about future environmental events, there is no conceptual problem. According to the Expected Utility Hypothesis, each trader is characterized by a subjective probability measure on the set of complete histories of the environment. Since, by definition, the evolution of the environment is exogenous, a trader’s conditional probability of a future event, given the information to date, is well defined.

It is not so obvious how to proceed with regard to trader’s expectations about future prices. I shall contrast two possible approaches. In the first, which I shall call the perfect foresight approach, let us assume that the behaviour of traders is such as to determine, for each complete history of the environment, a unique corresponding sequence of price system[s]. . .

Thus, the perfect foresight approach implies that, in equilibrium, traders have common price expectation functions. These price expectation functions indicate, for each date-event pair, what the equilibrium price system would be in the corresponding market at that date event pair. . . . [I]t follows that, in equilibrium the traders would have strategies (plans) such that if these strategies were carried out, the markets would be cleared at each date-event pair. Call such plans consistent. A set of common price expectations and corresponding consistent plans is called an equilibrium of plans, prices, and price expectations.

My only problem with Radner’s formulation here is that he is defining his equilibrium concept in terms of the intrinsic capacity of the traders to predict prices rather the simple fact that traders form correct expectations. For purposes of the formal definition of EPPE, it is irrelevant whether traders predictions of future prices are correct because they are endowed with the correct model of the economy or because they are all lucky and randomly have happened simultaneously to form the same expectations of future prices. Radner also formulates an alternative version of his perfect-foresight approach in which agents don’t all share the same information. In such cases, it becomes possible for traders to make inferences about the environment by observing prices differ from what they had expected.

The situation in which traders enter the market with different non-price information presents an opportunity for agents to learn about the environment from prices, since current prices reflect, in a possibly complicated manner, the non-price information signals received by the various agents. To take an extreme example, the “inside information” of a trader in a securities market may lead him to bid up the price to a level higher than it otherwise would have been. . . . [A]n astute market observer might be able to infer that an insider has obtained some favourable information, just by careful observation of the price movement.

The ability to infer non-price information from otherwise inexplicable movements in prices leads Radner to define a concept of rational expectations equilibrium.

[E]conomic agents have the opportunity to revise their individual models in the light of observations and published data. Hence, there is a feedback from the true relationship to the individual models. An equilibrium of this system, in which the individual models are identical with the true model, is called a rational expectations equilibrium. This concept of equilibrium is more subtle, of course, that the ordinary concept of equilibrium of supply and demand. In a rational expectations equilibrium, not only are prices determined so as to equate supply and demand, but individual economic agents correctly perceive the true relationship between the non-price information received by the market participants and the resulting equilibrium market prices.

Though this discussion is very interesting from several theoretical angles, as an explanation of what is entailed by an economic equilibrium, it misses the key point, which is the one that Hayek identified in his 1928 and (especially) 1937 articles mentioned in my previous posts. An equilibrium corresponds to a situation in which all agents have identical expectations of the future prices upon which they are making optimal plans given the commonly observed current prices and the expected future prices. If all agents are indeed formulating optimal plans based on the information that they have at that moment, their plans will be mutually consistent and will be executable simultaneously without revision as long as the state of their knowledge at that instant does not change. How it happened that they arrived at identical expectations — by luck chance or supernatural powers of foresight — is irrelevant to that definition of equilibrium. Radner does acknowledge that, under the perfect-foresight approach, he is endowing economic agents with a wildly unrealistic powers of imagination and computational capacity, but from his exposition, I am unable to decide whether he grasped the subtle but crucial point about the irrelevance of an assumption about the capacities of agents to the definition of EPPPE.

Although it is capable of describing a richer set of institutions and behavior than is the Arrow-Debreu model, the perfect-foresight approach is contrary to the spirit of much of competitive market theory in that it postulates that individual traders must be able to forecast, in some sense, the equilibrium prices that will prevail in the future under all alternative states of the environment. . . .[T]his approach . . . seems to require of the traders a capacity for imagination and computation far beyond what is realistic. . . .

These last considerations lead us in a different direction, which I shall call the bounded rationality approach. . . . An example of the bounded-rationality approach is the theory of temporary equilibrium.

By eschewing any claims about the rationality of the agents or their computational powers, one can simply talk about whether agents do or do not have identical expectations of future prices and what the implications of those assumptions are. When expectations do agree, there is at least a momentary equilibrium of plans, prices and price expectations. When they don’t agree, the question becomes whether even a temporary equilibrium exists and what kind of dynamic process is implied by the divergence of expectations. That it seems to me would be a fruitful way forward for macroeconomics to follow. In my next post, I will discuss some of the characteristics and implications of a temporary-equilibrium approach to macroeconomics.


Correct Foresight, Perfect Foresight, and Intertemporal Equilibrium

In my previous post, I discussed Hayek’s path-breaking insight into the meaning of intertemporal equilibrium. His breakthrough was to see that an equilibrium can be understood not as a stationary state in which nothing changes, but as a state in which decentralized plans are both optimal from the point of view of the individuals formulating the plans and mutually consistent, so that the individually optimal plans, at least potentially, could be simultaneously executed. In the simple one-period model, the plans of individuals extending over a single-period time horizon are constrained by the necessary equality for each agent between the value of all planned purchases and the value of all planned sales in that period. A single-period or stationary equilibrium, if it exists, is characterized by a set of prices such that the optimal plans corresponding to that set of prices such that total amount demanded for each product equals the total amount supplied for each product. Thus, an equilibrium price vector has the property that every individual is choosing optimally based on the choice criteria and the constraints governing the decisions for each individual and that those individually optimal choices are mutually consistent, that mutual consistency being manifested in the equality of the total amount demanded and the total amount supplied of each product in that single period.

The problem posed by the concept of intertemporal equilibrium is how to generalize the single-period notion of an equilibrium as a vector of all the observed prices of goods and services actually traded in that single period into a multi-period concept in which the prices on which optimal choices depend include both the actual prices of goods traded in the current period as well as the prices of goods and services that agents plan to buy or sell only in some future time period. In an intertemporal context, the prices on the basis of which optimal plans are chosen cannot be just those prices at which transactions are being executed in the current period; the relevant set of prices must also include those prices at which transactions already being planned in the current period will be executed. Because even choices about transactions today may depend on the prices at which future transactions will take place, future prices can affect not only future demands and supplies they can also affect current demands and supplies.

But because prices in future periods are typically not observable by individuals in the present, it is not observed — but expected — future prices on the basis of which individual agents are making the optimal choices reflected in their intertemporal plans. And insofar as optimal plans depend on expected future prices, those optimal plans can be mutually consistent only if they are based on the same expected future prices, because if their choices are based on different expected future prices, then it is not possible that all expectations are realized. If the expectations of at least one agent, and probably of many agents, will be disappointed, implying that the plans of at least one and probably of many agents will not be optimized and will have to be revised.

The recognition that the mutual consistency of optimal plans requires individuals to accurately foresee the future prices upon which their optimal choices are based suggested that individual agents must be endowed with remarkable capacities to foresee the future. To assume that all individual agents would be endowed with the extraordinary ability to foresee correctly all the future prices relevant to their optimal choices about their intertemporal plans seemed an exceedingly unrealistic assumption on which to premise an economic model.

This dismissive attitude toward the concept of intertemporal equilibrium and the seemingly related assumption of “perfect foresight” necessary for an intertemporal equilibrium to exist was stridently expressed by Oskar Morgenstern in his famous 1935 article “Perfect Foresight and Economic Equilibrium.”

