Archive for the 'intertemporal equilibrium' Category



Rational Expectations, or, The Road to Incoherence

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

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

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

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

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

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

Representative Agents, Homunculi and Faith-Based Macroeconomics

After my previous post comparing the neoclassical synthesis in its various versions to the mind-body problem, there was an interesting Twitter exchange between Steve Randy Waldman and David Andolfatto in which Andolfatto queried whether Waldman and I are aware that there are representative-agent models in which the equilibrium is not Pareto-optimal. Andalfatto raised an interesting point, but what I found interesting about it might be different from what Andalfatto was trying to show, which, I am guessing, was that a representative-agent modeling strategy doesn’t necessarily commit the theorist to the conclusion that the world is optimal and that the solutions of the model can never be improved upon by a monetary/fiscal-policy intervention. I concede the point. It is well-known I think that, given the appropriate assumptions, a general-equilibrium model can have a sub-optimal solution. Given those assumptions, the corresponding representative-agent will also choose a sub-optimal solution. So I think I get that, but perhaps there’s a more subtle point  that I’m missing. If so, please set me straight.

But what I was trying to argue was not that representative-agent models are necessarily optimal, but that representative-agent models suffer from an inherent, and, in my view, fatal, flaw: they can’t explain any real macroeconomic phenomenon, because a macroeconomic phenomenon has to encompass something more than the decision of a single agent, even an omniscient central planner. At best, the representative agent is just a device for solving an otherwise intractable general-equilibrium model, which is how I think Lucas originally justified the assumption.

Yet just because a general-equilibrium model can be formulated so that it can be solved as the solution of an optimizing agent does not explain the economic mechanism or process that generates the solution. The mathematical solution of a model does not necessarily provide any insight into the adjustment process or mechanism by which the solution actually is, or could be, achieved in the real world. Your ability to find a solution for a mathematical problem does not mean that you understand the real-world mechanism to which the solution of your model corresponds. The correspondence between your model may be a strictly mathematical correspondence which may not really be in any way descriptive of how any real-world mechanism or process actually operates.

Here’s an example of what I am talking about. Consider a traffic-flow model explaining how congestion affects vehicle speed and the flow of traffic. It seems obvious that traffic congestion is caused by interactions between the different vehicles traversing a thoroughfare, just as it seems obvious that market exchange arises as the result of interactions between the different agents seeking to advance their own interests. OK, can you imagine building a useful traffic-flow model based on solving for the optimal plan of a representative vehicle?

I don’t think so. Once you frame the model in terms of a representative vehicle, you have abstracted from the phenomenon to be explained. The entire exercise would be pointless – unless, that is, you assumed that interactions between vehicles are so minimal that they can be ignored. But then why would you be interested in congestion effects? If you want to claim that your model has any relevance to the effect of congestion on traffic flow, you can’t base the claim on an assumption that there is no congestion.

Or to take another example, suppose you want to explain the phenomenon that, at sporting events, all, or almost all, the spectators sit in their seats but occasionally get up simultaneously from their seats to watch the play on the field or court. Would anyone ever think that an explanation in terms of a representative spectator could explain that phenomenon?

In just the same way, a representative-agent macroeconomic model necessarily abstracts from the interactions between actual agents. Obviously, by abstracting from the interactions, the model can’t demonstrate that there are no interactions between agents in the real world or that their interactions are too insignificant to matter. I would be shocked if anyone really believed that the interactions between agents are unimportant, much less, negligible; nor have I seen an argument that interactions between agents are unimportant, the concept of network effects, to give just one example, being an important topic in microeconomics.

It’s no answer to say that all the interactions are accounted for within the general-equilibrium model. That is just a form of question-begging. The representative agent is being assumed because without him the problem of finding a general-equilibrium solution of the model is very difficult or intractable. Taking into account interactions makes the model too complicated to work with analytically, so it is much easier — but still hard enough to allow the theorist to perform some fancy mathematical techniques — to ignore those pesky interactions. On top of that, the process by which the real world arrives at outcomes to which a general-equilibrium model supposedly bears at least some vague resemblance can’t even be described by conventional modeling techniques.

