Posts Tagged 'Hicks'

The Neoclassical Synthesis and the Mind-Body Problem

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

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

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

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

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

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

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

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

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

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

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


Hicks on IS-LM and Temporary Equilibrium

Jan, commenting on my recent post about Krugman, Minsky and IS-LM, quoted the penultimate paragraph of J. R. Hicks’s 1980 paper on IS-LM in the Journal of Post-Keynesian Economics, a brand of economics not particularly sympathetic to Hicks’s invention. Hicks explained that in the mid-1930s he had been thinking along lines similar to Keynes’s even before the General Theory was published, and had the basic idea of IS-LM in his mind even before he had read the General Theory, while also acknowledging that his enthusiasm for the IS-LM construct had waned considerably over the years.

Hicks discussed both the similarities and the differences between his model and IS-LM. But as the discussion proceeds, it becomes clear that what he is thinking of as his model is what became his model of temporary equilibrium in Value and Capital. So it really is important to understand what Hicks felt were the similarities as well as the key differences between the temporary- equilibrium model, and the IS-LM model. Here is how Hicks put it:

I recognized immediately, as soon as I read The General Theory, that my model and Keynes’ had some things in common. Both of us fixed our attention on the behavior of an economy during a period—a period that had a past, which nothing that was done during the period could alter, and a future, which during the period was unknown. Expectations of the future would nevertheless affect what happened during the period. Neither of us made any assumption about “rational expectations” ; expectations, in our models, were strictly exogenous.3 (Keynes made much more fuss over that than I did, but there is the same implication in my model also.) Subject to these data— the given equipment carried over from the past, the production possibilities within the period, the preference schedules, and the given expectations— the actual performance of the economy within the period was supposed to be determined, or determinable. It would be determined as an equilibrium performance, with respect to these data.

There was all this in common between my model and Keynes’; it was enough to make me recognize, as soon as I saw The General Theory, that his model was a relation of mine and, as such, one which I could warmly welcome. There were, however, two differences, on which (as we shall see) much depends. The more obvious difference was that mine was a flexprice model, a perfect competition model, in which all prices were flexible, while in Keynes’ the level of money wages (at least) was exogenously determined. So Keynes’ was a model that was consistent with unemployment, while mine, in his terms, was a full employment model. I shall have much to say about this difference, but I may as well note, at the start, that I do not think it matters much. I did not think, even in 1936, that it mattered much. IS-LM was in fact a translation of Keynes’ nonflexprice model into my terms. It seemed to me already that that could be done; but how it is done requires explanation.

The other difference is more fundamental; it concerns the length of the period. Keynes’ (he said) was a “short-period,” a term with connotations derived from Marshall; we shall not go far wrong if we think of it as a year. Mine was an “ultra-short-period” ; I called it a week. Much more can happen in a year than in a week; Keynes has to allow for quite a lot of things to happen. I wanted to avoid so much happening, so that my (flexprice) markets could reflect propensities (and expectations) as they are at a moment. So it was that I made my markets open only on a Monday; what actually happened during the ensuing week was not to affect them. This was a very artificial device, not (I would think now) much to be recommended. But the point of it was to exclude the things which might happen, and must disturb the markets, during a period of finite length; and this, as we shall see, is a very real trouble in Keynes. (pp. 139-40)

Hicks then explained how the specific idea of the IS-LM model came to him as a result of working on a three-good Walrasian system in which the solution could be described in terms of equilibrium in two markets, the third market necessarily being in equilibrium if the other two were in equilibrium. That’s an interesting historical tidbit, but the point that I want to discuss is what I think is Hicks’s failure to fully understand the significance of his own model, whose importance, regrettably, he consistently underestimated in later work (e.g., in Capital and Growth and in this paper).

