Archive for the 'Robert Lucas' Category

There Is No Intertemporal Budget Constraint

Last week Nick Rowe posted a link to a just published article in a special issue of the Review of Keynesian Economics commemorating the 80th anniversary of the General Theory. Nick’s article discusses the confusion in the General Theory between saving and hoarding, and Nick invited readers to weigh in with comments about his article. The ROKE issue also features an article by Simon Wren-Lewis explaining the eclipse of Keynesian theory as a result of the New Classical Counter-Revolution, correctly identified by Wren-Lewis as a revolution inspired not by empirical success but by a methodological obsession with reductive micro-foundationalism. While deploring the New Classical methodological authoritarianism, Wren-Lewis takes solace from the ability of New Keynesians to survive under the New Classical methodological regime, salvaging a role for activist counter-cyclical policy by, in effect, negotiating a safe haven for the sticky-price assumption despite its shaky methodological credentials. The methodological fiction that sticky prices qualify as micro-founded allowed New Keynesianism to survive despite the ascendancy of micro-foundationalist methodology, thereby enabling the core Keynesian policy message to survive.

I mention the Wren-Lewis article in this context because of an exchange between two of the commenters on Nick’s article: the presumably pseudonymous Avon Barksdale and blogger Jason Smith about microfoundations and Keynesian economics. Avon began by chastising Nick for wasting time discussing Keynes’s 80-year old ideas, something Avon thinks would never happen in a discussion about a true science like physics, the 100-year-old ideas of Einstein being of no interest except insofar as they have been incorporated into the theoretical corpus of modern physics. Of course, this is simply vulgar scientism, as if the only legitimate way to do economics is to mimic how physicists do physics. This methodological scolding is typically charming New Classical arrogance. Sort of reminds one of how Friedrich Engels described Marxian theory as scientific socialism. I mean who, other than a religious fanatic, would be stupid enough to argue with the assertions of science?

Avon continues with a quotation from David Levine, a fine economist who has done a lot of good work, but who is also enthralled by the New Classical methodology. Avon’s scientism provoked the following comment from Jason Smith, a Ph. D. in physics with a deep interest in and understanding of economics.

You quote from Levine: “Keynesianism as argued by people such as Paul Krugman and Brad DeLong is a theory without people either rational or irrational”

This is false. The L in ISLM means liquidity preference and e.g. here …

http://krugman.blogs.nytimes.com/2013/11/18/the-new-keynesian-case-for-fiscal-policy-wonkish/

… Krugman mentions an Euler equation. The Euler equation essentially says that an agent must be indifferent between consuming one more unit today on the one hand and saving that unit and consuming in the future on the other if utility is maximized.

So there are agents in both formulations preferring one state of the world relative to others.

Avon replied:

Jason,

“This is false. The L in ISLM means liquidity preference and e.g. here”

I know what ISLM is. It’s not recursive so it really doesn’t have people in it. The dynamics are not set by any micro-foundation. If you’d like to see models with people in them, try Ljungqvist and Sargent, Recursive Macroeconomic Theory.

To which Jason retorted:

Avon,

So the definition of “people” is restricted to agents making multi-period optimizations over time, solving a dynamic programming problem?

Well then any such theory is obviously wrong because people don’t behave that way. For example, humans don’t optimize the dictator game. How can you add up optimizing agents and get a result that is true for non-optimizing agents … coincident with the details of the optimizing agents mattering.

Your microfoundation requirement is like saying the ideal gas law doesn’t have any atoms in it. And it doesn’t! It is an aggregate property of individual “agents” that don’t have properties like temperature or pressure (or even volume in a meaningful sense). Atoms optimize entropy, but not out of any preferences.

So how do you know for a fact that macro properties like inflation or interest rates are directly related to agent optimizations? Maybe inflation is like temperature — it doesn’t exist for individuals and is only a property of economics in aggregate.

These questions are not answered definitively, and they’d have to be to enforce a requirement for microfoundations … or a particular way of solving the problem.

Are quarks important to nuclear physics? Not really — it’s all pions and nucleons. Emergent degrees of freedom. Sure, you can calculate pion scattering from QCD lattice calculations (quark and gluon DoF), but it doesn’t give an empirically better result than chiral perturbation theory (pion DoF) that ignores the microfoundations (QCD).

Assuming quarks are required to solve nuclear physics problems would have been a giant step backwards.

To which Avon rejoined:

Jason

The microfoundation of nuclear physics and quarks is quantum mechanics and quantum field theory. How the degrees of freedom reorganize under the renormalization group flow, what effective field theory results is an empirical question. Keynesian economics is worse tha[n] useless. It’s wrong empirically, it has no theoretical foundation, it has no laws. It has no microfoundation. No serious grad school has taught Keynesian economics in nearly 40 years.

To which Jason answered:

Avon,

RG flow is irrelevant to chiral perturbation theory which is based on the approximate chiral symmetry of QCD. And chiral perturbation theory could exist without QCD as the “microfoundation”.

Quantum field theory is not a ‘microfoundation’, but rather a framework for building theories that may or may not have microfoundations. As Weinberg (1979) said:

” … quantum field theory itself has no content beyond analyticity, unitarity,
cluster decomposition, and symmetry.”

If I put together an NJL model, there is no requirement that the scalar field condensate be composed of quark-antiquark pairs. In fact, the basic idea was used for Cooper pairs as a model of superconductivity. Same macro theory; different microfoundations. And that is a general problem with microfoundations — different microfoundations can lead to the same macro theory, so which one is right?

And the IS-LM model is actually pretty empirically accurate (for economics):

http://informationtransfereconomics.blogspot.com/2014/03/the-islm-model-again.html

To which Avon responded:

First, ISLM analysis does not hold empirically. It just doesn’t work. That’s why we ended up with the macro revolution of the 70s and 80s. Keynesian economics ignores intertemporal budget constraints, it violates Ricardian equivalence. It’s just not the way the world works. People might not solve dynamic programs to set their consumption path, but at least these models include a future which people plan over. These models work far better than Keynesian ISLM reasoning.

As for chiral perturbation theory and the approximate chiral symmetries of QCD, I am not making the case that NJL models requires QCD. NJL is an effective field theory so it comes from something else. That something else happens to be QCD. It could have been something else, that’s an empirical question. The microfoundation I’m talking about with theories like NJL is QFT and the symmetries of the vacuum, not the short distance physics that might be responsible for it. The microfoundation here is about the basic laws, the principles.

ISLM and Keynesian economics has none of this. There is no principle. The microfoundation of modern macro is not about increasing the degrees of freedom to model every person in the economy on some short distance scale, it is about building the basic principles from consistent economic laws that we find in microeconomics.

Well, I totally agree that IS-LM is a flawed macroeconomic model, and, in its original form, it was borderline-incoherent, being a single-period model with an interest rate, a concept without meaning except as an intertemporal price relationship. These deficiencies of IS-LM became obvious in the 1970s, so the model was extended to include a future period, with an expected future price level, making it possible to speak meaningfully about real and nominal interest rates, inflation and an equilibrium rate of spending. So the failure of IS-LM to explain stagflation, cited by Avon as the justification for rejecting IS-LM in favor of New Classical macro, was not that hard to fix, at least enough to make it serviceable. And comparisons of the empirical success of augmented IS-LM and the New Classical models have shown that IS-LM models consistently outperform New Classical models.

What Avon fails to see is that the microfoundations that he considers essential for macroeconomics are themselves derived from the assumption that the economy is operating in macroeconomic equilibrium. Thus, insisting on microfoundations – at least in the formalist sense that Avon and New Classical macroeconomists understand the term – does not provide a foundation for macroeconomics; it is just question begging aka circular reasoning or petitio principia.

The circularity is obvious from even a cursory reading of Samuelson’s Foundations of Economic Analysis, Robert Lucas’s model for doing economics. What Samuelson called meaningful theorems – thereby betraying his misguided acceptance of the now discredited logical positivist dogma that only potentially empirically verifiable statements have meaning – are derived using the comparative-statics method, which involves finding the sign of the derivative of an endogenous economic variable with respect to a change in some parameter. But the comparative-statics method is premised on the assumption that before and after the parameter change the system is in full equilibrium or at an optimum, and that the equilibrium, if not unique, is at least locally stable and the parameter change is sufficiently small not to displace the system so far that it does not revert back to a new equilibrium close to the original one. So the microeconomic laws invoked by Avon are valid only in the neighborhood of a stable equilibrium, and the macroeconomics that Avon’s New Classical mentors have imposed on the economics profession is a macroeconomics that, by methodological fiat, is operative only in the neighborhood of a locally stable equilibrium.

