Posts Tagged 'George Stigler'

Does Economic Theory Entail or Support Free-Market Ideology?

A few weeks ago, via Twitter, Beatrice Cherrier solicited responses to this query from Dina Pomeranz

It is a serious — and a disturbing – question, because it suggests that the free-market ideology which is a powerful – though not necessarily the most powerful — force in American right-wing politics, and probably more powerful in American politics than in the politics of any other country, is the result of how economics was taught in the 1970s and 1980s, and in the 1960s at UCLA, where I was an undergrad (AB 1970) and a graduate student (PhD 1977), and at Chicago.

In the 1950s, 1960s and early 1970s, free-market economics had been largely marginalized; Keynes and his successors were ascendant. But thanks to Milton Friedman and his compatriots at a few other institutions of higher learning, especially UCLA, the power of microeconomics (aka price theory) to explain a very broad range of economic and even non-economic phenomena was becoming increasingly appreciated by economists. A very broad range of advances in economic theory on a number of fronts — economics of information, industrial organization and antitrust, law and economics, public choice, monetary economics and economic history — supported by the award of the Nobel Prize to Hayek in 1974 and Friedman in 1976, greatly elevated the status of free-market economics just as Margaret Thatcher and Ronald Reagan were coming into office in 1979 and 1981.

The growing prestige of free-market economics was used by Thatcher and Reagan to bolster the credibility of their policies, especially when the recessions caused by their determination to bring double-digit inflation down to about 4% annually – a reduction below 4% a year then being considered too extreme even for Thatcher and Reagan – were causing both Thatcher and Reagan to lose popular support. But the growing prestige of free-market economics and economists provided some degree of intellectual credibility and weight to counter the barrage of criticism from their opponents, enabling both Thatcher and Reagan to use Friedman and Hayek, Nobel Prize winners with a popular fan base, as props and ornamentation under whose reflected intellectual glory they could take cover.

And so after George Stigler won the Nobel Prize in 1982, he was invited to the White House in hopes that, just in time, he would provide some additional intellectual star power for a beleaguered administration about to face the 1982 midterm elections with an unemployment rate over 10%. Famously sharp-tongued, and far less a team player than his colleague and friend Milton Friedman, Stigler refused to play his role as a prop and a spokesman for the administration when asked to meet reporters following his celebratory visit with the President, calling the 1981-82 downturn a “depression,” not a mere “recession,” and dismissing supply-side economics as “a slogan for packaging certain economic ideas rather than an orthodox economic category.” That Stiglerian outburst of candor brought the press conference to an unexpectedly rapid close as the Nobel Prize winner was quickly ushered out of the shouting range of White House reporters. On the whole, however, Republican politicians have not been lacking of economists willing to lend authority and intellectual credibility to Republican policies and to proclaim allegiance to the proposition that the market is endowed with magical properties for creating wealth for the masses.

Free-market economics in the 1960s and 1970s made a difference by bringing to light the many ways in which letting markets operate freely, allowing output and consumption decisions to be guided by market prices, could improve outcomes for all people. A notable success of Reagan’s free-market agenda was lifting, within days of his inauguration, all controls on the prices of domestically produced crude oil and refined products, carryovers of the disastrous wage-and-price controls imposed by Nixon in 1971, but which, following OPEC’s quadrupling of oil prices in 1973, neither Nixon, Ford, nor Carter had dared to scrap. Despite a political consensus against lifting controls, a consensus endorsed, or at least not strongly opposed, by a surprisingly large number of economists, Reagan, following the advice of Friedman and other hard-core free-market advisers, lifted the controls anyway. The Iran-Iraq war having started just a few months earlier, the Saudi oil minister was predicting that the price of oil would soon rise from $40 to at least $50 a barrel, and there were few who questioned his prediction. One opponent of decontrol described decontrol as writing a blank check to the oil companies and asking OPEC to fill in the amount. So the decision to decontrol oil prices was truly an act of some political courage, though it was then characterized as an act of blind ideological faith, or a craven sellout to Big Oil. But predictions of another round of skyrocketing oil prices, similar to the 1973-74 and 1978-79 episodes, were refuted almost immediately, international crude-oil prices falling steadily from $40/barrel in January to about $33/barrel in June.

