Archive for the 'Keynes' Category

Mattei Misjudges Hawtrey

Published December 25, 2023 1920-21 Depression , Clara Mattei , gold standard , gold-exchange standard , Great Depression , Keynes , R. G. Hawtrey , World War I 1 Comment

Clara Mattei, associate professor of economics at the New School for Social Research, recently published a book, The Capital Order: How Economists Invented Austerity and Paved the Way to Fascism, (University of Chicago Press) in which she argues that the fiscal and monetary austerity imposed on Great Britain after World War I to restore the gold standard at the prewar parity of pound to the dollar provided a model for austerity policies imposed by Mussolini in Italy when he took control of the Italian state in the early 1920s. In making her argument, Mattei identifies Hawtrey, Director of Financial Enquiries in the British Treasury for the entire interwar period, as the eminence grise behind the austerity policies implemented by the Treasury and the Bank of England to restore convertibility at the prewar parity.

Mattei’s ideological position is obviously left of center, and her attempt to link British austerity policies during the 1920s with the rise of fascism in Italy furthers her ideological agenda. Although that agenda is not mine, my only interest here is to examine her claim that Hawtrey was the intellectual architect of the austerity policies she deplores. I leave it to others to assess her broader historical claims.

In her introductory chapter, Mattei (p. 10) justifies her attention to Hawtrey, by claiming that his “texts and memoranda . . . would serve as the guidelines for British austerity after World War I,” describing the Treasury officials Sir Basil Blackett and Sir Otto Niemeyer, under whom Hawtrey served, as “working at his side,” as if they were Hawtrey’s subordinates rather than the other way around. At the end of the chapter, Mattei (p. 20) writes: “I was riveted by the evidence of Hawtrey’s persuasion of the other two bureaucrats, and in turn how the two bureaucrats, neither one a trained economist, came to be missionaries in campaigns to export the British austerity agenda to other countries around the globe.” In a later passage (p. 171), she elaborates:

In the face of unrelenting opposition, Niemeyer and Blackett needed solid intellectual grounds to urge the chancellor of the exchequer to move for dear money and drastic cuts in public expenditures. In examining the controllers’ confidential Treasury files—virtually the only direct source of information we have about their economic beliefs—one is struck by the ubiquity and influence of the economist Ralph G. Hawtrey, the primary source of economic knowledge for Blackett and especially for Niemeyer. In fact, there is ample evidence that Hawtreyan economics refined and strengthened the economic stance of the senior Treasury officials, so as to enable the emergence of a full-blown austerity doctrine.

Given her emphasis on the documentary record left by Hawtrey during his nearly three decades as the in-house economist at the Treasury, I would have expected to see more than just the few direct quotations and citations from the voluminous internal memos written by Hawtrey to his Treasury colleagues to which Mattei makes general reference. The references to Hawtrey’s communications with his colleagues provide few specifics, while the more numerous citations to his writings seem to misinterpret, misrepresent or mischaracterize Hawtrey’s theoretical and policy views.

It should also be noted that Mattei’s estimation of Hawtrey’s influence at the Treasury is not shared by other researchers into Hawtrey’s life and career. R. D. C. Black, who wrote an admiring biographical essay on Hawtrey for the British Academy of which Hawtrey became a member in 1935, wrote dismissively of Hawtrey’s influence at the Treasury.

Hawtrey drew up many and varied reports and memoranda on economic and financial matters which are now to be found among the papers of senior Treasury officials of that period, but the impression prevails that they did not receive much attention, and that the Financial Enquiries Branch under Hawtrey was something of a backwater.

R. D. C. Black, “Ralph George Hawtrey, 1879-1975.” In Proceedings of the British Academy, 1977, p. 379.

Susan Howson, in her biographical essay on Hawtrey, believed that Hawtrey was influential eary in his tenure as Director of Financial Enquiries, primarily because of his important role in drafting the financial resolutions for the Genoa Conference of 1922, about which more will be said below, but that his influence declined subsequently. Mattei cites both Black and Howson in her book, but does not engage with their assesment of Hawtrey’s influence at Treasury. Mattei also cites the unpublished doctoral dissertation of Alan Gaukroger on Hawtrey, which focuses specifically on his service as Director of Financial Enquiries at the Treasury, but does not engage with his detailed assement, based on exhaustive reading of relevant Treasury memoranda, of Hawtrey’s influence on his Treasury colleagues and superiors. Here is how Gaukroger characterizes those memoranda:

In the case of Hawtrey, who was to some extent an outsider to the very small and closely knit group of influential policy makers, the written memorandum was his method of attempting to break into, and influence, the powerful central group. . . .

Many of Hawtrey’s memoranda were unsolicited. He produced them because he was critical of some spect of Government policy. In some of these memoranda there is a marked tone of anger. This was particularly apparent during the late 1920s when the United Kingdom had returned to the Gold
Standard and Hawtrey believed that the Bank of England was pursuing a foolish and unnecessarily high interest rate policy. At this time, his memoranda, critical of Bank or even Treasury policy, could, for such a mild-mannered man, be quite savage in tone. Often, his memoranda were produced as a result of a specific request. On a very small number of occasions they were produced as a result of a direct request for guidance, or information, from the Chancellor of the Exchequer. At other times Hawtrey prepared a memorandum as a result of a Parliamentary Question. Often a senior colleague wanted support in reparing a memorandum and would seek to use Hawtrey’s expertise, particularly with regard to currency and foreign exchange. Hawtrey would invariably write an unsolicited memorandum after press criticism of Treasury Policy.

A. Gaukroger, “The Director of Financial Enquiries.” Ph.D. Thesis. University of Huddersfield, 2008, pp. 29-32

In criticizing the austerity doctrines and policies of the British Treasury and the Bank of England in the decade after World War I, Mattei mounts a comprehensive attack on Hawtrey’s views (or what she inaccurately represents to be his views) to which she, unlike other researchers, ascribes immense influence. She begins with the decision to restore the gold standard and the subsequent deflationary policy adopted in the1920-22 period to reverse the wartime and postwar inflations, and subsequently to restore the gold standard at the prewar parity of the pound to the dollar ($4.86). Mattei’s overestimation of Hawtrey’s influence is evidenced by her failure even to mention the 1918 interim report of the Cunliffe Commission (headed by the former Governor of the Bank of England Lord Cunliffe) recommending the prompt restoration of the gold standard in as close a form as possible to the prewar gold standard. Although no precise parity was specified, the goal of minimizing the departure from the prewar gold standard (except for not reintroducing a full-bodied gold coinage) made the prewar parity to the dollar, restored in 1919 to its prewar gold parity of $20.67/ounce, the obvious benchmark for restoration.

Her next object of criticism is Hawtrey’s advocacy of deflation in his 1919 article “The Gold Standard,” to reverse, if only partially, the inflation during and after the war that had cut the purchasing power of the pound by roughly 60%. The inflation, especially the postwar inflation, had been deeply unsettling, and there was undoubtedly strong political pressure on the government to halt the inflation. Although opposed to both inflation and deflation, Hawtrey believed that some deflation was needed to achieve stabilization, especially given that the US, which had restored convertibility of the dollar into gold in June 1919, would likely adopt a deflationary policy.

Mattei cites Hawtrey’s approval of the April 1920 increase in Bank rate by the Bank of England to an unprecedented 7% to break the inflationary spiral then underway. Inflation was quickly tamed, but a brutal deflation followed, while Bank rate remained at 7% for more than 12 months before a half a percent cut in April 1922 with further half-percent cuts at bimonthly intervals till the rate was reduced to 3% in July 1922.

Hawtrey’s support for deflation was less categorical and durable than Mattei claims. Prices having risen much faster than wages since the war started, Hawtrey thought that deflation would cause prices to fall before downward pressure on wages started. (See G. C. Peden, The Treasury and British Public Policy 1906-1959, Oxford: Oxford University Press, p. 154.) Once unemployment increased and wages came under significant downward pressure, Hawtrey began to call for easing of the dear-money policy of the Bank. Montague Norman, Governor of the Bank of England, aware of Hawtrey’s criticisms of Bank of England policy, shared his annoyance with Hawtrey in a letter to his counterpart at the Federal Reserve, Benjamin Strong, mentioning criticism from “a ‘leading light’ of the Treasury [who] made it his particular business to quarrel with the policy of the Treasury and the Bank of England.” (See G. C. Peden, Id. pp. 155-56.) Hawtrey later articulated the basis for his criticism.

In 1920 it was justifiable to keep up Bank rate so long as there was any uncertainty whether inflation had been successfully checked. But even in the late summer of 1920 there was no real doubt that this was so, and by November 1920, it was abundantly clear that the danger was in the opposite direction, and was that of excessive deflation.

Hawtrey, A Century of Bank Rate, London: Longmans, Green and Co., 1938, p. 133.

Mattei further attacks Hawtrey for his central role in the Genoa Conference of 1922, which, besides resolutions on other topics of international concern, adopted resolutions aimed at restoring the international gold standard. As early as in his 1919 article on the gold standard and in his important book Currency and Credit of the same year, Hawtrey was warning urgently that restoring the gold standard could cause severe–possibly disastrous–deflation unless countries rejoining the gold standard cooperated to moderate their demand for gold reserves when setting fixed parities between their currencies and gold.

Hawtrey therefore proposed that countries other than the US and Britain rejoin the gold standard by discharging their obligations in dollars or pound sterling, which were either (in the case of the dollar) already convertible into gold, or (in the case of sterling) likely to be convertible in the future. By freeing national central banks from the need to hold actual gold reserves to discharge their obligations, the Genoa proposals aimed to limit the international demand for gold, thereby moderating or eliminating the deflationary pressure otherwise entailed by restoring the gold standard. Additionally, the resulting demand by central banks to hold sterling-denominated liabilities would ease the pressure on the British balance of payments, thereby making room for the Bank of England to reduce Bank rate.

Ignoring Hawtrey’s anti-deflationary intent in drafting those resolution, Mattei focuses on the legal independence for central banks proposed by the resolutions, intended to insulate them from demands by national governments to print money to fund fiscal deficits, money printing by governments or by banks under government pressure to do so, having been, historically, a primary cause of inflation. Mattei further misrepresents Hawtrey’s call for monetary management to avoid the likely deflationary consequences of an unmanaged restoration of the prewar gold standard as evidence that Hawtrey desired to impose an even more draconian austerity on British workers than an unmanaged restoration of the gold standard would have imposed, thereby imputing to Hawtrey an intention precisely the opposite of what he meant to accomplish.

Mattei equates Hawtrey’s support for central-bank independence in the Genoa Resolutions with hostility to democracy. Quoting from Hawtrey’s 1925 article “Currency and Public Administration,” which, she suggests, betrays a technocratic and anti-democratic mindset that he shared with contemporary Italian theoreticians of fascism, Mattei seizes on the following passage:

The central bank is free to follow the precept: “never explain; never regret; never apologize.” It need make no statement of policy. Critics may rage for nine days, but in face of the silence imposed by tradition they do not keep it up.”

Hawtrey, “Currency and Public Administration” Public Administration 3(3):232-45, 243

Mattei subjects the elitist tone of Hawtrey’s defense of central bank independence to withering criticism, a criticism echoed by her ideological opposite Milton Friedman, but she neglects to quote an important explanatory passage.

