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A Tale of Two Syntheses

Published May 8, 2020 Arrow-Debrew-McKenzie model , Axel Leijonfuvud , comparative statics , coordination failure , Don Patinkin , DSGE models , Franklin Fisher , general equilibrium , Hawtrey , Hayek , intertemporal equilibrium , Kenneth Arrow , macroeconomics , microfoundations , neoclassical synthesis , New Classical macroeconomics , New Keynesians , Oskar Morgensterm , Robert Lucas , Roy Radner , Samuelson , stability of general equilibrium , temporary equilibrium , Thomas Schelling , Walrasian equilibrium 13 Comments
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I recently finished reading a slender, but weighty, collection of essays, Microfoundtions Reconsidered: The Relationship of Micro and Macroeconomics in Historical Perspective, edited by Pedro Duarte and Gilberto Lima; it contains in addition to a brief introductory essay by the editors, and contributions by Kevin Hoover, Robert Leonard, Wade Hands, Phil Mirowski, Michel De Vroey, and Pedro Duarte. The volume is both informative and stimulating, helping me to crystalize ideas about which I have been ruminating and writing for a long time, but especially in some of my more recent posts (e.g., here, here, and here) and my recent paper “Hayek, Hicks, Radner and Four Equilibrium Concepts.”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

My Paper “Hayek, Hicks, Radner and Four Equilibrium Concepts” Is Now Available Online.

Published January 30, 2020 Hayek , intertemporal equilibrium , J. R. Hicks , Robert Lucas , Roy Radner , temporary equilibrium , Uncategorized 1 Comment

The paper, forthcoming in The Review of Austrian Economics, can be read online.

Here is the abstract:

Hayek was among the first to realize that for intertemporal equilibrium to obtain all agents must have correct expectations of future prices. Before comparing four categories of intertemporal, the paper explains Hayek’s distinction between correct expectations and perfect foresight. The four equilibrium concepts considered are: (1) Perfect foresight equilibrium of which the Arrow-Debreu-McKenzie (ADM) model of equilibrium with complete markets is an alternative version, (2) Radner’s sequential equilibrium with incomplete markets, (3) Hicks’s temporary equilibrium, as extended by Bliss; (4) the Muth rational-expectations equilibrium as extended by Lucas into macroeconomics. While Hayek’s understanding closely resembles Radner’s sequential equilibrium, described by Radner as an equilibrium of plans, prices, and price expectations, Hicks’s temporary equilibrium seems to have been the natural extension of Hayek’s approach. The now dominant Lucas rational-expectations equilibrium misconceives intertemporal equilibrium, suppressing Hayek’s insights thereby retreating to a sterile perfect-foresight equilibrium.

And here is my concluding paragraph:

Four score and three years after Hayek explained how challenging the subtleties of the notion of intertemporal equilibrium and the elusiveness of any theoretical account of an empirical tendency toward intertemporal equilibrium, modern macroeconomics has now built a formidable theoretical apparatus founded on a methodological principle that rejects all the concerns that Hayek found so vexing denies that all those difficulties even exist. Many macroeconomists feel proud of what modern macroeconomics has achieved, but there is reason to think that the path trod by Hayek, Hicks and Radner could have led macroeconomics in a more fruitful direction than the one on which it has been led by Lucas and his associates.

Cleaning Up After Burns’s Mess

Published May 8, 2019 Hayek , Milton Friedman , Paul Volcker , R. G. Hawtrey 12 Comments
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In my two recent posts (here and here) about Arthur Burns’s lamentable tenure as Chairman of the Federal Reserve System from 1970 to 1978, my main criticism of Burns has been that, apart from his willingness to subordinate monetary policy to the political interests of he who appointed him, Burns failed to understand that an incomes policy to restrain wages, thereby minimizing the tendency of disinflation to reduce employment, could not, in principle, reduce inflation if monetary restraint did not correspondingly reduce the growth of total spending and income. Inflationary (or employment-reducing) wage increases can’t be prevented by an incomes policy if the rate of increase in total spending, and hence total income, isn’t controlled. King Canute couldn’t prevent the tide from coming in, and neither Arthur Burns nor the Wage and Price Council could slow the increase in wages when total spending was increasing at a rate faster than was consistent with the 3% inflation rate that Burns was aiming for.

In this post, I’m going to discuss how the mess left behind by Burns, upon his departure from the Fed in 1978, had to be cleaned up. The mess got even worse under Burns’s successor, G. William Miller. The clean up didn’t begin until Carter appointed Paul Volcker in 1979 when it became obvious that the monetary policy of the Fed had failed to cope with problems left behind by Burns. After unleashing powerful inflationary forces under the cover of the wage-and-price controls he had persuaded Nixon to impose in 1971 as a precondition for delivering the monetary stimulus so desperately desired by Nixon to ensure his reelection, Burns continued providing that stimulus even after Nixon’s reelection, when it might still have been possible to taper off the stimulus before inflation flared up, and without aborting the expansion then under way. In his arrogance or ignorance, Burns chose not to adjust the policy that had already accomplished its intended result.

Not until the end of 1973, after crude oil prices quadrupled owing to a cutback in OPEC oil output, driving inflation above 10% in 1974, did Burns withdraw the monetary stimulus that had been administered in increasing doses since early 1971. Shocked out of his complacency by the outcry against 10% inflation, Burns shifted monetary policy toward restraint, bringing down the growth in nominal spending and income from over 11% in Q4 1973 to only 8% in Q1 1974.

After prolonging monetary stimulus unnecessarily for a year, Burn erred grievously by applying monetary restraint in response to the rise in oil prices. The largely exogenous rise in oil prices would most likely have caused a recession even with no change in monetary policy. By subjecting the economy to the added shock of reducing aggregate demand, Burns turned a mild recession into the worst recession since 1937-38 recession at the end of the Great Depression, with unemployment peaking at 8.8% in Q2 1975. Nor did the reduction in aggregate demand have much anti-inflationary effect, because the incremental reduction in total spending occasioned by the monetary tightening was reflected mainly in reduced output and employment rather than in reduced inflation.

But even with unemployment reaching the highest level in almost 40 years, inflation did not fall below 5% – and then only briefly – until a year after the bottom of the recession. When President Carter took office in 1977, Burns, hoping to be reappointed to another term, provided Carter with a monetary expansion to hasten the reduction in unemployment that Carter has promised in his Presidential campaign. However, Burns’s accommodative policy did not sufficiently endear him to Carter to secure the coveted reappointment.

The short and unhappy tenure of Carter’s first appointee, G. William Miller, during which inflation rose from 6.5% to 10%, ended abruptly when Carter, with his Administration in crisis, sacked his Treasury Secretary, replacing him with Miller. Under pressure from the financial community to address the seemingly intractable inflation that seemed to be accelerating in the wake of a second oil shock following the Iranian Revolution and hostage taking, Carter felt constrained to appoint Volcker, formerly a high official in the Treasury under both Kennedy and Nixon, then serving as President of the New York Federal Reserve Bank, who was known to be the favored choice of the financial community.

A year after leaving the Fed, Burns gave the annual Per Jacobson Lecture to the International Monetary Fund. Calling his lecture “The Anguish of Central Banking,” Burns offered a defense of his tenure, by arguing, in effect, that he should not be blamed for his poor performance, because the job of central banking is so very hard. Central bankers could control inflation, but only by inflicting unacceptably high unemployment. The political authorities and the public to whom central bankers are ultimately accountable would simply not tolerate the high unemployment that would be necessary for inflation to be controlled.

Viewed in the abstract, the Federal Reserve System had the power to abort the inflation at its incipient stage fifteen years ago or at any later point, and it has the power to end it today. At any time within that period, it could have restricted money supply and created sufficient strains in the financial and industrial markets to terminate inflation with little delay. It did not do so because the Federal Reserve was itself caught up in the philosophic and political currents that were transforming American life and culture.

Burns’s framing of the choices facing a central bank was tendentious; no policy maker had suggested that, after years of inflation had convinced the public to expect inflation to continue indefinitely, the Fed should “terminate inflation with little delay.” And Burns was hardly a disinterested actor as Fed chairman, having orchestrated a monetary expansion to promote the re-election chances of his benefactor Richard Nixon after securing, in return for that service, Nixon’s agreement to implement an incomes policy to limit the growth of wages, a policy that Burns believed would contain the inflationary consequences of the monetary expansion.

However, as I explained in my post on Hawtrey and Burns, the conceptual rationale for an incomes policy was not to allow monetary expansion to increase total spending, output and employment without causing increased inflation, but to allow the monetary restraint to be administered without increasing unemployment. But under the circumstances in the summer of 1971, when a recovery from the 1970 recession was just starting, and unemployment was still high, monetary expansion might have hastened a recovery in output and employment the resulting increase in total spending and income might still increase output and employment rather than being absorbed in higher wages and prices.

But using controls over wages and prices to speed the return to full employment could succeed only while substantial unemployment and unused capacity allowed output and employment to increase; the faster the recovery, the sooner increased spending would show up in rising prices and wages, or in supply shortages, rather than in increased output. An incomes policy to enable monetary expansion to speed the recovery from recession and restore full employment might theoretically be successful, but, only if the monetary stimulus were promptly tapered off before driving up inflation.

Thus, if Burns wanted an incomes policy to be able to hasten the recovery through monetary expansion and maximize the political benefit to Nixon in time for the 1972 election, he ought to have recognized the need to withdraw the stimulus after the election. But for a year after Nixon’s reelection, Burns continued the monetary expansion without let up. Burns’s expression of anguish at the dilemma foisted upon him by circumstances beyond his control hardly evokes sympathy, sounding more like an attempt to deflect responsibility for his own mistakes or malfeasance in serving as an instrument of the criminal Campaign to Re-elect the President without bothering to alter that politically motivated policy after its dishonorable mission had been accomplished.