Avon dismisses Keynesian economics because it ignores intertemporal budget constraints. But the intertemporal budget constraint doesn’t exist in any objective sense. Certainly macroeconomics has to take into account intertemporal choice, but the idea of an intertemporal budget constraint analogous to the microeconomic budget constraint underlying the basic theory of consumer choice is totally misguided. In the static theory of consumer choice, the consumer has a given resource endowment and known prices at which consumers can transact at will, so the utility-maximizing vector of purchases and sales can be determined as the solution of a constrained-maximization problem.

In the intertemporal context, consumers have a given resource endowment, but prices are not known. So consumers have to make current transactions based on their expectations about future prices and a variety of other circumstances about which consumers can only guess. Their budget constraints are thus not real but totally conjectural based on their expectations of future prices. The optimizing Euler equations are therefore entirely conjectural as well, and subject to continual revision in response to changing expectations. The idea that the microeconomic theory of consumer choice is straightforwardly applicable to the intertemporal choice problem in a setting in which consumers don’t know what future prices will be and agents’ expectations of future prices are a) likely to be very different from each other and thus b) likely to be different from their ultimate realizations is a huge stretch. The intertemporal budget constraint has a completely different role in macroeconomics from the role it has in microeconomics.

If I expect that the demand for my services will be such that my disposable income next year would be $500k, my consumption choices would be very different from what they would have been if I were expecting a disposable income of $100k next year. If I expect a disposable income of $500k next year, and it turns out that next year’s income is only $100k, I may find myself in considerable difficulty, because my planned expenditure and the future payments I have obligated myself to make may exceed my disposable income or my capacity to borrow. So if there are a lot of people who overestimate their future incomes, the repercussions of their over-optimism may reverberate throughout the economy, leading to bankruptcies and unemployment and other bad stuff.

A large enough initial shock of mistaken expectations can become self-amplifying, at least for a time, possibly resembling the way a large initial displacement of water can generate a tsunami. A financial crisis, which is hard to model as an equilibrium phenomenon, may rather be an emergent phenomenon with microeconomic sources, but whose propagation can’t be described in microeconomic terms. New Classical macroeconomics simply excludes such possibilities on methodological grounds by imposing a rational-expectations general-equilibrium structure on all macroeconomic models.

This is not to say that the rational expectations assumption does not have a useful analytical role in macroeconomics. But the most interesting and most important problems in macroeconomics arise when the rational expectations assumption does not hold, because it is when individual expectations are very different and very unstable – say, like now, for instance — that macroeconomies become vulnerable to really scary instability.

Simon Wren-Lewis makes a similar point in his paper in the Review of Keynesian Economics.

Much discussion of current divisions within macroeconomics focuses on the ‘saltwater/freshwater’ divide. This understates the importance of the New Classical Counter Revolution (hereafter NCCR). It may be more helpful to think about the NCCR as involving two strands. The one most commonly talked about involves Keynesian monetary and fiscal policy. That is of course very important, and plays a role in the policy reaction to the recent Great Recession. However I want to suggest that in some ways the second strand, which was methodological, is more important. The NCCR helped completely change the way academic macroeconomics is done.

Before the NCCR, macroeconomics was an intensely empirical discipline: something made possible by the developments in statistics and econometrics inspired by The General Theory. After the NCCR and its emphasis on microfoundations, it became much more deductive. As Hoover (2001, p. 72) writes, ‘[t]he conviction that macroeconomics must possess microfoundations has changed the face of the discipline in the last quarter century’. In terms of this second strand, the NCCR was triumphant and remains largely unchallenged within mainstream academic macroeconomics.

Perhaps I will have some more to say about Wren-Lewis’s article in a future post. And perhaps also about Nick Rowe’s article.

HT: Tom Brown

Update (02/11/16):

On his blog Jason Smith provides some further commentary on his exchange with Avon on Nick Rowe’s blog, explaining at greater length how irrelevant microfoundations are to doing real empirically relevant physics. He also expands on and puts into a broader meta-theoretical context my point about the extremely narrow range of applicability of the rational-expectations equilibrium assumptions of New Classical macroeconomics.

David Glasner found a back-and-forth between me and a commenter (with the pseudonym “Avon Barksdale” after [a] character on The Wire who [didn’t end] up taking an economics class [per Tom below]) on Nick Rowe’s blog who expressed the (widely held) view that the only scientific way to proceed in economics is with rigorous microfoundations. “Avon” held physics up as a purported shining example of this approach.
I couldn’t let it go: even physics isn’t that reductionist. I gave several examples of cases where the microfoundations were actually known, but not used to figure things out: thermodynamics, nuclear physics. Even modern physics is supposedly built on string theory. However physicists do not require every pion scattering amplitude be calculated from QCD. Some people do do so-called lattice calculations. But many resort to the “effective” chiral perturbation theory. In a sense, that was what my thesis was about — an effective theory that bridges the gap between lattice QCD and chiral perturbation theory. That effective theory even gave up on one of the basic principles of QCD — confinement. It would be like an economist giving up opportunity cost (a basic principle of the micro theory). But no physicist ever said to me “your model is flawed because it doesn’t have true microfoundations”. That’s because the kind of hard core reductionism that surrounds the microfoundations paradigm doesn’t exist in physics — the most hard core reductionist natural science!
In his post, Glasner repeated something that he had before and — probably because it was in the context of a bunch of quotes about physics — I thought of another analogy.

Glasner says:

But the comparative-statics method is premised on the assumption that before and after the parameter change the system is in full equilibrium or at an optimum, and that the equilibrium, if not unique, is at least locally stable and the parameter change is sufficiently small not to displace the system so far that it does not revert back to a new equilibrium close to the original one. So the microeconomic laws invoked by Avon are valid only in the neighborhood of a stable equilibrium, and the macroeconomics that Avon’s New Classical mentors have imposed on the economics profession is a macroeconomics that, by methodological fiat, is operative only in the neighborhood of a locally stable equilibrium.

 

This hits on a basic principle of physics: any theory radically simplifies near an equilibrium.

Go to Jason’s blog to read the rest of his important and insightful post.

Thompson’s Reformulation of Macroeconomic Theory, Part V: A Neoclassical Black Hole

It’s been over three years since I posted the fourth of my four previous installments in this series about Earl Thompson’s unpublished paper “A Reformulation of Macroeconomic Theory,” Thompson’s strictly neoclassical alternative to the standard Keynesian IS-LM model. Given the long hiatus, a short recapitulation seems in order.

The first installment was an introduction summarizing Thompson’s two main criticisms of the Keynesian model: 1) the disconnect between the standard neoclassical marginal productivity theory of production and factor pricing and the Keynesian assertion that labor receives a wage equal to its marginal product, thereby implying the existence of a second scarce factor of production (capital), but with the market for capital services replaced in the IS-LM model by the Keynesian expenditure functions, creating a potential inconsistency between the IS-LM model and a deep property of neoclassical theory; 2) the market for capital services having been excluded from the IS-LM model, the model lacks a variable that equilibrates the choice between holding money or real assets, so that the Keynesian investment function is incompletely specified, the Keynesian equilibrium condition for spending – equality between savings and investment – taking no account of the incentive for capital accumulation or the relationship, explicitly discussed by Keynes, between current investment and the (expected) future price level. Excluding the dependence of the equilibrium rate of spending on (expected) inflation from the IS-LM model renders the model logically incomplete.

The second installment was a discussion of the Hicksian temporary-equilibrium method used by Thompson to rationalize the existence of involuntary unemployment. For Thompson involuntary unemployment means unemployment caused by overly optimistic expectations by workers of wage offers, leading them to mistakenly set reservation wages too high. The key idea of advantage of the temporary-equilibrium method is that it reconciles the convention of allowing a market-clearing price to equilibrate supply and demand with the phenomenon of substantial involuntary unemployment in business-cycle downturns. Because workers have an incentive to withhold their services in order to engage in further job search or job training or leisure, their actual short-run supply of labor services in a given time period is highly elastic at the expected wage. If wage offers are below expectations, workers (mistakenly = involuntarily) choose unemployment, but given those mistaken expectations, the labor market is cleared with the observed wage equilibrating the demand for labor services and supply of labor services. There are clearly problems with this way of modeling the labor market, but it does provide an analytical technique that can account for cyclical fluctuations in unemployment within a standard microeconomic framework.

