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Bookblogging: Micro-based macro

October 8th, 2009

Another installment of my slowly-emerging book on Zombie Economics: Undead ideas that threaten the world economy. This is from the Beginnings section of the Chapter on Micro-based Macro. I’ve now posted drafts of the first three chapters (+Intro) at my wikidot site, so you can get some context. In particular, before commenting on omissions, take a quick look to see that the point hasn’t been covered elsewhere.

Micro-based macro is here

Macroeconomics began with Keynes. [1]Before Keynes wrote The General Theory of Employment, Interest and Money, economic theory consisted almost entirely of what is now called microeconomics. The difference between the two is commonly put by saying that microeconomics is concerned with individual markets and macroeconomics with the economy as a whole, but that formulation implicitly assumes a view of the world that is at least partly Keynesian. Long before Keynes, neoclassical economists had both a theory of how prices are determined in individual markets so as to match supply and demand (‘partial equilibrium theory’) and a theory of how all the price in the economy are jointly determined to produce a ‘general equilibrium’ in which there are no unsold goods or unemployed workers.

The strongest possible version of this claim was presented as Say’s Law, named, somewhat misleadingly, for the classical economist Jean-Baptiste Say. Say’s Law, as developed by later economists such as James Mill, states, in essence, that recessions are impossible since ‘supply creates its own demand’. To spell this idea out, think of a new entrant to the labour force looking for a job, and therefore adding to the supply of labor. According to the classical view of Say’s Law, this new worker plans to spend the wages he or she earns on goods and service produced by others, so that demand is increased by an exactly equal amount. Similarly, any decision to forgo consumption and save money implies a plan to invest, so planned savings must equal planned investment and the sum of consumption and savings must always equal total income and therefore can’t be changed by policy. Say’s argument allows the possibility if prices are slow to adjust, there might be excess supply in some markets, but implies that, if so, there must be excess demand in some other market. It is this idea that is at the core of general equilibrium theory.

The first formal ‘general equilibrium’ theory was produced by the great French economist Leon Walras in the 1870s. Walras, like many of the pioneers of neoclassical economics, was inclined towards socialist views, but his general equilibrium theory was used by advocates of laissez-faire to promote the view that, even if subject to severe shocks, the economy would always return to full employment unless it was prevented from doing so by government mismanagement or by the actions of unions that might hold wages above the market price of labour.
The point of Keynes’ title was that “general equilibrium” was not general enough. A fully general theory of employment must give an account of equilibrium states where unemployment remains high, with no tendency to return to full employment.

In the simplest version of the Keynesian model, equilibrium can be consistent with sustained unemployment because, unlike in the classical account of Say, the demand associated with workers’ willingness to supply labour is not effective and does not actually influence the decisions of firms. So unsold goods and unemployed labour can co-exist. The second part of Keynes’ analysis shows that the standard monetary mechanism by which equilibrium should be restored, may not work in the extreme recession conditions referred to as a ‘liquidity trap’. This concept is illustrated by the experience of Japan in the 1990s and by most of the developed world in the recent crisis. Even with interest rates reduced to zero, banks were unwilling to lend, and businesses unwilling to invest.

Keynes General Theory provided a justification for policies such as public works programs that had long been advocated, and to a limited extent implemented, as a response to the unemployment created by recessions and depressions ( Jean-Baptiste Say himself supported such measures in the early 19th century). More generally, Keynes analysis gave rise to a system of macroeconomic management based primarily on the use of fiscal policy to stabilise aggregate demand. During periods of recession, Keynes analysis suggested that governments should increase spending and reduce taxes, so as to stimulate demand (the first approach being seen as more reliable since the recipients of tax cuts might just save the money). On the other hand, during booms, governments should run budget surpluses, both to restrain excess demand and to balance the deficits incurred during recessions.

At first, it seemed, both to Keynes’ opponents and to some of his supporters, that Keynesian economics was fundamentally inconsistent with traditional neoclassical economics. But the work of John Hicks and others produced what came to be called the Keynesian-neoclassical synthesis, in which individual markets were analyzed using the traditional approach (now christened ‘microeconomics’) while the determination of aggregate output and employment was the domain of Keynesian macroeconomics.

The synthesis was not particuarly satisfactory at a theoretical level, but it had the huge practical merit that it worked, or at least appeared to. In the postwar era, the mixed economy derived from the Keynesian-neoclassical synthesis provided an attractive alternative both to the failed system of laissez-faire reliance on free markets and to the alternative of comprehensive economic planning, represented by the (still rapidly growing) Soviet Union. Modified to include a theory of market failure, neoclassical microeconomics allowed for some (but only some!) government intervention in particular markets to combat monopolies, finance the provision of public goods and so on. Meanwhile, the tools of Keynesian macroeconomic management could be used to maintain stable full employment without requiring centralised economic planning or controls over individual markets.