But it was not until Burns’s successor, G. William Miller, was succeeded by Paul Volcker in August 1979 that the Fed was willing to adopt — and maintain — an anti-inflationary policy. In his recently published memoir Volcker recounts how, responding to President Carter’s request in July 1979 that he accept appointment as Fed chairman, he told Mr. Carter that, to bring down inflation, he would adopt a tighter monetary policy than had been followed by his predecessor. He also writes that, although he did not regard himself as a Friedmanite Monetarist, he had become convinced that to control inflation it was necessary to control the quantity of money, though he did not agree with Friedman that a rigid rule was required to keep the quantity of money growing at a constant rate. To what extent the Fed would set its policy in terms of a fixed target rate of growth in the quantity of money became the dominant issue in Fed policy during Volcker’s first term as Fed chairman.

In a review of Volcker’s memoir widely cited in the econ blogosphere, Tim Barker decried Volcker’s tenure, especially his determination to control inflation even at the cost of spilling blood — other people’s blood – if that was necessary to eradicate the inflationary psychology of the 1970s, which become a seemingly permanent feature of the economic environment at the time of Volcker’s appointment.

If someone were to make a movie about neoliberalism, there would need to be a starring role for the character of Paul Volcker. As chair of the Federal Reserve from 1979 to 1987, Volcker was the most powerful central banker in the world. These were the years when the industrial workers movement was defeated in the United States and United Kingdom, and third world debt crises exploded. Both of these owe something to Volcker. On October 6, 1979, after an unscheduled meeting of the Fed’s Open Market Committee, Volcker announced that he would start limiting the growth of the nation’s money supply. This would be accomplished by limiting the growth of bank reserves, which the Fed influenced by buying and selling government securities to member banks. As money became more scarce, banks would raise interest rates, limiting the amount of liquidity available in the overall economy. Though the interest rates were a result of Fed policy, the money supply target let Volcker avoid the politically explosive appearance of directly raising rates himself. The experiment—known as the Volcker Shock—lasted until 1982, inducing what remains the worst unemployment since the Great Depression and finally ending the inflation that had troubled the world economy since the late 1960s. To catalog all the results of the Volcker Shock—shuttered factories, broken unions, dizzying financialization—is to describe the whirlwind we are still reaping in 2019. . . .

Barker is correct that Volcker had been persuaded that to tighten monetary policy the quantity of reserves that the Fed was providing to the banking system had to be controlled. But making the quantity of bank reserves the policy instrument was a technical change. Monetary policy had been — and could still have been — conducted using an interest-rate instrument, and it would have been entirely possible for Volcker to tighten monetary policy using the traditional interest-rate instrument.

It is possible that, as Barker asserts, it was politically easier to tighten policy using a quantity instrument than an interest-rate instrument. But even so, the real difficulty was not the instrument used, but the economic and political consequences of a tight monetary policy. The choice of the instrument to carry out the policy could hardly have made more than a marginal difference on the balance of political forces favoring or opposing that policy. The real issue was whether a tight monetary policy aimed at reducing inflation was more effectively conducted using the traditional interest-rate instrument or the quantity-instrument that Volcker adopted. More on this point below.

Those who praise Volcker like to say he “broke the back” of inflation. Nancy Teeters, the lone dissenter on the Fed Board of Governors, had a different metaphor: “I told them, ‘You are pulling the financial fabric of this country so tight that it’s going to rip. You should understand that once you tear a piece of fabric, it’s very difficult, almost impossible, to put it back together again.” (Teeters, also the first woman on the Fed board, told journalist William Greider that “None of these guys has ever sewn anything in his life.”) Fabric or backbone: both images convey violence. In any case, a price index doesn’t have a spine or a seam; the broken bodies and rent garments of the early 1980s belonged to people. Reagan economic adviser Michael Mussa was nearer the truth when he said that “to establish its credibility, the Federal Reserve had to demonstrate its willingness to spill blood, lots of blood, other people’s blood.”

Did Volcker consciously see unemployment as the instrument of price stability? A Rhode Island representative asked him “Is it a necessary result to have a large increase in unemployment?” Volcker responded, “I don’t know what policies you would have to follow to avoid that result in the short run . . . We can’t undertake a policy now that will cure that problem [unemployment] in 1981.” Call this the necessary byproduct view: defeating inflation is the number one priority, and any action to put people back to work would raise inflationary expectations. Growth and full employment could be pursued once inflation was licked. But there was more to it than that. Even after prices stabilized, full employment would not mean what it once had. As late as 1986, unemployment was still 6.6 percent, the Reagan boom notwithstanding. This was the practical embodiment of Milton Friedman’s idea that there was a natural rate of unemployment, and attempts to go below it would always cause inflation (for this reason, the concept is known as NAIRU or non-accelerating inflation rate of unemployment). The logic here is plain: there needed to be millions of unemployed workers for the economy to work as it should.

I want to make two points about Volcker’s policy. The first, which I made in my book Free Banking and Monetary Reform over 30 years ago, and which I have reiterated in several posts on this blog and which I discussed in my recent paper “Rules versus Discretion in Monetary Policy Historically Contemplated” (for an ungated version click here) is that using a quantity instrument to tighten monetary policy, as advocated by Milton Friedman, and acquiesced in by Volcker, induces expectations about the future actions of the monetary authority that undermine the policy, rendering it untenable. Volcker eventually realized the perverse expectational consequences of trying to implement a monetary policy using a fixed rule for the quantity instrument, but his learning experience in following Friedman’s advice needlessly exacerbated and prolonged the agony of the 1982 downturn for months after inflationary expectations had been broken.

The problem was well-known in the nineteenth century thanks to British experience under the Bank Charter Act that imposed a fixed quantity limit on the total quantity of banknotes issued by the Bank of England. When the total of banknotes approached the legal maximum, a precautionary demand for banknotes was immediately induced by those who feared that they might not later be able to obtain credit if it were needed because the Bank of England would be barred from making additional credit available.

Here is how I described Volcker’s Monetarist experiment in my book.

The danger lurking in any Monetarist rule has been perhaps best summarized by F. A. Hayek, who wrote:

As regards Professor Friedman’s proposal of a legal limit on the rate at which a monopolistic issuer of money was to be allowed to increase the quantity in circulation, I can only say that I would not like to see what would happen if under such a provision it ever became known that the amount of cash in circulation was approaching the upper limit and therefore a need for increased liquidity could not be met.

Hayek’s warnings were subsequently borne out after the Federal Reserve Board shifted its policy from targeting interest rates to targeting the monetary aggregates. The apparent shift toward a less inflationary monetary policy, reinforced by the election of a conservative, antiinflationary president in 1980, induced an international shift from other currencies into the dollar. That shift caused the dollar to appreciate by almost 30 percent against other major currencies.

At the same time the domestic demand for deposits was increasing as deregulation of the banking system reduced the cost of holding deposits. But instead of accommodating the increase in the foreign and domestic demands for dollars, the Fed tightened monetary policy. . . . The deflationary impact of that tightening overwhelmed the fiscal stimulus of tax cuts and defense buildup, which, many had predicted, would cause inflation to speed up. Instead the economy fell into the deepest recession since the 1930s, while inflation, by 1982, was brought down to the lowest levels since the early 1960s. The contraction, which began in July 1981, accelerated in the fourth quarter of 1981 and the first quarter of 1982.

The rapid disinflation was bringing interest rates down from the record high levels of mid-1981 and the economy seemed to bottom out in the second quarter, showing a slight rise in real GNP over the first quarter. Sticking to its Monetarist strategy, the Fed reduced its targets for monetary growth in 1982 to between 2.5 and 5.5 percent. But in January and February, the money supply increased at a rapid rate, perhaps in anticipation of an incipient expansion. Whatever its cause, the early burst of the money supply pushed M-1 way over its target range.

For the next several months, as M-1 remained above its target, financial and commodity markets were preoccupied with what the Fed was going to do next. The fear that the Fed would tighten further to bring M-1 back within its target range reversed the slide in interest rates that began in the fall of 1981. A striking feature of the behavior of interest rates at that time was that credit markets seemed to be heavily influenced by the announcements every week of the change in M-1 during the previous week. Unexpectedly large increases in the money supply put upward pressure on interest rates.

The Monetarist explanation was that the announcements caused people to raise their expectations of inflation. But if the increase in interest rates had been associated with a rising inflation premium, the announcements should have been associated with weakness in the dollar on foreign exchange markets and rising commodities prices. In fact, the dollar was rising and commodities prices were falling consistently throughout this period – even immediately after an unexpectedly large jump in M-1 was announced. . . . (pp. 218-19)

I pause in my own earlier narrative to add the further comment that the increase in interest rates in early 1982 clearly reflected an increasing liquidity premium, caused by the reduced availability of bank reserves, making cash more desirable to hold than real assets, thereby inducing further declines in asset values.

However, increases in M-1 during July turned out to be far smaller than anticipated, relieving some of the pressure on credit and commodities markets and allowing interest rates to begin to fall again. The decline in interest rates may have been eased slightly by . . . Volcker’s statement to Congress on July 20 that monetary growth at the upper range of the Fed’s targets would be acceptable. More important, he added that he Fed was willing to let M-1 remain above its target range for a while if the reason seemed to be a precautionary demand for liquidity. By August, M-1 had actually fallen back within its target range. As fears of further tightening by the Fed subsided, the stage was set for the decline in interest rates to accelerate, [and] the great stock market rally began on August 17, when the Dow . . . rose over 38 points [almost 5%].

But anticipation of an incipient recovery again fed monetary growth. From the middle of August through the end of September, M-1 grew at an annual rate of over 15 percent. Fears that rapid monetary growth would induce the Fed to tighten monetary policy slowed down the decline in interest rates and led to renewed declines in commodities price and the stock market, while pushing up the dollar to new highs. On October 5 . . . the Wall Street Journal reported that bond prices had fallen amid fears that the Fed might tighten credit conditions to slow the recent strong growth in the money supply. But on the very next day it was reported that the Fed expected inflation to stay low and would therefore allow M-1 to exceed its targets. The report sparked a major decline in interest rates and the Dow . . . soared another 37 points. (pp. 219-20)

The subsequent recovery, which began at the end of 1982, quickly became very powerful, but persistent fears that the Fed would backslide, at the urging of Milton Friedman and his Monetarist followers, into its bad old Monetarist habits periodically caused interest-rate spikes reflecting rising liquidity premiums as the public built up precautionary cash balances. Luckily, Volcker was astute enough to shrug off the overwrought warnings of Friedman and other Monetarists that rapid increases in the monetary aggregates foreshadowed the imminent return of double-digit inflation.