The modeling approach seems like that of a neuroscientist saying that, because he could simulate the functions, electrical impulses, chemical reactions, and neural connections in the brain – which he can’t do and isn’t even close to doing, even though a neuroscientist’s understanding of the brain far surpasses any economist’s understanding of the economy – he can explain consciousness. Simulating the operation of a brain would not explain consciousness, because the computer on which the neuroscientist performed the simulation would not become conscious in the course of the simulation.

Many neuroscientists and other materialists like to claim that consciousness is not real, that it’s just an epiphenomenon. But we all have the subjective experience of consciousness, so whatever it is that someone wants to call it, consciousness — indeed the entire world of mental phenomena denoted by that term — remains an unexplained phenomenon, a phenomenon that can only be dismissed as unreal on the basis of a metaphysical dogma that denies the existence of anything that can’t be explained as the result of material and physical causes.

I call that metaphysical belief a dogma not because it’s false — I have no way of proving that it’s false — but because materialism is just as much a metaphysical belief as deism or monotheism. It graduates from belief to dogma when people assert not only that the belief is true but that there’s something wrong with you if you are unwilling to believe it as well. The most that I would say against the belief in materialism is that I can’t understand how it could possibly be true. But I admit that there are a lot of things that I just don’t understand, and I will even admit to believing in some of those things.

New Classical macroeconomists, like, say, Robert Lucas and, perhaps, Thomas Sargent, like to claim that unless a macroeconomic model is microfounded — by which they mean derived from an explicit intertemporal optimization exercise typically involving a representative agent or possibly a small number of different representative agents — it’s not an economic model, because the model, being vulnerable to the Lucas critique, is theoretically superficial and vacuous. But only models of intertemporal equilibrium — a set of one or more mutually consistent optimal plans — are immune to the Lucas critique, so insisting on immunity to the Lucas critique as a prerequisite for a macroeconomic model is a guarantee of failure if your aim to explain anything other than an intertemporal equilibrium.

Unless, that is, you believe that real world is in fact the realization of a general equilibrium model, which is what real-business-cycle theorists, like Edward Prescott, at least claim to believe. Like materialist believers that all mental states are epiphenomenous, and that consciousness is an (unexplained) illusion, real-business-cycle theorists purport to deny that there is such a thing as a disequilibrium phenomenon, the so-called business cycle, in their view, being nothing but a manifestation of the intertemporal-equilibrium adjustment of an economy to random (unexplained) productivity shocks. According to real-business-cycle theorists, such characteristic phenomena of business cycles as surprise, regret, disappointed expectations, abandoned and failed plans, the inability to find work at wages comparable to wages that other similar workers are being paid are not real phenomena; they are (unexplained) illusions and misnomers. The real-business-cycle theorists don’t just fail to construct macroeconomic models; they deny the very existence of macroeconomics, just as strict materialists deny the existence of consciousness.

What is so preposterous about the New-Classical/real-business-cycle methodological position is not the belief that the business cycle can somehow be modeled as a purely equilibrium phenomenon, implausible as that idea seems, but the insistence that only micro-founded business-cycle models are methodologically acceptable. It is one thing to believe that ultimately macroeconomics and business-cycle theory will be reduced to the analysis of individual agents and their interactions. But current micro-founded models can’t provide explanations for what many of us think are basic features of macroeconomic and business-cycle phenomena. If non-micro-founded models can provide explanations for those phenomena, even if those explanations are not fully satisfactory, what basis is there for rejecting them just because of a methodological precept that disqualifies all non-micro-founded models?

According to Kevin Hoover, the basis for insisting that only micro-founded macroeconomic models are acceptable, even if the microfoundation consists in a single representative agent optimizing for an entire economy, is eschatological. In other words, because of a belief that economics will eventually develop analytical or computational techniques sufficiently advanced to model an entire economy in terms of individual interacting agents, an analysis based on a single representative agent, as the first step on this theoretical odyssey, is somehow methodologically privileged over alternative models that do not share that destiny. Hoover properly rejects the presumptuous notion that an avowed, but unrealized, theoretical destiny, can provide a privileged methodological status to an explanatory strategy. The reductionist microfoundationalism of New-Classical macroeconomics and real-business-cycle theory, with which New Keynesian economists have formed an alliance of convenience, is truly a faith-based macroeconomics.

