Archive for the 'rational expectations' Category

Axel Leijonhufvud and Modern Macroeconomics

For many baby boomers like me growing up in Los Angeles, UCLA was an almost inevitable choice for college. As an incoming freshman, I was undecided whether to major in political science or economics. PoliSci 1 didn’t impress me, but Econ 1 did. More than my Econ 1 professor, it was the assigned textbook, University Economics, 1st edition, by Alchian and Allen that impressed me. That’s how my career in economics started.

After taking introductory micro and macro as a freshman, I started the intermediate theory sequence of micro (utility and cost theory, econ 101a), (general equilibrium theory, 101b), and (macro theory, 102) as a sophomore. It was in the winter 1968 quarter that I encountered Axel Leijonhufvud. This was about a year before his famous book – his doctoral dissertation – Keynesian Economics and the Economics of Keynes was published in the fall of 1968 to instant acclaim. Although it must have been known in the department that the book, which he’d been working on for several years, would soon appear, I doubt that its remarkable impact on the economics profession could have been anticipated, turning Axel almost overnight from an obscure untenured assistant professor into a tenured professor at one of the top economics departments in the world and a kind of academic rock star widely sought after to lecture and appear at conferences around the globe. I offer the following scattered recollections of him, drawn from memories at least a half-century old, to those interested in his writings, and some reflections on his rise to the top of the profession, followed by a gradual loss of influence as theoretical marcroeconomics, fell under the influence of Robert Lucas and the rational-expectations movement in its various forms (New Classical, Real Business-Cycle, New-Keynesian).

Axel, then in his early to mid-thirties, was an imposing figure, very tall and gaunt with a short beard and a shock of wavy blondish hair, but his attire reflecting the lowly position he then occupied in the academic hierarchy. He spoke perfect English with a distinct Swedish lilt, frequently leavening his lectures and responses to students’ questions with wry and witty comments and asides.  

Axel’s presentation of general-equilibrium theory was, as then still the norm, at least at UCLA, mostly graphical, supplemented occasionally by some algebra and elementary calculus. The Edgeworth box was his principal technique for analyzing both bilateral trade and production in the simple two-output, two-input case, and he used it to elucidate concepts like Pareto optimality, general-equilibrium prices, and the two welfare theorems, an exposition which I, at least, found deeply satisfying. The assigned readings were the classic paper by F. M. Bator, “The Simple Analytics of Welfare-Maximization,” which I relied on heavily to gain a working grasp of the basics of general-equilibrium theory, and as a supplementary text, Peter Newman’s The Theory of Exchange, much of which was too advanced for me to comprehend more than superficially. Axel also introduced us to the concept of tâtonnement and highlighting its importance as an explanation of sorts of how the equilibrium price vector might, at least in theory, be found, an issue whose profound significance I then only vaguely comprehended, if at all. Another assigned text was Modern Capital Theory by Donald Dewey, providing an introduction to the role of capital, time, and the rate of interest in monetary and macroeconomic theory and a bridge to the intermediate macro course that he would teach the following quarter.

A highlight of Axel’s general-equilibrium course was the guest lecture by Bob Clower, then visiting UCLA from Northwestern, with whom Axel became friendly only after leaving Northwestern, and two of whose papers (“A Reconsideration of the Microfoundations of Monetary Theory,” and “The Keynesian Counterrevolution: A Theoretical Appraisal”) were discussed at length in his forthcoming book. (The collaboration between Clower and Leijonhufvud and their early Northwestern connection has led to the mistaken idea that Clower had been Axel’s thesis advisor. Axel’s dissertation was actually written under Meyer Burstein.) Clower himself came to UCLA economics a few years later when I was already a third-year graduate student, and my contact with him was confined to seeing him at seminars and workshops. I still have a vivid memory of Bob in his lecture explaining, with the aid of chalk and a blackboard, how ballistic theory was developed into an orbital theory by way of a conceptual experiment imagining that the distance travelled by a projectile launched from a fixed position being progressively lengthened until the projectile’s trajectory transitioned into an orbit around the earth.

Axel devoted the first part of his macro course to extending the Keynesian-cross diagram we had been taught in introductory macro into the Hicksian IS-LM model by making investment a negative function of the rate of interest and adding a money market with a fixed money stock and a demand for money that’s a negative function of the interest rate. Depending on the assumptions about elasticities, IS-LM could be an analytical vehicle that could accommodate either the extreme Keynesian-cross case, in which fiscal policy is all-powerful and monetary policy is ineffective, or the Monetarist (classical) case, in which fiscal policy is ineffective and monetary policy all-powerful, which was how macroeconomics was often framed as a debate about the elasticity of the demand for money curve with respect to interest rate. Friedman himself, in his not very successful attempt to articulate his own framework for monetary analysis, accepted that framing, one of the few rhetorical and polemical misfires of his career.

In his intermediate macro course, Axel presented the standard macro model, and I don’t remember his weighing in that much with his own criticism; he didn’t teach from a standard intermediate macro textbook, standard textbook versions of the dominant Keynesian model not being at all to his liking. Instead, he assigned early sources of what became Keynesian economics like Hicks’s 1937 exposition of the IS-LM model and Alvin Hansen’s A Guide to Keynes (1953), with Friedman’s 1956 restatement of the quantity theory serving as a counterpoint, and further developments of Keynesian thought like Patinkin’s 1948 paper on price flexibility and full employment, A. W. Phillips original derivation of the Phillips Curve, Harry Johnson on the General Theory after 25 years, and his own preview “Keynes and the Keynesians: A Suggested Interpretation” of his forthcoming book, and probably others that I’m not now remembering. Presenting the material piecemeal from original sources allowed him to underscore the weaknesses and questionable assumptions latent in the standard Keynesian model.

Of course, for most of us, it was a challenge just to reproduce the standard model and apply it to some specific problems, but we at least we got the sense that there was more going on under the hood of the model than we would have imagined had we learned its structure from a standard macro text. I have the melancholy feeling that the passage of years has dimmed my memory of his teaching too much to adequately describe how stimulating, amusing and enjoyable his lectures were to those of us just starting our journey into economic theory.

The following quarter, in the fall 1968 quarter, when his book had just appeared in print, Axel created a new advanced course called macrodynamics. He talked a lot about Wicksell and Keynes, of course, but he was then also fascinated by the work of Norbert Wiener on cybernetics, assigning Wiener’s book Cybernetics as a primary text and a key to understanding what Keynes was really trying to do. He introduced us to concepts like positive and negative feedback, servo mechanisms, stable and unstable dynamic systems and related those concepts to economic concepts like the price mechanism, stable and unstable equilibria, and to business cycles. Here’s how a put it in On Keynesian Economics and the Economics of Keynes:

Cybernetics as a formal theory, of course, began to develop only during the was and it was only with the appearance of . . . Weiner’s book in 1948 that the first results of serious work on a general theory of dynamic systems – and the term itself – reached a wider public. Even then, research in this field seemed remote from economic problems, and it is thus not surprising that the first decade or more of the Keynesian debate did not go in this direction. But it is surprising that so few monetary economists have caught on to developments in this field in the last ten or twelve years, and that the work of those who have has not triggered a more dramatic chain reaction. This, I believe, is the Keynesian Revolution that did not come off.

In conveying the essential departure of cybernetics from traditional physics, Wiener once noted:

Here there emerges a very interesting distinction between the physics of our grandfathers and that of the present day. In nineteenth-century physics, it seemed to cost nothing to get information.

In context, the reference was to Maxwell’s Demon. In its economic reincarnation as Walras’ auctioneer, the demon has not yet been exorcised. But this certainly must be what Keynes tried to do. If a single distinction is to be drawn between the Economics of Keynes and the economics of our grandfathers, this is it. It is only on this basis that Keynes’ claim to have essayed a more “general theory” can be maintained. If this distinction is not recognized as both valid and important, I believe we must conclude that Keynes’ contribution to pure theory is nil.

Axel’s hopes that cybernetics could provide an analytical tool with which to bring Keynes’s insights into informational scarcity on macroeconomic analysis were never fulfilled. A glance at the index to Axel’s excellent collection of essays written from the late 1960s and the late 1970s Information and Coordination reveals not a single reference either to cybernetics or to Wiener. Instead, to his chagrin and disappointment, macroeconomics took a completely different path following the path blazed by Robert Lucas and his followers of insisting on a nearly continuous state of rational-expectations equilibrium and implicitly denying that there is an intertemporal coordination problem for macroeconomics to analyze, much less to solve.

After getting my BA in economics at UCLA, I stayed put and began my graduate studies there in the next academic year, taking the graduate micro sequence given that year by Jack Hirshleifer, the graduate macro sequence with Axel and the graduate monetary theory sequence with Ben Klein, who started his career as a monetary economist before devoting himself a few years later entirely to IO and antitrust.

Not surprisingly, Axel’s macro course drew heavily on his book, which meant it drew heavily on the history of macroeconomics including, of course, Keynes himself, but also his Cambridge predecessors and collaborators, his friendly, and not so friendly, adversaries, and the Keynesians that followed him. His main point was that if you take Keynes seriously, you can’t argue, as the standard 1960s neoclassical synthesis did, that the main lesson taught by Keynes was that if the real wage in an economy is somehow stuck above the market-clearing wage, an increase in aggregate demand is necessary to allow the labor market to clear at the prevailing market wage by raising the price level to reduce the real wage down to the market-clearing level.

This interpretation of Keynes, Axel argued, trivialized Keynes by implying that he didn’t say anything that had not been said previously by his predecessors who had also blamed high unemployment on wages being kept above market-clearing levels by minimum-wage legislation or the anticompetitive conduct of trade-union monopolies.

Axel sought to reinterpret Keynes as an early precursor of search theories of unemployment subsequently developed by Armen Alchian and Edward Phelps who would soon be followed by others including Robert Lucas. Because negative shocks to aggregate demand are rarely anticipated, the immediate wage and price adjustments to a new post-shock equilibrium price vector that would maintain full employment would occur only under the imaginary tâtonnement system naively taken as the paradigm for price adjustment under competitive market conditions, Keynes believed that a deliberate countercyclical policy response was needed to avoid a potentially long-lasting or permanent decline in output and employment. The issue is not price flexibility per se, but finding the equilibrium price vector consistent with intertemporal coordination. Price flexibility that doesn’t arrive quickly (immediately?) at the equilibrium price vector achieves nothing. Trading at disequilibrium prices leads inevitably to a contraction of output and income. In an inspired turn of phrase, Axel called this cumulative process of aggregate demand shrinkage Say’s Principle, which years later led me to write my paper “Say’s Law and the Classical Theory of Depressions” included as Chapter 9 of my recent book Studies in the History of Monetary Theory.

Attention to the implications of the lack of an actual coordinating mechanism simply assumed (either in the form of Walrasian tâtonnement or the implicit Marshallian ceteris paribus assumption) by neoclassical economic theory was, in Axel’s view, the great contribution of Keynes. Axel deplored the neoclassical synthesis, because its rote acceptance of the neoclassical equilibrium paradigm trivialized Keynes’s contribution, treating unemployment as a phenomenon attributable to sticky or rigid wages without inquiring whether alternative informational assumptions could explain unemployment even with flexible wages.