Thus, the Monetarist obsession with controlling the monetary aggregates senselessly prolonged an already deep recession that, by Q1 1982, had already slain the inflationary dragon, inflation having fallen to less than half its 1981 peak while GDP actually contracted in nominal terms. But because the money supply was expanding at a faster rate than was acceptable to Monetarist ideology, the Fed continued in its futile, but destructive, effort to keep the monetary aggregates from overshooting their arbitrary Monetarist target range. It was not until Volcker, in the summer of 1982, finally and belatedly decided that enough was enough and announced that the Fed would declare victory over inflation and call off its Monetarist crusade even if doing so meant incurring Friedman’s wrath and condemnation for abandoning the true Monetarist doctrine.

Which brings me to my second point about Volcker’s policy. While it’s clear that Volcker’s decision to adopt control over the monetary aggregates as the focus of monetary policy was disastrously misguided, monetary policy can’t be conducted without some target. Although the Fed’s interest rate can serve as a policy instrument, it is not a plausible policy target. The preferred policy target is generally thought to be the rate of inflation. The Fed after all is mandated to achieve price stability, which is usually understood to mean targeting a rate of inflation of about 2%. A more sophisticated alternative would be to aim at a suitable price level, thereby allowing some upward movement, say, at a 2% annual rate, the difference between an inflation target and a moving price level target being that an inflation target is unaffected by past deviations of actual from targeted inflation while a moving price level target would require some catch up inflation to make up for past below-target inflation and reduced inflation to compensate for past above-target inflation.

However, the 1981-82 recession shows exactly why an inflation target and even a moving price level target are bad ideas. By almost any comprehensive measure, inflation was still positive throughout the 1981-82 recession, though the producer price index was nearly flat. Thus, inflation targeting during the 1981-82 recession would have been almost as bad a target for monetary policy as the monetary aggregates, with most measures of inflation showing that inflation was then between 3 and 5 percent even at the depth of the recession. Inflation targeting is thus, on its face, an unreliable basis for conducting monetary policy.

But the deeper problem with targeting inflation is that seeking to achieve an inflation target during a recession, when the very existence of a recession is presumptive evidence of the need for monetary stimulus, is actually a recipe for disaster, or, at the very least, for needlessly prolonging a recession. In a recession, the goal of monetary policy should be to stabilize the rate of increase in nominal spending along a time path consistent with the desired rate of inflation. Thus, as long as output is contracting or increasing very slowly, the desired rate of inflation should be higher than the desired rate over the long-term. The appropriate strategy for achieving an inflation target ought to be to let inflation be reduced by the accelerating expansion of output and employment characteristic of most recoveries relative to a stable expansion of nominal spending.

The true goal of monetary policy should always be to maintain a time path of total spending consistent with a desired price-level path over time. But it should not be the objective of the monetary policy to always be as close as possible to the desired path, because trying to stay on that path would likely destabilize the real economy. Market monetarists argue that the goal of monetary policy ought to be to keep nominal GDP expanding at that whatever rate is consistent with maintaining the desired long-run price-level path. That is certainly a reasonable practical rule for monetary policy, but the policy criterion I have discussed here would, at least in principle, be consistent with a more activist approach in which the monetary authority would seek to hasten the restoration of full employment during recessions by temporarily increasing the rate of monetary expansion and in nominal GDP as long as real output and employment remained below the maximum levels consistent with desired price level path over time. But such a strategy would require the monetary authority to be able to fine tune its monetary expansion so that it was tapered off just as the economy was reaching its maximum sustainable output and employment path. Whether such fine-tuning would be possible in practice is a question to which I don’t think we now know the answer.

 

Hayek v. Rawls on Social Justice: Correcting the False Narrative

Published August 22, 2018 Hayek , John Rawls , Uncategorized 1 Comment
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Matt Yglesias, citing an article (“John Rawls, Socialist?“) by Ed Quish in the Jacobin arguing that Rawls, in his later years, drifted from his welfare-state liberalism to democratic socialism, tweeted a little while ago

https://twitter.com/mattyglesias/status/1032410530173075456

I’m an admirer of, but no expert on, Rawls, so I won’t weigh in on where to pigeon-hole Rawls on the ideological spectrum. In general, I think such pigeon-holing is as likely to mislead as to clarify because it tends to obscure the individuality of the individual or thinker being pigeon-hold. Rawls was above all a Rawlsian and to reduce his complex and nuanced philosophy to simple catch-phrase like “socialism” or even “welfare-state liberalism” cannot possibly do his rich philosophical contributions justice (no pun intended).

A good way to illustrate both the complexity of Rawls’s philosophy and that of someone like F. A. Hayek, often regarded as standing on the opposite end of the philosophical spectrum from Rawls, is to quote from two passages of volume 2 of Law, Legislation and Liberty. Hayek entitled this volume The Mirage of Social Justice, and the main thesis of that volume is that the term “justice” is meaningful only in the context of the foreseen or foreseable consequences of deliberate decisions taken by responsible individual agents. Social justice, because it refers to the outcomes of complex social processes that no one is deliberately aiming at, is not a meaningful concept.

Because Rawls argued in favor of the difference principle, which says that unequal outcomes are only justifiable insofar as they promote the absolute (though not the relative) well-being of the least well-off individuals in society, most libertarians, including famously Robert Nozick whose book Anarchy, State and Utopia was a kind of rejoinder to Rawls’s book A Theory of Justice, viewed Rawls as an ideological opponent.

Hayek, however, had a very different take on Rawls. At the end of his preface to volume 2, explaining why he had not discussed various recent philosophical contributions on the subject of social justice, Hayek wrote:

[A]fter careful consideration I have come to the conclusion that what I might have to say about John Rawls’ A theory of Justice would not assist in the pursuit of my immediate object because the differences between us seemed more verbal than substantial. Though the first impression of readers may be different, Rawls’ statement which I quote later in this volume (p. 100) seems to me to show that we agree on what is to me the essential point. Indeed, as I indicate in a note to that passage, it appears to me that Rawls has been widely misunderstood on this central issue. (pp. xii-xiii)

Here is what Hayek says about Rawls in the cited passage.

Before leaving this subject I want to point out once more that the recognition that in such combinations as “social”, “economic”, “distributive”, or “retributive” justice the term “justice” is wholly empty should not lead us to throw the baby out with the bath water. Not only as the basis of the legal rules of just conduct is the justice which the courts of justice administer exceedingly important; there unquestionably also exists a genuine problem of justice in connection with the deliberate design of political institutions the problem to which Professor John Rawls has recently devoted an important book. The fact which I regret and regard as confusing is merely that in this connection he employs the term “social justice”. But I have no basic quarrel with an author who, before he proceeds to that problem, acknowledges that the task of selecting specific systems or distributions of desired things as just must be abandoned as mistaken in principle and it is, in any case, not capable of a definite answer. Rather, the principles of justice define the crucial constraints which institutions and joint activities must satisfy if persons engaging in them are to have no complaints against them. If these constraints are satisfied, the resulting distribution, whatever it is, may be accepted as just (or at least not unjust).” This is more or less what I have been trying to argue in this chapter.

In the footnote at the end of the quotation, Hayek cites the source from which he takes the quotation and then continues:

John Rawls, “Constitutional Liberty and the Concept of Justice,” Nomos IV, Justice (New York, 1963), p. 102. where the passage quoted is preceded by the statement that “It is the system of institutions which has to be judged and judged from a general point of view.” I am not aware that Professor Rawls’ later more widely read work A Theory of Justice contains a comparatively clear statement of the main point, which may explain why this work seems often, but as it  appears to me wrongly, to have been interpreted as lending support to socialist demands, e.g., by Daniel Bell, “On Meritocracy and Equality”, Public Interest, Autumn 1972, p. 72, who describes Rawls’ theory as “the most comprehensive effort in modern philosophy to justify a socialist ethic.”

Hirshleifer on the Private and Social Value of Information

Published August 12, 2018 Hayek , intellectual property , Jack Hirshleifer , patents 3 Comments

I have written a number posts (here here here, and here) over the past few years citing an article by one of my favorite UCLA luminaries, Jack Hirshleifer, of the fabled UCLA economics department of the 1950s, 1960s, 1970s and 1980s. Like everything Hirshleifer wrote, the article, “The Private and Social Value of Information and the Reward to Inventive Activity,” published in 1971 in the American Economic Review, is deeply insightful, carefully reasoned, and lucidly explained, reflecting the author’s comprehensive mastery of the whole body of neoclassical microeconomic theory.

Hirshleifer’s article grew out of a whole literature inspired by two of Hayek’s most important articles “Economics and Knowledge” in 1937 and “The Use of Knowledge in Society” in 1945. Both articles were concerned with the fact that, contrary to the assumptions in textbook treatments, economic agents don’t have complete information about all the characteristics of the goods being traded and about the prices at which those goods are available. Hayek was aiming to show that markets are characteristically capable of transmitting information held by some agents in a condensed form to make it usable by other agents. That role is performed by prices. It is prices that provide both information and incentives to economic agents to formulate and tailor their plans, and if necessary, to readjust those plans in response to changed conditions. Agents need not know what those underlying changes are; they need only observe, and act on, the price changes that result from those changes.

Hayek’s argument, though profoundly insightful, was not totally convincing in demonstrating the superiority of the pure “free market,” for three reasons.

First, economic agents base decisions, as Hayek himself was among the first to understand, not just on actual current prices, but also on expected future prices. Although traders sometimes – but usually don’t — know what the current price of something is, one can only guess – not know — what the price of that thing will be in the future. So, the work of providing the information individuals need to make good economic decisions cannot be accomplished – even in principle – just by the adjustment of prices in current markets. People also need enough information to make good guesses – form correct expectations — about future prices.