The impossibly high claims which are attributed to the intellectual efficiency of the economic subject immediately indicate that there are included in this equilibrium system not ordinary men, but rather, at least to one another, exactly equal demi-gods, in case the claim of complete foresight is fulfilled. If this is the case, there is, of course, nothing more to be done. If “full” or “perfect” foresight is to provide the basis of the theory of equilibrium in the strictly specified sense, and in the meaning obviously intended by the economic authors, then, a completely meaningless assumption is being considered. If limitations are introduced in such a way that the perfection of foresight is not reached, then these limitations are to be stated very precisely. They would have to be so narrowly drawn that the fundamental aim of producing ostensibly full rationality of the system by means of high, de facto unlimited, foresight, would be lost. For the theoretical economist, there is no way out of this dilemma. ln this discussion, “full” and “perfect” foresight are not only used synonymously, but both are employed, moreover, in the essentialIy more exact sense of limitlessness. This expression would have to be preferred because with the words “perfect” or “imperfect”, there arise superficial valuations which play no role here at all.

Morgenstern then went on to make an even more powerful attack on the idea of perfect foresight: that the idea is itself self-contradictory. Interestingly, he did so by positing an example that would figure in Morgenstern’s later development of game theory with his collaborator John von Neumann (and, as we now know, with his research assistant who in fact was his mathematical guide and mentor, Abraham Wald, fcredited as a co-author of The Theory of Games and Economic Behavior).

Sherlock Holmes, pursued by his opponent, Moriarity, leaves London for Dover. The train stops at a station on the way, and he alights there rather than traveling on to Dover. He has seen Moriarity at the railway station, recognizes that he is very clever and expects that Moriarity will take a faster special train in order to catch him in Dover. Holmes’ anticipation turns out to be correct. But what if Moriarity had been still more clever, had estimated Holmes’ mental abilities better and had foreseen his actions accordingly? Then, obviously, he would have traveled to the intermediate station. Holmes, again, would have had to calculate that, and he himself would have decided to go on to Dover. Whereupon, Moriarity would again have “reacted” differently. Because of so much thinking they might not have been able to act at all or the intellectually weaker of the two would have surrendered to the other in the Victoria Station, since the whole flight would have become unnecessary. Examples of this kind can be drawn from everywhere. However, chess, strategy, etc. presuppose expert knowledge, which encumbers the example unnecessarily.

One may be easily convinced that here lies an insoluble paradox. And the situation is not improved, but, rather, greatly aggravated if we assume that more than two individuals-as, for example, is the case with exchange-are brought together into a position, which would correspond to the one brought forward here. Always, there is exhibited an endless chain of reciprocally conjectural reactions and counter-reactions. This chain can never be broken by an act of knowledge but always only through an arbitrary act-a resolution. This resolution, again, would have to be foreseen by the two or more persons concerned. The paradox still remains no matter how one attempts to twist or turn things around. Unlimited foresight and economic equilibrium are thus irreconcilable with one another. But can equilibrium really take place with a faulty, heterogeneous foresight, however, it may be disposed? This is the question which arises at once when an answer is sought. One can even say this: has foresight been truly introduced at all into the consideration of equilibrium, or, rather, does not the theorem of equilibrium generally stand in no proven connection with the assumptions about foresight, so that a false assumption is being considered?

As Carlo Zappia has shown, it was probably Morgenstern’s attack on the notion of intertemporal equilibrium and perfect foresight that led Hayek to his classic restatement of the idea in his 1937 paper “Economics and Knowledge.” The point that Hayek clarified in his 1937 version, but had not been clear in his earlier expositions of the concept, is that correct foresight is not an assumption from which the existence of an intertemporal equilibrium can be causally deduced; there is no assertion that a state of equilibrium is the result of correct foresight. Rather, correct foresight is the characteristic that defines what is meant when the term “intertemporal equilibrium” is used in economic theory. Morgenstern’s conceptual error was to mistake a tautological statement about what would have to be true if an intertemporal equilibrium were to obtain for a causal statement about what conditions would bring an intertemporal equilibrium into existence.

The idea of correct foresight does not attribute any special powers to the economic agents who might under hypothetical circumstances possess correct expectations of future prices. The term is not meant to be a description of an actual state of affairs, but a description of what would have to be true for a state of affairs to be an equilibrium state of affairs.

As an aside, I would simply mention that many years ago when I met Hayek and had the opportunity to ask him about his 1937 paper and his role in developing the concept of intertemporal equilibrium, he brought my attention to his 1928 paper in which he first described an intertemporal equilibrium as state of affairs in which agents had correct expectations about future prices. My recollection of that conversation is unfortunately rather vague, but I do remember that he expressed some regret for not having had the paper translated into English, which would have established his priority in articulating the intertemporal equilibrium concept. My recollection is that the reason he gave for not having had the paper translated into English was that there was something about the paper about which he felt dissatisfied, but I can no longer remember what it was that he said he was dissatisfied with. However, I would now be inclined to conjecture that he was dissatisfied with not having disambiguated, as he did in the 1937 paper, between correct foresight as a defining characteristic of what intertemporal equilibrium means versus perfect foresight as the cause that brings intertemporal equilibruim into existence.

It is also interesting to note that the subsequent development of game theory in which Morgenstern played a not insubstantial role, shows that under a probabilistic interpretation of the interaction between Holmes and Moriarity, there could be an optimal mixed strategy that would provide an equilibrium solution of repeated Holmes-Moriarity interactions. But if the interaction is treated as a single non-repeatable event with no mixed strategy available to either party, the correct interpretation of the interaction is certainly that there is no equilibrium solution to the interaction. If there is no equilibrium solution, then it is precisely the absence of an equilibrium solution that implies the impossibility of correct foresight, correct foresight and the existence of an equilibrium being logically equivalent concepts.

A Primer on Equilibrium

After my latest post about rational expectations, Henry from Australia, one of my most prolific commenters, has been engaging me in a conversation about what assumptions are made – or need to be made – for an economic model to have a solution and for that solution to be characterized as an equilibrium, and in particular, a general equilibrium. Equilibrium in economics is not always a clearly defined concept, and it can have a number of different meanings depending on the properties of a given model. But the usual understanding is that the agents in the model (as consumers or producers) are trying to do as well for themselves as they can, given the endowments of resources, skills and technology at their disposal and given their preferences. The conversation was triggered by my assertion that rational expectations must be “compatible with the equilibrium of the model in which those expectations are embedded.”

That was the key insight of John Muth in his paper introducing the rational-expectations assumption into economic modelling. So in any model in which the current and future actions of individuals depend on their expectations of the future, the model cannot arrive at an equilibrium unless those expectations are consistent with the equilibrium of the model. If the expectations of agents are incompatible or inconsistent with the equilibrium of the model, then, since the actions taken or plans made by agents are based on those expectations, the model cannot have an equilibrium solution.

