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The Road to Incoherence: Arthur Burns and the Agony of Central Banking

Published September 3, 2023 Arthur Burns , incomes policy , J. K. Galbraith , Milton Friedman , Nathan Tankus , Phillips Curve , political business cycles , R. G. Hawtrey , wage and price controls , wage-price guideposts 14 Comments
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UPDATE: My concluding paragraph was inadverently deleted from my post, so even if you’ve already read the post, you may want to go back and read my concluding paragraph.

Last December, Nathan Tankus wrote an essay for his substack site defending Arthur Burns and his record as Fed Chairman in the 1970s when inflation rose to double digits, setting the stage for Volcker’s shock therapy in 1981-82. Tankus believes that Burns has been blamed unfairly for the supposedly dreadful performance of the economy in the 1970s, a decade that probably ranks second for dreadfulness, after the 1930s, in the economic history of the 20th century. Nathan is not the first commentator or blogger I’ve seen over the past 10 years or so to offer a revisionist, favorable, take on Burns’s tenure at the Fed. Here are links to my earlier posts on Burns revisionism (link, link, link)

Nathan properly criticizes the treatment of the 1970s in journalistic mentions to that fraught decade. The decade endured a lot of unpleasantness along with the chronically high inflation that remains its most memorable feature, but it was also a decade of considerable economic growth, and, despite three recessions and rising unemployment, a huge increase in total US employment.

Nathan believes that Burns has been denigrated unfairly as a weak Fed Chairman who either ignored the inflationary forces, or succumbed, despite his conservative, anti-inflationary, political inclinations, to Nixon’s entreaties and pressure tactics, and deployed monetary policy to assist Nixon’s 1972 re-election campaign. Although the latter charge has at least some validity – it’s no accident that the literature on political business cycles, especially a seminal 1975 paper on that topic by William Nordhaus, a future Nobel laureate, was inspired by the Burns-Nixon episode – it’s not the whole story.

But, what is more important than Burns being cajoled or coerced by Nixon to speed the recovery from the 1969-70 recession, is that Burns was the victim of his own conceptual error in supposing that, if the incomes policy that he favored were adtoped, monetary expansion by the Fed wouldn’t lead to the inflationary consequences that they ultimately did have. Burns’s conceptual failure — whether willful or thoughtless — was to overlook the relationship between aggregate income and inflation. Although his confusion about that critical relationship was then widely, though not universally, held, his failure seems obvious, almost banal. But there were then only a few able to both identify and explain the failure and draw the appropriate policy implications. (In an earlier post about Burns, I’ve discussed Ralph Hawtrey’s final book published in 1966, but likely never noticed by Burns, in which the confusions were clearly dispelled and the appropriate policy implications clearly delineated.)

Nathan attributes the deterioration of Burns’s reputation to the influence of Milton Friedman, who wrote his doctoral dissertation under Burns at Columbia. Friedman, to be sure, was sharply critical of Burns’s performance at the Fed, but the acerbity of Friedman’s criticism also reflects his outrage that Burns had betrayed conservative, or “free-market”, principles by helping to persuade Nixon to adopt wage-and-price controls in 1971. Though I share Friedman’s disapproval of Burns’s role in the adoption of wage-and-price controls, Burns’s monetary-policy can be assessed independently of how one views the merits of the wage-and-price controls sought by Burns.

Here’s how Nathan describes Burns:

The actual Burns was – in his time – a well respected Monetary Policy “Hawk” who believed deeply in restrictive austerity. This was nearly universally acknowledged during his tenure, and then for a few years after. A New York Times article from 1978 about Burns’s successor, George Miller illustrates this well. Entitled “Miller Fights Inflation In Arthur Burns’s Style”, the article argues that Miller tightened monetary policy far more aggressively than the Carter administration expected and spoke in conservative, inflation focused and austere terms. In other words, he was a clone of Arthur Burns.

The reason this has been forgotten is the total victory of one influential dissenter: Milton Friedman. Milton Friedman, in real time, pilloried his former mentor as a money supply expanding inflationist. That view deserves its own piece sometime (spoiler: it’s mostly wrong.)

Given Friedman’s dictum — “inflation is always and everywhere a monetary phenomenon” – it’s no surprise that Friedman blamed the Federal Reserve and Burns for inflation. While confidently asserting on the one hand that changes in the quantity of money cause corresponding changes in prices, Friedman, on the other hand, invoked unexplained long and variable lags between changes in the quantity of money and changes in prices to parry evidence that the supposed correlations were less than clear-cut. So, Friedman’s narrow focus on the quantity of money rather than on total spending – increaes in the quantity of money being as much an effect as a cause of increased nominal spending and income — actually undercut his critique of Fed policy. In what follows I will therefore not discuss the quantity of money, which was, in Friedman’s mind, the key variable that had to be controlled to reduce or stop inflation. Instead, I focus on the behavior of total nominal spending (aka aggregate demand) and total nominal income, which is what monetary policy (perhaps in conjunction with fiscal policy) has some useful capacity to control.

Upon becoming Fed Chairman early in 1970, Burns continued the monetary tightening initiated by his predecessor in 1969 when inflation had risen to 6%. Although the recession caused by that tightening had started only two months before Burns succeeded Martin, inflation hardly declined, notwithstanding a steady rise in unemployment from the 3.4% rate inherited by Nixon in January 1969, at the start of his Presidency, to 4.2% when Burns became Chairman, and to 6.1% at the end of 1970.

The minimal impact of recession on inflation was troubling to Burns, reinforcing his doubts about the efficacy of conventional monetary and fiscal policy tools in an economy that seemed no longer to operate as supposed by textbook theory. It wasn’t long before Burn, in Congressional testimony (5/18/1970) voiced doubts about the efficacy of monetary policy in restraining inflation.

Another deficiency in the formulation of stabilization policies in the United States has been our tendency to rely too heavily on monetary restriction as a device to curb inflation…. severely restrictive monetary policies distort the structure of production. General monetary controls… have highly uneven effects on different sectors of the economy. On the one hand, monetary restraint has relatively slight impact on consumer spending or on the investments of large businesses. On the other hand, the homebuilding industry, State and local construction, real estate firms, and other small businesses are likely to be seriously handicapped in their operations. When restrictive monetary policies are pursued vigorously over a prolonged period, these sectors may be so adversely affected that the consequences become socially and economically intolerable.

We are in the transitional period of cost-push inflation, and we therefore need to adjust our policies to the special character of the inflationary pressures that we are now experiencing. An effort to offset, through monetary and fiscal restraints, all of the upward push that rising costs are now exerting on prices would be most unwise. Such an effort would restrict aggregate demand so severely as to increase greatly the risks of a very serious business recession. . . . There may be a useful… role for an incomes policy to play in shortening the period between suppression of excess demand and restoration of reasonable price stability.

Quoted by R. Hetzel in “Arthur Burns and Inflation” Federal Reserve Bank of Richmond Economic Quarterly, Winter 1998

The cost-push view of inflation that Burns articulated was not a new one for Burns. He had discussed it in a 1967 lecture at a seminar organized by the American Enterprise Institute concerning the wage-price guideposts, which had been invoked during the Eisenhower administration when he was CEA Chairman, and were continued in the Kennedy-Johnson administrations, to discourage labor and business from “excessive” increases in wages and prices.

The seminar consisted of two lectures, one by Burns (presumably offering a “conservative” or Republican view) and another by Paul Samuelson (offering a “liberal” or Democratic view), followed by the responses each to the other, and finally by questions from an audience of economists drawn from Washington-area universities, think-tanks and government agencies, and the responses of Burns and Samuelson. Transcripts of the lectures and the follow-up discusions were included in a volume published by AEI.

Inflation had become a contentious political issue in 1967, Republicans blaming the Johnson Administration for the highest inflation since the early 1950s. Though Burns, while voicing mild criticism of how the guideposts were administered and skepticism about their overall effect on inflation, neither rejected them on principle nor dismissed them as ineffective.

So, Burns did not arrive at the Fed as an ideological opponent of government intervention in the decisions of business and organized labor. Had Milton Friedman participated in the AEI seminar, he would have voiced implacable opposition to the guideposts as ineffective in practice and an arbitrary — extra-legal and therefore especially obnoxious — exercise of government power over the private sector. Burns’s conservatism, unlike Friedman’s, was the conventional Republican pro-business attitude, and, as Nathan himself notes, business wasn’t at all averse to government assistance in resisting union wage demands.

That doesn’t mean that Burns’s views hadn’t changed since 1967 when he voiced tepid support for guideposts as benchmarks for business and labor in setting prices and negotiating labor contracts. But the failure of monetary tightening and a deepening recession to cause more than a minimal slowdown in inflation seems to have shattered Burns’s shaky confidence that monetary policy could control inflation.

Unlike the preceding recessions in which increased (but still low) inflation quickly led to monetary tightening, the 1969-70 recession began only after inflation had risen steadily for five years from less than 2% in 1965 to 6% in 1969. It’s actually not surprising — it, at least, shouldn’t have been — that, after rising steadily for five years and becoming ingrained in public expectations, inflation would become less responsive to monetary tightening and recession than it had been before becoming ingrained in expectations. Nevertheless, the failure of a recession induced by monetary tightening to curtail inflation seems to have been considered by Burns proof that inflation is not a purely monetary phenomenon.

The further lesson drawn by Burns from the minimal decline in inflation after a year of monetary tightening followed by a recession and rising unemployment was that persistent inflation reflects the power of big business and big labor to keep raising prices and wages regardless of market conditions. The latter lesson became the basis of his approach to the inflation problem. Inflation control had to reckon with the new reality that, even if restrictive monetary and fiscal policies were adopted, it was big business and big labor that controlled pricing and inflation.

While the rationale that Burns offered for an incomes policy differed little from the rationale for the wage-price guideposts to which Burns had earlier paid lip-service, in articulating the old rationale, perhaps to provide the appearance of novelty, Burns found it useful to package the rationale in a new terminology — the vague British catchphrase “incomes policy” covering both informal wage-price guideposts and mandatory wage-price controls. The phrase helped him justify shifting monetary policy from restraint to stimulus, even though inflation was still unacceptably high, by asserting that responsibility for controlling inflation was merely being transferred, not abandoned, to another government entity with the legal power and authority to exercise that control.

It’s also noteworthy that both Burns’s diagnosis of inflation and the treatment that he recommended were remarkably similar to the diagnosis and treatment advanced in a 1967 best-selling book, The New Industrial State, by the famed Harvard economist and former adviser to President Kennedy, J. K. Galbraith.

Despite their very different political views and affiliations, Burns and Galbraith, both influenced by the Institutionalist School of economics, were skeptical of the standard neoclassical textbook paradigm. Galbraith argued that big corporations make their plans based on the prices and wages that they can impose on their smaller suppliers and smaller customers (especially, in Galbraith’s view, through the skillful deployment of modern advertising techniques) while negotiating pricing terms with labor unions and other large suppliers and with their large customers. (For more on Galbraith see this post.)

Though more sympathetic to big business and less sympathetic to big labor than Galbraith, Burns, by 1970, seems to have fully internalized, whether deliberately or inadvertently, the Galbrathian view of inflation.