Second, economic agents don’t automatically know all prices. The assumption that every trader knows exactly what prices are before executing plans to buy and sell is true, if at all, only in highly organized markets where prices are publicly posted and traders can always buy and sell at the posted price. In most other markets, transactors must devote time and effort to find out what prices are and to find out the characteristics of the goods that they are interested in buying. It takes effort or search or advertising or some other, more or less costly, discovery method for economic agents to find out what current prices are and what characteristics those goods have. If agents aren’t fully informed even about current prices, they don’t necessarily make good decisions.

Libertarians, free marketeers, and other Hayek acolytes often like to credit Hayek with having solved or having shown how “the market” solves “the knowledge problem,” a problem that Hayek definitively showed a central-planning regime to be incapable of solving. But the solution at best is only partial, and certainly not robust, because markets never transmit all available relevant information. That’s because markets transmit only information about costs and valuations known to private individuals, but there is a lot of information about public or social valuations and costs that is not known to private individuals and rarely if ever gets fed into, or is transmitted by, the price system — valuations of public goods and the social costs of pollution for example.

Third, a lot of information is not obtained or transmitted unless it is acquired, and acquiring information is costly. Economic agents must search for relevant information about the goods and services that they are interested in obtaining and about the prices at which those goods and services are available. Moreover, agents often engage in transactions with counterparties in which one side has an information advantage over the other. When traders have an information advantage over their counterparties, the opportunity for one party to take advantage of the inferior information of the counterparty may make it impossible for the two parties to reach mutually acceptable terms, because a party who realizes that the counterparty has an information advantage may be unwilling to risk being taken advantage of. Sometimes these problems can be surmounted by creative contractual arrangements or legal interventions, but often they can’t.

To recognize the limitations of Hayek’s insight is not to minimize its importance, either in its own right or as a stimulus to further research. Important early contributions (all published between 1961 and 1970) by Stigler (“The Economics of Information”) Ozga (“Imperfect Markets through Lack of Knowledge”), Arrow (“Economic Welfare and the Allocation of Resources for Invention”), Demsetz (“Information and Efficiency: Another Viewpoint”) and Alchian (“Information Costs, Pricing, and Resource Unemployment”) all analyzed the problem of incomplete and limited information and the incentives for acquiring information, the institutions and market arrangements that arise to cope with limited information and the implications for economic efficiency of these limitations and incentives. They can all be traced directly or indirectly to Hayek’s early contributions. Among the important results that seem to follow from these early papers was that the inability of those discovering or creating new knowledge to appropriate the net benefits accruing from the knowledge implied that the incentive to create new knowledge is less than optimal owing to their inability to claim full property rights over new knowledge through patents or other forms of intellectual property.

Here is where Hirshleifer’s paper enters the picture. Is more information always better? It would certainly seem that more of any good is better than less. But how valuable is new information? And are the incentives to create or discover new information aligned with the value of that information? Hayek’s discussion implicitly assumed that the amount of information in existence is a given stock, at least in the aggregate. How can the information that already exists be optimally used? Markets help us make use of the information that already exists. But the problem addressed by Hirshleifer was whether the incentives to discover and create new information call forth the optimal investment of time, effort and resources to make new discoveries and create new knowledge.

Instead of focusing on the incentives to search for information about existing opportunities, Hirshleifer analyzed the incentives to learn about uncertain resource endowments and about the productivity of those resources.

This paper deals with an entirely different aspect of the economics of information. We here revert to the textbook assumption that markets are perfect and costless. The individual is always fully acquainted with the supply-demand offers of all potential traders, and an equilibrium integrating all individuals’ supply-demand offers is attained instantaneously. Individuals are unsure only about the size of their own commodity endowments and/or about the returns attainable from their own productive investments. They are subject to technological uncertainty rather than market uncertainty.

Technological uncertainty brings immediately to mind the economics of research and invention. The traditional position been that the excess of the social over the private value of new technological knowledge leads to underinvestment in inventive activity. The main reason is that information, viewed as a product, is only imperfectly appropriable by its discoverer. But this paper will show that there is a hitherto unrecognized force operating in opposite direction. What has been scarcely appreciated in the literature, if recognized at all, is the distributive aspect of access to superior information. It will be seen below how this advantage provides a motivation for the private acquisition and dissemination of technological information that is quite apart from – and may even exist in the absence – of any social usefulness of that information. (p. 561)

The key insight motivating Hirshleifer was that privately held knowledge enables someone possessing that knowledge to anticipate future price movements once the privately held information becomes public. If you can anticipate a future price movement that no one else can, you can confidently trade with others who don’t know what you know, and then wait for the profit to roll in when the less well-informed acquire the knowledge that you have. By assumption the newly obtained knowledge doesn’t affect the quantity of goods available to be traded, so acquiring new knowledge or information provides no social benefit. In a pure-exchange model, newly discovered knowledge provides no net social benefit; it only enables better-informed traders to anticipate price movements that less well-informed traders don’t see coming. Any gains from new knowledge are exactly matched by the losses suffered by those without that knowledge. Hirshleifer called the kind of knowledge that enables one to anticipate future price movements “foreknowledge,” which he distinguished from actual discovery .

The type of information represented by foreknowledge is exemplified by ability to successfully predict tomorrow’s (or next year’s) weather. Here we have a stochastic situation: with particular probabilities the future weather might be hot or cold, rainy or dry, etc. But whatever does actually occur will, in due time, be evident to all: the only aspect of information that may be of advantage is prior knowledge as to what will happen. Discovery, in contrast, is correct recognition of something that is hidden from view. Examples include the determination of the properties of materials, of physical laws, even of mathematical attributes (e.g., the millionth digit in the decimal expansion of “π”). The essential point is that in such cases nature will not automatically reveal the information; only human action can extract it. (562)

Hirshleifer’s result, though derived in the context of a pure-exchange economy, is very powerful, implying that any expenditure of resources devoted to finding out new information that enables the first possessor of the information to predict price changes and reap profits from trading is unambiguously wasteful by reducing total consumption of the community.

[T]he community as a whole obtains no benefit, under pure exchange, from either the acquisition or the dissemination (by resale or otherwise) of private foreknowledge. . . .

[T]he expenditure of real resources for the production of technological information is socially wasteful in pure exchange, as the expenditure of resources for an increase in the quantity of money by mining gold is wasteful, and for essentially the same reason. Just as a smaller quantity of money serves monetary functions as well as a larger, the price level adjusting correspondingly, so a larger amount of foreknowledge serves no social purpose under pure exchange that the smaller amount did not. (pp. 565-66)

Relaxing the assumption that there is no production does not alter the conclusion, because the kind of information that is discovered, even if it did lead to efficient production decisions that increase the output of goods whose prices rise sooner as a result of the new information than they would have otherwise. But if the foreknowledge is privately obtained, the private incentive is to use that information by trading with another, less-well-informed, trader, at a price the other trader would not agree to if he weren’t at an information disadvantage. The private incentive to use foreknowledge that might cause a change in production decisions is not to use the information to alter production decisions but to use it to trade with, and profit from, those with inferior knowledge.

[A]s under the regime of pure exchange, private foreknowledge makes possible large private profit without leading to socially useful activity. The individual would have just as much incentive as under pure exchange (even more, in fact) to expend real resources in generating socially useless private information. (p. 567)

If the foreknowledge is publicly available, there would be a change in production incentives to shift production toward more valuable products. However, the private gain if the information is kept private greatly exceeds the private value of the information if the information is public. Under some circumstances, private individuals may have an incentive to publicize their private information to cause the price increases in expectation of which they have taken speculative positions. But it is primarily the gain from foreseen price changes, not the gain from more efficient production decisions, that creates the incentive to discover foreknowledge.

The key factor underlying [these] results . . . is the distributive significance of private foreknowledge. When private information fails to lead to improved productive alignments (as must necessarily be the case in a world of pure exchange, and also in a regime of production unless there is dissemination effected in the interest of speculation or resale), it is evident that the individual’s source of gain can only be at the expense of his fellows. But even where information is disseminated and does lead to improved productive commitments, the distributive transfer gain will surely be far greater than the relatively minor productive gain the individual might reap from the redirection of his own real investment commitments. (Id.)

Moreover, better-informed individuals – indeed individuals who wrongly believe themselves to be better informed — will perceive it to be in their self-interest to expend resources to disseminate the information in the expectation that the ensuing price changes would redound to their profit. The private gain expected from disseminating information far exceeds the social benefit from the prices changes once the new information is disseminated; the social benefit from the price changes resulting from the disseminated information corresponds to an improved allocation of resources, but that improvement will be very small compared to the expected private profit from anticipating the price change and trading with those that don’t anticipate it.

Hirshleifer then turns from the value of foreknowledge to the value of discovering new information about the world or about nature that makes a contribution to total social output by causing a shift of resources to more productive uses. Inasmuch as the discovery of new information about the world reveals previously unknown productive opportunities, it might be thought that the private incentive to devote resources to the discovery of technological information about productive opportunities generates substantial social benefits. But Hirshleifer shows that here, too, because the private discovery of information about the world creates private opportunities for gain by trading based on the consequent knowledge of future price changes, the private incentive to discover technological information always exceeds the social value of the discovery.

We need only consider the more general regime of production and exchange. Given private, prior, and sure information of event A [a state of the world in which a previously unknown natural relationship has been shown to exist] the individual in a world of perfect markets would not adapt his productive decisions if he were sure the information would remain private until after the close of trading. (p. 570)

Hirshleifer is saying that the discovery of a previously unknown property of the world can lead to an increase in total social output only by causing productive resources to be reallocated, but that reallocation can occur only if and when the new information is disclosed. So if someone discovers a previously unknown property of the world, the discoverer can profit from that information by anticipating the price effect likely to result once the information is disseminated and then making a speculative transaction based on the expectation of a price change. A corollary of this argument is that individuals who think that they are better informed about the world will take speculative positions based on their beliefs, but insofar as their investments in discovering properties of the world lead them to incorrect beliefs, their investments in information gathering and discovery will not be rewarded. The net social return to information gathering and discovery is thus almost certainly negative.

The obvious way of acquiring the private information in question is, of course, by performing technological research. By a now familiar argument we can show once again that the distributive advantage of private information provides an incentive for information-generating activity that may quite possibly be in excess of the social value of the information. (Id.)

