CEPR POLICY INSIGHT No. 53 a 1 cast thus synthesis neoclassical old This wages. downward the to due be to had unemployment that conclusion inescapable of economics Keynes, led verbal after years of debate to the seemingly the formalise to attempt wages wouldproducefinancialcatastrophe. the economy to full employment and very flexible in which flexible money wages would not restore the In A lookback problems liedeeper? our Might ever. than mess worse a in us landed from there. on moving then and – assumptions its of theory more the besetting or one changing by time given any at prevailing troubles to responding of history long a has now by Macroeconomics • • • failure. Butisittherightstrategy? general equilibrium(DSGE)theory. examining the stochastic dynamic reigning the modifying of systematically assumptions necessary, deemed by where should and, they addressed that agreed be are alike defenders and critics but problems its are serious how on T UCLA andUniversity of Trento Axel Leijonhufvud Nature of aneconomy h I-M oe, hc oiiae a an as originated which model, IS-LM The have to now seems strategy collective this But conceptual to reaction natural rather a is This areoois fr xml, n ejnuvd (1981 and 1992). Leijonhufvud in example, for macroeconomics, we maynotevenbeaware? which of presumptions the count we do How we which within frameworkidentifytheassumptionsthatseemcritical? the is What need tobereexamined? How manycriticalassumptionsaretherethat hv tid o el h soy f h eouin of evolution the of story the tell to tried have I areooi ter. pnos differ Opinions theory. macroeconomic of state the of reappraisals prompted have he financial crisis and the ensuing recession General Theory General POLICY INSIGHT abcd 1 To download thisandother Policy Insights, visit , Keynes proposed a theory theory a proposed Keynes , inflexibility of money of the IS-LMbrandofKeynesianeconomics. of heel Achilles the became This model. IS-LM response was onto to the paste the Phillips curve hoc’ ‘ad The 70’s. and 1960’s the in adrift came economies Western of scale nominal the when harbouring dangerousinstabilities. economy an of theory a than rather “friction”, a with system stable a as economics Keynesian oet ua blee i Fida’ ter but theory Friedman’s in believed Lucas Robert present thatwearenowliving through. or,– future the for problems say,I should the for about the potential instability of credit stored up was and going US onto a the pure convertibility fiatgold standard. when of Butvestiges forgetting last time the shedding a at objective this to price the level. It was stabilising certainly natural to with give priority concerned exclusively was doctrine with policy regimes Monetarist money. in convertible credit of stabilisation the on focused had Thornton Henry of days the since saving andinvestment. of coordination the markets hindering credit or of furthering role in the of neglect a well as entail to came This problem. saving-investment that on converge rate. Monetarist theory completely neglected the it make not flexibility would wages unemployment, of of rate at investment natural equal the not did saving desired If for 40years. macroeconomics in sway held that doctrine a – unemployment of rate natural this on converge would economy the that guarantee to sufficient of unemployment.” rate “natural the of concept the introduced interest nominal on however,doing, so of course the In rates. also he premium Fisher the and same the the time both at for the instability of the Phillips Curve accounting fashioned attack, of tool (1968) perfect Friedman differences, y ettn te uniy hoy n first in Theory Quantity the restating By Models with “rigid wages” were not of much use remna Mntrs dd o ls long. last not did Monetarism Friedmanian theory policy monetary in tradition main The false. was proposition this theory, Keynes’ In were wages of flexibility theory, Monetarist In www.cepr.org