The point that I want to focus on is in the second paragraph quoted above where Hicks says “mine [i.e. temporary equilibrium] was a flexprice model, a perfect competition model, in which all prices were flexible, while in Keynes’ the level of money wages (at least) was exogenously determined. So Keynes’ was a model that was consistent with unemployment, while mine, in his terms, was a full employment model.” This, it seems to me, is all wrong, because Hicks, is taking a very naïve and misguided view of what perfect competition and flexible prices mean. Those terms are often mistakenly assumed to meant that if prices are simply allowed to adjust freely, all  markets will clear and all resources will be utilized.

I think that is a total misconception, and the significance of the temporary-equilibrium construct is in helping us understand why an economy can operate sub-optimally with idle resources even when there is perfect competition and markets “clear.” What prevents optimality and allows resources to remain idle despite freely adjustming prices and perfect competition is that the expectations held by agents are not consistent. If expectations are not consistent, the plans based on those expectations are not consistent. If plans are not consistent, then how can one expect resources to be used optimally or even at all? Thus, for Hicks to assert, casually without explicit qualification, that his temporary-equilibrium model was a full-employment model, indicates to me that Hicks was unaware of the deeper significance of his own model.

If we take a full equilibrium as our benchmark, and look at how one of the markets in that full equilibrium clears, we can imagine the equilibrium as the intersection of a supply curve and a demand curve, whose positions in the standard price/quantity space depend on the price expectations of suppliers and of demanders. Different, i.e, inconsistent, price expectations would imply shifts in both the demand and supply curves from those corresponding to full intertemporal equilibrium. Overall, the price expectations consistent with a full intertemporal equilibrium will in some sense maximize total output and employment, so when price expectations are inconsistent with full intertemporal equilibrium, the shifts of the demand and supply curves will be such that they will intersect at points corresponding to less output and less employment than would have been the case in full intertemporal equilibrium. In fact, it is possible to imagine that expectations on the supply side and the demand side are so inconsistent that the point of intersection between the demand and supply curves corresponds to an output (and hence employment) that is way less than it would have been in full intertemporal equilibrium. The problem is not that the price in the market doesn’t allow the market to clear. Rather, given the positions of the demand and supply curves, their point of intersection implies a low output, because inconsistent price expectations are such that potentially advantageous trading opportunities are not being recognized.

So for Hicks to assert that his flexprice temporary-equilibrium model was (in Keynes’s terms) a full-employment model without noting the possibility of a significant contraction of output (and employment) in a perfectly competitive flexprice temporary-equilibrium model when there are significant inconsistencies in expectations suggests strongly that Hicks somehow did not fully comprehend what his own creation was all about. His failure to comprehend his own model also explains why he felt the need to abandon the flexprice temporary-equilibrium model in his later work for a fixprice model.

There is, of course, a lot more to be said about all this, and Hicks’s comments concerning the choice of a length of the period are also of interest, but the clear (or so it seems to me) misunderstanding by Hicks of what is entailed by a flexprice temporary equilibrium is an important point to recognize in evaluating both Hicks’s work and his commentary on that work and its relation to Keynes.

Krugman on Minsky, IS-LM and Temporary Equilibrium

Catching up on my blog reading, I found this one from Paul Krugman from almost two weeks ago defending the IS-LM model against Hyman Minsky’s criticism (channeled by his student Lars Syll) that IS-LM misrepresented the message of Keynes’s General Theory. That is an old debate, and it’s a debate that will never be resolved because IS-LM is a nice way of incorporating monetary effects into the pure income-expenditure model that was the basis of Keynes’s multiplier analysis and his policy prescriptions. On the other hand, the model leaves out much of what most interesting and insightful in the General Theory — precisely the stuff that could not easily be distilled into a simple analytic model.

Here’s Krugman:

Lars Syll approvingly quotes Hyman Minsky denouncing IS-LM analysis as an “obfuscation” of Keynes; Brad DeLong disagrees. As you might guess, so do I.

There are really two questions here. The less important is whether something like IS-LM — a static, equilibrium analysis of output and employment that takes expectations and financial conditions as given — does violence to the spirit of Keynes. Why isn’t this all that important? Because Keynes was a smart guy, not a prophet. The General Theory is interesting and inspiring, but not holy writ.

