Archive for the 'New Classical macroeconomics' Category

Lucas and Sargent on Optimization and Equilibrium in Macroeconomics

In a famous contribution to a conference sponsored by the Federal Reserve Bank of Boston, Robert Lucas and Thomas Sargent (1978) harshly attacked Keynes and Keynesian macroeconomics for shortcomings both theoretical and econometric. The econometric criticisms, drawing on the famous Lucas Critique (Lucas 1976), were focused on technical identification issues and on the dependence of estimated regression coefficients of econometric models on agents’ expectations conditional on the macroeconomic policies actually in effect, rendering those econometric models an unreliable basis for policymaking. But Lucas and Sargent reserved their harshest criticism for abandoning what they called the classical postulates.

Economists prior to the 1930s did not recognize a need for a special branch of economics, with its own special postulates, designed to explain the business cycle. Keynes founded that subdiscipline, called macroeconomics, because he thought that it was impossible to explain the characteristics of business cycles within the discipline imposed by classical economic theory, a discipline imposed by its insistence on . . . two postulates (a) that markets . . . clear, and (b) that agents . . . act in their own self-interest [optimize]. The outstanding fact that seemed impossible to reconcile with these two postulates was the length and severity of business depressions and the large scale unemployment which they entailed. . . . After freeing himself of the straight-jacket (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[1]. . . .

In recent years, the meaning of the term “equilibrium” has undergone such dramatic development that a theorist of the 1930s would not recognize it. It is now routine to describe an economy following a multivariate stochastic process as being “in equilibrium,” by which is meant nothing more than that at each point in time, postulates (a) and (b) above are satisfied. This development, which stemmed mainly from work by K. J. Arrow and G. Debreu, implies that simply to look at any economic time series and conclude that it is a “disequilibrium phenomenon” is a meaningless observation. Indeed, a more likely conjecture, on the basis of recent work by Hugo Sonnenschein, is that the general hypothesis that a collection of time series describes an economy in competitive equilibrium is without content. (pp. 58-59)

Lucas and Sargent maintain that ‘classical” (by which they obviously mean “neoclassical”) economics is based on the twin postulates of (a) market clearing and (b) optimization. But optimization is a postulate about individual conduct or decision making under ideal conditions in which individuals can choose costlessly among alternatives that they can rank. Market clearing is not a postulate about individuals, it is the outcome of a process that neoclassical theory did not, and has not, described in any detail.

Instead of describing the process by which markets clear, neoclassical economic theory provides a set of not too realistic stories about how markets might clear, of which the two best-known stories are the Walrasian auctioneer/tâtonnement story, widely regarded as merely heuristic, if not fantastical, and the clearly heuristic and not-well-developed Marshallian partial-equilibrium story of a “long-run” equilibrium price for each good correctly anticipated by market participants corresponding to the long-run cost of production. However, the cost of production on which the Marhsallian long-run equilibrium price depends itself presumes that a general equilibrium of all other input and output prices has been reached, so it is not an alternative to, but must be subsumed under, the Walrasian general equilibrium paradigm.

Thus, in invoking the neoclassical postulates of market-clearing and optimization, Lucas and Sargent unwittingly, or perhaps wittingly, begged the question how market clearing, which requires that the plans of individual optimizing agents to buy and sell reconciled in such a way that each agent can carry out his/her/their plan as intended, comes about. Rather than explain how market clearing is achieved, they simply assert – and rather loudly – that we must postulate that market clearing is achieved, and thereby submit to the virtuous discipline of equilibrium.

Because they could provide neither empirical evidence that equilibrium is continuously achieved nor a plausible explanation of the process whereby it might, or could be, achieved, Lucas and Sargent try to normalize their insistence that equilibrium is an obligatory postulate that must be accepted by economists by calling it “routine to describe an economy following a multivariate stochastic process as being ‘in equilibrium,’ by which is meant nothing more than that at each point in time, postulates (a) and (b) above are satisfied,” as if the routine adoption of any theoretical or methodological assumption becomes ipso facto justified once adopted routinely. That justification was unacceptable to Lucas and Sargent when made on behalf of “sticky wages” or Keynesian “rules of thumb, but somehow became compelling when invoked on behalf of perpetual “equilibrium” and neoclassical discipline.

Using the authority of Arrow and Debreu to support the normalcy of the assumption that equilibrium is a necessary and continuous property of reality, Lucas and Sargent maintained that it is “meaningless” to conclude that any economic time series is a disequilibrium phenomenon. A proposition ismeaningless if and only if neither the proposition nor its negation is true. So, in effect, Lucas and Sargent are asserting that it is nonsensical to say that an economic time either reflects or does not reflect an equilibrium, but that it is, nevertheless, methodologically obligatory to for any economic model to make that nonsensical assumption.

It is curious that, in making such an outlandish claim, Lucas and Sargent would seek to invoke the authority of Arrow and Debreu. Leave aside the fact that Arrow (1959) himself identified the lack of a theory of disequilibrium pricing as an explanatory gap in neoclassical general-equilibrium theory. But if equilibrium is a necessary and continuous property of reality, why did Arrow and Debreu, not to mention Wald and McKenzie, devoted so much time and prodigious intellectual effort to proving that an equilibrium solution to a system of equations exists. If, as Lucas and Sargent assert (nonsensically), it makes no sense to entertain the possibility that an economy is, or could be, in a disequilibrium state, why did Wald, Arrow, Debreu and McKenzie bother to prove that the only possible state of the world actually exists?

Having invoked the authority of Arrow and Debreu, Lucas and Sargent next invoke the seminal contribution of Sonnenschein (1973), though without mentioning the similar and almost simultaneous contributions of Mantel (1974) and Debreu (1974), to argue that it is empirically empty to argue that any collection of economic time series is either in equilibrium or out of equilibrium. This property has subsequently been described as an “Anything Goes Theorem” (Mas-Colell, Whinston, and Green, 1995).

Presumably, Lucas and Sargent believe the empirically empty hypothesis that a collection of economic time series is, or, alternatively is not, in equilibrium is an argument supporting the methodological imperative of maintaining the assumption that the economy absolutely and necessarily is in a continuous state of equilibrium. But what Sonnenschein (and Mantel and Debreu) showed was that even if the excess demands of all individual agents are continuous, are homogeneous of degree zero, and even if Walras’s Law is satisfied, aggregating the excess demands of all agents would not necessarily cause the aggregate excess demand functions to behave in such a way that a unique or a stable equilibrium. But if we have no good argument to explain why a unique or at least a stable neoclassical general-economic equilibrium exists, on what methodological ground is it possible to insist that no deviation from the admittedly empirically empty and meaningless postulate of necessary and continuous equilibrium may be tolerated by conscientious economic theorists? Or that the gatekeepers of reputable neoclassical economics must enforce appropriate standards of professional practice?

As Franklin Fisher (1989) showed, inability to prove that there is a stable equilibrium leaves neoclassical economics unmoored, because the bread and butter of neoclassical price theory (microeconomics), comparative statics exercises, is conditional on the assumption that there is at least one stable general equilibrium solution for a competitive economy.

But it’s not correct to say that general equilibrium theory in its Arrow-Debreu-McKenzie version is empirically empty. Indeed, it has some very strong implications. There is no money, no banks, no stock market, and no missing markets; there is no advertising, no unsold inventories, no search, no private information, and no price discrimination. There are no surprises and there are no regrets, no mistakes and no learning. I could go on, but you get the idea. As a theory of reality, the ADM general-equilibrium model is simply preposterous. And, yet, this is the model of economic reality on the basis of which Lucas and Sargent proposed to build a useful and relevant theory of macroeconomic fluctuations. OMG!

Lucas, in various writings, has actually disclaimed any interest in providing an explanation of reality, insisting that his only aim is to devise mathematical models capable of accounting for the observed values of the relevant time series of macroeconomic variables. In Lucas’s conception of science, the only criterion for scientific knowledge is the capacity of a theory – an algorithm for generating numerical values to be measured against observed time series – to generate predicted values approximating the observed values of the time series. The only constraint on the algorithm is Lucas’s methodological preference that the algorithm be derived from what he conceives to be an acceptable microfounded version of neoclassical theory: a set of predictions corresponding to the solution of a dynamic optimization problem for a “representative agent.”

In advancing his conception of the role of science, Lucas has reverted to the approach of ancient astronomers who, for methodological reasons of their own, believed that the celestial bodies revolved around the earth in circular orbits. To ensure that their predictions matched the time series of the observed celestial positions of the planets, ancient astronomers, following Ptolemy, relied on epicycles or second-order circular movements of planets while traversing their circular orbits around the earth to account for their observed motions.

