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Axel Leijonhufvud abcd a POLICY INSIGHT No.53 FEBRUARY 2011 Nature of an economy Axel Leijonhufvud UCLA and University of Trento he financial crisis and the ensuing recession Keynesian economics as a stable system with a have prompted reappraisals of the state of “friction”, rather than a theory of an economy Tmacroeconomic theory. Opinions differ harbouring dangerous instabilities. on how serious are its problems but critics and Models with “rigid wages” were not of much use defenders alike are agreed that they should when the nominal scale of Western economies be addressed by systematically examining came adrift in the 1960’s and 70’s. The ‘ad hoc’ and, where deemed necessary, modifying the response was to paste the Phillips curve onto the assumptions of the reigning dynamic stochastic IS-LM model. This became the Achilles heel of general equilibrium (DSGE) theory. the IS-LM brand of Keynesian economics. This is a rather natural reaction to conceptual By restating the Quantity Theory in first failure. But is it the right strategy? differences, Friedman (1968) fashioned the perfect tool of attack, accounting at the same • How many critical assumptions are there that time both for the instability of the Phillips Curve need to be reexamined? and the Fisher premium on nominal interest rates. In the course of so doing, however, he also • What is the framework within which we introduced the concept of the “natural rate of identify the assumptions that seem critical? unemployment.” In Monetarist theory, flexibility of wages were • How do we count the presumptions of which sufficient to guarantee that the economy would we may not even be aware? converge on this natural rate of unemployment – a doctrine that held sway in macroeconomics Macroeconomics by now has a long history of for 40 years. responding to troubles besetting the theory In Keynes’ theory, this proposition was false. prevailing at any given time by changing one or If desired saving did not equal investment at more of its assumptions – and then moving on the natural rate of unemployment, flexibility from there. of wages would not make it converge on that But this collective strategy seems now to have rate. Monetarist theory completely neglected the landed us in a worse mess than ever. Might our saving-investment problem. This came to entail problems lie deeper? as well a neglect of the role of credit markets in furthering or hindering the coordination of A look back1 saving and investment. The main tradition in monetary policy theory In the General Theory, Keynes proposed a theory since the days of Henry Thornton had focused in which flexible money wages would not restore on the stabilisation of credit in regimes with the economy to full employment and very flexible convertible money. Monetarist policy doctrine wages would produce financial catastrophe. was exclusively concerned with stabilising the The IS-LM model, which originated as an price level. It was certainly natural to give priority attempt to formalise the verbal economics of to this objective at a time when the US was Keynes, led after years of debate to the seemingly shedding the last vestiges of gold convertibility inescapable conclusion that unemployment had and going onto a pure fiat standard. But forgetting to be due to the downward inflexibility of money about the potential instability of credit stored up wages. This old neoclassical synthesis thus cast problems for the future – or, should I say, for the present that we are now living through. 1 I have tried to tell the story of the evolution of Friedmanian Monetarism did not last long. macroeconomics, for example, in Leijonhufvud (1981 Robert Lucas believed in Friedman’s theory but CEPR POLICY INSIGHT No. 53 CEPR POLICY INSIGHT No. and 1992). To download this and other Policy Insights, visit www.cepr.org 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 economists 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”.
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