A good rundown of the state of macroeconomics so far. Sourced from Alex Leijonhufvud’s CEPR Policy Insight No 53 “Nature of an economy”.
- Keynes proposed that flexible money wages would not lead to full employment. In fact, very flexible wages would produce financial catastrophe (The General Theory).
- IS-LM model showed that unemployment was due to sticky wages, i.e. downward inflexibility of money (nominal) wages.
- Then the problem came when the Phillips curve was pasted onto the IS-LM model. How can you have both rising inflation and rising unemployment? So, came the Quantity Theory of Money, which Friedman used to attack Keynesian economics. It gave logical reasoning to the conundrum faced when Phillips curve was combined with IS-LM model. The concept of ‘natural rate of unemployment’ came up.
- The Monetarists believed that flexible wages were sufficient to guarantee that the economy would converge to the natural rate of unemployment. Keynesians argued that if desired saving did not equal investment, then flexibility of wages would not make it converge to the natural rate of unemployment. Monetarists ignored S-I problem and also the role of credit markets in furthering or hindering the coordination of saving and investment. Monetarists were more interested in stabilizing price level.
- Robert Lucas argued that the instability of the Phillips curve and the Fisher premium could be explained while obeying the dictates of optimal choice theory (rational expectations). He believed that only “unanticipated” changes in the growth rate of the stock of money would cause unemployment to deviate from its natural rate. Friedman did not share this position. S-I problem was forgotten.
- Edward Prescott came up with Real Business Cycle theory, which showed variations in output and employment were optimal responses to exogenous (i.e. unexplained) variations in productivity growth. It became the main vehicle for the development of dynamic stochastic general equilibrium (GSGE) theory.
- New Classicals and New Keynesians converged on 'the ‘New Neoclassical Synthesis”, which incorporated some of the “frictions” of the Keynesians while the latter adopted the DSGE framework developed by the former.
- However, though advances were made in understanding the advances of markets, little progress was made in understand how an economy works. The Old Synthesis was wrong back then and the New Synthesis is also wrong today. It does not recognize the instabilities lurking in the economic system, argues Leijonhufvud. The behavior of individual agents and of the economy as a whole differ in a deep recession or high inflation from normal times.
- Leijonhufvud maintains that economists did not pay attention to their ontological presuppositions, i.e. they failed to grasp the nature of the reality (the object of study) and to adapt one’s methods of inquiry to it. Economists have imposed preconceived methods on economic reality in such a manner as to distort their understanding of it. They start from optimal choice and fashion an image of reality to fit it.
- A “closed” model (and optimal choice) in economics essentially implies that agents are automatons lacking free will and a choice. So, whatever happens, there is always equilibrium. It assumes that economic agents possessed the knowledge of the future required for the calculation of intertemporal optima. So, the present beliefs about the future induce actions that create the future (what George Soros calls “reflexivity”). Rational expectations is a special case of reflexivity. It makes the economy a closed system. Agents are supposed to possess (probabilistic) knowledge of an objective reality—a reality that they have been able to learn.
- The mathematical representation of the system closed by assuming rational expectations made it possible to prove a variety of propositions—such as Ricardian equivalence and other policy ineffectiveness theorems—that ran counter to the received wisdom of the time.
- The heterogeneity of expectations associated with the lack of synchronicity means that there will be a range of indeterminancy within which the market clearing price may temporarily settle.
- In the “open system” many prices will be indeterminate (albeit within limits), economic behavior has to be understood as fundamentally adaptive, behavioral time horizons are variable, and the sets of markets and relative prices may change endogenously.
- In economics crises, budget constraints are not “soft” but they are broken. In deflation or depression crises, the budget constraint violations are concentrated in the private sector. In high inflation or hyperinflation crises, it is the sovereign that violates equal-value-in-exchange. Standard general equilibrium theory, even in its modern dynamic stochastic variants, is not particularly helpful when budget constraints are violated.
- The image of a capitalist economy as a stable general equilibrium system somewhat hampered in its functioning by “frictions” is an inadequate guide to the realities we have to cop with. Instability is a part of the capitalist system.
- Government resources have to be used to bring the private sector out of a deep recession or depression. Resources have to be transferred from the private to the public sector to bring high inflation under control. It gets further troublesome if the finances of one sector are already strained when the other gets into trouble.
So, two main points: (i) Think of an economy as an “open system” in the ontological sense of Tony Lawson; and (ii) The economy is not globally stable but harbors instabilities.