Kepler and later Galileo conceived of the solar system in a radically different way from the ancients, placing the sun, not the earth, at the fixed center of the solar system and proposing that the orbits of the planets were elliptical, not circular. For a long time, however, the actual time series of geocentric predictions outperformed the new heliocentric predictions. But even before the heliocentric predictions started to outperform the geocentric predictions, the greater simplicity and greater realism of the heliocentric theory attracted an increasing number of followers, forcing methodological supporters of the geocentric theory to take active measures to suppress the heliocentric theory.

I hold no particular attachment to the pre-Lucasian versions of macroeconomic theory, whether Keynesian, Monetarist, or heterodox. Macroeconomic theory required a grounding in an explicit intertemporal setting that had been lacking in most earlier theories. But the ruthless enforcement, based on a preposterous methodological imperative, lacking scientific or philosophical justification, of formal intertemporal optimization models as the only acceptable form of macroeconomic theorizing has sidetracked macroeconomics from a more relevant inquiry into the nature and causes of intertemporal coordination failures that Keynes, along with many some of his predecessors and contemporaries, had initiated.

Just as the dispute about whether planetary motion is geocentric or heliocentric was a dispute about what the world is like, not just about the capacity of models to generate accurate predictions of time series variables, current macroeconomic disputes are real disputes about what the world is like and whether aggregate economic fluctuations are the result of optimizing equilibrium choices by economic agents or about coordination failures that cause economic agents to be surprised and disappointed and rendered unable to carry out their plans in the manner in which they had hoped and expected to be able to do. It’s long past time for this dispute about reality to be joined openly with the seriousness that it deserves, instead of being suppressed by a spurious pseudo-scientific methodology.

HT: Arash Molavi Vasséi, Brian Albrecht, and Chris Edmonds


[1] Lucas and Sargent are guilty of at least two misrepresentations in this paragraph. First, Keynes did not “found” macroeconomics, though he certainly influenced its development decisively. Keynes used the term “macroeconomics,” and his work, though crucial, explicitly drew upon earlier work by Marshall, Wicksell, Fisher, Pigou, Hawtrey, and Robertson, among others. See Laidler (1999). Second, having explicitly denied and argued at length that his results did not depend on the assumption of sticky wages, Keynes certainly never introduced the assumption of sticky wages himself. See Leijonhufvud (1968)

Axel Leijonhufvud and Modern Macroeconomics

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.

Three Propagation Mechanisms in Lucas and Sargent with a Response from Brad DeLong

UPDATE (4/3/2022): Reupping this post with the response to my query sent by Brad DeLong.

I’m writing this post in hopes of eliciting some guidance from readers about the three propagation mechanisms to which Robert Lucas and Thomas Sargent refer in their famous 1978 article, “After Keynesian Macroeconomics.” The three propagation mechanisms were mentioned to parry criticisms of the rational-expectations principle underlying the New Classical macroeconomics that Lucas and Sargent were then developing as an alternative to Keynesian macroeconomics. I am wondering how subsequent research has dealt with these propagation mechanisms and how they are now treated in current macro-theory. Here is the relevant passage from Lucas and Sargent:

A second line of criticism stems from the correct observation that if agents’ expectations are rational and if their information sets include lagged values of the variable being forecast, then agents’ forecast errors must be a serially uncorrelated random process. That is, on average there must be no detectable relationships between a period’s forecast error and any previous period’s. This feature has led several critics to conclude that equilibrium models cannot account for more than an insignificant part of the highly serially correlated movements we observe in real output, employment, unemployment, and other series. Tobin (1977, p. 461) has put the argument succinctly:

One currently popular explanation of variations in employment is temporary confusion of relative and absolute prices. Employers and workers are fooled into too many jobs by unexpected inflation, but only until they learn it affects other prices, not just the prices of what they sell. The reverse happens temporarily when inflation falls short of expectation. This model can scarcely explain more than transient disequilibrium in labor markets.

So how can the faithful explain the slow cycles of unemployment we actually observe? Only by arguing that the natural rate itself fluctuates, that variations in unemployment rates are substantially changes in voluntary, frictional, or structural unemployment rather than in involuntary joblessness due to generally deficient demand.

The critics typically conclude that the theory only attributes a very minor role to aggregate demand fluctuations and necessarily depends on disturbances to aggregate supply to account for most of the fluctuations in real output over the business cycle. “In other words,” as Modigliani (1977) has said, “what happened to the United States in the 1930’s was a severe attack of contagious laziness.” This criticism is fallacious because it fails to distinguish properly between sources of impulses and propagation mechanisms, a distinction stressed by Ragnar Frisch in a classic 1933 paper that provided many of the technical foundations for Keynesian macroeconometric models. Even though the new classical theory implies that the forecast errors which are the aggregate demand impulses are serially uncorrelated, it is certainly logically possible that propagation mechanisms are at work that convert these impulses into serially correlated movements in real variables like output and employment. Indeed, detailed theoretical work has already shown that two concrete propagation mechanisms do precisely that.

One mechanism stems from the presence of costs to firms of adjusting their stocks of capital and labor rapidly. The presence of these costs is known to make it optimal for firms to spread out over time their response to the relative price signals they receive. That is, such a mechanism causes a firm to convert the serially uncorrelated forecast errors in predicting relative prices into serially correlated movements in factor demands and output.

A second propagation mechanism is already present in the most classical of economic growth models. Households’ optimal accumulation plans for claims on physical capital and other assets convert serially uncorrelated impulses into serially correlated demands for the accumulation of real assets. This happens because agents typically want to divide any unexpected changes in income partly between consuming and accumulating assets. Thus, the demand for assets next period depends on initial stocks and on unexpected changes in the prices or income facing agents. This dependence makes serially uncorrelated surprises lead to serially correlated movements in demands for physical assets. Lucas (1975) showed how this propagation mechanism readily accepts errors in forecasting aggregate demand as an impulse source.

A third likely propagation mechanism has been identified by recent work in search theory. (See, for example, McCall 1965, Mortensen 1970, and Lucas and Prescott 1974.) Search theory tries to explain why workers who for some reason are without jobs find it rational not necessarily to take the first job offer that comes along but instead to remain unemployed for awhile until a better offer materializes. Similarly, the theory explains why a firm may find it optimal to wait until a more suitable job applicant appears so that vacancies persist for some time. Mainly for technical reasons, consistent theoretical models that permit this propagation mechanism to accept errors in forecasting aggregate demand as an impulse have not yet been worked out, but the mechanism seems likely eventually to play an important role in a successful model of the time series behavior of the unemployment rate. In models where agents have imperfect information, either of the first two mechanisms and probably the third can make serially correlated movements in real variables stem from the introduction of a serially uncorrelated sequence of forecasting errors. Thus theoretical and econometric models have been constructed in which in principle the serially uncorrelated process of forecasting errors can account for any proportion between zero and one of the steady state variance of real output or employment. The argument that such models must necessarily attribute most of the variance in real output and employment to variations in aggregate supply is simply wrong logically.

My problem with the Lucas-Sargent argument is that even if the deviations from a long-run equilibrium path are serially correlated, shouldn’t those deviations be diminishing over time after the initial disturbance. Can these propagation mechanisms account for amplification of the initial disturbance before the adjustment toward the equilibrium path begins? I would gratefully welcome any responses.

David Glasner has a question about the “rational expectations” business-cycle theories developed in the 1970s:

David GlasnerThree Propagation Mechanisms in Lucas & Sargent: ‘I’m… hop[ing for]… some guidance… about… propagation mechanisms… [in] Robert Lucas and Thomas Sargent[‘s]… “After Keynesian Macroeconomics.”… 

The critics typically conclude that the theory only attributes a very minor role to aggregate demand fluctuations and necessarily depends on disturbances to aggregate supply…. [But] even though the new classical theory implies that the forecast errors which are the aggregate demand impulses are serially uncorrelated, it is certainly logically possible that propagation mechanisms are at work that convert these impulses into serially correlated movements in real variables like output and employment… the presence of costs to firms of adjusting their stocks of capital and labor rapidly…. accumulation plans for claims on physical capital and other assets convert serially uncorrelated impulses into serially correlated demands for the accumulation of real assets… workers who for some reason are without jobs find it rational not necessarily to take the first job offer that comes along but instead to remain unemployed for awhile until a better offer materializes…. In principle the serially uncorrelated process of forecasting errors can account for any proportion between zero and one of the [serially correlated] steady state variance of real output or employment. The argument that such models must necessarily attribute most of the variance in real output and employment to variations in aggregate supply is simply wrong logically…

My problem with the Lucas-Sargent argument is that even if the deviations from a long-run equilibrium path are serially correlated, shouldn’t those deviations be diminishing over time after the initial disturbance? Can these propagation mechanisms account for amplification of the initial disturbance before the adjustment toward the equilibrium path begins? I would gratefully welcome any responses…

In some ways this is of only history-of-thought interest. For Lucas and Prescott, at least, had within five years of the writing of “After Keynesian Macroeconomics” decided that the critics were right: that their models of how mistaken decisions driven by serially-uncorrelated forecast errors could not account for the bulk of the serially correlated business-cycle variance of real output and employment, and they needed to shift to studying real business cycle theory instead of price-misperceptions theory. The first problem was that time-series methods generated shocks that came at the wrong times to explain recessions. The second problem was that the propagation mechanisms did not amplify but rather damped the shock: at best they produced some kind of partial-adjustment process that extended the impact of a shock on real variables to N periods and diminished its impact in any single period to 1/N. There was no… what is the word?…. multiplier in the system.

