Archive for the 'neoclassical synthesis' Category

Axel Leijonhufvud and Modern Macroeconomics

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

An Austrian Tragedy

Published May 24, 2020 Alfred Marshall , Carl Menger , E. v. Bohm-Bawerk , expectations , general equilibrium , Great Depression , Hayek , Irving Fisher , IS-LM , Israel Kirzner , Joseph Schumpeter , Keynes , Leon Walras , Ludwig Lachmann , Ludwig von Mises , macroeconomics , neoclassical synthesis , New Classical macroeconomics , New Keynesians , Old Keynesians , Oskar Morgensterm , rational expectations , rational expectations equilibrium , representative agent , Walrasian equilibrium 32 Comments
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It was hardly predictable that the New York Review of Books would take notice of Marginal Revolutionaries by Janek Wasserman, marking the susquicentenial of the publication of Carl Menger’s Grundsätze (Principles of Economics) which, along with Jevons’s Principles of Political Economy and Walras’s Elements of Pure Economics ushered in the marginal revolution upon which all of modern economics, for better or for worse, is based. The differences among the three founding fathers of modern economic theory were not insubstantial, and the Jevonian version was largely superseded by the work of his younger contemporary Alfred Marshall, so that modern neoclassical economics is built on the work of only one of the original founders, Leon Walras, Jevons’s work having left little impression on the future course of economics.

Menger’s work, however, though largely, but not totally, eclipsed by that of Marshall and Walras, did leave a more enduring imprint and a more complicated legacy than Jevons’s — not only for economics, but for political theory and philosophy, more generally. Judging from Edward Chancellor’s largely favorable review of Wasserman’s volume, one might even hope that a start might be made in reassessing that legacy, a process that could provide an opportunity for mutually beneficial interaction between long-estranged schools of thought — one dominant and one marginal — that are struggling to overcome various conceptual, analytical and philosophical problems for which no obvious solutions seem available.

In view of the failure of modern economists to anticipate the Great Recession of 2008, the worst financial shock since the 1930s, it was perhaps inevitable that the Austrian School, a once favored branch of economics that had made a specialty of booms and busts, would enjoy a revival of public interest.

The theme of Austrians as outsiders runs through Janek Wasserman’s The Marginal Revolutionaries: How Austrian Economists Fought the War of Ideas, a general history of the Austrian School from its beginnings to the present day. The title refers both to the later marginalization of the Austrian economists and to the original insight of its founding father, Carl Menger, who introduced the notion of marginal utility—namely, that economic value does not derive from the cost of inputs such as raw material or labor, as David Ricardo and later Karl Marx suggested, but from the utility an individual derives from consuming an additional amount of any good or service. Water, for instance, may be indispensable to humans, but when it is abundant, the marginal value of an extra glass of the stuff is close to zero. Diamonds are less useful than water, but a great deal rarer, and hence command a high market price. If diamonds were as common as dewdrops, however, they would be worthless.

Menger was not the first economist to ponder . . . the “paradox of value” (why useless things are worth more than essentials)—the Italian Ferdinando Galiani had gotten there more than a century earlier. His central idea of marginal utility was simultaneously developed in England by W. S. Jevons and on the Continent by Léon Walras. Menger’s originality lay in applying his theory to the entire production process, showing how the value of capital goods like factory equipment derived from the marginal value of the goods they produced. As a result, Austrian economics developed a keen interest in the allocation of capital. Furthermore, Menger and his disciples emphasized that value was inherently subjective, since it depends on what consumers are willing to pay for something; this imbued the Austrian school from the outset with a fiercely individualistic and anti-statist aspect.

Menger’s unique contribution is indeed worthy of special emphasis. He was more explicit than Jevons or Walras, and certainly more than Marshall, in explaining that the value of factors of production is derived entirely from the value of the incremental output that could be attributed (or imputed) to their services. This insight implies that cost is not an independent determinant of value, as Marshall, despite accepting the principle of marginal utility, continued to insist – famously referring to demand and supply as the two blades of the analytical scissors that determine value. The cost of production therefore turns out to be nothing but the value the output foregone when factors are used to produce one output instead of the next most highly valued alternative. Cost therefore does not determine, but is determined by, equilibrium price, which means that, in practice, costs are always subjective and conjectural. (I have made this point in an earlier post in a different context.) I will have more to say below about the importance of Menger’s specific contribution and its lasting imprint on the Austrian school.

Menger’s Principles of Economics, published in 1871, established the study of economics in Vienna—before then, no economic journals were published in Austria, and courses in economics were taught in law schools. . . .