The new literature on search theories of unemployment advanced by Alchian, Phelps, et al. and the success of his book gave Axel hope that a deepened version of neoclassical economic theory that paid attention to its underlying informational assumptions could lead to a meaningful reconciliation of the economics of Keynes with neoclassical theory and replace the superficial neoclassical synthesis of the 1960s. That quest for an alternative version of neoclassical economic theory was for a while subsumed under the trite heading of finding microfoundations for macroeconomics, by which was meant finding a way to explain Keynesian (involuntary) unemployment caused by deficient aggregate demand without invoking special ad hoc assumptions like rigid or sticky wages and prices. The objective was to analyze the optimizing behavior of individual agents given limitations in or imperfections of the information available to them and to identify and provide remedies for the disequilibrium conditions that characterize coordination failures.

For a short time, perhaps from the early 1970s until the early 1980s, a number of seemingly promising attempts to develop a disequilibrium theory of macroeconomics appeared, most notably by Robert Barro and Herschel Grossman in the US, and by and J. P. Benassy, J. M. Grandmont, and Edmond Malinvaud in France. Axel and Clower were largely critical of these efforts, regarding them as defective and even misguided in many respects.

But at about the same time, another, very different, approach to microfoundations was emerging, inspired by the work of Robert Lucas and Thomas Sargent and their followers, who were introducing the concept of rational expectations into macroeconomics. Axel and Clower had focused their dissatisfaction with neoclassical economics on the rise of the Walrasian paradigm which used the obviously fantastical invention of a tâtonnement process to account for the attainment of an equilibrium price vector perfectly coordinating all economic activity. They argued for an interpretation of Keynes’s contribution as an attempt to steer economics away from an untenable theoretical and analytical paradigm rather than, as the neoclassical synthesis had done, to make peace with it through the adoption of ad hoc assumptions about price and wage rigidity, thereby draining Keynes’s contribution of novelty and significance.

And then Lucas came along to dispense with the auctioneer, eliminate tâtonnement, while achieving the same result by way of a methodological stratagem in three parts: a) insisting that all agents be treated as equilibrium optimizers, and b) who therefore form identical rational expectations of all future prices using the same common knowledge, so that c) they all correctly anticipate the equilibrium price vector that earlier economists had assumed could be found only through the intervention of an imaginary auctioneer conducting a fantastical tâtonnement process.

This methodological imperatives laid down by Lucas were enforced with a rigorous discipline more befitting a religious order than an academic research community. The discipline of equilibrium reasoning, it was decreed by methodological fiat, imposed a question-begging research strategy on researchers in which correct knowledge of future prices became part of the endowment of all optimizing agents.

While microfoundations for Axel, Clower, Alchian, Phelps and their collaborators and followers had meant relaxing the informational assumptions of the standard neoclassical model, for Lucas and his followers microfoundations came to mean that each and every individual agent must be assumed to have all the knowledge that exists in the model. Otherwise the rational-expectations assumption required by the model could not be justified.

The early Lucasian models did assume a certain kind of informational imperfection or ambiguity about whether observed price changes were relative changes or absolute changes, which would be resolved only after a one-period time lag. However, the observed serial correlation in aggregate time series could not be rationalized by an informational ambiguity resolved after just one period. This deficiency in the original Lucasian model led to the development of real-business-cycle models that attribute business cycles to real-productivity shocks that dispense with Lucasian informational ambiguity in accounting for observed aggregate time-series fluctuations. So-called New Keynesian economists chimed in with ad hoc assumptions about wage and price stickiness to create a new neoclassical synthesis to replace the old synthesis but with little claim to any actual analytical insight.

The success of the Lucasian paradigm was disheartening to Axel, and his research agenda gradually shifted from macroeconomic theory to applied policy, especially inflation control in developing countries. Although my own interest in macroeconomics was largely inspired by Axel, my approach to macroeconomics and monetary theory eventually diverged from Axel’s, when, in my last couple of years of graduate work at UCLA, I became close to Earl Thompson whose courses I had not taken as an undergraduate or a graduate student. I had read some of Earl’s monetary theory papers when preparing for my preliminary exams; I found them interesting but quirky and difficult to understand. After I had already started writing my dissertation, under Harold Demsetz on an IO topic, I decided — I think at the urging of my friend and eventual co-author, Ron Batchelder — to sit in on Earl’s graduate macro sequence, which he would sometimes offer as an alternative to Axel’s more popular graduate macro sequence. It was a relatively small group — probably not more than 25 or so attended – that met one evening a week for three hours. Each session – and sometimes more than one session — was devoted to discussing one of Earl’s published or unpublished macroeconomic or monetary theory papers. Hearing Earl explain his papers and respond to questions and criticisms brought them alive to me in a way that just reading them had never done, and I gradually realized that his arguments, which I had previously dismissed or misunderstood, were actually profoundly insightful and theoretically compelling.

For me at least, Earl provided a more systematic way of thinking about macroeconomics and a more systematic critique of standard macro than I could piece together from Axel’s writings and lectures. But one of the lessons that I had learned from Axel was the seminal importance of two Hayek essays: “The Use of Knowledge in Society,” and, especially “Economics and Knowledge.” The former essay is the easier to understand, and I got the gist of it on my first reading; the latter essay is more subtle and harder to follow, and it took years and a number of readings before I could really follow it. I’m not sure when I began to really understand it, but it might have been when I heard Earl expound on the importance of Hicks’s temporary-equilibrium method first introduced in Value and Capital.

In working out the temporary equilibrium method, Hicks relied on the work of Myrdal, Lindahl and Hayek, and Earl’s explanation of the temporary-equilibrium method based on the assumption that markets for current delivery clear, but those market-clearing prices are different from the prices that agents had expected when formulating their optimal intertemporal plans, causing agents to revise their plans and their expectations of future prices. That seemed to be the proper way to think about the intertemporal-coordination failures that Axel was so concerned about, but somehow he never made the connection between Hayek’s work, which he greatly admired, and the Hicksian temporary-equilibrium method which I never heard him refer to, even though he also greatly admired Hicks.

It always seemed to me that a collaboration between Earl and Axel could have been really productive and might even have led to an alternative to the Lucasian reign over macroeconomics. But for some reason, no such collaboration ever took place, and macroeconomics was impoverished as a result. They are both gone, but we still benefit from having Duncan Foley still with us, still active, and still making important contributions to our understanding, And we should be grateful.

On the Labor Supply Function

The bread and butter of economics is demand and supply. The basic idea of a demand function (or a demand curve) is to describe a relationship between the price at which a given product, commodity or service can be bought and the quantity that will bought by some individual. The standard assumption is that the quantity demanded increases as the price falls, so that the demand curve is downward-sloping, but not much more can be said about the shape of a demand curve unless special assumptions are made about the individual’s preferences.

Demand curves aren’t natural phenomena with concrete existence; they are hypothetical or notional constructs pertaining to individual preferences. To pass from individual demands to a market demand for a product, commodity or service requires another conceptual process summing the quantities demanded by each individual at any given price. The conceptual process is never actually performed, so the downward-sloping market demand curve is just presumed, not observed as a fact of nature.

The summation process required to pass from individual demands to a market demand implies that the quantity demanded at any price is the quantity demanded when each individual pays exactly the same price that every other demander pays. At a price of $10/widget, the widget demand curve tells us how many widgets would be purchased if every purchaser in the market can buy as much as desired at $10/widget. If some customers can buy at $10/widget while others have to pay $20/widget or some can’t buy any widgets at any price, then the quantity of widgets actually bought will not equal the quantity on the hypothetical widget demand curve corresponding to $10/widget.

Similar reasoning underlies the supply function or supply curve for any product, commodity or service. The market supply curve is built up from the preferences and costs of individuals and firms and represents the amount of a product, commodity or service that would be willing to offer for sale at different prices. The market supply curve is the result of a conceptual summation process that adds up the amounts that would be hypothetically be offered for sale by every agent at different prices.

The point of this pedantry is to emphasize the that the demand and supply curves we use are drawn on the assumption that a single uniform market price prevails in every market and that all demanders and suppliers can trade without limit at those prices and their trading plans are fully executed. This is the equilibrium paradigm underlying the supply-demand analysis of econ 101.

Economists quite unself-consciously deploy supply-demand concepts to analyze labor markets in a variety of settings. Sometimes, if the labor market under analysis is limited to a particular trade or a particular skill or a particular geographic area, the supply-demand framework is reasonable and appropriate. But when applied to the aggregate labor market of the whole economy, the supply-demand framework is inappropriate, because the ceteris-paribus proviso (all prices other than the price of the product, commodity or service in question are held constant) attached to every supply-demand model is obviously violated.

Thoughtlessly applying a simple supply-demand model to analyze the labor market of an entire economy leads to the conclusion that widespread unemployment, when some workers are unemployed, but would have accepted employment offers at wages that comparably skilled workers are actually receiving, implies that wages are above the market-clearing wage level consistent with full employment.

The attached diagram for simplest version of this analysis. The market wage (W1) is higher than the equilibrium wage (We) at which all workers willing to accept that wage could be employed. The difference between the number of workers seeking employment at the market wage (LS) and the number of workers that employers seek to hire (LD) measures the amount of unemployment. According to this analysis, unemployment would be eliminated if the market wage fell from W1 to We.

Applying supply-demand analysis to aggregate unemployment fails on two levels. First, workers clearly are unable to execute their plans to offer their labor services at the wage at which other workers are employed, so individual workers are off their supply curves. Second, it is impossible to assume, supply-demand analysis requires, that all other prices and incomes remain constant so that the demand and supply curves do not move as wages and employment change. When multiple variables are mutually interdependent and simultaneously determined, the analysis of just two variables (wages and employment) cannot be isolated from the rest of the system. Focusing on the wage as the variable that needs to change to restore full employment is an example of the tunnel vision.

Keynes rejected the idea that economy-wide unemployment could be eliminated by cutting wages. Although Keynes’s argument against wage cuts as a cure for unemployment was flawed, he did have at least an intuitive grasp of the basic weakness in the argument for wage cuts: that high aggregate unemployment is not usefully analyzed as a symptom of excessive wages. To explain why wage cuts aren’t the cure for high unemployment, Keynes introduced a distinction between voluntary and involuntary unemployment.

Forty years later, Robert Lucas began his effort — not the first such effort, but by far the most successful — to discredit the concept of involuntary unemployment. Here’s an early example:

Keynes [hypothesized] that measured unemployment can be decomposed into two distinct components: ‘voluntary’ (or frictional) and ‘involuntary’, with full employment then identified as the level prevailing when involuntary employment equals zero. It seems appropriate, then, to begin by reviewing Keynes’ reasons for introducing this distinction in the first place. . . .

Accepting the necessity of a distinction between explanations for normal and cyclical unemployment does not, however, compel one to identify the first as voluntary and the second as involuntary, as Keynes goes on to do. This terminology suggests that the key to the distinction lies in some difference in the way two different types of unemployment are perceived by workers. Now in the first place, the distinction we are after concerns sources of unemployment, not differentiated types. . . .[O]ne may classify motives for holding money without imagining that anyone can subdivide his own cash holdings into “transactions balances,” “precautionary balances”, and so forth. The recognition that one needs to distinguish among sources of unemployment does not in any way imply that one needs to distinguish among types.

Nor is there any evident reason why one would want to draw this distinction. Certainly the more one thinks about the decision problem facing individual workers and firms the less sense this distinction makes. The worker who loses a good job in prosperous time does not volunteer to be in this situation: he has suffered a capital loss. Similarly, the firm which loses an experienced employee in depressed times suffers an undesirable capital loss. Nevertheless, the unemployed worker at any time can always find some job at once, and a firm can always fill a vacancy instantaneously. That neither typically does so by choice is not difficult to understand given the quality of the jobs and the employees which are easiest to find. Thus there is an involuntary element in all unemployment, in the sense that no one chooses bad luck over good; there is also a voluntary element in all unemployment, in the sense that however miserable one’s current work options, one can always choose to accept them.