It was stunning to watch in real time in the early 1980s. As Paul Volcker hit the economy on the head with the monetary-stringency brick, repeatedly, quarter after quarter; as his serially correlated and hence easily anticipated policy moves had large and highly serially correlated effects on output; Robert Lucas and company simply… pretended it was not happening: that monetary policy was not having major effects on output and employment in the first half of the 1980s, and that it was not the case thjat the monetary policies that were having such profound real impacts had no plausible interpretation as “surprises” leading to “misperceptions”. Meanwhile, over in the other corner, Robert Barro was claiming that he saw no break in the standard pattern of federal deficits from the Reagan administration’s combination of tax cuts plus defense buildup.

Those of us who were graduate students at the time watched this, and drew conclusions about the likelihood that Lucas, Prescott, and company had good enough judgment and close enough contact with reality that their proposed “real business cycle” research program would be a productive one—conclusions that, I think, time has proved fully correct.

Behind all this, of course, was this issue: the “microfoundations” of the Lucas “island economy” model were totally stupid: people are supposed to “misperceive” relative prices because they know the nominal prices at which they sell but do not know the nominal prices at which they buy, hence people confuse a monetary shock-generated rise in the nominal price level with an increase in the real price of what they produce, and hence work harder and longer and produce more? (I forget who it was who said at the time that the model seemed to require a family in which the husband worked and the wife went to the grocery store and the husband never listened to anything the wife said.) These so-called “microfoundations” could only be rationally understood as some kind of metaphor. But what kind of metaphor? And why should it have any special status, and claim on our attention?

Paul Krugman’s judgment on the consequences of this intellectual turn is even harsher than mine:

What made the Dark Ages dark was the fact that so much knowledge had been lost, that so much known to the Greeks and Romans had been forgotten by the barbarian kingdoms that followed. And that’s what seems to have happened to macroeconomics in much of the economics profession. The knowledge that S=I doesn’t imply the Treasury view—the general understanding that macroeconomics is more than supply and demand plus the quantity equation — somehow got lost in much of the profession. I’m tempted to go on and say something about being overrun by barbarians in the grip of an obscurantist faith…

I would merely say that it has left us, over what is now two generations, with a turn to DSGE models—Dynamic Stochastic General Equilibrium—that must satisfy a set of formal rhetorical requirements that really do not help us fit the data, and that it gave many, many people an excuse not to read and hence a license to remain ignorant of James Tobin.

Brad

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Robert Lucas and the Pretense of Science

F. A. Hayek entitled his 1974 Nobel Lecture whose principal theme was to attack the simple notion that the long-observed correlation between aggregate demand and employment was a reliable basis for conducting macroeconomic policy, “The Pretence of Knowledge.” Reiterating an argument that he had made over 40 years earlier about the transitory stimulus provided to profits and production by monetary expansion, Hayek was informally anticipating the argument that Robert Lucas famously repackaged two years later in his famous critique of econometric policy evaluation. Hayek’s argument hinged on a distinction between “phenomena of unorganized complexity” and phenomena of organized complexity.” Statistical relationships or correlations between phenomena of disorganized complexity may be relied upon to persist, but observed statistical correlations displayed by phenomena of organized complexity cannot be relied upon without detailed knowledge of the individual elements that constitute the system. It was the facile assumption that observed statistical correlations in systems of organized complexity can be uncritically relied upon in making policy decisions that Hayek dismissed as merely the pretense of knowledge.

Adopting many of Hayek’s complaints about macroeconomic theory, Lucas founded his New Classical approach to macroeconomics on a methodological principle that all macroeconomic models be grounded in the axioms of neoclassical economic theory as articulated in the canonical Arrow-Debreu-McKenzie models of general equilibrium models. Without such grounding in neoclassical axioms and explicit formal derivations of theorems from those axioms, Lucas maintained that macroeconomics could not be considered truly scientific. Forty years of Keynesian macroeconomics were, in Lucas’s view, largely pre-scientific or pseudo-scientific, because they lacked satisfactory microfoundations.

Lucas’s methodological program for macroeconomics was thus based on two basic principles: reductionism and formalism. First, all macroeconomic models not only had to be consistent with rational individual decisions, they had to be reduced to those choices. Second, all the propositions of macroeconomic models had to be explicitly derived from the formal definitions and axioms of neoclassical theory. Lucas demanded nothing less than the explicit assumption individual rationality in every macroeconomic model and that all decisions by agents in a macroeconomic model be individually rational.

In practice, implementing Lucasian methodological principles required that in any macroeconomic model all agents’ decisions be derived within an explicit optimization problem. However, as Hayek had himself shown in his early studies of business cycles and intertemporal equilibrium, individual optimization in the standard Walrasian framework, within which Lucas wished to embed macroeconomic theory, is possible only if all agents are optimizing simultaneously, all individual decisions being conditional on the decisions of other agents. Individual optimization can only be solved simultaneously for all agents, not individually in isolation.

The difficulty of solving a macroeconomic equilibrium model for the simultaneous optimal decisions of all the agents in the model led Lucas and his associates and followers to a strategic simplification: reducing the entire model to a representative agent. The optimal choices of a single agent would then embody the consumption and production decisions of all agents in the model.

The staggering simplification involved in reducing a purported macroeconomic model to a representative agent is obvious on its face, but the sleight of hand being performed deserves explicit attention. The existence of an equilibrium solution to the neoclassical system of equations was assumed, based on faulty reasoning by Walras, Fisher and Pareto who simply counted equations and unknowns. A rigorous proof of existence was only provided by Abraham Wald in 1936 and subsequently in more general form by Arrow, Debreu and McKenzie, working independently, in the 1950s. But proving the existence of a solution to the system of equations does not establish that an actual neoclassical economy would, in fact, converge on such an equilibrium.

Neoclassical theory was and remains silent about the process whereby equilibrium is, or could be, reached. The Marshallian branch of neoclassical theory, focusing on equilibrium in individual markets rather than the systemic equilibrium, is often thought to provide an account of how equilibrium is arrived at, but the Marshallian partial-equilibrium analysis presumes that all markets and prices except the price in the single market under analysis, are in a state of equilibrium. So the Marshallian approach provides no more explanation of a process by which a set of equilibrium prices for an entire economy is, or could be, reached than the Walrasian approach.

Lucasian methodology has thus led to substituting a single-agent model for an actual macroeconomic model. It does so on the premise that an economic system operates as if it were in a state of general equilibrium. The factual basis for this premise apparently that it is possible, using versions of a suitable model with calibrated coefficients, to account for observed aggregate time series of consumption, investment, national income, and employment. But the time series derived from these models are derived by attributing all observed variations in national income to unexplained shocks in productivity, so that the explanation provided is in fact an ex-post rationalization of the observed variations not an explanation of those variations.

Nor did Lucasian methodology have a theoretical basis in received neoclassical theory. In a famous 1960 paper “Towards a Theory of Price Adjustment,” Kenneth Arrow identified the explanatory gap in neoclassical theory: the absence of a theory of price change in competitive markets in which every agent is a price taker. The existence of an equilibrium does not entail that the equilibrium will be, or is even likely to be, found. The notion that price flexibility is somehow a guarantee that market adjustments reliably lead to an equilibrium outcome is a presumption or a preconception, not the result of rigorous analysis.

However, Lucas used the concept of rational expectations, which originally meant no more than that agents try to use all available information to anticipate future prices, to make the concept of equilibrium, notwithstanding its inherent implausibility, a methodological necessity. A rational-expectations equilibrium was methodologically necessary and ruthlessly enforced on researchers, because it was presumed to be entailed by the neoclassical assumption of rationality. Lucasian methodology transformed rational expectations into the proposition that all agents form identical, and correct, expectations of future prices based on the same available information (common knowledge). Because all agents reach the same, correct expectations of future prices, general equilibrium is continuously achieved, except at intermittent moments when new information arrives and is used by agents to revise their expectations.

In his Nobel Lecture, Hayek decried a pretense of knowledge about correlations between macroeconomic time series that lack a foundation in the deeper structural relationships between those related time series. Without an understanding of the deeper structural relationships between those time series, observed correlations cannot be relied on when formulating economic policies. Lucas’s own famous critique echoed the message of Hayek’s lecture.