The Austrian School was also bound together through family and social ties: [his two leading disciples, [Eugen von] Böhm-Bawerk and Friedrich von Wieser [were brothers-in-law]. [Wieser was] a close friend of the statistician Franz von Juraschek, Friedrich Hayek’s maternal grandfather. Young Austrian economists bonded on Alpine excursions and met in Böhm-Bawerk’s famous seminars (also attended by the Bolshevik Nikolai Bukharin and the German Marxist Rudolf Hilferding). Ludwig von Mises continued this tradition, holding private seminars in Vienna in the 1920s and later in New York. As Wasserman notes, the Austrian School was “a social network first and last.”

After World War I, the Habsburg Empire was dismantled by the victorious Allies. The Austrian bureaucracy shrank, and university placements became scarce. Menger, the last surviving member of the first generation of Austrian economists, died in 1921. The economic school he founded, with its emphasis on individualism and free markets, might have disappeared under the socialism of “Red Vienna.” Instead, a new generation of brilliant young economists emerged: Schumpeter, Hayek, and Mises—all of whom published best-selling works in English and remain familiar names today—along with a number of less well known but influential economists, including Oskar Morgenstern, Fritz Machlup, Alexander Gerschenkron, and Gottfried Haberler.

Two factual corrections are in order. Menger outlived Böhm-Bawerk, but not his other chief disciple von Wieser, who died in 1926, not long after supervising Hayek’s doctoral dissertation, later published in 1927, and, in 1933, translated into English and published as Monetary Theory and the Trade Cycle. Moreover, a 16-year gap separated Mises and Schumpeter, who were exact contemporaries, from Hayek (born in 1899) who was a few years older than Gerschenkron, Haberler, Machlup and Morgenstern.

All the surviving members or associates of the Austrian school wound up either in the US or Britain after World War II, and Hayek, who had taken a position in London in 1931, moved to the US in 1950, taking a position in the Committee on Social Thought at the University of Chicago after having been refused a position in the economics department. Through the intervention of wealthy sponsors, Mises obtained an academic appointment of sorts at the NYU economics department, where he succeeded in training two noteworthy disciples who wrote dissertations under his tutelage, Murray Rothbard and Israel Kirzner. (Kirzner wrote his dissertation under Mises at NYU, but Rothbard did his graduate work at Colulmbia.) Schumpeter, Haberler and Gerschenkron eventually took positions at Harvard, while Machlup (with some stops along the way) and Morgenstern made their way to Princeton. However, Hayek’s interests shifted from pure economic theory to deep philosophical questions. While Machlup and Haberler continued to work on economic theory, the Austrian influence on their work after World War II was barely recognizable. Morgenstern and Schumpeter made major contributions to economics, but did not hide their alienation from the doctrines of the Austrian School.

So there was little reason to expect that the Austrian School would survive its dispersal when the Nazis marched unopposed into Vienna in 1938. That it did survive is in no small measure due to its ideological usefulness to anti-socialist supporters who provided financial support to Hayek, enabling his appointment to the Committee on Social Thought at the University of Chicago, and Mises’s appointment at NYU, and other forms of research support to Hayek, Mises and other like-minded scholars, as well as funding the Mont Pelerin Society, an early venture in globalist networking, started by Hayek in 1947. Such support does not discredit the research to which it gave rise. That the survival of the Austrian School would probably not have been possible without the support of wealthy benefactors who anticipated that the Austrians would advance their political and economic interests does not invalidate the research thereby enabled. (In the interest of transparency, I acknowledge that I received support from such sources for two books that I wrote.)

Because Austrian School survivors other than Mises and Hayek either adapted themselves to mainstream thinking without renouncing their earlier beliefs (Haberler and Machlup) or took an entirely different direction (Morgenstern), and because the economic mainstream shifted in two directions that were most uncongenial to the Austrians: Walrasian general-equilibrium theory and Keynesian macroeconomics, the Austrian remnant, initially centered on Mises at NYU, adopted a sharply adversarial attitude toward mainstream economic doctrines.

