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.”

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