Lucas, Studies in Business Cycle Theory, pp. 241-43

Consider this revision of Lucas’s argument:

The expressway driver who is slowed down in a traffic jam does not volunteer to be in this situation; he has suffered a waste of his time. Nevertheless, the driver can get off the expressway at the next exit to find an alternate route. Thus, there is an involuntary element in every traffic jam, in the sense that no one chooses to waste time; there is also a voluntary element in all traffic jams, in the sense that however stuck one is in traffic, one can always take the next exit on the expressway.

What is lost on Lucas is that, for an individual worker, taking a wage cut to avoid being laid off by the employer accomplishes nothing, because the willingness of a single worker to accept a wage cut would not induce the employer to increase output and employment. Unless all workers agreed to take wage cuts, a wage cut to one employee would have not cause the employer to reconsider its plan to reduce in the face of declining demand for its product. Only the collective offer of all workers to accept a wage cut would induce an output response by the employer and a decision not to lay off part of its work force.

But even a collective offer by all workers to accept a wage cut would be unlikely to avoid an output reduction and layoffs. Consider a simple case in which the demand for the employer’s output declines by a third. Suppose the employer’s marginal cost of output is half the selling price (implying a demand elasticity of -2). Assume that demand is linear. With no change in its marginal cost, the firm would reduce output by a third, presumably laying off up to a third of its employees. Could workers avoid the layoffs by accepting lower wages to enable the firm to reduce its price? Or asked in another way, how much would marginal cost have to fall for the firm not to reduce output after the demand reduction?

Working out the algebra, one finds that for the firm to keep producing as much after a one-third reduction in demand, the firm’s marginal cost would have to fall by two-thirds, a decline that could only be achieved by a radical reduction in labor costs. This is surely an oversimplified view of the alternatives available to workers and employers, but the point is that workers facing a layoff after the demand for the product they produce have almost no ability to remain employed even by collectively accepting a wage cut.

That conclusion applies a fortiori when decisions whether to accept a wage cut are left to individual workers, because the willingness of workers individually to accept a wage cut is irrelevant to their chances of retaining their jobs. Being laid off because of decline in the demand for the product a worker is producing is a much different situation from being laid off, because a worker’s employer is shifting to a new technology for which the workers lack the requisite skills, and can remain employed only by accepting re-assignment to a lower-paying job.

Let’s follow Lucas a bit further:

Keynes, in chapter 2, deals with the situation facing an individual unemployed worker by evasion and wordplay only. Sentences like “more labor would, as a rule, be forthcoming at the existing money wage if it were demanded” are used again and again as though, from the point of view of a jobless worker, it is unambiguous what is meant by “the existing money wage.” Unless we define an individual’s wage rate as the price someone else is willing to pay him for his labor (in which case Keynes’s assertion is defined to be false to be false), what is it?

Lucas, Id.

I must admit that, reading this passage again perhaps 30 or more years after my first reading, I’m astonished that I could have once read it without astonishment. Lucas gives the game away by accusing Keynes of engaging in evasion and wordplay before embarking himself on sustained evasion and wordplay. The meaning of the “existing money wage” is hardly ambiguous, it is the money wage the unemployed worker was receiving before losing his job and the wage that his fellow workers, who remain employed, continue to receive.

Is Lucas suggesting that the reason that the worker lost his job while his fellow workers who did not lose theirs is that the value of his marginal product fell but the value of his co-workers’ marginal product did not? Perhaps, but that would only add to my astonishment. At the current wage, employers had to reduce the number of workers until their marginal product was high enough for the employer to continue employing them. That was not necessarily, and certainly not primarily, because some workers were more capable than those that were laid off.

The fact is, I think, that Keynes wanted to get labor markets out of the way in chapter 2 so that he could get on to the demand theory which really interested him.

More wordplay. Is it fact or opinion? Well, he says that thinks it’s a fact. In other words, it’s really an opinion.

This is surely understandable, but what is the excuse for letting his carelessly drawn distinction between voluntary and involuntary unemployment dominate aggregative thinking on labor markets for the forty years following?

Mr. Keynes, really, what is your excuse for being such an awful human being?

[I]nvoluntary unemployment is not a fact or a phenomenon which it is the task of theorists to explain. It is, on the contrary, a theoretical construct which Keynes introduced in the hope it would be helpful in discovering a correct explanation for a genuine phenomenon: large-scale fluctuations in measured, total unemployment. Is it the task of modern theoretical economics to ‘explain’ the theoretical constructs of our predecessor, whether or not they have proved fruitful? I hope not, for a surer route to sterility could scarcely be imagined.

Lucas, Id.

Let’s rewrite this paragraph with a few strategic word substitutions:

Heliocentrism is not a fact or phenomenon which it is the task of theorists to explain. It is, on the contrary, a theoretical construct which Copernicus introduced in the hope it would be helpful in discovering a correct explanation for a genuine phenomenon the observed movement of the planets in the heavens. Is it the task of modern theoretical physics to “explain” the theoretical constructs of our predecessors, whether or not they have proved fruitful? I hope not, for a surer route to sterility could scarcely be imagined.

Copernicus died in 1542 shortly before his work on heliocentrism was published. Galileo’s works on heliocentrism were not published until 1610 almost 70 years after Copernicus published his work. So, under Lucas’s forty-year time limit, Galileo had no business trying to explain Copernican heliocentrism which had still not yet proven fruitful. Moreover, even after Galileo had published his works, geocentric models were providing predictions of planetary motion as good as, if not better than, the heliocentric models, so decisive empirical evidence in favor of heliocentrism was still lacking. Not until Newton published his great work 70 years after Galileo, and 140 years after Copernicus, was heliocentrism finally accepted as fact.

In summary, it does not appear possible, even in principle, to classify individual unemployed people as either voluntarily or involuntarily unemployed depending on the characteristics of the decision problem they face. One cannot, even conceptually, arrive at a usable definition of full employment

Lucas, Id.

Belying his claim to be introducing scientific rigor into macroeocnomics, Lucas restorts to an extended scholastic inquiry into whether an unemployed worker can really ever be unemployed involuntarily. Based on his scholastic inquiry into the nature of volunatriness, Lucas declares that Keynes was mistaken because would not accept the discipline of optimization and equilibrium. But Lucas’s insistence on the discipline of optimization and equilibrium is misplaced unless he can provide an actual mechanism whereby the notional optimization of a single agent can be reconciled with notional optimization of other individuals.

It was his inability to provide any explanation of the mechanism whereby the notional optimization of individual agents can be reconciled with the notional optimizations of other individual agents that led Lucas to resort to rational expectations to circumvent the need for such a mechanism. He successfully persuaded the economics profession that evading the need to explain such a reconciliation mechanism, the profession would not be shirking their explanatory duty, but would merely be fulfilling their methodological obligation to uphold the neoclassical axioms of rationality and optimization neatly subsumed under the heading of microfoundations.

Rational expectations and microfoundations provided the pretext that could justify or at least excuse the absence of any explanation of how an equilibrium is reached and maintained by assuming that the rational expectations assumption is an adequate substitute for the Walrasian auctioneer, so that each and every agent, using the common knowledge (and only the common knowledge) available to all agents, would reliably anticipate the equilibrium price vector prevailing throughout their infinite lives, thereby guaranteeing continuous equilibrium and consistency of all optimal plans. That feat having been securely accomplished, it was but a small and convenient step to collapse the multitude of individual agents into a single representative agent, so that the virtue of submitting to the discipline of optimization could find its just and fitting reward.

Robert Lucas and the Pretense of Science

F. A. Hayek entitled his 1974 Nobel Lecture whose principal theme was to attack the simple notion that the long-observed correlation between aggregate demand and employment was a reliable basis for conducting macroeconomic policy, “The Pretence of Knowledge.” Reiterating an argument that he had made over 40 years earlier about the transitory stimulus provided to profits and production by monetary expansion, Hayek was informally anticipating the argument that Robert Lucas famously repackaged two years later in his famous critique of econometric policy evaluation. Hayek’s argument hinged on a distinction between “phenomena of unorganized complexity” and phenomena of organized complexity.” Statistical relationships or correlations between phenomena of disorganized complexity may be relied upon to persist, but observed statistical correlations displayed by phenomena of organized complexity cannot be relied upon without detailed knowledge of the individual elements that constitute the system. It was the facile assumption that observed statistical correlations in systems of organized complexity can be uncritically relied upon in making policy decisions that Hayek dismissed as merely the pretense of knowledge.

Adopting many of Hayek’s complaints about macroeconomic theory, Lucas founded his New Classical approach to macroeconomics on a methodological principle that all macroeconomic models be grounded in the axioms of neoclassical economic theory as articulated in the canonical Arrow-Debreu-McKenzie models of general equilibrium models. Without such grounding in neoclassical axioms and explicit formal derivations of theorems from those axioms, Lucas maintained that macroeconomics could not be considered truly scientific. Forty years of Keynesian macroeconomics were, in Lucas’s view, largely pre-scientific or pseudo-scientific, because they lacked satisfactory microfoundations.

Lucas’s methodological program for macroeconomics was thus based on two basic principles: reductionism and formalism. First, all macroeconomic models not only had to be consistent with rational individual decisions, they had to be reduced to those choices. Second, all the propositions of macroeconomic models had to be explicitly derived from the formal definitions and axioms of neoclassical theory. Lucas demanded nothing less than the explicit assumption individual rationality in every macroeconomic model and that all decisions by agents in a macroeconomic model be individually rational.

In practice, implementing Lucasian methodological principles required that in any macroeconomic model all agents’ decisions be derived within an explicit optimization problem. However, as Hayek had himself shown in his early studies of business cycles and intertemporal equilibrium, individual optimization in the standard Walrasian framework, within which Lucas wished to embed macroeconomic theory, is possible only if all agents are optimizing simultaneously, all individual decisions being conditional on the decisions of other agents. Individual optimization can only be solved simultaneously for all agents, not individually in isolation.

The difficulty of solving a macroeconomic equilibrium model for the simultaneous optimal decisions of all the agents in the model led Lucas and his associates and followers to a strategic simplification: reducing the entire model to a representative agent. The optimal choices of a single agent would then embody the consumption and production decisions of all agents in the model.

The staggering simplification involved in reducing a purported macroeconomic model to a representative agent is obvious on its face, but the sleight of hand being performed deserves explicit attention. The existence of an equilibrium solution to the neoclassical system of equations was assumed, based on faulty reasoning by Walras, Fisher and Pareto who simply counted equations and unknowns. A rigorous proof of existence was only provided by Abraham Wald in 1936 and subsequently in more general form by Arrow, Debreu and McKenzie, working independently, in the 1950s. But proving the existence of a solution to the system of equations does not establish that an actual neoclassical economy would, in fact, converge on such an equilibrium.

Neoclassical theory was and remains silent about the process whereby equilibrium is, or could be, reached. The Marshallian branch of neoclassical theory, focusing on equilibrium in individual markets rather than the systemic equilibrium, is often thought to provide an account of how equilibrium is arrived at, but the Marshallian partial-equilibrium analysis presumes that all markets and prices except the price in the single market under analysis, are in a state of equilibrium. So the Marshallian approach provides no more explanation of a process by which a set of equilibrium prices for an entire economy is, or could be, reached than the Walrasian approach.