FEBRUARY 2011 No.53 FEBRUARY 2011 2

thought it lacking in microfoundations. He that I remember from my days as a student 50 showed how the instability of the Phillips curve years ago.3 and the Fisher premium could be explained while Important as these advances in our knowledge obeying the dictates of optimal choice theory. of how markets work undoubtedly are, our His model, however, had the property that only understanding of how an economy works has “unanticipated” changes in the growth rate of failed to progress in one important respect. the stock of money would cause unemployment The Old Neoclassical Synthesis, which saw the to deviate from its natural rate. economy as a stable general equilibrium system This was not a position that Friedman shared. hampered by the frictions of sticky wages, drew Before very long it also became generally the wrong lesson from the Great Depression regarded as untenable for a combination of and the dramatic wage deflation that it caused empirical and theoretical reasons. But this did in the US. The New Neoclassical Synthesis has not lead to a return to Friedmanian economics. brought us back full circle to this notion of the Instead, the analytical method pioneered by economy as a stable general equilibrium system Lucas and his New Classical collaborators with frictions. steered macroeconomics in a radically different direction. Important as these advances in our The problem, as it was seen at the time, was knowledge of how markets work to explain variations in employment without undoubtedly are, our understanding of how resort to “unanticipated money” or, of course, to the saving-investment problem which was an economy works has failed to progress by then forgotten. The response, led by Edward Prescott, was Real Business Cycle theory. In this The Old Synthesis was wrong back then and theory, variations in output and employment I believe the New Synthesis is wrong today. It were optimal responses to exogenous (i.e. does not recognise the instabilities lurking in the unexplained) variations in productivity growth. economic system.4 The business cycle was a perfectly coordinated equilibrium motion of the system. Real business Getting it backwards cycle theory became the main vehicle for the development of DSGE theory. This theory had no For a good many years, Tony Lawson has been independent role either for money or for finance. urging to pay attention to their Coordination in Real Business Cycle theory was ontological presuppositions (see Lawson 1997). only too perfect. The New Classical tradition had Economists have not paid much attention, by and large neglected problems of short-term perhaps because few of us know what “ontology” adjustment whereas a good deal of work on such means. This branch of philosophy stresses the matters had been done in a more or less Keynesian need to “grasp the nature of the reality” that is vein. In the years immediately preceding the the object of study – and to adapt one’s methods crisis, the New Classicals and the New Keynesians of inquiry to it. began to converge in what became known as Economics, it might be argued, has gotten this the “New Neoclassical Synthesis”. The New backwards. We have imposed our preconceived Classicals incorporated some of the “frictions” methods on economic reality in such manner as of the Keynesians while the latter adopted the to distort our understanding of it.5 We start from DSGE framework developed by the former. optimal choice and fashion an image of reality to No one would dispute that we have learned a fit it. We transmit this distorted picture of what great deal in the 50-60 years interval between the world is like to our students by insisting that the Old and the New Neoclassical Synthesis. they learn to perceive the subject matter trough One example is the Bernanke-Gertler Financial the lenses of our method. Accelerator and related Credit Channel work The central message of Lawson’s critique of (e.g. Kiyotaki and Moore 1997) that built modern economics is that an economy is an “open on the contributions of Akerlof, Stiglitz and Greenwald on the implications of asymmetric 3 I must note, however, that the frequent references to these matters as “frictions” reveal that other-worldly notions information in credit markets. Another example of “perfect markets” still has a hold over the profession’s is the development of the matching theory of thinking. labour markets for which Diamond, Mortensen 4 Cardoso and Palma (2009) also argue that we have gotten and Pissarides, building on McCall (1970)2, the relationship between method and subject matter backwards. Their complaint, however, is less that in so have just (and justly) received the Nobel. These doing we have distorted the nature of the reality under contributions have done away with the primitive investigation than that we have lost all definition of our and utterly naïve notions of “perfect capital subject matter, letting it become “things generally.” markets” and “perfectly flexible labour markets” 5 Cardoso and Palma (2009) also argue that we have gotten the relationship between method and subject matter backwards. Their complaint, however, is less that in so 2 For another example of important work stemming doing we have distorted the nature of the reality under ultimately from McCall, see Ljungqvist and Sargent investigation than that we have lost all definition of our

CEPR POLICY INSIGHT No. 53 CEPR POLICY INSIGHT No. (1998). subject matter, letting it become “things generally.” To download this and other Policy Insights, visit www.cepr.org FEBRUARY 2011 3

