Archive for the 'sticky prices' Category

Axel Leijonhufvud and Modern Macroeconomics

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Rises and Falls of Keynesianism and Monetarism

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

Krugman on Mr. Keynes and the Moderns

UPDATE: Re-upping this slightly revised post from July 11, 2011

Paul Krugman recently gave a lecture “Mr. Keynes and the Moderns” (a play on the title of the most influential article ever written about The General Theory, “Mr. Keynes and the Classics,” by another Nobel laureate J. R. Hicks) at a conference in Cambridge, England commemorating the publication of Keynes’s General Theory 75 years ago. Scott Sumner and Nick Rowe, among others, have already commented on his lecture. Coincidentally, in my previous posting, I discussed the views of Sumner and Krugman on the zero-interest lower bound, a topic that figures heavily in Krugman’s discussion of Keynes and his relevance for our current difficulties. (I note in passing that Krugman credits Brad Delong for applying the term “Little Depression” to those difficulties, a term that I thought I had invented, but, oh well, I am happy to share the credit with Brad).

In my earlier posting, I mentioned that Keynes’s, slightly older, colleague A. C. Pigou responded to the zero-interest lower bound in his review of The General Theory. In a way, the response enhanced Pigou’s reputation, attaching his name to one of the most famous “effects” in the history of economics, but it made no dent in the Keynesian Revolution. I also referred to “the layers upon layers of interesting personal and historical dynamics lying beneath the surface of Pigou’s review of Keynes.” One large element of those dynamics was that Keynes chose to make, not Hayek or Robbins, not French devotees of the gold standard, not American laissez-faire ideologues, but Pigou, a left-of-center social reformer, who in the early 1930s had co-authored with Keynes a famous letter advocating increased public-works spending to combat unemployment, the main target of his immense rhetorical powers and polemical invective.  The first paragraph of Pigou’s review reveals just how deeply Keynes’s onslaught had wounded Pigou.

When in 1919, he wrote The Economic Consequences of the Peace, Mr. Keynes did a good day’s work for the world, in helping it back towards sanity. But he did a bad day’s work for himself as an economist. For he discovered then, and his sub-conscious mind has not been able to forget since, that the best way to win attention for one’s own ideas is to present them in a matrix of sarcastic comment upon other people. This method has long been a routine one among political pamphleteers. It is less appropriate, and fortunately less common, in scientific discussion.  Einstein actually did for Physics what Mr. Keynes believes himself to have done for Economics. He developed a far-reaching generalization, under which Newton’s results can be subsumed as a special case. But he did not, in announcing his discovery, insinuate, through carefully barbed sentences, that Newton and those who had hitherto followed his lead were a gang of incompetent bunglers. The example is illustrious: but Mr. Keynes has not followed it. The general tone de haut en bas and the patronage extended to his old master Marshall are particularly to be regretted. It is not by this manner of writing that his desire to convince his fellow economists is best promoted.

Krugman acknowledges Keynes’s shady scholarship (“I know that there’s dispute about whether Keynes was fair in characterizing the classical economists in this way”), only to absolve him of blame. He then uses Keynes’s example to attack “modern economists” who deny that a failure of aggregate demand can cause of mass unemployment, offering up John Cochrane and Niall Ferguson as examples, even though Ferguson is a historian not an economist.

Krugman also addresses Robert Barro’s assertion that Keynes’s explanation for high unemployment was that wages and prices were stuck at levels too high to allow full employment, a problem easily solvable, in Barro’s view, by monetary expansion. Although plainly annoyed by Barro’s attempt to trivialize Keynes’s contribution, Krugman never addresses the point squarely, preferring instead to justify Keynes’s frustration with those (conveniently nameless) “classical economists.”

Keynes’s critique of the classical economists was that they had failed to grasp how everything changes when you allow for the fact that output may be demand-constrained.

Not so, as I pointed out in my first post. Frederick Lavington, an even more orthodox disciple than Pigou of Marshall, had no trouble understanding that “the inactivity of all is the cause of the inactivity of each.” It was Keynes who failed to see that the failure of demand was equally a failure of supply.

They mistook accounting identities for causal relationships, believing in particular that because spending must equal income, supply creates its own demand and desired savings are automatically invested.