The public interest in the broadest sense is profoundly affected by currency administration. Those who deprecate criticism fear an ill-judged pressure at critical times. Experience shows that, whenever an expansion of credit is developing to excess, a formidable opposition arises in the trading world to an increase in bank rate. When on the other hand, business is in a state of depression, no one minds what happens to bank rate. The influence of outside pressure is, therefore, just the contrary to what is required.

Perhaps that is so, because criticism is confined to financial and trading circles. When credits is expanding, traders want to borrow, and resent any measures which makes borrowing more difficult or more expensive. When business is depressed, they do not want to borrow. In neither case are they impelled to look beyond their own affairs to the effect of credit on the public interest.

Id.

It is interesting that Hawtrey would have written as he did in 1925 given his own recent experience in criticizing the dear money policy generally followed by the Bank of England since 1921 when the Bank of England steadfastly refused to lower Bank rate despite his own repeated pleas for rate reductions and criticisms of the Bank’s refusal to respond to those pleas.

In his lengthy and insightful doctoral dissertation about Hawtrey’s tenure at the Treasury, Alan Gaukroger, relying far more intensively and extensively than Mattei on the documentary record of Hawtrey’s tenure, discusses a Treasury Memorandum written by Hawtrey on December 5, 1925 soon after Bank of England raised Bank rate back to 5% after briefly reducing it to 4% immediately after restoration of the prewar parity with dollar in April.

The raising of the Bank rate to 5% is nothing less than a national disaster. That dear money causes unemployment is a proposition which ought not to admit of dispute. Not only is it the generally accepted opinion of theoretical economists, but it was well recognised by practical financiers and men of business before economists paid much attention to it.

Gaukroger, p. 194

Gaukroger (p. 193) also reports, relying on a recorded interview of Hawtrey conducted by Alexander Cairncross in 1965, that upon hearing the news that Bank rate had been raised back to 5%, Hawtrey went directly to Niemeyer’s office to express his fury at the news he had just heard, only to find, after he had begun denouncing the increase, that Montagu Norman himself had been seated in Niemeyer’s office behind the door he had just opened. Direct communication between Hawtrey and Norman never resumed.

Gaukroger also reports that Hawtrey’s view was dismissed not only by the Bank of England but by his superior Otto Niemeyer and by Niemeyer’s deputy Sir Frederick Leith-Ross, who invidiously compared Hawtrey in opposing an increase in Bank rate to Rudolf Havenstein, President of the German Reichsbank during the German hyperinflation of 1923.

As already mentioned, Mattei accuses Hawtrey of having harbored a deflationary bias owing to a belief that a credit economy is inherently predisposed toward inflation, a tendency that must be counteracted by restrictive monetary policy.

Mattei’s accusation of deflationary bias rests on a misunderstanding of Hawtrey’s monetary theory. In Hawtrey’s theory, if banks create too much credit, the result is inflation; if they create too little, the result is deflation. No endogenous mechanism keeps credit creation by banks on a stable non-inflationary, non-deflationary path. Once inflation or deflation sets in, a cumulative process leads to continuing, even accelerating, inflation or deflation. To achieve stability, an exogenous stabilizing mechanism, like a metallic standard or a central bank, is needed to constrain or stimulate, albeit imperfectly, credit creation by the banking system. It was only in the special conditions after World War I and the collapse of the prewar gold standard, which had been centered in London, that Hawtrey believed a limited deflation would be useful in pursuing the generally accepted goal of restoring the prewar gold standard. But the postwar deflation was far more extreme than the deflation contemplated, much less endorsed, by Hawtrey.

Mattei infers from Hawtrey’s support for deflation to reverse the postwar inflation, that he regarded inflation as a greater and more dangerous threat than inflation, without acknowledging that he regarded the 1920-22 deflation as excessive and unjustified. She also cites his endorsement of restoring convertibility of the pound at the prewar ($4.86) parity against the dollar, despite the deflationary implications of that restoration, as further evidence of Hawtrey’s approval of deflation. But Mattei ignores Hawtrey’s repeated arguments that, given the high rate of unemployment in Britain, there was ample room, even after restoration of the prewar parity, for the Bank of England to have reduced Bank rate to promote increased output and employment.

The advance of Bank rate to 5% in March 1925 supervened on a condition of things which promised to bring the pound sterling to par with the dollar without any effort at all. Credit was expanding and the price level in the United States, which may be taken as indicating the price level in terms of gold, was rising. This expansive tendency came abruptly to an end. The rediscount rate, it is true, was raised in New York, but only to 3.5%, and till 1928 the American Federal Reserve Bank adhered to moderate rediscount rates and a policy of credit relaxation. The deflationary tendency in the gold standard world was due to the continuance of dear money in London. In British industry unemployment remained practically undiminished.

Hawtrey, A Century of Bank Rate, London: Longmans, Green and Co., 1938, pp. 137-38

While Mattei acknowledges that Hawtrey favored easing monetary policy after the restoration of the prewar parity, she minimizes its significance by citing Hawtrey’s recommendation to increase Bank rate in 1939 from the 2% rate at which it had been pegged since July 1932. But by 1940 British inflation had risen above 10%, substantiating Hawtrey’s fear, with Britain about to enter into World War II, of renewed inflation.

Mattei even imputes a sinister motivation to Hawtrey’s opposition to inflation, suggesting that he blamed inflation on the moral turpitude of workers lacking the self-discipline to save any of their incomes rather than squander it all on wasteful purchases of alcohol and tobacco, in contrast to the virtuous habits of the bourgeoisie and the upper classes who saved a substantial portion of their incomes. In doing so, Mattei, in yet another misunderstanding and mischaracterization, mistakenly attributes an over-consumption theory of inflation to Hawtrey. The consumption habits of the working class are irrelevant to Hawtrey’s theory of income and prices in which total income is determined solely by the amount of credit created by the banking system.

If substantial idle resources are available, a reduced lending rate encourages retail and wholesale businesses and traders to increase their holdings of inventories by increasing orders to manufacturers who then increase output, thereby generating increased income which, in turn, leads to increased purchases of consumer and capital goods. The increase in output and income causes a further increase the desired holdings of inventories by businesses and traders, initiating a further round of increases in orders to manufacturers so that further increases in output and income are constrained by the limits of capacity, whereupon further reductions in lending rates would cause inflation rather than increased output.

While the composition of output between investment goods and consumption goods is governed, in Hawtrey’s theory, by the savings habits of households, the level of total output and income and the rate of inflation or deflation are determined entirely by the availability of credit. It was precisely on this theoretical basis that Hawtrey denied that increased public spending would increase output and employment during a depression unless that spending was financed by credit expansion (money creation); if financed by taxation or by borrowing, the public spending would simply reduce private spending by an equal amount. Mattei recognized the point in connection with public spending in her discussion of Hawtrey’s famous articulation of the Treasury View (see Hawtrey, “Public Expenditure and the Demand for Labour,”), but failed to recognize the same theoretical argument in the context of spending on consumption versus spending on investment.

I close this post with a quotation from Hawtrey’s Trade Depression and the Way Out, 2nd edition, a brilliant exposition of his monetary theory and its application to the problem of inadequate aggregate demand, a problem, as Keynes himself admitted, that he dealt with before Keynes had addressed it. I choose a passage from the last section, entitled “The Fear of Inflation,” of the penultimate chapter. Evidently, Mattei has not studied this book (which she does not cite or refer to). Otherwise, I cannot imagine how she could have written about Hawtrey in her book in the way that she did.

The fears that efforts to expand credit will be defeated in one way or anotherby the pessimism of traders are not wholly irrational. But that pessimism is no more than an obstacle to be overcome. And the much more usual view is that inflationary measures take effect only too easily

The real obstacle to measures of credit expansion is not the fear that they will not be effective, but the fear that they will. [author’s emphasis]

Yet what can be more irrational that that fear? The term inflation is very loosely used; sometimes it means any expansion of the currency or of bank credit, or any such expansion not covered by metallic reserves; sometimes it means an issue of currency by way of advances to the Government or else an issue backed by Government securities. But whatever the precise measures classed as inflationary may be, their common characteristic and the sole source of danger attributed to them is that they tend to bring about an enlargement of demand and a consequent rise of prices. And an enlargement of demand is the essential condition of recovery. To warnthe world against inflation is to warn it against economic revival.

If the economic system of the world had adjusted itself to the existing price level, there would be good reason to object to a renewed change. Inflation is rightly condemned, because it means an arbitrary change in the value of money in terms of wealth. But deflation equally means an arbitrary change in the value of money. The reason why inflation is more condemned and feared is that it is apt to appear convenient and attractive to financiers in difficulties. The consequences of deflation are so disastrous and the difficulties of carrying it out so great that no one thinks it necessary to attach any stigma to it. And since from time to time deflation has to be applied as a corrective of inflation, it is given the status of an austere and painful virtue.

But essentially it is not a virtue at all, and when it is wantonly imposed on the world, not as a corrective of inflation but as a departure from a pre-existing state of equilibrium, it ought to be regarded as a crime against humanity. [my emphasis]

Just as deflation may be needed as a corrective to an inflation to which the economic system has not adjusted itself, so at the present time inflation is needed as a corrective to deflation. If the monetary affairs of the world were wisely governed, both inflation and deflation would be avoided, or at any rate quickly corrected in their initial stages. Perhaps the ideal of monetary stability will be achieved in the future. But to start stereotyping conditions in which prices are utterly out of equilibrium with wages and debts, and with one another, would be to start the new polcy under impossible conditions.

The dread of inflation has been greatly accentuated by the experiences of the years following the war, when so many countries found that the monetary situation got completely out of control. The vicisous circle of inflation gained such power that it wrecked both the tax system and the investment market; it cut off all the normal resources for meeting public expenditure, and left Governments to subsist on issues of paper money. No country would willingly endure such a situation.

But that kind of monetary collapse does not come easily or suddenly. There is, I believe, no case in history in which inflation has got out of hand in less that three years. [author’s emphasis] . . .

The fear that one slip from parity means a fall into the abyss is entirely without foundation. Especially is that so when deflation is raging. The first impact of a monetary expansion is then felt rather in increased output than in higher prices. It is only when industry has become fully employed that the vicious circle of inflation is joined and prices begin to rise.

Ralph Hawtrey, Part 1: An Overview of his Career

Published October 28, 2023 Alfred Marshall , Clara Elizabeth Mattei , David Ricardo , gold standard , gold-exchange standard , Great Depression , Keynes , Milton Friedman , R. G. Hawtrey , Robert Hetzel , Winston Churchill 18 Comments
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One of my goals when launching this blog in 2011 was to revive interest in the important, but unfortunately neglected and largely forgotten, contributions to monetary and macroeconomic theory of Ralph Hawtrey. Two important books published within the last year have focused attention on Ralph Hawtrey: The Federal Reserve: A New History by Robert Hetzel, and The Capital Order by Clara Elizabeth Mattei.

While Hetzel’s discussion of Hawtrey’s monetary theory of the Great Depression is generally positive, it criticizes him for discounting, unlike Milton Friedman, the efficacy of open-market operations in reviving aggregate demand. But Hetzel’s criticism relies on an incomplete reading of Hawtrey’s discussions of open-market operations. Mattei’s criticism of Hawtrey is very different from Hetzel’s narrow technical criticism. Mattei is clearly deeply hostile to Hawtrey, portraying him as the grey eminence behind the austerity policies of the British Treasury and the Bank of England in the 1920s both before and after Britain restored the prewar gold standard. Mattei holds Hawtrey uniquely responsible for providing the intellectual rationale for the fiscal and monetary policies that ruthlessly tolerated high unemployment to suppress inflation and hold down wages.