Lucasian methodology has thus led to substituting a single-agent model for an actual macroeconomic model. It does so on the premise that an economic system operates as if it were in a state of general equilibrium. The factual basis for this premise apparently that it is possible, using versions of a suitable model with calibrated coefficients, to account for observed aggregate time series of consumption, investment, national income, and employment. But the time series derived from these models are derived by attributing all observed variations in national income to unexplained shocks in productivity, so that the explanation provided is in fact an ex-post rationalization of the observed variations not an explanation of those variations.

Nor did Lucasian methodology have a theoretical basis in received neoclassical theory. In a famous 1960 paper “Towards a Theory of Price Adjustment,” Kenneth Arrow identified the explanatory gap in neoclassical theory: the absence of a theory of price change in competitive markets in which every agent is a price taker. The existence of an equilibrium does not entail that the equilibrium will be, or is even likely to be, found. The notion that price flexibility is somehow a guarantee that market adjustments reliably lead to an equilibrium outcome is a presumption or a preconception, not the result of rigorous analysis.

However, Lucas used the concept of rational expectations, which originally meant no more than that agents try to use all available information to anticipate future prices, to make the concept of equilibrium, notwithstanding its inherent implausibility, a methodological necessity. A rational-expectations equilibrium was methodologically necessary and ruthlessly enforced on researchers, because it was presumed to be entailed by the neoclassical assumption of rationality. Lucasian methodology transformed rational expectations into the proposition that all agents form identical, and correct, expectations of future prices based on the same available information (common knowledge). Because all agents reach the same, correct expectations of future prices, general equilibrium is continuously achieved, except at intermittent moments when new information arrives and is used by agents to revise their expectations.

In his Nobel Lecture, Hayek decried a pretense of knowledge about correlations between macroeconomic time series that lack a foundation in the deeper structural relationships between those related time series. Without an understanding of the deeper structural relationships between those time series, observed correlations cannot be relied on when formulating economic policies. Lucas’s own famous critique echoed the message of Hayek’s lecture.

The search for microfoundations was always a natural and commendable endeavor. Scientists naturally try to reduce higher-level theories to deeper and more fundamental principles. But the endeavor ought to be conducted as a theoretical and empirical endeavor. If successful, the reduction of the higher-level theory to a deeper theory will provide insight and disclose new empirical implications to both the higher-level and the deeper theories. But reduction by methodological fiat accomplishes neither and discourages the research that might actually achieve a theoretical reduction of a higher-level theory to a deeper one. Similarly, formalism can provide important insights into the structure of theories and disclose gaps or mistakes the reasoning underlying the theories. But most important theories, even in pure mathematics, start out as informal theories that only gradually become axiomatized as logical gaps and ambiguities in the theories are discovered and filled or refined.

The resort to the reductionist and formalist methodological imperatives with which Lucas and his followers have justified their pretentions to scientific prestige and authority, and have used that authority to compel compliance with those imperatives, only belie their pretensions.

An Austrian Tragedy

It was hardly predictable that the New York Review of Books would take notice of Marginal Revolutionaries by Janek Wasserman, marking the susquicentenial of the publication of Carl Menger’s Grundsätze (Principles of Economics) which, along with Jevons’s Principles of Political Economy and Walras’s Elements of Pure Economics ushered in the marginal revolution upon which all of modern economics, for better or for worse, is based. The differences among the three founding fathers of modern economic theory were not insubstantial, and the Jevonian version was largely superseded by the work of his younger contemporary Alfred Marshall, so that modern neoclassical economics is built on the work of only one of the original founders, Leon Walras, Jevons’s work having left little impression on the future course of economics.

Menger’s work, however, though largely, but not totally, eclipsed by that of Marshall and Walras, did leave a more enduring imprint and a more complicated legacy than Jevons’s — not only for economics, but for political theory and philosophy, more generally. Judging from Edward Chancellor’s largely favorable review of Wasserman’s volume, one might even hope that a start might be made in reassessing that legacy, a process that could provide an opportunity for mutually beneficial interaction between long-estranged schools of thought — one dominant and one marginal — that are struggling to overcome various conceptual, analytical and philosophical problems for which no obvious solutions seem available.

In view of the failure of modern economists to anticipate the Great Recession of 2008, the worst financial shock since the 1930s, it was perhaps inevitable that the Austrian School, a once favored branch of economics that had made a specialty of booms and busts, would enjoy a revival of public interest.

The theme of Austrians as outsiders runs through Janek Wasserman’s The Marginal Revolutionaries: How Austrian Economists Fought the War of Ideas, a general history of the Austrian School from its beginnings to the present day. The title refers both to the later marginalization of the Austrian economists and to the original insight of its founding father, Carl Menger, who introduced the notion of marginal utility—namely, that economic value does not derive from the cost of inputs such as raw material or labor, as David Ricardo and later Karl Marx suggested, but from the utility an individual derives from consuming an additional amount of any good or service. Water, for instance, may be indispensable to humans, but when it is abundant, the marginal value of an extra glass of the stuff is close to zero. Diamonds are less useful than water, but a great deal rarer, and hence command a high market price. If diamonds were as common as dewdrops, however, they would be worthless.

Menger was not the first economist to ponder . . . the “paradox of value” (why useless things are worth more than essentials)—the Italian Ferdinando Galiani had gotten there more than a century earlier. His central idea of marginal utility was simultaneously developed in England by W. S. Jevons and on the Continent by Léon Walras. Menger’s originality lay in applying his theory to the entire production process, showing how the value of capital goods like factory equipment derived from the marginal value of the goods they produced. As a result, Austrian economics developed a keen interest in the allocation of capital. Furthermore, Menger and his disciples emphasized that value was inherently subjective, since it depends on what consumers are willing to pay for something; this imbued the Austrian school from the outset with a fiercely individualistic and anti-statist aspect.

Menger’s unique contribution is indeed worthy of special emphasis. He was more explicit than Jevons or Walras, and certainly more than Marshall, in explaining that the value of factors of production is derived entirely from the value of the incremental output that could be attributed (or imputed) to their services. This insight implies that cost is not an independent determinant of value, as Marshall, despite accepting the principle of marginal utility, continued to insist – famously referring to demand and supply as the two blades of the analytical scissors that determine value. The cost of production therefore turns out to be nothing but the value the output foregone when factors are used to produce one output instead of the next most highly valued alternative. Cost therefore does not determine, but is determined by, equilibrium price, which means that, in practice, costs are always subjective and conjectural. (I have made this point in an earlier post in a different context.) I will have more to say below about the importance of Menger’s specific contribution and its lasting imprint on the Austrian school.

Menger’s Principles of Economics, published in 1871, established the study of economics in Vienna—before then, no economic journals were published in Austria, and courses in economics were taught in law schools. . . .

The Austrian School was also bound together through family and social ties: [his two leading disciples, [Eugen von] Böhm-Bawerk and Friedrich von Wieser [were brothers-in-law]. [Wieser was] a close friend of the statistician Franz von Juraschek, Friedrich Hayek’s maternal grandfather. Young Austrian economists bonded on Alpine excursions and met in Böhm-Bawerk’s famous seminars (also attended by the Bolshevik Nikolai Bukharin and the German Marxist Rudolf Hilferding). Ludwig von Mises continued this tradition, holding private seminars in Vienna in the 1920s and later in New York. As Wasserman notes, the Austrian School was “a social network first and last.”

After World War I, the Habsburg Empire was dismantled by the victorious Allies. The Austrian bureaucracy shrank, and university placements became scarce. Menger, the last surviving member of the first generation of Austrian economists, died in 1921. The economic school he founded, with its emphasis on individualism and free markets, might have disappeared under the socialism of “Red Vienna.” Instead, a new generation of brilliant young economists emerged: Schumpeter, Hayek, and Mises—all of whom published best-selling works in English and remain familiar names today—along with a number of less well known but influential economists, including Oskar Morgenstern, Fritz Machlup, Alexander Gerschenkron, and Gottfried Haberler.

Two factual corrections are in order. Menger outlived Böhm-Bawerk, but not his other chief disciple von Wieser, who died in 1926, not long after supervising Hayek’s doctoral dissertation, later published in 1927, and, in 1933, translated into English and published as Monetary Theory and the Trade Cycle. Moreover, a 16-year gap separated Mises and Schumpeter, who were exact contemporaries, from Hayek (born in 1899) who was a few years older than Gerschenkron, Haberler, Machlup and Morgenstern.

All the surviving members or associates of the Austrian school wound up either in the US or Britain after World War II, and Hayek, who had taken a position in London in 1931, moved to the US in 1950, taking a position in the Committee on Social Thought at the University of Chicago after having been refused a position in the economics department. Through the intervention of wealthy sponsors, Mises obtained an academic appointment of sorts at the NYU economics department, where he succeeded in training two noteworthy disciples who wrote dissertations under his tutelage, Murray Rothbard and Israel Kirzner. (Kirzner wrote his dissertation under Mises at NYU, but Rothbard did his graduate work at Colulmbia.) Schumpeter, Haberler and Gerschenkron eventually took positions at Harvard, while Machlup (with some stops along the way) and Morgenstern made their way to Princeton. However, Hayek’s interests shifted from pure economic theory to deep philosophical questions. While Machlup and Haberler continued to work on economic theory, the Austrian influence on their work after World War II was barely recognizable. Morgenstern and Schumpeter made major contributions to economics, but did not hide their alienation from the doctrines of the Austrian School.

So there was little reason to expect that the Austrian School would survive its dispersal when the Nazis marched unopposed into Vienna in 1938. That it did survive is in no small measure due to its ideological usefulness to anti-socialist supporters who provided financial support to Hayek, enabling his appointment to the Committee on Social Thought at the University of Chicago, and Mises’s appointment at NYU, and other forms of research support to Hayek, Mises and other like-minded scholars, as well as funding the Mont Pelerin Society, an early venture in globalist networking, started by Hayek in 1947. Such support does not discredit the research to which it gave rise. That the survival of the Austrian School would probably not have been possible without the support of wealthy benefactors who anticipated that the Austrians would advance their political and economic interests does not invalidate the research thereby enabled. (In the interest of transparency, I acknowledge that I received support from such sources for two books that I wrote.)

Because Austrian School survivors other than Mises and Hayek either adapted themselves to mainstream thinking without renouncing their earlier beliefs (Haberler and Machlup) or took an entirely different direction (Morgenstern), and because the economic mainstream shifted in two directions that were most uncongenial to the Austrians: Walrasian general-equilibrium theory and Keynesian macroeconomics, the Austrian remnant, initially centered on Mises at NYU, adopted a sharply adversarial attitude toward mainstream economic doctrines.

Despite its minute numbers, the lonely remnant became a house divided against itself, Mises’s two outstanding NYU disciples, Murray Rothbard and Israel Kirzner, holding radically different conceptions of how to carry on the Austrian tradition. An extroverted radical activist, Rothbard was not content just to lead a school of economic thought, he aspired to become the leader of a fantastical anarchistic revolutionary movement to replace all established governments under a reign of private-enterprise anarcho-capitalism. Rothbard’s political radicalism, which, despite his Jewish ancestry, even included dabbling in Holocaust denialism, so alienated his mentor, that Mises terminated all contact with Rothbard for many years before his death. Kirzner, self-effacing, personally conservative, with no political or personal agenda other than the advancement of his own and his students’ scholarship, published hundreds of articles and several books filling 10 thick volumes of his collected works published by the Liberty Fund, while establishing a robust Austrian program at NYU, training many excellent scholars who found positions in respected academic and research institutions. Similar Austrian programs, established under the guidance of Kirzner’s students, were started at other institutions, most notably at George Mason University.

