Archive for the 'J. R. Hicks' Category

Axel Leijonhufvud and Modern Macroeconomics

Published June 20, 2022 Alchian , Axel Leijonfuvud , common knowledge , coordination failure , Earl Thompson , Hayek , IS-LM , J. R. Hicks , Keynes , microfoundations , Milton Friedman , neoclassical synthesis , New Classical macroeconomics , New Keynesians , rational expectations , rational expectations equilibrium , Robert Clower , Robert Lucas , search theories , sticky prices , sticky wages , tatonnement , temporary equilibrium , Thomas Sargent , Walrasian equilibrium 10 Comments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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.

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.

Hayek and Temporary Equilibrium

Published June 11, 2017 Axel Leijonfuvud , C. J. Bliss , expectations , general equilibrium , Hayek , incomplete markets , intertemporal equilibrium , J. R. Hicks , temporary equilibrium , Uncategorized 8 Comments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Hayek and Intertemporal Equilibrium

Published May 21, 2017 Arrow-Debrew-McKenzie model , C. J. Bliss , comparative statics , Erik Lindahl , general equilibrium , Hayek , intertemporal equilibrium , J. R. Hicks , John Muth , macroeconomics , Roy Radner , Samuelson , Say's Law , temporary equilibrium , Walrasian equilibrium 18 Comments
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I am starting to write a paper on Hayek and intertemporal equilibrium, and as I write it over the next couple of weeks, I am going to post sections of it on this blog. Comments from readers will be even more welcome than usual, and I will do my utmost to reply to comments, a goal that, I am sorry to say, I have not been living up to in my recent posts.

The idea of equilibrium is an essential concept in economics. It is an essential concept in other sciences as well, its meaning in economics is not the same as in other disciplines. The concept having originally been borrowed from physics, the meaning originally attached to it by economists corresponded to the notion of a system at rest, and it took a long time for economists to see that viewing an economy as a system at rest was not the only, or even the most useful, way of applying the equilibrium concept to economic phenomena.

What would it mean for an economic system to be at rest? The obvious answer was to say that prices and quantities would not change. If supply equals demand in every market, and if there no exogenous change introduced into the system, e.g., in population, technology, tastes, etc., it would seem that would be no reason for the prices paid and quantities produced to change in that system. But that view of an economic system was a very restrictive one, because such a large share of economic activity – savings and investment — is predicated on the assumption and expectation of change.

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, but that was the view of equilibrium that originally took hold in economics. The idea of a stationary timeless equilibrium can be traced back to the classical economists, especially Ricardo and Mill who wrote about the long-run tendency of an economic system toward a stationary state. But it was the introduction by Jevons, Menger, Walras and their followers of the idea of optimizing decisions by rational consumers and producers that provided the key insight for a more robust and fruitful version of the equilibrium concept.

If each economic agent (household or business firm) is viewed as making optimal choices based on some scale of preferences subject to limitations or constraints imposed by their capacities, endowments, technology and the legal system, then the equilibrium of an economy must describe a state in which each agent, given his own subjective ranking of the feasible alternatives, is making a optimal decision, and those optimal decisions are consistent with those of all other agents. The optimal decisions of each agent must simultaneously be optimal from the point of view of that agent while also 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.

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 not be articulated until a concept of optimality had been defined. That concept was utility maximization and it was further extended to include the ideas of cost minimization and profit maximization. Once the idea of an optimal plan was worked out, the necessary conditions for the mutual consistency of optimal plans could be articulated as the necessary conditions for a general economic equilibrium. Once equilibrium was defined as the consistency of optimal plans, the path was clear to define an intertemporal equilibrium as the consistency of optimal plans extending over time. Because current goods and services and otherwise identical goods and services in the future could be treated as economically distinct goods and services, defining the conditions for an intertemporal equilibrium was formally almost equivalent to defining the conditions for a static, stationary equilibrium. Just as the conditions for a static equilibrium could be stated in terms of equalities between marginal rates of substitution of goods in consumption and in production to their corresponding price ratios, an intertemporal equilibrium could be stated in terms of equalities between the marginal rates of intertemporal substitution in consumption and in production and their corresponding intertemporal price ratios.