The search for microfoundations was always a natural and commendable endeavor. Scientists naturally try to reduce higher-level theories to deeper and more fundamental principles. But the endeavor ought to be conducted as a theoretical and empirical endeavor. If successful, the reduction of the higher-level theory to a deeper theory will provide insight and disclose new empirical implications to both the higher-level and the deeper theories. But reduction by methodological fiat accomplishes neither and discourages the research that might actually achieve a theoretical reduction of a higher-level theory to a deeper one. Similarly, formalism can provide important insights into the structure of theories and disclose gaps or mistakes the reasoning underlying the theories. But most important theories, even in pure mathematics, start out as informal theories that only gradually become axiomatized as logical gaps and ambiguities in the theories are discovered and filled or refined.

The resort to the reductionist and formalist methodological imperatives with which Lucas and his followers have justified their pretentions to scientific prestige and authority, and have used that authority to compel compliance with those imperatives, only belie their pretensions.

An Austrian Tragedy

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

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.

 

Filling the Arrow Explanatory Gap

The following (with some minor revisions) is a Twitter thread I posted yesterday. Unfortunately, because it was my first attempt at threading the thread wound up being split into three sub-threads and rather than try to reconnect them all, I will just post the complete thread here as a blogpost.

1. Here’s an outline of an unwritten paper developing some ideas from my paper “Hayek Hicks Radner and Four Equilibrium Concepts” (see here for an earlier ungated version) and some from previous blog posts, in particular Phillips Curve Musings

2. Standard supply-demand analysis is a form of partial-equilibrium (PE) analysis, which means that it is contingent on a ceteris paribus (CP) assumption, an assumption largely incompatible with realistic dynamic macroeconomic analysis.

3. Macroeconomic analysis is necessarily situated a in general-equilibrium (GE) context that precludes any CP assumption, because there are no variables that are held constant in GE analysis.

4. In the General Theory, Keynes criticized the argument based on supply-demand analysis that cutting nominal wages would cure unemployment. Instead, despite his Marshallian training (upbringing) in PE analysis, Keynes argued that PE (AKA supply-demand) analysis is unsuited for understanding the problem of aggregate (involuntary) unemployment.

5. The comparative-statics method described by Samuelson in the Foundations of Econ Analysis formalized PE analysis under the maintained assumption that a unique GE obtains and deriving a “meaningful theorem” from the 1st- and 2nd-order conditions for a local optimum.

6. PE analysis, as formalized by Samuelson, is conditioned on the assumption that GE obtains. It is focused on the effect of changing a single parameter in a single market small enough for the effects on other markets of the parameter change to be made negligible.

7. Thus, PE analysis, the essence of micro-economics is predicated on the macrofoundation that all, but one, markets are in equilibrium.

8. Samuelson’s meaningful theorems were a misnomer reflecting mid-20th-century operationalism. They can now be understood as empirically refutable propositions implied by theorems augmented with a CP assumption that interactions b/w markets are small enough to be neglected.

9. If a PE model is appropriately specified, and if the market under consideration is small or only minimally related to other markets, then differences between predictions and observations will be statistically insignificant.

10. So PE analysis uses comparative-statics to compare two alternative general equilibria that differ only in respect of a small parameter change.

11. The difference allows an inference about the causal effect of a small change in that parameter, but says nothing about how an economy would actually adjust to a parameter change.

12. PE analysis is conditioned on the CP assumption that the analyzed market and the parameter change are small enough to allow any interaction between the parameter change and markets other than the market under consideration to be disregarded.

13. However, the process whereby one equilibrium transitions to another is left undetermined; the difference between the two equilibria with and without the parameter change is computed but no account of an adjustment process leading from one equilibrium to the other is provided.

14. Hence, the term “comparative statics.”

15. The only suggestion of an adjustment process is an assumption that the price-adjustment in any market is an increasing function of excess demand in the market.

16. In his seminal account of GE, Walras posited the device of an auctioneer who announces prices–one for each market–computes desired purchases and sales at those prices, and sets, under an adjustment algorithm, new prices at which desired purchases and sales are recomputed.

17. The process continues until a set of equilibrium prices is found at which excess demands in all markets are zero. In Walras’s heuristic account of what he called the tatonnement process, trading is allowed only after the equilibrium price vector is found by the auctioneer.

18. Walras and his successors assumed, but did not prove, that, if an equilibrium price vector exists, the tatonnement process would eventually, through trial and error, converge on that price vector.

19. However, contributions by Sonnenschein, Mantel and Debreu (hereinafter referred to as the SMD Theorem) show that no price-adjustment rule necessarily converges on a unique equilibrium price vector even if one exists.

20. The possibility that there are multiple equilibria with distinct equilibrium price vectors may or may not be worth explicit attention, but for purposes of this discussion, I confine myself to the case in which a unique equilibrium exists.

21. The SMD Theorem underscores the lack of any explanatory account of a mechanism whereby changes in market prices, responding to excess demands or supplies, guide a decentralized system of competitive markets toward an equilibrium state, even if a unique equilibrium exists.

22. The Walrasian tatonnement process has been replaced by the Arrow-Debreu-McKenzie (ADM) model in an economy of infinite duration consisting of an infinite number of generations of agents with given resources and technology.

23. The equilibrium of the model involves all agents populating the economy over all time periods meeting before trading starts, and, based on initial endowments and common knowledge, making plans given an announced equilibrium price vector for all time in all markets.

24. Uncertainty is accommodated by the mechanism of contingent trading in alternative states of the world. Given assumptions about technology and preferences, the ADM equilibrium determines the set prices for all contingent states of the world in all time periods.

25. Given equilibrium prices, all agents enter into optimal transactions in advance, conditioned on those prices. Time unfolds according to the equilibrium set of plans and associated transactions agreed upon at the outset and executed without fail over the course of time.

26. At the ADM equilibrium price vector all agents can execute their chosen optimal transactions at those prices in all markets (certain or contingent) in all time periods. In other words, at that price vector, excess demands in all markets with positive prices are zero.

27. The ADM model makes no pretense of identifying a process that discovers the equilibrium price vector. All that can be said about that price vector is that if it exists and trading occurs at equilibrium prices, then excess demands will be zero if prices are positive.

28. Arrow himself drew attention to the gap in the ADM model, writing in 1959:

29. In addition to the explanatory gap identified by Arrow, another shortcoming of the ADM model was discussed by Radner: the dependence of the ADM model on a complete set of forward and state-contingent markets at time zero when equilibrium prices are determined.

30. Not only is the complete-market assumption a backdoor reintroduction of perfect foresight, it excludes many features of the greatest interest in modern market economies: the existence of money, stock markets, and money-crating commercial banks.

31. Radner showed that for full equilibrium to obtain, not only must excess demands in current markets be zero, but whenever current markets and current prices for future delivery are missing, agents must correctly expect those future prices.

32. But there is no plausible account of an equilibrating mechanism whereby price expectations become consistent with GE. Although PE analysis suggests that price adjustments do clear markets, no analogous analysis explains how future price expectations are equilibrated.

33. But if both price expectations and actual prices must be equilibrated for GE to obtain, the notion that “market-clearing” price adjustments are sufficient to achieve macroeconomic “equilibrium” is untenable.

34. Nevertheless, the idea that individual price expectations are rational (correct), so that, except for random shocks, continuous equilibrium is maintained, became the bedrock for New Classical macroeconomics and its New Keynesian and real-business cycle offshoots.

35. Macroeconomic theory has become a theory of dynamic intertemporal optimization subject to stochastic disturbances and market frictions that prevent or delay optimal adjustment to the disturbances, potentially allowing scope for countercyclical monetary or fiscal policies.