One of the founders of the Cato Institute, which for nearly half a century has been the leading avowedly libertarian think tank in the US, Rothbard was eventually ousted by Cato, and proceeded to set up a rival think tank, the Ludwig von Mises Institute, at Auburn University, which has turned into a focal point for extreme libertarians and white nationalists to congregate, get acquainted, and strategize together.

Isolation and marginalization tend to cause a subspecies either to degenerate toward extinction, to somehow blend in with the members of the larger species, thereby losing its distinctive characteristics, or to accentuate its unique traits, enabling it to find some niche within which to survive as a distinct sub-species. Insofar as they have engaged in economic analysis rather than in various forms of political agitation and propaganda, the Rothbardian Austrians have focused on anarcho-capitalist theory and the uniquely perverse evils of fractional-reserve banking.

Rejecting the political extremism of the Rothbardians, Kirznerian Austrians differentiate themselves by analyzing what they call market processes and emphasizing the limitations on the knowledge and information possessed by actual decision-makers. They attribute this misplaced focus on equilibrium to the extravagantly unrealistic and patently false assumptions of mainstream models on the knowledge possessed by economic agents, which effectively make equilibrium the inevitable — and trivial — conclusion entailed by those extreme assumptions. In their view, the focus of mainstream models on equilibrium states with unrealistic assumptions results from a preoccupation with mathematical formalism in which mathematical tractability rather than sound economics dictates the choice of modeling assumptions.

Skepticism of the extreme assumptions about the informational endowments of agents covers a range of now routine assumptions in mainstream models, e.g., the ability of agents to form precise mathematical estimates of the probability distributions of future states of the world, implying that agents never confront decisions about which they are genuinely uncertain. Austrians also object to the routine assumption that all the information needed to determine the solution of a model is the common knowledge of the agents in the model, so that an existing equilibrium cannot be disrupted unless new information randomly and unpredictably arrives. Each agent in the model having been endowed with the capacity of a semi-omniscient central planner, solving the model for its equilibrium state becomes a trivial exercise in which the optimal choices of a single agent are taken as representative of the choices made by all of the model’s other, semi-omnicient, agents.

Although shreds of subjectivism — i.e., agents make choices based own preference orderings — are shared by all neoclassical economists, Austrian criticisms of mainstream neoclassical models are aimed at what Austrians consider to be their insufficient subjectivism. It is this fierce commitment to a robust conception of subjectivism, in which an equilibrium state of shared expectations by economic agents must be explained, not just assumed, that Chancellor properly identifies as a distinguishing feature of the Austrian School.

Menger’s original idea of marginal utility was posited on the subjective preferences of consumers. This subjectivist position was retained by subsequent generations of the school. It inspired a tradition of radical individualism, which in time made the Austrians the favorite economists of American libertarians. Subjectivism was at the heart of the Austrians’ polemical rejection of Marxism. Not only did they dismiss Marx’s labor theory of value, they argued that socialism couldn’t possibly work since it would lack the means to allocate resources efficiently.

The problem with central planning, according to Hayek, is that so much of the knowledge that people act upon is specific knowledge that individuals acquire in the course of their daily activities and life experience, knowledge that is often difficult to articulate – mere intuition and guesswork, yet more reliable than not when acted upon by people whose livelihoods depend on being able to do the right thing at the right time – much less communicate to a central planner.

Chancellor attributes Austrian mistrust of statistical aggregates or indices, like GDP and price levels, to Austrian subjectivism, which regards such magnitudes as abstractions irrelevant to the decisions of private decision-makers, except perhaps in forming expectations about the actions of government policy makers. (Of course, this exception potentially provides full subjectivist license and legitimacy for macroeconomic theorizing despite Austrian misgivings.) Observed statistical correlations between aggregate variables identified by macroeconomists are dismissed as irrelevant unless grounded in, and implied by, the purposeful choices of economic agents.

But such scruples about the use of macroeconomic aggregates and inferring causal relationships from observed correlations are hardly unique to the Austrian school. One of the most important contributions of the 20th century to the methodology of economics was an article by T. C. Koopmans, “Measurement Without Theory,” which argued that measured correlations between macroeconomic variables provide a reliable basis for business-cycle research and policy advice only if the correlations can be explained in terms of deeper theoretical or structural relationships. The Nobel Prize Committee, in awarding the 1975 Prize to Koopmans, specifically mentioned this paper in describing Koopmans’s contributions. Austrians may be more fastidious than their mainstream counterparts in rejecting macroeconomic relationships not based on microeconomic principles, but they aren’t the only ones mistrustful of mere correlations.

Chancellor cites mistrust about the use of statistical aggregates and price indices as a factor in Hayek’s disastrous policy advice warning against anti-deflationary or reflationary measures during the Great Depression.

Their distrust of price indexes brought Austrian economists into conflict with mainstream economic opinion during the 1920s. At the time, there was a general consensus among leading economists, ranging from Irving Fisher at Yale to Keynes at Cambridge, that monetary policy should aim at delivering a stable price level, and in particular seek to prevent any decline in prices (deflation). Hayek, who earlier in the decade had spent time at New York University studying monetary policy and in 1927 became the first director of the Austrian Institute for Business Cycle Research, argued that the policy of price stabilization was misguided. It was only natural, Hayek wrote, that improvements in productivity should lead to lower prices and that any resistance to this movement (sometimes described as “good deflation”) would have damaging economic consequences.

The argument that deflation stemming from economic expansion and increasing productivity is normal and desirable isn’t what led Hayek and the Austrians astray in the Great Depression; it was their failure to realize the deflation that triggered the Great Depression was a monetary phenomenon caused by a malfunctioning international gold standard. Moreover, Hayek’s own business-cycle theory explicitly stated that a neutral (stable) monetary policy ought to aim at keeping the flow of total spending and income constant in nominal terms while his policy advice of welcoming deflation meant a rapidly falling rate of total spending. Hayek’s policy advice was an inexcusable error of judgment, which, to his credit, he did acknowledge after the fact, though many, perhaps most, Austrians have refused to follow him even that far.

Considered from the vantage point of almost a century, the collapse of the Austrian School seems to have been inevitable. Hayek’s long-shot bid to establish his business-cycle theory as the dominant explanation of the Great Depression was doomed from the start by the inadequacies of the very specific version of his basic model and his disregard of the obvious implication of that model: prevent total spending from contracting. The promising young students and colleagues who had briefly gathered round him upon his arrival in England, mostly attached themselves to other mentors, leaving Hayek with only one or two immediate disciples to carry on his research program. The collapse of his research program, which he himself abandoned after completing his final work in economic theory, marked a research hiatus of almost a quarter century, with the notable exception of publications by his student, Ludwig Lachmann who, having decamped in far-away South Africa, labored in relative obscurity for most of his career.

The early clash between Keynes and Hayek, so important in the eyes of Chancellor and others, is actually overrated. Chancellor, quoting Lachmann and Nicholas Wapshott, describes it as a clash of two irreconcilable views of the economic world, and the clash that defined modern economics. In later years, Lachmann actually sought to effect a kind of reconciliation between their views. It was not a conflict of visions that undid Hayek in 1931-32, it was his misapplication of a narrowly constructed model to a problem for which it was irrelevant.

Although the marginalization of the Austrian School, after its misguided policy advice in the Great Depression and its dispersal during and after World War II, is hardly surprising, the unwillingness of mainstream economists to sort out what was useful and relevant in the teachings of the Austrian School from what is not was unfortunate not only for the Austrians. Modern economics was itself impoverished by its disregard for the complexity and interconnectedness of economic phenomena. It’s precisely the Austrian attentiveness to the complexity of economic activity — the necessity for complementary goods and factors of production to be deployed over time to satisfy individual wants – that is missing from standard economic models.

That Austrian attentiveness, pioneered by Menger himself, to the complementarity of inputs applied over the course of time undoubtedly informed Hayek’s seminal contribution to economic thought: his articulation of the idea of intertemporal equilibrium that comprehends the interdependence of the plans of independent agents and the need for them to all fit together over the course of time for equilibrium to obtain. Hayek’s articulation represented a conceptual advance over earlier versions of equilibrium analysis stemming from Walras and Pareto, and even from Irving Fisher who did pay explicit attention to intertemporal equilibrium. But in Fisher’s articulation, intertemporal consistency was described in terms of aggregate production and income, leaving unexplained the mechanisms whereby the individual plans to produce and consume particular goods over time are reconciled. Hayek’s granular exposition enabled him to attend to, and articulate, necessary but previously unspecified relationships between the current prices and expected future prices.

Moreover, neither mainstream nor Austrian economists have ever explained how prices are adjust in non-equilibrium settings. The focus of mainstream analysis has always been the determination of equilibrium prices, with the implicit understanding that “market forces” move the price toward its equilibrium value. The explanatory gap has been filled by the mainstream New Classical School which simply posits the existence of an equilibrium price vector, and, to replace an empirically untenable tâtonnement process for determining prices, posits an equally untenable rational-expectations postulate to assert that market economies typically perform as if they are in, or near the neighborhood of, equilibrium, so that apparent fluctuations in real output are viewed as optimal adjustments to unexplained random productivity shocks.

Alternatively, in New Keynesian mainstream versions, constraints on price changes prevent immediate adjustments to rationally expected equilibrium prices, leading instead to persistent reductions in output and employment following demand or supply shocks. (I note parenthetically that the assumption of rational expectations is not, as often suggested, an assumption distinct from market-clearing, because the rational expectation of all agents of a market-clearing price vector necessarily implies that the markets clear unless one posits a constraint, e.g., a binding price floor or ceiling, that prevents all mutually beneficial trades from being executed.)

Similarly, the Austrian school offers no explanation of how unconstrained price adjustments by market participants is a sufficient basis for a systemic tendency toward equilibrium. Without such an explanation, their belief that market economies have strong self-correcting properties is unfounded, because, as Hayek demonstrated in his 1937 paper, “Economics and Knowledge,” price adjustments in current markets don’t, by themselves, ensure a systemic tendency toward equilibrium values that coordinate the plans of independent economic agents unless agents’ expectations of future prices are sufficiently coincident. To take only one passage of many discussing the difficulty of explaining or accounting for a process that leads individuals toward a state of equilibrium, I offer the following as an example:

All that this condition amounts to, then, is that there must be some discernible regularity in the world which makes it possible to predict events correctly. But, while this is clearly not sufficient to prove that people will learn to foresee events correctly, the same is true to a hardly less degree even about constancy of data in an absolute sense. For any one individual, constancy of the data does in no way mean constancy of all the facts independent of himself, since, of course, only the tastes and not the actions of the other people can in this sense be assumed to be constant. As all those other people will change their decisions as they gain experience about the external facts and about other people’s actions, there is no reason why these processes of successive changes should ever come to an end. These difficulties are well known, and I mention them here only to remind you how little we actually know about the conditions under which an equilibrium will ever be reached.