The remarkable similarity between the reductionist microfoundational methodology of New-Classical macroeconomics and the reductionist materialist approach to the concept of mind suggests to me that there is also a close analogy between the representative agent and what philosophers of mind call a homunculus. The Cartesian materialist theory of mind maintains that, at some place or places inside the brain, there resides information corresponding to our conscious experience. The question then arises: how does our conscious experience access the latent information inside the brain? And the answer is that there is a homunculus (or little man) that processes the information for us so that we can perceive it through him. For example, the homunculus (see the attached picture of the little guy) views the image cast by light on the retina as if he were watching a movie projected onto a screen.

homunculus

But there is an obvious fallacy, because the follow-up question is: how does our little friend see anything? Well, the answer must be that there’s another, smaller, homunculus inside his brain. You can probably already tell that this argument is going to take us on an infinite regress. So what purports to be an explanation turns out to be just a form of question-begging. Sound familiar? The only difference between the representative agent and the homunculus is that the representative agent begs the question immediately without having to go on an infinite regress.

PS I have been sidetracked by other responsibilities, so I have not been blogging much, if at all, for the last few weeks. I hope to post more frequently, but I am afraid that my posting and replies to comments are likely to remain infrequent for the next couple of months.

Forget the Monetary Base and Just Pay Attention to the Price Level

Kudos to David Beckworth for eliciting a welcome concession or clarification from Paul Krugman that monetary policy is not necessarily ineffectual at the zero lower bound. The clarification is welcome because Krugman and Simon Wren Lewis seemed to be making a big deal about insisting that monetary policy at the zero lower bound is useless if it affects only the current, but not the future, money supply, and touting the discovery as if it were a point that was not already well understood.

Now it’s true that Krugman is entitled to take credit for having come up with an elegant way of showing the difference between a permanent and a temporary increase in the monetary base, but it’s a point that, WADR, was understood even before Krugman. See, for example, the discussion in chapter 5 of Jack Hirshleifer’s textbook on capital theory (published in 1970), Investment, Interest and Capital, showing that the Fisher equation follows straightforwardly in an intertemporal equilibrium model, so that the nominal interest rate can be decomposed into a real component and an expected-inflation component. If holding money is costless, then the nominal rate of interest cannot be negative, and expected deflation cannot exceed the equilibrium real rate of interest. This implies that, at the zero lower bound, the current price level cannot be raised without raising the future price level proportionately. That is all Krugman was saying in asserting that monetary policy is ineffective at the zero lower bound, even though he couched the analysis in terms of the current and future money supplies rather than in terms of the current and future price levels. But the entire argument is implicit in the Fisher equation. And contrary to Krugman, the IS-LM model (with which I am certainly willing to coexist) offers no unique insight into this proposition; it would be remarkable if it did, because the IS-LM model in essence is a static model that has to be re-engineered to be used in an intertemporal setting.

Here is how Hirshleifer concludes his discussion:

The simple two-period model of choice between dated consumptive goods and dated real liquidities has been shown to be sufficiently comprehensive as to display both the quantity theorists’ and the Keynesian theorists’ predicted results consequent upon “changes in the money supply.” The seeming contradiction is resolved by noting that one result or the other follows, or possibly some mixture of the two, depending upon the precise meaning of the phrase “changes in the quantity of money.” More exactly, the result follows from the assumption made about changes in the time-distributed endowments of money and consumption goods.  pp. 150-51

Another passage from Hirshleifer is also worth quoting:

Imagine a financial “panic.” Current money is very scarce relative to future money – and so monetary interest rates are very high. The monetary authorities might then provide an increment [to the money stock] while announcing that an equal aggregate amount of money would be retired at some date thereafter. Such a change making current money relatively more plentiful (or less scarce) than before in comparison with future money, would clearly tend to reduce the monetary rate of interest. (p. 149)

In this passage Hirshleifer accurately describes the objective of Fed policy since the crisis: provide as much liquidity as needed to prevent a panic, but without even trying to generate a substantial increase in aggregate demand by increasing inflation or expected inflation. The refusal to increase aggregate demand was implicit in the Fed’s refusal to increase its inflation target.