system” but economists insist on dealing with it corresponds to what was generally anticipated. as if it were “closed.” Controlled experiments in The economy is an open system in Lawson’s the natural sciences create closure and in so doing sense. The multiplier-accelerator models that make possible the unambiguous association were developed a decade or so later embodied of “cause” and “effects”. Macroeconomists, in this same perspective. particular, never have the privilege of dealing It is a practical matter. George Soros’ analysis of with systems that are closed in this controlled financial markets starts from the realisation that experiment sense. present beliefs about the future induce actions that create the future. He calls this conception We transmit this distorted picture of what “reflexivity” (Soros 2008). The investor who can the world is like to our students by insisting assess current market sentiment and infer how it will produce a future different from what is that they learn to perceive the subject generally expected can make a profit. If he reads matter through the lenses of our method. the market incorrectly or makes the wrong inference, he will suffer a loss. Our mathematical representations of both is the special, individual and system behaviour require the degenerate case of reflexivity where the future assumption of closure for the models to have actually realised is always a random draw from determinate solutions. Lawson, consequently, the universally believed and true Gaussian is critical of and, more distribution of possible futures. This assumption generally, of the role of deductivism in our field. makes the economy a closed system.7 Agents are Even those of us untutored in ontology may supposed to possess (probabilistic) knowledge reflect that it is not necessarily a reasonable of an objective reality – a reality that they have ambition to try to deduce the properties of very been able to learn. The Gaussian lottery might large complex systems from a small set of axioms. produce a gain or a loss. But the quality of the Our axioms are, after all, a good deal shakier than individual investor’s information about the Euclid’s. state of the market and his ability to draw the proper inferences from it have no bearing on the Optimisation, equilibrium and rational outcome of the lottery. In the general case of reflexivity agents do expectations not only have to form expectations about a future objective reality but must also form an The impetus to “closure” in modern opinion about the expectations of other market macroeconomics stems from the commitment to participants. A little reflection will show that optimising behaviour as the “microfoundations” behind such second-degree expectations lurk of the enterprise. Models of “optimal choice” ever higher degrees of expectations – a house of render agents as automatons lacking “free will” mirrors in which objective reality can get lost and thus deprived of choice in any genuine altogether.8 sense.6 Macrosystems composed of such automatons exclude the possibility of solutions Muth and the Cobweb that could be “disequilibria” in any meaningful sense. Whatever happens, they are always in The “Cobweb theorem” that prompted Richard equilibrium. Muth’s original Rational Expectations paper The extension of this formal program to “in (Muth 1961) came from agricultural economics time” behaviour required assuming that economic (Ezekiel 1938). It showed that if farmers chose agents possessed the knowledge of the future the acreage to plant for next year’s crop on the required for the calculation of intertemporal basis of the price received for this year’s, price and optima. Previous generations of economists output would fluctuate, producing an alternating had shied away from assuming perfect foresight sequence of foregone profits and actual losses.9 (Hicks 1938 and 1985). In the 1930s, theorists Farmers behaving in the manner presupposed by like Hayek, Lindahl and Hicks began dealing the Cobweb would make costly errors every time. systematically with the role of expectations in Muth demonstrated a way in which farmers the business cycle. To them, expectations about could learn to gear their planting decisions to the the future induce actions in the present that statistical expectation of next year’s price. Acting create the future – but the future realised seldom 7 As Daniel Heymann has long insisted, it is logically indefensible, therefore, to revise the structure of a rational 6 It is interesting to compare Lawson’s position to Spiro expectations model in light of experience. Latsis’ (1972) critique of . The 8 This problem was analysed at length and in depth – but literature that Latsis dealt with forty years ago did not take to little effect on the profession -- by Phelps, Frydman, di the substantive rationality of agents for granted. Instead, Tata and others in Frydman and Phelps, eds., (1983). the common strategy for obtaining unique theoretical 9 Given the price elasticity of output and the output behavior predictions was “situational determinism”, that elasticity of demand price for most crops, the usual is, to fashion assumptions that structure the decision- cobweb model should produce divergent oscillations –

CEPR POLICY INSIGHT No. 53 CEPR POLICY INSIGHT No. problem of agents so as to leave them only a “single exit.” making it still more implausible. To download this and other Policy Insights, visit www.cepr.org FEBRUARY 2011 4

on this rational expectation would eliminate the make systematic errors but they will continue to irrational cobweb fluctuations. The statistical make errors. inference procedure that Muth proposed is not The heterogeneity of expectations associated necessarily the most plausible learning model to with the lack of synchronicity means that there generate this result.10 A farmer badly burned two will be a range of indeterminacy within which the years in a row just might change his behaviour market clearing price may temporarily settle. This on the basis of a sample size of two! range will be bounded. There will be prices so high The more interesting point about Muth’s case, (or low) that the predominant opinion of market however, is that the conditions of the problem participants will deem them unsustainable – and are such as to make it plausible that the rational this will become a self-fulfilling belief. The width solution might be learned. First, there is an of this range of indeterminacy will vary over objective reality to be learned that is not subject time. Prolonged periods of tranquillity when to the whims and foibles of market sentiment, speculation tends to stabilise the level of the namely, the distribution of annual weather price within a narrow range will contrast with conditions and their effects on crop yields. occasional bouts of speculation extrapolating its Second, price adjustments must bring supply and rate of change which will greatly extend this range demand into balance within the fixed time interval of indeterminacy. of the crop year.11The conjunction of these two conditions creates an event correspondence The mathematical representation of between weather and price that, once learned, the system closed by assuming rational makes rational expectation behaviour possible.12 expectations made it possible to prove a variety of propositions -- such as Synchronicity Ricardian equivalence and other policy The conjunction of the two conditions above, ineffectiveness theorems -- that ran counter which make rational expectations somewhat to the received wisdom of the time. plausible, is seldom realised. The second condition, the existence of a fixed given time period over which “the law of supply and When the conditions of Muth’s case fail to be demand” must do its work, deserves some satisfied, we are not entitled to assume (1) that all additional comments because it is somewhat market participants will learn the same thing or unlikely to appear on the list of assumptions (2) that what they learn will be an objective truth. to be reexamined when macroeconomic theory Yet, economists have taken rational expectations runs into trouble. from the original context of this special case and Instead of markets for wheat or corn, consider have run with it in every conceivable direction. In the world markets for oil or natural gas or some macroeconomics, it has been applied to infinite mined minerals. In these latter cases, there is no dimensional state spaces spanning not only all “natural period” over which price equilibrates futures markets but an infinity of non-existing production and consumption. Price is not markets as well.13 uniquely determined by “fundamentals” of tastes The mathematical representation of the system and production functions. It is of course generally closed by assuming rational expectations made understood how changes in fundamentals will it possible to prove a variety of propositions -- affect prices over time. But at any given date, such as Ricardian equivalence and other policy expectations about the expectations of other ineffectiveness theorems -- that ran counter to market participants play an unavoidable role in the received wisdom of the time. Nothing is more the management of inventories and in decisions seductive to young recruits into a field than the to buy or sell. Learning will not eliminate the debunking of received wisdom. The attraction heterogeneity of expectations. Traders may not of rational expectations was further enhanced by the challenge of explaining how things might go wrong in a world where all agents 10 As Sydney Winter pointed out to me, the evidence from know perfectly well what they are doing.14 Thus, experimental economics is less than encouraging with regard to the ability of ordinary subjects to draw correct rational expectations generated a good deal of statistical inferences. 11 In markets for livestock where this condition does 13 The market clearing conditions is even asserted to hold not apply a few rounds of cobweb fluctuations will at each point of time in continuous time models where occasionally be observed. Kaldor’s term, “cobweb”, refers neither the “price” nor the equality of flow-densities of to a picture on a blackboard. The older name for it -- the supply and demand have any sensible interpretation. “hog cycle” – refers to events in an actual market. 14 The answer to the many varieties of this puzzle is, of 12 It remains an open system nonetheless, of course. The course, incentives. The further puzzle then becomes to correspondence between weather and realised price explain what rational agents have structured incentives may shift for a number of reasons, such as a lowering of for people in such a manner as to produce undesirable transport costs from a lower cost region – or, of course, results. The most popular answer to that one has been global warming. It is not necessarily the case, moreover, “politicians” or “government.” The cynical innocence that an exhaustive list of possible reasons can be of modern economics has a certain mathematical