I’ll address the inaccuracies in Hetzel’s discussion of Hawtrey and especially in Mattei’s deeply flawed misrepresentations of Hawtrey in future posts. In this post, I provide an overview of Hawtrey’s career drawn from papers I’ve written (two of which were co-authored by my friend Ron Batchelder) about Hawtrey included in my recent book, Studies in the History of Monetary Theory: Controversies and Clarifications (Chapters 10-14)

Ralph George Hawtrey, born in 1879, two years before his friend, fellow Cambridge man and Apostle, John Maynard Keynes, with whom he often disagreed, was in the 1920s and early 1930s almost as well-known as, and perhaps even more influential, at least among economists and policy-makers, than Keynes. Despite their Cambridge educations and careers in economics, as undergraduates, they both concentrated on mathematics[1] and philosophy and were deeply influenced by the Cambridge philosopher, G. E. Moore. Neither formally studied economics under Alfred Marshall.[2]

Perhaps the last autodidact to make significant contributions to economic theory, Hawtrey began his study of economics only when preparing for the civil-service exam at the Treasury. Hawtrey’s Cambridge background, his friendship with Keynes, and the similarities between his own monetary theories and those of Marshall, Keynes and other Cambridge economists contributed to the widespread impression that Hawtrey had ties to the Cambridge school of economics, a connection Hawtrey denied. Hawtrey’s powerful analytical mind, his command of monetary history and deep and wide knowledge of monetary and business institutions, acquired by dint of intense independent study, led to a rapid rise in the Treasury bureaucracy, eventually becoming Director of Economic Studies in 1919, a position he held until he retired from the Treasury in 1945.

Coincidentally, both Hawtrey and Keynes published their first books in 1913, Keynes writing about the reform of the Indian Currency system (Indian Currency and Finance) and Hawtrey propounding his monetary theory of the business cycle (Good and Bad Trade). A more substantive coincidence in their first books is that they both described a gold-exchange standard (resurrecting an idea described almost a century earlier by Ricardo in his Proposals for an Economical and Secure Currency) in which gold coins do not circulate and the central bank holds reserves, not in gold, but in foreign exchange denominated in currencies legally convertible into gold.

The trajectory of Hawtrey’s carrier (like Keynes’s) was sharply upward after publication of his first book. Hawtrey’s reputation was further enhanced by important academic articles about the history of monetary institutions and the gold standard. Those studies were incorporated in Hawtrey’s most important work on monetary economics, Currency and Credit published in 1919, a profound treatise on monetary economics in which his deep theoretical insights were deployed to shed light on important events and developments in the history of monetary institutions. A resounding success, the volume becoming a standard work routinely assigned to students of money and banking for over a decade, establishing Hawtrey as one of the most widely read and frequently cited economists in the 1920s and even the 1930s.

Although Keynes, by virtue of his celebrated book The Economic Consequences of the Peace became one of the most prominent public figures in Britain in the immediate postwar period, Hawtrey’s reputation among economists and policy makers likely overshadowed Keynes’s in the early 1920s. That distinction is exemplified by their roles at the 1922 Genoa Conference on postwar international cooperation and reconstruction.

In his writings about postwar monetary reconstruction, Hawtrey emphasized the necessity for international cooperation to restore international gold standard lest an uncoordinated restoration by individual countries with countries seeking to accumulate gold, thereby causing gold to appreciate and prices in terms of gold to fall. It was Hawtrey’s warnings, echoed independently by the Swedish economist Gustav Cassel, that caused the Treasury to recommend that planning for a coordinated restoration of the gold standard be included in agenda of the Genoa Conference.

While Hawtrey was the intellectual inspiration for including restoration of gold standard on the agenda of the Genoa Conference, Keynes’s role at Genoa was journalistic, serving as a correspondent for the Manchester Guardian. Keynes criticized the plan to reestablish an international gold standard even in the form of a gold-exchange standard that he and Hawtrey had described a decade earlier. Keynes observed that there was then only one nation with an effective gold standard, the United States. Conjecturing that the US, holding 40% of the world’s gold reserves, would likely choose to divest itself of at least part of its gold hoard, causing gold depreciation, Keynes argued that rejoining the gold standard would mean importing inflation from the United States. Keynes therefore recommended that Britain to adopt an independent monetary policy detached from gold to achieve a stable domestic price level. 

But after it became clear that the US had no intention of unburdening itself of its huge gold holdings, Keynes reversed his rationale for opposing restoration of the gold standard. Given the depreciation of sterling against the dollar during and after World War I, the goal of restoring the prewar dollar-sterling parity of $4.86/pound would require Britain to endure even more deflation than it had already suffered following the sharp US deflation of 1920-21.

When Winston Churchill, appointed Chancelor of the Exchequer in the new Conservative Government, announced in November 1924 that he would restore the gold standard at the prewar parity by April 1925, the pound appreciated against the dollar. But the market exchange rate with the dollar remained 10% below the prewar parity. Keynes began arguing against restoring the prewar parity because a further 10% deflation would impose an unacceptable hardship on an economy that had not recovered from the effects of the recession and high unemployment caused by earlier deflation.

After personally consulting Keynes in person about his argument against restoring the prewar parity, Churchill also invited Hawtrey to hear his argument in favor of restoring the prewar parity. Hawtrey believed that doing so would bolster London’s position as the preeminent international financial center. But he also urged that, to avoid the dire consequences that Keynes warned would follow restoration of the prewar parity, the Bank of England reduce Bank Rate to promote economic expansion and employment. Given the unique position of London as the center of international finance, Hawtrey was confident that the Bank of England could ease its monetary policy and that the Federal Reserve and other central banks would ease their policies as well, thereby allowing the gold standard to be restored without significant deflation.

Supported by his Treasury advisers including Hawtrey, Churchill restored the gold standard at the prewar dollar parity in April 1925, causing Keynes to publish his brutal critique of that decision in his pamphlet The Economic Consequences of Mr. Churchill. While the consequences were perhaps not as dire as Keynes had predicted, they were less favorable than Hawtrey had hoped, the Bank of England refusing to reduce Bank Rate below 5% as Hawtrey had urged. At any rate, after a brief downturn in the latter part of 1925, the British economy did expand moderately from 1926 through early 1929 with unemployment declining slightly before Britain, along with the rest of the world, plunged into the Great Depression in the second half of 1929.

Keynes and Hawtrey again came into indirect opposition in the 1929 general election campaign, when Lloyd George, leader of the Liberal Party, proposed a program of public works to increase employment. In rejecting Lloyd George’s proposal, Churchill cited the “traditional Treasury view” that public spending simply displaced an equal amount of private spending, merely shifting spending from the private to the public sector without increasing total output and employment.

The source of “the traditional Treasury” view” was Hawtrey, himself, who had made the argument at length in a 1925 article in the Economic Journal which he had previously made in less detail in Good and Bad Trade. Replying to Churchill, Keynes and Hubert Henderson co-authored a pamphlet Can Lloyd George Do It supporting Lloyd George’s proposal and criticizing the Treasury View.

Keynes and Hawtrey confronted each other in person when Hawtrey testified before the Macmillan Committee investigating the causes of high unemployment. As a member of the Committee, Keynes questioned Hawtrey about his argument that the Bank of England could have countered rising unemployment by reducing Bank Rate, seemingly exposing an inconsistency in Hawtrey’s responses to his questions. But, when considered in light of Hawtrey’s assumption that a reduction in Bank Rate by the Bank of England would have led to Federal Reserve and other central banks to reduce their interest rates rather than absorb further inflows of gold, the inconsistency is resolved (see this post for further explanation).

Although Hawtrey had warned of the dreadful consequences of restoring the gold standard without coordination among central bank to avoid rapid accumulation of gold reserves, his warnings were disregarded when France returned to the gold standard in 1927 and began rapidly increasing its gold reserves in 1928. Hawtrey’s association with the Treasury view fostered the misimpression that, despite his unheeded advocacy of reducing Bank Rate to reduce unemployment, Hawtrey was oblivious to, or unconcerned by, the problem of unemployment. While Keynes often tried out new ideas, as he did with his neo-Wicksellian theory of the business cycle in his Treatise on Money only to abandon it in response to criticism and the changing economic environment of the Great Depression before writing his General Theory of Interest, Income and Money, Hawtrey stuck to the same basic theory developed in his first two books.

While his output of new publications in the 1930s did not flag, Hawtrey’s reputation among economists and his influence in the Treasury gradually declined, especially after publication of Keynes’s General Theory as the attention of economists was increasingly occupied by an effort to comprehend and assimilate it into the received body of economic theory. By the time he retired from the Treasury in 1945 to become Professor of International Economics at the Royal Institute for International Affairs, Hawtrey was no longer at the cutting edge of the economics profession, and his work gradually fell from the view of younger economists.

Nevertheless, for the next two decades as he advanced to old age, Hawtrey continued to publish important works, mostly, but not exclusively concerning the conduct of British monetary policy, especially his lonely criticism of Britain’s 1947 devaluation of the pound. Elaborating on arguments advanced in his early writings, Hawtrey anticipated much of what would become known as the monetary approach to the balance of payments.

Given his monetary explanation of the Great Depression, it might have been expected that Monetarists, especially Milton Friedman, who, in the early 1950s, began his effort to develop a monetary theory of the Great Depression as an alternative to the Keynesian theory of a sudden decline in animal spirits that caused a stock-market crash and a drop in investment spending from which the private economy could not recover on its own, would have found Hawtrey’s explanation of the causes of the Great Depression to be worth their attention. However, one would search for Hawtrey’s name almost in vain in Friedman’s writings in general, and in his writings on the Great Depression, in particular. Certainly there was no recognition in the Monetarist literature on the Great Depression that a monetary theory of the Great Depression had actually been advanced by Hawtrey as the Great Depression was unfolding or that Hawtrey had warned in advance of the danger of the catastrophic deflation that would result from an uncoordinated restoration of the gold standard.

Years after Friedman’s magnum opus The Monetary History of the US was published, various researchers, including Peter Temin, Barry Eichengreen, Ben Bernanke, Kenneth Mouré, Clark Johnson, Scott Sumner, and Ronald Batchelder and I, recognized the critical importance of the newly restored gold standard in causing the Great Depression. While most of the later authors cited Hawtrey’s writings, the full extent of Hawtrey’s contributions that fully anticipated all the major conclusions of the later research remains generally unrecognized in most of the recent literature on the Great Depression, while Friedman’s very flawed account of the Great Depression continues to be regarded by most economists and financial historians as authoritative if not definitive.

In a future post, I’ll discuss Hetzel’s account of Hawtrey’s explanation of the Great Depression. Unlike earlier Monetarists who ignored Hawtrey’s explanation entirely, Hetzel does credit Hawtrey with having provided a coherent explanation of the causes of the Great Depression, without acknowledging the many respects in which Hawtrey’s explanation is more complete and more persuasive than Friedman’s. He also argues that Friedman provided a better account of the recovery than Hawtrey, because Friedman, unlike Hawtrey, recognized the effectiveness of open-market operations which Hawtrey maintained would be ineffective in initiating a recovery in situations of what Hawtrey called credit deadlock.