Aside from his likely sincere belief that conventional anti-inflationary monetary and fiscal policy were no longer effective in an economy dominated by big business and big labor, Burns had other more political motivations for shifting his policy preferences toward direct controls over wages and prices. A full account of his thinking would require closer attention to the documentary record than I have undertaken, but, Burns was undoubtedly under pressure from Nixon to avoid a recession in the 1972 election year like the one precipitated by the Fed in 1960 when the Fed moved to suppress a minor uptick in inflation following its possibly excessive monetary stimulus after the 1957-58 recession. Burns had warned Nixon in 1960 that a looming recession might hurt his chances in the upcoming election, and Nixon thereafter blamed his 1960 loss on the Fed and on the failure of the Eisenhower adminisration to increase spending to promote recovery. Moreover, the disastrous (for Republicans) losses in the 1958 midterm elections were widely attributed to the 1957-58 recession. Substantial GOP losses in the 1970 midterms, plainly attributable to the 1970 recession, further increased Nixon’s anxiety and his pressure on Burns to hasten a recovery through monetary expansion to ensure Nixon’s reelection.

But it’s worth taking note of a subtle difference between the rationale for wage-price guideposts and the rationale for an incomes policy. While wage-price guideposts were aimed solely at individual decisions about wages and prices, the idea of an incomes policy had a macroeconomic aspect: reconciling the income demands of labor and business in a way that ensured consistency between the flow of aggregate income and low inflation. According to Burns, reconciling those diverse and conflicting income demands with low inflation required an incomes policy to prevent unrestrained individual demands for increased wages and prices from expanding the flow of income so much that inflation would be the necessary result.

What Burns and most other advocates of incomes policies overlooked is that incomes are generated from the spending decisions of households, business firms and the government. Those spending decisions are influenced by the monetary- and fiscal-policy choices of the monetary and fiscal authorities. Any combination of monetary- and fiscal-policy choices entails corresponding flows of total spending and total income. For any inflation target, there is a set of monetary- and fiscal-policy combinations that entails flows of total spending and total income consistent with that target.

Burns’s fallacy (and that of most incomes-policy supporters) was to disregard the relationship between total spending and monetary- and fiscal-policy choices. The limits on wage increases imposed by an incomes policy can be maintained only if a monetary- and fiscal-policy combination consistent with those limits is chosen. Burns’s fallacy is commonly known as the fallacy of composition: the idea that what is true for one individual in a group must be true for the group as a whole. For example, one spectator watching a ball game can get a better view of the game by standing up, but if all spectators stand up together, none of them gets a better view.

Wage increases for one worker or for workers in one firm can be limited to the percentage specified by the incomes policy, but the wage increases for all workers can’t be limited to the percentage specified by the incomes policy unless the chosen monetary- and fiscal-policy combination is consistent with that percentage.

If aggregate nominal spending and income exceed the nominal income consistent with the inflation target, only two outcomes are possible. The first, and more likely, outcome is that the demand for labor associated with the actual increase in aggregate demand will overwhelm the prescribed limit on wage increases. If it’s in the interest of workers to receive wage increases exceeding the permitted increase — and it surely is — and if it’s also in the interest of employers trying to increase output because demand for their output increases by more than expected, making it profitable to hire additional workers at increased wages, it’s hard to imagine that wages wouldn’t increase by more than the incomes policy allows. Indeed, since price increases are typically allowed only if costs increase, there’s an added incentive for firms to agree to wage increases to make price increases allowable.

Second, even if the limits on wage increases were not exceeded, those limits imply an income transfer from workers to employers. The implicit income redistribution might involve some reduction in total spending and in aggregate demand, but, ultimately, as long as the total spending and total income associated with the chosen monetary- and fiscal-policy combination exceeds the total income consistent with the inflation target, excess demands for goods will either cause domestic prices to rise or induce increased imports at increased prices, thereby depreciating the domestic currency and raising the prices of imported final goods and raw materials. Those increased prices and costs will be a further source of inflationary pressure on prices and on wages, thereby increasing inflation above the target or forcing the chosen monetary- and fiscal-policy combination to be tightened to prevent further currency depreciation.

To recapitulate, Burns actually had the glimmering of an insight into the problem of reducing inflation in an economy in which most economic agents make plans and decisions based on their inflationary expectations. When people make plans and commitments in expectation of persistent future inflation, reducing, much less stopping, inflation is hard, because doing so must disappoint their expectations, rendering the plans and commitments based on those expectations costly, or even impossible, to fulfill. The promise of an incomes policy is that, by gradually reducing inflation and facilitating the implementation of the fiscal and monetary policies necessary to reduce inflation, it can reduce expectations of inflation, thereby reducing the cost of reducing inflation by monetary and fiscal restraint.

But instead of understanding that an incomes policy aimed at reducing inflation by limiting the increases in wages and prices to percentages consistent with reduced inflation could succeed only if monetary and fiscal policies were also amed at slowing the growth of total spending and total income to rates consistent with the inflation target, Burns conducted a monetary policy with little attention to its consistency with explicit or implicit inflation targets. The failure to reduce the growth of aggregate spending and income rendered the incomes policy unfeasible, thereby ensuring the incomes policy aiming to reduce inflation would fail. The failure to grasp the impossibility of controlling wage-and-pricing decisions at the micro level without controlling aggregate spending and income at the macro level was the fatal conceptual mistake that guaranteed Burns’s failure as Fed Chairman. Perhaps Burns’s failure was tragic, but failure it was.

Let’s now look at the results of Burns’s monetary policies. The chart below shows the annual rates of change in nominal GDP and real GDP from Q1-1968 to Q1-1980

https://fred.stlouisfed.org/graph/?graph_id=1249697#

To give Burns his due, the freeze and the cost-of-living council that replaced it 90 days afterwards was a splendid political success, igniting an immediate stock-market boom and increasing Nixon’s popularity with both Democrats and Republicans notwithstanding Nixon’s repudiation of his repeated pledges never to impose wage-and-price controls. Burns continued — though erratically — the monetary easing that he began at the end of 1970, providing sufficient stimulus to reduce unemployment, which had barely budged from the peak rate of 6.1% in December 1970 to 6.0% in September 1971. While the decline in the unemployment rate was modest, to 5.6% in October 1972, the last official report before the election, total US employment between June 1970 (when US employment was at its cyclical trough) and October 1972 increased by 5%, reflecting both cyclical recovery and the beginning of an influx of babyboomers and women into the labor force.

The monetary stimulus provided by the Fed between the end of the recession in November 1970 and October 1972 can be inferred from the increase in total spending and income (as measured by nominal GDP) from Q1-1971 and Q3-1972. In that 7-quarter period, total spending and income increased by 18.6% (corresponding to an annual rate of 10.6%). Because the economy in Q4-1970 was still in a recession, nominal spending and income could increase at a faster rate during the recovery while inflation was declining than would have been consistent with the inflation target if maintained permanently.

But as the expansion continued, with employment and output expanding rapidly, the monetary stimulus should have been gradually withdrawn to slow the growth of total spending and income to a rate consistent with a low inflation target. But rather than taper off monetary stimulus, the Fed actually allowed total spending and income growth to accelerate in the next three quarters (Q4-1972 through Q2-1973) to an annual rate of 12.7%.

Inflation, which at first had shown only minimal signs of increasing as output and employment expanded rapidly before the 1972 election, not surprisingly began to accelerate rapidly in the first half of 1973. (The chart below provides three broadly consistent measures of inflation (Consumer Price Index, Personal Consumption Expenditures, and GDP implicit price deflator at quarterly intervals). The chart shows that all three measures show inflation rising rapidly in the first hals of 1973, with inflation in Q2-1973 in a range between 6.3% and 8.6%.

https://fred.stlouisfed.org/graph/?graph_id=1247181&rn=117

Burns rejected criticisms that the Fed was responsible for resurgent inflation, citing a variety of special factors like rising commodity prices as the cause of rising inflation. But, having allowed the growth of total spending and income to accelerate from Q4-1972 and Q2-1973, in violation of the rationale for the incomes policy that he had recommended, Burns had no credible defense of the Fed’s monetary policy.

With inflation approaching double digit levels – the highest in over 20 years – Burns and the Fed had already begun to raise interest rates in the first half of 1973, but not until the third quarter did rates rise enough to slow the growth of total spending and income. A belated tightening was, of course, in order, but, as if to compensate for its tardiness, the Fed, as it has so often been wont to do, tightened too aggressively, causing the growth of total spending to decline from 11% in Q2 1973 to less than 5% in Q3 1973, a slowdown that caused real GDP to fall, and the unemployment rate, having just reached its lowest point (4.6%) since April 1970, a rate not matched again for two decades, to start rising.

Perhaps surprised by the depth of the third-quarter slowdown, the Fed eased policy somewhat in the fourth quarter until war broke out between Egypt, Syria and Israel, soon followed by a cutback in overall oil production by OPEC and a selective boycott by Arab oil producers of countries, like the US, considered supportive of Israel. With oil prices quadrupling over the next few months, the cutback in oil production triggered a classic inflationary supply shock.

It’s now widely, though not universally, understood that the optimal policy response to a negative supply shock is not to tighten monetary policy, but to allow the price level to increase permanently and inflation to increase transitorily, with no attempt to reverse th price-level and inflation effects. But, given the Fed’s failure to prevent inflation from accelerating in the first half of 1973, the knee-jerk reaction of Burns and the Fed was to tighten monetary policy again after the brief relaxation in Q4-1973, as if previous mistakes could be rectified by another in the opposite direction.

The result was, by some measures, the deepest recession since 1937-38 with unemployment rising rapidly to 9% by May 1975. Because of the negative supply shock, most measures of inflation, despite monetary tightening, were above 10% for almost all of 1974. While the reduction in nominal GDP growth during the recession was only to 8%, which, under normal conditions, would have been excessive, the appropriate target for NGDP growth, given the severity of the supply shock that was causing both labor and capital to be idled, would, at least initially, have been closer to the pre-recession rate of 12.7% than to 8%. The monetary response to a supply shock should take into account that, at least during the contraction and even in the early stages of a recovery, monetary expansion, by encouraging the reemployment of resources, thereby moderating the decline in output, can actually be disinflationary.

I pause here to observe that inflation need not increase just because unemployment is falling. That is an inference often mistakenly drawn from the Phillips Curve relationship between unemployment and inflation. It is a naive and vulgar misunderstanding of the Phillips Curve to assume that dcelining unemployment is always and everywhere inflationary. The kernel of truth in that inference is that monetary expansion tends to be inflationary when the economy operates at close to full employment without sufficient slack to allow output to increase in proportion to an increase in aggregate spending. However, when the economy is operating with slack and is far from full employment, the inference is invalid and counter-productive.

Burns eventually did loosen monetary policy to promote recovery in the second half of 1975, output expanding rapidly even as inflation declined to the mid-single digits while unemployment fell from 9% in May 1975 to 7.7% in October 1976. But, just as it did after the 1972 Presidential election, growth of NGDP actually increased after the 1976 Presidential election.

In the seven quarters from Q1-1975 through Q3-1976, nominal GDP grew at an average annual rate of 10.2%, with inflation fallng from a 7.7% to 9.4% range in Q1-1975 to a 5.3% to 6.5% range in Q3-1976; in the four quarters from Q4-1976 through Q3-1977, nominal GDP grew at an average rate of 10.9%, with inflation remaining roughly unchanged (in the 5% to 6.2% range). Burns may have been trying to accommodate the desires of the Carter Administration to promote a rapid reduction in unemployment as Carter had promised as a Presidential candidate. Unemployment in March 1977 stood at 7.4% no less than it was in May 1976. While the unemployment rate was concerning, unemployment rates in the 1970s reflected the influx of baby boomers and women lacking work experience into work force, which tended to increase measured unemployment despite rapid job growth. Between May 1976 and March 1977, for example, an average of over 200,000 new jobs a month were filled despite an unchanged unemployment rate.