CEPR POLICY INSIGHT No. 53 CEPR POLICY INSIGHT No. compiled. inevitability about it! To download this and other Policy Insights, visit www.cepr.org FEBRUARY 2011 5

revolutionary fervour in its time. The excitement thus to be seen as futile. The lesson is one that has ebbed but slowly as rational expectations Daniel Heymann has insisted on for a long time, theory has itself congealed into a new orthodoxy namely, that behavioural time horizons vary deemed suitable for the indoctrination of endogenously and macroeconomic theory has succeeding generations. to reflect this fact (Heymann and Leijonhufvud 1996 and Leijonhufvud 1997). Doing without One would not like to see macro theory Rational expectations envisage the economy as a reduced to little else than rummaging in train travelling through a Markovian switching the toy box of complex system dynamics. yard. Everybody on board! All with the same mental baggage neatly packed. At predetermined, constant intervals the train switches – clickety- Volatility shortens time horizons. Short-sighted clack – onto a new track chosen by a draw from adaptive behaviour generates non-linear a fair lottery. The tracks have been laid once dynamics. So volatility causes short-termism and for all (and there are no derailments). Not which causes volatility. This positive feedback necessarily the most profound image of the loop runs away with the economy in a crisis. human condition! Yet, giving up this conception Heymann and I discussed the disappearance of the nature of an economy would force us to of intertemporal markets and the volatility of modify our methods. Accepting that the future relative prices under high inflation conditions cannot be known with certainty, even as a in these terms. In recent credit crises, we have probability distribution, means recognising that seen a similar phenomenon at work when, at we are dealing with an open system. And then times, major monetary policy decisions had to the usefulness of many tools of the trade comes be made on Sundays because they could not wait into doubt. 'til Monday. Agents in such a system have to adapt15 to Making the distinction between tranquil events the probability of which they had not and volatile conditions does not by itself take estimated correctly – or which they may not us very far. But it serves to raise a number of even have imagined. Obviously, intertemporal questions that have not received the attention optimisation cannot then be a “true” by macroeconomists that they deserve. How representation of behaviour. The problem is that does the behaviour of individual agents and of treating behaviour as adaptive opens the door to the economy as a whole differ in a deep recession all sorts of non-linear behaviour and one would or high inflation from normal times? What, not like to see macro theory reduced to little if anything, do the two extremes of monetary else than rummaging in the toy box of complex instability have in common? In what respects are system dynamics. they each other’s opposites? What will take an Our accustomed analytical techniques may still economy across the boundary from tranquil to have their uses in studying the open system. In volatile conditions? How can we make it back? periods of prolonged tranquillity, agents are apt to pay attention to the rates of intertemporal Budget constraints substitution that they see themselves as facing and to do so for some distance into the future. So far I have argued that, in the “open” system, This will tend to dampen the economy’s many prices will be indeterminate (albeit tendency to fluctuate. It will at least suppress within limits), that economic behaviour has high-frequency oscillations. This is captured to be understood as fundamentally adaptive, by intertemporal optimisation models which that behavioural time horizons are variable, may thus provide approximations of observed and that the sets of markets and relative prices behaviour. In making such use of them, however, may change endogenously. General equilibrium we had better remember that transversality theorists are apt to think that I am making an conditions at an infinite time horizon are not to utter mess of our subject. Probably right. But be taken seriously. Every bubble that ever burst then, of course, reality may at times be even proves transversality false. So, how far to trust messier. To take account of that fact, I believe, these models becomes a question of judgment – we must reconsider also the role of the budget and not an easy one. constraint in economic theory. In volatile times, people find themselves We have learned that an economy may still forced to react to current events. These events, show a good measure of structured order even moreover, will often disrupt plans that may not if its participants are not super-intelligent or have been made at all long ago. Intertemporal all that rational. Gary Becker showed long ago planning over significant stretches of time come (1962) that demand curves would still slope downwards even if agents were “irrational’” 15 The Trento Summer Schools, of which there have been as long as they were disciplined by the budget eleven editions so far, have all come under the general constraint. More recently, Gode and Sunder