Finally, Hirshliefer turns to the implications for patent policy of his analysis of the private and social value of information.

The issues involved may be clarified by distinguishing the “technological” and “pecuniary” effects of invention. The technological effects are the improvements in production functions . . . consequent upon the new idea. The pecuniary effects are the wealth shifts due to the price revaluations that take place upon release and/or utilization of the information. The pecuniary effects are purely redistributive.

For concreteness, we can think in terms of a simple cost-reducing innovation. The technological benefit to society is, roughly, the integrated area between the old and new marginal-cost curves for the preinvention level of output plus, for any additional output, and the area between the demand curve and the new marginal-cost curve. The holder of a (perpetual) patent could ideally extract, via a perfectly discriminatory fee policy, this entire technological benefit. Equivalence between the social and private benefits of innovation would thus induce the optimal amount of private inventive activity. Presumably it is reasoning of this sort that underlies the economic case for patent protection. (p. 571)

Here Hirshleifer is uncritically restating the traditional analysis for the social benefit from new technological knowledge. But the analysis overstates the benefit, by assuming incorrectly that, with no patent protection, the discovery would never be made. If the discovery would be made without patent protection, then obviously the technological benefit to society is only the area indicated over a limited time horizon, so a perpetual patent enabling the holder of the patent to extract all additional consumer and producer surplus flowing from invention in perpetuity would overcompensate the patent holder for the invention.

Nor does Hirshleifer mention the tendency of patents to increase the costs of invention, research and development owing to the royalties subsequent inventors would have to pay existing patent holders for infringing inventions even if those inventions were, or would have been, discovered with no knowledge of the patented invention. While rewarding some inventions and inventors, patent protection penalizes or blocks subsequent inventions and inventors. Inventions are outputs, but they are also inputs. If the use of past inventions is made more costly by new inventors, it is not clear that the net result will be an increase in the rate of invention.

Moreover, the knowledge that a patented invention may block or penalize a new invention that infringes on an existing patent or a patent that issues before a new invention is introduced, may in some cases cause an overinvestment in research as inventors race to gain the sole right to an invention, in order to avoid being excluded while gaining the right to exclude others.

Hirshleifer does mention some reasons why maximally rewarding patent holders for their inventions may lead to suboptimal results, but fails to acknowledge that the conventional assessment of the social gain from new invention is substantially overstated or patents may well have a negative effect on inventive activity in fields in which patent holders have gained the right to exclude potentially infringing inventions even if the infringing inventions would have been made without the knowledge publicly disclosed by the patent holders in their patent applications.

On the other side are the recognized disadvantages of patents: the social costs of the administrative-judicial process, the possible anti-competitve impact, and restriction of output due to the marginal burden of patent fees. As a second-best kind of judgment, some degree of patent protection has seemed a reasonable compromise among the objectives sought.

Of course, that judgment about the social utility of patents is not universally accepted, and authorities from Arnold Plant, to Fritz Machlup, and most recently Michele Boldrin and David Levine have been extremely skeptical of the arguments in favor of patent protection, copyright and other forms of intellectual property.

However, Hirshleifer advances a different counter-argument against patent protection based on his distinction between the private and social gains derived from information.

But recognition of the unique position of the innovator for forecasting and consequently capturing portions of the pecuniary effects – the wealth transfers due to price revaluation – may put matters in a different light. The “ideal” case of the perfectly discriminating patent holder earning the entire technological benefit is no longer so ideal. (pp. 571-72)

Of course, as I have pointed out, the ‘“ideal” case’ never was ideal.

For the same inventor is in a position to reap speculative profits, too; counting these as well, he would clearly be overcompensated. (p. 572)

Indeed!

Hirshleifer goes on to recognize that the capacity to profit from speculative activity may be beyond the capacity or the ken of many inventors.

Given the inconceivably vast number of potential contingencies and the costs of establishing markets, the prospective speculator will find it costly or even impossible ot purchase neutrality from “irrelevant” risks. Eli Whitney [inventor of the cotton gin who obtained one of the first US patents for his invention in 1794] could not be sure that his gin would make cotton prices fall: while a considerable force would clearly be acting in that direction, a multitude of other contingencies might also have possibly affected the price of cotton. Such “uninsurable” risks gravely limit the speculation feasible with any degree of prudence. (Id.)

HIrshleifer concludes that there is no compelling case either for or against patent protection, because the standard discussion of the case for patent protection has not taken into consideration the potential profit that inventors can gain by speculating on the anticipated price effects of their patents. Of course the argument that inventors are unlikely to be adept at making such speculative plays is a serious argument, we have also seen the rise of patent trolls that buy up patent rights from inventors and then file lawsuits against suspected infringers. In a world without patent protection, it is entirely possible that patent trolls would reinvent themselves as patent speculators, buying up information about new inventions from inventors and using that information to engage in speculative activity based on that information. By acquiring a portfolio of patents such invention speculators could pool the risks of speculation over their entire portfolio, enabling them to speculate more effectively than any single inventor could on his own invention. Hirshleifer concludes as follows:

Even though practical considerations limit the effective scale and consequent impact of speculation and/or resale [but perhaps not as much as Hirshleifer thought], the gains thus achievable eliminate any a priori anticipation of underinvestment in the generation of new technological knowledge. (p. 574)

And I reiterate one last time that Hirshleifer arrived at his non-endorsement of patent protection even while accepting the overstated estimate of the social value of inventions and neglecting the tendency of patents to increase the cost of inventive activity.

My Paper on Hayek, Hicks and Radner and 3 Equilibrium Concepts Now Available on SSRN

Published July 30, 2018 Hayek , J. R. Hicks , Roy Radner 35 Comments
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A little over a year ago, I posted a series of posts (here, here, here, here, and here) that came together as a paper (“Hayek and Three Equilibrium Concepts: Sequential, Temporary and Rational-Expectations”) that I presented at the History of Economics Society in Toronto in June 2017. After further revisions I posted the introductory section and the concluding section in April before presenting the paper at the Colloquium on Market Institutions and Economic Processes at NYU.

I have since been making further revisions and tweaks to the paper as well as adding the names of Hicks and Radner to the title, and I have just posted the current version on SSRN where it is available for download.

Here is the abstract:

Along with Erik Lindahl and Gunnar Myrdal, F. A. Hayek was among the first to realize that the necessary conditions for intertemporal, as opposed to stationary, equilibrium could be expressed in terms of correct expectations of future prices, often referred to as perfect foresight. Subsequently, J. R. Hicks further elaborated the concept of intertemporal equilibrium in Value and Capital in which he also developed the related concept of a temporary equilibrium in which future prices are not correctly foreseen. This paper attempts to compare three important subsequent developments of that idea with Hayek’s 1937 refinement of his original 1928 paper on intertemporal equilibrium. As a preliminary, the paper explains the significance of Hayek’s 1937 distinction between correct expectations and perfect foresight. In non-chronological order, the three developments of interest are: (1) Roy Radner’s model of sequential equilibrium with incomplete markets as an alternative to the Arrow-Debreu-McKenzie model of full equilibrium with complete markets; (2) Hicks’s temporary equilibrium model, and an important extension of that model by C. J. Bliss; (3) the Muth rational-expectations model and its illegitimate extension by Lucas from its original microeconomic application into macroeconomics. While Hayek’s 1937 treatment most closely resembles Radner’s sequential equilibrium model, which Radner, echoing Hayek, describes as an equilibrium of plans, prices, and price expectations, Hicks’s temporary equilibrium model would seem to have been the natural development of Hayek’s approach. The now dominant Lucas rational-expectations approach misconceives intertemporal equilibrium and ignores the fundamental Hayekian insights about the meaning of intertemporal equilibrium.

Neo- and Other Liberalisms

Published May 25, 2018 Hayek , John Rawls , liberalism , Michael Oakeshott , neoliberalism , Ronald Dworkin 15 Comments
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Everybody seems to be worked up about “neoliberalism” these days. A review of Quinn Slobodian’s new book on the Austrian (or perhaps the Austro-Hungarian) roots of neoliberalism in the New Republic by Patrick Iber reminded me that the term “neoliberalism” which, in my own faulty recollection, came into somewhat popular usage only in the early 1980s, had actually been coined in the early the late 1930s at the now almost legendary Colloque Walter Lippmann and had actually been used by Hayek in at least one of his political essays in the 1940s. In that usage the point of neoliberalism was to revise and update the classical nineteenth-century liberalism that seemed to have run aground in the Great Depression, when the attempt to resurrect and restore what had been widely – and in my view mistakenly – regarded as an essential pillar of the nineteenth-century liberal order – the international gold standard – collapsed in an epic international catastrophe. The new liberalism was supposed to be a kinder and gentler — less relentlessly laissez-faire – version of the old liberalism, more amenable to interventions to aid the less well-off and to social-insurance programs providing a safety net to cushion individuals against the economic risks of modern capitalism, while preserving the social benefits and efficiencies of a market economy based on private property and voluntary exchange.

Any memory of Hayek’s use of “neo-liberalism” was blotted out by the subsequent use of the term to describe the unorthodox efforts of two young ambitious Democratic politicians, Bill Bradley and Dick Gephardt to promote tax reform. Bradley, who was then a first-term Senator from New Jersey, having graduated directly from NBA stardom to the US Senate in 1978, and Gephardt, then an obscure young Congressman from Missouri, made a splash in the first term of the Reagan administration by proposing to cut income tax rates well below the rates to which Reagan had proposed when running for President, in 1980, subsequently enacted early in his first term. Bradley and Gephardt proposed cutting the top federal income tax bracket from the new 50% rate to the then almost unfathomable 30%. What made the Bradley-Gephardt proposal liberal was the idea that special-interest tax exemptions would be eliminated, so that the reduced rates would not mean a loss of tax revenue, while making the tax system less intrusive on private decision-making, improving economic efficiency. Despite cutting the top rate, Bradley and Gephardt retained the principle of progressivity by reducing the entire rate structure from top to bottom while eliminating tax deductions and tax shelters.