It’s also a protean work that contains a lot of different ideas, not necessarily consistent with each other. Still, when I read Minsky putting into Keynes’s mouth the claim that

Only a theory that was explicitly cyclical and overtly financial was capable of being useful

I have to wonder whether he really read the book! As I read the General Theory — and I’ve read it carefully — one of Keynes’s central insights was precisely that you wanted to step back from thinking about the business cycle. Previous thinkers had focused all their energy on trying to explain booms and busts; Keynes argued that the real thing that needed explanation was the way the economy seemed to spend prolonged periods in a state of underemployment:

[I]t is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.

So Keynes started with a, yes, equilibrium model of a depressed economy. He then went on to offer thoughts about how changes in animal spirits could alter this equilibrium; but he waited until Chapter 22 (!) to sketch out a story about the business cycle, and made it clear that this was not the centerpiece of his theory. Yes, I know that he later wrote an article claiming that it was all about the instability of expectations, but the book is what changed economics, and that’s not what it says.

This all seems pretty sensible to me. Nevertheless, there is so much in the General Theory — both good and bad – that isn’t reflected in IS-LM, that to reduce the General Theory to IS-LM is a kind of misrepresentation. And to be fair, Hicks himself acknowledged that IS-LM was merely a way of representing one critical difference in the assumptions underlying the Keynesian and the “Classical” analyses of macroeconomic equilibrium.

But I would take issue with the following assertion by Krugman.

The point is that Keynes very much made use of the method of temporary equilibrium — interpreting the state of the economy in the short run as if it were a static equilibrium with a lot of stuff taken provisionally as given — as a way to clarify thought. And the larger point is that he was right to do this.

When people like me use something like IS-LM, we’re not imagining that the IS curve is fixed in position for ever after. It’s a ceteris paribus thing, just like supply and demand. Assuming short-run equilibrium in some things — in this case interest rates and output — doesn’t mean that you’ve forgotten that things change, it’s just a way to clarify your thought. And the truth is that people who try to think in terms of everything being dynamic all at once almost always end up either confused or engaging in a lot of implicit theorizing they don’t even realize they’re doing.

When I think of a temporary equilibrium, the most important – indeed the defining — characteristic of that temporary equilibrium is that expectations of at least some agents have been disappointed. The disappointment of expectations is likely to, but does not strictly require, a revision of disappointed expectations and of the plans conditioned on those expectations. The revision of expectations and plans as a result of expectations being disappointed is what gives rise to a dynamic adjustment process. But that is precisely what is excluded from – or at least not explicitly taken into account by – the IS-LM model. There is nothing in the IS-LM model that provides any direct insight into the process by which expectations are revised as a result of being disappointed. That Keynes could so easily think in terms of a depressed economy being in equilibrium suggests to me that he was missing what I regard as the key insight of the temporary-equilibrium method.

Of course, there are those who argue, perhaps most notably Roger Farmer, that economies have multiple equilibria, each with different levels of output and employment corresponding to different expectational parameters. That seems to me a more Keynesian approach, an approach recognizing that expectations can be self-fulfilling, than the temporary-equilibrium approach in which the focus is on mistaken and conflicting expectations, not their self-fulfillment.

Now to be fair, I have to admit that Hicks, himself, who introduced the temporary-equilibrium approach in Value and Capital (1939) later (1965) suggested in Capital and Growth (p. 65) that both the Keynes in the General Theory and the temporary-equilibrium approach of Value and Capital were “quasi-static.” The analysis of the General Theory “is not the analysis of a process; no means has been provided by which we can pass from one Keynesian period to the next. . . . The Temporary Equilibrium model of Value and Capital, also, is quasi-static in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes.

Despite Hicks’s identification of the temporary-equilibrium method with Keynes’s method in the General Theory, I think that Hicks was overly modest in assessing his own contribution in Value and Capital, failing to appreciate the full significance of the method he had introduced. Which, I suppose, just goes to show that you can’t assume that the person who invents a concept or an idea is necessarily the one who has the best, or most comprehensive, understanding of what the concept means of what its significance is.