In the third installment, I showed how Thompson derived his FF curve, representing combinations of price levels and interest rates consistent with (temporary) equilibrium in both factor markets (labor services and capital services) and two versions of the LM curve, representing price levels and interest rates consistent with equilibrium in the money market. The two versions of the LM curve (analogous, but not identical, to the Keynesian LM curve) correspond to different monetary regimes. In what Thompson called the classical case, the price level is fixed by convertibility of output into cash at a fixed exchange rate, with money being supplied by a competitive banking system paying competitive interest on cash balances. The LM curve in this case is vertical at the fixed price level, with any nominal rate of interest being consistent with equilibrium in the money market, inasmuch as the amount of money demanded depends not on the nominal interest rate, but on the difference between the nominal interest rate and the competitively determined interest rate paid on cash. In the modern case, cash is non-interest bearing and supplied monopolistically by the monetary authority, so the LM curve is upward-sloping, with the cost of holding cash rising with the rate of interest, thereby reducing the amount of money demanded and increasing the price level for a given quantity of money supplied by the monetary authority. The solution of the model corresponds to the intersection of the FF and LM curves. For the classical case, the intersection is unique, but in the modern case since both curves are upward sloping, multiple intersections are possible.

The focus of the fourth installment was on setting up a model analogous to the Keynesian model by replacing the market for capital services excluded by Walras’s Law with something similar to the Keynesian expenditure functions (consumption, investment, government spending, etc.). The key point is that the FF and LM curves implicitly define a corresponding CC curve (shown in Figure 4 of the third installment) with the property that, at all points on the CC curve, the excess demand for (supply of) money exactly equals the excess supply of (demand for) labor. Thus, the CC curve represents a stock equilibrium in the market for commodities (i.e., a single consumption/capital good) rather than a flow rate of expenditure and income as represented by the conventional IS curve. But the inconsistency between the upward-sloping CC curve and the downward sloping IS curve reflects the underlying inconsistency between the neoclassical and the Keynesian paradigms.

In this installment, I am going to work through Thompson’s argument about the potential for an unstable equilibrium in the version of his model with an upward-sloping LM curve corresponding to the case in which non-interest bearing money is monopolistically supplied by a central bank. Thompson makes the argument using Figure 5, a phase diagram showing the potential equilibria for such an economy in terms of the FF curve (representing price levels and nominal interest rates consistent with equilibrium in the markets for labor and capital services) and the CC curve (representing price levels and nominal interest rates consistent with equilibrium in the output market).

Thompson_Figure5A phase diagram shows the direction of price adjustment when the economy is not in equilibrium (one of the two points of intersection between the FF and the CC curves). A disequilibrium implies a price change in response to an excess supply or excess demand in some market. All points above and to the left of the FF curve correspond to an excess supply of capital services, implying a falling nominal interest rate; points below and to the right of the FF curve correspond to excess demand for capital services, implying a rising interest rate. Points above and to the left of the CC curve correspond to an excess demand for output, implying a rising price level; points below and to the right of the CC curve correspond to an excess supply of output, implying a falling price level. Points in between the FF and CC curves correspond either to an excess demand for commodities and for capital services, implying a rising price level and a rising nominal interest rate (in the region between the two points of intersection – Eu and Es — between the CC and FF curves) or to an excess supply of both capital services and commodities, implying a falling interest rate and a falling price level (in the regions below the lower intersection Eu and above the upper intersection Es). The arrows in the diagram indicate the direction in which the price level and the nominal interest rate are changing at any point in the diagram.

Given the direction of price change corresponding to points off the CC and FF curves, the upper intersection is shown to be a stable equilibrium, while the lower intersection is unstable. Moreover, the instability corresponding to the lower intersection is very dangerous, because entering the region between the CC and FF curves below Eu means getting sucked into a vicious downward spiral of prices and interest rates that can only be prevented by a policy intervention to shift the CC curve to the right, either directly by way of increased government spending or tax cuts, or indirectly, through monetary policy aimed at raising the price level and expected inflation, shifting the LM curve, and thereby the CC curve, to the right. It’s like stepping off a cliff into a black hole.

Although I have a lot of reservations about the practical relevance of this model as an analytical tool for understanding cyclical fluctuations and counter-cyclical policy, which I plan to discuss in a future post, the model does resonate with me, and it does so especially after my recent posts about the representative-agent modeling strategy in New Classical economics (here, here, and here). Representative-agent models, I argued, are inherently unable to serve as analytical tools in macroeconomics, because their reductionist approach implies that all relevant decision making can be reduced to the optimization of a single agent, insulating the analysis from any interactions between decision-makers. But it is precisely the interaction effects between decision makers that create analytical problems that constitute the subject matter of the discipline or sub-discipline known as macroeconomics. That Robert Lucas has made it his life’s work to annihilate this field of study is a sad commentary on his contribution, Nobel Prize or no Nobel Prize, as an economic theorist.

That is one reason why I regard Thompson’s model, despite its oversimplifications, as important: it is constructed on a highly aggregated, yet strictly neoclassical, foundation, including continuous market-clearing, arriving at the remarkable conclusion that not only is there an unstable equilibrium, but it is at least possible for an economy in the neighborhood of the unstable equilibrium to be caught in a vicious downward deflationary spiral in which falling prices do not restore equilibrium but, instead, suck the economy into a zero-output black hole. That result seems to me to be a major conceptual breakthrough, showing that the strict rationality assumptions of neoclassical theory can lead to aoutcome that is totally at odds with the usual presumption that the standard neoclassical assumptions inevitably generate a unique stable equilibrium and render macroeconomics superfluous.

The Neoclassical Synthesis and the Mind-Body Problem

The neoclassical synthesis that emerged in the early postwar period aimed at reconciling the macroeconomic (IS-LM) analysis derived from Keynes via Hicks and others with the neoclassical microeconomic analysis of general equilibrium derived from Walras. The macroeconomic analysis was focused on an equilibrium of income and expenditure flows while the Walrasian analysis was focused on the equilibrium between supply and demand in individual markets. The two types of analysis seemed to be incommensurate inasmuch as the conditions for equilibrium in the two analysis did not seem to match up against each other. How does an analysis focused on the equality of aggregate flows of income and expenditure get translated into an analysis focused on the equality of supply and demand in individual markets? The two languages seem to be different, so it is not obvious how a statement formulated in one language gets translated into the other. And even if a translation is possible, does the translation hold under all, or only under some, conditions? And if so, what are those conditions?

The original neoclassical synthesis did not aim to provide a definitive answer to those questions, but it was understood to assert that if the equality of income and expenditure was assured at a level consistent with full employment, one could safely assume that market forces would take care of the allocation of resources, so that markets would be cleared and the conditions of microeconomic general equilibrium satisfied, at least as a first approximation. This version of the neoclassical synthesis was obviously ad hoc and an unsatisfactory resolution of the incommensurability of the two levels of analysis. Don Patinkin sought to provide a rigorous reconciliation of the two levels of analysis in his treatise Money, Interest and Prices. But for all its virtues – and they are numerous – Patinkin’s treatise failed to bridge the gap between the two levels of analysis.

As I mentioned recently in a post on Romer and Lucas, Kenneth Arrow in a 1967 review of Samuelson’s Collected Works commented disparagingly on the neoclassical synthesis of which Samuelson was a leading proponent. The widely shared dissatisfaction expressed by Arrow motivated much of the work that soon followed on the microfoundations of macroeconomics exemplified in the famous 1970 Phelps volume. But the motivation for the search for microfoundations was then (before the rational expectations revolution) to specify the crucial deviations from the assumptions underlying the standard Walrasian general-equilibrium model that would generate actual or seeming price rigidities, which a straightforward – some might say superficial — understanding of neoclassical microeconomic theory suggested were necessary to explain why, after a macro-disturbance, equilibrium was not rapidly restored by price adjustments. Two sorts of explanations emerged from the early microfoundations literature: a) search and matching theories assuming that workers and employers must expend time and resources to find appropriate matches; b) institutional theories of efficiency wages or implicit contracts that explain why employers and workers prefer layoffs to wage cuts in response to negative demand shocks.

