Their Way Won't Do

(Today was the last day of classes here. The final slide for my macro course was an abridged version of this Brecht poem, which captures the discomfort any reasonable person ought to feel when they first study economics. The students could relate.)


Years Ago When I

Years ago when I was studying the ways of the Chicago Wheat Exchange
I suddenly grasped how they managed the whole world's wheat there
And yet I did not grasp it either and lowered the book
I knew at once: you've run
Into bad trouble.

There was no feeling of enmity in me and it was not the injustice
Frightened me, only the thought that
Their way of going about it won't do
Filled me completely.

These people, I saw, lived by the harm
Which they did, not by the good.
This was a situation, I saw, that could only be maintained
By crime because too bad for most people.
In this way every
Achievement of reason, invention or discovery
Must lead only to still greater wretchedness.

Such and suchlike I thought at the moment
Far from anger or lamenting, as I lowered the book
With its description of the Chicago wheat market and exchange.

Much trouble and tribulation
Awaited me.

Only Ever Equilibrium?

Roger Farmer has a somewhat puzzling guest post up at Noah Smith's place, arguing that economics is right to limit discussion to equilibrium:

An economic equilibrium, in the sense of Nash, is a situation where a group of decision makers takes a sequence of actions that is best, (in a well defined sense), on the assumption that every other decision maker in the group is acting in a similar fashion. In the context of a competitive economy with a large number of players, Nash equilibrium collapses to the notion of perfect competition.  The genius of the rational expectations revolution, largely engineered by Bob Lucas, was to apply that concept to macroeconomics by successfully persuading the profession to base our economic models on Chapter 7 of Debreu's Theory of Value... In Debreu's vision, a commodity is indexed by geographical location, by date and by the state of nature.  Once one applies Debreu's vision of general equilibrium theory to macroeconomics, disequilibrium becomes a misleading and irrelevant distraction. 

The use of equilibrium theory in economics has received a bad name for two reasons. 

First, many equilibrium environments are ones where the two welfare theorems of competitive equilibrium theory are true, or at least approximately true. That makes it difficult to think of them as realistic models of a depression, or of a financial collapse... Second, those macroeconomic models that have been studied most intensively, classical and new-Keynesian models, are ones where there is a unique equilibrium. Equilibrium, in this sense, is a mapping from a narrowly defined set of fundamentals to an outcome, where  an outcome is an observed temporal sequence of unemployment rates, prices, interest rates etc. Models with a unique equilibrium do not leave room for non-fundamental variables to influence outcomes... 

Multiple equilibrium models do not share these shortcomings... [But] a model with multiple equilibria is an incomplete model. It must be closed by adding an equation that explains the behavior of an agent when placed in an indeterminate environment. In my own work I have argued that this equation is a new fundamental that I call a belief function.

(Personally, I might just call it a convention.)

Some recent authors have argued that rational expectations must be rejected and replaced by a rule that describes how agents use the past to forecast the future. That approach has similarities to the use of a belief function to determine outcomes, and when added to a multiple equilibrium model of the kind I favor, it will play the same role as the belief function. The important difference of multiple equilibrium models, from the conventional approach to equilibrium theory, is that the belief function can coexist with the assumption of rational expectations. Agents using a rule of this kind, will not find that their predictions are refuted by observation. ...

So his point here is that in a model with multiple equilibria, there is no fundamental reason why the economy should occupy one rather than another. You need to specify agents' expectations independently, and once you do, whatever outcome they expect, they'll be correct. This allows for an economy to experience involuntary unemployment, for example, as expectations of high or low income lead to increased or curtailed expenditure, which results in expected income, whatever it was, being realized. This is the logic of the Samuelson Cross we teach in introductory macro. But it's not, says Farmer, a disequilibrium in any meaningful way:

If by disequilibrium, I am permitted to mean that the economy may deviate for a long time, perhaps permanently, from a social optimum; then I have no trouble with championing the cause. But that would be an abuse of the the term 'disequilibrium'. If one takes the more normal use of disequilibrium to mean agents trading at non-Walrasian prices, ... I do not think we should revisit that agenda. Just as in classical and new-Keynesian models where there is a unique equilibrium, the concept of disequilibrium in multiple equilibrium models is an irrelevant distraction.

I quote this at such length because it's interesting. But also because, to me at least, it's rather strange. There's nothing wrong with the multiple equilibrium approach he's describing here, which seems like a useful way of thinking about a number of important questions. But to rule out a priori any story in which people's expectations are not fulfilled rules out a lot of other useful ways about thinking about important questions.

At INET in Berlin, the great Axel Leijonhufvud gave a talk where he described the defining feature of a crisis as the existence of inconsistent contractual commitments, so that some of them would have to be voided or violated.

What is the nature of our predicament? The web of contracts has developed serious inconsistencies. All the promises cannot possibly be fulfilled. Insisting that they should be fulfilled will cause a collapse of very large portions of the web.

