The Marriage of Psychology with Multiple Equilibria in Economics

This is the first of a new weekly blog series, Monday’s Macro Memo with Roger Farmer, which will discuss a wide range of economic issues of the day. The blog will appear on both the NIESR site and on Roger Farmer’s Economic Window and in the first few weeks, I will be posting a series of videos, recorded at a conference held at the Bank England  on July 3rd and 4th of 2017.  The conference was titled "Applications of Behavioural Economics and Multiple Equilibrium Models to Macroeconomic Policy" and the photograph below is of the presenters, discussants and some of the attendees.

Participants at the Conference

I had been planning, for some time, to run a conference on the topic of multiple equilibria sponsored by Warwick University. Andy Haldane and Sujit Kapadia had been talking with Alan Taylor of U.C. Davis about organizing a conference on the topic of behavioural economics. After talking with Andy, Sujit and Alan, we decided it would be ideal to combine our plans into a single conference that would highlight the promise of studying the marriage of psychology with multiple equilibria in economics. The video, linked below, explains why this is a fruitful idea. 

For more than thirty years, I have advanced a research agenda which  promotes the idea that psychology, aka beliefs, matters for economics. Beliefs are central to determining economic outcomes and should be treated as a new fundamental. My own research and the research of my graduate students, Konstantin Platonov and Giovanni Nicolò, also featured at the conference, studies models of multiple equilibria. But these models are incomplete. When an economic model has multiple possible outcomes, the social scientist who constructed the model has not finished her job. She must explain what feature of the social world selects which of the many possible equilibrium outcomes will prevail. That’s where psychology enters the picture.  Economists talk of animal spirits as a factor that helps to determine the unemployment rate and the inflation rate in the real world. Psychology tells us where animal spirits come from and how they are determined.

There is increasing interest in the way that stories influence the real economy. This was the topic of Robert Shiller's 2017 Presidential address to the American Economic Association. Stories have no role to play in conventional economic models because Robert Lucas, writing in 1972, persuaded the profession that the expectations of market participants are determined by economic fundamentals. That idea makes sense in economic models where there is a unique equilibrium. It makes little or no sense in models like the ones I promoted in my 1993 book, the Macroeconomics of Self-Fulfilling Prophecies,  where there are multiple equilibria. The papers presented at the Bank of England conference are about the tensions between these two sets of ideas.

In addition to the introductory video, linked above, we also recorded videos from many of the conference presenters and discussants. I will be releasing these videos in a series of posts in the coming weeks and I will discuss the research associated with the accompanying topic. You can find links to the original papers on the conference website linked here. Stay tuned.

Post-Keynesians and New-Keynesians: A Lesson From Evolutionary Biology

Society for Economic Measurement

I was privileged last week to present one of six plenary lectures at the annual meetings of the Society for Economic Measurement in the brand new Samberg Center at MIT. The conference was organized by the eminent macroeconomist Bill Barnett, founder of the Society for Economic Measurement and founding Editor of Macroeconomic Dynamics. Other keynote speakers included Erik Brynjolfsson on the measurement of welfare, Peter Diamond and Larry Kotlikoff, with alternative takes on social security, Peter Ireland on the importance of divisia aggregates and Gita Gopinath on Global Trade.  My talk was predicated on the fact that there can be no measurement without theory and I revisited a theme that I first presented last June at a Post-Keynesian conference held at the University of Greenwich.

Here is an excerpt from a paper that I wrote for the Post-Keynesian conference, forthcoming in the European Journal of Economics and Economic Policies, with the title, Post-Keynesian Dynamic Stochastic General Equilibrium Theory.  A prepublication version is available on my website here and the slides for the MIT talk are here.  

Who is a Post-Keynesian? Who knows? Who cares? I believe that intellectuals are, or should be, inclusive in their acceptance of alternative approaches to interesting questions and I am not going to propose a Keynesian version of the Nicene Creed. If you self-identify as Post-Keynesian; that's good enough for me. I do think, however, that we can draw an interesting analogy with evolutionary biology. In his wonderful book, the Beak of the Finch, Jonathan Weiner describes evolution in action on the Galapagos Islands.