Now Henry thinks that this reasoning is circular. My argument would be circular if I defined an equilibrium to be the same thing as correct expectations. But I am not so defining an equilibrium. I am saying that the correctness of expectations by all agents implies 1) that their expectations are mutually consistent, and 2) that, having made plans, based on their expectations, which, by assumption, agents felt were the best set of choices available to them given those expectations, if the expectations of the agents are realized, then they would not regret the decisions and the choices that they made. Each agent would be as well off as he could have made himself, given his perceived opportunities when the decision were made. That the correctness of expectations implies equilibrium is the consequence of assuming that agents are trying to optimize their decision-making process, given their available and expected opportunities. If all expected opportunities are correctly foreseen, then all decisions will have been the optimal decisions under the circumstances. But nothing has been said that requires all expectations to be correct, or even that it is possible for all expectations to be correct. If an equilibrium does not exist, and just because you can write down an economic model, it does not mean that a solution to the model exists, then the sweet spot where all expectations are consistent and compatible is just a blissful fantasy. So a logical precondition to showing that rational expectations are even possible is to prove that an equilibrium exists. There is nothing circular about the argument.

Now the key to proving the existence of a general equilibrium is to show that the general equilibrium model implies the existence of what mathematicians call a fixed point. A fixed point is said to exist when there is a mapping – a rule or a function – that takes every point in a convex compact set of points and assigns that point to another point in the same set. A convex, compact set has two important properties: 1) the line connecting any two points in the set is entirely contained within the boundaries of the set, and 2) there are no gaps between any two points in set. The set of points in a circle or a rectangle is a convex compact set; the set of points contained in the Star of David is not a convex set. Any two points in the circle will be connected by a line that lies completely within the circle; the points at adjacent edges of a Star of David will be connected by a line that lies entirely outside the Star of David.

If you think of the set of all possible price vectors for an economy, those vectors – each containing a price for each good or service in the economy – could be mapped onto itself in the following way. Given all the equations describing the behavior of each agent in the economy, the quantity demanded and supplied of each good could be calculated, giving us the excess demand (the difference between amount demand and supplied) for each good. Then the price of every good in excess demand would be raised, the price of every good in negative excess demand would be reduced, and the price of every good with zero excess demand would be held constant. To ensure that the mapping was taking a point from a given convex set onto itself, all prices could be normalized so that they would have the property that the sum of all the individual prices would always equal 1. The fixed point theorem ensures that for a mapping from one convex compact set onto itself there must be at least one fixed point, i.e., at least one point in the set that gets mapped onto itself. The price vector corresponding to that point is an equilibrium, because, given how our mapping rule was defined, a point would be mapped onto itself if and only if all excess demands are zero, so that no prices changed. Every fixed point – and there may be one or more fixed points – corresponds to an equilibrium price vector and every equilibrium price vector is associated with a fixed point.

Before going on, I ought to make an important observation that is often ignored. The mathematical proof of the existence of an equilibrium doesn’t prove that the economy operates at an equilibrium, or even that the equilibrium could be identified under the mapping rule described (which is a kind of formalization of the Walrasian tatonnement process). The mapping rule doesn’t guarantee that you would ever discover a fixed point in any finite amount of iterations. Walras thought the price adjustment rule of raising the prices of goods in excess demand and reducing prices of goods in excess supply would converge on the equilibrium price vector. But the conditions under which you can prove that the naïve price-adjustment rule converges to an equilibrium price vector turn out to be very restrictive, so even though we can prove that the competitive model has an equilibrium solution – in other words the behavioral, structural and technological assumptions of the model are coherent, meaning that the model has a solution, the model has no assumptions about how prices are actually determined that would prove that the equilibrium is ever reached. In fact, the problem is even more daunting than the previous sentence suggest, because even Walrasian tatonnement imposes an incredibly powerful restriction, namely that no trading is allowed at non-equilibrium prices. In practice there are almost never recontracting provisions allowing traders to revise the terms of their trades once it becomes clear that the prices at which trades were made were not equilibrium prices.

I now want to show how price expectations fit into all of this, because the original general equilibrium models were either one-period models or formal intertemporal models that were reduced to single-period models by assuming that all trading for future delivery was undertaken in the first period by long-lived agents who would eventually carry out the transactions that were contracted in period 1 for subsequent consumption and production. Time was preserved in a purely formal, technical way, but all economic decision-making was actually concluded in the first period. But even though the early general-equilibrium models did not encompass expectations, one of the extraordinary precursors of modern economics, Augustin Cournot, who was way too advanced for his contemporaries even to comprehend, much less make any use of, what he was saying, had incorporated the idea of expectations into the solution of his famous economic model of oligopolistic price setting.

The key to oligopolistic pricing is that each oligopolist must take into account not just consumer demand for his product, and his own production costs; he must consider as well what actions will be taken by his rivals. This is not a problem for a competitive producer (a price-taker) or a pure monopolist. The price-taker simply compares the price at which he can sell as much as he wants with his production costs and decides how much it is worthwhile to produce by comparing his marginal cost to price ,and increases output until the marginal cost rises to match the price at which he can sell. The pure monopolist, if he knows, as is assumed in such exercises, or thinks he knows the shape of the customer demand curve, selects the price and quantity combination on the demand curve that maximizes total profit (corresponding to the equality of marginal revenue and marginal cost). In oligopolistic situations, each producer must take into account how much his rivals will sell, or what prices they will set.

It was by positing such a situation and finding an analytic solution, that Cournot made a stunning intellectual breakthrough. In the simple duopoly case, Cournot posited that if the duopolists had identical costs, then each could find his optimal price conditional on the output chosen by the other. This is a simple profit-maximization problem for each duopolist, given a demand curve for the combined output of both (assumed to be identical, so that a single price must obtain for the output of both) a cost curve and the output of the other duopolist. Thus, for each duopolist there is a reaction curve showing his optimal output given the output of the other. See the accompanying figure.cournot

If one duopolist produces zero, the optimal output for the other is the monopoly output. Depending on what the level of marginal cost is, there is some output by either of the duopolists that is sufficient to make it unprofitable for the other duopolist to produce anything. That level of output corresponds to the competitive output where price just equals marginal cost. So the slope of the two reaction functions corresponds to the ratio of the monopoly output to the competitive output, which, with constant marginal cost is 2:1. Given identical costs, the two reaction curves are symmetric and the optimal output for each, given the expected output of the other, corresponds to the intersection of the two reaction curves, at which both duopolists produce the same quantity. The combined output of the two duopolists will be greater than the monopoly output, but less than the competitive output at which price equals marginal cost. With constant marginal cost, it turns out that each duopolist produces one-third of the competitive output. In the general case with n oligoplists, the ratio of the combined output of all n firms to the competitive output equals n/(n+1).

Cournot’s solution corresponds to a fixed point where the equilibrium of the model implies that both duopolists have correct expectations of the output of the other. Given the assumptions of the model, if the duopolists both expect the other to produce an output equal to one-third of the competitive output, their expectations will be consistent and will be realized. If either one expects the other to produce a different output, the outcome will not be an equilibrium, and each duopolist will regret his output decision, because the price at which he can sell his output will differ from the price that he had expected. In the Cournot case, you could define a mapping of a vector of the quantities that each duopolist had expected the other to produce and the corresponding planned output of each duopolist. An equilibrium corresponds to a case in which both duopolists expected the output planned by the other. If either duopolist expected a different output from what the other planned, the outcome would not be an equilibrium.