36. Given incomplete markets, the assumption of nearly continuous intertemporal equilibrium implies that agents correctly foresee future prices except when random shocks occur, whereupon agents revise expectations in line with the new information communicated by the shocks.
37. Modern macroeconomics replaced the Walrasian auctioneer with agents able to forecast the time path of all prices indefinitely into the future, except for intermittent unforeseen shocks that require agents to optimally their revise previous forecasts.
38. When new information or random events, requiring revision of previous expectations, occur, the new information becomes common knowledge and is processed and interpreted in the same way by all agents. Agents with rational expectations always share the same expectations.
39. So in modern macro, Arrow’s explanatory gap is filled by assuming that all agents, given their common knowledge, correctly anticipate current and future equilibrium prices subject to unpredictable forecast errors that change their expectations of future prices to change.
40. Equilibrium prices aren’t determined by an economic process or idealized market interactions of Walrasian tatonnement. Equilibrium prices are anticipated by agents, except after random changes in common knowledge. Semi-omniscient agents replace the Walrasian auctioneer.
41. Modern macro assumes that agents’ common knowledge enables them to form expectations that, until superseded by new knowledge, will be validated. The assumption is wrong, and the mistake is deeper than just the unrealism of perfect competition singled out by Arrow.
42. Assuming perfect competition, like assuming zero friction in physics, may be a reasonable simplification for some problems in economics, because the simplification renders an otherwise intractable problem tractable.
43. But to assume that agents’ common knowledge enables them to forecast future prices correctly transforms a model of decentralized decision-making into a model of central planning with each agent possessing the knowledge only possessed by an omniscient central planner.
44. The rational-expectations assumption fills Arrow’s explanatory gap, but in a deeply unsatisfactory way. A better approach to filling the gap would be to acknowledge that agents have private knowledge (and theories) that they rely on in forming their expectations.
45. Agents’ expectations are – at least potentially, if not inevitably – inconsistent. Because expectations differ, it’s the expectations of market specialists, who are better-informed than non-specialists, that determine the prices at which most transactions occur.
46. Because price expectations differ even among specialists, prices, even in competitive markets, need not be uniform, so that observed price differences reflect expectational differences among specialists.
47. When market specialists have similar expectations about future prices, current prices will converge on the common expectation, with arbitrage tending to force transactions prices to converge toward notwithstanding the existence of expectational differences.
48. However, the knowledge advantage of market specialists over non-specialists is largely limited to their knowledge of the workings of, at most, a small number of related markets.
49. The perspective of specialists whose expectations govern the actual transactions prices in most markets is almost always a PE perspective from which potentially relevant developments in other markets and in macroeconomic conditions are largely excluded.
50. The interrelationships between markets that, according to the SMD theorem, preclude any price-adjustment algorithm, from converging on the equilibrium price vector may also preclude market specialists from converging, even roughly, on the equilibrium price vector.
51. A strict equilibrium approach to business cycles, either real-business cycle or New Keynesian, requires outlandish assumptions about agents’ common knowledge and their capacity to anticipate the future prices upon which optimal production and consumption plans are based.
52. It is hard to imagine how, without those outlandish assumptions, the theoretical superstructure of real-business cycle theory, New Keynesian theory, or any other version of New Classical economics founded on the rational-expectations postulate can be salvaged.
53. The dominance of an untenable macroeconomic paradigm has tragically led modern macroeconomics into a theoretical dead end.

Graeber Against Economics

David Graeber’s vitriolic essay “Against Economics” in the New York Review of Books has generated responses from Noah Smith and Scott Sumner among others. I don’t disagree with much that Noah or Scott have to say, but I want to dig a little deeper than they did into some of Graeber’s arguments, because even though I think he is badly misinformed on many if not most of the subjects he writes about, I actually have some sympathy for his dissatisfaction with the current state of economics. Graeber wastes no time on pleasantries.

There is a growing feeling, among those who have the responsibility of managing large economies, that the discipline of economics is no longer fit for purpose. It is beginning to look like a science designed to solve problems that no longer exist.

A serious polemicist should avoid blatant mischaracterizations, exaggerations and cheap shots, and should be well-grounded in the object of his critique, thereby avoiding criticisms that undermine his own claims to expertise. I grant that  Graeber has some valid criticisms to make, even agreeing with him, at least in part, on some of them. But his indiscriminate attacks on, and caricatures of, all neoclassical economics betrays a superficial understanding of that discipline.

Graeber begins by attacking what he considers the misguided and obsessive focus on inflation by economists.

A good example is the obsession with inflation. Economists still teach their students that the primary economic role of government—many would insist, its only really proper economic role—is to guarantee price stability. We must be constantly vigilant over the dangers of inflation. For governments to simply print money is therefore inherently sinful.

Every currency unit, or banknote issued by a central bank, now in circulation, as Graeber must know, has been “printed.” So to say that economists consider it sinful for governments to print money is either a deliberate falsehood, or an emotional rhetorical outburst, as Graeber immediately, and apparently unwittingly, acknowledges!

If, however, inflation is kept at bay through the coordinated action of government and central bankers, the market should find its “natural rate of unemployment,” and investors, taking advantage of clear price signals, should be able to ensure healthy growth. These assumptions came with the monetarism of the 1980s, the idea that government should restrict itself to managing the money supply, and by the 1990s had come to be accepted as such elementary common sense that pretty much all political debate had to set out from a ritual acknowledgment of the perils of government spending. This continues to be the case, despite the fact that, since the 2008 recession, central banks have been printing money frantically [my emphasis] in an attempt to create inflation and compel the rich to do something useful with their money, and have been largely unsuccessful in both endeavors.

Graeber’s use of the ambiguous pronoun “this” beginning the last sentence of the paragraph betrays his own confusion about what he is saying. Central banks are printing money and attempting to “create” inflation while supposedly still believing that inflation is a menace and printing money is a sin. Go figure.

We now live in a different economic universe than we did before the crash. Falling unemployment no longer drives up wages. Printing money does not cause inflation. Yet the language of public debate, and the wisdom conveyed in economic textbooks, remain almost entirely unchanged.

Again showing an inadequate understanding of basic economic theory, Graeber suggests that, in theory if not practice, falling unemployment should cause wages to rise. The Philips Curve, upon which Graeber’s suggestion relies, represents the empirically observed negative correlation between the rate of average wage increase and the rate of unemployment. But correlation does not imply causation, so there is no basis in economic theory to assert that falling unemployment causes the rate of increase in wages to accelerate. That the empirical correlation between unemployment and wage increases has not recently been in evidence provides no compelling reason for changing textbook theory.

From this largely unfounded and attack on economic theory – a theory which I myself consider, in many respects, inadequate and unreliable – Graeber launches a bitter diatribe against the supposed hegemony of economists over policy-making.

Mainstream economists nowadays might not be particularly good at predicting financial crashes, facilitating general prosperity, or coming up with models for preventing climate change, but when it comes to establishing themselves in positions of intellectual authority, unaffected by such failings, their success is unparalleled. One would have to look at the history of religions to find anything like it.

The ability to predict financial crises would be desirable, but that cannot be the sole criterion for whether economics has advanced our understanding of how economic activity is organized or what effects policy changes have. (I note parenthetically that many economists defensively reject the notion that economic crises are predictable on the grounds that if economists could predict a future economic crisis, those predictions would be immediately self-fulfilling. This response, of course, effectively disproves the idea that economists could predict that an economic crisis would occur in the way that astronomers predict solar eclipses. But this response slays a strawman. The issue is not whether economists can predict future crises, but whether they can identify conditions indicating an increased likelihood of a crisis and suggest precautionary measures to reduce the likelihood that a potential crisis will occur. But Graeber seems uninterested in or incapable of engaging the question at even this moderate level of subtlety.)

In general, I doubt that economists can make more than a modest contribution to improved policy-making, and the best that one can hope for is probably that they steer us away from the worst potential decisions rather than identifying the best ones. But no one, as far as I know, has yet been burned at the stake by a tribunal of economists.

To this day, economics continues to be taught not as a story of arguments—not, like any other social science, as a welter of often warring theoretical perspectives—but rather as something more like physics, the gradual realization of universal, unimpeachable mathematical truths. “Heterodox” theories of economics do, of course, exist (institutionalist, Marxist, feminist, “Austrian,” post-Keynesian…), but their exponents have been almost completely locked out of what are considered “serious” departments, and even outright rebellions by economics students (from the post-autistic economics movement in France to post-crash economics in Britain) have largely failed to force them into the core curriculum.

I am now happy to register agreement with something that Graeber says. Economists in general have become overly attached to axiomatic and formalistic mathematical models that create a false and misleading impression of rigor and mathematical certainty. In saying this, I don’t dispute that mathematical modeling is an important part of much economic theorizing, but it should not exclude other approaches to economic analysis and discourse.

As a result, heterodox economists continue to be treated as just a step or two away from crackpots, despite the fact that they often have a much better record of predicting real-world economic events. What’s more, the basic psychological assumptions on which mainstream (neoclassical) economics is based—though they have long since been disproved by actual psychologists—have colonized the rest of the academy, and have had a profound impact on popular understandings of the world.

That heterodox economists have a better record of predicting economic events than mainstream economists is an assertion for which Graeber offers no evidence or examples. I would not be surprised if he could cite examples, but one would have to weigh the evidence surrounding those examples before concluding that predictions by heterodox economists were more accurate than those of their mainstream counterparts.

Graeber returns to the topic of monetary theory, which seems a particular bugaboo of his. Taking the extreme liberty of holding up Mrs. Theresa May as a spokesperson for orthodox economics, he focuses on her definitive 2017 statement that there is no magic money tree.

The truly extraordinary thing about May’s phrase is that it isn’t true. There are plenty of magic money trees in Britain, as there are in any developed economy. They are called “banks.” Since modern money is simply credit, banks can and do create money literally out of nothing, simply by making loans. Almost all of the money circulating in Britain at the moment is bank-created in this way.