As it became evident, towards the end of 1977 that Burns would not be reappointed Chairman, and someone else more amentable to providing further monetary stimulus would replace him, the dollar started falling in foreign-exchange markets, almost 7% between September 1977 and March 1978, a depreciation that provoked a countervailing monetary tightening and an increase in interest rates by the Fed. The depreciation and the tightening were reflected in reduced NGDP growth and increased inflation in Q4 1977 and Q1 1978 just as Burns was being replaced by his successor G. William Miller in March 1978.

So, a retrospective on Burns’s record as Fed Chairman provides no support for a revisionist rehabilitation of that record. Not only did Burns lack a coherent theoretical understanding of the effects of monetary policy on macroeconomic performance, which, to be fair, didn’t set him apart from his predecessors or successors, but he allowed himself to be beguiled by the idea of an incomes policy as an alternative to monetary policy as a way to control inflation. Had he properly understood the rationale of an incomes policy, he would have realized that it could serve a useful function only insofar as it supplemented, not replaced, a monetary policy aiming to reduce the growth of aggregate demand to a rate consistent with reducing inflation. Instead, Burns viewed the incomes policy as a means to eliminate the upward pressure of wage increases on costs, increases that, for the most part, merely compensated workers for real-wage reductions resulting from previous unanticipated inflation. But the cause of the cost-push phenomenon that was so concerning to Burns is aggregate-demand growth, which either raises prices or encourages output increases that make it profitable for businesses to incur those increased costs. Burns’s failure to grasp these causal relationships led him to a series of incoherent policy decisions that gravely damaged the US economy.

Jason Furman Hyperventilates about Wages and Inflation

Published March 20, 2023 inflation , Jason , Jason Furman , transitory inflation 8 Comments
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Jason Furman has had an admirable career as an economist and policy adviser. He was on the staff of the Council of Economic Advisors in the Clinton administrations, was Assistant Director of the National Economic Policy under Larry Summers in Obama’s first term served as Chairman of the CEA in his second. I am friendly with a really smart economist who worked under Furman for a couple of years at the CEA, and he spoke glowingly about that experience in general and about Furman in particular, both as an economist and as a person. So I’m not anxious to write a critical blogpost about Furman. But a blogger’s gotta do what a blogger’s gotta do.

Following the lead of his former boss Larry Summers, Furman has, for over a year, been an outspoken anti-inflation hawk, calling for aggressive tightening by the Fed to prevent an inflationary wage-price spiral from returning us to the bad old days of the 1970s and its ugly aftermath — the 1981-82 Volcker recession. So, after the January core inflation reports showed an uptick in core inflation in the second half of 2022, Furman responded with an overwrought op-ed (“To Fight Inflation, Fed Tightening Should Go Faster and Further”) in the Wall Street Journal.

The Federal Reserve has said repeatedly that it responds to data and doesn’t set interest rates on autopilot. The data have changed dramatically. The Fed should prove it means what it says by shifting from a 25-basis-point increase at its next meeting to a 50-point increase. It should also shift expectations toward a terminal rate of around 6%.

The Fed should never react too much to any single data point, but when the annualized three-month core inflation rate jumps from 2.9% to 4.7%, the central bank must take notice. When that happens after strong jobs data and faster wage growth, the Fed should plan on action. The expectation that inflation would melt away on its own was always unjustified, but the latest economic data have been especially unkind to team transitory.

Let me first observe that Furman seems to overstate the size of the January increase in core inflation. Core inflation, which excludes volatile food and energy prices from the two broader inflation indexes: the personal consumption expenditures index (PCEI) computed by the Bureau of Economic Analysis of the Commerce Department and the Consumer Price Index (CPI) computed by the Bureau of Labor Statistics of the Labor Department. The two charts below show the 3-month and the 6-month moving averages of the core PCEI and the core CPI. Neither of the 3-month moving averages show a January increase as large as that asserted by Furman.

Yet, Furman is correct that the January increase in core inflation was significant, and also correct to observe that the Fed shouldn’t overreact to a single data point. Unfortunately, he immediately reversed himself by demanding that the Fed respond to the January increase by quickly and significantly tightening policy, because core inflation, notwithstanding the assurances of “team transitory”, has not subsided much on its own.

I can’t speak on behalf of team transitory, but, as far as I know, no one ever suggested that inflation would fall back to the Fed’s 2% target on its own. Everyone acknowledged that increased inflation last year was, at least partly, but not entirely, caused by macroeconomic policies that, during the pandemic and its aftermath, first supported, and then increased, aggregate demand.

But, as I’ve argued in many posts in the past year and a half (here, here, here, here, here, here, here, and here), increasing aggregate demand to avoid a cumulative collapse in output and income was well-advised under unprecedented Covid conditions. Because much of the income supplements provided in 2020-21 were held in cash, or used to repay debts, owing to the diminished availability of spending outlets during the pandemic, rather than spent, increased aggregate demand led not to an immediate, but a delayed, increase in inflation once the economy gradually recovered from the pandemic. Without the macroeconomic stimulus of 2020-21 that became a source of inflationary pressure in late 2021 and 2022, the downturn in 2020 would have been even deeper and lasted longer.

But aside from the underlying macroeconomic forces causing inflation to start rising in 2021, a variety of supply-chain slowdowns and interruptions appeared, just as a Russian invasion of Ukraine was becoming increasing likely, driving up oil and other energy prices well before the actual invasion on February 24, 2022. The transitory component of inflation corresponds to both the delayed spending of cash accumulated from income supplements and other spending undertaken in the pandemic, and to the supply-side problems caused by, or related to both the pandemic and Putin’s war. By the middle of 2022, both of these transitory causes of inflation were subsiding.

That leaves us with a core rate of inflation hovering in the 4-5% range, a somewhat higher rate than I would like, or recommend, as a policy target. Does that mean that further tightening to reduce overall inflation to the 2% target is required? I agree with Furman and others who think it is required, but I disagree that the tightening should be either drastic or immediate, and I find Furman’s rationale for rapid and substantial further tightening deeply misguided.

What makes the current inflation particularly troubling is that all the hoped-for saviors have come and gone without reducing underlying inflation very much. Inflation was supposed to go away after base effects receded, when the economy got over the Delta and Omicron surges, when the ports were unclogged, when timber prices fell, when the fiscal stimulus wore off, when microchips were available, when energy prices came back down again after the Russian invasion. All of that has happened, and yet the underlying inflation rate remains above 4.5% on just about every time horizon and every measure.

What makes Furman’s inflation anxiety particularly annoying is that, while he and others had been warning that, unless the Fed sharply tightened, inflation would accelerate — possibly to double-digit levels — he continues to hyperventilate about runaway inflation, even as headline inflation over the past year has dropped substantially, and core inflation has also fallen, albeit by much less than headline inflation. Having learned nothing from his earlier exaggerated warnings about inflation, Furman is now using a one-month uptick in inflation as a pretext for continued inflation alarmism and tight-money advocacy.

The Fed’s tightening over the past year prevented core inflation from accelerating even as the transitory factors that had raised inflation to the highest levels in 50 years gradually dissipated, causing the sharp decline in the volatile non-core items in the CPI and PCE indexes. The argument between team transitory and team non-transitory was never an all or nothing dispute, but a matter of emphasis.

Many of those opposed to rapid and severe tightening understood that responding too aggressively to temporarily high inflation carries risks of its own, potentially plunging the economy into a recession because of an exaggerated estimate of the inflationary threat, an underrated risk that is one of the 1970s lessons that many, including Furman and Summers, seem to overlook, but a risk of which the events of the past two weeks have provided an unwelcome and frightening reminder.

The modest decline in core inflation over the past year was accompanied by a gradual decline in the rate of NGDP growth since the first quarter of 2022 from over 11% to about 7%. For inflation to decline further toward the 2% target, a further modest — and ideally gradual — decline in NGDP growth to about 5% will be necessary.

Whether the decline in NGDP growth is possible without further monetary tightening is unclear, but it’s unlikely that the effects of monetary tightening over the past year have yet been fully absorbed by the economy, so it seems reasonable to postpone any decision about monetary tightening until at least the preliminary Q1 GDP report is released in about six weeks. And given the heightened risk to the banking and financial system, any increase in rates would be foolhardy.

If total domestic spending is increasing at a rate faster than 7%, further increases in interest rates might be warranted, but the current inversion of the yield curve suggests that an increase in short-term rates is presumptively inadvisable (see my posts on yield-curve inversion here and here). If long-term rates are below short-term rates, notwithstanding the incremental risk associated with holding securities of longer duration, the relatively low yield of longer-term securities suggests either that the liquidity premium on money is abnormally high (a symptom of financial distress), or that there is an expectation of sharply declining yields in the future. In the former case, a lack of liquidity and increasing default risk drive up short-term rates; in the latter, the longer-term outlook suggests that the inflation rate, or the profit rate, or both, will decline. So the watchword about policy changes should be: caution.

After that warmup, Furman, in diagnosing “underlying inflation, goes from being annoying to misguided.

Fundamentally, much of the economy’s underlying inflation had nothing to do with base effects or microchips or timber prices.

Correct! But let’s say that the underlying inflation rate really is, as Furman suggests, 5%. That would be 3% above the target rate. Not trivial, but hardly enough to impose the draconian tightening that Furman is recommending.

Furman continues with, what seems to me, a confused and confusing rationale for monetary tightening.

[Underlying inflation is] a product of extremely tight labor markets leading to rapid wage gains that passed [sic] through as higher prices. These higher prices have also led to faster wage gains. Some call it a “wage-price spiral,” but a better term is “wage-price persistence,” because inflation stays high even after the demand surge goes away.

This passage is beset by confusions, explicit or implied, that require unpacking. Having started with a correct observation that the economy’s “underlying inflation had nothing to do” with increases in any particular price or set of prices, Furman contradicts himself, attributing inflation to “rapid wage gains” that got passed through “as higher prices,” which, in turn, led to “faster wage gains.” That this ancient fallacy about the cause of inflation would be repeated by a former CEA chair, now a professor of economic policy at the Kennedy School at Harvard, is, well, dispiriting.

What’s the fallacy? An increase in one price – presumably, including the wage paid to labor — can never explain an increase in prices in general. To suggest otherwise is to commit the “fallacy of composition,” or something closes to it. (See “Fallacy of Composition”) An increase in wages relative to other prices could just as well be associated by wages remaining constant and all other prices falling; there is no logical necessity for wage increases to entail increases in other prices.

Of course, Furman might not be asserting a logical connection between wage increases and price increases. He might just be making an empirical observation that it was rising wages that initiated a series of price increases and an unending process of reciprocal wage and price increases. But even if wage increases did induce subsequent increases in other prices, that observation can’t account for an inflationary process in which wages and prices keep rising endlessly.

To account for such a continuing process, an explanation of why the process doesn’t eventually reach an endpoint is needed, but missing. There must be something that enables the inflationary process to conintue. That additional factor is, of course, the monetary or macroeconomic environment that determines aggregate demand and aggregate spending. Furman obviously believes that the process can be halted by monetary or macroeconomic policy measures, but, focused solely on wages, he ignores the role of policy in initiating and maintaining the process.

Other, related, confusions emerge in Furman’s next paragraph.

Wage growth is currently running at an annual rate of about 5%. Sustaining such wage growth with 2% inflation would require a large increase in productivity growth or continually falling profit margins. I’d root for either outcome, but I wouldn’t bet on them. Falling wage growth could bring down inflation, but in an economy with nearly two job openings for every person looking for work, don’t expect it to happen. Instead, the most probable outcome is that if the unemployment rate doesn’t rise, wages will continue to grow at that pace, which historically is associated with about 4% inflation.

