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Wednesday, 18 March 2015

Is the Walrasian Auctioneer microfounded?

For macroeconomists

I found this broadside against Keynesian economics by David K. Levine interesting. It is clear at the end that he is child of the New Classical revolution. Before this revolution he was far from ignorant of Keynesian ideas. He adds: “Knowledge of Keynesianism and Keynesian models is even deeper for the great Nobel Prize winners who pioneered modern macroeconomics - a macroeconomics with people who buy and sell things, who save and invest - Robert Lucas, Edward Prescott, and Thomas Sargent among others. They also grew up with Keynesian theory as orthodoxy - more so than I. And we rejected Keynesianism because it doesn't work not because of some aesthetic sense that the theory is insufficiently elegant.”

The idea is familiar: New Classical economists do things properly, by founding their analysis in the microeconomics of individual production, savings and investment decisions. [2] It is no surprise therefore that many of today’s exponents of this tradition view their endeavour as a natural extension of the Walrasian General Equilibrium approach associated with Arrow, Debreu and McKenzie. But there is one agent in that tradition that is as far from microfoundations as you can get: the Walrasian auctioneer. It is this auctioneer, and not people, who typically sets prices.

Within this framework, the key price when it comes to Keynesian economics is the real interest rate. In Real Business Cycle models it is the real interest rate that moves, by assumption, to ensure that there are no problems of deficient or excess demand. So these models rule out Keynesian features by imagining an intertemporal auctioneer.

You might say what is wrong with imagining an auctioneer. Auctioneers are really just an ‘as if’ story that are meant to approximate how markets work. However any story of how the real interest rate gets determined should acknowledge the existence of two critical features of actual economies: the existence of money and central banks.

When we allow for the existence of money, it becomes quite clear how the ‘wrong’ real interest rate can lead to a demand deficient outcome. Brad DeLong takes Levine to task for trying to use a barter economy and Say’s Law to refute Keynesian ideas, and Nick Rowe turns the knife. What New Keynesian models do is attempt to remove the intertemporal auctioneer from RBC models. To adapt the Levine quote above, to replace the auctioneer with a more modern macroeconomics - a macroeconomics where firms set prices and central banks change interest rates to achieve a target. 

Now your basic New Keynesian model contains a huge number of things that remain unrealistic or are just absent. However I have always found it extraordinary that some New Classical economists declare such models as lacking firm microfoundations, when these models at least try to make up for one area where RBC models lack any microfoundations at all, which is price setting. A clear case of the pot calling the kettle black! I have never understood why New Keynesians can be so defensive about their modelling of price setting. Their response every time should be ‘well at least it’s better than assuming an intertemporal auctioneer’.[1]

Levine himself makes no explicit reference to New Keynesian models. If he had, he would have to acknowledge that in these models temporary cuts in government spending will indeed reduce output - particularly if monetary policy is unable to respond. All his stuff about perpetual motion machines would have to go out of the window. As to the last sentence in the quote from Levine above, I have talked before about the assertion that Keynesian economics did not work, and the implication that RBC models work better. He does not talk about central banks, or monetary policy. If he had, he would have to explain why most of the people working for them seem to believe that New Keynesian type models are helpful in their job of managing the economy. Perhaps these things are not mentioned because it is so much easier to stay living in the 1980s, in those glorious days (for some) when it appeared as if Keynesian economics had been defeated for good.


[1] What criticisms of Calvo contracts and the like should do is indicate the limitations of the microfoundations methodology, but another consequence of the New Classical revolution is that most macroeconomists mistakenly view microfoundations as the only ‘proper’ way to do macro. There is no epistemological basis for this view.

[2] As Stephen Williamson points out, these microfoundations would do a pretty poor job at explaining the behaviour of any particular individual, but instead model common tendencies that emerge within large groups of individuals.  

22 comments:

  1. Sorry to see SW-L has aged so much in the last 24 hours! As to microfoundations I’ve always said that the hypothesis that people fall in love cannot be accepted unless the hypothesis can be verified by examining people’s DNA. Or even better, examining the individual atoms making up that DNA.