Forty years on, the search and matching theories do not seem capable of accounting for the magnitude of observed fluctuations in employment or the cyclical variation in layoffs, and the institutional theories are still difficult to reconcile with the standard neoclassical assumptions, remaining an ad hoc appendage to New Keynesian models that otherwise adhere to the neoclassical paradigm. Thus, although the original neoclassical synthesis in which the Keynesian income-expenditure model was seen as a pre-condition for the validity of the neoclassical model was rejected within a decade of Arrow’s dismissive comment about the neoclassical synthesis, Tom Sargent has observed in a recent review of Robert Lucas’s Collected Papers on Monetary Theory that Lucas has implicitly adopted a new version of the neoclassical synthesis dominated by an intertemporal neoclassical general-equilibrium model, but with the proviso that substantial shocks to aggregate demand and the price level are prevented by monetary policy, thereby making the neoclassical model a reasonable approximation to reality.

Ok, so you are probably asking what does all this have to do with the mind-body problem? A lot, I think in that both the neoclassical synthesis and the mind-body problem involve a disconnect between two kinds – two levels – of explanation. The neoclassical synthesis asserts some sort of connection – but a problematic one — between the explanatory apparatus – macroeconomics — used to understand the cyclical fluctuations of what we are used to think of as the aggregate economy and the explanatory apparatus – microeconomics — used to understand the constituent elements of the aggregate economy — households and firms — and how those elements are related to, and interact with, each other.

The mind-body problem concerns the relationship between the mental – our direct experience of a conscious inner life of thoughts, emotions, memories, decisions, hopes and regrets — and the physical – matter, atoms, neurons. A basic postulate of science is that all phenomena have material causes. So the existence of conscious states that seem to us, by way of our direct experience, to be independent of material causes is also highly problematic. There are a few strategies for handling the problem. One is to assert that the mind truly is independent of the body, which is to say that consciousness is not the result of physical causes. A second is to say that mind is not independent of the body; we just don’t understand the nature of the relationship. There are two possible versions of this strategy: a) that although the nature of the relationship is unknown to us now, advances in neuroscience could reveal to us the way in which consciousness is caused by the operation of the brain; b) although our minds are somehow related to the operation of our brains, the nature of this relationship is beyond the capacity of our minds or brains to comprehend owing to considerations analogous to Godel’s incompleteness theorem (a view espoused by the philosopher Colin McGinn among others); in other words, the mind-body problem is inherently beyond human understanding. And the third strategy is to deny the existence of consciousness, because a conscious state is identical with the physical state of a brain, so that consciousness is just an epiphenomenon of a brain state; we in our naivete may think that our conscious states have a separate existence, but those states are strictly identical with corresponding brain states, so that whatever conscious state that we think we are experiencing has been entirely produced by the physical forces that determine the behavior of our brains and the configuration of its physical constituents.

The first, and probably the last, thing that one needs to understand about the third strategy is that, as explained by Colin McGinn (see e.g., here), its validity has not been demonstrated by neuroscience or by any other branch of science; it is, no less than any of the other strategies, strictly a metaphysical position. The mind-body problem is a problem precisely because science has not even come close to demonstrating how mental states are caused by, let alone that they are identical to, brain states, despite some spurious misinterpretations of research that purport to show such an identity.

Analogous to the scientific principle that all phenomena have material or physical causes, there is in economics and social science a principle called methodological individualism, which roughly states that explanations of social outcomes should be derived from theories about the conduct of individuals, not from theories about abstract social entities that exist independently of their constituent elements. The underlying motivation for methodological individualism (as opposed to political individualism with which it is related but from which it is distinct) was to counter certain ideas popular in the nineteenth and twentieth centuries asserting the existence of metaphysical social entities like “history” that are somehow distinct from yet impinge upon individual human beings, and that there are laws of history or social development from which future states of the world can be predicted, as Hegel, Marx and others tried to do. This notion gave rise to a two famous books by Popper: The Open Society and its Enemies and The Poverty of Historicism. Methodological individualism as articulated by Popper was thus primarily an attack on the attribution of special powers to determine the course of future events to abstract metaphysical or mystical entities like history or society that are supposedly things or beings in themselves distinct from the individual human beings of which they are constituted. Methodological individualism does not deny the existence of collective entities like society; it simply denies that such collective entities exist as objective facts that can be observed as such. Our apprehension of these entities must be built up from more basic elements — individuals and their plans, beliefs and expectations — that we can apprehend directly.

However, methodological individualism is not the same as reductionism; methodological individualism teaches us to look for explanations of higher-level phenomena, e.g., a pattern of social relationships like the business cycle, in terms of the basic constituents forming the pattern: households, business firms, banks, central banks and governments. It does not assert identity between the pattern of relationships and the constituent elements; it says that the pattern can be understood in terms of interactions between the elements. Thus, a methodologically individualistic explanation of the business cycle in terms of the interactions between agents – households, businesses, etc. — would be analogous to an explanation of consciousness in terms of the brain if an explanation of consciousness existed. A methodologically individualistic explanation of the business cycle would not be analogous to an assertion that consciousness exists only as an epiphenomenon of brain states. The assertion that consciousness is nothing but the epiphenomenon of a corresponding brain state is reductionist; it asserts an identity between consciousness and brain states without explaining how consciousness is caused by brain states.

In business-cycle theory, the analogue of such a reductionist assertion of identity between higher-level and lower level phenomena is the assertion that the business cycle is not the product of the interaction of individual agents, but is simply the optimal plan of a representative agent. On this account, the business cycle becomes an epiphenomenon; apparent fluctuations being nothing more than the optimal choices of the representative agent. Of course, everyone knows that the representative agent is merely a convenient modeling device in terms of which a business-cycle theorist tries to account for the observed fluctuations. But that is precisely the point. The whole exercise is a sham; the representative agent is an as-if device that does not ground business-cycle fluctuations in the conduct of individual agents and their interactions, but simply asserts an identity between those interactions and the supposed decisions of the fictitious representative agent. The optimality conditions in terms of which the model is solved completely disregard the interactions between individuals that might cause an unintended pattern of relationships between those individuals. The distinctive feature of methodological individualism is precisely the idea that the interactions between individuals can lead to unintended consequences; it is by way of those unintended consequences that a higher-level pattern might emerge from interactions among individuals. And those individual interactions are exactly what is suppressed by representative-agent models.

So the notion that any analysis premised on a representative agent provides microfoundations for macroeconomic theory seems to be a travesty built on a total misunderstanding of the principle of methodological individualism that it purports to affirm.

Romer v. Lucas

A couple of months ago, Paul Romer created a stir by publishing a paper in the American Economic Review “Mathiness in the Theory of Economic Growth,” an attack on two papers, one by McGrattan and Prescott and the other by Lucas and Moll on aspects of growth theory. He accused the authors of those papers of using mathematical modeling as a cover behind which to hide assumptions guaranteeing results by which the authors could promote their research agendas. In subsequent blog posts, Romer has sharpened his attack, focusing it more directly on Lucas, whom he accuses of a non-scientific attachment to ideological predispositions that have led him to violate what he calls Feynman integrity, a concept eloquently described by Feynman himself in a 1974 commencement address at Caltech.

It’s a kind of scientific integrity, a principle of scientific thought that corresponds to a kind of utter honesty–a kind of leaning over backwards. For example, if you’re doing an experiment, you should report everything that you think might make it invalid–not only what you think is right about it: other causes that could possibly explain your results; and things you thought of that you’ve eliminated by some other experiment, and how they worked–to make sure the other fellow can tell they have been eliminated.

Details that could throw doubt on your interpretation must be given, if you know them. You must do the best you can–if you know anything at all wrong, or possibly wrong–to explain it. If you make a theory, for example, and advertise it, or put it out, then you must also put down all the facts that disagree with it, as well as those that agree with it. There is also a more subtle problem. When you have put a lot of ideas together to make an elaborate theory, you want to make sure, when explaining what it fits, that those things it fits are not just the things that gave you the idea for the theory; but that the finished theory makes something else come out right, in addition.

Romer contrasts this admirable statement of what scientific integrity means with another by George Stigler, seemingly justifying, or at least excusing, a kind of special pleading on behalf of one’s own theory. And the institutional and perhaps ideological association between Stigler and Lucas seems to suggest that Lucas is inclined to follow the permissive and flexible Stiglerian ethic rather than rigorous Feynman standard of scientific integrity. Romer regards this as a breach of the scientific method and a step backward for economics as a science.