In a previously quoted passage, Furman asserted that wage increases caused underlying inflation. But that was not what actually happened in the current episode. Since January 2021, just before the current inflation started, prices started rising before wages, and until the last six months or so prices have been rising faster than wages, causing real wages (i.e. adjusted for the purchasing power) to fall.

It’s one thing to say that wage increases cause the prices of things made by workers to increase; it’s quite another to say that wage increases cause the price of the things made by workers to increase faster than wages increase. By blaming current inflation on the current increase in wages, Furman is, in effect, calling for permanent real-wage cuts. Since wage increases cause “inflation persistence,” Furman proposes a restrictive monetary policy to reduce the overall demand for labor and the rate of increase in nominal and real wages.

Real wages (adjusted for the CPI) were barely higher in Q4 2022 than in Q4 2019 even though real GDP in Q4 2022 was 5.1% higher than in Q4 2019 and per-capita real GDP was 4.1% higher in Q4 2022 than in Q4 2019. If inflation is (in my view mistakenly) attributed to a distributional struggle that labor is clearly losing, then it’s obvious that it’s not wages that are to blame for inflation.

Furman makes another astonishing claim in the next paragraph.

Monetary policy operates with long and variable lags. Given that most of the tightening in financial conditions was already in place 10 months ago and, if anything, the real economy and demand have strengthened in recent months, it would be foolish to sit and wait for the medicine to work.

How long and variable the lags associated with monetary policy really are is a matter of some uncertainty. What is not uncertain, in Furman’s view, is that most of the tightening had occurred 10 months ago (May 2022). The FOMC began raising the Fed Funds target exactly a year ago in March 2022. How Furman can plausibly assert that most of the effect of the Fed’s tightening were in place 10 months ago is beyond me. The Table below shows that 10 months ago (May 2022) the effective Fed Funds rate (St. Louis Fed) was still only 0.77% and has since risen to 4.57% in Feburary.

Below is another table with the monthly average yield on constant maturity 10-year Treasuries, showing that the yield on 10-year Treasuries rose from 2.13% in March 2022 to 2.90% in May (reflecting expectations that further increases in the Fed Funds rate were likely). But the rate on 10-year Treasuries rose from slightly more than 2% to nearly 4% between March 2022 and October 2022, with rates fluctuating since October in a range between 3.5 and 4%.

So I can’t understand what Furman could was thinking when he asserted that most of the Fed’s tightening of financial conditions were already in place 10 months ago. The real economy has indeed strengthened, but that strengthening reflects the unusual economic circumstances in which both the real economy and monetary policy have been operating for the past three years: the pandemic, the partial shutdown, the monetary and fiscal stimulus, the supply-chain issues that initially obstructed and hobbled the return to full employment even as unemployment was falling to a record low rate of 3.5%.

Dramatic evidence that the effects of the tightening since January had not been fully absorbed by the economy was provided within days after Furman’s op-ed by the failure of SVB and Signature Bank and only days ago by the rescue of Credit Suisse. And there is no assurance that these are the last dominoes to fall in the banking system or that other effects attributable to the increase in rates will not emerge in the near future.

Furman also overlooks the permanent withdrawal of workers (mostly but exclusively babyboomers nearing retirement age) from the labor force during the pandemic. Despite a rapid decrease in unemployment (and increase in employment) since the summer of 2020, and total employment in February 2023 exceeded total employment in 2020 by only 1.9%. The labor-force participation rate has dropped from 63.3% in February 2020 to 62.5% in February 2023.

With fewer workers available as businesses were responding to increasing demand for their products, competition to hire new workers to replace those that left the labor force is hardly surprising. However, a largely transitory burst of inflation in the second half of 2021 and the first half of 2022 outpaced a perfectly normal increase in nominal wages, causing real wages to fall. But it would be shocking – and suspicious — if normally functioning market forces didn’t drive up nominal wages sufficiently to cause a real wages to recover given the increased tightness of labor markets after a significant negative labor-supply shock.

For Furman to suggest that a market adjustment to a labor-supply shock causing an excess demand for labor should be counteracted by tight monetary policy to reduce the derived demand for labor is extraordinary. There may be – and I believe that there are — good reasons for monetary to aim to bring down the growth of nominal spending from roughly 7% to about 5%. But those reasons have nothing to do with targeting either nominal or real wages.

In fact, lags are precisely why the Fed should do more now—considering it will take months for whatever the central bank does next to have a meaningful effect on inflation.

Furman seems to envision a process whereby wage increases are necessarily inflationary unless the Fed acts to suppress the demand for labor. That is not how inflation works. Inflation depends on aggregate spending and aggregate income, which is what monetary and macroeconomic policy can control. To subordinate monetary policy to some target rate of increase in wages is a distraction, and it is folly to think that, with real wages still below their level two years ago, it is the job of monetary policy to suppress wage increases.

A New Version of my Paper “Between Walras and Marshall: Menger’s Third Way” Is Now Available on SSRN

Published January 29, 2023 Alfred Marshall , Carl Menger , coordination failure , Franklin Fisher , general equilibrium , partial equilibrium , stability of general equilibrium , Walrasian equilibrium Leave a Comment

Last week I reposted a revised version of a blogpost from last November, which was a revised section from my paper “Between Walras and Marshall: Menger’s Third Way.” That paper was presented at a conference in September 2021 marking the 100th anniversary of Menger’s death. I have now completed my revision of the entire paper, and the new version is now posted on SSRN.

Here is the link to the new version, and here is the abstract of the paper:

Neoclassical economics is bifurcated between Marshall’s partial-equilibrium and Walras’s general-equilibrium. Neoclassical theory having failed to explain the Great Depression, Keynes proposed a theory of involuntary unemployment, later subsumed under the neoclassical synthesis of Keynesian and Walrasian theories. Lacking suitable microfoundations, that synthesis collapsed. But Walrasian theory provides no account of how equilibrium is achieved. Marshallian partial-equilibrium analysis offered a more plausible account of how general equilibrium is reached. But presuming that all markets, but the one being analyzed, are already in equilibrium, Marshallian partial equilibrium, like Walrasian general equilibrium, begs the question of how equilibrium is attained. A Mengerian approach to circumvent this conceptual impasse, relying in part on a critique of Franklin Fisher’s analysis of the stability of general equilibrium, is proposed.

Commnets, criticisms and suggestions are welcomed and encouraged.

An Updated Version of my Paper “Robert Lucas and the Pretense of Science” Has Been Posted on SSRN

Published January 25, 2023 Uncategorized Leave a Comment

I have just submitted the paper to the European Journal of the History of Economic Thought. The updated version is not substantively different from the previous version, but I have cut some marginally relevant material and made what I hope are editorial improvements. Here’s a link to the new version.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4260708

Any comments, questions, criticisms or suggestions would be greatly appreciated.

I hope to post a revised version of my paper “Between Walras and Marshall: Menger’s Third Way” on SSRN within the next week or two. In my previous post I copied a revision of the section on Franklin Fisher’s important book Disequilibrium Foundations of Equilibrium Economics.

Franklin Fisher on the Disequilibrium Foundations of Economics and the Stability of General Equilibrium Redux

Published January 22, 2023 Axel Leijonfuvud , Franklin Fisher , Kelvin Lancaster , Richard Lipsey , theory of second best 2 Comments

Last November I posted a revised section of a paper I’m now working on an earlier version of which is posted on SSRN. I have now further revised the paper and that section in particular, so I’m posting the current version of that section in hopes of receiving further comments, criticisms, and suggestions before I submit the paper to a journal. So I will be very grateful to all those who respond, and will try not to be too cranky in my replies.

I         Fisher’s model and the No Favorable Surprise Assumption

Unsuccessful attempts to prove, under standard neoclassical assumptions, the stability of general equilibrium led Franklin Fisher (1983 [Disequilibrium Foundations of Equilibrium Economics) to suggest an alternative approach to proving stability. based on three assumptions: (1) trading occurs at disequilibrium prices (in contrast to the standard assumption that no trading takes place until a new equilibrium is found with prices being adjusted under a tatonnement process); (2) all unsatisfied transactors — either unsatisfied demanders or unsatisfied suppliers — in any disequilibrated market are either all on the demand side or all on the supply side of that market; (3) the “no favorable surprises” (NFS) assumption previously advanced by Hahn (1978 [“On Non-Walrasian Equilibria”).

At the starting point of a disequilibrium process, some commodities would be in excess demand, some in excess supply, and, perhaps, some in equilibrium. Let Zi denote the excess demand for any commodity, i ranging from 1 to n; let commodities in excess demand be numbered from 1 to k, commodities initially in equilibrium numbered from k+1 to m, and commodities in excess supply numbered from m+1 to n. Thus, by assumption, no agent had an excess supply of commodities numbered from 1 to k, no agent had an excess demand for commodities numbered from m+1 to n, and no agent had either an excess demand or excess supply for commodities numbered between k+1 and m.[1]

Fisher argued that in disequilibrium, with prices, not necessarily uniform across all trades, rising in markets with excess demand and falling in markets with excess supply, and not changing in markets with zero excess demand, the sequence of adjustments would converge on an equilibrium price vector. Every agent would form plans to transact conditional on expectations of the prices at which it planned purchases or sales, either spot for forward, could be executed.[2] Because unsuccessful demanders and suppliers would respond to failed attempts to execute planned trades by raising the prices offered, or reducing the prices accepted, prices for goods or services in excess demand would rise, and would fall for goods and services in excess supply. Insofar as agents successfully execute their plans, prices for commodities in excess demand would rise and prices for commodities in excess supply would fall.

Fisher reduced this informal analysis to a formal model in which stability could be proved, at least under standard neoclassical assumptions augmented by plausible assumptions about the adjustment process. Stability of equilibrium is proved by defining some function (V) of the endogenous variables of the model (x1, . . ., xn, t) and showing that the function satisfies the Lyapounov stability conditions: V ≥ 0, dV/dt ≤ 0, and dV/dt = 0 in equilibrium. Fisher defined V as the sum of the expected utilities of households plus the expected profits of firms, all firm profits being distributed to households in equilibrium. Fisher argued that, under the NFS assumption, the expected utility of agents would decline as prices are adjusted when agents fail to execute their planned transactions, disappointed buyers raising the prices offered and disappointed sellers lowering the prices accepted. These adjustments would reduce the expected utility or profit from those transactions, and in equilibrium no further adjustment would be needed and the Lyapounov conditions satisfied. The combination of increased prices for goods purchased and decreased prices for goods sold implies that, with no favorable surprises, dV/dt would be negative until an equilibrium, in which all planned transactions are executed, is reached, so that the sum of expected utility and expected profit is stabilized, confirming the stability of the disequilibrium arbitrage process.

II         Two Problems with the No Favorable Surprise Assumption

Acknowledging that the NFS assumption is ad hoc, not a deep property of rationality implied by standard neoclassical assumptions, Fisher (1983, p. 87) justified the assumption on the pragmatic grounds. “It may well be true,” he wrote,

that an economy of rational agents who understand that there is disequilibrium and act on arbitrage opportunities is driven toward equilibrium, but not if these agents continually perceive new previously unanticipated opportunities for further arbitrage. The appearance of such new and unexpected opportunities will generally disturb the system until they are absorbed.

Such opportunities can be of different kinds. The most obvious sort is the appearance of unforeseen technological developments – the unanticipated development of new products or processes. There are other sorts of new opportunities as well. An unanticipated change in tastes or the development of new uses for old products is one; the discovery of new sources of raw materials another. Further, efficiency improvements in firms are not restricted to technological developments. The discovery of a more efficient mode of internal organization or of a better way of marketing can also present a new opportunity.