Having only a marginal effect on domestic gasoline prices, via an implicit subsidy to imported crude oil, controls on domestic crude-oil prices were primarily a mechanism by which domestic refiners could extract a share of the rents that otherwise would have accrued to domestic crude-oil producers. Because additional crude-oil imports increased a domestic refiner’s allocation of “entitlements” to cheap domestic crude oil, thereby reducing the net cost of foreign crude oil below the price paid by the refiner, one overall effect of the controls was to subsidize the importation of crude oil, notwithstanding the goal loudly proclaimed by all the Presidents overseeing the controls: to achieve US “energy independence.” In addition to increasing the demand for imported crude oil, the controls reduced the elasticity of refiners’ demand for imported crude, controls and “entitlements” transforming a given change in the international price of crude into a reduced change in the net cost to domestic refiners of imported crude, thereby raising OPEC’s profit-maximizing price for crude oil. Once domestic crude oil prices were decontrolled, market forces led almost immediately to reductions in the international price of crude oil, so the coincidence of a fall in oil prices with Reagan’s decision to lift all price controls on crude oil was hardly accidental.

The decontrol of domestic petroleum prices was surely as pure a victory for, and vindication of, free-market economics as one could have ever hoped for [personal disclosure: I wrote a book for The Independent Institute, a free-market think tank, Politics, Prices and Petroleum, explaining in rather tedious detail many of the harmful effects of price controls on crude oil and refined products]. Unfortunately, the coincidence of free-market ideology with good policy is not necessarily as comprehensive as Friedman and his many acolytes, myself included, had assumed.

To be sure, price-fixing is almost always a bad idea, and attempts at price-fixing almost always turn out badly, providing lots of ammunition for critics of government intervention of all kinds. But the implicit assumption underlying the idea that freely determined market prices optimally guide the decentralized decisions of economic agents is that the private costs and benefits taken into account by economic agents in making and executing their plans about how much to buy and sell and produce closely correspond to the social costs and benefits that an omniscient central planner — if such a being actually did exist — would take into account in making his plans. But in the real world, the private costs and benefits considered by individual agents when making their plans and decisions often don’t reflect all relevant costs and benefits, so the presumption that market prices determined by the elemental forces of supply and demand always lead to the best possible outcomes is hardly ironclad, as we – i.e., those of us who are not philosophical anarchists – all acknowledge in practice, and in theory, when we affirm that competing private armies and competing private police forces and competing judicial systems would not provide for common defense and for domestic tranquility more effectively than our national, state, and local governments, however imperfectly, provide those essential services. The only question is where and how to draw the ever-shifting lines between those decisions that are left mostly or entirely to the voluntary decisions and plans of private economic agents and those decisions that are subject to, and heavily — even mainly — influenced by, government rule-making, oversight, or intervention.

I didn’t fully appreciate how widespread and substantial these deviations of private costs and benefits from social costs and benefits can be even in well-ordered economies until early in my blogging career, when it occurred to me that the presumption underlying that central pillar of modern right-wing, free-market ideology – that reducing marginal income tax rates increases economic efficiency and promotes economic growth with little or no loss in tax revenue — implicitly assumes that all taxable private income corresponds to the output of goods and services whose private values and costs equal their social values and costs.

But one of my eminent UCLA professors, Jack Hirshleifer, showed that this presumption is subject to a huge caveat, because insofar as some people can earn income by exploiting their knowledge advantages over the counterparties with whom they trade, incentives are created to seek the kinds of knowledge that can be exploited in trades with less-well informed counterparties. The incentive to search for, and exploit, knowledge advantages implies excessive investment in the acquisition of exploitable knowledge, the private gain from acquiring such knowledge greatly exceeding the net gain to society from the acquisition of such knowledge, inasmuch as gains accruing to the exploiter are largely achieved at the expense of the knowledge-disadvantaged counterparties with whom they trade.