But Farmer is telling us that economists not only don't need to, but positively should not, attempt to understand crises in this sense. It's an "irrelevant distraction" to consider the case where people entered into contracts with inconsistent expectations, which will not all be capable of being fulfilled. Farmer can hardly be unfamiliar with these ideas; after all he edited Leijonhufvud's festschrift volume. So why is he being so dogmatic here?

I had an interesting conversation with Rajiv Sethi after Leijonhufvud's talk; he said he thought that the inability to consider cases where plans were not realized was a fundamental theoretical shortcoming of mainstream macro models. I don't disagree.

The thing about the equilibrium approach, as Farmer presents it, isn't just that it rules out the possibility of people being systematically wrong; it rules out the possibility that they disagree. This strikes me as a strong and importantly empirically false proposition. (Keynes suggested that the effectiveness of monetary policy depends on the existence of both optimists and pessimists in financial markets.) In Farmer's multiple equilibrium models, whatever outcome is set by convention, that's the outcome expected by everyone. This is certainly reasonable in some cases, like the multiple equilibria of driving on the left or the right side of the road. Indeed, I suspect that the fact that people are irrationally confident in these kinds of conventions, and expect them to hold even more consistently than they do, is one of the main things that stabilizes these kind of equilibria. But not everything in economics looks like that.

Here's Figure 1 from my Fisher dynamics paper with Arjun Jayadev:

See those upward slopes way over on the left? Between 1929 and 1933, household debt relative to GDP rose by abut 40 percent, and nonfinancial business debt relative to GDP nearly doubled. This is not, of course, because families and businesses were borrowing more in the Depression; on the contrary, they were paying down debt as fast as they could. But in the classic debt-deflation story, falling prices and output meant that incomes were falling even fast than debt, so leverage actually increased.

Roger Farmer, if I'm understanding him correctly, is saying that we must see this increase in debt-income ratios as an equilibrium phenomenon. He is saying that households and businesses taking out loans in 1928 must have known that their incomes were going to fall by half over the next five years, while their debt payments would stay unchanged, and chose to borrow anyway. He is saying not just that he believes that, but that as economists we should not consider any other view; we can rule out on methodological grounds the  possibility that the economic collapse of the early 1930s caught people by surprise. To Irving Fisher, to Keynes, to almost anyone, to me, the rise in debt ratios in the early 1930s looks like a pure disequilibrium phenomenon; people were trading at false prices, signing nominal contracts whose real terms would end up being quite different from what they expected. It's one of the most important stories in macroeconomics, but Farmer is saying that we should forbid ourselves from telling it. I don't get it.

What am I missing here?

New Post at Rortybomb

A week ago, Mike Konczal asked me to guest blog at Rortybomb. I've finally managed to post something, a critical look at arguments that low interest rates in the 2000s are the underlying cause of the Great Recession. Go read, and comment, there.

The Case of Keen

(Warning: To anyone reading this who's not immersed in the debates of the econo blogosphere, this post will fully live up the blog's subtitle.)

One of the big things this past week was Krugman's criticism of Steve Keen. This was a Big Deal, since it is, sadly, rare for someone of Krugman's stature to engage with anyone in the heterodox world. Unfortunately it wasn't a productive exchange; no real information was exchanged, and neither side, IMveryHO, covered themselves in glory. For anyone interested in what's wrong with Krugman's side, there's a good discussion in the comments to this Nick Rowe post. Here I am going to focus on Keen.

Keen's most recent paper is here; it gives the clearest statement of his view that I've seen. As I see it, there are two parts to it. First, he argues that a tradition running from Minsky back to Keynes and Schumpeter (and, I would add, Wicksell and on back to the "caps" in 17th century Sweden) sees money as endogenously created by the banking system, rather than exogenously set by central banks (or, earlier, by the supply of gold). This means that banks can lend to borrowers without a prior decision by anyone to save, which in turn means that changes in the terms on which banks extend credit are an important source of fluctuations in aggregate demand that drive movements in output and prices. With all this, I am in perfect agreement.

But then he tries to formalize these ideas. And about the best thing you can say about his formalization is that it uses terms in such an idiosyncratic way that communication is all but impossible. I know I'm not the only one who's found Keen's stuff a bit like the novel Untitled in Martin Amis' The Information, which literally cannot be read. But let's make an attempt. Here are what seem to be the two key elements.

Keen repeatedly says that "aggregate demand is income plus change in debt." There are many variations on this through his writing, he evidently regards it as a central contribution. But what does it mean? To a non-economist, it appears to be a challenge to another, presumably orthodox, view that aggregate demand is equal to income. But if you are an economist you know that there is no such view, whether neoclassical, Keynesian or radical.

What economist do believe, across the spectrum, is that total expenditure = total output = total income, or Y = Z = C + I + G + X - M. Given the way our national accounts are set up, this is an identity. The question, as always, is which way causality runs. The term "aggregate demand" is shorthand for the argument that causality runs from aggregate expenditure to aggregate income, whereas pre-Keynesian orthodoxy held that causality ran strictly from income to expenditure. (It's worth noting that in this debate Krugman is solidly with Keen -- and me -- on the Keynesian side.) But there isn't any separate variable called "aggregate demand"; AD is just another name for aggregate expenditure insofar as it determines output. Nobody ever says that AD is equal to income; what they typically say is that AD is a function of income, along with other variables such as interest rates, wealth, and changes in sentiment. (People do say that income is equal to AD, but that is a very different claim, and it's true by definition.)