However, I do want to make explicit a point of disagreement between me and Hirshleifer, Krugman and Beckworth. The point is more conceptual than analytical, by which I mean that although the analysis of monetary policy can formally be carried out either in terms of current and future money supplies, as Hirshleifer, Krugman and Beckworth do, or in terms of price levels, as I prefer to do so in terms of price levels. For one thing, reasoning in terms of price levels immediately puts you in the framework of the Fisher equation, while thinking in terms of current and future money supplies puts you in the framework of the quantity theory, which I always prefer to avoid.

The problem with the quantity theory framework is that it assumes that quantity of money is a policy variable over which a monetary authority can exercise effective control, a mistake — imprinted in our economic intuition by two or three centuries of quantity-theorizing, regrettably reinforced in the second-half of the twentieth century by the preposterous theoretical detour of monomaniacal Friedmanian Monetarism, as if there were no such thing as an identification problem. Thus, to analyze monetary policy by doing thought experiments that change the quantity of money is likely to mislead or confuse.

I can’t think of an effective monetary policy that was ever implemented by targeting a monetary aggregate. The optimal time path of a monetary aggregate can never be specified in advance, so that trying to target any monetary aggregate will inevitably fail, thereby undermining the credibility of the monetary authority. Effective monetary policies have instead tried to target some nominal price while allowing monetary aggregates to adjust automatically given that price. Sometimes the price being targeted has been the conversion price of money into a real asset, as was the case under the gold standard, or an exchange rate between one currency and another, as the Swiss National Bank is now doing with the franc/euro exchange rate. Monetary policies aimed at stabilizing a single price are easy to implement and can therefore be highly credible, but they are vulnerable to sudden changes with highly deflationary or inflationary implications. Nineteenth century bimetallism was an attempt to avoid or at least mitigate such risks. We now prefer inflation targeting, but we have learned (or at least we should have) from the Fed’s focus on inflation in 2008 that inflation targeting can also lead to disastrous consequences.

I emphasize the distinction between targeting monetary aggregates and targeting the price level, because David Beckworth in his post is so focused on showing 1) that the expansion of the Fed’s balance sheet under QE has been temoprary and 2) that to have been effective in raising aggregate demand at the zero lower bound, the increase in the monetary base needed to be permanent. And I say: both of the facts cited by David are implied by the fact that the Fed did not raise its inflation target or, preferably, replace its inflation target with a sufficiently high price-level target. With a higher inflation target or a suitable price-level target, the monetary base would have taken care of itself.

PS If your name is Scott Sumner, you have my permission to insert “NGDP” wherever “price level” appears in this post.

Hicks on IS-LM and Temporary Equilibrium

Jan, commenting on my recent post about Krugman, Minsky and IS-LM, quoted the penultimate paragraph of J. R. Hicks’s 1980 paper on IS-LM in the Journal of Post-Keynesian Economics, a brand of economics not particularly sympathetic to Hicks’s invention. Hicks explained that in the mid-1930s he had been thinking along lines similar to Keynes’s even before the General Theory was published, and had the basic idea of IS-LM in his mind even before he had read the General Theory, while also acknowledging that his enthusiasm for the IS-LM construct had waned considerably over the years.

Hicks discussed both the similarities and the differences between his model and IS-LM. But as the discussion proceeds, it becomes clear that what he is thinking of as his model is what became his model of temporary equilibrium in Value and Capital. So it really is important to understand what Hicks felt were the similarities as well as the key differences between the temporary- equilibrium model, and the IS-LM model. Here is how Hicks put it:

I recognized immediately, as soon as I read The General Theory, that my model and Keynes’ had some things in common. Both of us fixed our attention on the behavior of an economy during a period—a period that had a past, which nothing that was done during the period could alter, and a future, which during the period was unknown. Expectations of the future would nevertheless affect what happened during the period. Neither of us made any assumption about “rational expectations” ; expectations, in our models, were strictly exogenous.3 (Keynes made much more fuss over that than I did, but there is the same implication in my model also.) Subject to these data— the given equipment carried over from the past, the production possibilities within the period, the preference schedules, and the given expectations— the actual performance of the economy within the period was supposed to be determined, or determinable. It would be determined as an equilibrium performance, with respect to these data.