We can now recognize that Cournot’s solution anticipated John Nash’s concept of an equilibrium strategy in which player chooses a strategy that is optimal given his expectation of what the other player’s strategy will be. A Nash equilibrium corresponds to a fixed point in which each player chooses an optimal strategy based on the correct expectation of what the other player’s strategy will be. There may be more than one Nash equilibrium in many games. For example, rather than base their decisions on an expectation of the quantity choice of the other duopolist, the two duopolists could base their decisions on an expectation of what price the other duopolist would set. In the constant-cost case, this choice of strategies would lead to the competitive output because both duopolists would conclude that the optimal strategy of the other duopolist would be to charge a price just sufficient to cover his marginal cost. This was the alternative oligopoly model suggested by another French economist J. L. F. Bertrand. Of course there is a lot more to be said about how oligopolists strategize than just these two models, and the conditions under which one or the other model is the more appropriate. I just want to observe that assumptions about expectations are crucial to how we analyze market equilibrium, and that the importance of these assumptions for understanding market behavior has been recognized for a very long time.

But from a macroeconomic perspective, the important point is that expected prices become the critical equilibrating variable in the theory of general equilibrium and in macroeconomics in general. Single-period models of equilibrium, including general-equilibrium models that are formally intertemporal, but in which all trades are executed in the initial period at known prices in a complete array of markets determining all future economic activity, are completely sterile and useless for macroeconomics except as a stepping stone to analyzing the implications of imperfect forecasts of future prices. If we want to think about general equilibrium in a useful macroeconomic context, we have to think about a general-equilibrium system in which agents make plans about consumption and production over time based on only the vaguest conjectures about what future conditions will be like when the various interconnected stages of their plans will be executed.

Unlike the full Arrow-Debreu system of complete markets, a general-equilibrium system with incomplete markets cannot be equilibrated, even in principle, by price adjustments in the incomplete set of present markets. Equilibration depends on the consistency of expected prices with equilibrium. If equilibrium is characterized by a fixed point, the fixed point must be mapping of a set of vectors of current prices and expected prices on to itself. That means that expected future prices are as much equilibrating variables as current market prices. But expected future prices exist only in the minds of the agents, they are not directly subject to change by market forces in the way that prices in actual markets are. If the equilibrating tendencies of market prices in a system of complete markets are very far from completely effective, the equilibrating tendencies of expected future prices may not only be non-existent, but may even be potentially disequilibrating rather than equilibrating.

The problem of price expectations in an intertemporal general-equilibrium system is central to the understanding of macroeconomics. Hayek, who was the father of intertemporal equilibrium theory, which he was the first to outline in a 1928 paper in German, and who explained the problem with unsurpassed clarity in his 1937 paper “Economics and Knowledge,” unfortunately did not seem to acknowledge its radical consequences for macroeconomic theory, and the potential ineffectiveness of self-equilibrating market forces. My quarrel with rational expectations as a strategy of macroeconomic analysis is its implicit assumption, lacking any analytical support, that prices and price expectations somehow always adjust to equilibrium values. In certain contexts, when there is no apparent basis to question whether a particular market is functioning efficiently, rational expectations may be a reasonable working assumption for modelling observed behavior. However, when there is reason to question whether a given market is operating efficiently or whether an entire economy is operating close to its potential, to insist on principle that the rational-expectations assumption must be made, to assume, in other words, that actual and expected prices adjust rapidly to their equilibrium values allowing an economy to operate at or near its optimal growth path, is simply, as I have often said, an exercise in circular reasoning and question begging.

Making Sense of Rational Expectations

Almost two months ago I wrote a provocatively titled post about rational expectations, in which I argued against the idea that it is useful to make the rational-expectations assumption in developing a theory of business cycles. The title of the post was probably what led to the start of a thread about my post on the econjobrumors blog, the tenor of which  can be divined from the contribution of one commenter: “Who on earth is Glasner?” But, aside from the attention I received on econjobrumors, I also elicited a response from Scott Sumner

David Glasner has a post criticizing the rational expectations modeling assumption in economics:

What this means is that expectations can be rational only when everyone has identical expectations. If people have divergent expectations, then the expectations of at least some people will necessarily be disappointed — the expectations of both people with differing expectations cannot be simultaneously realized — and those individuals whose expectations have been disappointed will have to revise their plans. But that means that the expectations of those people who were correct were also not rational, because the prices that they expected were not equilibrium prices. So unless all agents have the same expectations about the future, the expectations of no one are rational. Rational expectations are a fixed point, and that fixed point cannot be attained unless everyone shares those expectations.

Beyond that little problem, Mason raises the further problem that, in a rational-expectations equilibrium, it makes no sense to speak of a shock, because the only possible meaning of “shock” in the context of a full intertemporal (aka rational-expectations) equilibrium is a failure of expectations to be realized. But if expectations are not realized, expectations were not rational.

I see two mistakes here. Not everyone must have identical expectations in a world of rational expectations. Now it’s true that there are ratex models where people are simply assumed to have identical expectations, such as representative agent models, but that modeling assumption has nothing to do with rational expectations, per se.

In fact, the rational expectations hypothesis suggests that people form optimal forecasts based on all publicly available information. One of the most famous rational expectations models was Robert Lucas’s model of monetary misperceptions, where people observed local conditions before national data was available. In that model, each agent sees different local prices, and thus forms different expectations about aggregate demand at the national level.

It is true that not all expectations must be identical in a world of rational expectations. The question is whether those expectations are compatible with the equilibrium of the model in which those expectations are embedded. If any of those expectations are incompatible with the equilibrium of the model, then, if agents’ decision are based on their expectations, the model will not arrive at an equilibrium solution. Lucas’s monetary misperception model was a clever effort to tweak the rational-expectations assumption just enough to allow for a temporary disequilibrium. But the attempt was a failure, because Lucas could only generate a one-period deviation from equilibrium, which was too little for the model to pose as a plausible account of a business cycle. That provided Kydland and Prescott the idea to discard Lucas’s monetary misperceptions idea and write their paper on real business cycles without adulterating the rational expectations assumption.

Here’s what Muth said about the rational expectations assumption in the paper in which he introduced “rational expectations” as a modeling strategy.

In order to explain these phenomena, I should like to suggest that expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory. At the risk of confusing this purely descriptive hypothesis with a pronouncement as to what firms ought to do, we call such expectations “rational.”

The hypothesis can be rephrased a little more precisely as follows: that expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the “objective” probability distributions of outcomes).

The hypothesis asserts three things: (1) Information is scarce, and the economic system generally does not waste it. (2) The way expectations are formed depends specifically on the structure of the relevant system describing the economy. (3) A “public prediction,” in the sense of Grunberg and Modigliani, will have no substantial effect on the operation of the economic system (unless it is based on inside information).

It does not assert that the scratch work of entrepreneurs resembles the system of equations in any way; nor does it state that predictions of entrepreneurs are perfect or that their expectations are all the same. For purposes of analysis, we shall use a specialized form of the hypothesis. In particular, we assume: 1. The random disturbances are normally distributed. 2. Certainty equivalents exist for the variables to be predicted. 3. The equations of the system, including the expectations formulas, are linear. These assumptions are not quite so strong as may appear at first because any one of them virtually implies the other two.

It seems to me that Muth was confused about what the rational-expectations assumption entails. He asserts that the expectations of entrepreneurs — and presumably that applies to other economic agents as well insofar as their decisions are influenced by their expectations of the future – should be assumed to be exactly what the relevant economic model predicts the expected outcomes to be. If so, I don’t see how it can be maintained that expectations could diverge from each other. If what entrepreneurs produce next period depends on the price they expect next period, then how is it possible that the total supply produced next period is independent of the distribution of expectations as long as the errors are normally distributed and the mean of the distribution corresponds to the equilibrium of the model? This could only be true if the output produced by each entrepreneur was a linear function of the expected price and all entrepreneurs had identical marginal costs or if the distribution of marginal costs was uncorrelated with the distribution of expectations. The linearity assumption is hardly compelling unless you assume that the system is in equilibrium and all changes are small. But making that assumption is just another form of question begging.