Despite its minute numbers, the lonely remnant became a house divided against itself, Mises’s two outstanding NYU disciples, Murray Rothbard and Israel Kirzner, holding radically different conceptions of how to carry on the Austrian tradition. An extroverted radical activist, Rothbard was not content just to lead a school of economic thought, he aspired to become the leader of a fantastical anarchistic revolutionary movement to replace all established governments under a reign of private-enterprise anarcho-capitalism. Rothbard’s political radicalism, which, despite his Jewish ancestry, even included dabbling in Holocaust denialism, so alienated his mentor, that Mises terminated all contact with Rothbard for many years before his death. Kirzner, self-effacing, personally conservative, with no political or personal agenda other than the advancement of his own and his students’ scholarship, published hundreds of articles and several books filling 10 thick volumes of his collected works published by the Liberty Fund, while establishing a robust Austrian program at NYU, training many excellent scholars who found positions in respected academic and research institutions. Similar Austrian programs, established under the guidance of Kirzner’s students, were started at other institutions, most notably at George Mason University.

One of the founders of the Cato Institute, which for nearly half a century has been the leading avowedly libertarian think tank in the US, Rothbard was eventually ousted by Cato, and proceeded to set up a rival think tank, the Ludwig von Mises Institute, at Auburn University, which has turned into a focal point for extreme libertarians and white nationalists to congregate, get acquainted, and strategize together.

Isolation and marginalization tend to cause a subspecies either to degenerate toward extinction, to somehow blend in with the members of the larger species, thereby losing its distinctive characteristics, or to accentuate its unique traits, enabling it to find some niche within which to survive as a distinct sub-species. Insofar as they have engaged in economic analysis rather than in various forms of political agitation and propaganda, the Rothbardian Austrians have focused on anarcho-capitalist theory and the uniquely perverse evils of fractional-reserve banking.

Rejecting the political extremism of the Rothbardians, Kirznerian Austrians differentiate themselves by analyzing what they call market processes and emphasizing the limitations on the knowledge and information possessed by actual decision-makers. They attribute this misplaced focus on equilibrium to the extravagantly unrealistic and patently false assumptions of mainstream models on the knowledge possessed by economic agents, which effectively make equilibrium the inevitable — and trivial — conclusion entailed by those extreme assumptions. In their view, the focus of mainstream models on equilibrium states with unrealistic assumptions results from a preoccupation with mathematical formalism in which mathematical tractability rather than sound economics dictates the choice of modeling assumptions.

Skepticism of the extreme assumptions about the informational endowments of agents covers a range of now routine assumptions in mainstream models, e.g., the ability of agents to form precise mathematical estimates of the probability distributions of future states of the world, implying that agents never confront decisions about which they are genuinely uncertain. Austrians also object to the routine assumption that all the information needed to determine the solution of a model is the common knowledge of the agents in the model, so that an existing equilibrium cannot be disrupted unless new information randomly and unpredictably arrives. Each agent in the model having been endowed with the capacity of a semi-omniscient central planner, solving the model for its equilibrium state becomes a trivial exercise in which the optimal choices of a single agent are taken as representative of the choices made by all of the model’s other, semi-omnicient, agents.

Although shreds of subjectivism — i.e., agents make choices based own preference orderings — are shared by all neoclassical economists, Austrian criticisms of mainstream neoclassical models are aimed at what Austrians consider to be their insufficient subjectivism. It is this fierce commitment to a robust conception of subjectivism, in which an equilibrium state of shared expectations by economic agents must be explained, not just assumed, that Chancellor properly identifies as a distinguishing feature of the Austrian School.

Menger’s original idea of marginal utility was posited on the subjective preferences of consumers. This subjectivist position was retained by subsequent generations of the school. It inspired a tradition of radical individualism, which in time made the Austrians the favorite economists of American libertarians. Subjectivism was at the heart of the Austrians’ polemical rejection of Marxism. Not only did they dismiss Marx’s labor theory of value, they argued that socialism couldn’t possibly work since it would lack the means to allocate resources efficiently.

The problem with central planning, according to Hayek, is that so much of the knowledge that people act upon is specific knowledge that individuals acquire in the course of their daily activities and life experience, knowledge that is often difficult to articulate – mere intuition and guesswork, yet more reliable than not when acted upon by people whose livelihoods depend on being able to do the right thing at the right time – much less communicate to a central planner.

Chancellor attributes Austrian mistrust of statistical aggregates or indices, like GDP and price levels, to Austrian subjectivism, which regards such magnitudes as abstractions irrelevant to the decisions of private decision-makers, except perhaps in forming expectations about the actions of government policy makers. (Of course, this exception potentially provides full subjectivist license and legitimacy for macroeconomic theorizing despite Austrian misgivings.) Observed statistical correlations between aggregate variables identified by macroeconomists are dismissed as irrelevant unless grounded in, and implied by, the purposeful choices of economic agents.