There was all this in common between my model and Keynes’; it was enough to make me recognize, as soon as I saw The General Theory, that his model was a relation of mine and, as such, one which I could warmly welcome. There were, however, two differences, on which (as we shall see) much depends. The more obvious difference was that mine was a flexprice model, a perfect competition model, in which all prices were flexible, while in Keynes’ the level of money wages (at least) was exogenously determined. So Keynes’ was a model that was consistent with unemployment, while mine, in his terms, was a full employment model. I shall have much to say about this difference, but I may as well note, at the start, that I do not think it matters much. I did not think, even in 1936, that it mattered much. IS-LM was in fact a translation of Keynes’ nonflexprice model into my terms. It seemed to me already that that could be done; but how it is done requires explanation.

The other difference is more fundamental; it concerns the length of the period. Keynes’ (he said) was a “short-period,” a term with connotations derived from Marshall; we shall not go far wrong if we think of it as a year. Mine was an “ultra-short-period” ; I called it a week. Much more can happen in a year than in a week; Keynes has to allow for quite a lot of things to happen. I wanted to avoid so much happening, so that my (flexprice) markets could reflect propensities (and expectations) as they are at a moment. So it was that I made my markets open only on a Monday; what actually happened during the ensuing week was not to affect them. This was a very artificial device, not (I would think now) much to be recommended. But the point of it was to exclude the things which might happen, and must disturb the markets, during a period of finite length; and this, as we shall see, is a very real trouble in Keynes. (pp. 139-40)

Hicks then explained how the specific idea of the IS-LM model came to him as a result of working on a three-good Walrasian system in which the solution could be described in terms of equilibrium in two markets, the third market necessarily being in equilibrium if the other two were in equilibrium. That’s an interesting historical tidbit, but the point that I want to discuss is what I think is Hicks’s failure to fully understand the significance of his own model, whose importance, regrettably, he consistently underestimated in later work (e.g., in Capital and Growth and in this paper).

The point that I want to focus on is in the second paragraph quoted above where Hicks says “mine [i.e. temporary equilibrium] was a flexprice model, a perfect competition model, in which all prices were flexible, while in Keynes’ the level of money wages (at least) was exogenously determined. So Keynes’ was a model that was consistent with unemployment, while mine, in his terms, was a full employment model.” This, it seems to me, is all wrong, because Hicks, is taking a very naïve and misguided view of what perfect competition and flexible prices mean. Those terms are often mistakenly assumed to meant that if prices are simply allowed to adjust freely, all  markets will clear and all resources will be utilized.

I think that is a total misconception, and the significance of the temporary-equilibrium construct is in helping us understand why an economy can operate sub-optimally with idle resources even when there is perfect competition and markets “clear.” What prevents optimality and allows resources to remain idle despite freely adjustming prices and perfect competition is that the expectations held by agents are not consistent. If expectations are not consistent, the plans based on those expectations are not consistent. If plans are not consistent, then how can one expect resources to be used optimally or even at all? Thus, for Hicks to assert, casually without explicit qualification, that his temporary-equilibrium model was a full-employment model, indicates to me that Hicks was unaware of the deeper significance of his own model.

If we take a full equilibrium as our benchmark, and look at how one of the markets in that full equilibrium clears, we can imagine the equilibrium as the intersection of a supply curve and a demand curve, whose positions in the standard price/quantity space depend on the price expectations of suppliers and of demanders. Different, i.e, inconsistent, price expectations would imply shifts in both the demand and supply curves from those corresponding to full intertemporal equilibrium. Overall, the price expectations consistent with a full intertemporal equilibrium will in some sense maximize total output and employment, so when price expectations are inconsistent with full intertemporal equilibrium, the shifts of the demand and supply curves will be such that they will intersect at points corresponding to less output and less employment than would have been the case in full intertemporal equilibrium. In fact, it is possible to imagine that expectations on the supply side and the demand side are so inconsistent that the point of intersection between the demand and supply curves corresponds to an output (and hence employment) that is way less than it would have been in full intertemporal equilibrium. The problem is not that the price in the market doesn’t allow the market to clear. Rather, given the positions of the demand and supply curves, their point of intersection implies a low output, because inconsistent price expectations are such that potentially advantageous trading opportunities are not being recognized.