[1] That is not to say that no-one paid attention to the economic issues with which macroeconomics is concerned: the business cycle, inflation and unemployment. On the contrary, the early 20th century saw the beginnings of serious empirical research into the business cycle, most notably by the National Bureau of Economic Research, established in the US. And there were some important theoretical contributions, from economists such as Irving Fisher. Most notably, the great economists of the Austrian School, FA von Hayek and Ludwig von Mises, produced an analysis of the business cycle based on fluctuations in credit markets that remains highly relevant today. But neither Fisher nor the Austrians took the final steps needed to create a theory of macroeconomics, and the Austrians in particular recoiled from the implications of their own ideas.

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  1. gerard
    October 8th, 2009 at 11:27 | #1

    the section on the Wiki under “Beginnings” is great. All stuff I’ve heard of here and there but never in detail before.

    this sentence is interesting: “the Austrians in particular recoiled from the implications of their own ideas…” how so? does Schumpeter fit in here (was he an “Austrian”)? Do you think there is a continuity between the Austrians and the New Classical school?

  2. Freelander
    October 8th, 2009 at 22:40 | #2

    An interesting rave by E Roy Weitraub who is a supporter of micro-based macro. No one sensible disagrees with him, appparently?

    http://www.econ.duke.edu/~erw/Preprints/Giorgio%20Israel%202005%20Seminar%20Short%20Polemic.pdf

  3. Michael of Summer Hill
    October 9th, 2009 at 07:09 | #3

    Update, Update, Update, Liberal dissenters prefer Julie Bishop over Turnbull and Hockey as Liberal leader. My guess Wilson Tuckey will be Deputy Leader and Turnbull or Hockey the tea lady. No bull.

  4. Michael of Summer Hill
    October 9th, 2009 at 07:27 | #4

    Sorry John, should have posted the above under the Monday Message Board.

  5. James
    October 9th, 2009 at 12:21 | #5

    Hi John,
    It’s not very clear how you would prefer comments to be made. In the blog here? In the form of changes to the wiki, or in a discussion page on the wiki a la wikipedia? (Wikidot.com will let you set up a discussion page btw).
    Comments:
    1) Surely the work of the Classical and Physiocratic economists (Quesnay, Malthus, Smith, Ricardo, Marx) is macroeconomic in nature, concerned as it is with the distribution of income between classes and the effects on national wealth which result. Marx even put forward a debt driven theory of business cycles, since formalised by Godwin. Your second sentence would be more accurate if it said “non-classical economic theory consisted almost entirely of what is now called microeconomics.” Or “20th century capitalist economic theory”.
    2) I hope you will note that Hicks later rejected his own synthesis model as an inaccurate distortion of Keynes’ work, which inappropriately applied equilibrium models where they shouldn’t be applied (Hicks, J. 1981, ‘IS-LM: An Explanation’, Journal of Post Keynesian Economics, vol. 3, no. 2, p. 152)

  6. jquiggin
    October 9th, 2009 at 16:58 | #6

    I’m not clear about the best place for comments, but here on the blog works fine.

  7. Sebastian
    October 9th, 2009 at 22:36 | #7

    Hmmm, there doesn’t seem to have been much action on this blog of late. My theories for this recent phenomenon are:

    - All the Quigginites are off at Centrelink collecting their hard-earned dole payments.
    - They are off protesting some inane policy decision, or attending “Cartwheels against Climate Change” or “Interpretive Dancers for Palestine” off in a field of daisies somewhere.
    - There is a postmodern art exhibition, or a French short film festival, or something of the sort that facilitates (or indeed necessitates) latte-fueled pseudo-intellectual wankery.

    FYI, Schumpeter was an Austrian economist, but was not a member of the Austrian School of Economics, unlike Menger, Mises, Hayek etc. As for the “recoiling”, I think what JQ means is that the Austrians did not submit to the “One True Faith” of Keynesianism, and hence JQ is baffled.

    By the way, it still doesn’t seem any less ironic that Keynesians see fit to lecture on the subject of “zombie ideas”.

  8. Michael of Summer Hill
    October 9th, 2009 at 23:13 | #8

    Sebastian, I’m buggered if I know why you are ranting and raving for it is wasn’t for Keynesian economic policies stopping the global financial credit crisis from spiralling out of control who knows where we would be today and you can thank the monetarists for causing the whole bucking mess.