In another post, I’ll discuss the highly critical, and I believe tendentious, treatment by Clara Elizabeth Mattei, of Hawtrey’s supposed role in devising and rationalizing the austerity policies of the British Treasury in the 1920s up to and including the Great Depression.

[1] While Keynes was an accomplished mathematician who wrote an important philosophical and mathematical work A Treatise on Probability praised extravagantly by Bertrand Russell, Hawtrey’s mathematical skills were sufficiently formidable to have drawn the attention of Russell who included a footnote in his Principia Mathematica replying to a letter from Hawtrey.

[2] Keynes, however, the son of John Neville Keynes, a Cambridge philosopher and economist, had a personal connection to Marshall apart from his formal studies at Cambridge. Rather than pursue graduate studies, Hawtrey chose a career in the civil service, first at the Admiralty and soon thereafter at the Treasury.

My Paper “Robert Lucas and the Pretense of Science” Is now Available on SSRN

Published January 4, 2023 Axel Leijonfuvud , Hayek , Keynes , Peter Howitt , Robert Clower , Robert Lucas Leave a Comment

Peter Howitt, whom I got to know slightly when he spent a year at UCLA while we were both graduate students, received an honorary doctorate from Côte d’Azur University in September. Here is a link to the press release of the University marking the award.

Peter wrote his dissertation under Robert Clower, and when Clower moved from Northwestern to UCLA in the early 1970s, Peter followed Clower as he was finishing up his dissertation. Much of Peter’s early work was devoted to trying to develop the macroeconomic ideas of Clower and Leijonhufvud. His book The Keynesian Recovery collects those important early papers which, unfortunately, did not thwart the ascendance, as Peter was writing those papers, of the ideas of Robert Lucas and his many followers, or the eventual dominance of those ideas over modern macroeconomics.

In addition to the award, a workshop on Coordination Issues in Historical Perspective was organized in Peter’s honor, and my paper, “Robert Lucas and the Pretense of Science,” which shares many of Peter’s misgivings about the current state of macroeconomics, was one of the papers presented at the workshop. In writing the paper, I drew on several posts that I have written for this blog over the years. I have continued to revise the paper since then, and the current version is now available on SSRN.

Here’s the abstract:

Hayek and Lucas were both known for their critiques of Keynesian theory on both theoretical and methodological grounds. Hayek (1934) criticized the idea that continuous monetary expansion could permanently increase total investment, foreshadowing Friedman’s (1968) argument that monetary expansion could permanently increase employment. Friedman’s analysis set the stage for Lucas’s (1976) critique of macroeconomic policy analysis, a critique that Hayek (1975) had also anticipated. Hayek’s (1942-43) advocacy of methodological individualism might also be considered an anticipation of Lucas’s methodological insistence on the necessity of rejecting Keynesian and other macroeconomic theories not based on explicit microeconomic foundations. This paper compares Hayek’s methodological individualism with Lucasian microfoundations. While Lucasian microfoundations requires all agents to make optimal choices, Hayek recognized that optimization by interdependent agents is a contingent, not a necessary, state of reconciliation and that the standard equilibrium theory on which Lucas relies does not prove that, or explain how, such a reconciliation is, or can be, achieved. The paper further argues that the Lucasian microfoundations is a form of what Popper called philosophical reductionism that is incompatible with Hayekian methodological individualism.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4260708

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.

Hayek and the Lucas Critique

Published May 23, 2022 Alvin Hansen , Hayek , Herbert Tout , intertemporal equilibrium , Keynes , Lucas Critique , microfoundations , Milton Friedman , natural rate of unemployment , Phillips Curve , Robert Lucas 3 Comments

In March I wrote a blog post, “Robert Lucas and the Pretense of Science,” which was a draft proposal for a paper for a conference on Coordination Issues in Historical Perspectives to be held in September. My proposal having been accepted I’m going to post sections of the paper on the blog in hopes of getting some feedback as a write the paper. What follows is the first of several anticipated draft sections.

Just 31 years old, F. A. Hayek rose rapidly to stardom after giving four lectures at the London School of Economics at the invitation of his almost exact contemporary, and soon to be best friend, Lionel Robbins. Hayek had already published several important works, of which Hayek ([1928], 1984) laying out basic conceptualization of an intertemporal equilibrium almost simultaneously with the similar conceptualizations of two young Swedish economists, Gunnar Myrdal (1927) and Erik Lindahl [1929] 1939), was the most important.

Hayek’s (1931a) LSE lectures aimed to provide a policy-relevant version of a specific theoretical model of the business cycle that drew upon but was a just a particular instantiation of the general conceptualization developed in his 1928 contribution. Delivered less than two years after the start of the Great Depression, Hayek’s lectures gave a historical overview of the monetary theory of business-cycles, an account of how monetary disturbances cause real effects, and a skeptical discussion of how monetary policy might, or more likely might not, counteract or mitigate the downturn then underway. It was Hayek’s skepticism about countercyclical policy that helped make those lectures so compelling but also elicited such a hostile reaction during the unfolding crisis.

The extraordinary success of his lectures established Hayek’s reputation as a preeminent monetary theorist alongside established figures like Irving Fisher, A. C. Pigou, D. H. Robertson, R. G. Hawtrey, and of course J. M. Keynes. Hayek’s (1931b) critical review of Keynes’s just published Treatise on Money (1930), published soon after his LSE lectures, provoking a heated exchange with Keynes, himself, showed him to be a skilled debater and a powerful polemicist.

Hayek’s meteoric rise was, however, followed by a rapid fall from the briefly held pinnacle of his early career. Aside from the imperfections and weaknesses of his own theoretical framework (Glasner and Zimmerman 2021), his diagnosis of the causes of the Great Depression (Glasner and Batchelder [1994] 2021a, 2021b) and his policy advice (Glasner 2021) were theoretically misguided and inappropriate to the deflationary conditions underlying the Great Depression).

Nevertheless, Hayek’s conceptualization of intertemporal equilibrium provided insight into the role not only of prices, but also of price expectations, in accounting for cyclical fluctuations. In Hayek’s 1931 version of his cycle theory, the upturn results from bank-financed investment spending enabled by monetary expansion that fuels an economic boom characterized by increased total spending, output and employment. However, owing to resource constraints, misalignments between demand and supply, and drains of bank reserves, the optimistic expectations engendered by the boom are doomed to eventual disappointment, whereupon a downturn begins.

I need not engage here with the substance of Hayek’s cycle theory which I have criticized elsewhere (see references above). But I would like to consider his 1934 explanation, responding to Hansen and Tout (1933), of why a permanent monetary expansion would be impossible. Hansen and Tout disputed Hayek’s contention that monetary expansion would inevitably lead to a recession, because an unconstrained monetary authority would not be forced by a reserve drain to halt a monetary expansion, allowing a boom to continue indefinitely, permanently maintaining an excess of investment over saving.

Hayek (1934) responded as follows:

[A] constant rate of forced saving (i.e., investment in excess of voluntary saving) a rate of credit expansion which will enable the producers of intermediate products, during each successive unit of time, to compete successfully with the producers of consumers’ goods for constant additional quantities of the original factors of production. But as the competing demand from the producers of consumers’ goods rises (in terms of money) in consequence of, and in proportion to, the preceding increase of expenditure on the factors of production (income), an increase of credit which is to enable the producers of intermediate products to attract additional original factors, will have to be, not only absolutely but even relatively, greater than the last increase which is now reflected in the increased demand for consumers’ goods. Even in order to attract only as great a proportion of the original factors, i.e., in order merely to maintain the already existing capital, every new increase would have to be proportional to the last increase, i.e., credit would have to expand progressively at a constant rate. But in order to bring about constant additions to capital, it would have to do more: it would have to increase at a constantly increasing rate. The rate at which this rate of increase must increase would be dependent upon the time lag between the first expenditure of the additional money on the factors of production and the re-expenditure of the income so created on consumers’ goods. . . .

But I think it can be shown . . . that . . . such a policy would . . . inevitably lead to a rapid and progressive rise in prices which, in addition to its other undesirable effects, would set up movements which would soon counteract, and finally more than offset, the “forced saving.” That it is impossible, either for a simple progressive increase of credit which only helps to maintain, and does not add to, the already existing “forced saving,” or for an increase in credit at an increasing rate, to continue for a considerable time without causing a rise in prices, results from the fact that in neither case have we reason to assume that the increase in the supply of consumers’ goods will keep pace with the increase in the flow of money coming on to the market for consumers’ goods. Insofar as, in the second case, the credit expansion leads to an ultimate increase in the output of consumers’ goods, this increase will lag considerably and increasingly (as the period of production increases) behind the increase in the demand for them. But whether the prices of consumers’ goods will rise faster or slower, all other prices, and particularly the prices of the original factors of production, will rise even faster. It is only a question of time when this general and progressive rise of prices becomes very rapid. My argument is not that such a development is inevitable once a policy of credit expansion is embarked upon, but that it has to be carried to that point if a certain result—a constant rate of forced saving, or maintenance without the help of voluntary saving of capital accumulated by forced saving—is to be achieved.

Friedman’s (1968) argument why monetary expansion could not permanently reduce unemployment below its “natural rate” closely mirrors (though he almost certainly never read) Hayek’s argument that monetary expansion could not permanently maintain a rate of investment spending above the rate of voluntary saving. Generalizing Friedman’s logic, Lucas (1976) transformed it into a critique of using econometric estimates of relationships like the Phillips Curve, the specific target of Friedman’s argument, as a basis for predicting the effects of policy changes, such estimates being conditional on implicit expectational assumptions which aren’t invariant to the policy changes derived from those estimates.

Restated differently, such econometric estimates are reduced forms that, without identifying restrictions, do not allow the estimated regression coefficients to be used to predict the effects of a policy change.

Only by specifying, and estimating, the deep structural relationships governing the response to a policy change could the effect of a potential policy change be predicted with some confidence that the prediction would not prove erroneous because of changes in the econometrically estimated relationships once agents altered their behavior in response to the policy change.

In his 1974 Nobel Lecture, Hayek offered a similar explanation of why an observed correlation between aggregate demand and employment provides no basis for predicting the effect of policies aimed at increasing aggregate demand and reducing unemployment if the likely changes in structural relationships caused by those policies are not taken into account.

[T]he very measures which the dominant “macro-economic” theory has recommended as a remedy for unemployment, namely the increase of aggregate demand, have become a cause of a very extensive misallocation of resources which is likely to make later large-scale unemployment inevitable. The continuous injection . . . money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour . . . into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained . . . The fact is that by a mistaken theoretical view we have been led into a precarious position in which we cannot prevent substantial unemployment from re-appearing; not because . . . this unemployment is deliberately brought about as a means to combat inflation, but because it is now bound to occur as a deeply regrettable but inescapable consequence of the mistaken policies of the past as soon as inflation ceases to accelerate.

Hayek’s point that an observed correlation between the rate of inflation (a proxy for aggregate demand) and unemployment cannot be relied on in making economic policy was articulated succinctly and abstractly by Lucas as follows:

In short, one can imagine situations in which empirical Phillips curves exhibit long lags and situations in which there are no lagged effects. In either case, the “long-run” output inflation relationship as calculated or simulated in the conventional way has no bearing on the actual consequences of pursing a policy of inflation.

[T]he ability . . . to forecast consequences of a change in policy rests crucially on the assumption that the parameters describing the new policy . . . are known by agents. Over periods for which this assumption is not approximately valid . . . empirical Phillips curves will appear subject to “parameter drift,” describable over the sample period, but unpredictable for all but the very near future.