It’s also wrong to say:

But if expectations are not realized, expectations were not rational.

Scott is right. What I said was wrong. What I ought to have said is: “But if expectations (being divergent) could not have been realized, those expectations were not rational.”

Suppose I am watching the game of roulette. I form the expectation that the ball will not land on one of the two green squares. Now suppose it does. Was my expectation rational? I’d say yes—there was only a 2/38 chance of the ball landing on a green square. It’s true that I lacked perfect foresight, but my expectation was rational, given what I knew at the time.

I don’t think that Scott’s response is compelling, because you can’t judge the rationality of an expectation in isolation, it has to be judged in a broader context. If you are forming your expectation about where the ball will fall in a game of roulette, the rationality of that expectation can only be evaluated in the context of how much you should be willing to bet that the ball will fall on one of the two green squares and that requires knowledge of what the payoff would be if the ball did fall on one of those two squares. And that would mean that someone else is involved in the game and would be taking an opposite position. The rationality of expectations could only be judged in the context of what everyone participating in the game was expecting and what the payoffs and penalties were for each participant.

In 2006, it might have been rational to forecast that housing prices would not crash. If you lived in many countries, your forecast would have been correct. If you happened to live in Ireland or the US, your forecast would have been incorrect. But it might well have been a rational forecast in all countries.

The rationality of a forecast can’t be assessed in isolation. A forecast is rational if it is consistent with other forecasts, so that it, along with the other forecasts, could potentially be realized. As a commenter on Scott’s blog observed, a rational expectation is an expectation that, at the time the forecast is made, is consistent with the relevant model. The forecast of housing prices may turn out to be incorrect, but the forecast might still have been rational when it was made if the forecast of prices was consistent with what the relevant model would have predicted. The failure of the forecast to be realized could mean either that forecast was not consistent with the model, or that between the time of the forecast and the time of its realization, new information,  not available at the time of the forecast, came to light and changed the the prediction of the relevant model.

The need for context in assessing the rationality of expectations was wonderfully described by Thomas Schelling in his classic analysis of cooperative games.

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

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

Viewed in this way, the intellectual process of arriving at “rational expectations” in the full-communication “pure” bargaining game is virtually identical with the intellectual process of arriving at a coordinated choice in the tacit game. The actual solutions might be different because the game contexts might be different, with different suggestive details; but the intellectual nature of the two solutions seems virtually identical since both depend on an agreement that is reached by tacit consent. This is true because the explicit agreement that is reached in the full communication game corresponds to the a prioir expectations that were reached (or in theory could have been reached) jointly but independently by the two players before the bargaining started. And it is a tacit “agreement” in the sense that both can hold confident rational expectation only if both are aware that both accept the indicated solution in advance as the outcome that they both know they both expect.

So I agree that rational expectations can simply mean that agents are forming expectations about the future incorporating as best as they can all the knowledge available to them. This is a weak common sense interpretation of rational expectations that I think is what Scott Sumner has in mind when he uses the term “rational expectations.” But in the context of formal modelling, rational expectations has a more restrictive meaning, which is that given all the information available, the expectations of all agents in the model must correspond to what the model itself predicts given that information. Even though Muth himself and others have tried to avoid the inference that all agents must have expectations that match the solution of the model, given the information underlying the model, the assumptions under which agents could hold divergent expectations are, in their own way, just as restrictive as the assumption that agents hold convergent expectations.

In a way, the disconnect between a common-sense understanding of what “rational expectations” means and what “rational expectations” means in the context of formal macroeconomic models is analogous to the disconnect between what “competition” means in normal discourse and what “competition” (and especially “perfect competition”) means in the context of formal microeconomic models. Much of the rivalrous behavior between competitors that we think of as being essential aspects of competition and the competitive process is simply ruled out by the formal assumption of perfect competition.

Rational Expectations, or, The Road to Incoherence

J. W. Mason left a very nice comment on my recent post about Paul Romer’s now-famous essay on macroeconomics, a comment now embedded in his interesting and insightful blog post on the Romer essay. As a wrote in my reply to Mason’s comment, I really liked the way he framed his point about rational expectations and intertemporal equilibrium. Sometimes when you see a familiar idea expressed in a particular way, the novelty of the expression, even though it’s not substantively different from other ways of expressing the idea, triggers a new insight. And that’s what I think happened in my own mind as I read Mason’s comment. Here’s what he wrote:

David Glasner’s interesting comment on Romer makes in passing a point that’s bugged me for years — that you can’t talk about transitions from one intertemporal equilibrium to another, there’s only the one. Or equivalently, you can’t have a model with rational expectations and then talk about what happens if there’s a “shock.” To say there is a shock in one period, is just to say that expectations in the previous period were wrong. Glasner:

the Lucas Critique applies even to micro-founded models, those models being strictly valid only in equilibrium settings and being unable to predict the adjustment of economies in the transition between equilibrium states. All models are subject to the Lucas Critique.

So the further point that I would make, after reading Mason’s comment, is just this. For an intertemporal equilibrium to exist, there must be a complete set of markets for all future periods and contingent states of the world, or, alternatively, there must be correct expectations shared by all agents about all future prices and the probability that each contingent future state of the world will be realized. By the way, If you think about it for a moment, the notion that probabilities can be assigned to every contingent future state of the world is mind-bogglingly unrealistic, because the number of contingent states must rapidly become uncountable, because every single contingency itself gives rise to further potential contingencies, and so on and on and on. But forget about that little complication. What intertemporal equilibrium requires is that all expectations of all individuals be in agreement – or at least not be inconsistent, some agents possibly having an incomplete set of expectations about future prices and future states of the world. If individuals differ in their expectations, so that their planned future purchases and sales are based on what they expect future prices to be when the time comes for those transactions to be carried out, then individuals will not be able to execute their plans as intended when at least one of them finds that actual prices are different from what they had been expected to be.

What this means is that expectations can be rational only when everyone has identical expectations. If people have divergent expectations, then the expectations of at least some people will necessarily be disappointed — the expectations of both people with differing expectations cannot be simultaneously realized — and those individuals whose expectations have been disappointed will have to revise their plans. But that means that the expectations of those people who were correct were also not rational, because the prices that they expected were not equilibrium prices. So unless all agents have the same expectations about the future, the expectations of no one are rational. Rational expectations are a fixed point, and that fixed point cannot be attained unless everyone shares those expectations.

Beyond that little problem, Mason raises the further problem that, in a rational-expectations equilibrium, it makes no sense to speak of a shock, because the only possible meaning of “shock” in the context of a full intertemporal (aka rational-expectations) equilibrium is a failure of expectations to be realized. But if expectations are not realized, expectations were not rational. So the whole New Classical modeling strategy of identifying shocks  to a system in rational-expectations equilibrium, and “predicting” the responses to these shocks as if they had been anticipated is self-contradictory and incoherent.