I am not going to comment on the specific infraction that Romer accuses Lucas of having committed; I am not familiar with the mathematical question in dispute. Certainly if Lucas was aware that his argument in the paper Romer criticizes depended on the particular mathematical assumption in question, Lucas should have acknowledged that to be the case. And even if, as Lucas asserted in responding to a direct question by Romer, he could have derived the result in a more roundabout way, then he should have pointed that out, too. However, I don’t regard the infraction alleged by Romer to be more than a misdemeanor, hardly a scandalous breach of the scientific method.

Why did Lucas, who as far as I can tell was originally guided by Feynman integrity, switch to the mode of Stigler conviction? Market clearing did not have to evolve from auxiliary hypothesis to dogma that could not be questioned.

My conjecture is economists let small accidents of intellectual history matter too much. If we had behaved like scientists, things could have turned out very differently. It is worth paying attention to these accidents because doing so might let us take more control over the process of scientific inquiry that we are engaged in. At the very least, we should try to reduce the odds that that personal frictions and simple misunderstandings could once again cause us to veer off on some damaging trajectory.

I suspect that it was personal friction and a misunderstanding that encouraged a turn toward isolation (or if you prefer, epistemic closure) by Lucas and colleagues. They circled the wagons because they thought that this was the only way to keep the rational expectations revolution alive. The misunderstanding is that Lucas and his colleagues interpreted the hostile reaction they received from such economists as Robert Solow to mean that they were facing implacable, unreasoning resistance from such departments as MIT. In fact, in a remarkably short period of time, rational expectations completely conquered the PhD program at MIT.

More recently Romer, having done graduate work both at MIT and Chicago in the late 1970s, has elaborated on the personal friction between Solow and Lucas and how that friction may have affected Lucas, causing him to disengage from the professional mainstream. Paul Krugman, who was at MIT when this nastiness was happening, is skeptical of Romer’s interpretation.

My own view is that being personally and emotionally attached to one’s own theories, whether for religious or ideological or other non-scientific reasons, is not necessarily a bad thing as long as there are social mechanisms allowing scientists with different scientific viewpoints an opportunity to make themselves heard. If there are such mechanisms, the need for Feynman integrity is minimized, because individual lapses of integrity will be exposed and remedied by criticism from other scientists; scientific progress is possible even if scientists don’t live up to the Feynman standards, and maintain their faith in their theories despite contradictory evidence. But, as I am going to suggest below, there are reasons to doubt that social mechanisms have been operating to discipline – not suppress, just discipline – dubious economic theorizing.

My favorite example of the importance of personal belief in, and commitment to the truth of, one’s own theories is Galileo. As discussed by T. S. Kuhn in The Structure of Scientific Revolutions. Galileo was arguing for a paradigm change in how to think about the universe, despite being confronted by empirical evidence that appeared to refute the Copernican worldview he believed in: the observations that the sun revolves around the earth, and that the earth, as we directly perceive it, is, apart from the occasional earthquake, totally stationary — good old terra firma. Despite that apparently contradictory evidence, Galileo had an alternative vision of the universe in which the obvious movement of the sun in the heavens was explained by the spinning of the earth on its axis, and the stationarity of the earth by the assumption that all our surroundings move along with the earth, rendering its motion imperceptible, our perception of motion being relative to a specific frame of reference.

At bottom, this was an almost metaphysical world view not directly refutable by any simple empirical test. But Galileo adopted this worldview or paradigm, because he deeply believed it to be true, and was therefore willing to defend it at great personal cost, refusing to recant his Copernican view when he could have easily appeased the Church by describing the Copernican theory as just a tool for predicting planetary motion rather than an actual representation of reality. Early empirical tests did not support heliocentrism over geocentrism, but Galileo had faith that theoretical advancements and improved measurements would eventually vindicate the Copernican theory. He was right of course, but strict empiricism would have led to a premature rejection of heliocentrism. Without a deep personal commitment to the Copernican worldview, Galileo might not have articulated the case for heliocentrism as persuasively as he did, and acceptance of heliocentrism might have been delayed for a long time.

Imre Lakatos called such deeply-held views underlying a scientific theory the hard core of the theory (aka scientific research program), a set of beliefs that are maintained despite apparent empirical refutation. The response to any empirical refutation is not to abandon or change the hard core but to adjust what Lakatos called the protective belt of the theory. Eventually, as refutations or empirical anomalies accumulate, the research program may undergo a crisis, leading to its abandonment, or it may simply degenerate if it fails to solve new problems or discover any new empirical facts or regularities. So Romer’s criticism of Lucas’s dogmatic attachment to market clearing – Lucas frequently makes use of ad hoc price stickiness assumptions; I don’t know why Romer identifies market-clearing as a Lucasian dogma — may be no more justified from a history of science perspective than would criticism of Galileo’s dogmatic attachment to heliocentrism.

So while I have many problems with Lucas, lack of Feynman integrity is not really one of them, certainly not in the top ten. What I find more disturbing is his narrow conception of what economics is. As he himself wrote in an autobiographical sketch for Lives of the Laureates, he was bewitched by the beauty and power of Samuelson’s Foundations of Economic Analysis when he read it the summer before starting his training as a graduate student at Chicago in 1960. Although it did not have the transformative effect on me that it had on Lucas, I greatly admire the Foundations, but regardless of whether Samuelson himself meant to suggest such an idea (which I doubt), it is absurd to draw this conclusion from it:

I loved the Foundations. Like so many others in my cohort, I internalized its view that if I couldn’t formulate a problem in economic theory mathematically, I didn’t know what I was doing. I came to the position that mathematical analysis is not one of many ways of doing economic theory: It is the only way. Economic theory is mathematical analysis. Everything else is just pictures and talk.

Oh, come on. Would anyone ever think that unless you can formulate the problem of whether the earth revolves around the sun or the sun around the earth mathematically, you don’t know what you are doing? And, yet, remarkably, on the page following that silly assertion, one finds a totally brilliant description of what it was like to take graduate price theory from Milton Friedman.

Friedman rarely lectured. His class discussions were often structured as debates, with student opinions or newspaper quotes serving to introduce a problem and some loosely stated opinions about it. Then Friedman would lead us into a clear statement of the problem, considering alternative formulations as thoroughly as anyone in the class wanted to. Once formulated, the problem was quickly analyzed—usually diagrammatically—on the board. So we learned how to formulate a model, to think about and decide which features of a problem we could safely abstract from and which he needed to put at the center of the analysis. Here “model” is my term: It was not a term that Friedman liked or used. I think that for him talking about modeling would have detracted from the substantive seriousness of the inquiry we were engaged in, would divert us away from the attempt to discover “what can be done” into a merely mathematical exercise. [my emphasis].

Despite his respect for Friedman, it’s clear that Lucas did not adopt and internalize Friedman’s approach to economic problem solving, but instead internalized the caricature he extracted from Samuelson’s Foundations: that mathematical analysis is the only legitimate way of doing economic theory, and that, in particular, the essence of macroeconomics consists in a combination of axiomatic formalism and philosophical reductionism (microfoundationalism). For Lucas, the only scientifically legitimate macroeconomic models are those that can be deduced from the axiomatized Arrow-Debreu-McKenzie general equilibrium model, with solutions that can be computed and simulated in such a way that the simulations can be matched up against the available macroeconomics time series on output, investment and consumption.

This was both bad methodology and bad science, restricting the formulation of economic problems to those for which mathematical techniques are available to be deployed in finding solutions. On the one hand, the rational-expectations assumption made finding solutions to certain intertemporal models tractable; on the other, the assumption was justified as being required by the rationality assumptions of neoclassical price theory.

In a recent review of Lucas’s Collected Papers on Monetary Theory, Thomas Sargent makes a fascinating reference to Kenneth Arrow’s 1967 review of the first two volumes of Paul Samuelson’s Collected Works in which Arrow referred to the problematic nature of the neoclassical synthesis of which Samuelson was a chief exponent.