Big Ideas in Macroeconomics: A Review

Steve Williamson recently plugged a new book by Kartik Athreya (Big Ideas in Macroeconomics), an economist at the Federal Reserve Bank of Richmond, which tries to explain in relatively non-technical terms what modern macroeconomics is all about. I will acknowledge that my graduate training in macroeconomics predated the rise of modern macro, and I am not fluent in the language of modern macro, though I am trying to fill in the gaps. And this book is a good place to start. I found Athreya’s book a good overview of the field, explaining the fundamental ideas and how they fit together.

Big Ideas in Macroeconomics is a moderately big book, 415 pages, covering a very wide range of topics. It is noteworthy, I think, that despite its size, there is so little overlap between the topics covered in this book, and those covered in more traditional, perhaps old-fashioned, books on macroeconomics. The index contains not a single entry on the price level, inflation, deflation, money, interest, total output, employment or unemployment. Which is not to say that none of those concepts are ever mentioned or discussed, just that they are not treated, as they are in traditional macroeconomics books, as the principal objects of macroeconomic inquiry. The conduct of monetary or fiscal policy to achieve some explicit macroeconomic objective is never discussed. In contrast, there are repeated references to Walrasian equilibrium, the Arrow-Debreu-McKenzie model, the Radner model, Nash-equilibria, Pareto optimality, the first and second Welfare theorems. It’s a new world.

The first two chapters present a fairly detailed description of the idea of Walrasian general equilibrium and its modern incarnation in the canonical Arrow-Debreu-McKenzie (ADM) model.The ADM model describes an economy of utility-maximizing households and profit-maximizing firms engaged in the production and consumption of commodities through time and space. There are markets for commodities dated by time period, specified by location and classified by foreseeable contingent states of the world, so that the same physical commodity corresponds to many separate commodities, each corresponding to different time periods and locations and to contingent states of the world. Prices for such physically identical commodities are not necessarily uniform across times, locations or contingent states.The demand for road salt to de-ice roads depends on whether conditions, which depend on time and location and on states of the world. For each different possible weather contingency, there would be a distinct market for road salt for each location and time period.

The ADM model is solved once for all time periods and all states of the world. Under appropriate conditions, there is one (and possibly more than one) intertemporal equilibrium, all trades being executed in advance, with all deliveries subsequently being carried out, as time an contingencies unfold, in accordance with the terms of the original contracts.

Given the existence of an equilibrium, i.e., a set of prices subject to which all agents are individually optimizing, and all markets are clearing, there are two classical welfare theorems stating that any such equilibrium involves a Pareto-optimal allocation and any Pareto-optimal allocation could be supported by an equilibrium set of prices corresponding to a suitably chosen set of initial endowments. For these optimality results to obtain, it is necessary that markets be complete in the sense that there is a market for each commodity in each time period and contingent state of the world. Without a complete set of markets in this sense, the Pareto-optimality of the Walrasian equilibrium cannot be proved.

Readers may wonder about the process by which an equilibrium price vector would actually be found through some trading process. Athreya invokes the fiction of a Walrasian clearinghouse in which all agents (truthfully) register their notional demands and supplies at alternative price vectors. Based on these responses the clearinghouse is able to determine, by a process of trial and error, the equilibrium price vector. Since the Walrasian clearinghouse presumes that no trading occurs except at an equilibrium price vector, there can be no assurance that an equilibrium price vector would ever be arrived at under an actual trading process in which trading occurs at disequilibrium prices. Moreover, as Clower and Leijonhufvud showed over 40 years ago (“Say’s Principle: What it Means and What it Doesn’t Mean”), trading at disequilibrium prices may cause cumulative contractions of aggregate demand because the total volume of trade at a disequilibrium price will always be less than the volume of trade at an equilibrium price, the volume of trade being constrained by the lesser of quantity supplied and quantity demanded.