Price Stickiness Is a Symptom not a Cause

In my recent post about Nick Rowe and the law of reflux, I mentioned in passing that I might write a post soon about price stickiness. The reason that I thought it would be worthwhile writing again about price stickiness (which I have written about before here and here), because Nick, following a broad consensus among economists, identifies price stickiness as a critical cause of fluctuations in employment and income. Here’s how Nick phrased it:

An excess demand for land is observed in the land market. An excess demand for bonds is observed in the bond market. An excess demand for equities is observed in the equity market. An excess demand for money is observed in any market. If some prices adjust quickly enough to clear their market, but other prices are sticky so their markets don’t always clear, we may observe an excess demand for money as an excess supply of goods in those sticky-price markets, but the prices in flexible-price markets will still be affected by the excess demand for money.

Then a bit later, Nick continues:

If individuals want to save in the form of money, they won’t collectively be able to if the stock of money does not increase.There will be an excess demand for money in all the money markets, except those where the price of the non-money thing in that market is flexible and adjusts to clear that market. In the sticky-price markets there will nothing an individual can do if he wants to buy more money but nobody else wants to sell more. But in those same sticky-price markets any individual can always sell less money, regardless of what any other individual wants to do. Nobody can stop you selling less money, if that’s what you want to do.

Unable to increase the flow of money into their portfolios, each individual reduces the flow of money out of his portfolio. Demand falls in stick-price markets, quantity traded is determined by the short side of the market (Q=min{Qd,Qs}), so trade falls, and some traders that would be mutually advantageous in a barter or Walrasian economy even at those sticky prices don’t get made, and there’s a recession. Since money is used for trade, the demand for money depends on the volume of trade. When trade falls the flow of money falls too, and the stock demand for money falls, until the representative individual chooses a flow of money out of his portfolio equal to the flow in. He wants to increase the flow in, but cannot, since other individuals don’t want to increase their flows out.

The role of price stickiness or price rigidity in accounting for involuntary unemployment is an old and complicated story. If you go back and read what economists before Keynes had to say about the Great Depression, you will find that there was considerable agreement that, in principle, if workers were willing to accept a large enough cut in their wages, they could all get reemployed. That was a proposition accepted by Hawtry and by Keynes. However, they did not believe that wage cutting was a good way of restoring full employment, because the process of wage cutting would be brutal economically and divisive – even self-destructive – politically. So they favored a policy of reflation that would facilitate and hasten the process of recovery. However, there also those economists, e.g., Ludwig von Mises and the young Lionel Robbins in his book The Great Depression, (which he had the good sense to disavow later in life) who attributed high unemployment to an unwillingness of workers and labor unions to accept wage cuts and to various other legal barriers preventing the price mechanism from operating to restore equilibrium in the normal way that prices adjust to equate the amount demanded with the amount supplied in each and every single market.

But in the General Theory, Keynes argued that if you believed in the standard story told by microeconomics about how prices constantly adjust to equate demand and supply and maintain equilibrium, then maybe you should be consistent and follow the Mises/Robbins story and just wait for the price mechanism to perform its magic, rather than support counter-cyclical monetary and fiscal policies. So Keynes then argued that there is actually something wrong with the standard microeconomic story; price adjustments can’t ensure that overall economic equilibrium is restored, because the level of employment depends on aggregate demand, and if aggregate demand is insufficient, wage cutting won’t increase – and, more likely, would reduce — aggregate demand, so that no amount of wage-cutting would succeed in reducing unemployment.

To those upholding the idea that the price system is a stable self-regulating system or process for coordinating a decentralized market economy, in other words to those upholding microeconomic orthodoxy as developed in any of the various strands of the neoclassical paradigm, Keynes’s argument was deeply disturbing and subversive.

In one of the first of his many important publications, “Liquidity Preference and the Theory of Money and Interest,” Franco Modigliani argued that, despite Keynes’s attempt to prove that unemployment could persist even if prices and wages were perfectly flexible, the assumption of wage rigidity was in fact essential to arrive at Keynes’s result that there could be an equilibrium with involuntary unemployment. Modigliani did so by positing a model in which the supply of labor is a function of real wages. It was not hard for Modigliani to show that in such a model an equilibrium with unemployment required a rigid real wage.

Modigliani was not in favor of relying on price flexibility instead of counter-cyclical policy to solve the problem of involuntary unemployment; he just argued that the rationale for such policies had to be that prices and wages were not adjusting immediately to clear markets. But the inference that Modigliani drew from that analysis — that price flexibility would lead to an equilibrium with full employment — was not valid, there being no guarantee that price adjustments would necessarily lead to equilibrium, unless all prices and wages instantaneously adjusted to their new equilibrium in response to any deviation from a pre-existing equilibrium.

All the theory of general equilibrium tells us is that if all trading takes place at the equilibrium set of prices, the economy will be in equilibrium as long as the underlying “fundamentals” of the economy do not change. But in a decentralized economy, no one knows what the equilibrium prices are, and the equilibrium price in each market depends in principle on what the equilibrium prices are in every other market. So unless the price in every market is an equilibrium price, none of the markets is necessarily in equilibrium.

Now it may well be that if all prices are close to equilibrium, the small changes will keep moving the economy closer and closer to equilibrium, so that the adjustment process will converge. But that is just conjecture, there is no proof showing the conditions under which a simple rule that says raise the price in any market with an excess demand and decrease the price in any market with an excess supply will in fact lead to the convergence of the whole system to equilibrium. Even in a Walrasian tatonnement system, in which no trading at disequilibrium prices is allowed, there is no proof that the adjustment process will eventually lead to the discovery of the equilibrium price vector. If trading at disequilibrium prices is allowed, tatonnement is hopeless.

So the real problem is not that prices are sticky but that trading takes place at disequilibrium prices and there is no mechanism by which to discover what the equilibrium prices are. Modern macroeconomics solves this problem, in its characteristic fashion, by assuming it away by insisting that expectations are “rational.”

Economists have allowed themselves to make this absurd assumption because they are in the habit of thinking that the simple rule of raising price when there is an excess demand and reducing the price when there is an excess supply inevitably causes convergence to equilibrium. This habitual way of thinking has been inculcated in economists by the intense, and largely beneficial, training they have been subjected to in Marshallian partial-equilibrium analysis, which is built on the assumption that every market can be analyzed in isolation from every other market. But that analytic approach can only be justified under a very restrictive set of assumptions. In particular it is assumed that any single market under consideration is small relative to the whole economy, so that its repercussions on other markets can be ignored, and that every other market is in equilibrium, so that there are no changes from other markets that are impinging on the equilibrium in the market under consideration.

Neither of these assumptions is strictly true in theory, so all partial equilibrium analysis involves a certain amount of hand-waving. Nor, even if we wanted to be careful and precise, could we actually dispense with the hand-waving; the hand-waving is built into the analysis, and can’t be avoided. I have often referred to these assumptions required for the partial-equilibrium analysis — the bread and butter microeconomic analysis of Econ 101 — to be valid as the macroeconomic foundations of microeconomics, by which I mean that the casual assumption that microeconomics somehow has a privileged and secure theoretical position compared to macroeconomics and that macroeconomic propositions are only valid insofar as they can be reduced to more basic microeconomic principles is entirely unjustified. That doesn’t mean that we shouldn’t care about reconciling macroeconomics with microeconomics; it just means that the validity of proposition in macroeconomics is not necessarily contingent on being derived from microeconomics. Reducing macroeconomics to microeconomics should be an analytical challenge, not a methodological imperative.