Because favorable surprises following the displacement of a prior equilibrium would potentially violate the Lyapounov condition that V be non-increasing, the NFS assumption allows it to be proved that arbitrage of price differences leads to convergence on a new equilibrium. It is not, of course, only favorable surprises that can cause instability, inasmuch as the Lyapounov function must be non-negative as well as non-increasing, and a sufficiently large unfavorable surprise would violate the non-negativity condition.[3]

However, acknowledging the unrealism of the NFS assumption and its conflation of exogenous surprises with those that are endogenous, Fisher (pp. 90-91) argued that proving stability under the NFS assumption is still significant, because, if stability could not be proved under the assumption of no surprises of any kind, it likely could not be proved “under the more interesting weaker assumption” of No Exogenous Favorable Surprises.

The NFS assumption suffers from two problems deeper than Fisher acknowledged. First, it reckons only with equilibrating adjustments in current prices when trading is possible in both spot and forward markets for all goods and services, so that spot and forward prices for each commodity and service are being continuously arbitraged in his setup. Second, he does not take explicit account of interactions between markets of the sort that motivate Lipsey and Lancaster’s (1956 [“Tbe General Theory of Second Best) general theory of the second best.

          A. Semi-complete markets

Fisher does not introduce trading in state-contingent markets, so his model might be described as semi-complete. Because all traders have the choice, when transacting to engage, in either a spot or a forward transaction, depending on their liquidity position, so that when spot and forward trades are occurring for the same product or service, the ratio of those prices, reflecting own commodity interest rates, are constrained by arbitrage to match money interest rate. In an equilibrium, both spot and forward prices must adjusted so that the arbitrage relationships between spot and forward prices for all commodities and services in which both spot and forward prices are occurring is satisfied and all agents are able to execute the trads that they wish to make at the prices they expected when planning those purchases. In other words, an equilibrium requires that all agents that are actually trading commodities or services in which both spot and forward trades are occurring concurrently must share the same expectations of future prices. Otherwise, agents with differing expectations would have an incentive to switch from trading spot to forward or vice versa.

The point that I want to emphasize here is that, insofar as equilibration can be shown to occur in Fisher’s arbitrage model, it depends on the ability of agents to choose between purchasing spot or forward, thereby creating a market mechanism whereby agents’ expectations of future prices to be reconciled along with the adjustment of current prices (either spot or forward) to allow agents to execute their plans to transact. Equilibrium depends not only on the adjustment of current prices to equilibrium levels for spot transactions but on the adjustment of expectations of future spot prices to equilibrium levels. Unlike the market feedback on current prices in current markets conveyed by unsatisfied demanders and suppliers, inconsistencies in agents’ notional plans for future transactions convey no discernible feedback without a broad array of forward or futures markets in which those expectations are revealed and reconciled. Without such feedback on expectations, a plausible account of how expectations of future prices are equilibrated cannot — except under implausibly extreme assumptions — easily be articulated.[4] Nor can the existence of a temporary equilibrium of current prices in current markets, beset by agents’ inconsistent and conflicting expectations, be taken for granted under standard assumptions. And even if a temporary equilibrium exists, it cannot, under standard assumptions, be shown to be optimal (Arrow and Hahn, 1971, 136-51).

            B          Market interactions and the theory of second-best

Second, in Fisher’s account, price changes occur when transactors cannot execute their desired transactions at current prices, those price changes then creating arbitrage opportunities that induce further price changes. Fisher’s stability argument hinges on defining a Lyapounov function in which the prices of goods in excess demand rise as frustrated demanders offer increased prices and prices of goods in excess supply fall as disappointed suppliers accept reduced prices.

But the argument works only if a price adjustment in one market caused by a previous excess demand or excess supply does not simultaneously create excess demands or supplies in markets not previously in disequilibrium or further upset the imbalance between supply and demand in markets already in disequilibrium.

To understand why Fisher’s ad hoc assumptions do not guarantee that the Lyapounov function he defined will be continuously non-increasing, consider the famous Lipsey and Lancaster (1956) second-best theorem, according to which, if one optimality condition in an economic model is unsatisfied because a relevant variable is constrained, the second-best solution, rather than satisfy the other unconstrained optimum conditions, involves revision of at least some of the unconstrained optimum conditions.

Contrast Fisher’s statement of the No Favorable Surprise assumption with how Lipsey and Lancaster (1956, 11) described the import of their theorem.

From this theorem there follows the important negative corollary that there is no a priori way to judge as between various situations in which some of the Paretian optimum conditions are fulfilled while others are not. Specifically, it is not true that a situation in which more, but not all, of the optimum conditions are fulfilled is necessarily, or is even likely to be, superior to a situation in which fewer are fulfilled. It follows, therefore, that in a situation in which there exist many constraints which prevent the fulfilment of the Paretian optimum conditions the removal of any one constraint may affect welfare or efficiency either by raising it, by lowering it, or by leaving it unchanged.

The general theorem of the second best states that if one of the Paretian optimum conditions cannot be fulfilled a second-best optimum situation is achieved only by departing from all other optimum conditions. It is important to note that in general, nothing can be said about the direction or the magnitude of the secondary departures from optimum conditions made necessary by the original non-fulfillment of one condition.

Although Lipsey and Lancaster were not referring to the adjustment process following the displacement of a prior equilibrium, their discussion implies that the stability of an adjustment process depends on the specific sequence of adjustments in that process, inasmuch as each successive price adjustment, aside from its immediate effect on the particular market in which the price adjusts, transmits feedback effects to related markets. A price adjustment in one market may increase, decrease, or leave unchanged, the efficiency of other markets, and the equilibrating tendency of a price adjustment in one market may be offset by indirect disequilibrating tendencies in other markets. When a price adjustment in one market indirectly reduces efficiency in other markets, the resulting price adjustments may well trigger further indirect efficiency reductions.

Thus, in adjustment processes involving interrelated markets, a price change in one market can indeed cause a favorable surprises in one or more other markets by indirectly causing net increases in utility through feedback effects on other markets.

III        Conclusion

Consider a macroeconomic equilibrium satisfying all optimality conditions between marginal rates of substitution in production and consumption and relative prices. If that equilibrium is subjected to a macoreconomic disturbance affecting all, or most, individual markets, thereby changing all optimality conditions corresponding to the prior equilibrium, the new equilibrium will likely entail a different set of optimality conditions. While systemic optimality requires price adjustments to satisfy all the optimality conditions, actual price adjustments occur sequentially, in piecemeal fashion, with prices changing market by market or firm by firm, price changes occurring as agents perceive demand or cost changes. Those changes need not always induce equilibrating adjustments, nor is the arbitraging of price differences necessarily equilibrating when, under suboptimal conditions, prices have generally deviated from their equilibrium values. 

Smithian invisible-hand theorems are of little relevance in explaining the transition to a new equilibrium following a macroeconomic disturbance, because, in this context, the invisible-hand theorem begs the relevant question by assuming that the equilibrium price vector has been found. When all markets are in disequilibrium, moving toward equilibrium in one market has repercussions on other markets, and the simple story of how price adjustment in response to a disequilibrium in that market alone restores equilibrium breaks down, because market conditions in every market depend on market conditions in every other market. So, unless all optimality conditions are satisfied simultaneously, there is no assurance that piecemeal adjustments will bring the system closer to an optimal, or even a second-best, state.

If my interpretation of the NFS assumption is correct, Fisher’s stability results may provide support for Leijonhufvud’s (1973 “Effective Demand Failures”) suggestion that there is a corridor of stability around an equilibrium time path within which, under normal circumstances, an economy will not be displaced too far from path, so that an economy, unless displaced outside that corridor, will revert, more or less on its own, to its equilibrium path.[5]

Leijonhufvud attributed such resilience to the holding of buffer stocks of inventories of goods, holdings of cash and the availability of credit lines enabling agents to operate normally despite disappointed expectations. If negative surprises persist, agents will be unable to add to, or draw from, inventories indefinitely, or to finance normal expenditures by borrowing or drawing down liquid assets. Once buffer stocks are exhausted, the stabilizing properties of the economy have been overwhelmed by the destabilizing tendencies, income-constrained agents cut expenditures, as implied by the Keynesian multiplier analysis, triggering a cumulative contraction, and rendering a spontaneous recovery without compensatory fiscal or monetary measures, impossible.

But my critique of Fisher’s NFS assumption suggests other, perhaps deeper, reasons why displacements of equilibrium may not be self-correcting, such displacements may invalidate previously held expectations, and in the absence of a dense array of forward and futures markets, there is likely no market mechanism that would automatically equilibrate unsettled and inconsistent expectations. In such an environment, price adjustments in current spot markets may cause price adjustments that, under the logic of the Lipsey-Lancaster second-best theorem may in fact be welfare-diminishing rather than welfare-enhancing and may therefore not equilibrate, but only further disequilibrate the macroeconomy.

[1] Fisher’s stability analysis was conducted in the context of complete markets in which all agents could make transactions for future delivery at prices agreed on in the present. Thus, for Fisher arbitrage means that agents choose between contracting for future delivery or waiting to transact until later based on their expectations of whether the forward price now is more or less than the expected future price. In equilibrium, expectations of future prices are correct so that agents are indifferent between making forward transactions of waiting to make spot transactions unless liquidity considerations dictate a preference for selling forward now or postponing buying till later.

[2] Fisher assumed that, for every commodity or service, transactions can be made either spot or forward. When Fisher spoke of arbitrage, he was referring to the decisions of agents whether to transact spot or forward given the agent’s expectations of the spot price at the time of planned exchange, the forward prices adjusting so that, with no transactions costs, agents are indifferent, at the margin, between transacting spot or forward, given their expectations of the future spot price.

[3] It was therefore incorrect for Fisher (1983, 88) to assert: “we can hope to show that  that the continued presence new opportunities is a necessary condition for instability — for continued change,” inasmuch as continued negative surprises could also cause continued — or at least prolonged — change.

[4] Fisher does recognize (pp. 88-89) that changes in expectations can be destabilizing. However, he considers only the possibility of exogenous events that cause expectations to change, but does not consider the possibility that expectations may change endogenously in a destabilizing fashion in the course of an adjustment process following a displacement from a prior equilibrium. See, however, his discussion (p. 91) of the distinction between exogenous and endogenous shocks.

How is . . . an [“exogenous”] shock to be distinguished from the “endogenous” shock brought about by adjustment to the original shock? No Favorable Surprise may not be precisely what is wanted as an assumption in this area, but it is quite difficult to see exactly how to refine it.

A proof of stability under No Favorable Surprise, then, seems quite desirable for a number of related reasons. First, it is the strongest version of an assumption of No Favorable Exogenous Surprise (whatever that may mean precisely); hence, if stability does not hold under No Favorable Surprise it cannot be expected to hold under the more interesting weaker assumption.  

[5] Presumably because the income and output are maximized at the equilibrium path, it is unlikely that an economy will overshoot the path unless entrepreneurial or policy error cause such overshooting which is presumably an unlikely occurrence, although Austrian business cycle theory and perhaps certain other monetary business cycle theories suggest that such overshooting is not or has not always been an uncommon event.

