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.