Supply does create its own demand when economic agents succeed in executing their plans to supply; it is when, owing to their incorrect and inconsistent expectations about future prices, economic agents fail to execute their plans to supply, that both supply and demand start to contract. Lavington understood that; Pigou understood that. Keynes understood it, too, but believing that his new way of understanding how contractions are caused was superior to that of his predecessors, he felt justified in misrepresenting their views, and attributing to them a caricature of Say’s Law that they would never have taken seriously.

And to praise Keynes for understanding the difference between accounting identities and causal relationships that befuddled his predecessors is almost perverse, as Keynes’s notorious confusion about whether the equality of savings and investment is an equilibrium condition or an accounting identity was pointed out by Dennis Robertson, Ralph Hawtrey and Gottfried Haberler within a year after The General Theory was published. To quote Robertson:

(Mr. Keynes’s critics) have merely maintained that he has so framed his definition that Amount Saved and Amount Invested are identical; that it therefore makes no sense even to inquire what the force is which “ensures equality” between them; and that since the identity holds whether money income is constant or changing, and, if it is changing, whether real income is changing proportionately, or not at all, this way of putting things does not seem to be a very suitable instrument for the analysis of economic change.

It just so happens that in 1925, Keynes, in one of his greatest pieces of sustained, and almost crushing sarcasm, The Economic Consequences of Mr. Churchill, offered an explanation of high unemployment exactly the same as that attributed to Keynes by Barro. Churchill’s decision to restore the convertibility of sterling to gold at the prewar parity meant that a further deflation of at least 10 percent in wages and prices would be necessary to restore equilibrium.  Keynes felt that the human cost of that deflation would be intolerable, and held Churchill responsible for it.

Of course Keynes in 1925 was not yet the Keynes of The General Theory. But what historical facts of the 10 years following Britain’s restoration of the gold standard in 1925 at the prewar parity cannot be explained with the theoretical resources available in 1925? The deflation that began in England in 1925 had been predicted by Keynes. The even worse deflation that began in 1929 had been predicted by Ralph Hawtrey and Gustav Cassel soon after World War I ended, if a way could not be found to limit the demand for gold by countries, rejoining the gold standard in aftermath of the war. The United States, holding 40 percent of the world’s monetary gold reserves, might have accommodated that demand by allowing some of its reserves to be exported. But obsession with breaking a supposed stock-market bubble in 1928-29 led the Fed to tighten its policy even as the international demand for gold was increasing rapidly, as Germany, France and many other countries went back on the gold standard, producing the international credit crisis and deflation of 1929-31. Recovery came not from Keynesian policies, but from abandoning the gold standard, thereby eliminating the deflationary pressure implicit in a rapidly rising demand for gold with a more or less fixed total supply.

Keynesian stories about liquidity traps and Monetarist stories about bank failures are epiphenomena obscuring rather than illuminating the true picture of what was happening.  The story of the Little Depression is similar in many ways, except the source of monetary tightness was not the gold standard, but a monetary regime that focused attention on rising price inflation in 2008 when the appropriate indicator, wage inflation, had already started to decline.

Price Stickiness Is a Symptom not a Cause

In my recent post about Nick Rowe and the law of reflux, I mentioned in passing that I might write a post soon about price stickiness. The reason that I thought it would be worthwhile writing again about price stickiness (which I have written about before here and here), because Nick, following a broad consensus among economists, identifies price stickiness as a critical cause of fluctuations in employment and income. Here’s how Nick phrased it:

An excess demand for land is observed in the land market. An excess demand for bonds is observed in the bond market. An excess demand for equities is observed in the equity market. An excess demand for money is observed in any market. If some prices adjust quickly enough to clear their market, but other prices are sticky so their markets don’t always clear, we may observe an excess demand for money as an excess supply of goods in those sticky-price markets, but the prices in flexible-price markets will still be affected by the excess demand for money.

Then a bit later, Nick continues:

If individuals want to save in the form of money, they won’t collectively be able to if the stock of money does not increase.There will be an excess demand for money in all the money markets, except those where the price of the non-money thing in that market is flexible and adjusts to clear that market. In the sticky-price markets there will nothing an individual can do if he wants to buy more money but nobody else wants to sell more. But in those same sticky-price markets any individual can always sell less money, regardless of what any other individual wants to do. Nobody can stop you selling less money, if that’s what you want to do.