Dangerous Metaphors

Published January 5, 2023 Brad Delong , Olivier Blanchard , Paul Krugman 2 Comments
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A couple of days ago, I wrote post gently (I hope) chiding Olivier Blanchard for what seemed to me to be a muddled attempt to attribute inflation to conflicts between various interest groups (labor, capital, creditors, debtors) that the political system is unable, or unwilling, to resolve,leavin, those conflicts to be addressed, albeit implicitly, by the monetary authority. In those circumstances, groups seek to protect, or even advance their interests, by seeking prices increases for their goods or services, triggering a continuing cycle of price and wage increases, aka a wage-price spiral.

My criticism of Blanchard wasn’t that the distributional conflicts that worry him don’t exist — they obviously do — or are irrelevant — they clearly aren’t, but that focusing attention on those conflicts tells us very little about the mechanisms that generate inflation: the macroeconomic policies (monetary or fiscal) under the control of governments and central banks. We live in complex societies consisting of many diverse and independent, yett deeply interrelated and interdependent, agents. Macroeconomic polilcies are adopted and implemented in an economic and social environment shaped by the various, and possibly conflicting, interests of these agents, so it would be absurd to argue that the conflicts and tensions that inevitably arise between those agents do not influence, or even dictate, the policy choices of governments and monetary authorities responsible for adopting and implementing macroeconomic policies.

Because distributional conflicts are inherent in any economy composed of a diverse set of agents pursuing their own inconsistent self-interests, so it seems quixotic to suppose or even imagine that distributional conflicts can be resolved by a formal negotiating process in the way that Blanchard seems to be suggesting. There are too many interests at play, too many conflicts to reconcile, too many terms to negotiate, too many uncertain conditions and too many unforeseen events requiring previously reached agreements to be renegotiated for these deep-seated conflicts to be resolved by any conceivable negotiation process.

The point that I tried to make is that, because it is unrealistic to think that the fundamental conflicts of interest characteristic of any modern economy can be reconciled by negotiation, the monetary authority should aim to adopt a policy on which economic agents can rely on in forming their expectations about the future. The best policy that the monetary authority can hope to achieve is one that aims for total nominal spending and total nominal income to increase at a predictable rate consistent with an inflation rate low enough to be politically uncontroversial. If such a policy is implemented, with nominal spending and income increasing at roughly the target rate, private expectations would likely converge toward that targeted rate, thereby contributing to the mutual consistency of private expectaions that would allow inflation to remain at an acceptably low rate.

Brad Delong kindly noticed my comment about Blanchard on his substack blog and on Twitter, opining that Blanchard and I were not really disagreeing but were talking past each other.

I don’t necessarily disagree with Brad’s take, but I’m not sure that I agree either, because I’m not sure that I understand what Blanchard is actually saying. I actually tried to hint at my uncertainty about what Blanchard’s argument actually is (and whether I disagree with it) by borrowing (with slight modification) the lyric of George and Ira Gershwin’s standard “Let’s Call the Whole Thing Off.” (Or, try out this version.)

Paul Krugman also weighed in, defending Blanchard’s analysis against the argument which he attributes to John Cochrane and to me that inflation is always the result of excessive demand.

Although Blanchard is nobody’s idea of a leftist (OK, Republicans seem to consider anyone more liberal than Attila the Hun a Marxist, but still), he nonetheless got immediate pushback from economists who insisted that inflation is always the result of excessive demand, of too much money chasing too few goods or, what is roughly the same thing, the consequence of an excessively hot economy.

https://www.nytimes.com/2023/01/03/opinion/inflation-economy.html?searchResultPosition=1

I’m always grateful to be noticed by Krugman, but I’ll just note in passing that he’s not quite correct in attributing to me the view that inflation is always the consequence of an excessively hot economy; I was simply working with Blanchard’s own framing in his original Twitter thread.

But the point in Krugman’s post that I want to comment on is his football metaphor.

At one level, of course Blanchard is right. Companies that charge higher prices and workers who demand higher wages aren’t doing so because the money supply has increased; they’re trying to increase their incomes (or offset declines in their incomes caused by, say, rising energy prices). And inflation happens when the attempts of firms and workers to claim a bigger share of the economic pie are inconsistent, when the additional purchasing power being demanded exceeds what the economy can deliver.

Reading the discussion, I found myself remembering a remark made way back in the 1970s by William Nordhaus, another eminent economist (and Nobel laureate) who happens to have been my first mentor in the field. Nordhaus compared inflation to what happens in a football stadium when the action on the field is especially exciting. (If you don’t find American football exciting, think of it as a soccer match.) Everyone stands up to get a better view, but this is collectively self-defeating — your view doesn’t improve because the people in front of you are also standing, and you’re less comfortable besides.

Nordhaus’s football metaphor is very apt as far as it goes. You can imagine that inflation starts as the result of an attempt by agents to increase their prices (wages) that turns out to be self-defeating because everyone’s attempt to increase his price or wage relative to everyone else’s turns out to be self-defeating when everyone else does the same thing, so that no one really improves his position compared to everyone else.

I will just observe parenthetically that it is not strictly true that no one improves his view of the field, because people who are taller than average likely will improve their view of the field, especially if they are sitting behind short people. But that is likely a second-order effect. Similarly, some people raising their prices may be well-positioned to increase their prices more than average, so that they may be net gainers from the process. But again those are likely second-order effects.

But here is where the football metaphor breaks down. Blanchard is not worried about a once and for all increase in the price level, which is what the football metaphor translates into. People standing up in a football game do not keep growing taller once they stand up. The process comes to an end, and is eventually reversed after people sit down again.

But inflation is unpopular because it supposedly is a continuing process of increasing prices. Larry Summers and Blanchard have been invoking the experience of the 1970s in which there was supposedly a self-generating or self-reinforcing wage-price spiral that could only be stopped by a brutal monetary tightening administered by Paul Volcker causing a severe recession with double-digit unemployment. To avoid another such catastrophic recession, Blanchard is urging everyone to be reasonable and not to try to increase prices or wages in a likely futile attempt to gain at the expense of others.

The problem with football metaphor is that it can’t explain how the inflation process can continue if it is not enabled by macroeconomic policies that cause the rate of nominal spending and income to keep increasing. Maybe Blanchard and Krugman believe that total nominal spending and total nominal income can keep increasing even if macroeconomic policies aren’t causing nominal spending and nominal income to increase.

I don’t think that’s what they believe, but if they do believe that, then they should explain how continuing increases in nominal spending and income can be generated without corresponding macroeconomic policies that promote those increases in nominal spending and income. As long as macroeconomic policy is focused on keeping the rate of increase in nominal spending at a rate consistent with the target rate of inflation, inflation will be just as transitory as episodes of standing by fans at football games.

My Paper “Robert Lucas and the Pretense of Science” Is now Available on SSRN

Published January 4, 2023 Axel Leijonfuvud , Hayek , Keynes , Peter Howitt , Robert Clower , Robert Lucas Leave a Comment

Peter Howitt, whom I got to know slightly when he spent a year at UCLA while we were both graduate students, received an honorary doctorate from Côte d’Azur University in September. Here is a link to the press release of the University marking the award.

Peter wrote his dissertation under Robert Clower, and when Clower moved from Northwestern to UCLA in the early 1970s, Peter followed Clower as he was finishing up his dissertation. Much of Peter’s early work was devoted to trying to develop the macroeconomic ideas of Clower and Leijonhufvud. His book The Keynesian Recovery collects those important early papers which, unfortunately, did not thwart the ascendance, as Peter was writing those papers, of the ideas of Robert Lucas and his many followers, or the eventual dominance of those ideas over modern macroeconomics.

In addition to the award, a workshop on Coordination Issues in Historical Perspective was organized in Peter’s honor, and my paper, “Robert Lucas and the Pretense of Science,” which shares many of Peter’s misgivings about the current state of macroeconomics, was one of the papers presented at the workshop. In writing the paper, I drew on several posts that I have written for this blog over the years. I have continued to revise the paper since then, and the current version is now available on SSRN.

Here’s the abstract:

Hayek and Lucas were both known for their critiques of Keynesian theory on both theoretical and methodological grounds. Hayek (1934) criticized the idea that continuous monetary expansion could permanently increase total investment, foreshadowing Friedman’s (1968) argument that monetary expansion could permanently increase employment. Friedman’s analysis set the stage for Lucas’s (1976) critique of macroeconomic policy analysis, a critique that Hayek (1975) had also anticipated. Hayek’s (1942-43) advocacy of methodological individualism might also be considered an anticipation of Lucas’s methodological insistence on the necessity of rejecting Keynesian and other macroeconomic theories not based on explicit microeconomic foundations. This paper compares Hayek’s methodological individualism with Lucasian microfoundations. While Lucasian microfoundations requires all agents to make optimal choices, Hayek recognized that optimization by interdependent agents is a contingent, not a necessary, state of reconciliation and that the standard equilibrium theory on which Lucas relies does not prove that, or explain how, such a reconciliation is, or can be, achieved. The paper further argues that the Lucasian microfoundations is a form of what Popper called philosophical reductionism that is incompatible with Hayekian methodological individualism.

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4260708

You Say Potato, I Say Potahto; You Say Tomato, I Say Tomahto; You Say Distribution, I Say Expectation

Published January 1, 2023 expectations , Larry Summers , Little Depression , Olivier Blanchard , R. G. Hawtrey 4 Comments

Once again, the estimable Olivier Blanchard is weighing in on the question of inflation, expressing fears about an impending wage-price spiral that cannot be controlled by conventional monetary policy unless the monetary authority is prepared to impose sufficiently tight monetary conditions that would entail substantially higher unemployment than we have experienced since the aftermath of the 2008 financial crisis and Little Depression (aka Great Recession). Several months ago, Blanchard, supporting Larry Summers’s warnings that rising inflation was not likely to be transitory and instead would likely remain high and possibly increase over time, I tried to explain why his fears of high and rising inflation were likely exaggerated. Unpersuaded, he now returns to provide a deeper explanation of his belief that, unless the deep systemic forces that cause inflation are addressed politically rather than left, by default, to be handled by the monetary authority, inflation will remain a persistent and vexing problem.

I’m sorry to say that Professor Blanchard starts off with a massive overstatement. While I don’t discount the possibility — even the reality — that inflation may sometimes be triggered by the attempt of a particular sector of the economy to increase the relative price of the goods or services that it provides, thereby increasing its share of total income at the expense of other sectors, I seriously question whether this is a typical, or even frequent, source of inflation. For example, oil-price increases in the 1970s and wage increases in France after the May 1968 student uprisings did trigger substantial inflation. Inflation served as a method of (1) mitigating ing adverse macroeconomic effects on output and employment and (2) diluting the size of the resulting wealth transfer from other sectors.

Blanchard continues:

2/8. The source of the conflict may be too hot an economy: In the labor market, workers may be in a stronger position to bargain for higher wages given prices. But, in the goods market, firms may also be in a stronger position to increase prices given wages. And, on, it goes.

Again, I’m sorry to say that I find this remark incomprehensible. Blanchard says “the source of the conflict may be too hot an economy,” and in the very next breath says that in the labor market (as if it made sense to view the labor market, accounting for more than half the nominal income of the economy, as a single homogeneous market with stable supply and demand curves), “workers may be in a strong position to bargain for higher wages given prices,” while in the goods market firms may be in a strong position to bargain for higher prices relative to wages. What kind of bargaining position is Blanchard talking about? Is it real, reflecting underlying economic conditions, or is it nominal, reflecting macroeconomic conditions. He doesn’t seem to know. And if he does know, he’s not saying. But he began by saying that the source of the conflict “may be too hot an economy,” suggesting that the source of the conflict is macroeconomic, not a conflict over shares. So I’m confused. We can only follow him a bit further to see what he may be thinking.