Here is how David Ignatius described Bradley’s role in achieving the 1986 tax reform in the Washington Post (May 18, 1986)

Bradley’s intellectual breakthrough on tax reform was to combine the traditional liberal approach — closing loopholes that benefit mainly the rich — with the supply-side conservatives’ demand for lower marginal tax rates. The result was Bradley’s 1982 “Fair Tax” plan, which proposed removing many tax preferences and simplifying the tax code with just three rates: 14 percent, 26 percent and 30 percent. Most subsequent reform plans, including the measure that passed the Senate Finance Committee this month, were modelled on Bradley’s.

The Fair Tax was an example of what Democrats have been looking for — mostly without success — for much of the last decade. It synthesized liberal and conservative ideas in a new package that could appeal to middle-class Americans. As Bradley noted in an interview this week, the proposal offered “lower rates for the middle-income people who are the backbone of America, who are paying most of the freight.” And who, it might be added, increasingly have been voting Republican in recent presidential elections.

The Bradley proposal also offered Democrats a way to shed their anti-growth, tax-and-spend image by allowing them, as Bradley says, “to advocate economic growth and fairness simultaneously.” The only problem with the idea was that it challenged the party’s penchant for soak-the-rich rhetoric and interest-group politics.

So the new liberalism of Bradley and Gephardt was an ideological movement in the opposite direction from that of the earlier version of neoliberalism; the point of neoliberalism 1.0 was to moderate classical laissez-faire liberal orthodoxy; neoliberalism 2.0 aimed to counter the knee-jerk interventionism of New Deal liberalism that favored highly progressive income taxation to redistribute income from rich to poor and price ceilings and controls to protect the poor from exploitation by ruthless capitalists and greedy landlords and as an anti-inflation policy. The impetus for reassessing mid-twentieth-century American liberalism was the evident failure in the 1970s of wage and price controls, which had been supported with little evidence of embarrassment by most Democratic economists (with the notable exception of James Tobin) when imposed by Nixon in 1971, and by the decade-long rotting residue of Nixon’s controls — controls on crude oil and gasoline prices — finally scrapped by Reagan in 1981.

Although the neoliberalism 2.0 enjoyed considerable short-term success, eventually providing the template for the 1986 Reagan tax reform, and establishing Bradley and Gephardt as major figures in the Democratic Party, neoliberalism 2.0 was never embraced by the Democratic grassroots. Gephardt himself abandoned the neo-liberal banner in 1988 when he ran for President as a protectionist, pro-Labor Democrat, providing the eventual nominee, the mildly neoliberalish Michael Dukakis, with plenty of material with which to portray Gephardt as a flip-flopper. But Dukasis’s own failure in the general election did little to enhance the prospects of neoliberalism as a winning electoral strategy. The Democratic acceptance of low marginal tax rates in exchange for eliminating tax breaks, exemptions and shelters was short-lived, and Bradley himself abandoned the approach in 2000 when he ran for the Democratic Presidential nomination from the left against Al Gore.

So the notion that “neoliberalism” has any definite meaning is as misguided as the notion that “liberalism” has any definite meaning. “Neoliberalism” now serves primarily as a term of abuse for leftists to impugn the motives of their ideological and political opponents in exactly the same way that right-wingers use “liberal” as a term of abuse — there are so many of course — with which to dismiss and denigrate their ideological and political opponents. That archetypical classical liberal Ludwig von Mises was openly contemptuous of the neoliberalism that emerged from the Colloque Walter Lipmann and of its later offspring Ordoliberalism (frequently described as the Germanic version of neoliberalism) referring to it as “neo-interventionism.” Similarly, modern liberals who view themselves as upholders of New Deal liberalism deploy “neoliberalism” as a useful pejorative epithet with which to cast a rhetorical cloud over those sharing a not so dissimilar political background or outlook but who are more willing to tolerate the outcomes of market forces than they are.

There are many liberalisms and perhaps almost as many neoliberalisms, so it’s pointless and futile to argue about which is the true or legitimate meaning of “liberalism.” However, one can at least say about the two versions of neoliberalism that I’ve mentioned that they were attempts to moderate more extreme versions of liberalism and to move toward the ideological middle of the road: from the extreme laissez-faire of classical liberalism on the one right and from the dirigisme of the New Deal on the left toward – pardon the cliché – a third way in the center.

But despite my disclaimer that there is no fixed, essential, meaning of “liberalism,” I want to suggest that it is possible to find some common thread that unites many, if not all, of the disparate strands of liberalism. I think it’s important to do so, because it wasn’t so long ago that even conservatives were able to speak approvingly about the “liberal democratic” international order that was created, largely thanks to American leadership, in the post-World War II era. That time is now unfortunately past, but it’s still worth remembering that it once was possible to agree that “liberal” did correspond to an admirable political ideal.

The deep underlying principle that I think reconciles the different strands of the best versions of liberalism is a version of Kant’s categorical imperative: treat every individual as an end not a means. Individuals must not be used merely as tools or instruments with which other individuals or groups satisfy their own purposes. If you want someone else to serve you in accomplishing your ends, that other person must provide that assistance to you voluntarily not because you require him to do so. If you want that assistance you must secure it not by command but by persuasion. Persuasion can be secured in two ways, either by argument — persuading the other person to share your objective — or if you can’t, or won’t, persuade the person to share your objective, you can still secure his or her agreement to help you by offering some form of compensation to induce the person to provide you the services you desire.

The principle has an obvious libertarian interpretation: all cooperation is secured through voluntary agreements between autonomous agents. Force and fraud are impermissible. But the Kantian ideal doesn’t necessarily imply a strictly libertarian political system. The choices of autonomous agents can — actually must — be restricted by a set of legal rules governing the conduct of those agents. And the content of those legal rules must be worked out either by legislation or by an evolutionary process of common law adjudication or some combination of the two. The content of those rules needn’t satisfy a libertarian laissez-faire standard. Rather the liberal standard that legal rules must satisfy is that they don’t prescribe or impose ends, goals, or purposes that must be pursued by autonomous agents, but simply govern the means agents can employ in pursuing their objectives.

Legal rules of conduct are like semantic rules of grammar. Like rules of grammar that don’t dictate the ideas or thoughts expressed in speech or writing, only the manner of their expression, rules of conduct don’t specify the objectives that agents seek to achieve, only the acceptable means of accomplishing those objectives. The rules of conduct need not be libertarian; some choices may be ruled out for reasons of ethics or morality or expediency or the common good. What makes the rules liberal is that they apply equally to all citizens, and that the rules allow sufficient space to agents to conduct their own lives according to their own purposes, goals, preferences, and values.

In other words, the rule of law — not the rule of particular groups, classes, occupations — prevails. Agents are subject to an impartial legal standard, not to the will or command of another agent, or of the ruler. And for this to be the case, the ruler himself must be subject to the law. But within this framework of law that imposes no common goals and purposes on agents, a good deal of collective action to provide for common purposes — far beyond the narrow boundaries of laissez-faire doctrine — is possible. Citizens can be taxed to pay for a wide range of public services that the public, through its elected representatives, decides to provide. Those elected representatives can enact legislation that governs the conduct of individuals as long as the legislation does not treat individuals differently based on irrelevant distinctions or based on criteria that disadvantage certain people unfairly.

My view that the rule of law, not laissez-faire, not income redistribution, is the fundamental value and foundation of liberalism is a view that I learned from Hayek, who, in his later life was as much a legal philosopher as an economist, but it is a view that John Rawls, Ronald Dworkin on the left, and Michael Oakeshott on the right, also shared. Hayek, indeed, went so far as to say that he was fundamentally in accord with Rawls’s magnum opus A Theory of Justice, which was supposed to have provided a philosophical justification for modern welfare-state liberalism. Liberalism is a big tent, and it can accommodate a wide range of conflicting views on economic and even social policy. What sets liberalism apart is a respect for and commitment to the rule of law and due process, a commitment that ought to take precedence over any specific policy goal or preference.

But here’s the problem. If the ruler can also make or change the laws, the ruler is not really bound by the laws, because the ruler can change the law to permit any action that the ruler wants to take. How then is the rule of law consistent with a ruler that is empowered to make the law to which he is supposedly subject. That is the dilemma that every liberal state must cope with. And for Hayek, at least, the issue was especially problematic in connection with taxation.

With the possible exception of inflation, what concerned Hayek most about modern welfare-state policies was the highly progressive income-tax regimes that western countries had adopted in the mid-twentieth century. By almost any reasonable standard, top marginal income-tax rates were way too high in the mid-twentieth century, and the economic case for reducing the top rates was compelling when reducing the top rates would likely entail little, if any, net revenue loss. As a matter of optics, reductions in the top marginal rates had to be coupled with reductions of lower tax brackets which did entail revenue losses, but reforming an overly progressive tax system without a substantial revenue loss was not that hard to do.

But Hayek’s argument against highly progressive income tax rates was based more on principle than on expediency. Hayek regarded steeply progressive income tax rates as inherently discriminatory by imposing a disproportionate burden on a minority — the wealthy — of the population. Hayek did not oppose modest progressivity to ease the tax burden on the least well-off, viewing such progressivity treating as a legitimate concession that a well-off majority could allow to a less-well-off minority. But he greatly feared attempts by the majority to shift the burden of taxation onto a well-off minority, viewing that kind of progressivity as a kind of legalized hold-up, whereby the majority uses its control of the legislature to write the rules to their own advantage at the expense of the minority.

While Hayek’s concern that a wealthy minority could be plundered by a greedy majority seems plausible, a concern bolstered by the unreasonably high top marginal rates that were in place when he wrote, he overstated his case in arguing that high marginal rates were, in and of themselves, unequal treatment. Certainly it would be discriminatory if different tax rates applied to people because of their religion or national origin or for reasons unrelated to income, but even a highly progressive income tax can’t be discriminatory on its face, as Hayek alleged, when the progressivity is embedded in a schedule of rates applicable to everyone that reaches specified income thresholds.