In response to a prolonged period of drought, Weiner describes how the characteristics of the birds that inhabit different parts of the island begin to diverge. If drought conditions persist, the finches on one part of the island stop breeding with those on another and, slowly, separate species begin to emerge. When eventually, the rains return with the arrival of El Niño, inter-breeding recommences and the divergent characteristics of the emergent populations are merged, once more, into a single species.

When did Post-Keynesians stop interbreeding with their orthodox cousins? It was in 1955. That was the year when Paul Samuelson introduced the neo-classical synthesis into the third edition of his influential introductory textbook.[1] According to the neo-classical synthesis, the economy is Keynesian in the short-run, when prices and wages are ͚sticky͛, and classical in the long-run when they have time to converge to their Walrasian levels. Participants at this conference do not need me to point out that this idea has very little to do with Keynes.

The intellectual descendent of the neo-classical synthesis is New-Keynesian economics, an approach that is neither new nor Keynesian and that has more in common with Hume's essay, Of Money, than with The General Theory. New-Keynesian economics was constructed on the core of a representative agent real business cycle model by a group of neoclassical economists, notably Michael Woodford in his Magnus opus Interest and Prices. It is built onto the real business cycle framework by adding costs of changing prices and the resulting theoretical construction makes Frankenstein͛'s monster look like a beauty queen.[2]

But although the New Keynesian reconciliation of Keynes with Walras is ugly, we should not infer that all possible reconciliations of Keynes with Walras will be similarly unattractive. New Keynesian economics is built on two assumptions. The first is that aggregate quantities can be modeled ‘as if’  they were chosen by a single optimizing household with superhuman perceptions of future prices. The second is that an ‘evil agent’ throws sand into the adjustment process and prevents prices from quickly moving to equate the demands and supplies of all commodities.

I argue in my body of work that we can make considerable progress in advancing our understanding of the macroeconomy by relaxing each of these assumptions. Lets discuss these two assumptions in turn. First, by dropping the representative-agent assumption, I have constructed models with multiple equilibria that can be Pareto ranked. Second, I have introduced a new branch of search theory that I referred to in Prosperity for All as Keynesian search theory. This alternative approach to search theory provides a reconciliation of Keynes’s concept of involuntary unemployment with Walrasian equilibrium theory that is different and more elegant than the sticky-price explanation of New Keynesian economics.

In my talk, I also discussed my work with Konstantin Platonov, "Animal Spirits in a Monetary Economy", in which we develop a micro-founded version of the IS-LM model that maintains the Keynesian idea that involuntary unemployment can be maintained as a long-run steady state equilibrium. In June I presented these ideas to a group of  Post-Keynesians. Last week, I presented the same ideas at MIT, the intellectual home of the New-Keynesians. I continue to be encouraged by the ever growing embrace of my ideas and my agenda and the recent Greenwich and MIT conferences were no exception. To quote once more from my JEEP paper,

Post-Keynesian finches and their New Keynesian cousins have avoided each other for far too long. Just as the arrival of El Niño in the Galapagos Islands allowed diverging species to once more merge, it is my hope that the shock of the Great Recession will catalyse interbreeding between New Keynesian and heterodox economists. If I am right, more of my neoclassical contemporaries will need to listen to the drum beat that post-Keynesians have been sounding for 60 years. And post-Keynesians will need to explain to neoclassical and New Keynesian economists, in their own language, what they are doing wrong. General equilibrium theory, broadly interpreted, like mathematics, is a language. If you are young enough to have not yet been corrupted by establishment elites of either subspecies, I urge you to think hard about joining me in establishing post-Keynesian DSGE theory as the future of macroeconomics.

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1.  See Kerry Pearce and Kevin Hoover (1995) for a discussion of the evolution of the ideas contained in Samuelson’s textbook, Economics: An Introductory Analysis. The neoclassical synthesis first appeared in the third edition in 1955. I discuss the history of the development of New Keynesian economics, and its roots in Samuelson’s interpretation of Keynes, in my book, How the Economy Works.

2. Anyone who has ever tried to teach the New Keynesian Phillips curve will grasp my meaning. The student is first introduced to the ‘Calvo fairy,’ a mythical creature who randomly decides which firms, in any period, are allowed to contemplate changing prices. Next, one must assume that, in an inflationary environment, firms do not pick a price, they pick a mechanistic rule for adjusting their price on a weekly basis. The pricing rule must be aggregated over identical monopolistically competitive firms and the resulting equation must be linearized around a hypothetical stationary growth path. See my book, Prosperity for All for a discussion of the connection between the ugly and unrealistic assumptions that underpin the New Keynesian model and the concentric circles used by Ptolemacian astronomers to justify their assumption that the Earth is at the center of the Solar System. I first discussed the relationship between Ptolemacian astronomy and New Keynesian economics in my paper, "Animal Spirits, Persistent Unemployment and the Belief Function".

