Thursday, July 10, 2014

Some Post-Keynesian Suggestions for Brad DeLong

G.L.S. Shackle
Commenting on a Lars P. Syll post, Brad DeLong  grants that there may be something profound in the Post-Keynesian view that neither market participants nor economists “know the data-generating process.” “OK,” Professor DeLong allows, “suppose we decide to give up” this assumption, “what do we then do - what kind of economic arguments do we make – once we have made those decisions?"
I have a few suggestions, but first let’s be more specific about the Post-Keynesian complaint.  There is no “data-generating process” if, by this, Brad means a stationary, ergodic process (See P. Davidson, John Hicks, and even K. Arrow). (For reference, here’s Wikipedia’s definition of “ergodic”: “A stochastic system is called ergodic if it tends in probability to a limiting form that is independent of the initial conditions”).
More generally, the application of the probability calculus to the behavior of market participants isn’t wholly satisfying (See J.M. Keynes [weight of an argument], G.L.S Shackle [conceptual deficiencies of the probability calculus], and Taleb [Black Swans and Fat Tails]).
If one accepts these skeptical propositions (at least provisionally), then the following analytical suggestions seem worthy of consideration.  (I offer these without explanation, hoping the connections aren’t too hard to figure out):
1. “History” should take its place alongside “Equilibrium” in economic modeling and argument;
2. Hysteresis isn’t an “add-on."  Many (maybe even most) real-world outcomes are path dependent;
3. Disequilibrium is the normal state of the “macroeconomy,” the ex post accounting world rarely corresponds to the ex ante expectations that produced it, and you can't ignore "out-of-equilibrium behavior";
4. Agent-based modeling (Santa Fe style) may prove useful in thinking about interactions among agents with different “views of the world,” the bulls and the bears, etc.;
5. Leave Tobin’s “Liquidity as Behavior Towards Risk” aside in favor of G.L.S. Shackle’s analysis of the elemental need that’s satisfied by money in a contemporary economy the future states of which can’t be known today; and

6. Coordination problems are important (if there are no rational expectations to replace the missing futures markets of Arrow and Debreu).

Tuesday, July 8, 2014

Kenneth Arrow on Some "Big Ideas in Macroeconomics"

What’s the significance of Arrow & Debreu’s canonical article, “Existence of an Equilibrium for a Competitive Economy” (1951)?  According to one school of thought, which is well summarized by Kartik Athreya in Big Ideas in Macroeconomics (2013), Arrow-Debreu (and McKenzie) is the “bedrock” on which mainstream macroeconomics has been constructed.  The implicit premise of this body of work, which, on Athreya’s view, includes the best of both New Classical and New Keynesian Economics, is that real-world economies can be usefully modeled within a general equilibrium framework in which all markets clear.

According to a different school of thought, however, Arrow-Debreu is more profitably understood as a compendium of the stringent conditions that must be satisfied if, as Arrow’s collaborator, Frank Hahn put it, there are to be no “Keynesian problems.”  Although this latter scheme of thought seems to have petered out (Hahn isn’t even mentioned in Athreya’s book), it’s nevertheless an avenue worth exploring.

Kenneth Arrow, himself, has been asked on several occasions about the scheme of thought described in Athreya’s book.  In 1995, in an interview conducted at the Federal Reserve Bank of Minnesota, Arrow was asked whether he was surprised by the advances made by New Classical economists who were “greatly influenced by your [i.e., Arrow’s] work in the 1950s in general equilibrium.”  Arrow replied,

“The vision I had that wasn't articulated in my articles exactly was that the macroeconomy was the disequilibrium phenomenon. The idea that we could interpret economic fluctuations as an equilibrium phenomenon was something that did not cross my mind. And I'm still not sure that the disequilibrium interpretation isn't more appropriate, although much more has been gotten out of this equilibrium theory than I would have ever dreamt.”

More than a decade later, in an interview published in MPRA (2005), Arrow was asked about a forthcoming article in the Journal of Political Economy, "New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis," by Harold Cole and Lee Ohanian, which argues that large fluctuations, like the Great Depression, may be the result of poor policy in a general equilibrium framework.  Arrow’s response,

“Do you know their explanation for depression? That the total factor productivity in 1932 was 24% lower, so they say, than it was in 1929. That's what explains the depression, as they see it. In their model, that drop in productivity is exogenous. In my book that's not an explanation.”