What Graeber chooses to ignore is that banks do not operate magically; they make loans and create deposits in seeking to earn profits; their decisions are not magical, but are oriented toward making profits. Whether they make good or bad decisions is debatable, but the debate isn’t about a magical process; it’s a debate about theory and evidence. Graeber describe how he thinks that economists think about how banks create money, correctly observing that there is a debate about how that process works, but without understanding those differences or their significance.

Economists, for obvious reasons, can’t be completely oblivious to the role of banks, but they have spent much of the twentieth century arguing about what actually happens when someone applies for a loan. One school insists that banks transfer existing funds from their reserves, another that they produce new money, but only on the basis of a multiplier effect). . . Only a minority—mostly heterodox economists, post-Keynesians, and modern money theorists—uphold what is called the “credit creation theory of banking”: that bankers simply wave a magic wand and make the money appear, secure in the confidence that even if they hand a client a credit for $1 million, ultimately the recipient will put it back in the bank again, so that, across the system as a whole, credits and debts will cancel out. Rather than loans being based in deposits, in this view, deposits themselves were the result of loans.

The one thing it never seemed to occur to anyone to do was to get a job at a bank, and find out what actually happens when someone asks to borrow money. In 2014 a German economist named Richard Werner did exactly that, and discovered that, in fact, loan officers do not check their existing funds, reserves, or anything else. They simply create money out of thin air, or, as he preferred to put it, “fairy dust.”

Graeber is right that economists differ in how they understand banking. But the simple transfer-of-funds view, a product of the eighteenth century, was gradually rejected over the course of the nineteenth century; the money-multiplier view largely superseded it, enjoying a half-century or more of dominance as a theory of banking, still remains a popular way for introductory textbooks to explain how banking works, though it would be better if it were decently buried and forgotten. But since James Tobin’s classic essay “Commercial banks as creators of money” was published in 1963, most economists who have thought carefully about banking have concluded that the amount of deposits created by banks corresponds to the quantity of deposits that the public, given their expectations about the future course of the economy and the future course of prices, chooses to hold. The important point is that while a bank can create deposits without incurring more than the negligible cost of making a book-keeping, or an electronic, entry in a customer’s account, the creation of a deposit is typically associated with a demand by the bank to hold either reserves in its account with the Fed or to hold some amount of Treasury instruments convertible, on very short notice, into reserves at the Fed.

Graeber seems to think that there is something fundamental at stake for the whole of macroeconomics in the question whether deposits created loans or loans create deposits. I agree that it’s an important question, but not as significant as Graeber believes. But aside from that nuance, what’s remarkable is that Graeber actually acknowledges that the weight of professional opinion is on the side that says that loans create deposits. He thus triumphantly cites a report by Bank of England economists that correctly explained that banks create money and do so in the normal course of business by making loans.

Before long, the Bank of England . . . rolled out an elaborate official report called “Money Creation in the Modern Economy,” replete with videos and animations, making the same point: existing economics textbooks, and particularly the reigning monetarist orthodoxy, are wrong. The heterodox economists are right. Private banks create money. Central banks like the Bank of England create money as well, but monetarists are entirely wrong to insist that their proper function is to control the money supply.

Graeber, I regret to say, is simply exposing the inadequacy of his knowledge of the history of economics. Adam Smith in The Wealth of Nations explained that banks create money who, in doing so, saved the resources that would have been wasted on creating additional gold and silver. Subsequent economists from David Ricardo through Henry Thornton, J. S. Mill and R. G. Hawtrey were perfectly aware that banks can supply money — either banknotes or deposits — at less than the cost of mining and minting new coins, as they extend their credit in making loans to borrowers. So what is at issue, Graeber to the contrary notwithstanding, is not a dispute between orthodoxy and heterodoxy.

In fact, central banks do not in any sense control the money supply; their main function is to set the interest rate—to determine how much private banks can charge for the money they create.

Central banks set a rental price for reserves, thereby controlling the quantity of reserves into which bank deposits are convertible that is available to the economy. One way to think about that quantity is that the quantity of reserves along with the aggregate demand to hold reserves determines the exchange value of reserves and hence the price level; another way to think about it is that the interest rate or the implied policy stance of the central bank helps to determine the expectations of the public about the future course of the price level which is what determines – within some margin of error or range – what the future course of the price level will turn out to be.

Almost all public debate on these subjects is therefore based on false premises. For example, if what the Bank of England was saying were true, government borrowing didn’t divert funds from the private sector; it created entirely new money that had not existed before.

This is just silly. Funds may or may not be diverted from the private sector, but the total available resources to society is finite. If the central bank creates additional money, it creates additional claims to those resources and the creation of additional claims to resources necessarily has an effect on the prices of inputs and of outputs.

One might have imagined that such an admission would create something of a splash, and in certain restricted circles, it did. Central banks in Norway, Switzerland, and Germany quickly put out similar papers. Back in the UK, the immediate media response was simply silence. The Bank of England report has never, to my knowledge, been so much as mentioned on the BBC or any other TV news outlet. Newspaper columnists continued to write as if monetarism was self-evidently correct. Politicians continued to be grilled about where they would find the cash for social programs. It was as if a kind of entente cordiale had been established, in which the technocrats would be allowed to live in one theoretical universe, while politicians and news commentators would continue to exist in an entirely different one.

Even if we stipulate that this characterization of what the BBC and newspaper columnists believe is correct, what we would have — at best — is a commentary on the ability of economists to communicate their understanding of how the economy works to the intelligentsia that communicates to ordinary citizens. It is not in and of itself a commentary on the state of economic knowledge, inasmuch as Graeber himself concedes that most economists don’t accept monetarism. And that has been the case, as Noah Smith pointed out in his Bloomberg column on Graeber, since the early 1980s when the Monetarist experiment in trying to conduct monetary policy by controlling the monetary aggregates proved entirely unworkable and had to be abandoned as it was on the verge of precipitating a financial crisis.

Only after this long warmup decrying the sorry state of contemporary economic theory does Graeber begin discussing the book under review Money and Government by Robert Skidelsky.

What [Skidelsky] reveals is an endless war between two broad theoretical perspectives. . . The crux of the argument always seems to turn on the nature of money. Is money best conceived of as a physical commodity, a precious substance used to facilitate exchange, or is it better to see money primarily as a credit, a bookkeeping method or circulating IOU—in any case, a social arrangement? This is an argument that has been going on in some form for thousands of years. What we call “money” is always a mixture of both, and, as I myself noted in Debt (2011), the center of gravity between the two tends to shift back and forth over time. . . .One important theoretical innovation that these new bullion-based theories of money allowed was, as Skidelsky notes, what has come to be called the quantity theory of money (usually referred to in textbooks—since economists take endless delight in abbreviations—as QTM).

But these two perspectives are not mutually exclusive, and, depending on time, place, circumstances, and the particular problem that is the focus of attention, either of the two may be the appropriate paradigm for analysis.

The QTM argument was first put forward by a French lawyer named Jean Bodin, during a debate over the cause of the sharp, destablizing price inflation that immediately followed the Iberian conquest of the Americas. Bodin argued that the inflation was a simple matter of supply and demand: the enormous influx of gold and silver from the Spanish colonies was cheapening the value of money in Europe. The basic principle would no doubt have seemed a matter of common sense to anyone with experience of commerce at the time, but it turns out to have been based on a series of false assumptions. For one thing, most of the gold and silver extracted from Mexico and Peru did not end up in Europe at all, and certainly wasn’t coined into money. Most of it was transported directly to China and India (to buy spices, silks, calicoes, and other “oriental luxuries”), and insofar as it had inflationary effects back home, it was on the basis of speculative bonds of one sort or another. This almost always turns out to be true when QTM is applied: it seems self-evident, but only if you leave most of the critical factors out.

In the case of the sixteenth-century price inflation, for instance, once one takes account of credit, hoarding, and speculation—not to mention increased rates of economic activity, investment in new technology, and wage levels (which, in turn, have a lot to do with the relative power of workers and employers, creditors and debtors)—it becomes impossible to say for certain which is the deciding factor: whether the money supply drives prices, or prices drive the money supply.

As a matter of logic, if the value of money depends on the precious metals (gold or silver) from which coins were minted, the value of money is necessarily affected by a change in the value of the metals used to coin money. Because a large increase in the stock of gold and silver, as Graeber concedes, must reduce the value of those metals, subsequent inflation then being attributable, at least in part, to the gold and silver discoveries even if the newly mined gold and silver was shipped mainly to privately held Indian and Chinese hoards rather than minted into new coins. An exogenous increase in prices may well have caused the quantity of credit money to increase, but that is analytically distinct from the inflationary effect of a reduced value of gold or silver when, as was the case in the sixteenth century, money is legally defined as a specific weight of gold or silver.