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    1. Actually that (love) would be an emergent property of a sufficiently accurate model of the brain. Given sufficient computational resources and experimental effort it could in theory be done (although it would be highly unethical - a sufficiently accurate model would also be conscious.).

      You'd need to model patterns of DNA expression right through development, but I think the atoms would be overkill.. (I should mention that I have an interest in things like AI and impossible modelling)

      Likewise - and it's a simpler problem - there is no general objection to the idea that you can simulate the economy, or an economy, by modelling the actions of sufficiently well-characterized agents. Note that what you can't do is generalize - these agents would have to have the same kind of life cycle and heterogeneity as the real population. This is the formally correct approach; any other approach will at best be a bulk-parameterisation approach; works for physics and chemistry, doesn't work for much else.

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    2. I bet at some point microfoundations are going to meet their own uncertainty principle.

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    3. Andrew, you might be interested in my comment below: the equilibrium price is an emergent property and the Walrasian auctioneer is just enforcing entropy maximization.

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    4. The picture of Dorian Gray - the price for spouting so much unfounded theorizing.

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  2. The Walrasian Auctioneer is the unmoved mover of economics. Interesting in a theoretical context, but leave him out of real world applications.

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  3. Thanks for this blog post. As an amateur economist, I find it very interesting.

    I find it mind-boggling that the Levines of the world don't understand this. You failed to link to Krugman's blogpost where Krugman links to a 2009 letter from Levine.

    http://krugman.blogs.nytimes.com/2015/03/16/economic-ignorance-blogging/

    Economic Ignorance Blogging
    by Krugman
    16 March, 2015

    We need a name for a syndrome related to, but not quite the same as, the Dunning-Kruger effect. That effect, you may or may not know, shows that truly incompetent people are so incompetent that they believe themselves competent.

    So, my related phenomenon involves not competence but knowledge. The truly ignorant, I often find, don’t know that they’re ignorant — in fact, they’re often under the delusion of having deep knowledge and understanding.

    Today’s case in point: Brad DeLong goes on a well-justified rant against David K. Levine, who apparently cannot even conceive of the possibility of a general deficiency of demand — which puts him a couple of centuries out of date.

    What Brad may have forgotten, or perhaps never noticed, was Levine’s rant against me back in 2009, accusing me* of failing to understand the depth and power of modern economic analysis."

    *http://www.huffingtonpost.com/david-k-levine/an-open-letter-to-paul-kr_b_289768.html

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    1. What I pointed out to blogger Scott Sumner who is against fiscal stimulus, if not monetary stimulus, is that the New Classical types are not just arguing against Krugman and DeLong, they're main beef is really with big institutions like the OECD, IMF, central banks (as you point out) and even the American Congressional Budget Office.

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  4. Hi Simon,

    It is interesting that the idea behind the Walrasian auctioneer -- no single agent can strongly affect the price -- is very similar to the idea that no single atom can impact the temperature. In fact, t√Ętonnement moving prices towards a utility maximizing equilibrium looks like an entropic force pushing entropy to its maximum:

    http://informationtransfereconomics.blogspot.com/2015/03/entropy-and-walrasian-auctioneer.html

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  5. "What New Keynesian models do is attempt to remove the intertemporal auctioneer from RBC models."

    That attempt to is important. The only NK model I'm at all familiar with is Jordi Gali's basic textbook model. There's not much of a story there about how households form their view of growth prospects in the distant future. Of course NK beats RBC in that at least it tries.

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  6. Really the Walrassian Auctioneer is solving the socialist calculation problem, which is NP complete, and he does so perfectly, instantly, and at zero cost. He is also a dictator, in that he determines prices and quantities. Introducing the auctioneer means that you can drop prices entirely as they perform no useful role in coordinating economic activity.

    This seems like a huge step backwards for the cause of free markets or our understanding of how these markets work. I'm not sure what is gained in exchange for dropping the most basic tenant of private entreprise -- a general claim of pareto optimality? Is being able to claim optimality worth the price of abandoning the study of de-centralized markets?

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  7. Without a Walrasian Auctioneer "false trading" (Hicks) is not the exception from the rule - it becomes the rule. I think it was Rober Clower who showed in the 60s or 70s that deficient demand (deficient effective demand as distinguished from notional demand) follows almost directly from false trading.
    Why do modern macroeconomists think that only Walrasian economics supply "microfoundations". What about Marshallian micro? In Marshall's world firms are guided by excess profits or losses (quasirents) and they react with quantities.