Samuelson has not addressed himself to one of the major scandals of current price theory, the relation between microeconomics and macroeconomics. Neoclassical microeconomic equilibrium with fully flexible prices presents a beautiful picture of the mutual articulations of a complex structure, full employment being one of its major elements. What is the relation between this world and either the real world with its recurrent tendencies to unemployment of labor, and indeed of capital goods, or the Keynesian world of underemployment equilibrium? The most explicit statement of Samuelson’s position that I can find is the following: “Neoclassical analysis permits of fully stable underemployment equilibrium only on the assumption of either friction or a peculiar concatenation of wealth-liquidity-interest elasticities. . . . [The neoclassical analysis] goes far beyond the primitive notion that, by definition of a Walrasian system, equilibrium must be at full employment.” . . .

In view of the Phillips curve concept in which Samuelson has elsewhere shown such interest, I take the second sentence in the above quotation to mean that wages are stationary whenever unemployment is X percent, with X positive; thus stationary unemployment is possible. In general, one can have a neoclassical model modified by some elements of price rigidity which will yield Keynesian-type implications. But such a model has yet to be constructed in full detail, and the question of why certain prices remain rigid becomes of first importance. . . . Certainly, as Keynes emphasized the rigidity of prices has something to do with the properties of money; and the integration of the demand and supply of money with general competitive equilibrium theory remains incomplete despite attempts beginning with Walras himself.

If the neoclassical model with full price flexibility were sufficiently unrealistic that stable unemployment equilibrium be possible, then in all likelihood the bulk of the theorems derived by Samuelson, myself, and everyone else from the neoclassical assumptions are also contrafactual. The problem is not resolved by what Samuelson has called “the neoclassical synthesis,” in which it is held that the achievement of full employment requires Keynesian intervention but that neoclassical theory is valid when full employment is reached. . . .

Obviously, I believe firmly that the mutual adjustment of prices and quantities represented by the neoclassical model is an important aspect of economic reality worthy of the serious analysis that has been bestowed on it; and certain dramatic historical episodes – most recently the reconversion of the United States from World War II and the postwar European recovery – suggest that an economic mechanism exists which is capable of adaptation to radical shifts in demand and supply conditions. On the other hand, the Great Depression and the problems of developing countries remind us dramatically that something beyond, but including, neoclassical theory is needed.

Perhaps in a future post, I may discuss this passage, including a few sentences that I have omitted here, in greater detail. For now I will just say that Arrow’s reference to a “neoclassical microeconomic equilibrium with fully flexible prices” seems very strange inasmuch as price flexibility has absolutely no role in the proofs of the existence of a competitive general equilibrium for which Arrow and Debreu and McKenzie are justly famous. All the theorems Arrow et al. proved about the neoclassical equilibrium were related to existence, uniqueness and optimaiity of an equilibrium supported by an equilibrium set of prices. Price flexibility was not involved in those theorems, because the theorems had nothing to do with how prices adjust in response to a disequilibrium situation. What makes this juxtaposition of neoclassical microeconomic equilibrium with fully flexible prices even more remarkable is that about eight years earlier Arrow wrote a paper (“Toward a Theory of Price Adjustment”) whose main concern was the lack of any theory of price adjustment in competitive equilibrium, about which I will have more to say below.

Sargent also quotes from two lectures in which Lucas referred to Don Patinkin’s treatise Money, Interest and Prices which provided perhaps the definitive statement of the neoclassical synthesis Samuelson espoused. In one lecture (“My Keynesian Education” presented to the History of Economics Society in 2003) Lucas explains why he thinks Patinkin’s book did not succeed in its goal of integrating value theory and monetary theory:

I think Patinkin was absolutely right to try and use general equilibrium theory to think about macroeconomic problems. Patinkin and I are both Walrasians, whatever that means. I don’t see how anybody can not be. It’s pure hindsight, but now I think that Patinkin’s problem was that he was a student of Lange’s, and Lange’s version of the Walrasian model was already archaic by the end of the 1950s. Arrow and Debreu and McKenzie had redone the whole theory in a clearer, more rigorous, and more flexible way. Patinkin’s book was a reworking of his Chicago thesis from the middle 1940s and had not benefited from this more recent work.

In the other lecture, his 2003 Presidential address to the American Economic Association, Lucas commented further on why Patinkin fell short in his quest to unify monetary and value theory:

When Don Patinkin gave his Money, Interest, and Prices the subtitle “An Integration of Monetary and Value Theory,” value theory meant, to him, a purely static theory of general equilibrium. Fluctuations in production and employment, due to monetary disturbances or to shocks of any other kind, were viewed as inducing disequilibrium adjustments, unrelated to anyone’s purposeful behavior, modeled with vast numbers of free parameters. For us, today, value theory refers to models of dynamic economies subject to unpredictable shocks, populated by agents who are good at processing information and making choices over time. The macroeconomic research I have discussed today makes essential use of value theory in this modern sense: formulating explicit models, computing solutions, comparing their behavior quantitatively to observed time series and other data sets. As a result, we are able to form a much sharper quantitative view of the potential of changes in policy to improve peoples’ lives than was possible a generation ago.

So, as Sargent observes, Lucas recreated an updated neoclassical synthesis of his own based on the intertemporal Arrow-Debreu-McKenzie version of the Walrasian model, augmented by a rationale for the holding of money and perhaps some form of monetary policy, via the assumption of credit-market frictions and sticky prices. Despite the repudiation of the updated neoclassical synthesis by his friend Edward Prescott, for whom monetary policy is irrelevant, Lucas clings to neoclassical synthesis 2.0. Sargent quotes this passage from Lucas’s 1994 retrospective review of A Monetary History of the US by Friedman and Schwartz to show how tightly Lucas clings to neoclassical synthesis 2.0 :

In Kydland and Prescott’s original model, and in many (though not all) of its descendants, the equilibrium allocation coincides with the optimal allocation: Fluctuations generated by the model represent an efficient response to unavoidable shocks to productivity. One may thus think of the model not as a positive theory suited to all historical time periods but as a normative benchmark providing a good approximation to events when monetary policy is conducted well and a bad approximation when it is not. Viewed in this way, the theory’s relative success in accounting for postwar experience can be interpreted as evidence that postwar monetary policy has resulted in near-efficient behavior, not as evidence that money doesn’t matter.

Indeed, the discipline of real business cycle theory has made it more difficult to defend real alternaltives to a monetary account of the 1930s than it was 30 years ago. It would be a term-paper-size exercise, for example, to work out the possible effects of the 1930 Smoot-Hawley Tariff in a suitably adapted real business cycle model. By now, we have accumulated enough quantitative experience with such models to be sure that the aggregate effects of such a policy (in an economy with a 5% foreign trade sector before the Act and perhaps a percentage point less after) would be trivial.

Nevertheless, in the absence of some catastrophic error in monetary policy, Lucas evidently believes that the key features of the Arrow-Debreu-McKenzie model are closely approximated in the real world. That may well be true. But if it is, Lucas has no real theory to explain why.

In his 1959 paper (“Towards a Theory of Price Adjustment”) I just mentioned, Arrow noted that the theory of competitive equilibrium has no explanation of how equilibrium prices are actually set. Indeed, the idea of competitive price adjustment is beset by a paradox: all agents in a general equilibrium being assumed to be price takers, how is it that a new equilibrium price is ever arrived at following any disturbance to an initial equilibrium? Arrow had no answer to the question, but offered the suggestion that, out of equilibrium, agents are not price takers, but price searchers, possessing some measure of market power to set price in the transition between the old and new equilibrium. But the upshot of Arrow’s discussion was that the problem and the paradox awaited solution. Almost sixty years on, some of us are still waiting, but for Lucas and the Lucasians, there is neither problem nor paradox, because the actual price is the equilibrium price, and the equilibrium price is always the (rationally) expected price.

If the social functions of science were being efficiently discharged, this rather obvious replacement of problem solving by question begging would not have escaped effective challenge and opposition. But Lucas was able to provide cover for this substitution by persuading the profession to embrace his microfoundational methodology, while offering irresistible opportunities for professional advancement to younger economists who could master the new analytical techniques that Lucas and others were rapidly introducing, thereby neutralizing or coopting many of the natural opponents to what became modern macroeconomics. So while Romer considers the conquest of MIT by the rational-expectations revolution, despite the opposition of Robert Solow, to be evidence for the advance of economic science, I regard it as a sign of the social failure of science to discipline a regressive development driven by the elevation of technique over substance.