Technically, this comes down to a choice between what are called exogenous and endogenous theories of money. Should money be treated as an outside factor, like all those Spanish dubloons supposedly sweeping into Antwerp, Dublin, and Genoa in the days of Philip II, or should it be imagined primarily as a product of economic activity itself, mined, minted, and put into circulation, or more often, created as credit instruments such as loans, in order to meet a demand—which would, of course, mean that the roots of inflation lie elsewhere?

There is no such choice, because any theory must posit certain initial conditions and definitions, which are given or exogenous to the analysis. How the theory is framed and which variables are treated as exogenous and which are treated as endogenous is a matter of judgment in light of the problem and the circumstances. Graeber is certainly correct that, in any realistic model, the quantity of money is endogenously, not exogenously, determined, but that doesn’t mean that the value of gold and silver may not usefully be treated as exogenous in a system in which money is defined as a weight of gold or silver.

To put it bluntly: QTM is obviously wrong. Doubling the amount of gold in a country will have no effect on the price of cheese if you give all the gold to rich people and they just bury it in their yards, or use it to make gold-plated submarines (this is, incidentally, why quantitative easing, the strategy of buying long-term government bonds to put money into circulation, did not work either). What actually matters is spending.

Graeber is talking in circles, failing to distinguish between the quantity theory of money – a theory about the value of a pure medium of exchange with no use except to be received in exchange — and a theory of the real value of gold and silver when money is defined as a weight of gold or silver. The value of gold (or silver) in monetary uses must be roughly equal to its value in non-monetary uses. which is determined by the total stock of gold and the demand to hold gold or to use it in coinage or for other uses (e.g., jewelry and ornamentation). An increase in the stock of gold relative to demand must reduce its value. That relationship between price and quantity is not the same as QTM. The quantity of a metallic money will increase as its value in non-monetary uses declines. If there is literally an unlimited demand for newly mined gold to be immediately sent unused into hoards, Graeber’s argument would be correct. But the fact that much of the newly mined gold initially went into hoards does not mean that all of the newly mined gold went into hoards.

In sum, Graeber is confused between the quantity theory of money and a theory of a commodity money used both as money and as a real commodity. The quantity theory of money of a pure medium of exchange posits that changes in the quantity of money cause proportionate changes in the price level. Changes in the quantity of a real commodity also used as money have nothing to do with the quantity theory of money.

Relying on a dubious account of the history of monetary theory by Skidelsky, Graeber blames the obsession of economists with the quantity theory for repeated monetary disturbances starting with the late 17th century deflation in Britain when silver appreciated relative to gold causing prices measured in silver to fall. Graeber thus fails to see that under a metallic money, real disturbances do have repercussion on the level of prices, repercussions having nothing to do with an exogenous prior change in the quantity of money.

According to Skidelsky, the pattern was to repeat itself again and again, in 1797, the 1840s, the 1890s, and, ultimately, the late 1970s and early 1980s, with Thatcher and Reagan’s (in each case brief) adoption of monetarism. Always we see the same sequence of events:

(1) The government adopts hard-money policies as a matter of principle.

(2) Disaster ensues.

(3) The government quietly abandons hard-money policies.

(4) The economy recovers.

(5) Hard-money philosophy nonetheless becomes, or is reinforced as, simple universal common sense.

There is so much indiscriminate generalization here that it is hard to know what to make of it. But the conduct of monetary policy has always been fraught, and learning has been slow and painful. We can and must learn to do better, but blanket condemnations of economics are unlikely to lead to better outcomes.

How was it possible to justify such a remarkable string of failures? Here a lot of the blame, according to Skidelsky, can be laid at the feet of the Scottish philosopher David Hume. An early advocate of QTM, Hume was also the first to introduce the notion that short-term shocks—such as Locke produced—would create long-term benefits if they had the effect of unleashing the self-regulating powers of the market:

Actually I agree that Hume, as great and insightful a philosopher as he was and as sophisticated an economic observer as he was, was an unreliable monetary theorist. And one of the reasons he was led astray was his unwarranted attachment to the quantity theory of money, an attachment that was not shared by his close friend Adam Smith.

Ever since Hume, economists have distinguished between the short-run and the long-run effects of economic change, including the effects of policy interventions. The distinction has served to protect the theory of equilibrium, by enabling it to be stated in a form which took some account of reality. In economics, the short-run now typically stands for the period during which a market (or an economy of markets) temporarily deviates from its long-term equilibrium position under the impact of some “shock,” like a pendulum temporarily dislodged from a position of rest. This way of thinking suggests that governments should leave it to markets to discover their natural equilibrium positions. Government interventions to “correct” deviations will only add extra layers of delusion to the original one.

I also agree that focusing on long-run equilibrium without regard to short-run fluctuations can lead to terrible macroeconomic outcomes, but that doesn’t mean that long-run effects are never of concern and may be safely disregarded. But just as current suffering must not be disregarded when pursuing vague and uncertain long-term benefits, ephemeral transitory benefits shouldn’t obscure serious long-term consequences. Weighing such alternatives isn’t easy, but nothing is gained by denying that the alternatives exist. Making those difficult choices is inherent in policy-making, whether macroeconomic or climate policy-making.

Although Graeber takes a valid point – that a supposed tendency toward an optimal long-run equilibrium does not justify disregard of an acute short-term problem – to an extreme, his criticism of the New Classical approach to policy-making that replaced the flawed mainstream Keynesian macroeconomics of the late 1970s is worth listening to. The New Classical approach self-consciously rejected any policy aimed at short-run considerations owing to a time-inconsistency paradox was based almost entirely on the logic of general-equilibrium theory and an illegitimate methodological argument rejecting all macroeconomic theories not rigorously deduced from the unarguable axiom of optimizing behavior by rational agents (and therefore not, in the official jargon, microfounded) as unscientific and unworthy of serious consideration in the brave New Classical world of scientific macroeconomics.

It’s difficult for outsiders to see what was really at stake here, because the argument has come to be recounted as a technical dispute between the roles of micro- and macroeconomics. Keynesians insisted that the former is appropriate to studying the behavior of individual households or firms, trying to optimize their advantage in the marketplace, but that as soon as one begins to look at national economies, one is moving to an entirely different level of complexity, where different sorts of laws apply. Just as it is impossible to understand the mating habits of an aardvark by analyzing all the chemical reactions in their cells, so patterns of trade, investment, or the fluctuations of interest or employment rates were not simply the aggregate of all the microtransactions that seemed to make them up. The patterns had, as philosophers of science would put it, “emergent properties.” Obviously, it was necessary to understand the micro level (just as it was necessary to understand the chemicals that made up the aardvark) to have any chance of understand the macro, but that was not, in itself, enough.

As an aisde, it’s worth noting that the denial or disregard of the possibility of any emergent properties by New Classical economists (of which what came to be known as New Keynesian economics is really a mildly schismatic offshoot) is nicely illustrated by the un-self-conscious alacrity with which the representative-agent approach was adopted as a modeling strategy in the first few generations of New Classical models. That New Classical theorists now insist that representative agency is not an essential to New Classical modeling is true, but the methodologically reductive nature of New Classical macroeconomics, in which all macroeconomic theories must be derived under the axiom of individually maximizing behavior except insofar as specific “frictions” are introduced by explicit assumption, is essential. (See here, here, and here)

The counterrevolutionaries, starting with Keynes’s old rival Friedrich Hayek . . . took aim directly at this notion that national economies are anything more than the sum of their parts. Politically, Skidelsky notes, this was due to a hostility to the very idea of statecraft (and, in a broader sense, of any collective good). National economies could indeed be reduced to the aggregate effect of millions of individual decisions, and, therefore, every element of macroeconomics had to be systematically “micro-founded.”

Hayek’s role in the microfoundations movement is important, but his position was more sophisticated and less methodologically doctrinaire than that of the New Classical macroeconomists, if for no other reason than that Hayek didn’t believe that macroeconomics should, or could, be derived from general-equilibrium theory. His criticism, like that of economists like Clower and Leijonhufvud, of Keynesian macroeconomics for being insufficiently grounded in microeconomic principles, was aimed at finding microeconomic arguments that could explain and embellish and modify the propositions of Keynesian macroeconomic theory. That is the sort of scientific – not methodological — reductivism that Hayek’s friend Karl Popper advocated: a theoretical and empirical challenge of reducing a higher level theory to its more fundamental foundations, e.g., when physicists and chemists search for theoretical breakthroughs that allow the propositions of chemistry to be reduced to more fundamental propositions of physics. The attempt to reduce chemistry to underlying physical principles is very different from a methodological rejection of all chemistry that cannot be derived from underlying deep physical theories.