Unable to increase the flow of money into their portfolios, each individual reduces the flow of money out of his portfolio. Demand falls in stick-price markets, quantity traded is determined by the short side of the market (Q=min{Qd,Qs}), so trade falls, and some traders that would be mutually advantageous in a barter or Walrasian economy even at those sticky prices don’t get made, and there’s a recession. Since money is used for trade, the demand for money depends on the volume of trade. When trade falls the flow of money falls too, and the stock demand for money falls, until the representative individual chooses a flow of money out of his portfolio equal to the flow in. He wants to increase the flow in, but cannot, since other individuals don’t want to increase their flows out.

The role of price stickiness or price rigidity in accounting for involuntary unemployment is an old and complicated story. If you go back and read what economists before Keynes had to say about the Great Depression, you will find that there was considerable agreement that, in principle, if workers were willing to accept a large enough cut in their wages, they could all get reemployed. That was a proposition accepted by Hawtry and by Keynes. However, they did not believe that wage cutting was a good way of restoring full employment, because the process of wage cutting would be brutal economically and divisive – even self-destructive – politically. So they favored a policy of reflation that would facilitate and hasten the process of recovery. However, there also those economists, e.g., Ludwig von Mises and the young Lionel Robbins in his book The Great Depression, (which he had the good sense to disavow later in life) who attributed high unemployment to an unwillingness of workers and labor unions to accept wage cuts and to various other legal barriers preventing the price mechanism from operating to restore equilibrium in the normal way that prices adjust to equate the amount demanded with the amount supplied in each and every single market.

But in the General Theory, Keynes argued that if you believed in the standard story told by microeconomics about how prices constantly adjust to equate demand and supply and maintain equilibrium, then maybe you should be consistent and follow the Mises/Robbins story and just wait for the price mechanism to perform its magic, rather than support counter-cyclical monetary and fiscal policies. So Keynes then argued that there is actually something wrong with the standard microeconomic story; price adjustments can’t ensure that overall economic equilibrium is restored, because the level of employment depends on aggregate demand, and if aggregate demand is insufficient, wage cutting won’t increase – and, more likely, would reduce — aggregate demand, so that no amount of wage-cutting would succeed in reducing unemployment.

To those upholding the idea that the price system is a stable self-regulating system or process for coordinating a decentralized market economy, in other words to those upholding microeconomic orthodoxy as developed in any of the various strands of the neoclassical paradigm, Keynes’s argument was deeply disturbing and subversive.

In one of the first of his many important publications, “Liquidity Preference and the Theory of Money and Interest,” Franco Modigliani argued that, despite Keynes’s attempt to prove that unemployment could persist even if prices and wages were perfectly flexible, the assumption of wage rigidity was in fact essential to arrive at Keynes’s result that there could be an equilibrium with involuntary unemployment. Modigliani did so by positing a model in which the supply of labor is a function of real wages. It was not hard for Modigliani to show that in such a model an equilibrium with unemployment required a rigid real wage.

Modigliani was not in favor of relying on price flexibility instead of counter-cyclical policy to solve the problem of involuntary unemployment; he just argued that the rationale for such policies had to be that prices and wages were not adjusting immediately to clear markets. But the inference that Modigliani drew from that analysis — that price flexibility would lead to an equilibrium with full employment — was not valid, there being no guarantee that price adjustments would necessarily lead to equilibrium, unless all prices and wages instantaneously adjusted to their new equilibrium in response to any deviation from a pre-existing equilibrium.

All the theory of general equilibrium tells us is that if all trading takes place at the equilibrium set of prices, the economy will be in equilibrium as long as the underlying “fundamentals” of the economy do not change. But in a decentralized economy, no one knows what the equilibrium prices are, and the equilibrium price in each market depends in principle on what the equilibrium prices are in every other market. So unless the price in every market is an equilibrium price, none of the markets is necessarily in equilibrium.