There are other reasons to think that Hayek went too far in his opposition to progressive tax rates. First, he assumed that earned income accurately measures the value of the incremental contribution to social output. But Hayek overlooked that much of earned income reflects either rents that are unnecessary to call forth the efforts required to earn that income, in which case increasing the marginal tax rate on such earnings does not diminish effort and output. We also know as a result of a classic 1971 paper by Jack Hirshleifer that earned incomes often do not correspond to net social output. For example, incomes earned by stock and commodity traders reflect only in part incremental contributions to social output; they also reflect losses incurred by other traders. So resources devoted to acquiring information with which to make better predictions of future prices add less to output than those resources are worth, implying a net reduction in total output. Insofar as earned incomes reflect not incremental contributions to social output but income transfers from other individuals, raising taxes on those incomes can actually increase aggregate output.

So the economic case for reducing marginal tax rates is not necessarily more compelling than the philosophical case, and the economic arguments certainly seem less compelling than they did some three decades ago when Bill Bradley, in his youthful neoliberal enthusiasm, argued eloquently for drastically reducing marginal rates while broadening the tax base. Supporters of reducing marginal tax rates still like to point to the dynamic benefits of increasing incentives to work and invest, but they don’t acknowledge that earned income does not necessarily correspond closely to net contributions to aggregate output.

Drastically reducing the top marginal rate from 70% to 28% within five years, greatly increased the incentive to earn high incomes. The taxation of high incomes having been reducing so drastically, the number of people earning very high incomes since 1986 has grown very rapidly. Does that increase in the number of people earning very high incomes reflect an improvement in the overall economy, or does it reflect a shift in the occupational choices of talented people? Since the increase in very high incomes has not been associated with an increase in the overall rate of economic growth, it hardly seems obvious that the increase in the number of people earning very high incomes is closely correlated with the overall performance of the economy. I suspect rather that the opportunity to earn and retain very high incomes has attracted a many very talented people into occupations, like financial management, venture capital, investment banking, and real-estate brokerage, in which high incomes are being earned, with correspondingly fewer people choosing to enter less lucrative occupations. And if, as I suggested above, these occupations in which high incomes are being earned often contribute less to total output than lower-paying occupations, the increased opportunity to earn high incomes has actually reduced overall economic productivity.

Perhaps the greatest effect of reducing marginal income tax rates has been sociological. I conjecture that, as a consequence of reduced marginal income tax rates, the social status and prestige of people earning high incomes has risen, as has the social acceptability of conspicuous — even brazen — public displays of wealth. The presumption that those who have earned high incomes and amassed great fortunes are morally deserving of those fortunes, and therefore entitled to deference and respect on account of their wealth alone, a presumption that Hayek himself warned against, seems to be much more widely held now than it was forty or fifty years ago. Others may take a different view, but I find this shift towards increased respect and admiration for the wealthy, curiously combined with a supposedly populist political environment, to be decidedly unedifying.

Hayek, Radner and Rational-Expectations Equilibrium

Published April 23, 2018 Alchian , Hayek , John Muth , rational expectations , Roy Radner 9 Comments
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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.

 

On Equilibrium in Economic Theory

Published April 18, 2018 Arrow-Debrew-McKenzie model , Hayek , intertemporal equilibrium , J. R. Hicks , Radner model , rational expectations equilibrium , Roy Radner , temporary equilibrium 9 Comments
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Here is the introduction to a new version of my paper, “Hayek and Three Concepts of Intertemporal Equilibrium” which I presented last June at the History of Economics Society meeting in Toronto, and which I presented piecemeal in a series of posts last May and June. This post corresponds to the first part of this post from last May 21.

Equilibrium is an essential concept in economics. While equilibrium is an essential concept in other sciences as well, and was probably imported into economics from physics, its meaning in economics cannot be straightforwardly transferred from physics into economics. The dissonance between the physical meaning of equilibrium and its economic interpretation required a lengthy process of explication and clarification, before the concept and its essential, though limited, role in economic theory could be coherently explained.

The concept of equilibrium having originally been imported from physics at some point in the nineteenth century, economists probably thought it natural to think of an economic system in equilibrium as analogous to a physical system at rest, in the sense of a system in which there was no movement or in the sense of all movements being repetitive. But what would it mean for an economic system to be at rest? The obvious answer was to say that prices of goods and the quantities produced, exchanged and consumed would not change. If supply equals demand in every market, and if there no exogenous disturbance displaces the system, e.g., in population, technology, tastes, etc., then there would seem to be no reason for the prices paid and quantities produced to change in that system. But that conception of an economic system at rest was understood to be overly restrictive, given the large, and perhaps causally important, share of economic activity – savings and investment – that is predicated on the assumption and expectation that prices and quantities not remain constant.

The model of a stationary economy at rest in which all economic activity simply repeats what has already happened before did not seem very satisfying or informative to economists, but that view of equilibrium remained dominant in the nineteenth century and for perhaps the first quarter of the twentieth. Equilibrium was not an actual state that an economy could achieve, it was just an end state that economic processes would move toward if given sufficient time to play themselves out with no disturbing influences. This idea of a stationary timeless equilibrium is found in the writings of the classical economists, especially Ricardo and Mill who used the idea of a stationary state as the end-state towards which natural economic processes were driving an an economic system.

This, not very satisfactory, concept of equilibrium was undermined when Jevons, Menger, Walras, and their followers began to develop the idea of optimizing decisions by rational consumers and producers. The notion of optimality provided the key insight that made it possible to refashion the earlier classical equilibrium concept into a new, more fruitful and robust, version.

If each economic agent (household or business firm) is viewed as making optimal choices, based on some scale of preferences, and subject to limitations or constraints imposed by their capacities, endowments, technologies, and the legal system, then the equilibrium of an economy can be understood as a state in which each agent, given his subjective ranking of the feasible alternatives, is making an optimal decision, and each optimal decision is both consistent with, and contingent upon, those of all other agents. The optimal decisions of each agent must simultaneously be optimal from the point of view of that agent while being consistent, or compatible, with the optimal decisions of every other agent. In other words, the decisions of all buyers of how much to purchase must be consistent with the decisions of all sellers of how much to sell. But every decision, just like every piece in a jig-saw puzzle, must fit perfectly with every other decision. If any decision is suboptimal, none of the other decisions contingent upon that decision can be optimal.

The idea of an equilibrium as a set of independently conceived, mutually consistent, optimal plans was latent in the earlier notions of equilibrium, but it could only be coherently articulated on the basis of a notion of optimality. Originally framed in terms of utility maximization, the notion was gradually extended to encompass the ideas of cost minimization and profit maximization. The general concept of an optimal plan having been grasped, it then became possible to formulate a generically economic idea of equilibrium, not in terms of a system at rest, but in terms of the mutual consistency of optimal plans. Once equilibrium was conceived as the mutual consistency of optimal plans, the needlessly restrictiveness of defining equilibrium as a system at rest became readily apparent, though it remained little noticed and its significance overlooked for quite some time.

Because the defining characteristics of economic equilibrium are optimality and mutual consistency, change, even non-repetitive change, is not logically excluded from the concept of equilibrium as it was from the idea of an equilibrium as a stationary state. An optimal plan may be carried out, not just at a single moment, but over a period of time. Indeed, the idea of an optimal plan is, at the very least, suggestive of a future that need not simply repeat the present. So, once the idea of equilibrium as a set of mutually consistent optimal plans was grasped, it was to be expected that the concept of equilibrium could be formulated in a manner that accommodates the existence of change and development over time.

But the manner in which change and development could be incorporated into an equilibrium framework of optimality was not entirely straightforward, and it required an extended process of further intellectual reflection to formulate the idea of equilibrium in a way that gives meaning and relevance to the processes of change and development that make the passage of time something more than merely a name assigned to one of the n dimensions in vector space.

This paper examines the slow process by which the concept of equilibrium was transformed from a timeless or static concept into an intertemporal one by focusing on the pathbreaking contribution of F. A. Hayek who first articulated the concept, and exploring the connection between his articulation and three noteworthy, but very different, versions of intertemporal equilibrium: (1) an equilibrium of plans, prices, and expectations, (2) temporary equilibrium, and (3) rational-expectations equilibrium.

But before discussing these three versions of intertemporal equilibrium, I summarize in section two Hayek’s seminal 1937 contribution clarifying the necessary conditions for the existence of an intertemporal equilibrium. Then, in section three, I elaborate on an important, and often neglected, distinction, first stated and clarified by Hayek in his 1937 paper, between perfect foresight and what I call contingently correct foresight. That distinction is essential for an understanding of the distinction between the canonical Arrow-Debreu-McKenzie (ADM) model of general equilibrium, and Roy Radner’s 1972 generalization of that model as an equilibrium of plans, prices and price expectations, which I describe in section four.

Radner’s important generalization of the ADM model captured the spirit and formalized Hayek’s insights about the nature and empirical relevance of intertemporal equilibrium. But to be able to prove the existence of an equilibrium of plans, prices and price expectations, Radner had to make assumptions about agents that Hayek, in his philosophically parsimonious view of human knowledge and reason, had been unwilling to accept. In section five, I explore how J. R. Hicks’s concept of temporary equilibrium, clearly inspired by Hayek, though credited by Hicks to Erik Lindahl, provides an important bridge connecting the pure hypothetical equilibrium of correct expectations and perfect consistency of plans with the messy real world in which expectations are inevitably disappointed and plans routinely – and sometimes radically – revised. The advantage of the temporary-equilibrium framework is to provide the conceptual tools with which to understand how financial crises can occur and how such crises can be propagated and transformed into economic depressions, thereby making possible the kind of business-cycle model that Hayek tried unsuccessfully to create. But just as Hicks unaccountably failed to credit Hayek for the insights that inspired his temporary-equilibrium approach, Hayek failed to see the potential of temporary equilibrium as a modeling strategy that combines the theoretical discipline of the equilibrium method with the reality of expectational inconsistency across individual agents.

In section six, I discuss the Lucasian idea of rational expectations in macroeconomic models, mainly to point out that, in many ways, it simply assumes away the problem of plan expectational consistency with which Hayek, Hicks and Radner and others who developed the idea of intertemporal equilibrium were so profoundly concerned.