So the assumption, derived from Modigliani’s 1944 paper that “price stickiness” is what prevents an economic system from moving automatically to a new equilibrium after being subjected to some shock or disturbance, reflects either a misunderstanding or a semantic confusion. It is not price stickiness that prevents the system from moving toward equilibrium, it is the fact that individuals are engaging in transactions at disequilibrium prices. We simply do not know how to compare different sets of non-equilibrium prices to determine which set of non-equilibrium prices will move the economy further from or closer to equilibrium. Our experience and out intuition suggest that in some neighborhood of equilibrium, an economy can absorb moderate shocks without going into a cumulative contraction. But all we really know from theory is that any trading at any set of non-equilibrium prices can trigger an economic contraction, and once it starts to occur, a contraction may become cumulative.

It is also a mistake to assume that in a world of incomplete markets, the missing markets being markets for the delivery of goods and the provision of services in the future, any set of price adjustments, however large, could by themselves ensure that equilibrium is restored. With an incomplete set of markets, economic agents base their decisions not just on actual prices in the existing markets; they base their decisions on prices for future goods and services which can only be guessed at. And it is only when individual expectations of those future prices are mutually consistent that equilibrium obtains. With inconsistent expectations of future prices, the adjustments in current prices in the markets that exist for currently supplied goods and services that in some sense equate amounts demanded and supplied, lead to a (temporary) equilibrium that is not efficient, one that could be associated with high unemployment and unused capacity even though technically existing markets are clearing.

So that’s why I regard the term “sticky prices” and other similar terms as very unhelpful and misleading; they are a kind of mental crutch that economists are too ready to rely on as a substitute for thinking about what are the actual causes of economic breakdowns, crises, recessions, and depressions. Most of all, they represent an uncritical transfer of partial-equilibrium microeconomic thinking to a problem that requires a system-wide macroeconomic approach. That approach should not ignore microeconomic reasoning, but it has to transcend both partial-equilibrium supply-demand analysis and the mathematics of intertemporal optimization.

What’s Wrong with EMH?

Scott Sumner wrote a post commenting on my previous post about Paul Krugman’s column in the New York Times last Friday. I found Krugman’s column really interesting in his ability to pack so much real economic content into an 800-word column written to help non-economists understand recent fluctuations in the stock market. Part of what I was doing in my post was to offer my own criticism of the efficient market hypothesis (EMH) of which Krugman is probably not an enthusiastic adherent either. Nevertheless, both Krugman and I recognize that EMH serves as a useful way to discipline how we think about fluctuating stock prices.

Here is a passage of Krugman’s that I commented on:

But why are long-term interest rates so low? As I argued in my last column, the answer is basically weakness in investment spending, despite low short-term interest rates, which suggests that those rates will have to stay low for a long time.

My comment was:

Again, this seems inexactly worded. Weakness in investment spending is a symptom not a cause, so we are back to where we started from. At the margin, there are no attractive investment opportunities.

Scott had this to say about my comment:

David is certainly right that Krugman’s statement is “inexactly worded”, but I’m also a bit confused by his criticism. Certainly “weakness in investment spending” is not a “symptom” of low interest rates, which is how his comment reads in context.  Rather I think David meant that the shift in the investment schedule is a symptom of a low level of AD, which is a very reasonable argument, and one he develops later in the post.  But that’s just a quibble about wording.  More substantively, I’m persuaded by Krugman’s argument that weak investment is about more than just AD; the modern information economy (with, I would add, a slowgrowing working age population) just doesn’t generate as much investment spending as before, even at full employment.

Just to be clear, what I was trying to say was that investment spending is determined by “fundamentals,” i.e., expectations about future conditions (including what demand for firms’ output will be, what competing firms are planning to do, what cost conditions will be, and a whole range of other considerations. It is the combination of all those real and psychological factors that determines the projected returns from undertaking an investment, and those expected returns must be compared with the cost of capital to reach a final decision about which projects will be undertaken, thereby giving rise to actual investment spending. So I certainly did not mean to say that weakness in investment spending is a symptom of low interest rates. I meant that it is a symptom of the entire economic environment that, depending on the level of interest rates, makes specific investment projects seem attractive or unattractive. Actually, I don’t think that there is any real disagreement between Scott and me on this particular point; I just mention the point to avoid possible misunderstandings.

But the differences between Scott and me about the EMH seem to be substantive. Scott quotes this passage from my previous post:

The efficient market hypothesis (EMH) is at best misleading in positing that market prices are determined by solid fundamentals. What does it mean for fundamentals to be solid? It means that the fundamentals remain what they are independent of what people think they are. But if fundamentals themselves depend on opinions, the idea that values are determined by fundamentals is a snare and a delusion.

Scott responded as follows:

I don’t think it’s correct to say the EMH is based on “solid fundamentals”.  Rather, AFAIK, the EMH says that asset prices are based on rational expectations of future fundamentals, what David calls “opinions”.  Thus when David tries to replace the EMH view of fundamentals with something more reasonable, he ends up with the actual EMH, as envisioned by people like Eugene Fama.  Or am I missing something?

In fairness, David also rejects rational expectations, so he would not accept even my version of the EMH, but I think he’s too quick to dismiss the EMH as being obviously wrong. Lots of people who are much smarter than me believe in the EMH, and if there was an obvious flaw I think it would have been discovered by now.

I accept Scott’s correction that EMH is based on the rational expectation of future fundamentals, but I don’t think that the distinction is as meaningful as Scott does. The problem is that in a typical rational-expectations model, the fundamentals are given and don’t change, so that fundamentals are actually static. The seemingly non-static property of a rational-expectations model is achieved by introducing stochastic parameters with known means and variances, so that the ultimate realizations of stochastic variables within the model are not known in advance. However, the rational expectations of all stochastic variables are unbiased, and they are – in some sense — the best expectations possible given the underlying stochastic nature of the variables. But given that stochastic structure, current asset prices reflect the actual – and unchanging — fundamentals, the stochastic elements in the model being fully reflected in asset prices today. Prices may change ex post, but, conditional on the realizations of the stochastic variables (whose probability distributions are assumed to have been known in advance), those changes are fully anticipated. Thus, in a rational-expectations equilibrium, causation still runs from fundamentals to expectations.

The problem with rational expectations is not a flaw in logic. In fact, the importance of rational expectations is that it is a very important logical test for the coherence of a model. If a model cannot be solved for a rational-expectations equilibrium, it suffers from a basic lack of coherence. Something is basically wrong with a model in which the expectation of the equilibrium values predicted by the model does not lead to their realization. But a logical property of the model is not the same as a positive theory of how expectations are formed and how they evolve. In the real world, knowledge is constantly growing, and new knowledge implies that the fundamentals underlying the economy must be changing as knowledge grows. The future fundamentals that will determine the future prices of a future economy cannot be rationally expected in the present, because we have no way of specifying probability distributions corresponding to dynamic evolving systems.

If future fundamentals are logically unknowable — even in a probabilistic sense — in the present, because we can’t predict what our future knowledge will be, because if we could, future knowledge would already be known, making it present knowledge, then expectations of the future can’t possibly be rational because we never have the knowledge that would be necessary to form rational expectations. And so I can’t accept Scott’s assertion that asset prices are based on rational expectations of future fundamentals. It seems to me that the causation goes in the other direction as well: future fundamentals will be based, at least in part, on current expectations.