Now it may well be that if all prices are close to equilibrium, the small changes will keep moving the economy closer and closer to equilibrium, so that the adjustment process will converge. But that is just conjecture, there is no proof showing the conditions under which a simple rule that says raise the price in any market with an excess demand and decrease the price in any market with an excess supply will in fact lead to the convergence of the whole system to equilibrium. Even in a Walrasian tatonnement system, in which no trading at disequilibrium prices is allowed, there is no proof that the adjustment process will eventually lead to the discovery of the equilibrium price vector. If trading at disequilibrium prices is allowed, tatonnement is hopeless.

So the real problem is not that prices are sticky but that trading takes place at disequilibrium prices and there is no mechanism by which to discover what the equilibrium prices are. Modern macroeconomics solves this problem, in its characteristic fashion, by assuming it away by insisting that expectations are “rational.”

Economists have allowed themselves to make this absurd assumption because they are in the habit of thinking that the simple rule of raising price when there is an excess demand and reducing the price when there is an excess supply inevitably causes convergence to equilibrium. This habitual way of thinking has been inculcated in economists by the intense, and largely beneficial, training they have been subjected to in Marshallian partial-equilibrium analysis, which is built on the assumption that every market can be analyzed in isolation from every other market. But that analytic approach can only be justified under a very restrictive set of assumptions. In particular it is assumed that any single market under consideration is small relative to the whole economy, so that its repercussions on other markets can be ignored, and that every other market is in equilibrium, so that there are no changes from other markets that are impinging on the equilibrium in the market under consideration.

Neither of these assumptions is strictly true in theory, so all partial equilibrium analysis involves a certain amount of hand-waving. Nor, even if we wanted to be careful and precise, could we actually dispense with the hand-waving; the hand-waving is built into the analysis, and can’t be avoided. I have often referred to these assumptions required for the partial-equilibrium analysis — the bread and butter microeconomic analysis of Econ 101 — to be valid as the macroeconomic foundations of microeconomics, by which I mean that the casual assumption that microeconomics somehow has a privileged and secure theoretical position compared to macroeconomics and that macroeconomic propositions are only valid insofar as they can be reduced to more basic microeconomic principles is entirely unjustified. That doesn’t mean that we shouldn’t care about reconciling macroeconomics with microeconomics; it just means that the validity of proposition in macroeconomics is not necessarily contingent on being derived from microeconomics. Reducing macroeconomics to microeconomics should be an analytical challenge, not a methodological imperative.

So the assumption, derived from Modigliani’s 1944 paper that “price stickiness” is what prevents an economic system from moving automatically to a new equilibrium after being subjected to some shock or disturbance, reflects either a misunderstanding or a semantic confusion. It is not price stickiness that prevents the system from moving toward equilibrium, it is the fact that individuals are engaging in transactions at disequilibrium prices. We simply do not know how to compare different sets of non-equilibrium prices to determine which set of non-equilibrium prices will move the economy further from or closer to equilibrium. Our experience and out intuition suggest that in some neighborhood of equilibrium, an economy can absorb moderate shocks without going into a cumulative contraction. But all we really know from theory is that any trading at any set of non-equilibrium prices can trigger an economic contraction, and once it starts to occur, a contraction may become cumulative.

It is also a mistake to assume that in a world of incomplete markets, the missing markets being markets for the delivery of goods and the provision of services in the future, any set of price adjustments, however large, could by themselves ensure that equilibrium is restored. With an incomplete set of markets, economic agents base their decisions not just on actual prices in the existing markets; they base their decisions on prices for future goods and services which can only be guessed at. And it is only when individual expectations of those future prices are mutually consistent that equilibrium obtains. With inconsistent expectations of future prices, the adjustments in current prices in the markets that exist for currently supplied goods and services that in some sense equate amounts demanded and supplied, lead to a (temporary) equilibrium that is not efficient, one that could be associated with high unemployment and unused capacity even though technically existing markets are clearing.

So that’s why I regard the term “sticky prices” and other similar terms as very unhelpful and misleading; they are a kind of mental crutch that economists are too ready to rely on as a substitute for thinking about what are the actual causes of economic breakdowns, crises, recessions, and depressions. Most of all, they represent an uncritical transfer of partial-equilibrium microeconomic thinking to a problem that requires a system-wide macroeconomic approach. That approach should not ignore microeconomic reasoning, but it has to transcend both partial-equilibrium supply-demand analysis and the mathematics of intertemporal optimization.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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