In this theoretical muddle, Keynesian economics and the neoclassical synthesis were abandoned, because the key proposition of Keynesian economics was supposedly the tendency of a modern economy toward an equilibrium with involuntary unemployment while the neoclassical synthesis rejected that proposition, so that the supposed synthesis was no more than an agreement to disagree. That divided house could not stand. The inability of Keynesian economists such as Hicks, Modigliani, Samuelson and Patinkin to find a satisfactory (at least in terms of a preferred Walrasian general-equilibrium model) rationalization for Keynes’s conclusion that an economy would likely become stuck in an equilibrium with involuntary unemployment led to the breakdown of the neoclassical synthesis and the displacement of Keynesianism as the dominant macroeconomic paradigm.

But perhaps the way out of the muddle is to abandon the idea that a systemic tendency toward equilibrium is a property of an economic system, and, instead, to recognize that equilibrium is, as Hayek suggested, a contingent, not a necessary, property of a complex economy. Ludwig Lachmann, cited by Chancellor for his remark that the early theoretical clash between Hayek and Keynes was a conflict of visions, eventually realized that in an important sense both Hayek and Keynes shared a similar subjectivist conception of the crucial role of individual expectations of the future in explaining the stability or instability of market economies. And despite the efforts of New Classical economists to establish rational expectations as an axiomatic equilibrating property of market economies, that notion rests on nothing more than arbitrary methodological fiat.

Chancellor concludes by suggesting that Wasserman’s characterization of the Austrians as marginalized is not entirely accurate inasmuch as “the Austrians’ view of the economy as a complex, evolving system continues to inspire new research.” Indeed, if economics is ever to find a way out of its current state of confusion, following Lachmann in his quest for a synthesis of sorts between Keynes and Hayek might just be a good place to start from.

Filling the Arrow Explanatory Gap

The following (with some minor revisions) is a Twitter thread I posted yesterday. Unfortunately, because it was my first attempt at threading the thread wound up being split into three sub-threads and rather than try to reconnect them all, I will just post the complete thread here as a blogpost.

1. Here’s an outline of an unwritten paper developing some ideas from my paper “Hayek Hicks Radner and Four Equilibrium Concepts” (see here for an earlier ungated version) and some from previous blog posts, in particular Phillips Curve Musings

2. Standard supply-demand analysis is a form of partial-equilibrium (PE) analysis, which means that it is contingent on a ceteris paribus (CP) assumption, an assumption largely incompatible with realistic dynamic macroeconomic analysis.

3. Macroeconomic analysis is necessarily situated a in general-equilibrium (GE) context that precludes any CP assumption, because there are no variables that are held constant in GE analysis.

4. In the General Theory, Keynes criticized the argument based on supply-demand analysis that cutting nominal wages would cure unemployment. Instead, despite his Marshallian training (upbringing) in PE analysis, Keynes argued that PE (AKA supply-demand) analysis is unsuited for understanding the problem of aggregate (involuntary) unemployment.

5. The comparative-statics method described by Samuelson in the Foundations of Econ Analysis formalized PE analysis under the maintained assumption that a unique GE obtains and deriving a “meaningful theorem” from the 1st- and 2nd-order conditions for a local optimum.

6. PE analysis, as formalized by Samuelson, is conditioned on the assumption that GE obtains. It is focused on the effect of changing a single parameter in a single market small enough for the effects on other markets of the parameter change to be made negligible.

7. Thus, PE analysis, the essence of micro-economics is predicated on the macrofoundation that all, but one, markets are in equilibrium.

8. Samuelson’s meaningful theorems were a misnomer reflecting mid-20th-century operationalism. They can now be understood as empirically refutable propositions implied by theorems augmented with a CP assumption that interactions b/w markets are small enough to be neglected.

9. If a PE model is appropriately specified, and if the market under consideration is small or only minimally related to other markets, then differences between predictions and observations will be statistically insignificant.

10. So PE analysis uses comparative-statics to compare two alternative general equilibria that differ only in respect of a small parameter change.

11. The difference allows an inference about the causal effect of a small change in that parameter, but says nothing about how an economy would actually adjust to a parameter change.

12. PE analysis is conditioned on the CP assumption that the analyzed market and the parameter change are small enough to allow any interaction between the parameter change and markets other than the market under consideration to be disregarded.

13. However, the process whereby one equilibrium transitions to another is left undetermined; the difference between the two equilibria with and without the parameter change is computed but no account of an adjustment process leading from one equilibrium to the other is provided.

14. Hence, the term “comparative statics.”

15. The only suggestion of an adjustment process is an assumption that the price-adjustment in any market is an increasing function of excess demand in the market.

16. In his seminal account of GE, Walras posited the device of an auctioneer who announces prices–one for each market–computes desired purchases and sales at those prices, and sets, under an adjustment algorithm, new prices at which desired purchases and sales are recomputed.

17. The process continues until a set of equilibrium prices is found at which excess demands in all markets are zero. In Walras’s heuristic account of what he called the tatonnement process, trading is allowed only after the equilibrium price vector is found by the auctioneer.

18. Walras and his successors assumed, but did not prove, that, if an equilibrium price vector exists, the tatonnement process would eventually, through trial and error, converge on that price vector.

19. However, contributions by Sonnenschein, Mantel and Debreu (hereinafter referred to as the SMD Theorem) show that no price-adjustment rule necessarily converges on a unique equilibrium price vector even if one exists.

20. The possibility that there are multiple equilibria with distinct equilibrium price vectors may or may not be worth explicit attention, but for purposes of this discussion, I confine myself to the case in which a unique equilibrium exists.

21. The SMD Theorem underscores the lack of any explanatory account of a mechanism whereby changes in market prices, responding to excess demands or supplies, guide a decentralized system of competitive markets toward an equilibrium state, even if a unique equilibrium exists.

22. The Walrasian tatonnement process has been replaced by the Arrow-Debreu-McKenzie (ADM) model in an economy of infinite duration consisting of an infinite number of generations of agents with given resources and technology.

23. The equilibrium of the model involves all agents populating the economy over all time periods meeting before trading starts, and, based on initial endowments and common knowledge, making plans given an announced equilibrium price vector for all time in all markets.

24. Uncertainty is accommodated by the mechanism of contingent trading in alternative states of the world. Given assumptions about technology and preferences, the ADM equilibrium determines the set prices for all contingent states of the world in all time periods.

25. Given equilibrium prices, all agents enter into optimal transactions in advance, conditioned on those prices. Time unfolds according to the equilibrium set of plans and associated transactions agreed upon at the outset and executed without fail over the course of time.

26. At the ADM equilibrium price vector all agents can execute their chosen optimal transactions at those prices in all markets (certain or contingent) in all time periods. In other words, at that price vector, excess demands in all markets with positive prices are zero.

27. The ADM model makes no pretense of identifying a process that discovers the equilibrium price vector. All that can be said about that price vector is that if it exists and trading occurs at equilibrium prices, then excess demands will be zero if prices are positive.

28. Arrow himself drew attention to the gap in the ADM model, writing in 1959:

29. In addition to the explanatory gap identified by Arrow, another shortcoming of the ADM model was discussed by Radner: the dependence of the ADM model on a complete set of forward and state-contingent markets at time zero when equilibrium prices are determined.

30. Not only is the complete-market assumption a backdoor reintroduction of perfect foresight, it excludes many features of the greatest interest in modern market economies: the existence of money, stock markets, and money-crating commercial banks.

31. Radner showed that for full equilibrium to obtain, not only must excess demands in current markets be zero, but whenever current markets and current prices for future delivery are missing, agents must correctly expect those future prices.

32. But there is no plausible account of an equilibrating mechanism whereby price expectations become consistent with GE. Although PE analysis suggests that price adjustments do clear markets, no analogous analysis explains how future price expectations are equilibrated.

33. But if both price expectations and actual prices must be equilibrated for GE to obtain, the notion that “market-clearing” price adjustments are sufficient to achieve macroeconomic “equilibrium” is untenable.

34. Nevertheless, the idea that individual price expectations are rational (correct), so that, except for random shocks, continuous equilibrium is maintained, became the bedrock for New Classical macroeconomics and its New Keynesian and real-business cycle offshoots.

35. Macroeconomic theory has become a theory of dynamic intertemporal optimization subject to stochastic disturbances and market frictions that prevent or delay optimal adjustment to the disturbances, potentially allowing scope for countercyclical monetary or fiscal policies.

36. Given incomplete markets, the assumption of nearly continuous intertemporal equilibrium implies that agents correctly foresee future prices except when random shocks occur, whereupon agents revise expectations in line with the new information communicated by the shocks.
37. Modern macroeconomics replaced the Walrasian auctioneer with agents able to forecast the time path of all prices indefinitely into the future, except for intermittent unforeseen shocks that require agents to optimally their revise previous forecasts.
38. When new information or random events, requiring revision of previous expectations, occur, the new information becomes common knowledge and is processed and interpreted in the same way by all agents. Agents with rational expectations always share the same expectations.
39. So in modern macro, Arrow’s explanatory gap is filled by assuming that all agents, given their common knowledge, correctly anticipate current and future equilibrium prices subject to unpredictable forecast errors that change their expectations of future prices to change.
40. Equilibrium prices aren’t determined by an economic process or idealized market interactions of Walrasian tatonnement. Equilibrium prices are anticipated by agents, except after random changes in common knowledge. Semi-omniscient agents replace the Walrasian auctioneer.
41. Modern macro assumes that agents’ common knowledge enables them to form expectations that, until superseded by new knowledge, will be validated. The assumption is wrong, and the mistake is deeper than just the unrealism of perfect competition singled out by Arrow.
42. Assuming perfect competition, like assuming zero friction in physics, may be a reasonable simplification for some problems in economics, because the simplification renders an otherwise intractable problem tractable.
43. But to assume that agents’ common knowledge enables them to forecast future prices correctly transforms a model of decentralized decision-making into a model of central planning with each agent possessing the knowledge only possessed by an omniscient central planner.
44. The rational-expectations assumption fills Arrow’s explanatory gap, but in a deeply unsatisfactory way. A better approach to filling the gap would be to acknowledge that agents have private knowledge (and theories) that they rely on in forming their expectations.
45. Agents’ expectations are – at least potentially, if not inevitably – inconsistent. Because expectations differ, it’s the expectations of market specialists, who are better-informed than non-specialists, that determine the prices at which most transactions occur.
46. Because price expectations differ even among specialists, prices, even in competitive markets, need not be uniform, so that observed price differences reflect expectational differences among specialists.
47. When market specialists have similar expectations about future prices, current prices will converge on the common expectation, with arbitrage tending to force transactions prices to converge toward notwithstanding the existence of expectational differences.
48. However, the knowledge advantage of market specialists over non-specialists is largely limited to their knowledge of the workings of, at most, a small number of related markets.
49. The perspective of specialists whose expectations govern the actual transactions prices in most markets is almost always a PE perspective from which potentially relevant developments in other markets and in macroeconomic conditions are largely excluded.
50. The interrelationships between markets that, according to the SMD theorem, preclude any price-adjustment algorithm, from converging on the equilibrium price vector may also preclude market specialists from converging, even roughly, on the equilibrium price vector.
51. A strict equilibrium approach to business cycles, either real-business cycle or New Keynesian, requires outlandish assumptions about agents’ common knowledge and their capacity to anticipate the future prices upon which optimal production and consumption plans are based.
52. It is hard to imagine how, without those outlandish assumptions, the theoretical superstructure of real-business cycle theory, New Keynesian theory, or any other version of New Classical economics founded on the rational-expectations postulate can be salvaged.
53. The dominance of an untenable macroeconomic paradigm has tragically led modern macroeconomics into a theoretical dead end.