The only formal adjustment required in the necessary conditions for static equilibrium to be extended to intertemporal equilibrium was to recognize that, inasmuch as future prices (typically) are unobservable, and hence unknown to economic agents, the intertemporal price ratios cannot be ratios between actual current prices and actual future prices, but, instead, ratios between current prices and expected future prices. From this it followed that for optimal plans to be mutually consistent, all economic agents must have the same expectations of the future prices in terms of which their plans were optimized.

The concept of an intertemporal equilibrium was first presented in English by F. A. Hayek in his 1937 article “Economics and Knowledge.” But it was through J. R. Hicks’s Value and Capital published two years later in 1939 that the concept became more widely known and understood. In explaining and applying the concept of intertemporal equilibrium and introducing the derivative concept of a temporary equilibrium in which current markets clear, but individual expectations of future prices are not the same, Hicks did not claim originality, but instead of crediting Hayek for the concept, or even mentioning Hayek’s 1937 paper, Hicks credited the Swedish economist Erik Lindahl, who had published articles in the early 1930s in which he had articulated the concept. But although Lindahl had published his important work on intertemporal equilibrium before Hayek’s 1937 article, Hayek had already explained the concept in a 1928 article “Das intertemporale Gleichgewichtasystem der Priese und die Bewegungen des ‘Geltwertes.'” (English translation: “Intertemporal price equilibrium and movements in the value of money.“)

Having been a junior colleague of Hayek’s in the early 1930s when Hayek arrived at the London School of Economics, and having come very much under Hayek’s influence for a few years before moving in a different theoretical direction in the mid-1930s, Hicks was certainly aware of Hayek’s work on intertemporal equilibrium, so it has long been a puzzle to me why Hicks did not credit Hayek along with Lindahl for having developed the concept of intertemporal equilibrium. It might be worth pursuing that question, but I mention it now only as an aside, in the hope that someone else might find it interesting and worthwhile to try to find a solution to that puzzle. As a further aside, I will mention that Murray Milgate in a 1979 article “On the Origin of the Notion of ‘Intertemporal Equilibrium’” has previously tried to redress the failure to credit Hayek’s role in introducing the concept of intertemporal equilibrium into economic theory.

What I am going to discuss in here and in future posts are three distinct ways in which the concept of intertemporal equilibrium has been developed since Hayek’s early work – his 1928 and 1937 articles but also his 1941 discussion of intertemporal equilibrium in The Pure Theory of Capital. Of course, the best known development of the concept of intertemporal equilibrium is the Arrow-Debreu-McKenzie (ADM) general-equilibrium model. But although it can be thought of as a model of intertemporal equilibrium, the ADM model is set up in such a way that all economic decisions are taken before the clock even starts ticking; the transactions that are executed once the clock does start simply follow a pre-determined script. In the ADM model, the passage of time is a triviality, merely a way of recording the sequential order of the predetermined production and consumption activities. This feat is accomplished by assuming that all agents are present at time zero with their property endowments in hand and capable of transacting – but conditional on the determination of an equilibrium price vector that allows all optimal plans to be simultaneously executed over the entire duration of the model — in a complete set of markets (including state-contingent markets covering the entire range of contingent events that will unfold in the course of time whose outcomes could affect the wealth or well-being of any agent with the probabilities associated with every contingent event known in advance).

Just as identical goods in different physical locations or different time periods can be distinguished as different commodities that cn be purchased at different prices for delivery at specific times and places, identical goods can be distinguished under different states of the world (ice cream on July 4, 2017 in Washington DC at 2pm only if the temperature is greater than 90 degrees). Given the complete set of state-contingent markets and the known probabilities of the contingent events, an equilibrium price vector for the complete set of markets would give rise to optimal trades reallocating the risks associated with future contingent events and to an optimal allocation of resources over time. Although the ADM model is an intertemporal model only in a limited sense, it does provide an ideal benchmark describing the characteristics of a set of mutually consistent optimal plans.