The lesson inferred by both Hayek and Lucas was that Keynesian macroeconomic models of aggregate demand, inflation and employment can’t reliably guide economic policy and should be discarded in favor of models more securely grounded in the microeconomic theories of supply and demand that emerged from the Marginal Revolution of the 1870s and eventually becoming the neoclassical economic theory that describes the characteristics of an efficient, decentralized and self-regulating economic system. This was the microeconomic basis on which Hayek and Lucas believed macroeconomic theory ought to be based instead of the Keynesian system that they were criticizing. But that superficial similarity obscures the profound methodological and substantive differences between them.

Those differences will be considered in future posts.

References

Friedman, M. 1968. “The Role of Monetary Policy.” American Economic Review 58(1):1-17.

Glasner, D. 2021. “Hayek, Deflation, Gold and Nihilism.” Ch. 16 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Glasner, D. and Batchelder, R. W. [1994] 2021. “Debt, Deflation, the Gold Standard and the Great Depression.” Ch. 13 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Glasner, D. and Batchelder, R. W. 2021. “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?” Ch. 14 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Glasner, D. and Zimmerman, P. 2021.  “The Sraffa-Hayek Debate on the Natural Rate of Interest.” Ch. 15 in D. Glasner Studies in the History of Monetary Theory: Controversies and Clarifications. London: Palgrave Macmillan.

Hansen, A. and Tout, H. 1933. “Annual Survey of Business Cycle Theory: Investment and Saving in Business Cycle Theory,” Econometrica 1(2): 119-47.

Hayek, F. A. [1928] 1984. “Intertemporal Price Equilibrium and Movements in the Value of Money.” In R. McCloughry (Ed.), Money, Capital and Fluctuations: Early Essays (pp. 171–215). Routledge.

Hayek, F. A. 1931a. Prices and Produciton. London: Macmillan.

Hayek, F. A. 1931b. “Reflections on the Pure Theory of Money of Mr. Keynes.” Economica 33:270-95.

Hayek, F. A. 1934. “Capital and Industrial Fluctuations.” Econometrica 2(2): 152-67.

Keynes, J. M. 1930. A Treatise on Money. 2 vols. London: Macmillan.

Lindahl. E. [1929] 1939. “The Place of Capital in the Theory of Price.” In E. Lindahl, Studies in the Theory of Money and Capital. George, Allen & Unwin.

Lucas, R. E. [1976] 1985. “Econometric Policy Evaluation: A Critique.” In R. E. Lucas, Studies in Business-Cycle Theory. Cambridge: MIT Press.

Myrdal, G. 1927. Prisbildningsproblemet och Foranderligheten (Price Formation and the Change Factor). Almqvist & Wicksell.

The Rises and Falls of Keynesianism and Monetarism

Published January 9, 2022 Alfred Marshall , Arrow-Debrew-McKenzie model , Carl Menger , common knowledge , comparative statics , Erik Lindahl , general equilibrium , Great Depression , Keynes , Leon Walras , macroeconomics , Milton Friedman , Monetarism , partial equilibrium , sticky prices , sticky wages , supply-demand analysis , tatonnement , W. S. Jevons , Walrasian equilibrium 16 Comments

The following is extracted from a paper on the history of macroeconomics that I’m now writing. I don’t know yet where or when it will be published and there may or may not be further installments, but I would be interested in any comments or suggestions that readers might have. Regular readers, if there are any, will probably recognize some familiar themes that I’ve been writing about in a number of my posts over the past several months. So despite the diminished frequency of my posting, I haven’t been entirely idle.

Recognizing the cognitive dissonance between the vision of the optimal equilibrium of a competitive market economy described by Marshallian economic theory and the massive unemployment of the Great Depression, Keynes offered an alternative, and, in his view, more general, theory, the optimal neoclassical equilibrium being a special case.[1] The explanatory barrier that Keynes struggled, not quite successfully, to overcome in the dire circumstances of the 1930s, was why market-price adjustments do not have the equilibrating tendencies attributed to them by Marshallian theory. The power of Keynes’s analysis, enhanced by his rhetorical gifts, enabled him to persuade much of the economics profession, especially many of the most gifted younger economists at the time, that he was right. But his argument, failing to expose the key weakness in the neoclassical orthodoxy, was incomplete.

The full title of Keynes’s book, The General Theory of Employment, Interest and Money identifies the key elements of his revision of neoclassical theory. First, contrary to a simplistic application of Marshallian theory, the mass unemployment of the Great Depression would not be substantially reduced by cutting wages to “clear” the labor market. The reason, according to Keynes, is that the levels of output and unemployment depend not on money wages, but on planned total spending (aggregate demand). Mass unemployment is the result of too little spending not excessive wages. Reducing wages would simply cause a corresponding decline in total spending, without increasing output or employment.

If wage cuts do not increase output and employment, the ensuing high unemployment, Keynes argued, is involuntary, not the outcome of optimizing choices made by workers and employers. Ever since, the notion that unemployment can be involuntary has remained a contested issue between Keynesians and neoclassicists, a contest requiring resolution in favor of one or the other theory or some reconciliation of the two.

Besides rejecting the neoclassical theory of employment, Keynes also famously disputed the neoclassical theory of interest by arguing that the rate of interest is not, as in the neoclassical theory, a reward for saving, but a reward for sacrificing liquidity. In Keynes’s view, rather than equilibrate savings and investment, interest equilibrates the demand to hold the money issued by the monetary authority with the amount issued by the monetary authority. Under the neoclassical theory, it is the price level that adjusts to equilibrate the demand for money with the quantity issued.

Had Keynes been more attuned to the Walrasian paradigm, he might have recast his argument that cutting wages would not eliminate unemployment by noting the inapplicability of a Marshallian supply-demand analysis of the labor market (accounting for over 50 percent of national income), because wage cuts would shift demand and supply curves in almost every other input and output market, grossly violating the ceteris-paribus assumption underlying Marshallian supply-demand paradigm. When every change in the wage shifts supply and demand curves in all markets for good and services, which in turn causes the labor-demand and labor-supply curves to shift, a supply-demand analysis of aggregate unemployment becomes a futile exercise.

Keynes’s work had two immediate effects on economics and economists. First, it immediately opened up a new field of research – macroeconomics – based on his theory that total output and employment are determined by aggregate demand. Representing only one element of Keynes’s argument, the simplified Keynesian model, on which macroeconomic theory was founded, seemed disconnected from either the Marshallian or Walrasian versions of neoclassical theory.

Second, the apparent disconnect between the simple Keynesian macro-model and neoclassical theory provoked an ongoing debate about the extent to which Keynesian theory could be deduced, or even reconciled, with the premises of neoclassical theory. Initial steps toward a reconciliation were provided when a model incorporating the quantity of money and the interest rate into the Keynesian analysis was introduced, soon becoming the canonical macroeconomic model of undergraduate and graduate textbooks.

Critics of Keynesian theory, usually those opposed to its support for deficit spending as a tool of aggregate demand management, its supposed inflationary bias, and its encouragement or toleration of government intervention in the free-market economy, tried to debunk Keynesianism by pointing out its inconsistencies with the neoclassical doctrine of a self-regulating market economy. But proponents of Keynesian precepts were also trying to reconcile Keynesian analysis with neoclassical theory. Future Nobel Prize winners like J. R. Hicks, J. E. Meade, Paul Samuelson, Franco Modigliani, James Tobin, and Lawrence Klein all derived various Keynesian propositions from neoclassical assumptions, usually by resorting to the un-Keynesian assumption of rigid or sticky prices and wages.

What both Keynesian and neoclassical economists failed to see is that, notwithstanding the optimality of an economy with equilibrium market prices, in either the Walrasian or the Marshallian versions, cannot explain either how that set of equilibrium prices is, or can be, found, or how it results automatically from the routine operation of free markets.

The assumption made implicitly by both Keynesians and neoclassicals was that, in an ideal perfectly competitive free-market economy, prices would adjust, if not instantaneously, at least eventually, to their equilibrium, market-clearing, levels so that the economy would achieve an equilibrium state. Not all Keynesians, of course, agreed that a perfectly competitive economy would reach that outcome, even in the long-run. But, according to neoclassical theory, equilibrium is the state toward which a competitive economy is drawn.

Keynesian policy could therefore be rationalized as an instrument for reversing departures from equilibrium and ensuring that such departures are relatively small and transitory. Notwithstanding Keynes’s explicit argument that wage cuts cannot eliminate involuntary unemployment, the sticky-prices-and-wages story was too convenient not to be adopted as a rationalization of Keynesian policy while also reconciling that policy with the neoclassical orthodoxy associated with the postwar ascendancy of the Walrasian paradigm.

The Walrasian ascendancy in neoclassical theory was the culmination of a silent revolution beginning in the late 1920s when the work of Walras and his successors was taken up by a younger generation of mathematically trained economists. The revolution proceeded along many fronts, of which the most important was proving the existence of a solution of the system of equations describing a general equilibrium for a competitive economy — a proof that Walras himself had not provided. The sophisticated mathematics used to describe the relevant general-equilibrium models and derive mathematically rigorous proofs encouraged the process of rapid development, adoption and application of mathematical techniques by subsequent generations of economists.

Despite the early success of the Walrasian paradigm, Kenneth Arrow, perhaps the most important Walrasian theorist of the second half of the twentieth century, drew attention to the explanatory gap within the paradigm: how the adjustment of disequilibrium prices is possible in a model of perfect competition in which every transactor takes market price as given. The Walrasian theory shows that a competitive equilibrium ensuring the consistency of agents’ plans to buy and sell results from an equilibrium set of prices for all goods and services. But the theory is silent about how those equilibrium prices are found and communicated to the agents of the model, the Walrasian tâtonnement process being an empirically empty heuristic artifact.

In fact, the explanatory gap identified by Arrow was even wider than he had suggested or realized, for another aspect of the Walrasian revolution of the late 1920s and 1930s was the extension of the equilibrium concept from a single-period equilibrium to an intertemporal equilibrium. Although earlier works by Irving Fisher and Frank Knight laid a foundation for this extension, the explicit articulation of intertemporal-equilibrium analysis was the nearly simultaneous contribution of three young economists, two Swedes (Myrdal and Lindahl) and an Austrian (Hayek) whose significance, despite being partially incorporated into the canonical Arrow-Debreu-McKenzie version of the Walrasian model, remains insufficiently recognized.

These three economists transformed the concept of equilibrium from an unchanging static economic system at rest to a dynamic system changing from period to period. While Walras and Marshall had conceived of a single-period equilibrium with no tendency to change barring an exogenous change in underlying conditions, Myrdal, Lindahl and Hayek conceived of an equilibrium unfolding through time, defined by the mutual consistency of the optimal plans of disparate agents to buy and sell in the present and in the future.

In formulating optimal plans that extend through time, agents consider both the current prices at which they can buy and sell, and the prices at which they will (or expect to) be able to buy and sell in the future. Although it may sometimes be possible to buy or sell forward at a currently quoted price for future delivery, agents planning to buy and sell goods or services rely, for the most part, on their expectations of future prices. Those expectations, of course, need not always turn out to have been accurate.