Richard Lipsey and the Phillips Curve

Richard Lipsey has had an extraordinarily long and productive career as both an economic theorist and an empirical economist, making numerous important contributions in almost all branches of economics. (See, for example, the citation about Lipsey as a fellow of the Canadian Economics Association.) In addition, his many textbooks have been enormously influential in advocating that economists should strive to make their discipline empirically relevant by actually subjecting their theories to meaningful empirical tests in which refutation is a realistic possibility not just a sign that the researcher was insufficiently creative in theorizing or in performing the data analysis.

One of Lipsey’s most important early contributions was his 1960 paper on the Phillips Curve “The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1862-1957: A Further Analysis” in which he extended W A. Phillips’s original results, and he has continued to write about the Phillips Curve ever since. Lipsey, in line with his empiricist philosophical position, has consistently argued that a well-supported empirical relationship should not be dismissed simply because of a purely theoretical argument about how expectations are formed. In other words, the argument that adjustments in inflation expectations would cause the short-run Phillips curve relation captured by empirical estimates of the relationship between inflation and unemployment may well be valid (as was actually recognized early on by Samuelson and Solow in their famous paper suggesting that the Phillips Curve could be interpreted as a menu of alternative combinations of inflation and unemployment from which policy-makers could choose) in some general qualitative sense. But that does not mean that it had to be accepted as an undisputable axiom of economics that the long-run relationship between unemployment and inflation is necessarily vertical, as Friedman and Phelps and Lucas convinced most of the economics profession in the late 1960s and early 1970s.

A few months ago, Lipsey was kind enough to send me a draft of the paper that he presented at the annual meeting of the History of Economics Society; the paper is called “The Phillips Curve and the Tyranny of an Assumed Unique Macro Equilibrium.” Here is the abstract of the paper.

To make the argument that the behaviour of modern industrial economies since the 1990s is inconsistent with theories in which there is a unique ergodic macro equilibrium, the paper starts by reviewing both the early Keynesian theory in which there was no unique level of income to which the economy was inevitably drawn and the debate about the amount of demand pressure at which it was best of maintain the economy: high aggregate demand and some inflationary pressure or lower aggregate demand and a stable price level. It then covers the rise of the simple Phillips curve and its expectations-augmented version, which introduced into current macro theory a natural rate of unemployment (and its associated equilibrium level of national income). This rate was also a NAIRU, the only rate consistent with stable inflation. It is then argued that the current behaviour of many modern economies in which there is a credible policy to maintain a low and steady inflation rate is inconsistent with the existence of either a unique natural rate or a NAIRU but is consistent with evolutionary theory in which there is perpetual change driven by endogenous technological advance. Instead of a NAIRU evolutionary economies have a non-inflationary band of unemployment (a NAIBU) indicating a range of unemployment and income over with the inflation rate is stable. The paper concludes with the observation that the great pre-Phillips curve debates of the 1950s that assumed that there was a range within which the economy could be run with varying pressures of demand, and varying amounts of unemployment and inflationary pressure, were not as silly as they were made to seem when both Keynesian and New Classical economists accepted the assumption of a perfectly inelastic, long-run Phillips curve located at the unique equilibrium level of unemployment.

Back in January, I wrote a post about the Lucas Critique in which I pointed out that his “proof” that the Phillips Curve is vertical in his celebrated paper on econometric policy evaluation was no proof at all, but simply a very special example in which the only disequilibrium permitted in the model – a misperception of the future price level – would lead an econometrician to estimate a negatively sloped relation between inflation and employment even though under correct expectations of inflation the relationship would be vertical. Allowing for a wider range of behavioral responses, I suggested, might well change the relation between inflation and output even under correctly expected inflation. In his new paper, Lipsey correctly points out that Friedman and Phelps and Lucas, and subsequent New Classical and New Keynesian theoreticians, who have embraced the vertical Phillips Curve doctrine as an article of faith, are also assuming, based on essentially no evidence, that there is a unique macro equilibrium. But, there is very strong evidence to suggest that, in fact, any deviation from an initial equilibrium (or equilibrium time path) is likely to cause changes that, in and of themselves, cause a change in conditions that will propel the system toward a new and different equilibrium time path, rather than return to the time path the system had been moving along before it was disturbed. See my post of almost a year ago about a paper, “Does history matter?: Empirical analysis of evolutionary versus stationary equilibrium views of the economy,” by Carlaw and Lipsey.)

Lipsey concludes his paper with a quotation from his article “The Phillips Curve” published in the volume Famous Figures and Diagrams in Economics edited by Mark Blaug and Peter Lloyd.

Perhaps [then] Keynesians were too hasty in following the New Classical economists in accepting the view that follows from static [and all EWD] models that stable rates of wage and price inflation are poised on the razor’s edge of a unique NAIRU and its accompanying Y*. The alternative does not require a long term Phillips curve trade off, nor does it deny the possibility of accelerating inflations of the kind that have bedevilled many third world countries. It is merely states that industrialised economies with low expected inflation rates may be less precisely responsive than current theory assumes because they are subject to many lags and inertias, and are operating in an ever-changing and uncertain world of endogenous technological change, which has no unique long term static equilibrium. If so, the economy may not be similar to the smoothly functioning mechanical world of Newtonian mechanics but rather to the imperfectly evolving world of evolutionary biology. The Phillips relation then changes from being a precise curve to being a band within which various combinations of inflation and unemployment are possible but outside of which inflation tends to accelerate or decelerate. Perhaps then the great [pre-Phillips curve] debates of the 1940s and early 1950s that assumed that there was a range within which the economy could be run with varying pressures of demand, and varying amounts of unemployment and inflation[ary pressure], were not as silly as they were made to seem when both Keynesian and New Classical economists accepted the assumption of a perfectly inelastic, one-dimensional, long run Phillips curve located at a unique equilibrium Y* and NAIRU.”

Scott Sumner, Meet Robert Lucas

I just saw Scott Sumner’s latest post. It’s about the zero fiscal multiplier. Scott makes a good and important point, which is that, under almost any conditions, fiscal policy cannot be effective if monetary policy is aiming at a policy objective that is inconsistent with that fiscal policy. Here’s how Scott puts it in his typical understated fashion.

From today’s news:

The marked improvement in the labor market since the U.S. central bank began its third round of quantitative easing, or QE3, has added an edge to calls by some policy hawks to dial down the stimulus. The roughly 50 percent jump in monthly job creation since the program began has even won renewed support from centrists, raising at least some chance the Fed could ratchet back its buying as early as next month.

I hope I don’t have to do any more of these.  The fiscal multiplier theory is as dead as John Cleese’s parrot.  The growth in jobs didn’t slow with fiscal austerity, it sped up!  And the Fed is saying that any job improvement due to fiscal stimulus will be offset with tighter money.  They talk like the multiplier is zero, and their actions produce a zero multiplier.

This is classic Sumner, and he deserves credit for rediscovering an argument that Ralph Hawtrey made in 1925, but was ignored and then forgotten until Sumner figured it out for himself. When I went through Hawtrey’s analysis in my recent series of posts on Hawtrey and Keynes, Scott immediately identified the identity between what Hawtrey was saying and what he was saying. So up to this point, I am with Scott all the way. But then he loses me, by asking the following question

Has there ever been a more decisive refutation of a major economic theory?

What’s wrong with that question? Well, it seems to me to fly in the face of another critique by another famous economist whom, I think, Scott actually knows: Robert Lucas. Almost 40 years ago, Lucas published a paper about the Phillips Curve in which he argued that the existence of an empirical relationship between inflation and unemployment, even if empirically well-founded, was not a relationship that policy makers could use as a basis for their policy decisions, because the expectations (of low inflation or stable prices) under which the negative relationship between inflation and unemployment was observed would break down once policy makers used that relationship to try to reduce unemployment by increasing inflation. That simple point, dressed up with just enough mathematical notation to obscure its obviousness, helped Lucas win the Noble Prize, and before long became widely known as the Lucas Critique.

The crux of the Lucas Critique is that economic theory posits deep structural relationships governing economic activity. These structural relationships are necessarily sensitive to the expectations of decision makers, so that no observed empirical relationship between economic variables is invariant to the expectational effects of the policy rules governing policy decisions. Observed relationships between economic variables are useless for policy makers unless they understand those deep structural relationships and how they are affected by expectations.