The seminal work of Roy Radner in relaxing some of the extreme assumptions of the ADM model puts Hayek’s contribution to the understanding of the necessary conditions for an intertemporal equilibrium into proper perspective. At an informal level, Hayek was addressing the same kinds of problems that Radner analyzed with far more powerful analytical tools than were available to Hayek. But the were both concerned with a common problem: under what conditions could an economy with an incomplete set of markets be said to be in a state of intertemporal equilibrium? In an economy lacking the full set of forward and state contingent markets describing the ADM model, intertemporal equilibrium cannot predetermined before trading even begins, but must, if such an equilibrium obtains, unfold through the passage of time. Outcomes might be expected, but they would not be predetermined in advance. Echoing Hayek, though to my knowledge he does not refer to Hayek in his work, Radner describes his intertemporal equilibrium under uncertainty as an equilibrium of plans, prices, and price expectations. Even if it exists, the Radner equilibrium is not the same as the ADM equilibrium, because without a full set of markets, agents can’t fully hedge against, or insure, all the risks to which they are exposed. The distinction between ex ante and ex post is not eliminated in the Radner equilibrium, though it is eliminated in the ADM equilibrium.

Additionally, because all trades in the ADM model have been executed before “time” begins, it seems impossible to rationalize holding any asset whose only use is to serve as a medium of exchange. In his early writings on business cycles, e.g., Monetary Theory and the Trade Cycle, Hayek questioned whether it would be possible to rationalize the holding of money in the context of a model of full equilibrium, suggesting that monetary exchange, by severing the link between aggregate supply and aggregate demand characteristic of a barter economy as described by Say’s Law, was the source of systematic deviations from the intertemporal equilibrium corresponding to the solution of a system of Walrasian equations. Hayek suggested that progress in analyzing economic fluctuations would be possible only if the Walrasian equilibrium method could be somehow be extended to accommodate the existence of money, uncertainty, and other characteristics of the real world while maintaining the analytical discipline imposed by the equilibrium method and the optimization principle. It proved to be a task requiring resources that were beyond those at Hayek’s, or probably anyone else’s, disposal at the time. But it would be wrong to fault Hayek for having had to insight to perceive and frame a problem that was beyond his capacity to solve. What he may be criticized for is mistakenly believing that he he had in fact grasped the general outlines of a solution when in fact he had only perceived some aspects of the solution and offering seriously inappropriate policy recommendations based on that seriously incomplete understanding.

In Value and Capital, Hicks also expressed doubts whether it would be possible to analyze the economic fluctuations characterizing the business cycle using a model of pure intertemporal equilibrium. He proposed an alternative approach for analyzing fluctuations which he called the method of temporary equilibrium. The essence of the temporary-equilibrium method is to analyze the behavior of an economy under the assumption that all markets for current delivery clear (in some not entirely clear sense of the term “clear”) while understanding that demand and supply in current markets depend not only on current prices but also upon expected future prices, and that the failure of current prices to equal what they had been expected to be is a potential cause for the plans that economic agents are trying to execute to be modified and possibly abandoned. In the Pure Theory of Capital, Hayek discussed Hicks’s temporary-equilibrium method a possible method of achieving the modification in the Walrasian method that he himself had proposed in Monetary Theory and the Trade Cycle. But after a brief critical discussion of the method, he dismissed it for reasons that remain obscure. Hayek’s rejection of the temporary-equilibrium method seems in retrospect to have been one of Hayek’s worst theoretical — or perhaps, meta-theoretical — blunders.