3/8. The source of the conflict may be in too high prices of commodities, such as energy. Firms want to increase prices given wages, to reflect the higher cost of intermediate inputs. Workers want to resist the decrease in the real wage, and ask for higher wages. And on it goes.

Now Blanchard seems to be attributing the conflict to an exogenous — and unexmplained — increase in commodity prices. One sector presumably enjoys an improvement in its bargaining position relative to the rest of the economy, thereby being enabled to increase its share of total income. Rather than consider the appropriate response to such an exercise of raw market power, Blanchard simply assumes that, but doesn’t explain how, this increase in share triggers a vicious cycle of compensating increases in the prices and wages of other sectors, rather than a one-off distributional change to reflect a new balance of economic power. This is a complicated story with interesting macroeconomic implications, but Blanchard doesn’t bother to do more than assert that the disturbance sets in motion an ongoing, possibly unlimited, cycle of price and wage increases.

4/8. The state can play various roles. Through fiscal policy, it can slow down the economy and eliminate the overheating. It can subsidize the cost of energy, limiting the decrease in the real wage and the pressure on nominal wages.

5/8. It can finance the subsidies by increasing taxes on some current taxpayers, say exceptional profit taxes, or through deficits and eventual taxes on future taxpayers (who have little say in the process…)

These two statements from the thread are largely innocuous and contribute little or nothing to an understanding of the cause or causes of inflation or of the policies that might mitigate inflation or its effect,

6/8. But, in the end, forcing the players to accept the outcome, and thus stabilizing inflation, is typically left to the central bank. By slowing down the economy, it can force firms to accept lower prices given wages, and workers to accept lower wages given prices.

It’s not clear to me what constitutes “acceptance” of the outcome. Under any circumstance, the players will presumably still seek to choose and execute what, given the situation in which they find themselves, they regard as an optimal plan. Whether the players can execute the plan that they choose will depend on the plans chosen by other players and on the policies adopted by the central bank and other policy makers. If policy makers adopt a consistent set of policies that are feasible and are aligned with the outcomes expected by the players, then the players will likely succeed in implementing what they regard as optimal plans. If the policies that are followed are not consistent and not feasible, then those policies will not be aligned with the outcomes expected by the players. In the latter case, matters will likely get worse not better.

7/8. It is a highly inefficient way to deal with distributional conflicts. One can/should dream of a negotiation between workers, firms, and the state, in which the outcome is achieved without triggering inflation and requiring a painful slowdown.

I can’t help but observe the vagueness associated with the pronoun “it” and its unidentified antecedent. The outcome of a complex economic process cannot be achieved by a negotiation between workers,firms and the state. Things don’t work that way. Whatever negotiation Professor Blanchard is dreaming about, no negotiation can possibly determine the details of an outcome. What is possible is some agreement on policy goals or targets for inflation and some feasible set of policies aimed at achieving, or coming close to, a target rate of inflation. The key variable over which policy makers have some control is total aggregate demand for the economy measured either as a rate of nominal spending and nominal income over a year or as a rate of growth in spending and income compared to the previous year. Since inflation is itself a rate of change, presumaby the relevant target should be a rate of change in total nominal spending and nominal income. Thus, the appropriate target for policy makers to aim for is the yearly rate of growth in total nominal spending and total nominal income.

Given some reasonable expectation about the rate of technical progress (labor productivity) and the rate of increase in the labor force, a target rate of inflation implies a target rate of increase in total nominal spending and total nominal income. Given expectations about the increase in labor productivity, there is an implied rate of increase in nominal wages that is broadly consistent with the inflation target. But that average rate of increase in nominal wages can hardly be expected to be uniform for all industries and all firms and all workers, and it would be folly, on purely technical reasons, to attempt to enforce such a target in average nominal wage growth. And for legal and political reasons, it would be an even greater folly to try to do so.

Besides announcing the underlying basis for the targeted rate of nominal income growth, and encouraging workers and firms to take those targets seriously when negotiating wage contracts and setting prices, while recognizing that deviations from those targets are often reasonable and appropriate in the light of the specific circumstances in which particular firms and industries and labor unions are operating, policy makers have no constructive role to play in the setting of prices or wages for individual firms industries or labor contracts. But providing useful benchmarks for private agents to use as a basis for forming their own expectations about the future to guide their planning for the future is entirely appropriate and useful.

I should acknowledge that, as I have done previously, that the approach to policy making summarized here is based on the analysis developed by Ralph Hawtrey over the course of more than a half century as both a monetary theorist and a policy advisor, and, especially, as Hawtrey explained over a half-century ago in his final book, Incomes and Money.

8/8. But, unfortunately, this requires more trust than can be hoped for and just does not happen. Still, this way of thinking inflation shows what the problem is, and how to think of the least painful solution.

Insofar as policymakers can show that they are coming reasonably close to meeting their announced targets, they will encourage private actors to take those announced targets seriously when forming their own expectations and when negotiating with counterparties on the terms of their economic relationships. The least painful solutions are those in which economic agents align their expectations with the policy targets announced — and achieved — by policy makers.

Originally tweeted by Olivier Blanchard (@ojblanchard1) on December 30, 2022.

Franklin Fisher on the Disequilibrium Foundations of Economics and the Stability of General Equilibium

Published November 16, 2022 Uncategorized 14 Comments

As I’ve pointed out many times on this blog, equilibrium is an extremely important, but very problematic, concept in economic theory. What economists even mean when they talk about equilibrium is often unclear and how the concept relates to the real world as opposed to an imagined abstract world is even less clear. Nevertheless, almost all the propositions of economic theory that are used by economists in analyzing the world and in making either conditional or unconditional predictions about the world or in analyzing current or historical events are based on propositions of economic theory deduced from the theoretical analysis of equilibrium states,

Last year I wrote a paper for a conference marking the hundredth anniversary of Carl Menger’s death in 1921 and 150 years after his seminal work launching, along with Jevons and Walras, what eventually became neoclassical economic theory. Here is a link to that paper. Of late I have been revising the paper and I have now substantially rewritten (and I hope improved) one of the sections of the paper discussing Franklin Fisher’s important work on the stability of general equilibrium, which I have been puzzling over and writing about for several years, e.g., here and here, as well as chapter 17 of my book, Studies in the History of Monetary Theory: Controversies and Clarifications.

I’ve recently been revising that paper — one of a number of distractions that have prevented me from posting recently — and have substantially rewritten a couple sections of the paper, especially section 7 about Fisher’s treatment of the stability of general equilibrium. Because I’m not totally sure that I’ve properly characterized Fisher’s own proof of stability under a different set of assumptions than the standard treatments of stability, I’m posting my new version of the section in hopes of eliciting feedback from readers. Here’s the new version of section 7 (not yet included in the SSRN version).

Unsuccessful attempts to prove, under standard neoclassical assumptions, the stability of general equilibrium led Franklin Fisher (1983) to suggest an alternative approach to proving stability. Fisher based his approach on three assumptions: (1) trading occurs at disequilibrium prices (in contrast to the standard assumption that no trading takes place until a new equilibrium is found with prices being adjusted under a tatonnement process); (2) all unsatisfied transactors — either unsatisfied demanders or unsatisfied suppliers — in any disequilibrated market are all either on the demand side or on the supply side of that market; (3) the “no favorable surprises” (NFS) assumption previously advanced by Hahn (1978).

At the starting point of a disequilibrium process, some commodities would be in excess demand, some in excess supply, and, perhaps, some in equilibrium. Let Zi denote the excess demand for any commodity, i ranging between 1 and n; let commodities in excess demand be numbered from 1 to k, commodities initially in equilibrium numbered from k+1 to m, and commodities in excess supply numbered from m+1 to n. Thus, by assumption, no agent had an excess supply of commodities numbered from 1 to k, no agent had an excess demand for commodities numbered from m+1 to n, and no agent had an excess demand or excess supply for commodities numbered between k+1 and m.

Fisher argued that, with prices rising in markets with excess demand and falling in markets with excess supply, and not changing in markets with zero excess demand, the sequence of adjustments would converge on an equilibrium price vector. Prices would rise in markets with excess demand and fall in markets with excess supply, because unsatisfied demanders and suppliers would seek to execute their unsuccessful attempts by offering to pay more for commodities in excess demand, or accept less for commodities in excess supply, than currently posted prices. And insofar as those attempts were successful, arbitrage would cause all prices for commodities in excess demand to increase and all prices for commodities in excess supply to decrease.

Fisher then defined a function in which the actual utility of agents after trading would be subtracted from their expected utility before trading. For agents who succeed in executing planned purchases at the expected prices, the value of the function would be zero, but for agents unable to execute planned purchases at the expected prices, the value of the function would be positive, their realized utility being less than their expected utility, as agents with excess demands had to pay higher prices than they had expected and agents with excess supplies had to accept lower prices than expected. As prices of goods in excess demand rise while prices of goods in excess supply fall, the value of the function would fall until equilibrium was reached, thereby satisfying the stability condition for a Lyapunov function, thereby confirming the stability of the disequilibrium arbitrage proces.

It may well be true that an economy of rational agents who understand that there is disequilibrium and act arbitrage opportunities is driven toward equilibrium, but not if these agents continually perceive new previously unanticipated opportunities for further arbitrage. The appearance of such new and unexpected opportunities will generally disturb the system until they are absorbed.

Such opportunities can be of different kinds. The most obvious sort is the appearance of unforeseen technological developments – the unanticipated development of new products or processes. There are other sorts of new opportunities as well. An unanticipated change in tastes or the development of new uses for old products is one; the discovery of new sources of raw materials another. Further, efficiency improvements in firms are not restricted to technological developments. The discovery of a more efficidnt mode of internal organization or of a better way of marketing can also present a new opportunity.

Because a favorable surprise during the adjustment process following the displacement of a prior equilibrium would potentially violate the stability condition that a Lyapunov function be non-increasing, the NFS assumption is needed for a proof that arbitrage of price differences leads to convergence on a new equilibrium. It is not, of course, only favorable surprises that can cause instability, inasmuch as the Lyapunov function must be positive as well as being non-increasing, and a sufficiently large unfavorable surprise would violate the non-negativity condition.[1] While listing several possible causes of favorable surprises that might prevent convergence, Fisher considered the assumption plausible enough to justify accepting stability as a working hypothesis for applied microeconomics and macroeconomics.

However, the NFS assumption suffers from two problems deeper than Fisher acknowledged. First, it reckons only with equilibrating adjustments in current prices without considering that equilibrating adjustments are required in agents’ expectations of future prices on which their plans for current and future transactions depend. Unlike the market feedback on current prices in current markets conveyed by unsatisfied demanders and suppliers, inconsistencies in agents’ notional plans for future transactions convey no discernible feedback, in an economic setting of incomplete markets, on their expectations of future prices. Without such feedback on expectations, a plausible account of how expectations of future prices are equilibrated cannot — except under implausibly extreme assumptions — easily be articulated.[2] Nor can the existence of a temporary equilibrium of current prices in current markets, beset by agents’ inconsistent and conflicting expectations, be taken for granted under standard assumptions. And even if a temporary equilibrium exists, it cannot, under standard assumptions, be shown to be optimal. (Arrow and Hahn, 1971, 136-51).

Second, in Fisher’s account, price changes occur when transactors cannot execute their desired transactions at current prices, those price changes then creating arbitrage opportunities that induce further price changes. Fisher’s stability argument hinges on defining a Lyapunov function in which actual prices of goods in excess demand gradually rise to eliminate excess demands and actual prices of goods in excess supply gradually fall to eliminate those excess demands and supplies. But the argument works only if a price adjustment in one market caused by a previous excess demand or excess supply does not simultaneously create excess demands or supplies in markets not previously in disequilibrium, cause markets previously in excess demand to become markets in excess supply, or cause excess demands or excess supplies to increase rather than decrease.