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  8. "I am he as you are he as you are me and we are all together."

    Sounds like microfoundations to me.

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  9. Vacuonomics
    Comment on ‘Is the Walrasian Auctioneer microfounded?’

    With a modicum of scientific intuition and after a deeper look into the matter everyone arrives with logical necessity at the following conclusion.

    “At long last, it can be said that the history of general equilibrium theory from Walras to Arrow-Debreu has been a journey down a blind alley, and it is historians of economic thought who seem to have finally hammered down the nails in this coffin. ... General equilibrium theory is simply a research program that has run into the sands.” (Blaug, 2001, p. 160)

    Clearly, general equilibrium and all its offshoots and variants are unacceptable. Why is the Walrasian approach applied nonetheless? Because economists are not only without scientific intuition they are also ignorant of scientific standards.

    “In economics we should strive to proceed, wherever we can, exactly according to the standards of the other, more advanced, sciences, where it is not possible, once an issue has been decided, to continue to write about it as if nothing had happened.” (Morgenstern, 1941, pp. 369-370)

    The third reason is the obvious lack of imagination, that is, of some hunch of a promising alternative approach.

    “There is another alternative: to formulate a completely new research program and conceptual approach. As we have seen, this is often spoken of, but there is still no indication of what it might mean.” (Ingrao and Israel, 1990, p. 362)

    For lack of a promising alternative research program the representative economist simply clings to the familiar utility-demand-supply-equilibrium core - always open and prepared, of course, for more realism or some fancy face lift.

    To be sure, in his time Keynes was one big step ahead. He realized that something was wrong with the orthodox approach. With admirable consequence he took a different route and formulated the foundational syllogism of macroeconomics.

    “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (1973, p. 63)

    Actually, the fault in Keynes's two-liner is in the premise income = value of output. This equality holds only in the limiting case of zero profit in both the consumption and investment good industry (2014).

    Profit does not appear in Keynes's elementary formalism. That is, he in effect talks about a market economy without profit. Note well that Walras's original economy was also a zero profit economy. No such thing existed ever on this planet.

    Neither New Classicals nor New Keynesians provide a consistent description of the market economy. The representative economist is intensely involved in discussions about nonentities like equilibrium, auctioneers, intertemporal optimization, rational expectation, real exchange and other features of his economic Disneyworld. Yet he has not the slightest idea about what profit really is.

    “Suffice it to say that, in my opinion, what we presently possess by way of so-called pure economic theory is objectively indistinguishable from what the physicist Richard Feynman, in an unflattering sketch of nonsense ‘science,’ called ‘cargo cult science’.” (Clower, 1994, p. 809)

    There can be no microfoundation of macroeconomics because microeconomics is itself unfounded. In technical terms: the behavioral axioms of microeconomics and macroeconomics are unacceptable.

    “Cunningham in 1891 remarked that in the choice of premises ‘it is not always easy to tell when a professor of the dismal science is making a joke’ and I suspect that Cunningham meant that if the professor was not joking, then he was making a fool of himself.” (Viner, 1963, p. 12)

    Time to leave the auctioneer and all the jokes and fools behind and to make economics a science.

    Egmont Kakarot-Handtke

    References see http://axecorg.blogspot.de/2015/03/vacuonomics.html

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    1. The hammer is worn out from hammering down the nails on that coffin. Still the equilibrium zombie walks. It actually was kind of a cute idea back in Gracian's aphorism, before the physiocrats got their invincible hands on it.

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  10. Can I ask an ignorant question--ignorant because I'm still trying to put together the complex picture of macroeconomic theory? Where does Roger Farmer fit into all of this? I have not read his papers closely yet (although I hope to before long), but my guess is that he has microfoundations that are different from those of the reigning economic orthodoxy. Even though his seem problematic (from what I know, and I could be wrong), they seem more realistic and might have a better fit with evidence (at least related to his subjects).

    Or is this totally off base? And how does the rest of the field view Farmer's work?