Decades later, C. J. Bliss developed the concept of temporary equilibrium to show that temporary equilibrium method can rationalize both holding an asset purely for its services as a medium of exchange and the existence of financial intermediaries (private banks) that supply financial assets held exclusively to serve as a medium of exchange. In such a temporary-equilibrium model with financial intermediaries, it seems possible to model not only the existence of private suppliers of a medium of exchange, but also the conditions – in a very general sense — under which the system of financial intermediaries breaks down. The key variable of course is vectors of expected prices subject to which the plans of individual households, business firms, and financial intermediaries are optimized. The critical point that emerges from Bliss’s analysis is that there are sets of expected prices, which if held by agents, are inconsistent with the existence of even a temporary equilibrium. Thus price flexibility in current market cannot, in principle, result in even a temporary equilibrium, because there is no price vector of current price in markets for present delivery that solves the temporary-equilibrium system. Even perfect price flexibility doesn’t lead to equilibrium if the equilibrium does not exist. And the equilibrium cannot exist if price expectations are in some sense “too far out of whack.”

Expected prices are thus, necessarily, equilibrating variables. But there is no economic mechanism that tends to cause the adjustment of expected prices so that they are consistent with the existence of even a temporary equilibrium, much less a full equilibrium.

Unfortunately, modern macroeconomics continues to neglect the temporary-equilibrium method; instead macroeconomists have for the most part insisted on the adoption of the rational-expectations hypothesis, a hypothesis that elevates question-begging to the status of a fundamental axiom of rationality. The crucial error in the rational-expectations hypothesis was to misunderstand the role of the comparative-statics method developed by Samuelson in The Foundations of Economic Analysis. The role of the comparative-statics method is to isolate the pure theoretical effect of a parameter change under a ceteris-paribus assumption. Such an effect could be derived only by comparing two equilibria under the assumption of a locally unique and stable equilibrium before and after the parameter change. But the method of comparative statics is completely inappropriate to most macroeconomic problems which are precisely concerned with the failure of the economy to achieve, or even to approximate, the unique and stable equilibrium state posited by the comparative-statics method.

Moreover, the original empirical application of the rational-expectations hypothesis by Muth was in the context of the behavior of a single market in which the market was dominated by well-informed specialists who could be presumed to have well-founded expectations of future prices conditional on a relatively stable economic environment. Under conditions of macroeconomic instability, there is good reason to doubt that the accumulated knowledge and experience of market participants would enable agents to form accurate expectations of the future course of prices even in those markets about which they expert knowledge. Insofar as the rational expectations hypothesis has any claim to empirical relevance it is only in the context of stable market situations that can be assumed to be already operating in the neighborhood of an equilibrium. For the kinds of problems that macroeconomists are really trying to answer that assumption is neither relevant nor appropriate.

Roger Farmer’s Prosperity for All

Published February 24, 2017 Arrow-Debrew-McKenzie model , J. R. Hicks , New Keynesians , Roger Farmer , Roy Radner , temporary equilibrium , Uncategorized 25 Comments

I have just read a review copy of Roger Farmer’s new book Prosperity for All, which distills many of Roger’s very interesting ideas into a form which, though readable, is still challenging — at least, it was for me. There is a lot that I like and agree with in Roger’s book, and the fact that he is a UCLA economist, though he came to UCLA after my departure, is certainly a point in his favor. So I will begin by mentioning some of the things that I really liked about Roger’s book.

What I like most is that he recognizes that beliefs are fundamental, which is almost exactly what I meant when I wrote this post (“Expectations Are Fundamental”) five years ago. The point I wanted to make is that the idea that there is some fundamental existential reality that economic agents try — and, if they are rational, will — perceive is a gross and misleading oversimplification, because expectations themselves are part of reality. In a world in which expectations are fundamental, the Keynesian beauty-contest theory of expectations and stock prices (described in chapter 12 of The General Theory) is not absurd as it is widely considered to be believers in the efficient market hypothesis. The almost universal unprofitability of simple trading rules or algorithms is not inconsistent with a market process in which the causality between prices and expectations goes in both directions, in which case anticipating expectations is no less rational than anticipating future cash flows.