To understand why, Fisher’s ad hoc assumptions do not guarantee that the Lyapunov function he defined will be continuously non-increasing, it will be helpful to refer to the famous Lipsey and Lancaster (1956) second-best theorem. According to their theorem, if one optimality condition in an economic model is unsatisfied because a relevant variable is constrained, the second-best solution, rather than satisfy the other unconstrained optimum conditions, involves revision of at least some of the unconstrained optimum conditions to take account of the constraint.

Contrast Fisher’s statement of the No Favorable Surprise assumption with how Lipsey and Lancaster (1956, 11) described the import of their theorem.

From this theorem there follows the important negative corollary that there is no a priori way to judge as between various situations in which some of the Paretian optimum conditions are fulfilled while others are not. Specifically, it is not true that a situation in which more, but not all, of the optimum conditions are fulfilled is necessarily, or is even likely to be, superior to a situation in which fewer are fulfilled. It follows, therefore, that in a situation in which there exist many constraints which prevent the fulfilment of the Paretian optimum conditions the removal of any one constraint may affect welfare or efficiency either by raising it, by lowering it, or by leaving it unchanged.

The general theorem of the second best states that if one of the Paretian optimum conditions cannot be fulfilled a second-best optimum situation is achieved only by departing from all other optimum conditions. It is important to note that in general, nothing can be said about the direction or the magnitude of the secondary departures from optimum conditions made necessary by the original non-fulfillment of one condition.

Although Lipsey and Lancaster were not referring to the adjustment process triggered by an adjustment process that follows a displacement from a prior equilibrium, nevertheless, their discussion implies that the stability of an adjustment process depends on the specific sequence of adjustments in that process, inasmuch as each successive price adjustment, aside from its immediate effect on the particular market in which the price adjusts, transmits feedback effects to related markets. A price adjustment in one market may increase, decrease, or leave unchanged, the efficiency of other markets, and the equilibrating tendency of a price adjustment in one market may be offset by indirect disequilibrating tendencies in other markets. When a price adjustment in one market indirectly reduces efficiency in other markets, the resulting price adjustments that follow may well trigger yet further indirect efficiency reductions.

Thus, in adjustment processes involving interrelated markets, price changes in one market can cause favorable surprises in other markets in which prices are not already at their general-equilibrium levels, by indirectly causing net increases in utility through feedback effects on related markets.

Consider a macroeconomic equilibrium satisfying all optimality conditions between marginal rates of substitution in production and consumption and relative prices. If that equilibrium is subjected to a macoreconomic disturbance affecting all, or most, individual markets, thereby changing all optimality conditions corresponding to the prior equilibrium, the new equilibrium will likely entail a different set of optimality conditions. While systemic optimality requires price adjustments to satisfy all the optimality conditions, actual price adjustments occur sequentially, in piecemeal fashion, with prices changing market by market or firm by firm, price changes occurring as agents perceive demand or cost changes. Those changes need not always induce equilibrating adjustments, nor is the arbitraging of price differences necessarily equilibrating when, under suboptimal conditions, prices have generally deviated from their equilibrium values. 

Smithian invisible-hand theorems are of little relevance in explaining the transition to a new equilibrium following a macroeconomic disturbance, because, in this context, the invisible-hand theorem begs the relevant question by assuming that the equilibrium price vector has been found. When all markets are in disequilibrium, moving toward equilibrium in one market will have repercussions on other markets, and the simple story of how price adjustment in response to a disequilibrium restores equilibrium breaks down, because market conditions in every market depend on market conditions in every other market. So, unless all optimality conditions are satisfied simultaneously, there is no assurance that piecemeal adjustments will bring the system closer to an optimal, or even a second-best, state.

If my interpretation of the NFS assumption is correct, Fisher’s stability results may provide support for Leijonhufvud’s (1973) suggestion that there is a corridor of stability around an equilibrium time path within which, under normal circumstances, an economy will not be displaced too far from path, so that an economy, unless displaced outside that corridor, will revert, more or less on its own, to its equilibrium path.[3]

Leijonhufvud attributed such resilience to the holding of buffer stocks of inventories of goods, holdings of cash and the availability of credit lines enabling agents to operate normally despite disappointed expectations. If negative surprises persist, agents will be unable to add to, or draw from, inventories indefinitely, or to finance normal expenditures by borrowing or drawing down liquid assets. Once buffer stocks are exhausted, the stabilizing properties of the economy have been overwhelmed by the destabilizing tendencies, income-constrained agents cut expenditures, as implied by the Keynesian multiplier analysis, triggering a cumulative contraction, and rendering a spontaneous recovery without compensatory fiscal or monetary measures, impossible.

[1] It was therefore incorrect for Fisher (1983, 88) to assert: “we can hope to show that  that the continued presence new opportunities is a necessary condition for instability — for continued change,” inasmuch as continued negative surprises can also cause continued — or at least prolonged — change.

[2] Fisher does recognize (pp. 88-89) that changes in expectations can be destabilizing. However, he considers only the possibility of exogenous events that cause expectations to change, but does not consider the possibility that expectations may change endogenously in a destabilizing fashion in the course of an adjustment process following a displacement from a prior equilibrium. See, however, his discussion (p. 91)

How is . . . an [“exogenous”] shock to be distinguished from the “endogenous” shock brought about by adjustment to the original shock? No Favorable Surprise may not be precisely what is wanted as an assumption in this area, but it is quite difficult to see exactly how to refine it.

A proof of stability under No Favorable Surprise, then, seems quite desirable for a number of related reasons. First, it is the strongest version of an assumption of No Favorable Exogenous Surprise (whatever that may mean precisely); hence, if stability does not hold under No Favorable Surprise it cannot be expected to hold under the more interesting weaker assumption.  

[3] Presumably because the income and output are maximized at the equilibrium path, it is unlikely that an economy will overshoot the path unless entrepreneurial or policy error cause such overshooting which is presumably an unlikely occurrence, although Austrian business cycle theory and perhaps certain other monetary business cycle theories suggest that such overshooting is not or has not always been an uncommon event.

Robert Lucas and Real Business-Cycle Theory

Published August 17, 2022 Charles Plosser , Edward Prescott , Finn Kydland , real-business cycle theory , Robert Lucas , Uncategorized 5 Comments

In 1978 Robert Lucas and Thomas Sargent launched a famous attack on Keynes and Keynesian economics, which they viewed as having been discredited by the confluence of high inflation and high unemployment in the 1970s. They also expressed optimistism that an equilibrium approach to business-cycle modeling would succeed in replicating reasonably well the observed time-series variables relating to output and employment. In particular they posited that a model subjected to an unexpected monetary shock causing an immediate downturn from an equilibrium time path would be followed by a gradual reversion to that time path, thereby capturing the main stylized facts of historical business cycles. Their optimism was disappointed, because the model that Lucas had developed, based on an informational imperfection preventing agents from distinguishing immediately between real and nominal price changes, could not account for downturns because the informational imperfection assumed by Lucas could not account for the typical multi-period duration of business-cycle downturns.

It was this empirical anomaly in Lucas’s monetary business-cycle model that prompted Kydland and Prescott to construct their real-business cycle model. Lucas warmly welcomed their contribution, the abandonment of the monetary-theoretical motivation that Lucas had inherited from his academic training at Chicago being a small price to pay for the advancement of the larger research agenda derived from his methodological imperatives.

The real-business cycle variant of the Lucasian research program rested on two empirical pillars: (1) the identification of technology shocks with deviations, as measured by the Solow residual, from the trend rate of increase in total factor productivity, positive residuals corresponding to positive shocks and negative residuals corresponding to negative shocks; and (2) estimates of elasticities of intertemporal rates of labor substitution.

Positive productivity shocks induce wage increases, and negative shocks induce wage decreases. Responding to the shifts in wages, presumed to be temporary, workers increase the amount of labor supplied in response to above-trend increases in wages and decrease the amount of labor supplied in response to below-trend increases in wages. The higher the elasticity of intertemporal labor substitution, the greater the supply response to a given deviation of actual wages from the expected trend rate of increase in wages. Real-business-cycle theorists used calibration techniques to obtain estimates labor-supply elasticities from microeconomic studies.

The real-business-cycle variant of the Lucasian research program embraced all the dubious methodological precepts of its parent while adding further dubious practices of its own. Most problematic, of course, is the methodological insistence that equilibrium is necessarily and continuously maintained, which is possible only if all agents correctly anticipate future prices and wages. If equilibrium is not continuously maintained, then Solow residuals may capture not productivity shocks, but, depending on their sign, either movements away from, or toward, equilibrium. In disequilibrium, labor and capital may be held idle by firms in anticipation of subsequent increases in output, so that measured productivity does not reflect the state of technology, but the inherent inefficiency of unemployment resulting from coordination failure, a contingency explicitly deemed by Lucasian methodology to be off limits.

Such ad hocery is generally frowned upon by scientists. Ad hoc assumptions are not always unscientific or unproductive, as famously exemplified by the discovery of Neptune. But in the latter case, the ad hoc assumption was subject to empirical testing; Neptune might not have been there waiting to be discovered. But no independent test of the presence or absence of a technology shock, aside from the Solow residual itself, is available. Even this situation might be tolerable, if Lucasian methodology permitted one to inquire whether the world or an economy might not be in an equilibrium state. But Lucasian methodology forbids such an inquiry.

The use of calibration to estimate intertemporal labor-supply elasticities from microeconomic studies are also extremely dubious, because microeconomic estimates of labor-supply elasticities are typically made under conditions approximating equilibrium, when workers have some flexibility in choosing whether to work more or less in the present or in the future. Those are not the conditions in which workers find themselves in periods of high aggregate unemployment, and are, therefore, not confident that they will retain their jobs in the present and near future, or, if they lose their jobs, that they will succeed in finding another job at an acceptable wage. The calibrated estimates of labor-supply elasticity are, for exactly the reasons identified in the Lucas Critique, unreliable for use in replicating time series.

An early real-business-cycle theorist Charles Plosser (“Understanding Real Business Cycles”) responded to criticisms of the RBC techniques as follows:

If the measured technological shocks are poor estimates (that is, they are confounded by other factors such as “demand” shocks, preference shocks or change in government policies, and so on) then feeding these values into our real business cycle model should result in poor predictions for the behavior of consumption, investment, hours worked, wages and output.

Plosser’s response ignores the question-begging nature of the RBC model; the supposed productivity shocks that cause cyclical fluctuations in the model are identified by the very time series that the model purports to explain. Nor does calibration provide clear and unambiguous estimates that the modeler can transfer without exercising discretion about which studies and which values to insert into an RBC model. Plosser’s defense of RBC is not so very different from the sort of defense made on behalf of the highly accurate epicyclical replications of observed planetary movements, replications that were based largely on the ingenuity and diligence of the epicyclist.

Eventually, the methodological prohibitions against heliocentrism were overcome. Perhaps, one day, the methodological prohibitions against non-reductionist macroeconomic theories will also be overcome.

Lucasian macroeconomics gained not only ascendance, but dominance, on the basis of  conceptual and methodological misunderstandings. The continued dominance of the offspring of the early Lucasian theories has been portrayed as a scientific advance by Lucas and his followers. In fact, the theories and the supposed methodological imperatives by which they have been justified are scientifically suspect because they rely on circular, question-begging arguments and reject alternative theories based on specious reductionist arguments.

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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