But now Scott seems to be turning the Lucas Critique on its head by saying that the expectations that result from a particular policy regime — a policy regime that has been subjected to withering criticism by none other than Scott himself – refutes a structural theory (that government spending can increase aggregate spending and income) of how the economy works. I don’t think so. The fact that the Fed has adopted and tenaciously sticks to a perverse reaction function cannot refute a theory in which the Fed’s reaction function is a matter of choice not necessity.

I agree with Scott that monetary policy is usually the best tool for macroeconomic stabilization. But that doesn’t mean that fiscal policy can never ever promote recovery. Even Ralph Hawtrey, originator of the “Treasury view” that fiscal policy is powerless to affect aggregate spending, acknowledged that, in a credit deadlock, when expectations are so pessimistic that the monetary authority is powerless to increase private spending, deficit spending by the government financed by money creation might be the only way to increase aggregate spending. That, to be sure, is a pathological situation. But, with at least some real interest rates, currently below zero, it is not impossible to suppose that we are, or have been, in something like a Hawtreyan credit deadlock. I don’t say that we are in one, just that it’s possible that we are close enough to being there that we can’t confidently exclude the possibility, if only the Fed would listen to Scott and stop targeting 2% inflation, of a positive fiscal multiplier.

With US NGDP not even increasing at a 4% annual rate, and the US economy far below its pre-2008 trendline of 5% annual NGDP growth, I don’t understand why one wouldn’t welcome the aid of fiscal policy in getting NDGP to increase at a faster rate than it has for the last 5 years. Sure the economy has been expanding despite a sharp turn toward contractionary fiscal policy two years ago. If fiscal stimulus had not been withdrawn so rapidly, can we be sure that the economy would not have grown faster? Under conditions such as these, as Hawtrey himself well understood, the prudent course of action is to err on the side of recklessness.

The Lucas Critique Revisited

After writing my previous post, I reread Robert Lucas’s classic article “Econometric Policy Evaluation: A Critique,” surely one of the most influential economics articles of the last half century. While the main point of the article was not entirely original, as Lucas himself acknowledged in the article, so powerful was his explanation of the point that it soon came to be known simply as the Lucas Critique. The Lucas Critique says that if a certain relationship between two economic variables has been estimated econometrically, policy makers, in formulating a policy for the future, cannot rely on that relationship to persist once a policy aiming to exploit the relationship is adopted. The motivation for the Lucas Critique was the Friedman-Phelps argument that a policy of inflation would fail to reduce the unemployment rate in the long run, because workers would eventually adjust their expectations of inflation, thereby draining inflation of any stimulative effect. By restating the Friedman-Phelps argument as the application of a more general principle, Lucas reinforced and solidified the natural-rate hypothesis, thereby establishing a key principle of modern macroeconomics.

In my previous post I argued that microeconomic relationships, e.g., demand curves and marginal rates of substitution, are, as a matter of pure theory, not independent of the state of the macroeconomy. In an interdependent economy all variables are mutually determined, so there is no warrant for saying that microrelationships are logically prior to, or even independent of, macrorelationships. If so, then the idea of microfoundations for macroeconomics is misleading, because all economic relationships are mutually interdependent; some relationships are not more basic or more fundamental than others. The kernel of truth in the idea of microfoundations is that there are certain basic principles or axioms of behavior that we don’t think an economic model should contradict, e.g., arbitrage opportunities should not be left unexploited – people should not pass up obvious opportunities, such as mutually beneficial offers of exchange, to increase their wealth or otherwise improve their state of well-being.

So I was curious to how see whether Lucas, while addressing the issue of how price expectations affected output and employment, recognized the possibility that a microeconomic relationship could be dependent on the state of the macroeconomy. For my purposes, the relevant passage occurs in section 5.3 (subtitled “Phillips Curves”) of the paper. After working out the basic theory earlier in the page, Lucas, in section 5, provided three examples of how econometric estimates of macroeconomic relationships would mislead policy makers if the effect of expectations on those relationships were not taken into account. The first two subsections treated consumption expenditures and the investment tax credit. The passage that I want to focus on consists of the first two paragraphs of subsection 5.3 (which I now quote verbatim except for minor changes in Lucas’s notation).

A third example is suggested by the recent controversy over the Phelps-Friedman hypothesis that permanent changes in the inflation rate will not alter the average rate of unemployment. Most of the major econometric models have been used in simulation experiments to test this proposition; the results are uniformly negative. Since expectations are involved in an essential way in labor and product market supply behavior, one would presumed, on the basis of the considerations raised in section 4, that these tests are beside the point. This presumption is correct, as the following example illustrates.

It will be helpful to utilize a simple, parametric model which captures the main features of the expectational view of aggregate supply – rational agents, cleared markets, incomplete information. We imagine suppliers of goods to be distributed over N distinct markets i, I = 1, . . ., N. To avoid index number problems, suppose that the same (except for location) good is traded in each market, and let y_it be the log of quantity supplied in market i in period t. Assume, further, that the supply y_it is composed of two factors

y_it = Py_it + Cy_it,

where Py_it denotes normal or permanent supply, and Cy_it cyclical or transitory supply (both again in logs). We take Py_it to be unresponsive to all but permanent relative price changes or, since the latter have been defined away by assuming a single good, simply unresponsive to price changes. Transitory supply Cy_it varies with perceived changes in the relative price of goods in i:

Cy_it = β(p_it – Ep_it),

where p_it is the log of the actual price in i at time t, and Ep_it is the log of the general (geometric average) price level in the economy as a whole, as perceived in market i.

Let’s take a moment to ponder the meaning of Lucas’s simplifying assumption that there is just one good. Relative prices (except for spatial differences in an otherwise identical good) are fixed by assumption; a disequilibrium (or suboptimal outcome) can arise only because of misperceptions of the aggregate price level. So, by explicit assumption, Lucas rules out the possibility that any microeconomic relationship depends on macroeconomic conditions. Note also that Lucas does not provide an account of the process by which market prices are established at each location, nothing being said about demand conditions. For example, if suppliers at location i perceive a price (transitorily) above the equilibrium price, and respond by (mistakenly) increasing output, thereby increasing their earnings, do those suppliers increase their demand to consume output? Suppose suppliers live and purchase at locations other than where they are supplying product, so that a supplier at location i purchases at location j, where i does not equal j. If a supplier at location i perceives an increase in price at location i, will his demand to purchase the good at location j increase as well? Will the increase in demand at location j cause an increase in the price at location j? What if there is a one-period lag between supplier receipts and their consumption demands? Lucas provides no insight into these possible ambiguities in his model.

Stated more generally, the problem with Lucas’s example is that it seems to be designed to exclude a priori the possibility of every type of disequilibrium but one, a disequilibrium corresponding to a single type of informational imperfection. Reasoning on the basis of that narrow premise, Lucas shows that, under a given expectation of the future price level, an econometrician would find a positive correlation between the price level and output — a negatively sloped Phillips Curve. Yet, under the same assumptions, Lucas also shows that an anticipated policy to raise the rate of inflation would fail to raise output (or, by implication, increase employment). But, given his very narrow underlying assumptions, it seems plausible to doubt the robustness of Lucas’s conclusion. Proving the validity of a proposition requires more than constructing an example in which the proposition is shown to be valid. That would be like trying to prove that the sides of every triangle are equal in length by constructing a triangle whose angles are all equal to 60 degrees, and then claiming that, because the sides of that triangle are equal in length, the sides of all triangles are equal in length.

Perhaps a better model than the one Lucas posited would have been one in which the amount supplied in each market was positively correlated with the amount supplied in every other market, inasmuch as an increase (decrease) in the amount supplied in one market will tend to increase (decrease) demand in other markets. In that case, I conjecture, deviations from permanent supply would tend to be cumulative (though not necessarily permanent), implying a more complex propagation mechanism than Lucas’s simple model does. Nor is it obvious to me how the equilibrium of such a model would compare to the equilibrium in the Lucas model. It does not seem inconceivable that a model could be constructed in which equilibrium output depended on the average price level. But this is just conjecture on my part, because I haven’t tried to write out and solve such a model. Perhaps an interested reader out there will try to work it out and report back to us on the results.

PS:  Congratulations to Scott Sumner on his excellent op-ed on nominal GDP level targeting in today’s Financial Times.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. 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.

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

Join 400 other followers


Follow

Get every new post delivered to your Inbox.

Join 400 other followers