But such scruples about the use of macroeconomic aggregates and inferring causal relationships from observed correlations are hardly unique to the Austrian school. One of the most important contributions of the 20th century to the methodology of economics was an article by T. C. Koopmans, “Measurement Without Theory,” which argued that measured correlations between macroeconomic variables provide a reliable basis for business-cycle research and policy advice only if the correlations can be explained in terms of deeper theoretical or structural relationships. The Nobel Prize Committee, in awarding the 1975 Prize to Koopmans, specifically mentioned this paper in describing Koopmans’s contributions. Austrians may be more fastidious than their mainstream counterparts in rejecting macroeconomic relationships not based on microeconomic principles, but they aren’t the only ones mistrustful of mere correlations.

Chancellor cites mistrust about the use of statistical aggregates and price indices as a factor in Hayek’s disastrous policy advice warning against anti-deflationary or reflationary measures during the Great Depression.

Their distrust of price indexes brought Austrian economists into conflict with mainstream economic opinion during the 1920s. At the time, there was a general consensus among leading economists, ranging from Irving Fisher at Yale to Keynes at Cambridge, that monetary policy should aim at delivering a stable price level, and in particular seek to prevent any decline in prices (deflation). Hayek, who earlier in the decade had spent time at New York University studying monetary policy and in 1927 became the first director of the Austrian Institute for Business Cycle Research, argued that the policy of price stabilization was misguided. It was only natural, Hayek wrote, that improvements in productivity should lead to lower prices and that any resistance to this movement (sometimes described as “good deflation”) would have damaging economic consequences.

The argument that deflation stemming from economic expansion and increasing productivity is normal and desirable isn’t what led Hayek and the Austrians astray in the Great Depression; it was their failure to realize the deflation that triggered the Great Depression was a monetary phenomenon caused by a malfunctioning international gold standard. Moreover, Hayek’s own business-cycle theory explicitly stated that a neutral (stable) monetary policy ought to aim at keeping the flow of total spending and income constant in nominal terms while his policy advice of welcoming deflation meant a rapidly falling rate of total spending. Hayek’s policy advice was an inexcusable error of judgment, which, to his credit, he did acknowledge after the fact, though many, perhaps most, Austrians have refused to follow him even that far.

Considered from the vantage point of almost a century, the collapse of the Austrian School seems to have been inevitable. Hayek’s long-shot bid to establish his business-cycle theory as the dominant explanation of the Great Depression was doomed from the start by the inadequacies of the very specific version of his basic model and his disregard of the obvious implication of that model: prevent total spending from contracting. The promising young students and colleagues who had briefly gathered round him upon his arrival in England, mostly attached themselves to other mentors, leaving Hayek with only one or two immediate disciples to carry on his research program. The collapse of his research program, which he himself abandoned after completing his final work in economic theory, marked a research hiatus of almost a quarter century, with the notable exception of publications by his student, Ludwig Lachmann who, having decamped in far-away South Africa, labored in relative obscurity for most of his career.

The early clash between Keynes and Hayek, so important in the eyes of Chancellor and others, is actually overrated. Chancellor, quoting Lachmann and Nicholas Wapshott, describes it as a clash of two irreconcilable views of the economic world, and the clash that defined modern economics. In later years, Lachmann actually sought to effect a kind of reconciliation between their views. It was not a conflict of visions that undid Hayek in 1931-32, it was his misapplication of a narrowly constructed model to a problem for which it was irrelevant.

Although the marginalization of the Austrian School, after its misguided policy advice in the Great Depression and its dispersal during and after World War II, is hardly surprising, the unwillingness of mainstream economists to sort out what was useful and relevant in the teachings of the Austrian School from what is not was unfortunate not only for the Austrians. Modern economics was itself impoverished by its disregard for the complexity and interconnectedness of economic phenomena. It’s precisely the Austrian attentiveness to the complexity of economic activity — the necessity for complementary goods and factors of production to be deployed over time to satisfy individual wants – that is missing from standard economic models.

That Austrian attentiveness, pioneered by Menger himself, to the complementarity of inputs applied over the course of time undoubtedly informed Hayek’s seminal contribution to economic thought: his articulation of the idea of intertemporal equilibrium that comprehends the interdependence of the plans of independent agents and the need for them to all fit together over the course of time for equilibrium to obtain. Hayek’s articulation represented a conceptual advance over earlier versions of equilibrium analysis stemming from Walras and Pareto, and even from Irving Fisher who did pay explicit attention to intertemporal equilibrium. But in Fisher’s articulation, intertemporal consistency was described in terms of aggregate production and income, leaving unexplained the mechanisms whereby the individual plans to produce and consume particular goods over time are reconciled. Hayek’s granular exposition enabled him to attend to, and articulate, necessary but previously unspecified relationships between the current prices and expected future prices.