One of the treats of reading this book is Farmer’s recollections of his time as a graduate student at Penn in the early 1980s when David Cass, Karl Shell, and Costas Azariadis were developing their theory of sunspot equilibrium in which expectations are self-fulfilling, an idea skillfully deployed by Roger to revise the basic New Keynesian model and re-orient it along a very different path from the standard New Keynesian one. I am sympathetic to that reorientation, and the main reason for that re-orientation is that Roger rejects the idea that there is a unique equilibrium to which the economy automatically reverts, albeit somewhat more slowly than if speeded along by the appropriate monetary policy, on its own. The notion that there is a unique equilibrium to which the economy automatically reverts is an assumption with no basis in theory or experience. The most that the natural-rate hypothesis can tell us is that if an economy is operating at its natural rate of unemployment, monetary expansion cannot permanently reduce the rate of unemployment below that natural rate. Eventually — once economic agents come to expect that the monetary expansion and the correspondingly higher rate of inflation will be maintained indefinitely — the unemployment rate must revert to the natural rate. But the natural-rate hypothesis does not tell us that monetary expansion cannot reduce unemployment when the actual unemployment rate exceeds the natural rate, although it is often misinterpreted as making that assertion.

In his book, Roger takes the anti-natural-rate argument a step further, asserting that the natural rate of unemployment rate is not unique. There is actually a range of unemployment rates at which the economy can permanently remain; which of those alternative natural rates the economy winds up at depends on the expectations held by the public about nominal future income. The higher expected future income, the greater consumption spending and, consequently, the greater employment. Things are a bit more complicated than I have just described them, because Roger also believes that consumption depends not on current income but on wealth. However, in the very simplified model with which Roger operates, wealth depends on expectations about future income. The more optimistic people are about their income-earning opportunities, the higher asset values; the higher asset values, the wealthier the public, and the greater consumption spending. The relationship between current income and expected future income is what Roger calls the belief function.

Thus, Roger juxtaposes a simple New Keynesian model against his own monetary model. The New Keynesian model consists of 1) an investment equals saving equilibrium condition (IS curve) describing the optimal consumption/savings decision of the representative individual as a locus of combinations of expected real interest rates and real income, based on the assumed rate of time preference of the representative individual, expected future income, and expected future inflation; 2) a Taylor rule describing how the monetary authority sets its nominal interest rate as a function of inflation and the output gap and its target (natural) nominal interest rate; 3) a short-run Phillips Curve that expresses actual inflation as a function of expected future inflation and the output gap. The three basic equations allow three endogenous variables, inflation, real income and the nominal rate of interest to be determined. The IS curve represents equilibrium combinations of real income and real interest rates; the Taylor rule determines a nominal interest rate; given the nominal rate determined by the Taylor rule, the IS curve can be redrawn to represent equilibrium combinations of real income and inflation. The intersection of the redrawn IS curve with the Phillips curve determines the inflation rate and real income.

Roger doesn’t like the New Keynesian model because he rejects the notion of a unique equilibrium with a unique natural rate of unemployment, a notion that I have argued is theoretically unfounded. Roger dismisses the natural-rate hypothesis on empirical grounds, the frequent observations of persistently high rates of unemployment being inconsistent with the idea that there are economic forces causing unemployment to revert back to the natural rate. Two responses to this empirical anomaly are possible: 1) the natural rate of unemployment is unstable, so that the observed persistence of high unemployment reflect increases in the underlying but unobservable natural rate of unemployment; 2) the adverse economic shocks that produce high unemployment are persistent, with unemployment returning to a natural level only after the adverse shocks have ceased. In the absence of independent empirical tests of the hypothesis that the natural rate of unemployment has changed, or of the hypothesis that adverse shocks causing unemployment to rise above the natural rate are persistent, neither of these responses is plausible, much less persuasive.