There is probably more than a grain of truth in Graeber’s belief that there was a political and ideological subtext in the demand for microfoundations by New Classical macroeconomists, but the success of the microfoundations program was also the result of philosophically unsophisticated methodological error. How to apportion the share of blame going to mistaken methodology, professional and academic opportunism, and a hidden political agenda is a question worthy of further investigation. The easy part is to identify the mistaken methodology, which Graeber does. As for the rest, Graeber simply asserts bad faith, but with little evidence.

In Graeber’s comprehensive condemnation of modern economics, the efficient market hypothesis, being closely related to the rational-expectations hypothesis so central to New Classical economics, is not spared either. Here again, though I share and sympathize with his disdain for EMH, Graeber can’t resist exaggeration.

In other words, we were obliged to pretend that markets could not, by definition, be wrong—if in the 1980s the land on which the Imperial compound in Tokyo was built, for example, was valued higher than that of all the land in New York City, then that would have to be because that was what it was actually worth. If there are deviations, they are purely random, “stochastic” and therefore unpredictable, temporary, and, ultimately, insignificant.

Of course, no one is obliged to pretend that markets could not be wrong — and certainly not by a definition. The EMH simply asserts that the price of an asset reflects all the publicly available information. But what EMH asserts is certainly not true in many or even most cases, because people with non-public information (or with superior capacity to process public information) may affect asset prices, and such people may profit at the expense of those less knowledgeable or less competent in anticipating price changes. Moreover, those advantages may result from (largely wasted) resources devoted to acquiring and processing information, and it is those people who make fortunes betting on the future course of asset prices.

Graeber then quotes Skidelsky approvingly:

There is a paradox here. On the one hand, the theory says that there is no point in trying to profit from speculation, because shares are always correctly priced and their movements cannot be predicted. But on the other hand, if investors did not try to profit, the market would not be efficient because there would be no self-correcting mechanism. . .

Secondly, if shares are always correctly priced, bubbles and crises cannot be generated by the market….

This attitude leached into policy: “government officials, starting with [Fed Chairman] Alan Greenspan, were unwilling to burst the bubble precisely because they were unwilling to even judge that it was a bubble.” The EMH made the identification of bubbles impossible because it ruled them out a priori.

So the apparent paradox that concerns Skidelsky and Graeber dissolves upon (only a modest amount of) further reflection. Proper understanding and revision of the EMH makes it clear that bubbles can occur. But that doesn’t mean that bursting bubbles is a job that can be safely delegated to any agency, including the Fed.

Moreover, the housing bubble peaked in early 2006, two and a half years before the financial crisis in September 2008. The financial crisis was not unrelated to the housing bubble, which undoubtedly added to the fragility of the financial system and its vulnerability to macroeconomic shocks, but the main cause of the crisis was Fed policy that was unnecessarily focused on a temporary blip in commodity prices persuading the Fed not to loosen policy in 2008 during a worsening recession. That was a scenario similar to the one in 1929 when concern about an apparent stock-market bubble caused the Fed to repeatedly tighten money, raising interest rates, thereby causing a downturn and crash of asset prices triggering the Great Depression.

Graeber and Skidelsky correctly identify some of the problems besetting macroeconomics, but their indiscriminate attack on all economic theory is unlikely to improve the situation. A pity, because a focused and sophisticated critique of economics than they have served up has never been more urgently needed than it is now to enable economists to perform the modest service to mankind of which they might be capable.

Rational Expectations, or, The Road to Incoherence

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

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

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

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

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

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

Paul Romer on Modern Macroeconomics, Or, the “All Models Are False” Dodge

Paul Romer has been engaged for some time in a worthy campaign against the travesty of modern macroeconomics. A little over a year ago I commented favorably about Romer’s takedown of Robert Lucas, but I also defended George Stigler against what I thought was an unfair attempt by Romer to identify George Stigler as an inspiration and role model for Lucas’s transgressions. Now just a week ago, a paper based on Romer’s Commons Memorial Lecture to the Omicron Delta Epsilon Society, has become just about the hottest item in the econ-blogosophere, even drawing the attention of Daniel Drezner in the Washington Post.

I have already written critically about modern macroeconomics in my five years of blogging, and here are some links to previous posts (link, link, link, link). It’s good to see that Romer is continuing to voice his criticisms, and that they are gaining a lot of attention. But the macroeconomic hierarchy is used to criticism, and has its standard responses to criticism, which are being dutifully deployed by defenders of the powers that be.

Romer’s most effective rhetorical strategy is to point out that the RBC core of modern DSGE models posit unobservable taste and technology shocks to account for fluctuations in the economic time series, but that these taste and technology shocks are themselves simply inferred from the fluctuations in the times-series data, so that the entire structure of modern macroeconometrics is little more than an elaborate and sophisticated exercise in question-begging.

In this post, I just want to highlight one of the favorite catch-phrases of modern macroeconomics which serves as a kind of default excuse and self-justification for the rampant empirical failures of modern macroeconomics (documented by Lipsey and Carlaw as I showed in this post). When confronted by evidence that the predictions of their models are wrong, the standard and almost comically self-confident response of the modern macroeconomists is: All models are false. By which the modern macroeconomists apparently mean something like: “And if they are all false anyway, you can’t hold us accountable, because any model can be proven wrong. What really matters is that our models, being microfounded, are not subject to the Lucas Critique, and since all other models than ours are not micro-founded, and, therefore, being subject to the Lucas Critique, they are simply unworthy of consideration. This is what I have called methodological arrogance. That response is simply not true, because the Lucas Critique applies even to micro-founded models, those models being strictly valid only in equilibrium settings and being unable to predict the adjustment of economies in the transition between equilibrium states. All models are subject to the Lucas Critique.

Here is Romer’s take:

In response to the observation that the shocks are imaginary, a standard defense invokes Milton Friedman’s (1953) methodological assertion from unnamed authority that “the more significant the theory, the more unrealistic the assumptions (p.14).” More recently, “all models are false” seems to have become the universal hand-wave for dismissing any fact that does not conform to the model that is the current favorite.

Friedman’s methodological assertion would have been correct had Friedman substituted “simple” for “unrealistic.” Sometimes simplifications are unrealistic, but they don’t have to be. A simplification is a generalization of something complicated. By simplifying, we can transform a problem that had been too complex to handle into a problem more easily analyzed. But such simplifications aren’t necessarily unrealistic. To say that all models are false is simply a dodge to avoid having to account for failure. The excuse of course is that all those other models are subject to the Lucas Critique, so my model wins. But your model is subject to the Lucas Critique even though you claim it’s not, so even according to the rules you have arbitrarily laid down, you don’t win.

So I was just curious about where the little phrase “all models are false” came from. I was expecting that Karl Popper might have said it, in which case to use the phrase as a defense mechanism against empirical refutation would have been a particularly fraudulent tactic, because it would have been a perversion of Popper’s methodological stance, which was to force our theoretical constructs to face up to, not to insulate it from, empirical testing. But when I googled “all theories are false” what I found was not Popper, but the British statistician, G. E. P. Box who wrote in his paper “Science and Statistics” based on his R. A. Fisher Memorial Lecture to the American Statistical Association: “All models are wrong.” Here’s the exact quote:

Since all models are wrong the scientist cannot obtain a “correct” one by excessive elaboration. On the contrary following William of Occam he should seek an economical description of natural phenomena. Just as the ability to devise simple but evocative models is the signature of the great scientist so overelaboration and overparameterization is often the mark of mediocrity.

Since all models are wrong the scientist must be alert to what is importantly wrong. It is inappropriate to be concerned about mice when there are tigers abroad. Pure mathematics is concerned with propositions like “given that A is true, does B necessarily follow?” Since the statement is a conditional one, it has nothing whatsoever to do with the truth of A nor of the consequences B in relation to real life. The pure mathematician, acting in that capacity, need not, and perhaps should not, have any contact with practical matters at all.

In applying mathematics to subjects such as physics or statistics we make tentative assumptions about the real world which we know are false but which we believe may be useful nonetheless. The physicist knows that particles have mass and yet certain results, approximating what really happens, may be derived from the assumption that they do not. Equally, the statistician knows, for example, that in nature there never was a normal distribution, there never was a straight line, yet with normal and linear assumptions, known to be false, he can often derive results which match, to a useful approximation, those found in the real world. It follows that, although rigorous derivation of logical consequences is of great importance to statistics, such derivations are necessarily encapsulated in the knowledge that premise, and hence consequence, do not describe natural truth.

It follows that we cannot know that any statistical technique we develop is useful unless we use it. Major advances in science and in the science of statistics in particular, usually occur, therefore, as the result of the theory-practice iteration.

One of the most annoying conceits of modern macroeconomists is the constant self-congratulatory references to themselves as scientists because of their ostentatious use of axiomatic reasoning, formal proofs, and higher mathematical techniques. The tiresome self-congratulation might get toned down ever so slightly if they bothered to read and take to heart Box’s lecture.


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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