CEPR POLICY INSIGHT No. 53 CEPR POLICY INSIGHT No. heading of “Adaptive Economic Dynamics”. To download this and other Policy Insights, visit www.cepr.org FEBRUARY 2011 6

(1993), in a contribution that has spawned quite instabilities stem from budget constraint a literature, demonstrated that markets would violations. It is best to begin by distinguishing attain a high degree of efficiency even with “zero between budget constraint violations by private intelligence traders.”16 The mechanism that parties and by the sovereign. ensures this result is again the budget constraint. Imagine first a state space representation of The budget constraint is one of these the private sector divided into three regions. assumptions that seem to escape attention when Over the first region (M1) of the space the market the real world generates yet another example of sector would show “normal” behaviour. Negative something being amiss with economic theory. feedback controls dominate in all markets and Janos Kornai is a rare example of an “stabilisation policies” in the conventional who has paid attention to it. A quarter century sense are not useful. In the second region (M2), ago, he came to focus on the budget constraint destabilising (positive) adaptive feedbacks occur in trying to understand the inefficiencies of but are fairly tightly bounded. The Keynesian socialism. In a system where plan objectives multiplier and the financial accelerator are would often override the break-even requirement examples. The economy goes through “business for enterprises, the budget constraint was “soft”. cycles”. Monetary and fiscal policies may be Kornai showed that the price mechanism would useful to change liquidity or directly affect not perform the allocative functions we usually aggregate demand. In the third region (M3), we attribute to it under these conditions. find the really dangerous instabilities such as In economic crises, budget constraints are default avalanches. Somewhere in this region not “soft” but they are broken (Leijonhufvud lies the “black hole” of a Fisherian debt-deflation 1998 and Heymann 2008). In deflation or catastrophe. depression crises, the budget constraint violations are concentrated in the private sector. The image of a capitalist economy as In high inflation or hyperinflation crises, it is the a stable general equilibrium system sovereign that violates equal-value-in-exchange. somewhat hampered in its functioning The sovereign’s prerogative to “create money” means that the macroeconomic consequences by “frictions” is an inadequate guide differ drastically from those arising from private to the realities we have to cope with. sector financial crises. The “normal” functioning of a capitalist In the process that can propel the economy from economy depends on budget constraints being Region M2 into Region M3, leverage (Geanakoplos binding. When large and/or widespread violations 2010 and Leijonhufvud 2009a) plays the of the equal-value-in-exchange condition occur, crucial role. The slow build-up of leverage in the adaptive dynamics of such a system will be the economy increases the connectivity of very different. Nothing much works as supposed the network (Leijonhufvud 2009b) of debts in economic theory unless budget constraints and claims and combines with the underlying actually do bind.17 Standard general equilibrium maturity mismatch to make the system more theory, even in its modern dynamic stochastic fragile. When the financial sector eventually variants, is not particularly helpful when budget switches into deleveraging, the connectedness constraints are violated. of the system will bring several deviation- counteracting mechanisms into “sync”. Nature of an economy: Instabilities The state space for a system governed by the finances of the sovereign would give usa first The image of a capitalist economy as a stable region (S1) with budget surpluses or credibly general equilibrium system somewhat hampered sustainable deficits. A second region (S2) has in its functioning by “frictions” is, I believe, an deficits that engender expected inflation with a inadequate guide to the realities we have to cope corresponding Fisher premium on the interest with. It is in the nature of an economy to harbour rate. In this region, however, the government the possibility of serious instabilities. It is possible retains some substantial measure of control of the to make some conjectures about the qualitative situation. The third region (S3) on the public side properties of its dynamics.18 The most damaging is one of high inflation where control has been lost. Short-term inflation expectations respond 16 Of course, Becker as well as Gode and Sunder analysed with great alacrity to government actions while simple low-dimensional cases but I am willing to believe longer-term expectations are too ill-defined that the general import of their results might often apply also in higher dimensions. To believe that they always to support intertemporal markets of any kind. apply requires too much faith in transversality however! The “black hole” on this side is, of course, true 17 Insurable risks of default can, of course, be handled hyperinflation (Heymann and Leijonhufvud with standard tools. But the risks that materialise in a 1995 and Leijonhufvud 1998). financial crisis have not been insured against. In cases of contingent contracts, deciding what constitutes breach of contract can be a tricky business. For some discussion, see Heymann (2008, p. 76) from my (2010). It elaborates a bit on the “corridor