The Equilibrium of Each Is the Result of the Equilibrium of All, or, the Rational Expectation of Each is the Result of the Rational Expectation of All

A few weeks ago, I wrote a post whose title (“The Idleness of Each Is the Result of the Idleness of All”) was taken from the marvelous remark of the great, but sadly forgotten, Cambridge economist Frederick Lavington’s book The Trade Cycle. Lavington was born two years after Ralph Hawtrey and two years before John Maynard Keynes. The brilliant insight expressed so eloquently by Lavington is that the inability of some those unemployed to find employment may not be the result of a voluntary decision made by an individual worker any more than the inability of a driver stuck in a traffic jam to drive at the speed he wants to drive at is a voluntary decision. The circumstances in which an unemployed worker finds himself may be such that he or she has no practical alternative other than to remain unemployed.

In this post I merely want to express the same idea from two different vantage points. In any economic model, the equilibrium decision of any agent in the model is conditional on a corresponding set of equilibrium decisions taken by all other agents in the model. Unless all other agents are making optimal choices, the equilibrium (optimal) choice of any individual agent is neither feasible nor optimal, because the optimality of any decision is conditional on the decisions taken by all other agents. Only if the optimal decisions of each are mutually consistent are they individually optimal. (Individual optimality does not necessarily result in overall optimality owing to interdependencies (aka externalities) among the individuals). My ability to buy as much as I want to, and to sell as much as I want to, at market-clearing prices is contingent on everyone else being able to buy and sell as much as I and they want to at those same prices.

Now let’s take the argument a step further. Suppose the equilibrium decisions involve making purchases and sales in both the present and the future, according to current expectations of what future conditions will be like. If you are running a business, how much inputs you buy today to turn into output to be sold tomorrow will depend on the price at which you expect to be able to sell the output produced tomorrow. If decisions to purchase and sell today depend not only on current prices but also on expected future prices, then your optimal decisions now about how much to buy and sell now will depend on your expectations of buying and selling prices in the future. For an equilibrium in which everyone can execute his or her plans (as originally formulated) to exist, each person must have rational expectations about what future prices will be, and such rational expectations are possible only when those expectations are mutually consistent. In game-theoretical terms, a Nash equilibrium obtains only when all the individual expectations on which decisions are conditional converge.

Here is how Tom Schelling explained the idea of rational – i.e., convergent – expectations in a classic discussion 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.

If expectations of everyone do not converge — individuals having conflicting expectations about what will happen — then the expectations of none of the individuals can be rational. Even if one individual correctly anticipates the outcome, from the point of view of the disequilibrium system as a whole, the correct expectations are not rational because those expectations are inconsistent with equilibrium of the entire system. A change in the expectations of any other individual would imply that future prices would change from what had been expected. Only equilibrium expectations can be considered rational, and equilibrium expectations are a set of individual expectations that are convergent.

Phillips Curve Musings

There’s a lot of talk about the Phillips Curve these days; people wonder why, with the unemployment rate reaching historically low levels, nominal and real wages have increased minimally with inflation remaining securely between 1.5 and 2%. The Phillips Curve, for those untutored in basic macroeconomics, depicts a relationship between inflation and unemployment. The original empirical Philips Curve relationship showed that high rates of unemployment were associated with low or negative rates of wage inflation while low rates of unemployment were associated with high rates of wage inflation. This empirical relationship suggested a causal theory that the rate of wage increase tends to rise when unemployment is low and tends to fall when unemployment is high, a causal theory that seems to follow from a simple supply-demand model in which wages rise when there is an excess demand for labor (unemployment is low) and wages fall when there is an excess supply of labor (unemployment is high).

Viewed in this light, low unemployment, signifying a tight labor market, signals that inflation is likely to rise, providing a rationale for monetary policy to be tightened to prevent inflation from rising at it normally does when unemployment is low. Seeming to accept that rationale, the Fed has gradually raised interest rates for the past two years or so. But the increase in interest rates has now slowed the expansion of employment and decline in unemployment to historic lows. Nor has the improving employment situation resulted in any increase in price inflation and at most a minimal increase in the rate of increase in wages.

In a couple of previous posts about sticky wages (here and here), I’ve questioned whether the simple supply-demand model of the labor market motivating the standard interpretation of the Phillips Curve is a useful way to think about wage adjustment and inflation-employment dynamics. I’ve offered a few reasons why the supply-demand model, though applicable in some situations, is not useful for understanding how wages adjust.

The particular reason that I want to focus on here is Keynes’s argument in chapter 19 of the General Theory (though I express it in terms different from his) that supply-demand analysis can’t explain how wages and employment are determined. The upshot of his argument I believe is that supply demand-analysis only works in a partial-equilibrium setting in which feedback effects from the price changes in the market under consideration don’t affect equilibrium prices in other markets, so that the position of the supply and demand curves in the market of interest can be assumed stable even as price and quantity in that market adjust from one equilibrium to another (the comparative-statics method).

Because the labor market, affecting almost every other market, is not a small part of the economy, partial-equilibrium analysis is unsuitable for understanding that market, the normal stability assumption being untenable if we attempt to trace the adjustment from one labor-market equilibrium to another after an exogenous disturbance. In the supply-demand paradigm, unemployment is a measure of the disequilibrium in the labor market, a disequilibrium that could – at least in principle — be eliminated by a wage reduction sufficient to equate the quantity of labor services supplied with the amount demanded. Viewed from this supply-demand perspective, the failure of the wage to fall to a supposed equilibrium level is attributable to some sort of endogenous stickiness or some external impediment (minimum wage legislation or union intransigence) in wage adjustment that prevents the normal equilibrating free-market adjustment mechanism. But the habitual resort to supply-demand analysis by economists, reinforced and rewarded by years of training and professionalization, is actually misleading when applied in an inappropriate context.

So Keynes was right to challenge this view of a potentially equilibrating market mechanism that is somehow stymied from behaving in the manner described in the textbook version of supply-demand analysis. Instead, Keynes argued that the level of employment is determined by the level of spending and income at an exogenously given wage level, an approach that seems to be deeply at odds with idea that price adjustments are an essential part of the process whereby a complex economic system arrives at, or at least tends to move toward, an equilibrium.

One of the main motivations for a search for microfoundations in the decades after the General Theory was published was to be able to articulate a convincing microeconomic rationale for persistent unemployment that was not eliminated by the usual tendency of market prices to adjust to eliminate excess supplies of any commodity or service. But Keynes was right to question whether there is any automatic market mechanism that adjusts nominal or real wages in a manner even remotely analogous to the adjustment of prices in organized commodity or stock exchanges – the sort of markets that serve as exemplars of automatic price adjustments in response to excess demands or supplies.

Keynes was also correct to argue that, even if there was a mechanism causing automatic wage adjustments in response to unemployment, the labor market, accounting for roughly 60 percent of total income, is so large that any change in wages necessarily affects all other markets, causing system-wide repercussions that might well offset any employment-increasing tendency of the prior wage adjustment.

But what I want to suggest in this post is that Keynes’s criticism of the supply-demand paradigm is relevant to any general-equilibrium system in the following sense: if a general-equilibrium system is considered from an initial non-equilibrium position, does the system have any tendency to move toward equilibrium? And to make the analysis relatively tractable, assume that the system is such that a unique equilibrium exists. Before proceeding, I also want to note that I am not arguing that traditional supply-demand analysis is necessarily flawed; I am just emphasizing that traditional supply-demand analysis is predicated on a macroeconomic foundation: that all markets but the one under consideration are in, or are in the neighborhood of, equilibrium. It is only because the system as a whole is in the neighborhood of equilibrium, that the microeconomic forces on which traditional supply-demand analysis relies appear to be so powerful and so stabilizing.

However, if our focus is a general-equilibrium system, microeconomic supply-demand analysis of a single market in isolation provides no basis on which to argue that the system as a whole has a self-correcting tendency toward equilibrium. To make such an argument is to commit a fallacy of composition. The tendency of any single market toward equilibrium is premised on an assumption that all markets but the one under analysis are already at, or in the neighborhood of, equilibrium. But when the system as a whole is in a disequilibrium state, the method of partial equilibrium analysis is misplaced; partial-equilibrium analysis provides no ground – no micro-foundation — for an argument that the adjustment of market prices in response to excess demands and excess supplies will ever – much less rapidly — guide the entire system back to an equilibrium state.

The lack of automatic market forces that return a system not in the neighborhood — for purposes of this discussion “neighborhood” is left undefined – of equilibrium back to equilibrium is implied by the Sonnenschein-Mantel-Debreu Theorem, which shows that, even if a unique general equilibrium exists, there may be no rule or algorithm for increasing (decreasing) prices in markets with excess demands (supplies) by which the general-equilibrium price vector would be discovered in a finite number of steps.

The theorem holds even under a Walrasian tatonnement mechanism in which no trading at disequilibrium prices is allowed. The reason is that the interactions between individual markets may be so complicated that a price-adjustment rule will not eliminate all excess demands, because even if a price adjustment reduces excess demand in one market, that price adjustment may cause offsetting disturbances in one or more other markets. So, unless the equilibrium price vector is somehow hit upon by accident, no rule or algorithm for price adjustment based on the excess demand in each market will necessarily lead to discovery of the equilibrium price vector.

The Sonnenschein Mantel Debreu Theorem reinforces the insight of Kenneth Arrow in an important 1959 paper “Toward a Theory of Price Adjustment,” which posed the question: how does the theory of perfect competition account for the determination of the equilibrium price at which all agents can buy or sell as much as they want to at the equilibrium (“market-clearing”) price? As Arrow observed, “there exists a logical gap in the usual formulations of the theory of perfectly competitive economy, namely, that there is no place for a rational decision with respect to prices as there is with respect to quantities.”

Prices in perfect competition are taken as parameters by all agents in the model, and optimization by agents consists in choosing optimal quantities. The equilibrium solution allows the mutually consistent optimization by all agents at the equilibrium price vector. This is true for the general-equilibrium system as a whole, and for partial equilibrium in every market. Not only is there no positive theory of price adjustment within the competitive general-equilibrium model, as pointed out by Arrow, but the Sonnenschein-Mantel-Debreu Theorem shows that there’s no guarantee that even the notional tatonnement method of price adjustment can ensure that a unique equilibrium price vector will be discovered.

While acknowledging his inability to fill the gap, Arrow suggested that, because perfect competition and price taking are properties of general equilibrium, there are inevitably pockets of market power, in non-equilibrium states, so that some transactors in non-equilibrium states, are price searchers rather than price takers who therefore choose both an optimal quantity and an optimal price. I have no problem with Arrow’s insight as far as it goes, but it still doesn’t really solve his problem, because he couldn’t explain, even intuitively, how a disequilibrium system with some agents possessing market power (either as sellers or buyers) transitions into an equilibrium system in which all agents are price-takers who can execute their planned optimal purchases and sales at the parametric prices.

One of the few helpful, but, as far as I can tell, totally overlooked, contributions of the rational-expectations revolution was to solve (in a very narrow sense) the problem that Arrow identified and puzzled over, although Hayek, Lindahl and Myrdal, in their original independent formulations of the concept of intertemporal equilibrium, had already provided the key to the solution. Hayek, Lindahl, and Myrdal showed that an intertemporal equilibrium is possible only insofar as agents form expectations of future prices that are so similar to each other that, if future prices turn out as expected, the agents would be able to execute their planned sales and purchases as expected.