So for Hicks to assert that his flexprice temporary-equilibrium model was (in Keynes’s terms) a full-employment model without noting the possibility of a significant contraction of output (and employment) in a perfectly competitive flexprice temporary-equilibrium model when there are significant inconsistencies in expectations suggests strongly that Hicks somehow did not fully comprehend what his own creation was all about. His failure to comprehend his own model also explains why he felt the need to abandon the flexprice temporary-equilibrium model in his later work for a fixprice model.

There is, of course, a lot more to be said about all this, and Hicks’s comments concerning the choice of a length of the period are also of interest, but the clear (or so it seems to me) misunderstanding by Hicks of what is entailed by a flexprice temporary equilibrium is an important point to recognize in evaluating both Hicks’s work and his commentary on that work and its relation to Keynes.

Temporary Equilibrium One More Time

It’s always nice to be noticed, especially by Paul Krugman. So I am not upset, but in his response to my previous post, I don’t think that Krugman quite understood what I was trying to convey. I will try to be clearer this time. It will be easiest if I just quote from his post and insert my comments or explanations.

Glasner is right to say that the Hicksian IS-LM analysis comes most directly not out of Keynes but out of Hicks’s own Value and Capital, which introduced the concept of “temporary equilibrium”.

Actually, that’s not what I was trying to say. I wasn’t making any explicit connection between Hicks’s temporary-equilibrium concept from Value and Capital and the IS-LM model that he introduced two years earlier in his paper on Keynes and the Classics. Of course that doesn’t mean that the temporary equilibrium method isn’t connected to the IS-LM model; one would need to do a more in-depth study than I have done of Hicks’s intellectual development to determine how much IS-LM was influenced by Hicks’s interest in intertemporal equilibrium and in the method of temporary equilibrium as a way of analyzing intertemporal issues.

This involves using quasi-static methods to analyze a dynamic economy, not because you don’t realize that it’s dynamic, but simply as a tool. In particular, V&C discussed at some length a temporary equilibrium in a three-sector economy, with goods, bonds, and money; that’s essentially full-employment IS-LM, which becomes the 1937 version with some price stickiness. I wrote about that a long time ago.

Now I do think that it’s fair to say that the IS-LM model was very much in the spirit of Value and Capital, in which Hicks deployed an explicit general-equilibrium model to analyze an economy at a Keynesian level of aggregation: goods, bonds, and money. But the temporary-equilibrium aspect of Value and Capital went beyond the Keynesian analysis, because the temporary equilibrium analysis was explicitly intertemporal, all agents formulating plans based on explicit future price expectations, and the inconsistency between expected prices and actual prices was explicitly noted, while in the General Theory, and in IS-LM, price expectations were kept in the background, making an appearance only in the discussion of the marginal efficiency of capital.

So is IS-LM really Keynesian? I think yes — there is a lot of temporary equilibrium in The General Theory, even if there’s other stuff too. As I wrote in the last post, one key thing that distinguished TGT from earlier business cycle theorizing was precisely that it stopped trying to tell a dynamic story — no more periods, forced saving, boom and bust, instead a focus on how economies can stay depressed. Anyway, does it matter? The real question is whether the method of temporary equilibrium is useful.

That is precisely where I think Krugman’s grasp on the concept of temporary equilibrium is slipping. Temporary equilibrium is indeed about periods, and it is explicitly dynamic. In my previous post I referred to Hicks’s discussion in Capital and Growth, about 25 years after writing Value and Capital, in which he wrote

The Temporary Equilibrium model of Value and Capital, also, is “quasi-static” [like the Keynes theory] – in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes.

As I read this passage now — and it really bothered me when I read it as I was writing my previous post — I realize that what Hicks was saying was that his desire to conform to the Keynesian paradigm led him to compromise the integrity of the temporary equilibrium model, by forcing it to be “quasi-static” when it really was essentially dynamic. The challenge has been to convert a “quasi-static” IS-LM model into something closer to the temporary-equilibrium method that Hicks introduced, but did not fully execute in Value and Capital.