CEPR POLICY INSIGHT No. 53 CEPR POLICY INSIGHT No. 18 The following sketch of 2 x 3 state space regions is taken hypothesis” I advanced about 40 years ago. To download this and other Policy Insights, visit www.cepr.org FEBRUARY 2011 7

On this side, the main mechanism taking the perceive the options in the same way. The main system from Region S2 into Region S3 is the difference may be that the US authorities have Olivera-Tanzi effect (Olivera 1967 and Tanzi learned that volatility in the world economy 1977) that is, of course, well-known to all increases the demand for dollar-denominated Argentine readers. assets in the medium run even as the fiscal balance One more point under this heading. In of the federal government looks increasingly the main, macroeconomics has dealt with precarious over the longer run. No other country relationships between flow variables. The enjoys this benefit – and the temptations that unstated presumption is that balance sheets have come with it. developed more or less “on track”.19 In Regions 3M and 3S, balance sheets are seriously “out of We economists have to be clear about balance” and this dominates the dynamics of the the limits to our knowledge. system (Koo 2003). In severe recessions, it is the attempts in the private sector to deleverage so as to restore balance sheets to a reasonably healthy Europe and the US acting at cross-purposes never state that are the main problem. In high inflation, did bode well for the economic recovery of what it is the complete atrophy of the financial sector used to be known as the “Western powers.” The that prevents the economy from growing because Republican election victory now spells the end of growth cannot be financed. renewed stimulus spending. This leaves us with redoubled efforts at “quantitative easing” by the Double jeopardy central banks. That strategy, I am afraid, carries some risk of putting us in triple jeopardy. We are used to thinking of depressions and high In this situation, we economists have to be inflations as opposite extremes on a spectrum of clear about the limits to our knowledge. We know possible macroeconomic conditions. But one is something about what needs to be done to stop a caused by insolvencies in the private sector and high inflation or recover from a deep recession.21 the other by the insolvency of the government. I do not think we have very reliable knowledge The one condition, unfortunately, does not about how to play these games of double – or exclude the other (Heymann 2008). triple – jeopardy. Government resources have to be used to bring the private sector out of a deep recession Distribution or depression. Resources have to be transferred from the private to the public sector to bring Modern macroeconomics has relied heavily on high inflation under control. But if the finances the neoclassical production function and has of one sector are already strained when the other accepted the marginal productivity theory of gets into trouble, there may be no very palatable distribution that comes with it. Intellectual heirs policy options. Latin American financial history of Adam Smith, who believe that economic growth contains a number of episodes where in order stems largely from the increasing elaboration to avoid depression, governments nationalised of the Division of Labour, will regard this as the bad assets of their banking systems – and the unsubstantiated nonsense. If the productive policy so undermined the public finances as to structure of an economy shows increasing throw the economy into high inflation.20 returns in a great many of its dimensions, it At present, as we are all aware, the policies of the cannot be true that factors are generally paid US and of Europe are in conflict. On both sides of their respective marginal products. the Atlantic, governments see themselves facing Whatever position one takes on this, however, a double jeopardy – a significant probability of it is obviously an issue within equilibrium finding yourself damned if you do and damned if economics and that branch of our subject does you don’t. Germany, so far thriving on its exports, not have much to tell us about the distributional is forcing the Eurozone to give priority to the consequences of highly unstable processes. The longer-run financial stability of governments. main consequences are not changes in relative The new UK government is moving in the same earnings from productive effort but redistributions direction. So far the U.S. administration has of wealth. Ultimately, endowments will turn been willing to go deeper into deficit in order out to have been reshuffled but the process of to bring the private sector back towards a more reaching clarity on “who owns what” is long, satisfactory level of employment. drawn out and very costly. Both sides find themselves having to play the The distributional incidence of a great financial same game of double jeopardy but they do not crash does not make sense to ordinary people. The gains and losses that they experience and 19 This is true also, I would say, of the General Theory and it observe bear no relation to the rules by which is a major reason not uncritically to “go back to Keynes” as so may people have argued in response to the present crisis. 21 But had economists been able to live up to their 20 I learned this lesson from Daniel Vaz (1999) and have pretensions of knowledge, Japan would not have had to