Ohanian applied the same general equilibrium model to explain the Great Recession in the U.S., though in this case the culprit isn’t a decline in total productivity, but a decline in hours worked, which Ohanian attributes to a sudden increase in the marginal value of leisure relative to the marginal product of labor, leading to a voluntary reduction in hours worked.  Perhaps Arrow would now find this “equilibrium” approach more congenial, but in 1995, he said,

“I do think the interpretation of unemployment specifically is not well represented in the equilibrium models. I don't believe that unemployment is all voluntary, by anticipation of future wage movements or this sort of thing. I know you can modify the models by taking into account the indivisibilities, but I don't really think that people are voluntarily unemployed. When a job is offered, not so much today but say a few years ago, you would have had many applicants for it--people who do not seem to be conspicuously differently qualified than those who are now working.”

Of course Arrow doesn’t get the last word on whether “Minnesota macro” rests comfortably on the foundations of Arrow-Debreu.  But readers of Athreya’s Big Ideas in Macroeconomics and Stephen Williamson’s blog, where Big Ideas was recommended, should be aware that some very good economists have drawn quite different lessons from Arrow & Debreu’s ingenious conception of general equilibrium.

Saturday, May 17, 2014

One Thing Keynes Would Have Said to Lucas and Sargent

In 1979, Robert Lucas and Thomas Sargent published a brief manifesto entitled "After Keynesian Macroeconomics."  In the article, they mock the General Theory's` mere "'talk' about economic activity," and look forward to a scientific economics built around mathematical models that are clear, logically consistent, and testable by means of econometric techniques. 

KEYNES: (strolls in) The kind of lucidity you’re looking for can be found in physics . . .

LUCAS: Yes, precisely.

KEYNES: It can also be found in ancient myth.

SARGENT: Whatever do you mean?

KEYNES: Do you know the legendary story of Septuagint?

SARGENT: Never heard of it.

KEYNES: Let me tell you the story then. 

SARGENT: Yes, please.

KEYNES: Very good. King Ptolemy gathered seventy scholars together and gave each one an ancient Hebrew text. He placed them in separate rooms and told them, one-at-a-time, to translate the Hebrew text into Greek. And, lo and behold, they emerged with seventy identical translations. 

LUCAS: I don’t get it.

KEYNES: Well, let me put it this way. Let's suppose we put seventy econometricians into separate rooms, each one with the same model and the same data, and each one of these econometricians having “a different economist perched on his a priori.”  Would we expect the same miracle of consistency? 

Friday, March 28, 2014

An imagined Q&A between the Mayor of Seattle and a local reporter about inequality in Seattle -

Reporter:     Mayor Murray, you've established an
                    Inequality Committee to consider a 
                    $15/hour minimum wage in Seattle . . . 

Mayor:        Yes, that's right.  We’re determined to reduce the excessive inequalities of wealth and income in Seattle.

Reporter:     Well, if you’re really serious about reducing inequality, then why is the Seattle City Employees’ Retirement System planning to triple its investment in Private Equity?

Mayor:        Private Equity?  You mean the sort of thing Mitt Romney was involved in?

Reporter:     Yes, Private Equity is the province of the very wealthy, and Private Equity investors enjoy one of the most unjust loopholes in the Federal tax code.

Mayor:        Which loophole is that?

Reporter:     It's the so-called "carried interest" loophole that allows Private Equity investors to pay lower tax rates than most Seattle workers pay.  (See here and here).

Mayor:       That is unfair!  But the City of Seattle can't do anything about the Federal tax code.

Reporter:    Well, not directly, but Private Equity firms hire lobbyists to preserve this tax break, and Seattle invests money with these firms. (See here).

Mayor:        OK, I take your point.  But the Seattle Retirement System must act prudently, not politically, when it invests.

Reporter:    Yes, of course, but did you know that the Seattle Retirement System's largest investment in Private Equity, a $20 million bet on a Private Equity firm located in the Cayman Islands, is now worthless? (See here and here).

Mayor:       All investors make mistakes.

Reporter:    Granted, but according to the Retirement System’s own website (here), Seattle's Private Equity investments have underperformed their benchmark by 7.5%/year over the last five years, and by 1.5%/year since April 2007.  And these figures don't even include the high fees charged by Private Equity firms.