The dynamic equilibrium described by Myrdal, Lindahl and Hayek is a contingent event in which all agents have correctly anticipated the future prices on which they have based their plans. In the event that some, if not all, agents have incorrectly anticipated future prices, those agents whose plans were based on incorrect expectations may have to revise their plans or be unable to execute them. But unless all agents share the same expectations of future prices, their expectations cannot all be correct, and some of those plans may not be realized.

The impossibility of an intertemporal equilibrium of optimal plans if agents do not share the same expectations of future prices implies that the adjustment of perfectly flexible market prices is not sufficient an optimal equilibrium to be achieved. I shall have more to say about this point below, but for now I want to note that the growing interest in the quiet Walrasian revolution in neoclassical theory that occurred almost simultaneously with the Keynesian revolution made it inevitable that Keynesian models would be recast in explicitly Walrasian terms.

What emerged from the Walrasian reformulation of Keynesian analysis was the neoclassical synthesis that became the textbook version of macroeconomics in the 1960s and 1970s. But the seemingly anomalous conjunction of both inflation and unemployment during the 1970s led to a reconsideration and widespread rejection of the Keynesian proposition that output and employment are directly related to aggregate demand.

Indeed, supporters of the Monetarist views of Milton Friedman argued that the high inflation and unemployment of the 1970s amounted to an empirical refutation of the Keynesian system. But Friedman’s political conservatism, free-market ideology, and his acerbic criticism of Keynesian policies obscured the extent to which his largely atheoretical monetary thinking was influenced by Keynesian and Marshallian concepts that rendered his version of Monetarism an unattractive alternative for younger monetary theorists, schooled in the Walrasian version of neoclassicism, who were seeking a clear theoretical contrast with the Keynesian macro model.

The brief Monetarist ascendancy following 1970s inflation conveniently collapsed in the early 1980s, after Friedman’s Monetarist policy advice for controlling the quantity of money proved unworkable, when central banks, foolishly trying to implement the advice, prolonged a needlessly deep recession while central banks consistently overshot their monetary targets, thereby provoking a long series of embarrassing warnings from Friedman about the imminent return of double-digit inflation.

[1] Hayek, both a friend and a foe of Keynes, would chide Keynes decades after Keynes’s death for calling his theory a general theory when, in Hayek’s view, it was a special theory relevant only in periods of substantially less than full employment when increasing aggregate demand could increase total output. But in making this criticism, Hayek, himself, implicitly assumed that which he had himself admitted in his theory of intertemporal equilibrium that there is no automatic equilibration mechanism that ensures that general equilibrium obtains.

My Paper “Between Walras and Marshall: Menger’s Third Way” Is Now Posted on SSRN

Published November 18, 2021 Alfred Marshall , Carl Menger , general equilibrium , Keynes , partial equilibrium 8 Comments

As regular readers of this blog will realize, several of my recent posts (here, here, here, here, and here) have been incorporated in my new paper, which I have been writing for the upcoming Carl Menger 2021 Conference next week in Nice, France. The paper is now available on SSRN.

Here is the abstract to the paper:

Neoclassical economics is bifurcated between Marshall’s partial-equilibrium and Walras’s general-equilibrium analyses. Given the failure of neoclassical theory to explain the Great Depression, Keynes proposed an explanation of involuntary unemployment. Keynes’s contribution was later subsumed under the neoclassical synthesis of the Keynesian and Walrasian theories. Lacking microfoundations consistent with Walrasian theory, the neoclassical synthesis collapsed. But Walrasian GE theory provides no plausible account of how GE is achieved. Whatever plausibility is attributed to the assumption that price flexibility leads to equilibrium derives from Marshallian PE analysis, with prices equilibrating supply and demand. But Marshallian PE analysis presumes that all markets, but the small one being analyzed, are at equilibrium, so that price adjustments in the analyzed market neither affect nor are affected by other markets. The demand and cost (curves) of PE analysis are drawn on the assumption that all other prices reflect Walrasian GE values. While based on Walrasian assumptions, modern macroeconomics relies on the Marshallian intuition that agents know or anticipate the prices consistent with GE. Menger’s third way offers an alternative to this conceptual impasse by recognizing that nearly all economic activity is subjective and guided by expectations of the future. Current prices are set based on expectations of future prices, so equilibrium is possible only if agents share the same expectations of future prices. If current prices are set based on differing expectations, arbitrage opportunities are created, causing prices and expectations to change, leading to further arbitrage, expectational change, and so on, but not necessarily to equilibrium.

Here is a link to the paper: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3964127

The current draft if preliminary, and any comments, suggestions or criticisms from readers would be greatly appreciated.

The Walras-Marshall Divide in Neoclassical Theory, Part II

Published September 1, 2021 Alfred Marshall , Carl Menger , comparative statics , expectations , general equilibrium , Keynes , Leon Walras , Michel De Vroey , partial equilibrium , tatonnement 9 Comments

In my previous post, which itself followed up an earlier post “General Equilibrium, Partial Equilibrium and Costs,” I laid out the serious difficulties with neoclassical theory in either its Walrasian or Marshallian versions: its exclusive focus on equilibrium states with no plausible explanation of any economic process that leads from disequilibrium to equilibrium.

The Walrasian approach treats general equilibrium as the primary equilibrium concept, because no equilibrium solution in a single market can be isolated from the equilibrium solutions for all other markets. Marshall understood that no single market could be in isolated equilibrium independent of all other markets, but the practical difficulty of framing an analysis of the simultaneous equilibration of all markets made focusing on general equilibrium unappealing to Marshall, who wanted economic analysis to be relevant to the concerns of the public, i.e., policy makers and men of affairs whom he regarded as his primary audience.

Nevertheless, in doing partial-equilibrium analysis, Marshall conceded that it had to be embedded within a general-equilibrium context, so he was careful to specify the ceteris-paribus conditions under which partial-equilibrium analysis could be undertaken. In particular, any market under analysis had to be sufficiently small, or the disturbance to which that market was subject had to be sufficiently small, for the repercussions of the disturbance in that market to have only minimal effect on other markets, or, if substantial, those effects had to concentrated on a specific market (e.g., the market for a substitute, or complementary, good).

By focusing on equilibrium in a single market, Marshall believed he was making the analysis of equilibrium more tractable than the Walrasian alternative of focusing on the analysis of simultaneous equilibrium in all markets. Walras chose to make his approach to general equilibrium, if not tractable, at least intuitive by appealing to the fiction of tatonnement conducted by an imaginary auctioneer adjusting prices in all markets in response to any inconsistencies in the plans of transactors preventing them from executing their plans at the announced prices.

But it eventually became clear, to Walras and to others, that tatonnement could not be considered a realistic representation of actual market behavior, because the tatonnement fiction disallows trading at disequilibrium prices by pausing all transactions while a complete set of equilibrium prices for all desired transactions is sought by a process of trial and error. Not only is all economic activity and the passage of time suspended during the tatonnement process, there is not even a price-adjustment algorithm that can be relied on to find a complete set of equilibrium prices in a finite number of iterations.

Despite its seeming realism, the Marshallian approach, piecemeal market-by-market equilibration of each distinct market, is no more tenable theoretically than tatonnement, the partial-equilibrium method being premised on a ceteris-paribus assumption in which all prices and all other endogenous variables determined in markets other than the one under analysis are held constant. That assumption can be maintained only on the condition that all markets are in equilibrium. So the implicit assumption of partial-equilibrium analysis is no less theoretically extreme than Walras’s tatonnement fiction.

In my previous post, I quoted Michel De Vroey’s dismissal of Keynes’s rationale for the existence of involuntary unemployment, a violation in De Vroey’s estimation, of Marshallian partial-equilibrium premises. Let me quote De Vroey again.

When the strict Marshallian viewpoint is adopted, everything is simple: it is assumed that the aggregate supply price function incorporates wages at their market-clearing magnitude. Instead, when taking Keynes’s line, it must be assumed that the wage rate that firms consider when constructing their supply price function is a “false” (i.e., non-market-clearing) wage. Now, if we want to keep firms’ perfect foresight assumption (and, let me repeat, we need to lest we fall into a theoretical wilderness), it must be concluded that firms’ incorporation of a false wage into their supply function follows from their correct expectation that this is indeed what will happen in the labor market. That is, firms’ managers are aware that in this market something impairs market clearing. No other explanation than the wage floor assumption is available as long as one remains in the canonical Marshallian framework. Therefore, all Keynes’s claims to the contrary notwithstanding, it is difficult to escape the conclusion that his effective demand reasoning is based on the fixed-wage hypothesis. The reason for unemployment lies in the labor market, and no fuss should be made about effective demand being [the reason rather] than the other way around.

A History of Macroeconomics from Keynes to Lucas and Beyond, pp. 22-23

My interpretation of De Vroey’s argument is that the strict Marshallian viewpoint requires that firms correctly anticipate the wages that they will have to pay in making their hiring and production decisions, while presumably also correctly anticipating the future demand for their products. I am unable to make sense of this argument unless it means that firms — and why should firm owners or managers be the only agents endowed with perfect or correct foresight? – correctly foresee the prices of the products that they sell and of the inputs that they purchase or hire. In other words, the strict Marshallian viewpoint invoked by De Vroey assumes that each transactor foresees, without the intervention of a timeless tatonnement process guided by a fictional auctioneer, the equilibrium price vector. In other words, when the strict Marshallian viewpoint is adopted, everything is simple; every transactor is a Walrasian auctioneer.

My interpretation of Keynes – and perhaps I’m just reading my own criticism of partial-equilibrium analysis into Keynes – is that he understood that the aggregate labor market can’t be analyzed in a partial-equilibrium setting, because Marshall’s ceteris-paribus proviso can’t be maintained for a market that accounts for roughly half the earnings of the economy. When conditions change in the labor market, everything else also changes. So the equilibrium conditions of the labor market must be governed by aggregate equilibrium conditions that can’t be captured in, or accounted for by, a Marshallian partial-equilibrium framework. Because something other than supply and demand in the labor market determines the equilibrium, what happens in the labor market can’t, by itself, restore an equilibrium.

That, I think, was Keynes’s intuition. But while identifying a serious defect in the Marshallian viewpoint, that intuition did not provide an adequate theory of adjustment. But the inadequacy of Keynes’s critique doesn’t rehabilitate the Marshallian viewpoint, certainly not in the form in which De Vroey represents it.

But there’s a deeper problem with the Marshallian viewpoint than just the interdependence of all markets. Although Marshall accepted marginal-utility theory in principle and used it to explain consumer demand, he tried to limit its application to demand while retaining the classical theory of the cost of production as a coordinate factor explaining the relative prices of goods and services. Marginal utility determines demand while cost determines supply, so that the interaction of supply and demand (cost and utility) jointly determine price just as the two blades of a scissor jointly cut a piece of cloth or paper.

This view of the role of cost could be maintained only in the context of the typical Marshallian partial-equilibrium exercise in which all prices — including input prices — except the price of a single output are held fixed at their general-equilibrium values. But the equilibrium prices of inputs are not determined independently of the values of the outputs they produce, so their equilibrium market values are derived exclusively from the value of whatever outputs they produce.

This was a point that Marshall, desiring to minimize the extent to which the Marginal Revolution overturned the classical theory of value, either failed to grasp, or obscured: that both prices and costs are simultaneously determined. By focusing on partial-equilibrium analysis, in which input prices are treated as exogenous variables rather than, as in general-equilibrium analysis, endogenously determined variables, Marshall was able to argue as if the classical theory that the cost incurred to produce something determines its value or its market price, had not been overturned.

