Archive for the 'Franklin Fisher' Category

Price Stickiness and Macroeconomics

Noah Smith has a classically snide rejoinder to Stephen Williamson’s outrage at Noah’s Bloomberg paean to price stickiness and to the classic Ball and Maniw article on the subject, an article that provoked an embarrassingly outraged response from Robert Lucas when published over 20 years ago. I don’t know if Lucas ever got over it, but evidently Williamson hasn’t.

Now to be fair, Lucas’s outrage, though misplaced, was understandable, at least if one understands that Lucas was so offended by the ironic tone in which Ball and Mankiw cast themselves as defenders of traditional macroeconomics – including both Keynesians and Monetarists – against the onslaught of “heretics” like Lucas, Sargent, Kydland and Prescott that he just stopped reading after the first few pages and then, in a fit of righteous indignation, wrote a diatribe attacking Ball and Mankiw as religious fanatics trying to halt the progress of science as if that was the real message of the paper – not, to say the least, a very sophisticated reading of what Ball and Mankiw wrote.

While I am not hostile to the idea of price stickiness — one of the most popular posts I have written being an attempt to provide a rationale for the stylized (though controversial) fact that wages are stickier than other input, and most output, prices — it does seem to me that there is something ad hoc and superficial about the idea of price stickiness and about many explanations, including those offered by Ball and Mankiw, for price stickiness. I think that the negative reactions that price stickiness elicits from a lot of economists — and not only from Lucas and Williamson — reflect a feeling that price stickiness is not well grounded in any economic theory.

Let me offer a slightly different criticism of price stickiness as a feature of macroeconomic models, which is simply that although price stickiness is a sufficient condition for inefficient macroeconomic fluctuations, it is not a necessary condition. It is entirely possible that even with highly flexible prices, there would still be inefficient macroeconomic fluctuations. And the reason why price flexibility, by itself, is no guarantee against macroeconomic contractions is that macroeconomic contractions are caused by disequilibrium prices, and disequilibrium prices can prevail regardless of how flexible prices are.

The usual argument is that if prices are free to adjust in response to market forces, they will adjust to balance supply and demand, and an equilibrium will be restored by the automatic adjustment of prices. That is what students are taught in Econ 1. And it is an important lesson, but it is also a “partial” lesson. It is partial, because it applies to a single market that is out of equilibrium. The implicit assumption in that exercise is that nothing else is changing, which means that all other markets — well, not quite all other markets, but I will ignore that nuance – are in equilibrium. That’s what I mean when I say (as I have done before) that just as macroeconomics needs microfoundations, microeconomics needs macrofoundations.

Now it’s pretty easy to show that in a single market with an upward-sloping supply curve and a downward-sloping demand curve, that a price-adjustment rule that raises price when there’s an excess demand and reduces price when there’s an excess supply will lead to an equilibrium market price. But that simple price-adjustment rule is hard to generalize when many markets — not just one — are in disequilibrium, because reducing disequilibrium in one market may actually exacerbate disequilibrium, or create a disequilibrium that wasn’t there before, in another market. Thus, even if there is an equilibrium price vector out there, which, if it were announced to all economic agents, would sustain a general equilibrium in all markets, there is no guarantee that following the standard price-adjustment rule of raising price in markets with an excess demand and reducing price in markets with an excess supply will ultimately lead to the equilibrium price vector. Even more disturbing, the standard price-adjustment rule may not, even under a tatonnement process in which no trading is allowed at disequilibrium prices, lead to the discovery of the equilibrium price vector. Of course, in the real world trading occurs routinely at disequilibrium prices, so that the “mechanical” forces tending an economy toward equilibrium are even weaker than the standard analysis of price-adjustment would suggest.

This doesn’t mean that an economy out of equilibrium has no stabilizing tendencies; it does mean that those stabilizing tendencies are not very well understood, and we have almost no formal theory with which to describe how such an adjustment process leading from disequilibrium to equilibrium actually works. We just assume that such a process exists. Franklin Fisher made this point 30 years ago in an important, but insufficiently appreciated, volume Disequilibrium Foundations of Equilibrium Economics. But the idea goes back even further: to Hayek’s important work on intertemporal equilibrium, especially his classic paper “Economics and Knowledge,” formalized by Hicks in the temporary-equilibrium model described in Value and Capital.

The key point made by Hayek in this context is that there can be an intertemporal equilibrium if and only if all agents formulate their individual plans on the basis of the same expectations of future prices. If their expectations for future prices are not the same, then any plans based on incorrect price expectations will have to be revised, or abandoned altogether, as price expectations are disappointed over time. For price adjustment to lead an economy back to equilibrium, the price adjustment must converge on an equilibrium price vector and on correct price expectations. But, as Hayek understood in 1937, and as Fisher explained in a dense treatise 30 years ago, we have no economic theory that explains how such a price vector, even if it exists, is arrived at, and even under a tannonement process, much less under decentralized price setting. Pinning the blame on this vague thing called price stickiness doesn’t address the deeper underlying theoretical issue.

Of course for Lucas et al. to scoff at price stickiness on these grounds is a bit rich, because Lucas and his followers seem entirely comfortable with assuming that the equilibrium price vector is rationally expected. Indeed, rational expectation of the equilibrium price vector is held up by Lucas as precisely the microfoundation that transformed the unruly field of macroeconomics into a real science.

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Franklin Fisher on the Stability(?) of General Equilibrium

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

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

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

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

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

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

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

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

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

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

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


About Me

David Glasner
Washington, DC

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

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