Milton Friedman and the Phillips Curve

Published January 12, 2018 Hayek , Milton Friedman , Phillips Curve , Taylor rule , Uncategorized 8 Comments

In December 1967, Milton Friedman delivered his Presidential Address to the American Economic Association in Washington DC. In those days the AEA met in the week between Christmas and New Years, in contrast to the more recent practice of holding the convention in the week after New Years. That’s why the anniversary of Friedman’s 1967 address was celebrated at the 2018 AEA convention. A special session was dedicated to commemoration of that famous address, published in the March 1968 American Economic Review, and fittingly one of the papers at the session as presented by the outgoing AEA president Olivier Blanchard, who also wrote one of the papers discussed at the session. Other papers were written by Thomas Sargent and Robert Hall, and by Greg Mankiw and Ricardo Reis. The papers were discussed by Lawrence Summers, Eric Nakamura, and Stanley Fischer. An all-star cast.

Maybe in a future post, I will comment on the papers presented in the Friedman session, but in this post I want to discuss a point that has been generally overlooked, not only in the three “golden” anniversary papers on Friedman and the Phillips Curve, but, as best as I can recall, in all the commentaries I’ve seen about Friedman and the Phillips Curve. The key point to understand about Friedman’s address is that his argument was basically an extension of the idea of monetary neutrality, which says that the real equilibrium of an economy corresponds to a set of relative prices that allows all agents simultaneously to execute their optimal desired purchases and sales conditioned on those relative prices. So it is only relative prices, not absolute prices, that matter. Taking an economy in equilibrium, if you were suddenly to double all prices, relative prices remaining unchanged, the equilibrium would be preserved and the economy would proceed exactly – and optimally – as before as if nothing had changed. (There are some complications about what is happening to the quantity of money in this thought experiment that I am skipping over.) On the other hand, if you change just a single price, not only would the market in which that price is determined be disequilibrated, at least one, and potentially more than one, other market would be disequilibrated. The point here is that the real economy rules, and equilibrium in the real economy depends on relative, not absolute, prices.

What Friedman did was to argue that if money is neutral with respect to changes in the price level, it should also be neutral with respect to changes in the rate of inflation. The idea that you can wring some extra output and employment out of the economy just by choosing to increase the rate of inflation goes against the grain of two basic principles: (1) monetary neutrality (i.e., the real equilibrium of the economy is determined solely by real factors) and (2) Friedman’s famous non-existence (of a free lunch) theorem. In other words, you can’t make the economy as a whole better off just by printing money.

Or can you?

Actually you can, and Friedman himself understood that you can, but he argued that the possibility of making the economy as a whole better of (in the sense of increasing total output and employment) depends crucially on whether inflation is expected or unexpected. Only if inflation is not expected does it serve to increase output and employment. If inflation is correctly expected, the neutrality principle reasserts itself so that output and employment are no different from what they would have been had prices not changed.

What that means is that policy makers (monetary authorities) can cause output and employment to increase by inflating the currency, as implied by the downward-sloping Phillips Curve, but that simply reflects that actual inflation exceeds expected inflation. And, sure, the monetary authorities can always surprise the public by raising the rate of inflation above the rate expected by the public , but that doesn’t mean that the public can be perpetually fooled by a monetary authority determined to keep inflation higher than expected. If that is the strategy of the monetary authorities, it will lead, sooner or later, to a very unpleasant outcome.

So, in any time period – the length of the time period corresponding to the time during which expectations are given – the short-run Phillips Curve for that time period is downward-sloping. But given the futility of perpetually delivering higher than expected inflation, the long-run Phillips Curve from the point of view of the monetary authorities trying to devise a sustainable policy must be essentially vertical.

Two quick parenthetical remarks. Friedman’s argument was far from original. Many critics of Keynesian policies had made similar arguments; the names Hayek, Haberler, Mises and Viner come immediately to mind, but the list could easily be lengthened. But the earliest version of the argument of which I am aware is Hayek’s 1934 reply in Econometrica to a discussion of Prices and Production by Alvin Hansen and Herbert Tout in their 1933 article reviewing recent business-cycle literature in Econometrica in which they criticized Hayek’s assertion that a monetary expansion that financed investment spending in excess of voluntary savings would be unsustainable. They pointed out that there was nothing to prevent the monetary authority from continuing to create money, thereby continually financing investment in excess of voluntary savings. Hayek’s reply was that a permanent constant rate of monetary expansion would not suffice to permanently finance investment in excess of savings, because once that monetary expansion was expected, prices would adjust so that in real terms the constant flow of monetary expansion would correspond to the same amount of investment that had been undertaken prior to the first and unexpected round of monetary expansion. To maintain a rate of investment permanently in excess of voluntary savings would require progressively increasing rates of monetary expansion over and above the expected rate of monetary expansion, which would sooner or later prove unsustainable. The gist of the argument, more than three decades before Friedman’s 1967 Presidential address, was exactly the same as Friedman’s.

A further aside. But what Hayek failed to see in making this argument was that, in so doing, he was refuting his own argument in Prices and Production that only a constant rate of total expenditure and total income is consistent with maintenance of a real equilibrium in which voluntary saving and planned investment are equal. Obviously, any rate of monetary expansion, if correctly foreseen, would be consistent with a real equilibrium with saving equal to investment.

My second remark is to note the ambiguous meaning of the short-run Phillips Curve relationship. The underlying causal relationship reflected in the negative correlation between inflation and unemployment can be understood either as increases in inflation causing unemployment to go down, or as increases in unemployment causing inflation to go down. Undoubtedly the causality runs in both directions, but subtle differences in the understanding of the causal mechanism can lead to very different policy implications. Usually the Keynesian understanding of the causality is that it runs from unemployment to inflation, while a more monetarist understanding treats inflation as a policy instrument that determines (with expected inflation treated as a parameter) at least directionally the short-run change in the rate of unemployment.

Now here is the main point that I want to make in this post. The standard interpretation of the Friedman argument is that since attempts to increase output and employment by monetary expansion are futile, the best policy for a monetary authority to pursue is a stable and predictable one that keeps the economy at or near the optimal long-run growth path that is determined by real – not monetary – factors. Thus, the best policy is to find a clear and predictable rule for how the monetary authority will behave, so that monetary mismanagement doesn’t inadvertently become a destabilizing force causing the economy to deviate from its optimal growth path. In the 50 years since Friedman’s address, this message has been taken to heart by monetary economists and monetary authorities, leading to a broad consensus in favor of inflation targeting with the target now almost always set at 2% annual inflation. (I leave aside for now the tricky question of what a clear and predictable monetary rule would look like.)

But this interpretation, clearly the one that Friedman himself drew from his argument, doesn’t actually follow from the argument that monetary expansion can’t affect the long-run equilibrium growth path of an economy. The monetary neutrality argument, being a pure comparative-statics exercise, assumes that an economy, starting from a position of equilibrium, is subjected to a parametric change (either in the quantity of money or in the price level) and then asks what will the new equilibrium of the economy look like? The answer is: it will look exactly like the prior equilibrium, except that the price level will be twice as high with twice as much money as previously, but with relative prices unchanged. The same sort of reasoning, with appropriate adjustments, can show that changing the expected rate of inflation will have no effect on the real equilibrium of the economy, with only the rate of inflation and the rate of monetary expansion affected.

This comparative-statics exercise teaches us something, but not as much as Friedman and his followers thought. True, you can’t get more out of the economy – at least not for very long – than its real equilibrium will generate. But what if the economy is not operating at its real equilibrium? Even Friedman didn’t believe that the economy always operates at its real equilibrium. Just read his Monetary History of the United States. Real-business cycle theorists do believe that the economy always operates at its real equilibrium, but they, unlike Friedman, think monetary policy is useless, so we can forget about them — at least for purposes of this discussion. So if we have reason to think that the economy is falling short of its real equilibrium, as almost all of us believe that it sometimes does, why should we assume that monetary policy might not nudge the economy in the direction of its real equilibrium?

The answer to that question is not so obvious, but one answer might be that if you use monetary policy to move the economy toward its real equilibrium, you might make mistakes sometimes and overshoot the real equilibrium and then bad stuff would happen and inflation would run out of control, and confidence in the currency would be shattered, and you would find yourself in a re-run of the horrible 1970s. I get that argument, and it is not totally without merit, but I wouldn’t characterize it as overly compelling. On a list of compelling arguments, I would put it just above, or possibly just below, the domino theory on the basis of which the US fought the Vietnam War.

But even if the argument is not overly compelling, it should not be dismissed entirely, so here is a way of taking it into account. Just for fun, I will call it a Taylor Rule for the Inflation Target (IT). Let us assume that the long-run inflation target is 2% and let us say that (Y – Y*) is the output gap between current real GDP and potential GDP (i.e., the GDP corresponding to the real equilibrium of the economy). We could then define the following Taylor Rule for the inflation target:

IT = α(2%) + β((Y – Y*)/ Y*).

This equation says that the inflation target in any period would be a linear combination of the default Inflation Target of 2% times an adjustment coefficient α designed to keep successively chosen Inflation targets from deviating from the long-term price-level-path corresponding to 2% annual inflation and some fraction β of the output gap expressed as a percentage of potential GDP. Thus, for example, if the output gap was -0.5% and β was 0.5, the short-term Inflation Target would be raised to 4.5% if α were 1.

However, if on average output gaps are expected to be negative, then α would have to be chosen to be less than 1 in order for the actual time path of the price level to revert back to a target price-level corresponding to a 2% annual rate.

Such a procedure would fit well with the current dual inflation and employment mandate of the Federal Reserve. The long-term price level path would correspond to the price-stability mandate, while the adjustable short-term choice of the IT would correspond to and promote the goal of maximum employment by raising the inflation target when unemployment was high as a countercyclical policy for promoting recovery. But short-term changes in the IT would not be allowed to cause a long-term deviation of the price level from its target path. The dual mandate would ensure that relatively higher inflation in periods of high unemployment would be compensated for by periods of relatively low inflation in periods of low unemployment.

Alternatively, you could just target nominal GDP at a rate consistent with a long-run average 2% inflation target for the price level, with the target for nominal GDP adjusted over time as needed to ensure that the 2% average inflation target for the price level was also maintained.

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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