  9. October 10th, 2009 at 02:46 | #9

    My overall impression from the “micro-based” section includes one troubling, global reaction: I question your narrative stance/voice/frame — I’m not sure what the right word is. My personal opinions on the subjects you tackle tend to align perfectly with your own, and yet, I still question the arrogance of your narrative voice. There’s something too Olympian about your perspective, I think — it doesn’t give me any room, as Reader, to let myself be informed without accepting your whole doctrine, largely unexplained, in substitution. In the “micro” bit, I was troubled by the peroration on “emergence”. And, I’ve opined much the same thing — it’s not that I disagree, really. But, I feel like you could inform your Readers, without necessarily requiring them to subscribe to some rhetoric about emergent phenomena.

    Your title, Zombie Economics, put me in a frame of mind, where I recall the words of Thomas H. Huxley: “The great tragedy of science – the slaying of a beautiful hypothesis by an ugly fact.” The trouble with economics has always been its reluctance to accept that a fault of logic or conflict with facts should finally and permanently kill an idea.

    Economists want their analytical theories to be maps of the world, without the necessity of actually observing the world, or trying to figure out how it works. I don’t know that a micro-based understanding of macroeconomics is necessarily a bad idea. As a heuristic, or a research agenda even, it would seem a perfectly sensible thing to try. That’s why, I suspect, that I find your peroration on emergence a bit off-putting; that’s just a competing heuristic agenda. There are always going to be competing ideas and agenda. The problem with micro-based approaches is that they have never been allowed to fail upon confrontation with the facts. Nick Rowe, at Worthwhile Canadian Initiative, was musing on his own, personal history in economics recently, and, in his telling, the Lucas/Phelps agenda had come to grief — IN THE PROFESSIONAL CONSENSUS VIEW — as early as 1982, with the shape of the second half of the Carter-Reagan recession!

    Micro-based macro, as an agenda, is not a bad idea, in itself, at least prior to filling it in with propositions and findings. But, it became, as your title implies, a cooperative effort, despite a ritual show of hostility, between New Classicals and New Keynesians, to resurrect a dead economics of general equilibrium analysis — out of a dead microeconomics of equilibrating market prices. It is an agenda that failed, intellectually, long before it failed so publicly, in world economic crisis.

    And, it failed, not because it failed to recognize the goodness of emergence (sorry, but that’s how your voice sounds to me), but on its own terms. The microeconomics of Michael Woodford, the New Keynesian authority, is really bad microeconomics. The micro-world of market price equilibrium that they need for their theory to work, doesn’t exist. But, try to tell them that many real markets do not have market-clearing prices, that prices are administered, about technical efficiency — they cannot hear any of it. Alan Blinder published a volume, investigating actual price formation, under the false impression that macroeconomics, who keep talking up micro foundations, might be interested to learn, say, that many firms set prices in the context of declining marginal cost, with marginal cost well below average cost; he was ignored. There’s no interest in incorporating a realistic, consistent-with-actual-facts, micro “foundation”.

    You might want to consider doing a bit more of autopsy, and determining the actual cause of death — showing that the ideas were actually dead long before the current crisis came along to embarrass the Frankensteins of Economics. You’re doing important work. Drive your stake deep!

  10. Michael Harris
    October 11th, 2009 at 12:17 | #10

    @Freelander

    Freelander :
    An interesting rave by E Roy Weitraub who is a supporter of micro-based macro. No one sensible disagrees with him, appparently?
    http://www.econ.duke.edu/~erw/Preprints/Giorgio%20Israel%202005%20Seminar%20Short%20Polemic.pdf

    At the time of his writing, economists were all “supporters of micro-based macro now”. There wasn’t another game in town. It depends how you define “microfoundations”. Weintraub himself wrote one of the earliest overview books of the history of microfoundations of macroeconomics — see here — which came out before the formalised move to “New Keynesianism”.

    But in the “micro-based macro” that emerged, it depended on what market-failure-ish assumptions one was willing to build into the foundations of an otherwise recognisable constrained optimisation model. Market power? Asymmetric information? One or other form of externality? Uncertainty? Some rigidity somewhere preventing immediate price/quantity adjustment?

    The freshwater schools were less interested in assumptions that were (implicitly) admitting that people/markets/institutions could be somehow “irrationally” slow to adjust (e.g. why WOULDN’T people have rational expectations?). The freshwater guys in the new classical tradition wanted to assume rational expectations AND market clearing. Which is to say, they were strong on rationality, and strong on the ability of markets and institutions to adjust quickly. No irrationality, no significant rigidities. So what to do to explain business cycle movements?