CEPR POLICY INSIGHT No. 53 CEPR POLICY INSIGHT No. referred to his work frequently ever since. languish in recession for all those years. To download this and other Policy Insights, visit www.cepr.org FEBRUARY 2011 8 Conclusion they have led their lives. The emergency policies needed to stop the collapse of a financial house I have stressed two themes in this paper. of cards midway – which ordinary tax-payers ultimately have to pay for -- do not make sense • The first is that we have to think of an economy to them either. Widespread disorientation and as an “open system” in the ontological sense anger provide a favourable environment for of Tony Lawson. demagoguery and scape-goating of ethnic groups, of immigrants, or of foreign nations. The loss of This will require us to adapt out methods to a sense of social solidarity makes it increasingly the nature of an economy – to change how we do difficult to muster sufficient consensus for economics. policies to deal with the crisis. Needless to say, consensus among nations is even more difficult • The second is that the economy is not globally to obtain. stable but harbours instabilities. One example of these distributional issues is worth discussing in some detail, not because it is Some of these are fairly tightly bounded but of great quantitative importance, but because it others are potentially catastrophic to economic illustrates the kind of problems that come to the welfare and can be deeply damaging to social fore in the unstable Region 3 of the system’s state solidarity and to political stability. space. It also illustrates how some of these issues Macroeconomics in the years leading up have escaped public scrutiny. to the recent crisis had become a technically demanding subject and was naturally dominated The crisis should have cured us of the by people who were good at that sort of thing. “pretence of knowledge” – of the illusion But unless you took much pride and joy in its technical aspects, it had also become deadly dull. that had solved problems of macroeconomic The crisis should have cured us of the “pretence instabilityto general satisfaction. of knowledge” (Caballero 2010) – of the illusion that we understood problems of macroeconomic In the heydays of Monetarism, the neutrality of instability very well and had solved them all to money was very widely accepted although it was general satisfaction. Once cured of this pretence – also conceded that money was not quite super- which is to say, once cognizant of our ignorance neutral. Neutrality meant that monetary policy – we can see that macroeconomics poses a would not have any distributional consequences great many important questions to which my except those arising from people’s occasional generation did not provide good answers. failures accurately to predict the inflation rate. That should make the subject full of intellectual Today, in the US, the Federal Reserve System lends excitement for those who are a few decades reserves to the banking system at an essentially younger. zero interest rate. The banks use these reserves to buy Treasuries at close to 4%. This is a hefty Note: This was an invited Lecture presented at the subsidy to the banking system ultimately to be Meetings of the Argentine Economic Association, borne by taxpayers – but neither the subsidy nor Buenos Aires, 15-19 November 2010. An earlier the tax liability has been voted on by Congress. version was given at the INET Conference, Budapest, Moreover, the zero interest policy of the central 6 – 8 September 2010 bank drives down the interest rate available to savers to a small fraction of 1%. At the same References time, banks leverage their capital by a factor of 15 or higher, thus earning a truly outstanding Becker, Gary (1962) “Irrational Behaviour and rate on their capital from buying 4% bonds Economic Theory,” Journal of Political Economy, with costless Fed money. Wall Street bankers are LXX:1, February, pp. 1-13. then able once again to collect the bonuses they Buiter, Willem (2009) “The Unfortunate became used to in the good old days before the Uselessness of most “State of the Art” Academic crash22 and which are supposedly well-deserved Monetary Economics,” http://blogs.ft.com/ because of the genius required to perform this maverecon, March 3. operation. These bonuses are in effect transfers Caballero, Ricardo J. (2010) “Macroeconomics from the mostly aged savers who cannot find an After the Crisis: Time to Deal with the Pretense- alternative safe placement for their retirement of-Knowledge Syndrome,” NBER Working funds. Paper 16429, October. Cardoso, Jose’ Luis, and Nuno Palma (2009) “The Science of Things Generally?” In: Amos Witztum and Frank Cowell (eds.), Lionel 22 They are also able to use these profits to repay the Robbins’s Essay on the Nature and Significance money committed by the government to save them from of Economic Science – 75th Anniversary insolvency. And the government will then claim that the

CEPR POLICY INSIGHT No. 53 CEPR POLICY INSIGHT No. bail-outs ultimately did not cost the tax payers! To download this and other Policy Insights, visit www.cepr.org FEBRUARY 2011 9