 Mayor:       (Sigh) That's depressing.  Have you talked the Retirement System's private financial advisors about this?

Reporter:    Oh, they love Private Equity.  But then they get much higher fees when Seattle invests in actively managed funds like Private Equity.

Mayor:        So, the upshot is that, by getting out of Private Equity, Seattle can make better investments and strike a blow against the unjust tax loopholes that benefit the very rich.

Reporter:     Well, many economists, including several Nobel Prize winners, think so. (See here).

Mayor:        Perhaps I should talk with Councilmember Licata; he's the Chair of the Seattle City Employees’ Retirement Board.

Reporter:    You’ve both said you want to address

Sunday, March 16, 2014

The Wonderland of Long Ago, Before Macroeconomics Was Invented

In reviewing a paper that revolves around a New-Keynesian DSGE (Dynamic Stochastic General Equilibrium) model, Axel Leijonhufvud reminisces, “It makes me feel transported into a Wonderland of long ago – to a time before macroeconomics was invented” (I mentioned this passage in my last post). But, Leijonhufvud quickly concedes, “One has to recognize, of course, that DSGE practitioners of a New Classical persuasion feel that it would have been altogether better if macroeconomics had not been invented” (emphasis added).
         These provocative observations are worth exploring. Let’s begin with Axel’s conception of economic theory before “macroeconomics was invented.”  This is the “Wonderland” of pre-Keynesian economics where supply and demand are brought into equilibrium by the price system, which, in its most imaginative incarnation, assumes the form of a centralized auctioneer who assists in bringing the conditional intentions of all market participants into harmony before trading begins.
When brought to bear on the unemployment problems of the 1920s and 1930s, the orthodoxy, stripped to essentials, said that if workers are unemployed, it’s because wages are too high. Firms won’t hire additional labor at the going wage if the marginal worker’s value added is less than the prevailing wage. This view became “pre-Keynesian” after Keynes explained why lower wages wouldn’t restore full employment (at least not without a great deal of unnecessary suffering). Keynes granted that lower wages would increase employment, provided everything else remains constant. But it doesn’t. If, as the orthodoxy holds, prices equal marginal costs, and if marginal costs consist predominantly of wages, then falling wages must lead to falling prices, leaving real wages more or less unchanged (i.e., not much help on the cost side of the business ledger). In addition to this unavailing dynamic, there’s also the problem that if total wage payments fall, then sales of wage goods will almost certainly fall too (i.e., no help on the revenue side of the business ledger).
At first glance, it looks as if Keynes is offering a GE critique of a Partial Equilibrium analysis, drawing attention to the fact that falling wages in the labor market will spill over into the goods market where both prices, and revenue from the sale of wage goods, will decline hand-in-hand with the reduction in wage rates and in total wage income. These self-defeating effects of wage cuts could be avoided if every agent’s plans were brought into harmony before trading began. Indeed, compared to the circumstances of massive unemployment, real wages might well be higher if plans were brought into harmony before “the market opened.”
Although Keynes’s assumed the interconnectedness of markets, he was not, of course, a Walrasian. In fact, both the Treatise and the General Theory can profitably be read as inquiries into the nature of economies in which the plans of market participants are not pre-reconciled before decisions are taken. In the General Theory, the equilibrium level of employment doesn’t represent a coherent fitting together of plans, nor is the equilibrium reached by a process of t√Ętonnement or re-contracting. Rather, it’s the total employment chosen by profit-maximizing firms given their estimated costs and expected sales revenue. And, of course, there’s nothing in this arrangement that assures resources will be fully employed.

We’re now in a better position to appreciate Leijonhufvud’s complaint about DSGE models. They conceal from view the coordination problems that plague actual economies, where the plans of households and firms are not pre-reconciled before decisions are made. In most of these models, there’s no way in which a reduction in spending can simply become a reduction in income, no possibility that a rush of deleveraging will become self-reinforcing, in fact, there are no troublesome positive feedback loops at all. To conclude with Leijonhufvud’s own words, “Representative agent constructions that do not admit fallacies of composition [e.g., the Paradox of Thrift] thereby eliminate from the models the major sources of instability in the economy.”