The absolute dependence of input prices on the value of the outputs that they are being used to produce was grasped more clearly by Carl Menger than by Walras and certainly more clearly than by Marshall. What’s more, unlike either Walras or Marshall, Menger explicitly recognized the time lapse between the purchasing and hiring of inputs by a firm and the sale of the final output, inputs having been purchased or hired in expectation of the future sale of the output. But expected future sales are at prices anticipated, but not known, in advance, making the valuation of inputs equally conjectural and forcing producers to make commitments without knowing either their costs or their revenues before undertaking those commitments.

It is precisely this contingent relationship between the expectation of future sales at unknown, but anticipated, prices and the valuations that firms attach to the inputs they purchase or hire that provides an alternative to the problematic Marshallian and Walrasian accounts of how equilibrium market prices are actually reached.

The critical role of expected future prices in determining equilibrium prices was missing from both the Marshallian and the Walrasian theories of price determination. In the Walrasian theory, price determination was attributed to a fictional tatonnement process that Walras originally thought might serve as a kind of oversimplified and idealized version of actual market behavior. But Walras seems eventually to have recognized and acknowledged how far removed from reality his tatonnement invention actually was.

The seemingly more realistic Marshallian account of price determination avoided the unrealism of the Walrasian auctioneer, but only by attributing equally, if not more, unrealistic powers of foreknowledge to the transactors than Walras had attributed to his auctioneer. Only Menger, who realistically avoided attributing extraordinary knowledge either to transactors or to an imaginary auctioneer, instead attributing to transactors only an imperfect and fallible ability to anticipate future prices, provided a realistic account, or at least a conceptual approach toward a realistic account, of how prices are actually formed.

In a future post, I will try spell out in greater detail my version of a Mengerian account of price formation and how this account might tell us about the process by which a set of equilibrium prices might be realized.

The Walras-Marshall Divide in Neoclassical Theory, Part I

Published August 27, 2021 Alfred Marshall , general equilibrium , Keynes , Leon Walras , Michel De Vroey , partial equilibrium 7 Comments

This year, 2021, puts us squarely in the midst of the sesquicentennial period of the great marginal revolution in economics that began with the almost simultaneous appearance in 1871 of Menger’s Grundsatze der Volkwirtschaft and Jevons’s Theory of Political Economy followed in 1874 by Walras’s Elements d’Economie Politique Pure. Jevons left few students behind to continue his work, so his influence pales in comparison with that of his younger contemporary Alfred Marshall who, working along similar lines, published his Principles of Economics in 1890. It was Marshall’s version of marginal utility theory that defined for more than a generation what became known as neoclassical theory in the Anglophone world. Menger’s work, via his disciples, Bohm-Bawerk and Wieser, was actually the most influential work on marginal-utility theory for at least 50 years, the work of Walras and his successor, Vilfredo Pareto, being too mathematical, even for professional economists, to become influential before the 1930s.

But after it was restated in a form not only more accessible, but more coherent and more sophisticated by J. R. Hicks in his immensely influential treatise Value and Capital, Walras’s work became the standard for rigorous formal economic analysis. Although the Walrasian paradigm became the standard for formal theoretical work, the Marshallian paradigm remained influential for applied microeconomic theory and empirical research, especially in fields like industrial organization, labor economics and international trade. Neoclassical economics, the corpus of economic mainstream economic theory that grew out of the marginal revolution was therefore built almost entirely on the works of Marshall and Walras, the influence of Menger, like that of Jevons, having been largely, but not entirely, assimilated into the main body of neoclassical theory.

The subsequent development of monetary theory and macroeconomics, especially after the Keynesian Revolution swept the economics profession, was also influenced by both Marshall and Walras. And the question whether Keynes belonged to the Marshallian tradition in which he was trained, or became, either consciously or unconsciously, a Walrasian has been an ongoing dispute among historians of macroeconomics since the late 1940s.

The first attempt to merge Keynes into the Walrasian paradigm led to the first neoclassical synthesis, which gained a brief ascendancy in the 1960s and early 1970s before being eclipsed by the New Classical rational expectations macroeconomics of Lucas and Sargent that led to a transformation of macroeconomics.

With that in mind, I’ve been reading Michel De Vroey’s excellent History of Macroeconomics from Keynes to Lucas and Beyond. An important feature of De Vroey’s book is its classification of macrotheories as either Marshallian or Walrasian in structure and orientation. I believe that the Walras vs. Marshall distinction is important, but I would frame that distinction differently from how De Vroey does. To be sure, De Vroey identifies some key differences between the Marshallian and Walrasian schemas, but I question whether he focuses on the differences between Marshall and Walras that really matter. And I also believe that he fails to address adequately the important problem that both Marhsall and Walras failed to address, namely their inability adequately describe a market mechanism that actually does, or even might, lead an economy toward an equilibrium position.

One reason for De Vroey’s misplaced emphasis is that he focuses on the different stories told by Walras and Marshall to explain how equilibrium — either for the entire system (Walras) or for a single market (Marshall) – is achieved. The story that Walras famously told was the tatonnement stratagem conceived by Walras to provide an account of how market forces, left undisturbed, would automatically bring an economy to a state of rest (general equilibrium). But Walras eventually realized that tatonnement could never be realistic for an economy with both exchange and production. The point of tatonnement is to prevent trading at disequilibium prices, but assuming that production is suspended during tatonnement is untenable, because production cannot be interrupted until the search for the equilibrium price vector is successfully completed.

Nevertheless, De Vroey treats tatonnement, despite its hopeless unrealism, as sine qua non for any model to be classified as Walrasian. In chapter 19 (“The History of Macroeconomics through the lens of the Marshall-Walras Divide”), DeVroey provides a comprehensive list of differences between the Marshallian and Walrasian modeling approaches which makes tatonnement a key distinction between the two approaches. I will discuss the three that seem most important.

1 Price formation: Walras assumes all exchange occurs at equilibrium prices found through tatonnement conducted by a deus-ex-machina auctioneer. All agents are therefore price takers even in “markets” in which, absent the auctioneer, market power could be exercised. Marshall assumes that prices are determined in the course of interaction of suppliers and demanders in distinct markets, so that the mix of price-taking and price-setting agents depends on the characteristics of those distinct markets.

This dichotomy between the Walrasian and Marshallian accounts of how prices are determined sheds light on the motivation that led Marshall and Walras to adopt their differing modeling approaches, but there is an important distinction between a model and the intuition that motivates or rationalizes the model. The model stands on its own whatever the intuition motivating the model. The motivation behind the model can inform how the model is assessed, but the substance of the model and its implications remain in tact even if the intuition behind the model is rejected.

2 Market equilibrium: Walras assumes that no market is in equilibrium unless general equilibrium obtains. Marshall assumes partial equililbrium is reached separately in each market. General equilibrium is achieved when all markets are in partial equilibrium. The Walrasian approach is top-down, the Marshallian bottom-up.

3 Realism: Marshall is more realistic than Walras in depicting individual markets in which transactors themselves engage in the price-setting process, assessing market conditions, and gaining information about supply-and-demand conditions; Walras assumes that all agents are passive price takers merely calculating their optimal, but provisional, plans to buy and sell at any price vector announced by the auctioneer who then processes those plans to determine whether the plans are mutually consistent or whether a new price vector must be tried. But whatever the gain in realism, it comes at a cost, because, except in obvious cases of complementarity or close substitutability between products or services, the Marshallian paradigm ignores the less obvious, but not necessarily negligible, interactions between markets. Those interactions render the Marshallian ceteris-paribus proviso for partial-equilibrium analysis logically dubious, except under the most stringent assumptions.

The absence of an auctioneer from Marshall’s schema leads De Vroey to infer that market participants in that schema must be endowed with knowledge of market demand-and-supply conditions. I claim no expertise as a Marshallian scholar, but I find it hard to accept that, given his emphasis on realism, Marshall would have attributed perfect knowledge to market participants. The implausibility of the Walrasian assumptions is thus matched, in De Vroey’s view, by different, but scarcely less implausible, Marshallian assumptions.

De Vroey proceeds to argue that Keynes himself was squarely on the Marshallian, not the Walrasian, side of the divide. Here’s how, focusing on the IS-LM model, he puts it:

As far as the representation of the economy is concerned, the economy that the IS-LM model analyzes is composed of markets that function separately, each of them being an autonomous locus of equilibrium. Turning to trade technology, no auctioneer is supposedly present. As for the information assumption, it is true that economists using the IS-LM model scarcely evoke the possibility that it might rest on the assumption that agents are omniscient. But then nobody seems to have raised the issue of how equilibrium is reached in this model. Once raised, I see no other explanation than assuming agents’ ability to reconstruct the equilibrium values of the economy, that is, their being omniscient. On all these scores, the IS-LM model is Marshallian.

A History of Macroeconomics from Keynes to Lucas and Beyond, p. 350

De Vroey’s dichotomy between the Walrasian and Marshallian modeling approaches leads him to make needlessly sharp distinctions between them. The basic IS-LM model determines the quantity of money, consumption, saving and investment, income and the rate of interest rate. Presumably, by autonomous locus of equilibrium,” De Vroey means that the adjustment of some variable determined in one of the IS-LM markets adjusts in response to disequilibrium in that market alone, but even so, the markets are not isolated from each other as they are in Marshallian partial-equilibrium analysis. The equilibrium values of the variables in the IS-LM model are simultaneously determined in all markets, so the autonomy of each market does not preclude simultaneous determination. Nor does the equilibrium of the model depend, as De Vroey seems to suggest, on the existence of an auctioneer; the role of the auctioneer is merely to provide a story (however implausible) about how the equilibrium is, or might be, reached.

Elsewhere De Vroey faults Keynes for characterizing cyclical unemployment as involuntary, because that characterization is incompatible with a Marshallian analysis of the labor market. Without endorsing Keynes’s reasoning, I cannot accept De Vroey’s argument against Keynes, because the argument is based explicitly on the assumption of perfect foresight. Describing the difference between a strict Marshallian approach and that taken by Keynes, De Vroey writes as follows:

When the strict Marshallian viewpoint is adopted, everything is simple: it is assumed that the aggregate supply price function incorporates wages at their market-clearing magnitude. Instead, when taking Keynes’s line, it must be assumed that the wage rate that firms consider when constructing their supply price function is a “false” (i.e., non-market-clearing) wage. Now, if we want to keep firms’ perfect foresight assumption (and, let me repeat, we need to lest we fall into a theoretical wilderness), it must be concluded that firms’ incorporation of a false wage into their supply function follows from their correct expectation that this is indeed what will happen in the labor market. That is, firms’ managers are aware that in this market something impairs market clearing. No other explanation than the wage floor assumption is available as long as one remains in the canonical Marshallian framework. Therefore, all Keynes’s claims to the contrary notwithstanding, it is difficult to escape the conclusion that his effective demand reasoning is based on the fixed-wage hypothesis. The reason for unemployment lies in the labor market, and no fuss should be made about effective demand being [the reason rather] than the other way around.

Id. pp. 22-23

De Vroey seems to be saying that if firms anticipate an equilibrium outcome, the equilibrium outcome will be realized. This is not an argument; it is question-begging, question-begging which De Vroey justifies by warning that the alternative to question-begging is to “fall into a theoretical wilderness.” Thus, Keynes’s argument for involuntary unemployment is rejected based on the argument that the in the only foreseeable outcome under the assumption of perfect information, unemployment cannot be involuntary.