Conference Proceedings. London: London Leijonhufvud, Axel (1992) "Keynesian Economics: School of Economics, STICERD, pp. 387-402. Past Confusions, Future Prospects," in A. Vercelli Friedman, Milton (1968) “The Role of Monetary and N. Dimitri, eds., Macroeconomics: A Survey Policy,” American Economic Review, 58:1, 1 – 17. of Research Strategies, Oxford: Oxford Univ. Ezekiel, Mordecai (1938) “The Cobweb Theorem,” Press, pp. 16-37., reprinted in Leijonhufvud, Quarterly Journal of Economics, 52, 255–280. Macroeconomic Instability and Coordination: Frydman, Roman and Edmund S. Phelps, eds. Selected Essays, Cheltenham, UK: Edward Elgar (1983) Individual Forecasting and Aggregate 2000, pp.33-51. Outcomes: “Rational Expectations” Examined, Leijonhufvud, Axel (1997) “Macroeconomic Cambridge: Cambridge University Press. Complexity: Inflation Theory”, in W. Brian Geanakoplos, John (2010) “The Leverage Cycle”, Arthur, Steven N. Durlauf and David A. Lane, in D. Acemoglu, K. Rogoff and M. Woodford, eds., The Economy as an Evolving Complex System eds., NBER Macroeconomic Annual 2009, II, New York: Addison Wesley and the Santa Chicago: Chicago University Press. FeInstitute. Gode, Dhananjay K. and Shyam Sunder (1993) Leijonhufvud, Axel (1998) “Two Types of Crises,” “Efficiency of Markets with Zero Intelligence Zagreb Economic Journal, Dec. Traders: Market as a Substitute for Individual Leijonhufvud, Axel (2009a) “Two Systemic Rationality,: Journal of Political Economy, CI: 1, Problems,” CEPR Policy Insight 29, January February, pp. 119-37. Leijonhufvud, Axel (2009b) “Curbing Instability: Hicks, John R. (193x) Value and Capital, Oxford: Policy and Regulation,” CEPR Policy Insight 36, Oxford University Press July Hicks, John R. (1985) Methods of Dynamic Leijonhufvud, Axel (2009c) “Instabilities”, Economics, Oxford: Oxford University Press. paper delivered at inaugural INET conference, Heymann, Daniel (2008) “Macroeconomics Cambridge, UK, April 8-11, 2010. of Broken Promises,” in Roger Farmer, ed., Lars Ljungqvist and Thomas J. Sargent. 1998. Macroeconomics in the Large and the Small, “The European Unemployment Dilemma.” Cheltenham: Edward Elgar. Journal of Political Economy, Vol. 106(3), pp. Heymann, Daniel and Axel Leijonhufvud (1996) 514–50. High Inflation, Oxford: Oxford University Press. McCall, John J. (1970) “Economics of Information Kiyotaki, Nobuhiro and John Moore (1997) and Job Search.” Quarterly Journal of Economics, “Credit Cycles,” Journal of Political Economy, Vol. 84(1), pp. 113–26. Vol. 105:2, pp. 211-48. Muth, John F. (1961) “Rational Expectations and Koo, Richard C. (2003) Balance Sheet Recession: the Theory of Price Movements,” Econometrica, Japan’s Struggle with Unchartered Economics and Vol. 29:6 its Global Implications, Singapore: Wiley. Olivera, Julio G.H. (1967) “Money, Prices Kornai, Janos (1986) “The Soft Budget and Fiscal Lags: A Note on the Dynamics of Constraint,” Kyklos, 39:1, pp. 3-30. Inflation,” Banca Nazionale del Lavoro Quarterly Lawson, Tony (1997) Economics and Reality, Review, Vol. 20: 258-267. London: Routledge Soros, George (2008) The New Paradigm for Latsis, Spiro J. (1972) “Situational Determinism Financial Markets: The Credit Crisis of 2008 and in Economics,” British Journal for the Philosophy What It Means, New York: Perseus Books of Science, Vol. 27, pp. 51-60. Tanzi, Vito (1977) “Inflation, Lags in Collection, Leijonhufvud, Axel (1981) "The Wicksell and te Real Value of Tax Revenue,” IMF Staff Connection: Variations on a Theme" in Papers, Vol. 24: 154-167. Information and Coordination: Essays in Vaz, Daniel (1999) “Four Banking Crises: Their Macroeconomic Theory, New York: Oxford Causes and Consequences,” Revista de Economia, University Press 1981, pp. 131-202. Vol. 6: 1, pp. 29-346.

Axel Leijonhufvud was born in Stockholm, and obtained his bachelors degree at the University of Lund. After coming to the United States in 1960, he earned an M.A. from the and his Ph.D. from . He came to the University of California at Los Angeles in 1964 and was named Full Professor in 1971 and served repeatedly as Chairman of the Economics Department. In 1991, he started the Center for Computable Economics at UCLA and remained its Director until 1997. In 1995 he was appointed Professor of Monetary Theory and Policy at the University of Trento, Italy. At Trento, he has organized a program in Adaptive Economic Dynamics which offers annual Summer Schools for Ph.D. students and postdocs. CEPR POLICY INSIGHT No. 53 CEPR POLICY INSIGHT No.

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The Centre for Economic Policy Research, founded in 1983, is a network of over 700 researchers based mainly in universities throughout Europe, who collaborate through the Centre in research and its dissemination. The Centre’s goal is to promote research excellence and policy relevance in European economics. CEPR Research Fellows and Affiliates are based in over 237 different institutions in 28 countries. Because it draws on such a large network of researchers, CEPR is able to produce a wide range of research which not only addresses key policy issues, but also reflects a broad spectrum of individual viewpoints and perspectives. CEPR has made key contributions to a wide range of European and global policy issues for over two decades. CEPR research may include views on policy, but the Executive Committee of the Centre does not give prior review to its publications, and the Centre takes no institutional policy positions. The opinions expressed in this paper are those of the author and not necessarily those of the Centre for Economic Policy Research. CEPR POLICY INSIGHT No. 53 CEPR POLICY INSIGHT No.

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