But if agents have different expectations about the future price(s) of some commodity(ies), and if their plans for future purchases and sales are conditioned on those expectations, then when the expectations of at least some agents are inevitably disappointed, those agents will necessarily have to abandon (or revise) the plans that their previously formulated plans.

What led to Arrow’s confusion about how equilibrium prices are arrived at was the habit of thinking that market prices are determined by way of a Walrasian tatonnement process (supposedly mimicking the haggling over price by traders). So the notion that a mythical market auctioneer, who first calls out prices at random (prix cries au hasard), and then, based on the tallied market excess demands and supplies, adjusts those prices until all markets “clear,” is untenable, because continual trading at disequilibrium prices keeps changing the solution of the general-equilibrium system. An actual system with trading at non-equilibrium prices may therefore be moving away from, rather converging on, an equilibrium state.

Here is where the rational-expectations hypothesis comes in. The rational-expectations assumption posits that revisions of previously formulated plans are never necessary, because all agents actually do correctly anticipate the equilibrium price vector in advance. That is indeed a remarkable assumption to make; it is an assumption that all agents in the model have the capacity to anticipate, insofar as their future plans to buy and sell require them to anticipate, the equilibrium prices that will prevail for the products and services that they plan to purchase or sell. Of course, in a general-equilibrium system, all prices being determined simultaneously, the equilibrium prices for some future prices cannot generally be forecast in isolation from the equilibrium prices for all other products. So, in effect, the rational-expectations hypothesis supposes that each agent in the model is an omniscient central planner able to solve an entire general-equilibrium system for all future prices!

But let us not be overly nitpicky about details. So forget about false trading, and forget about the Sonnenschein-Mantel-Debreu theorem. Instead, just assume that, at time t, agents form rational expectations of the future equilibrium price vector in period (t+1). If agents at time t form rational expectations of the equilibrium price vector in period (t+1), then they may well assume that the equilibrium price vector in period t is equal to the expected price vector in period (t+1).

Now, the expected price vector in period (t+1) may or may not be an equilibrium price vector in period t. If it is an equilibrium price vector in period t as well as in period (t+1), then all is right with the world, and everyone will succeed in buying and selling as much of each commodity as he or she desires. If not, prices may or may not adjust in response to that disequilibrium, and expectations may or may not change accordingly.

Thus, instead of positing a mythical auctioneer in a contrived tatonnement process as the mechanism whereby prices are determined for currently executed transactions, the rational-expectations hypothesis posits expected future prices as the basis for the prices at which current transactions are executed, providing a straightforward solution to Arrow’s problem. The prices at which agents are willing to purchase or sell correspond to their expectations of prices in the future. If they find trading partners with similar expectations of future prices, they will reach agreement and execute transactions at those prices. If they don’t find traders with similar expectations, they will either be unable to transact, or will revise their price expectations, or they will assume that current market conditions are abnormal and then decide whether to transact at prices different from those they had expected.

When current prices are more favorable than expected, agents will want to buy or sell more than they would have if current prices were equal to their expectations for the future. If current prices are less favorable than they expect future prices to be, they will not transact at all or will seek to buy or sell less than they would have bought or sold if current prices had equaled expected future prices. The dichotomy between observed current prices, dictated by current demands and supplies, and expected future prices is unrealistic; all current transactions are made with an eye to expected future prices and to their opportunities to postpone current transactions until the future, or to advance future transactions into the present.

If current prices for similar commodities are not uniform in all current transactions, a circumstance that Arrow attributes to the existence of varying degrees of market power across imperfectly competitive suppliers, price dispersion may actually be caused, not by market power, but by dispersion in the expectations of future prices held by agents. Sellers expecting future prices to rise will be less willing to sell at relatively low prices now than are suppliers with pessimistic expectations about future prices. Equilibrium occurs when all transactors share the same expectations of future prices and expected future prices correspond to equilibrium prices in the current period.

Of course, that isn’t the only possible equilibrium situation. There may be situations in which a future event that will change a subset of prices can be anticipated. If the anticipation of the future event affects not only expected future prices, it must also and necessarily affect current prices insofar as current supplies can be carried into the future from the present or current purchases can be postponed until the future or future consumption shifted into the present.

The practical upshot of these somewhat disjointed reflections is, I think,primarily to reinforce skepticism that the traditional Phillips Curve supposition that low and falling unemployment necessarily presages an increase in inflation. Wages are not primarily governed by the current state of the labor market, whatever the labor market might even mean in macroeconomic context.

Expectations rule! And the rational-expectations revolution to the contrary notwithstanding, we have no good theory of how expectations are actually formed and there is certainly no reason to assume that, as a general matter, all agents share the same set of expectations.

The current fairly benign state of the economy reflects the absence of any serious disappointment of price expectations. If an economy is operating not very far from an equilibrium, although expectations are not the same, they likely are not very different. They will only be very different after the unexpected strikes. When that happens, borrowers and traders who had taken positions based on overly optimistic expectations find themselves unable to meet their obligations. It is only then that we will see whether the economy is really as strong and resilient as it now seems.

Expecting the unexpected is hard to do, but you can be sure that, sooner or later, the unexpected is going to happen.

Hayek, Radner and Rational-Expectations Equilibrium

In revising my paper on Hayek and Three Equilibrium Concepts, I have made some substantial changes to the last section which I originally posted last June. So I thought I would post my new updated version of the last section. The new version of the paper has not been submitted yet to a journal; I will give a talk about it at the colloquium on Economic Institutions and Market Processes at the NYU economics department next Monday. Depending on the reaction I get at the Colloquium and from some other people I will send the paper to, I may, or may not, post the new version on SSRN and submit to a journal.

In this section, I want to focus on a particular kind of intertemporal equilibrium: rational-expectations equilibrium. It is noteworthy that in his discussions of intertemporal equilibrium, Roy Radner assigns a  meaning to the term “rational-expectations equilibrium” very different from the one normally associated with that term. Radner describes a rational-expectations equilibrium as the equilibrium that results when some agents can make inferences about the beliefs of other agents when observed prices differ from the prices that the agents had expected. Agents attribute the differences between observed and expected prices to the superior information held by better-informed agents. As they assimilate the information that must have caused observed prices to deviate from their expectations, agents revise their own expectations accordingly, which, in turn, leads to further revisions in plans, expectations and outcomes.

There is a somewhat famous historical episode of inferring otherwise unknown or even secret information from publicly available data about prices. In 1954, one very rational agent, Armen Alchian, was able to identify which chemicals were being used in making the newly developed hydrogen bomb by looking for companies whose stock prices had risen too rapidly to be otherwise explained. Alchian, who spent almost his entire career at UCLA while moonlighting at the nearby Rand Corporation, wrote a paper at Rand listing the chemicals used in making the hydrogen bomb. When news of his unpublished paper reached officials at the Defense Department – the Rand Corporation (from whose files Daniel Ellsberg took the Pentagon Papers) having been started as a think tank with funding by the Department of Defense to do research on behalf of the U.S. military – the paper was confiscated from Alchian’s office at Rand and destroyed. (See Newhard’s paper for an account of the episode and a reconstruction of Alchian’s event study.)

But 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 future prices based on common knowledge. Radner’s result reinforces Hayek’s insight, upon which I remarked above, that although expectations are equilibrating variables there is no economic mechanism that tends to bring expectations toward their equilibrium values. There is no feedback mechanism, corresponding to the normal mechanism for adjusting market prices in response to perceived excess demands or supplies, that operates on price expectations. The heavy lifting of bringing expectations into correspondence with what the future holds must be done by the agents themselves; the magic of the market goes only so far.

Although Radner’s conception of rational expectations differs from the more commonly used meaning of the term, his conception helps us understand the limitations of the conventional “rational expectations” assumption in modern macroeconomics, which is that the price expectations formed by the agents populating 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 an important property of any model. If one assumes that the outcome expected by agents in a model is the equilibrium predicted by the model, then, under those expectations, the solution of the model ought to be the equilibrium of the model. If the solution of the model is somehow different from what agents in the model expect, then there is something really wrong with the model.

What kind of crazy model would have the property that correct expectations turn out not to be self-fulfilling? A model in which correct expectations are not self-fulfilling is a nonsensical model. But there is a huge difference between saying (a) that a model should have the property that correct expectations are self-fulfilling and saying (b) that the agents populating the model understand how the model works and, based know their knowledge of the model, form expectations of the equilibrium predicted by the model.

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 credibly 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 methodological imperative. But the current sacrosanct status of rational expectations in modern macroeconomics has been achieved largely through methodological tyrannizing.

In his 1937 paper, 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 faithful description of empirical reality in 1937 – that there is an observed general tendency for markets to move toward equilibrium, implying that, over time, expectations somehow do tend to become more accurate.

It is worth pointing out that when the idea of rational expectations was introduced by John Muth (1961), 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 particular market. The motivation for Muth to introduce the idea of a rational expectation was the cobweb-cycle model in which producers base current decisions about how much to produce for the following period on the currently observed price. But with a one-period time lag between production decisions and realized output, as is the case in agricultural markets in which the initial application of inputs does not result in output until a subsequent time period, 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 – one that Hayek understood better than perhaps anyone else — is that there is a 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. It is those subtle interactions that allow the kinds of informational inferences that, based on differences between expected and realized prices of the sort contemplated by Alchian and Radner, can sometimes be made. 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.

The key — but far from the only — error of the rational-expectations methodology that rules modern macroeconomics is that rational expectations somehow cause or bring about an intertemporal equilibrium. It is certainly a fact that people try very hard to use all the information available to them to predict what the future has in store, and any new bit of information not previously possessed will be rapidly assessed and assimilated and will inform a possibly revised set of expectations of the future. But there is no reason to think that this ongoing process of information gathering and processing and evaluation leads people to formulate correct expectations of the future or of future prices. Indeed, Radner proved that, even under strong assumptions, there is no necessity that the outcome of a process of information revision based on the observed differences between observed and expected prices leads to an equilibrium.

So it cannot be rational expectations that leads to equilibrium, On the contrary, rational expectations are a property of equilibrium. To speak of a “rational-expectations equilibrium” is to speak about a truism. There can be no rational expectations in the macroeconomic except in an equilibrium state, because correct expectations, as Hayek showed, is a defining characteristic of equilibrium. Outside of equilibrium, expectations cannot be rational. Failure to grasp that point is what led Morgenstern astray in thinking that Holmes-Moriarty story demonstrated the nonsensical nature of equilibrium. It simply demonstrated that Holmes and Moriarity were playing a non-repeated game in which an equilibrium did not exist.

To think about rational expectations as if it somehow results in equilibrium is nothing but a category error, akin to thinking about a triangle being caused by having angles whose angles add up to 180 degrees. The 180-degree sum of the angles of a triangle don’t cause the triangle; it is a property of the triangle.

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 are just a couple of variables about which agents have to form their rational expectations. The radical simplification of the expectational requirements for achieving a supposedly micro-founded equilibrium belies the claim to have achieved anything of the sort. Whether the micro-foundational pretense affected — with apparently sincere methodological fervor — by modern macroeconomics is merely self-delusional or a deliberate hoax perpetrated on a generation of unsuspecting students is an interesting distinction, but a distinction lacking any practical significance.

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 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.

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.


About Me

David Glasner
Washington, DC

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

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

Follow me on Twitter @david_glasner

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