In the view of modern macroeconomics, then, Walrasian general equilibrium, as characterized by the ADM model, is the basic and overarching paradigm of macroeconomic analysis. To be sure, modern macroeconomics tries to go beyond the highly restrictive assumptions of the ADM model, but it is not clear whether the concessions made by modern macroeconomics to the real world go very far in enhancing the realism of the basic model.

Chapter 3, contains some interesting reflections on the importance of efficiency (Pareto-optimality) as a policy objective and on the trade-offs between efficiency and equity and between ex-ante and ex-post efficiency. But these topics are on the periphery of macroeconomics, so I will offer no comment here.

In chapter 4, Athreya turns to some common criticisms of modern macroeconomics: that it is too highly aggregated, too wedded to the rationality assumption, too focused on equilibrium steady states, and too highly mathematical. Athreya correctly points out that older macroeconomic models were also highly aggregated, so that if aggregation is a problem it is not unique to modern macroeconomics. That’s a fair point, but skirts some thorny issues. As Athreya acknowledges in chapter 5, an important issue separating certain older macroeconomic traditions (both Keynesian and Austrian among others) is the idea that macroeconomic dysfunction is a manifestation of coordination failure. It is a property – a remarkable property – of Walrasian general equilibrium that it achieves perfect (i.e., Pareto-optimal) coordination of disparate, self-interested, competitive individual agents, fully reconciling their plans in a way that might have been achieved by an omniscient and benevolent central planner. Walrasian general equilibrium fully solves the coordination problem. Insofar as important results of modern macroeconomics depend on the assumption that a real-life economy can be realistically characterized as a Walrasian equilibrium, modern macroeconomics is assuming that coordination failures are irrelevant to macroeconomics. It is only after coordination failures have been excluded from the purview of macroeconomics that it became legitimate (for the sake of mathematical tractability) to deploy representative-agent models in macroeconomics, a coordination failure being tantamount, in the context of a representative agent model, to a form of irrationality on the part of the representative agent. Athreya characterizes choices about the level of aggregation as a trade-off between realism and tractability, but it seems to me that, rather than making a trade-off between realism and tractability, modern macroeconomics has simply made an a priori decision that coordination problems are not a relevant macroeconomic concern.

A similar argument applies to Athreya’s defense of rational expectations and the use of equilibrium in modern macroeconomic models. I would not deny that there are good reasons to adopt rational expectations and full equilibrium in some modeling situations, depending on the problem that theorist is trying to address. The question is whether it can be appropriate to deviate from the assumption of a full rational-expectations equilibrium for the purposes of modeling fluctuations over the course of a business cycle, especially a deep cyclical downturn. In particular, the idea of a Hicksian temporary equilibrium in which agents hold divergent expectations about future prices, but markets clear period by period given those divergent expectations, seems to offer (as in, e.g., Thompson’s “Reformulation of Macroeconomic Theory“) more realism and richer empirical content than modern macromodels of rational expectations.

Athreya offers the following explanation and defense of rational expectations:

[Rational expectations] purports to explain the expectations people actually have about the relevant items in their own futures. It does so by asking that their expectations lead to economy-wide outcomes that do not contradict their views. By imposing the requirement that expectations not be systematically contradicted by outcomes, economists keep an unobservable object from becoming a source of “free parameters” through which we can cheaply claim to have “explained” some phenomenon. In other words, in rational-expectations models, expectations are part of what is solved for, and so they are not left to the discretion of the modeler to impose willy-nilly. In so doing, the assumption of rational expectations protects the public from economists.

This defense of rational expectations plainly belies betrays the methodological arrogance of modern macroeconomics. I am all in favor of solving a model for equilibrium expectations, but solving for equilibrium expectations is certainly not the same as insisting that the only interesting or relevant result of a model is the one generated by the assumption of full equilibrium under rational expectations. (Again see Thompson’s “Reformulation of Macroeconomic Theory” as well as the classic paper by Foley and Sidrauski, and this post by Rajiv Sethi on his blog.) It may be relevant and useful to look at a model and examine its properties in a state in which agents hold inconsistent expectations about future prices; the temporary equilibrium existing at a point in time does not correspond to a steady state. Why is such an equilibrium uninteresting and uninformative about what happens in a business cycle? But evidently modern macroeconomists such as Athreya consider it their duty to ban such models from polite discourse — certainly from the leading economics journals — lest the public be tainted by economists who might otherwise dare to abuse their models by making illicit assumptions about expectations formation and equilibrium concepts.