    The premise of Lucas’s “surprise supply function” is that shocks would happen, causing price changes, and people would be uncertain about how much of a price change was an absolute change in the price level (meaning, something that should have no effect on their production/consumption decisions) and a change in relative prices (which SHOULD affect their decisions). Any government-induced policy shock that caused inflation could thus have temporary real effects by fooling the punters, but only for as long as it took the rational punters to wise up.

    Saltwater folks admitted far more eclectic assumptions into their models, allowing for “irrationalities” and “rigidities” that affected how people and institutions respectively responded to shocks.

    I haven’t had the time to follow all of John’s drafting process (the drafts and the discussion around them), so maybe some of this has been covered. I’m also less clear on the where-to-from-here issue. Is it the need for microfoundations that’s the issue/problem, or is it simply what’s ADMISSABLE as suitable microfoundations in the Temple of Economics?

    Back to Weintraub: his complaint is against a broad-brush insider (quasi-outsider) critique of “economics” in the broad, using essentially one iconic mathematical model from the 1950s to act as the exemplar of “This is what modern economics is!”

    Two complaints about economics (both with some, partial, legitimacy) often get conflated. One is ideology — that economists are ideological before they are analytical, and push a free-market (“market liberalist”) agenda come what may. A second, separate complaint, is formalism — that economics is abstractly mathematical and divorced from anything related to the real world.

    Both of these complaints have their place, but are often overstated, and (less justifiably) conflated. It’s being revealed now just HOW much some freshwater economists are driven by ideological positioning over sober analysis (Krugman and DeLong etc vs Cochrane, Fama, Lucas et al.), which means the big conferences could be interesting (tense!) events in the next few years. But formalism and free-market ideology are not even close to being the same thing, or causally related. Until the 1970s, Chicago work (the heyday of the old-school Chicago School, producing the majority of their Nobels) was discursive, modestly mathematical at best, sometimes decidedly empirical, and institutionally grounded, whether one agreed with what came out of there.

    The hyper-mathematical stuff came out of (often) coastal schools, with early pioneers being the likes of Arrow and Samuelson (neither one a free market fundamentalist), and since it was easy to build “fragile” models which didn’t immediately satisfy Pareto efficiency, the mathematical whiz-kids were often far more agnostic about the wonderful efficiency properties of general equilibrium or growth models.

    That, to me, is the disconnect Weintraub is highlighting with his complaint. It’s easy to look at two fundamental recent failures of the profession: first, the failure to see the crisis coming, and second, the intellectual melt-down over the stimulus, and think (or claim!), “OK, that’s it! Economics is royally screwed and needs to be abandoned and replaced with something meaningful and grounded in reality.” It’s EASY, but it misses the point.

    The point, to start with, is to figure out where the hell the bathwater ends and the baby begins. If we get that fundamentally wrong, all we’re left with is name-blame-and-shaming and finger-pointing. Reading a few of the cxomments threads around the place (Hi, Crooked Timber!), that seems like it’s all some people want to do.

  11. Michael Harris
    October 11th, 2009 at 12:25 | #11

    @Bruce Wilder
    It would be very instructive to look at Blinder’s book on price formation as a case study of how an eminent orthodox economist’s work was ignored or undervalued for being too “real world”, because this DOES potentially put meat on the bones of the critique of economists for enjoying formalism at the expense of real data and information.

    I think Truman Bewley of Yale also did something of this nature a goodly few years back.

    Speaking of Yale, I don’t know who else has brought to wider attention that noted formalist abstractionist John Geanakoplos was warning of a credit-inspired recession in the late ’90s.

  12. jquiggin
    October 11th, 2009 at 15:38 | #12

    @Michael Harris Tobin is an even more striking example. On your earlier points, stay tuned for coming sections which will address many of these points.

  13. James
    October 12th, 2009 at 09:17 | #13

    To shout out for my current favourite dead economist, Blinder’s findings of declining marginal cost align well with Sraffa’s contention that businesses set prices on the basis of supply cost + markup/profit on a flat or declinng supply curve.

    Given, as Michael says, that the ideological posturings behind the allegedly sober analyses are now being revealed, I am watching with interest to see who gets the pseudo-Nobel in Economics this year, since it can’t be seen as anything other than an ideological endorsement in the current circumstances (I vote for Nouriel Roubini. Slim hope). This is particularly so given the political nature of the Peace prize this year (don’t get me wrong, I like Obama, but I would have liked to see him achieve nuclear disarmament/korean detente/middle east ceasefire/something BEFORE getting the prize).

  14. Freelander
    October 12th, 2009 at 09:52 | #14

    @Michael Harris

    I am away on holiday so don’t interpret an absence of response as any agreement with your points…

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