Stock Prices, the Economy and Self-Fulfilling Prophecies

Paul Krugman has a nice column today warning us that the recent record highs in the stock market indices don’t mean that happy days are here again. While I agree with much of what he says, I don’t agree with all of it, so let me try to sort out what I think is right and what I think may not be right.

Like most economists, I don’t usually have much to say about stocks. Stocks are even more susceptible than other markets to popular delusions and the madness of crowds, and stock prices generally have a lot less to do with the state of the economy or its future prospects than many people believe.

I think that’s generally right. The efficient market hypothesis (EMH) is at best misleading in positing that market prices are determined by solid fundamentals. What does it mean for fundamentals to be solid? It means that the fundamentals remain what they are independent of what people think they are. But if fundamentals themselves depend on opinions, the idea that values are determined by fundamentals is a snare and a delusion. So the fundamental idea on which the EMH is premised that there are fundamentals is itself fundamentally wrong. Fundamentals are no more than conjectures and psychologically flimsy perceptions, and individual perceptions are themselves very much influenced by how other people perceive the world and their perceptions. That’s why fads are contagious and bubbles can arise. But because fundamentals are nothing but opinions, expectations can be self-fulfilling. So it is possible for some ex ante bubbles to wind up being justified ex post, but only because expectations can be self-fulfilling.

Still, we shouldn’t completely ignore stock prices. The fact that the major averages have lately been hitting new highs — the Dow has risen 177 percent from its low point in March 2009 — is newsworthy and noteworthy. What are those Wall Street indexes telling us?

Stock prices are in fact governed by expectations, but expectations may or may not be rational, where a rational expectation is an expectation that could actually be realized in some possible state of the world.

The answer, I’d suggest, isn’t entirely positive. In fact, in some ways the stock market’s gains reflect economic weaknesses, not strengths. And understanding how that works may help us make sense of the troubling state our economy is in. . . .

The truth . . . is that there are three big points of slippage between stock prices and the success of the economy in general. First, stock prices reflect profits, not overall incomes. Second, they also reflect the availability of other investment opportunities — or the lack thereof. Finally, the relationship between stock prices and real investment that expands the economy’s capacity has gotten very tenuous.

To put this into the slightly different language of basic financial theory, stock prices reflect the expected future cash flows from owning shares of publicly traded corporations. So stock prices reflect the net value of the tangible and intangible capital assets of these corporations. The public valuations of those assets reflected in stock prices reflect expectations about the future income streams associated with those assets, but those expected future income streams must be discounted so that they can be expressed as a present value. The rate at which future income streams are discounted into the present represents what Krugman calls “the availability of other investment opportunities.” If lots of good investment opportunities are available, then future income streams will be discounted at a higher rate than if there aren’t so many good investment opportunities. In theory the discount rate at which future income streams are discounted would reflect the rate of return corresponding to the marginal investment opportunities that are on the verge of being adopted or abandoned, because they just break even. What Krugman means by the tenuous relationship between stock prices and real investment that expands the economy’ capacity will have to be considered below.

Krugman maintains that, over the past two decades, even though the economy as a whole has not done all that well, stock prices have increased a lot, because the share of capital in total GDP has increased at the expense of labor. He also points out that the low — even negative — real interest rates on government bonds are indicative of the poor opportunities now available (at the margin) to investors.

And these days those options [“for converting money today into income tomorrow”] are pretty poor, with interest rates on long-term government bonds not only very low by historical standards but zero or negative once you adjust for inflation. So investors are willing to pay a lot for future income, hence high stock prices for any given level of profits.

Two points should be noted here. First, scare talk about low interest rates causing bubbles because investors search for yield is nonsense. Even in a fundamentalist EMH universe, a deterioration of marginal investment opportunities causing a drop in the real interest rate will, for given expectations of future income streams, imply that the present value of the assets generating those streams would rise. Rising asset prices in such circumstances are totally rational, which is exactly what bubbles are not. Second, the low interest rates on long-term government bonds are not the cause of poor investment opportunities but the result of poor investment opportunities. Krugman certainly understands that, but many of his readers might not.

But why are long-term interest rates so low? As I argued in my last column, the answer is basically weakness in investment spending, despite low short-term interest rates, which suggests that those rates will have to stay low for a long time.

Again, this seems inexactly worded. Weakness in investment spending is a symptom not a cause, so we are back to where we started from. At the margin, there are no attractive investment opportunities. The mystery deepens:

This may seem, however, to present a paradox. If the private sector doesn’t see itself as having a lot of good investment opportunities, how can profits be so high? The answer, I’d suggest, is that these days profits often seem to bear little relationship to investment in new capacity. Instead, profits come from some kind of market power — brand position, the advantages of an established network, or good old-fashioned monopoly. And companies making profits from such power can simultaneously have high stock prices and little reason to spend.

Why do profits bear only a weak relationship to investment in new capacity? Krugman suggests that the cause  is that rising profits are due to the exercise of market power, firms increasing profits not by increasing output, but by restricting output to raise prices (not necessarily in absolute terms but relative to costs). This is a kind of microeconomic explanation of a macroeconomic phenomenon, which does not necessarily make it wrong, but it is a somewhat anomalous argument for a Keynesian. Be that as it may, to be credible such an argument must explain how the share of corporate profits in total income has been able to grow steadily for nearly twenty years. What would account for a steady economy-wide increase in the market power of corporations lasting for two decades?

Consider the fact that the three most valuable companies in America are Apple, Google and Microsoft. None of the three spends large sums on bricks and mortar. In fact, all three are sitting on huge reserves of cash. When interest rates go down, they don’t have much incentive to spend more on expanding their businesses; they just keep raking in earnings, and the public becomes willing to pay more for a piece of those earnings.

Krugman’s example suggests that the continuing increase in market power, if that is what has been happening, has been structural. By structural I mean that much of the growth in the economy over the past two decades has been in sectors characterized by strong network effects or aggressive enforcement of intellectual property rights. Network effects and strong intellectual property rights tend to create, enhance, and entrench market power, supporting very large gaps between prices and variable costs, which is the standard metric for identifying exercises of market power. The nature of what these companies offer consumers is such that their marginal cost of production is very low, so that reducing price and expanding output would not require a substantial increase in their demand for inputs (at least compared to other industries with higher marginal costs), but would cause a big loss of profit.

But I would suggest looking at the problem from a different perspective, using the distinction between two kinds of capital investment proposed by Ralph Hawtrey. One kind of investment is capital deepening, which involves an increase in the capital intensity of production, the idea being to reduce the cost of production by installing new or better equipment to economize on other inputs (usually labor); the other kind of investment is capital widening, which involves an increase in the scale of output but not in capital intensity, for example building a new plant or expanding an existing one. Capital deepening tends to reduce the demand for labor while capital widening tends to increase it.

More of the investment now being undertaken may be of the capital-deepening sort than has been true historically. Aside from the structural shifts mentioned above, the reduction in capital-widening investment may be the result of declining optimism by businesses in their projections about future demand for their products, making capital-widening investments seem less profitable. For the economy as a whole, a decline in optimism about future demand may turn out to be self-fulfilling. Thus, an increasing share of total investment has become capital-deepening and a declining share capital-widening. But for the economy as a whole, this self-fulfilling pessimism implies that total investment declines. The question is whether monetary (or fiscal) policy could now do anything to increase expectations of future demand sufficiently to induce an self-fulfilling increase in optimism and in capital-widening investment.


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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