Chapter 5 is the most important chapter of the book. It is in this chapter that Athreya examines in more detail the kinds of adjustments that modern macroeconomists make in the Walrasian/ADM paradigm to accommodate the incompleteness of markets and the imperfections of expectation formation that limit the empirical relevance of the full ADM model as a macroeconomic paradigm. To do so, Athreya starts by explaining how the Radner model in which a less than the full complement of Arrow-Debreu contingent-laims markets is available. In the Radner model, unlike the ADM model, trading takes place through time for those markets that actually exist, so that the full Walrasian equilibrium exists only if agents are able to form correct expectations about future prices. And even if the full Walrasian equilibrium exists, in the absence of a complete set of Arrow-Debreu markets, the classical welfare theorems may not obtain.

To Athreya, these limitations on the Radner version of the Walrasian model seem manageable. After all, if no one really knows how to improve on the equilibrium of the Radner model, the potential existence of Pareto improvements to the Radner equilibrium is not necessarily that big a deal. Athreya expands on the discussion of the Radner model by introducing the neoclassical growth model in both its deterministic and stochastic versions, all the elements of the dynamic stochastic general equilibrium (DSGE) model that characterizes modern macroeconomics now being in place. Athreya closes out the chapter with additional discussions of the role of further modifications to the basic Walrasian paradigm, particularly search models and overlapping-generations models.

I found the discussion in chapter 5 highly informative and useful, but it doesn’t seem to me that Athreya faces up to the limitations of the Radner model or to the implied disconnect between the Walraisan paradigm and macroeconomic analysis. A full Walrasian equilibrium exists in the Radner model only if all agents correctly anticipate future prices. If they don’t correctly anticipate future prices, then we are in the world of Hicksian temporary equilibrium. But in that world, the kind of coordination failures that Athreya so casually dismisses seem all too likely to occur. In a world of temporary equilibrium, there is no guarantee that intertemporal budget constraints will be effective, because those budget constraint reflect expected, not actual, future prices, and, in temporary equilibrium, expected prices are not the same for all transactors. Budget constraints are not binding in a world in which trading takes place through time based on possibly incorrect expectations of future prices. Not only does this mean that all the standard equilibrium and optimality conditions of Walrasian theory are violated, but that defaults on IOUs and, thus, financial-market breakdowns, are entirely possible.

In a key passage in chapter 5, Athreya dismisses coordination-failure explanations, invidiously characterized as Keynesian, for inefficient declines in output and employment. While acknowledging that such fluctuations could, in theory, be caused by “self-fulfilling pessimism or fear,” Athreya invokes the benchmark Radner trading arrangement of the ADM model. “In the Radner economy, Athreya writes, “households and firms have correct expectations for the spot market prices one period hence.” The justification for that expectational assumption, which seems indistinguishable from the assumption of a full, rational-expectations equilibrium, is left unstated. Athreya continues:

Granting that they indeed have such expectations, we can now ask about the extent to which, in a modern economy, we can have outcomes that are extremely sensitive to them. In particular, is it the case that under fairly plausible conditions, “optimism” and “pessimism” can be self-fulfilling in ways that make everyone (or nearly everyone) better off in the former than the latter?

Athreya argues that this is possible only if the aggregate production function of the economy is characterized by increasing returns to scale, so that productivity increases as output rises.

[W]hat I have in mind is that the structure of the economy must be such that when, for example, all households suddenly defer consumption spending (and save instead), interest rates do not adjust rapidly to forestall such a fall in spending by encouraging firms to invest.