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  11. And please, avoid Williamson. That web page you referred to in note #2: poor showing on Williamson's part, filled with ad hominem and errors galore. Two ways to address much of this would be to really, truly understand 1) statistical mechanics, and 2) emergent properties at higher levels of social organization. Scholars in natural sciences use these quite well. In chemistry, you NEED the microfoundations, not only to make sense of the chemistry you are studying, but especially to open up new vistas in what you can explain and do with chemistry. But you can still do chemistry without them. (This second point seems to be what SWL and Krugman have been saying.) Statistical mechanics can also help cope with the problem of microfoundations, but it will take a lot more work before economists come close to using this fruitfully--if at all.

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    1. Williamson, or right-wing Neoclassical economists in general, are the scum of the earth.

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  12. Mario Augusto Bunge, a philosopher teaching in Canada, says that "Keynesianism is for rich countries only" (because less well-to-do, indebted countries could not raise the money to fund public expenditure). I would like to see an economist doing some work on the subject, as all countries cannot put in the same bag. This lack of differentiation in economic theory has created tremendous problems in Latin America, where trained Keynesian economists applied their master theories with gusto, only to discover they did not have the money to pay for them, and leading their countries to deep economic crisis. Argentina being a prime example.

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  13. Mario Augusto Bunge, a philosopher teaching in Canada, says that "Keynesianism is for rich countries only" (because less well-to-do, indebted countries could not raise the money to fund public expenditure). I would like to see an economist doing some work on the subject, as all countries cannot put in the same bag. This lack of differentiation in economic theory has created tremendous problems in Latin America, where trained Keynesian economists applied their master theories with gusto, only to discover they did not have the money to pay for them, and leading their countries to deep economic crisis. Argentina being a prime example.

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  14. Simon, you really are far too polite about this piece.

    Firstly, it is full of rather snide remarks unfitting of a serious academic and more suited to a school balloon debate ("And we might wonder if the reason that Keynes is so popular with those that do not do math is because they cannot measure the angles carefully".) Yeah - right - Keynesian economists don't understand maths, which is why they can't see just how how Mr Levine is.

    Secondly, he considers a particular set of policy prescriptions (more government spending) as being the real essence of a Keynesian stance, and rubbishes it on entirely political grounds (oh you youngsters, thinking that government might solve anything!). I'm not sure exactly what "proof" of the useless of government spending an Escher picture is supposed to be, but maybe only professors understand science at that level.

    Which brings me to the main point ... despite his long CV of reading and teaching "keynesian economics", he simply seems not to get what Keynes contribution really was. The long digression on phones basically boils down to "say's law in the end" - eventually everything supplied has to be demanded, or things won't work out.

    But this is to completely miss the point of what Keynes achieved. Keynes essentially destroyed the classical theory of interest, by showing that the causality implicit in the classical model is, frankly, bogus. Keynes left the interest rate hanging in the air, because it is no longer determined by the classical forces of supply and demand of "saving".

    Aggregate saving is essentially a residual in Keynes' model, determined by the level of investment. Saving has no independent macroeconomic significance in Keynes GT - it is just that part of the income flow that is accumulated as financial assets, rather than spent on consumption goods.

    It is true, of course, that no "growth" comes from saving in Keynes' GT. But the GT is not about evolution in the long run supply side of the economy, it is about equilibrium output in the short run.

    He then goes off to explain how stupid this Keynesian belief in saving not leading to growth is, because, look, China has a high savings rate!

    Well, I'm pretty sure Keynes would have understood that if consumption consumed 100% of all real output, long term growth isn't going to be too fast. Keynes simply abstracted away from these issues in the GT. That doesn't mean he didn't understand them.

    Moreover, China's growth is not due to the high savings rate per se, but the fact that they have a high investment rate, which the high savings rate "makes space" for. China's high investment is not CAUSED by the high savings rate, it allows it. That's the point.

    For someone who claims to have imbibed and studied the keynesian literature so deeply, this little display of intellectual disingenuity is not impressive at all.

    I'm adding him to the "John Cochrane" list. Very smart guys whose arrogance and hubris about makes me despair.

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  15. typos -

    "how smart Mr Levine is" (first para)

    "about economics" (last sentence)

    apologies

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