Uneasy Money

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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