So Roger recasts the basic New Keynesian model in a very different form. While maintaining the Taylor Rule, he rewrites the IS curve so that it describes a relationship between the nominal interest rate and the expected growth of nominal income given the assumed rate of time preference, and in place of the Phillips Curve, he substitutes his belief function, which says that the expected growth of nominal income in the next period equals the current rate of growth. The IS curve and the Taylor Rule provide two steady state equations in three variables, nominal income growth, nominal interest rate and inflation, so that the rate of inflation is left undetermined. Once the belief function specifies the expected rate of growth of nominal income, the nominal interest rate consistent with expected nominal-income growth is determined. Since the belief function tells us only that the expected nominal-income growth equals the current rate of nominal-income growth, any change in nominal-income growth persists into the next period.

At any rate, Roger’s policy proposal is not to change the interest-rate rule followed by the monetary authority, but to propose a rule whereby the monetary authority influences the public’s expectations of nominal-income growth. The greater expected nominal-income growth, the greater wealth, and the greater consumption expenditures. The greater consumption expenditures, the greater income and employment. Expectations are self-fulfilling. Roger therefore advocates a policy by which the government buys and sells a stock-market index fund in order to keep overall wealth at a level that will generate enough consumption expenditures to support maximum sustainable employment.

This is a quick summary of some of the main substantive arguments that Roger makes in his book, and I hope that I have not misrepresented them too badly. As I have already said, I very much sympathize with his criticism of the New Keynesian model, and I agree with nearly all of his criticisms. I also agree wholeheartedly with his emphasis on the importance of expectations and on self-fulfilling character of expectations. Nevertheless, I have to admit that I have trouble taking Roger’s own monetary model and his policy proposal for stabilizing a broad index of equity prices over time seriously. And the reason I am so skeptical about Roger’s model and his policy recommendation is that his model, which does after all bear at least a family resemblance to the simple New Keynesian model, strikes me as being far too simplified to be credible as a representation of a real-world economy. His model, like the New Keynesian model, is an intertemporal model with neither money nor real capital, and the idea that there is an interest rate in such model is, though theoretically defensible, not very plausible. There may be a sequence of periods in such a model in which some form of intertemporal exchange takes place, but without explicitly introducing at least one good that is carried over from period to period, the extent of intertemporal trading is limited and devoid of the arbitrage constraints inherent in a system in which real assets are held from one period to the next.

So I am very skeptical about any macroeconomic model with no market for real assets so that the interest rate interacts with asset values and expected future prices in such a way that the existing stock of durable assets is willingly held over time. The simple New Keynesian model in which there is no money and no durable assets, but simply bonds whose existence is difficult to rationalize in the absence of money or durable assets, does not strike me as a sound foundation for making macroeconomic policy. An interest rate may exist in such a model, but such a model strikes me as woefully inadequate for macroeconomic policy analysis. And although Roger has certainly offered some interesting improvements on the simple New Keynesian model, I would not be willing to rely on Roger’s monetary model for the sweeping policy and institutional recommendations that he proposes, especially his proposal for stabilizing the long-run growth path of a broad index of stock prices.

This is an important point, so I will try to restate it within a wider context. Modern macroeconomics, of which Roger’s model is one of the more interesting examples, flatters itself by claiming to be grounded in the secure microfoundations of the Arrow-Debreu-McKenzie general equilibrium model. But the great achievement of the ADM model was to show the logical possibility of an equilibrium of the independently formulated, optimizing plans of an unlimited number of economic agents producing and trading an unlimited number of commodities over an unlimited number of time periods.

To prove the mutual consistency of such a decentralized decision-making process coordinated by a system of equilibrium prices was a remarkable intellectual achievement. Modern macroeconomics deceptively trades on the prestige of this achievement in claiming to be founded on the ADM general-equilibrium model; the claim is at best misleading, because modern macroeconomics collapses the multiplicity of goods, services, and assets into a single non-durable commodity, so that the only relevant plan the agents in the modern macromodel are called upon to make is a decision about how much to spend in the current period given a shared utility function and a shared production technology for the single output. In the process, all the hard work performed by the ADM general-equilibrium model in explaining how a system of competitive prices could achieve an equilibrium of the complex independent — but interdependent — intertemporal plans of a multitude of decision-makers is effectively discarded and disregarded.