I can imagine various more or less sensible things Keen might have meant by the statement, but it feels kind of silly to speculate. As written it makes no sense at all.

The second formalism is Keen's equation, which he gives the jawbreaker of a name "the Walras-Schumpeter-Minsky's Law":

Y(t) + dD/dt = GDP(t) + NAT(t).

Y is income, D is debt, and NAT is net asset turnover. This last is defined as "the price index for assets P, times their quantity Q, times the annual turnover T expressed as a fraction of the number of assets, T<1: NAT = P*Q*T."

And now we really run into problems.

First of all, is this an accounting identity, or a behavioral equation? Does it hold exactly by definition, or does it describe an empirical regularity that holds only approximately? This is the most basic thing you need to know about any equation in economics, but Keen, as far as I can tell, doesn't say.

Second, in the national accounts and every economic tradition that I'm aware of, aggregate income Y is identically equal to GDP. They're just two ways of representing the same quantity. So it seems that Keen is using "income" in some idiosyncratic way that he never specifies. Alternatively, and more in the spirit of Minsky and Schumpeter, perhaps he is thinking of Y as anticipated or current-period income, and GDP as realized or next-period income. But again, it's not much use to speculate about what Keen might have meant.

The next problem is units. GDP and presumably Y are flows over a specified period (a year or a quarter); they are in units of dollars. dD/dt is an instantaneous rate of flow; it is in units of dollars per unit time. And NAT, as defined, is the product of two indexes times a fraction, so it is a dimensionless number. Well, you can't add variables with different units. That is just algebra. So again, whatever Keen has in mind, it is something other than what he wrote. And while it's easy enough to replace dD/dt with delta-D over the period that GDP is being measured, I really have no idea what to do with the NAT term.[1]

It doesn't help that at no point in the paper -- or in any of his other stuff that I've seen -- does he give any values for Y or NAT. He has lots of graphs of debt, output, employment, etc., showing -- to the surprise of no one -- that these cyclical variables are correlated. But since Y and NAT don't figure in any of them, it's not clear what work the Walras-Schumpeter-Minsky's Law is supposed to be doing. Again, if his point is that endogenous changes in credit supply are important to business cycles, I'm with him 100%. (Though so are, it's worth noting, some perfectly orthodox New Keynesians.) But if your idea is just that there is some important connection between A and B and C, the equation A = B + C is not a good way of saying it.

Honestly, it sometimes feels as though Steve Keen read a bunch of Minsky and Schumpeter and realized that the pace of credit creation plays a big part in the evolution of GDP. So he decided to theorize that relationship by writing, credit squiggly GDP. And when you try to find out what exactly is meant by squiggly, what you get are speeches about how orthodox economics ignores the role of the banking system.

Keen is taken seriously by serious people. He's presenting this paper at the big INET conference in Berlin next week. It's not OK that he writes in a way that makes it impossible to understand or evaluate his ideas. For better or worse, we in the world of unconventional economics cannot rely on the usual professional gatekeepers. So we have a special duty to police each other's work, not of course for ideology, but for meeting basic standards of logic and evidence. There are very important arguments in Schumpeter, Minsky, etc. about the role of the financial system in capitalism, which mainstream economics has downplayed, just as Keen says. And he may well have something important to add to those arguments. But until he writes in a language spoken by people other than himself, there's no way to know.



[1] Not to mention the odd stipulation that T < 0. Why is it impossible for the average turnover time of assets to be less than a year? Or does he really mean the fraction of assets that change hands at least once? What possible economic meaning could that have?


EDIT: I'm a bit unhappy about this post. It's too harsh on Keen. As Steve Randy Waldman suggests in comments, there probably is a valid insight in there, if one can just get past his opaque terminology. (Altho that's all the more reason for him to stop speaking in idiolect...) More importantly, posting this critique of Keen makes it seem like I am on Krugman's side, when his contributions to the debate have been every bit as bad in their own way -- as lucid as Keen is impenetrable, but also just embarassingly wrong, at least form where I'm sitting. This post by Michael Stephens Randy Wray at the Levy Institute blog does a good job laying out the issues. I agree with everything he says, I think.


EDIT 2:... and now here's Keen saying that

Krugman’s part of the economic establishment, which for thirty or forty years has got away with arguing that you can model a capitalist economy as if it had no banks in it, no money, and no debt… You just don’t have a model of capitalism if you don’t include those components. 

I'm also unhappy with that. Krugman (and New Keynesians/monetarists in general) are very specifically modeling an economy with money, but without banks. I agree with Keen that you do need to think about the financial system to understand macro dynamics, but you can't make the case for that if you can't correctly describe the position you are arguing against. I don't think we will make intellectual progress without being more careful about this stuff.