Moreover, neither mainstream nor Austrian economists have ever explained how prices are adjust in non-equilibrium settings. The focus of mainstream analysis has always been the determination of equilibrium prices, with the implicit understanding that “market forces” move the price toward its equilibrium value. The explanatory gap has been filled by the mainstream New Classical School which simply posits the existence of an equilibrium price vector, and, to replace an empirically untenable tâtonnement process for determining prices, posits an equally untenable rational-expectations postulate to assert that market economies typically perform as if they are in, or near the neighborhood of, equilibrium, so that apparent fluctuations in real output are viewed as optimal adjustments to unexplained random productivity shocks.

Alternatively, in New Keynesian mainstream versions, constraints on price changes prevent immediate adjustments to rationally expected equilibrium prices, leading instead to persistent reductions in output and employment following demand or supply shocks. (I note parenthetically that the assumption of rational expectations is not, as often suggested, an assumption distinct from market-clearing, because the rational expectation of all agents of a market-clearing price vector necessarily implies that the markets clear unless one posits a constraint, e.g., a binding price floor or ceiling, that prevents all mutually beneficial trades from being executed.)

Similarly, the Austrian school offers no explanation of how unconstrained price adjustments by market participants is a sufficient basis for a systemic tendency toward equilibrium. Without such an explanation, their belief that market economies have strong self-correcting properties is unfounded, because, as Hayek demonstrated in his 1937 paper, “Economics and Knowledge,” price adjustments in current markets don’t, by themselves, ensure a systemic tendency toward equilibrium values that coordinate the plans of independent economic agents unless agents’ expectations of future prices are sufficiently coincident. To take only one passage of many discussing the difficulty of explaining or accounting for a process that leads individuals toward a state of equilibrium, I offer the following as an example:

All that this condition amounts to, then, is that there must be some discernible regularity in the world which makes it possible to predict events correctly. But, while this is clearly not sufficient to prove that people will learn to foresee events correctly, the same is true to a hardly less degree even about constancy of data in an absolute sense. For any one individual, constancy of the data does in no way mean constancy of all the facts independent of himself, since, of course, only the tastes and not the actions of the other people can in this sense be assumed to be constant. As all those other people will change their decisions as they gain experience about the external facts and about other people’s actions, there is no reason why these processes of successive changes should ever come to an end. These difficulties are well known, and I mention them here only to remind you how little we actually know about the conditions under which an equilibrium will ever be reached.

In this theoretical muddle, Keynesian economics and the neoclassical synthesis were abandoned, because the key proposition of Keynesian economics was supposedly the tendency of a modern economy toward an equilibrium with involuntary unemployment while the neoclassical synthesis rejected that proposition, so that the supposed synthesis was no more than an agreement to disagree. That divided house could not stand. The inability of Keynesian economists such as Hicks, Modigliani, Samuelson and Patinkin to find a satisfactory (at least in terms of a preferred Walrasian general-equilibrium model) rationalization for Keynes’s conclusion that an economy would likely become stuck in an equilibrium with involuntary unemployment led to the breakdown of the neoclassical synthesis and the displacement of Keynesianism as the dominant macroeconomic paradigm.

But perhaps the way out of the muddle is to abandon the idea that a systemic tendency toward equilibrium is a property of an economic system, and, instead, to recognize that equilibrium is, as Hayek suggested, a contingent, not a necessary, property of a complex economy. Ludwig Lachmann, cited by Chancellor for his remark that the early theoretical clash between Hayek and Keynes was a conflict of visions, eventually realized that in an important sense both Hayek and Keynes shared a similar subjectivist conception of the crucial role of individual expectations of the future in explaining the stability or instability of market economies. And despite the efforts of New Classical economists to establish rational expectations as an axiomatic equilibrating property of market economies, that notion rests on nothing more than arbitrary methodological fiat.

Chancellor concludes by suggesting that Wasserman’s characterization of the Austrians as marginalized is not entirely accurate inasmuch as “the Austrians’ view of the economy as a complex, evolving system continues to inspire new research.” Indeed, if economics is ever to find a way out of its current state of confusion, following Lachmann in his quest for a synthesis of sorts between Keynes and Hayek might just be a good place to start from.

A Tale of Two Syntheses

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

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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