What are the alternatives? One — which took over much of macro — is to do intertemporal equilibrium all the way, with consumers making lifetime consumption plans, prices set with the future rationally expected, and so on. That’s DSGE — and I think Glasner and I agree that this hasn’t worked out too well. In fact, economists who never learned temporary-equiibrium-style modeling have had a strong tendency to reinvent pre-Keynesian fallacies (cough-Say’s Law-cough), because they don’t know how to think out of the forever-equilibrium straitjacket.

Yes, I agree! Rational expectations, full-equilibrium models have turned out to be a regression, not an advance. But the way I would make the point is that the temporary-equilibrium method provides a sort of a middle way to do intertemporal dynamics without presuming that consumption plans and investment plans are always optimal.

What about disequilibrium dynamics all the way? Basically, I have never seen anyone pull this off. Like the forever-equilibrium types, constant-disequilibrium theorists have a remarkable tendency to make elementary conceptual mistakes.

Again, I agree. We can’t work without some sort of equilibrium conditions, but temporary equilibrium provides a way to keep the discipline of equilibrium without assuming (nearly) full optimality.

Still, Glasner says that temporary equilibrium must involve disappointed expectations, and fails to take account of the dynamics that must result as expectations are revised.

Perhaps I was unclear, but I thought I was saying just the opposite. It’s the “quasi-static” IS-LM model, not temporary equilibrium, that fails to take account of the dynamics produced by revised expectations.

I guess I’d say two things. First, I’m not sure that this is always true. Hicks did indeed assume static expectations — the future will be like the present; but in Keynes’s vision of an economy stuck in sustained depression, such static expectations will be more or less right.

Again, I agree. There may be self-fulfilling expectations of a low-income, low-employment equilibrium. But I don’t think that that is the only explanation for such a situation, and certainly not for the downturn that can lead to such an equilibrium.

Second, those of us who use temporary equilibrium often do think in terms of dynamics as expectations adjust. In fact, you could say that the textbook story of how the short-run aggregate supply curve adjusts over time, eventually restoring full employment, is just that kind of thing. It’s not a great story, but it is the kind of dynamics Glasner wants — and it’s Econ 101 stuff.

Again, I agree. It’s not a great story, but, like it or not, the story is not a Keynesian story.

So where does this leave us? I’m not sure, but my impression is that Krugman, in his admiration for the IS-LM model, is trying too hard to identify IS-LM with the temporary-equilibrium approach, which I think represented a major conceptual advance over both the Keynesian model and the IS-LM representation of the Keynesian model. Temporary equilibrium and IS-LM are not necessarily inconsistent, but I mainly wanted to point out that the two aren’t the same, and shouldn’t be conflated.

A New Version of my Paper (with Paul Zimmerman) on the Hayek-Sraffa Debate Is Available on SSRN

One of the good things about having a blog (which I launched July 5, 2011) is that I get comments about what I am writing about from a lot of people that I don’t know. One of my most popular posts – it’s about the sixteenth most visited — was one I wrote, just a couple of months after starting the blog, about the Hayek-Sraffa debate on the natural rate of interest. Unlike many popular posts, to which visitors are initially drawn from very popular blogs that linked to those posts, but don’t continue to drawing a lot of visitors, this post initially had only modest popularity, but still keeps on drawing visitors.

That post also led to a collaboration between me and my FTC colleague Paul Zimmerman on a paper “The Sraffa-Hayek Debate on the Natural Rate of Interest” which I presented two years ago at the History of Economics Society conference. We have now finished our revisions of the version we wrote for the conference, and I have just posted the new version on SSRN and will be submitting it for publication later this week.

Here’s the abstract posted on the SSRN site:

Hayek’s Prices and Production, based on his hugely successful lectures at LSE in 1931, was the first English presentation of Austrian business-cycle theory, and established Hayek as a leading business-cycle theorist. Sraffa’s 1932 review of Prices and Production seems to have been instrumental in turning opinion against Hayek and the Austrian theory. A key element of Sraffa’s attack was that Hayek’s idea of a natural rate of interest, reflecting underlying real relationships, undisturbed by monetary factors, was, even from Hayek’s own perspective, incoherent, because, without money, there is a multiplicity of own rates, none of which can be uniquely identified as the natural rate of interest. Although Hayek’s response failed to counter Sraffa’s argument, Ludwig Lachmann later observed that Keynes’s treatment of own rates in Chapter 17 of the General Theory (itself a generalization of Fisher’s (1896) distinction between the real and nominal rates of interest) undercut Sraffa’s criticism. Own rates, Keynes showed, cannot deviate from each other by more than expected price appreciation plus the cost of storage and the commodity service flow, so that anticipated asset yields are equalized in intertemporal equilibrium. Thus, on Keynes’s analysis in the General Theory, the natural rate of interest is indeed well-defined. However, Keynes’s revision of Sraffa’s own-rate analysis provides only a partial rehabilitation of Hayek’s natural rate. There being no unique price level or rate of inflation in a barter system, no unique money natural rate of interest can be specified. Hayek implicitly was reasoning in terms of a constant nominal value of GDP, but barter relationships cannot identify any path for nominal GDP, let alone a constant one, as uniquely compatible with intertemporal equilibrium.

Aside from clarifying the conceptual basis of the natural-rate analysis and its relationship to Sraffa’s own-rate analysis, the paper also highlights the connection (usually overlooked but mentioned by Harald Hagemann in his 2008 article on the own rate of interest for the International Encyclopedia of the Social Sciences) between the own-rate analysis, in either its Sraffian or Keynesian versions, and Fisher’s early distinction between the real and nominal rates of interest. The conceptual identity between Fisher’s real and nominal distinction and Keynes’s own-rate analysis in the General Theory only magnifies the mystery associated with Keynes’s attack in chapter 13 of the General Theory on Fisher’s distinction between the real and the nominal rates of interest.

I also feel that the following discussion of Hayek’s role in developing the concept of intertemporal equilibrium, though tangential to the main topic of the paper, makes an important point about how to think about intertemporal equilibrium.

Perhaps the key analytical concept developed by Hayek in his early work on monetary theory and business cycles was the idea of an intertemporal equilibrium. Before Hayek, the idea of equilibrium had been reserved for a static, unchanging, state in which economic agents continue doing what they have been doing. Equilibrium is the end state in which all adjustments to a set of initial conditions have been fully worked out. Hayek attempted to generalize this narrow equilibrium concept to make it applicable to the study of economic fluctuations – business cycles – in which he was engaged. Hayek chose to formulate a generalized equilibrium concept. He did not do so, as many have done, by simply adding a steady-state rate of growth to factor supplies and technology. Nor did Hayek define equilibrium in terms of any objective or measurable magnitudes. Rather, Hayek defined equilibrium as the mutual consistency of the independent plans of individual economic agents.

The potential consistency of such plans may be conceived of even if economic magnitudes do not remain constant or grow at a constant rate. Even if the magnitudes fluctuate, equilibrium is conceivable if the fluctuations are correctly foreseen. Correct foresight is not the same as perfect foresight. Perfect foresight is necessarily correct; correct foresight is only contingently correct. All that is necessary for equilibrium is that fluctuations (as reflected in future prices) be foreseen. It is not even necessary, as Hayek (1937) pointed out, that future price changes be foreseen correctly, provided that individual agents agree in their anticipations of future prices. If all agents agree in their expectations of future prices, then the individual plans formulated on the basis of those anticipations are, at least momentarily, equilibrium plans, conditional on the realization of those expectations, because the realization of those expectations would allow the plans formulated on the basis of those expectations to be executed without need for revision. What is required for intertemporal equilibrium is therefore a contingently correct anticipation by future agents of future prices, a contingent anticipation not the result of perfect foresight, but of contingently, even fortuitously, correct foresight. The seminal statement of this concept was given by Hayek in his classic 1937 paper, and the idea was restated by J. R. Hicks (1939), with no mention of Hayek, two years later in Value and Capital.

I made the following comment in a footnote to the penultimate sentence of the quotation:

By defining correct foresight as a contingent outcome rather than as an essential property of economic agents, Hayek elegantly avoided the problems that confounded Oskar Morgenstern ([1935] 1976) in his discussion of the meaning of equilibrium.

I look forward to reading your comments.


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.

Archives

Enter your email address to follow this blog and receive notifications of new posts by email.

Join 2,567 other followers

Follow Uneasy Money on WordPress.com