Because neither the Walrasian nor the Marshallian modeling approach gives a plausible account of how an equilibrium is reached, De Vroey’s insistence that either implausible story is somehow essential to the corresponding modeling approach is misplaced, each approach committing the fallacy of misplaced concreteness in focusing on an equilibrium solution that cannot plausibly be realized. For De Vroey instead to argue that, because the Marshallian approach cannot otherwise explain how equilibrium is realized, the agents must be omniscient is akin to the advice of one Senator during the Vietnam war for President Nixon to declare victory and then withdraw all American troops.

I will have more to say about the Walras-Marshall divide and how to surmount the difficulties with both in a future post (or posts).

General Equilibrium, Partial Equilibrium and Costs

Published August 4, 2021 Alfred Marshall , comparative statics , general equilibrium , Irving Fisher , Kenneth Arrow , Keynes , Leon Walras , macroeconomics , microfoundations , partial equilibrium , supply-demand analysis , Walrasian equilibrium 27 Comments

Neoclassical economics is now bifurcated between Marshallian partial-equilibrium and Walrasian general-equilibrium analyses. With the apparent inability of neoclassical theory to explain the coordination failure of the Great Depression, J. M. Keynes proposed an alternative paradigm to explain the involuntary unemployment of the 1930s. But within two decades, Keynes’s contribution was subsumed under what became known as the neoclassical synthesis of the Keynesian and Walrasian theories (about which I have written frequently, e.g., here and here). Lacking microfoundations that could be reconciled with the assumptions of Walrasian general-equilibrium theory, the neoclassical synthesis collapsed, owing to the supposedly inadequate microfoundations of Keynesian theory.

But Walrasian general-equilibrium theory provides no plausible, much less axiomatic, account of how general equilibrium is, or could be, achieved. Even the imaginary tatonnement process lacks an algorithm that guarantees that a general-equilibrium solution, if it exists, would be found. Whatever plausibility is attributed to the assumption that price flexibility leads to equilibrium derives from Marshallian partial-equilibrium analysis, with market prices adjusting to equilibrate supply and demand.

Yet modern macroeconomics, despite its explicit Walrasian assumptions, implicitly relies on the Marshallian intuition that the fundamentals of general-equilibrium, prices and costs are known to agents who, except for random disturbances, continuously form rational expectations of market-clearing equilibrium prices in all markets.

I’ve written many earlier posts (e.g., here and here) contesting, in one way or another, the notion that all macroeconomic theories must be founded on first principles (i.e., microeconomic axioms about optimizing individuals). Any macroeconomic theory not appropriately founded on the axioms of individual optimization by consumers and producers is now dismissed as scientifically defective and unworthy of attention by serious scientific practitioners of macroeconomics.

When contesting the presumed necessity for macroeconomics to be microeconomically founded, I’ve often used Marshall’s partial-equilibrium method as a point of reference. Though derived from underlying preference functions that are independent of prices, the demand curves of partial-equilibrium analysis presume that all product prices, except the price of the product under analysis, are held constant. Similarly, the supply curves are derived from individual firm marginal-cost curves whose geometric position or algebraic description depends critically on the prices of raw materials and factors of production used in the production process. But neither the prices of alternative products to be purchased by consumers nor the prices of raw materials and factors of production are given independently of the general-equilibrium solution of the whole system.

Thus, partial-equilibrium analysis, to be analytically defensible, requires a ceteris-paribus proviso. But to be analytically tenable, that proviso must posit an initial position of general equilibrium. Unless the analysis starts from a state of general equilibrium, the assumption that all prices but one remain constant can’t be maintained, the constancy of disequilibrium prices being a nonsensical assumption.

The ceteris-paribus proviso also entails an assumption about the market under analysis; either the market itself, or the disturbance to which it’s subject, must be so small that any change in the equilibrium price of the product in question has de minimus repercussions on the prices of every other product and of every input and factor of production used in producing that product. Thus, the validity of partial-equilibrium analysis depends on the presumption that the unique and locally stable general-equilibrium is approximately undisturbed by whatever changes result from by the posited change in the single market being analyzed. But that presumption is not so self-evidently plausible that our reliance on it to make empirical predictions is always, or even usually, justified.

Perhaps the best argument for taking partial-equilibrium analysis seriously is that the analysis identifies certain deep structural tendencies that, at least under “normal” conditions of moderate macroeconomic stability (i.e., moderate unemployment and reasonable price stability), will usually be observable despite the disturbing influences that are subsumed under the ceteris-paribus proviso. That assumption — an assumption of relative ignorance about the nature of the disturbances that are assumed to be constant — posits that those disturbances are more or less random, and as likely to cause errors in one direction as another. Consequently, the predictions of partial-equilibrium analysis can be assumed to be statistically, though not invariably, correct.

Of course, the more interconnected a given market is with other markets in the economy, and the greater its size relative to the total economy, the less confidence we can have that the implications of partial-equilibrium analysis will be corroborated by empirical investigation.

Despite its frequent unsuitability, economists and commentators are often willing to deploy partial-equilibrium analysis in offering policy advice even when the necessary ceteris-paribus proviso of partial-equilibrium analysis cannot be plausibly upheld. For example, two of the leading theories of the determination of the rate of interest are the loanable-funds doctrine and the Keynesian liquidity-preference theory. Both these theories of the rate of interest suppose that the rate of interest is determined in a single market — either for loanable funds or for cash balances — and that the rate of interest adjusts to equilibrate one or the other of those two markets. But the rate of interest is an economy-wide price whose determination is an intertemporal-general-equilibrium phenomenon that cannot be reduced, as the loanable-funds and liquidity preference theories try to do, to the analysis of a single market.

Similarly partial-equilibrium analysis of the supply of, and the demand for, labor has been used of late to predict changes in wages from immigration and to advocate for changes in immigration policy, while, in an earlier era, it was used to recommend wage reductions as a remedy for persistently high aggregate unemployment. In the General Theory, Keynes correctly criticized those using a naïve version of the partial-equilibrium method to recommend curing high unemployment by cutting wage rates, correctly observing that the conditions for full employment required the satisfaction of certain macroeconomic conditions for equilibrium that would not necessarily be satisfied by cutting wages.

However, in the very same volume, Keynes argued that the rate of interest is determined exclusively by the relationship between the quantity of money and the demand to hold money, ignoring that the rate of interest is an intertemporal relationship between current and expected future prices, an insight earlier explained by Irving Fisher that Keynes himself had expertly deployed in his Tract on Monetary Reform and elsewhere (Chapter 17) in the General Theory itself.

Evidently, the allure of supply-demand analysis can sometimes be too powerful for well-trained economists to resist even when they actually know better themselves that it ought to be resisted.

A further point also requires attention: the conditions necessary for partial-equilibrium analysis to be valid are never really satisfied; firms don’t know the costs that determine the optimal rate of production when they actually must settle on a plan of how much to produce, how much raw materials to buy, and how much labor and other factors of production to employ. Marshall, the originator of partial-equilibrium analysis, analogized supply and demand to the blades of a scissor acting jointly to achieve a intended result.

But Marshall erred in thinking that supply (i.e., cost) is an independent determinant of price, because the equality of costs and prices is a characteristic of general equilibrium. It can be applied to partial-equilibrium analysis only under the ceteris-paribus proviso that situates partial-equilibrium analysis in a pre-existing general equilibrium of the entire economy. It is only in general-equilibrium state, that the cost incurred by a firm in producing its output represents the value of the foregone output that could have been produced had the firm’s output been reduced. Only if the analyzed market is so small that changes in how much firms in that market produce do not affect the prices of the inputs used in to produce that output can definite marginal-cost curves be drawn or algebraically specified.

Unless general equilibrium obtains, prices need not equal costs, as measured by the quantities and prices of inputs used by firms to produce any product. Partial equilibrium analysis is possible only if carried out in the context of general equilibrium. Cost cannot be an independent determinant of prices, because cost is itself determined simultaneously along with all other prices.

But even aside from the reasons why partial-equilibrium analysis presumes that all prices, but the price in the single market being analyzed, are general-equilibrium prices, there’s another, even more problematic, assumption underlying partial-equilibrium analysis: that producers actually know the prices that they will pay for the inputs and resources to be used in producing their outputs. The cost curves of the standard economic analysis of the firm from which the supply curves of partial-equilibrium analysis are derived, presume that the prices of all inputs and factors of production correspond to those that are consistent with general equilibrium. But general-equilibrium prices are never known by anyone except the hypothetical agents in a general-equilibrium model with complete markets, or by agents endowed with perfect foresight (aka rational expectations in the strict sense of that misunderstood term).

At bottom, Marshallian partial-equilibrium analysis is comparative statics: a comparison of two alternative (hypothetical) equilibria distinguished by some difference in the parameters characterizing the two equilibria. By comparing the equilibria corresponding to the different parameter values, the analyst can infer the effect (at least directionally) of a parameter change.

But comparative-statics analysis is subject to a serious limitation: comparing two alternative hypothetical equilibria is very different from making empirical predictions about the effects of an actual parameter change in real time.

Comparing two alternative equilibria corresponding to different values of a parameter may be suggestive of what could happen after a policy decision to change that parameter, but there are many reasons why the change implied by the comparative-statics exercise might not match or even approximate the actual change.

First, the initial state was almost certainly not an equilibrium state, so systemic changes will be difficult, if not impossible, to disentangle from the effect of parameter change implied by the comparative-statics exercise.

Second, even if the initial state was an equilibrium, the transition to a new equilibrium is never instantaneous. The transitional period therefore leads to changes that in turn induce further systemic changes that cause the new equilibrium toward which the system gravitates to differ from the final equilibrium of the comparative-statics exercise.

Third, each successive change in the final equilibrium toward which the system is gravitating leads to further changes that in turn keep changing the final equilibrium. There is no reason why the successive changes lead to convergence on any final equilibrium end state. Nor is there any theoretical proof that the adjustment path leading from one equilibrium to another ever reaches an equilibrium end state. The gap between the comparative-statics exercise and the theory of adjustment in real time remains unbridged and may, even in principle, be unbridgeable.

Finally, without a complete system of forward and state-contingent markets, equilibrium requires not just that current prices converge to equilibrium prices; it requires that expectations of all agents about future prices converge to equilibrium expectations of future prices. Unless, agents’ expectations of future prices converge to their equilibrium values, an equilibrium many not even exist, let alone be approached or attained.

So the Marshallian assumption that producers know their costs of production and make production and pricing decisions based on that knowledge is both factually wrong and logically untenable. Nor do producers know what the demand curves for their products really looks like, except in the extreme case in which suppliers take market prices to be parametrically determined. But even then, they make decisions not on known prices, but on expected prices. Their expectations are constantly being tested against market information about actual prices, information that causes decision makers to affirm or revise their expectations in light of the constant flow of new information about prices and market conditions.

I don’t reject partial-equilibrium analysis, but I do call attention to its limitations, and to its unsuitability as a supposedly essential foundation for macroeconomic analysis, especially inasmuch as microeconomic analysis, AKA partial-equilibrium analysis, is utterly dependent on the uneasy macrofoundation of general-equilibrium theory. The intuition of Marshallian partial equilibrium cannot fil the gap, long ago noted by Kenneth Arrow, in the neoclassical theory of equilibrium price adjustment.

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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