Notice that Athreya makes no distinction between a reduction in consumption in which people shift into long-term real or financial assets and one in which people shift into holding cash. The two cases are hardly identical, but Athreya has nothing to say about the demand for money and its role in macroeconomics.

If they did, under what I will later describe as a “standard” production side for the economy, wages would, barring any countervailing forces, promptly rise (as the capital stock rises and makes workers more productive). In turn, output would not fall in response to pessimism.

What Athreya is saying is that if we assume that there is a reduction in the time preference of households, causing them to defer present consumption in order to increase their future consumption, the shift in time preference should be reflected in a rise in asset prices, causing an increase in the production of durable assets, and leading to an increase in wages insofar as the increase in the stock of fixed capital implies an increase in the marginal product of labor. Thus, if all the consequences of increased thrift are foreseen at the moment that current demand for output falls, there would be a smooth transition from the previous steady state corresponding to a high rate of time preference to the new steady state corresponding to a low rate of time preference.

Fine. If you assume that the economy always remains in full equilibrium, even in the transition from one steady state to another, because everyone has rational expectations, you will avoid a lot of unpleasantness. But what if entrepreneurial expectations do not change instantaneously, and the reduction in current demand for output corresponding to reduced spending on consumption causes entrepreneurs to reduce, not increase, their demand for capital equipment? If, after the shift in time preference, total spending actually falls, there may be a chain of disappointments in expectations, and a series of defaults on IOUs, culminating in a financial crisis. Pessimism may indeed be self-fulfilling. But Athreya has a just-so story to tell, and he seems satisfied that there is no other story to be told. Others may not be so easily satisfied, especially when his just-so story depends on a) the rational expectations assumption that many smart people have a hard time accepting as even remotely plausible, and b) the assumption that no trading takes place at disequilibrium prices. Athreya continues:

Thus, at least within the context of models in which households and firms are not routinely incorrect about the future, multiple self-fulfilling outcomes require particular features of the production side of the economy to prevail.

Actually what Athreya should have said is: “within the context of models in which households and firms always predict future prices correctly.”

In chapter 6, Athreya discusses how modern macroeconomics can and has contributed to the understanding of the financial crisis of 2007-08 and the subsequent downturn and anemic recovery. There is a lot of very useful information and discussion of various issues, especially in connection with banking and financial markets. But further comment at this point would be largely repetitive.

Anyway, despite my obvious and strong disagreements with much of what I read, I learned a lot from Athreya’s well-written and stimulating book, and I actually enjoyed reading it.

Hicks on Keynes and the Theory of the Demand for Money

One of my favorite papers is one published by J. R. Hicks in 1935 “A Suggestion for Simplifying the Demand for Theory of Money.” The aim of that paper was to explain how to reconcile the concept of a demand for money into the theory of rational choice. Although Marshall had attempted to do so in his writings, his formulations of the idea were not fully satisfactory, and other Cambridge economists, notably Pigou, Lavington, Robertson, and Keynes, struggled to express the idea in a more satisfactory way than Marshall had done.

In Hicks’s introductory essay to volume II of his Collected Essays on Economic Theory in which his 1935 essay appears, Hicks recounts that Keynes told him after reading his essay that the essay was similar to the theory of liquidity preference, on which Keynes was then working.

To anyone who comes over from the theory of value to the theory of money, there are a number of things which are rather startling. Chief of these is the preoccupation of monetary theorists with a certain equation, which states that the price of goods multiplied by the quantity of goods equals the amount of money which is spent on them. The equation crops up again and again, and it has all sorts of ingenious little arithmetical tricks performed on it. Sometimes it comes out as MV = PT . . .

Now we, of the theory of value, are not unfamiliar with this equation, and there was a time when we used to attach as much importance to it as monetary theorists seem to do still. This was in the middle of the last century, when we used to talk about value being “a ratio between demand and supply.” Even now, we accept the equation, and work it, more or less implicitly, into our systems. But we are rather inclined to take it for granted, since it is rather tautologous, and since we have found that another equation, not alternative to the quantity equation, but complementary with it, is much more significant. This is the equation which states that the relative value of two commodities depends upon their relative marginal utility.