This approach to macroeconomics is not microfounded, but its opposite. The approach relies on the assumption that all but a very small set of microeconomic issues are irrelevant to macroeconomics. Now it is legitimate for macroeconomics to disregard many microeconomic issues, but the assumption that there is continuous microeconomic coordination, apart from the handful of potential imperfections on which modern macroeconomics chooses to focus is not legitimate. In particular, to collapse the entire economy into a single output, implies that all the separate markets encompassed by an actual economy are in equilibrium and that the equilibrium is maintained over time. For that equilibrium to be maintained over time, agents must formulate correct expectations of all the individual relative prices that prevail in those markets over time. The ADM model sidestepped that expectational problem by assuming that a full set of current and forward markets exists in the initial period and that all the agents participating in the economy are present and endowed with wealth enabling them to trade in the initial period. Under those rather demanding assumptions, if an equilibrium price vector covering all current and future markets is arrived at, the optimizing agents will formulate a set of mutually consistent optimal plans conditional on that vector of equilibrium prices so that all the optimal plans can and will be carried out as time happily unfolds for as long as the agents continue in their blissful existence.

However, without a complete set of current and forward markets, achieving the full equilibrium of the ADM model requires that agents formulate consistent expectations of the future prices that will be realized only over the course of time not in the initial period. Roy Radner, who extended the ADM model to accommodate the case of incomplete markets, called such a sequential equilibrium, an equilibrium of plans, prices and expectations. The sequential equilibrium described by Radner has the property that expectations are rational, but the assumption of rational expectations for all future prices over a sequence of future time periods is so unbelievably outlandish as an approximation to reality — sort of like the assumption that it could be 76 degrees fahrenheit in Washington DC in February — that to build that assumption into a macroeconomic model is an absurdity of mind-boggling proportions. But that is precisely what modern macroeconomics, in both its Real Business Cycle and New Keynesian incarnations, has done.

If instead of the sequential equilibrium of plans, prices and expectations, one tries to model an economy in which the price expectations of agents can be inconsistent, while prices adjust within any period to clear markets – the method of temporary equilibrium first described by Hicks in Value and Capital – one can begin to develop a richer conception of how a macroeconomic system can be subject to the financial disturbances, and financial crises to which modern macroeconomies are occasionally, if not routinely, vulnerable. But that would require a reorientation, if not a repudiation, of the path on which macroeconomics has been resolutely marching for nigh on forty years. In his 1984 paper “Consistent Temporary Equilibrium,” published in a volume edited by J. P. Fitoussi, C. J. Bliss made a start on developing such a macroeconomic theory.

There are few economists better equipped than Roger Farmer to lead macroeconomics onto a new and more productive path. He has not done so in this book, but I am hoping that, in his next one, he will.

Price Stickiness and Macroeconomics

Published April 17, 2015 expectations , Franklin Fisher , general equilibrium , Hayek , J. R. Hicks , macroeconomics , microfoundations , Noah Smith , rational expectations , Stephen Williamson 29 Comments
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Noah Smith has a classically snide rejoinder to Stephen Williamson’s outrage at Noah’s Bloomberg paean to price stickiness and to the classic Ball and Maniw article on the subject, an article that provoked an embarrassingly outraged response from Robert Lucas when published over 20 years ago. I don’t know if Lucas ever got over it, but evidently Williamson hasn’t.

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

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

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

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

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

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

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

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

Hicks on IS-LM and Temporary Equilibrium

Published October 14, 2014 expectations , general equilibrium , intertemporal equilibrium , IS-LM , J. R. Hicks , Keynes , temporary equilibrium , wage stickiness , Walrasian equilibrium 9 Comments
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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

Published September 23, 2014 expectations , intertemporal equilibrium , IS-LM , J. R. Hicks , Paul Krugman , rational expectations , temporary equilibrium 2 Comments
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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.

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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