For example, substantial resources are now almost certainly wasted by various forms of financial research aiming to gain information that would have been revealed in due course anyway slightly sooner than the knowledge is gained by others, so that the better-informed traders can profit by trading with less knowledgeable counterparties. Similarly, the incentive to exploit knowledge advantages encourages the creation of financial products and structuring other kinds of transactions designed mainly to capitalize on and exploit individual weaknesses in underestimating the probability of adverse events (e.g., late repayment penalties, gambling losses when the house knows the odds better than most gamblers do). Even technical and inventive research encouraged by the potential to patent those discoveries may induce too much research activity by enabling patent-protected monopolies to exploit discoveries that would have been made eventually even without the monopoly rents accruing to the patent holders.

The list of examples of transactions that are profitable for one side only because the other side is less well-informed than, or even misled by, his counterparty could be easily multiplied. Because much, if not most, of the highest incomes earned, are associated with activities whose private benefits are at least partially derived from losses to less well-informed counterparties, it is not a stretch to suspect that reducing marginal income tax rates may have led resources to be shifted from activities in which private benefits and costs approximately equal social benefits and costs to more lucrative activities in which the private benefits and costs are very different from social benefits and costs, the benefits being derived largely at the expense of losses to others.

Reducing marginal tax rates may therefore have simultaneously reduced economic efficiency, slowed economic growth and increased the inequality of income. I don’t deny that this hypothesis is largely speculative, but the speculative part is strictly about the magnitude, not the existence, of the effect. The underlying theory is completely straightforward.

So there is no logical necessity requiring that right-wing free-market ideological policy implications be inferred from orthodox economic theory. Economic theory is a flexible set of conceptual tools and models, and the policy implications following from those models are sensitive to the basic assumptions and initial conditions specified in those models, as well as the value judgments informing an evaluation of policy alternatives. Free-market policy implications require factual assumptions about low transactions costs and about the existence of a low-cost process of creating and assigning property rights — including what we now call intellectual property rights — that imply that private agents perceive costs and benefits that closely correspond to social costs and benefits. Altering those assumptions can radically change the policy implications of the theory.

The best example I can find to illustrate that point is another one of my UCLA professors, the late Earl Thompson, who was certainly the most relentless economic reductionist whom I ever met, perhaps the most relentless whom I can even think of. Despite having a Harvard Ph.D. when he arrived back at UCLA as an assistant professor in the early 1960s, where he had been an undergraduate student of Armen Alchian, he too started out as a pro-free-market Friedman acolyte. But gradually adopting the Buchanan public-choice paradigm – Nancy Maclean, please take note — of viewing democratic politics as a vehicle for advancing the self-interest of agents participating in the political process (marketplace), he arrived at increasingly unorthodox policy conclusions to the consternation and dismay of many of his free-market friends and colleagues. Unlike most public-choice theorists, Earl viewed the political marketplace as a largely efficient mechanism for achieving collective policy goals. The main force tending to make the political process inefficient, Earl believed, was ideologically driven politicians pursuing ideological aims rather than the interests of their constituents, a view that seems increasingly on target as our political process becomes simultaneously increasingly ideological and increasingly dysfunctional.

Until Earl’s untimely passing in 2010, I regarded his support of a slew of interventions in the free-market economy – mostly based on national-defense grounds — as curiously eccentric, and I am still inclined to disagree with many of them. But my point here is not to argue whether Earl was right or wrong on specific policies. What matters in the context of the question posed by Dina Pomeranz is the economic logic that gets you from a set of facts and a set of behavioral and causality assumptions to a set of policy conclusion. What is important to us as economists has to be the process not the conclusion. There is simply no presumption that the economic logic that takes you from a set of reasonably accurate factual assumptions and a set of plausible behavioral and causality assumptions has to take you to the policy conclusions advocated by right-wing, free-market ideologues, or, need I add, to the policy conclusions advocated by anti-free-market ideologues of either left or right.

Certainly we are all within our rights to advocate for policy conclusions that are congenial to our own political preferences, but our obligation as economists is to acknowledge the extent to which a policy conclusion follows from a policy preference rather than from strict economic logic.

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

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

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

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

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

Here is Romer’s take:

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

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

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

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

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

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

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

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

Romer v. Lucas

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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.

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