Now to an ingénue, who comes over to monetary theory, it is extremely trying to be deprived of this sheet-anchor. It was marginal utility that really made sense of the theory of value; and to come to a branch of economics which does without marginal utility altogether! No wonder there are such difficulties and such differences! What is wanted is a “marginal revolution!”

That is my suggestion. But I know that it will meet with apparently crushing objections. I shall be told that the suggestion has been tried out before. It was tried by Wicksell, and though it led to interesting results, it did not lead to a marginal utility theory of money. It was tried by Mises, and led to the conclusion that money is a ghost of gold – because, so it appeared, money as such has no marginal utility. The suggestion has a history, and its history is not encouraging.

This would be enough to frighten one off, were it not for two things. Both in the theory of value and in the theory of money there have been developments in the twenty of thirty years since Wicksell and Mises wrote. And these developments have considerably reduced the barriers that blocked their way.

In the theory of value, the work of Pareto, Wicksteed, and their successors, has broadened and deepened our whole conception of marginal utility. We now realize that the marginal utility analysis is nothing else than a general theory of choice, which is applicable whenever the choice is between alternatives that are capable of quantitative expression. Now money is obviously capable of quantitative expression, and therefore the objection that money has no marginal utility must be wrong. People do choose to have money rather than other things, and therefore, in the relevant sense, money must have a marginal utility.

But merely to call their marginal utility X, and then proceed to draw curves, would not be very helpful. Fortunately the developments in monetary theory to which I alluded come to our rescue.

Mr. Keynes’s Treatise, so far as I have been able to discover, contains at least three theories of money. One of them is the Savings and Investment theory, which . . . seems to me only a quantity theory much glorified. One of them is a Wicksellian natural rate theory. But the third is altogether more interesting. It emerges when Mr. Keynes begins to talk about the price-level of investment goods; when he shows that this price-level depends upon the relative preference of the investor – to hold bank-deposits or to hold securities. Here at last we have something which to a value theorist looks sensible and interesting! Here at last we have a choice at the margin! And Mr. Keynes goes on to put substance into our X, by his doctrine that the relative preference depends upon the “bearishness” or “bullishness” of the public, upon their relative desire for liquidity or profit.

My suggestion may, therefore, be reformulated. It seems to me that this third theory of Mr. Keynes really contains the most important of his theoretical contribution; that here, at last, we have something which, on the analogy (the approximate analogy) of value theory, does begin to offer a chance of making the whole thing easily intelligible; that it si form this point, not from velocity of circulation, or Saving and Investment, that we ought to start in constructing the theory of money. But in saying this I am being more Keynesian than Keynes [note to Blue Aurora this was written in 1934 and published in 1935].

The point of this extended quotation, in case it is not obvious to the reader, is that Hicks is here crediting Keynes in his Treatise on Money with a crucial conceptual advance in formulating a theory of the demand for money consistent with the marginalist theory of value. Hicks himself recognized that Keynes in the General Theory worked out a more comprehensive version of the theory than that which he presented in his essay, even though they were not entirely the same. So there was no excuse for Friedman to present a theory of the demand for money which he described “as part of capital or wealth theory, concerned with the composition of the balance sheet or portfolio of assets,” without crediting Keynes for that theory, just because he rejected the idea of absolute liquidity preference.

Here is how Hicks summed up the relationship in his introductory essay referred to above.

Keynes’s Liquidity theory was so near to mine, and was put over in so much more effective a way than I could hope to achieve, that it seemed pointless, at first, to emphasize differences. Sometimes, indeed, he put his in such a way that there was hardly any difference. But, as time went on, what came to be regarded in many quarters, as Keynesian theory was something much more mechanical than he had probably intended. It was certainly more mechanical than I had intended. So in the end I had ot go back to “Simplifying,” and to insist that its message was a Declaration of Independence, not only from the “free market” school from which I was expressly liberating myself, but also from what came to pass as Keynesian economics.

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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