The Liberal Conscience (Bertrand Russell Edition)

One of my favorite blogs is the eclectic site, Brain Pickings, by Maria Popova. Maria has a post  here on the British Philosopher Bertrand Russell. I first came across Russell as a first year undergraduate where his History of Western Philosophy was essential reading. Later, I started reading Introduction to Mathematical Philosphy, still one of the clearest expositions of the roots of mathematics ever written. Maria reminds us that Russell was also a proponent of English liberalism, a philosophy that he summed up in ten principles to guide us all as educators. It first appeared in the December 16, 1951, issue of The New York Times Magazine, at the end of the article “The best answer to fanaticism: Liberalism.”

"Perhaps the essence of the Liberal outlook could be summed up in a new decalogue, not intended to replace the old one but only to supplement it. The Ten Commandments that, as a teacher, I should wish to promulgate, might be set forth as follows:

1. Do not feel absolutely certain of anything.
2. Do not think it worth while to proceed by concealing evidence, for the evidence is sure to come to light.
3. Never try to discourage thinking for you are sure to succeed.
4. When you meet with opposition, even if it should be from your husband or your children, endeavor to overcome it by argument and not by authority, for a victory dependent upon authority is unreal and illusory.
5. Have no respect for the authority of others, for there are always contrary authorities to be found.
6. Do not use power to suppress opinions you think pernicious, for if you do the opinions will suppress you.
7. Do not fear to be eccentric in opinion, for every opinion now accepted was once eccentric.
8. Find more pleasure in intelligent dissent than in passive agreement, for, if you value intelligence as you should, the former implies a deeper agreement than the latter.
9. Be scrupulously truthful, even if the truth is inconvenient, for it is more inconvenient when you try to conceal it.
10. Do not feel envious of the happiness of those who live in a fool’s paradise, for only a fool will think that it is happiness."

Liberalism, as understood by Russell, is a long way from its current use in the modern American political discourse. As educators, have we lost sight of Russell's guiding principles?  

David and Goliath: The sunspot agenda meets the MIT machine

Two interesting developments occurred on the DSGE front this week. CEPR, the London based research organization, published an ebook on the future of Dynamic Stochastic General Equilibrium Models and Aurélian Saïdi and Beatrice Cherrier released an updated version of their history of the Penn/CEPREMAP research agenda on indeterminacy and sunspots. There could have been, and should have been, considerable overlap in these two events. Sadly there was not. 

For forty years, macroeconomics has been dominated by a battle between classical ideas emanating from the universities of Minnesota and Chicago, and New Keynesian ideas, emanating from MIT. In the past decade or so, MIT has been dominant and MIT trained economists have steamrolled an agenda that developed from Samuelson's interpretation of Keynes. According to this interpretation, the economy is Keynesian in the short run, when prices are sticky, and classical in the long-run, when all prices have had time to adjust. The MIT machine is the Goliath of my story.

A parallel agenda developed in the 1980s at the University of Pennsylvania in the U.S. and at CEPREMAP in France. This separate agenda accepted some but not all of the ideas of Minnesota and Chicago and married them with notions of  indeterminacy, sunspots and multiple equilibria as a way of understanding the macroeconomy. The sunspot/indeterminacy program is the David of my tale.

There is much to like and to agree with in the CEPR ebook, edited by Refet Gürkaynak and Cédric Tille. As with other projects in this series, it consists of a series of short articles from practitioners in the field, each giving a different perspective on the current state of the art in macroeconomic modeling. I particularly liked the piece by Del Negro and Giannoni explaining progress made at the Federal Reserve Bank of New York (FRBNY) on developing a suite of models for forecasting and policy evaluation. The FRBNY DSGE model has been around for a while and is now available as free open source code written in the programming language Julia. Julia, like MatLab, is a matrix based language compiled in real time. It is up to ten times faster than MatLab and free. Time (for me) to make the switch.

The CEPR ebook ends with speculation by Jordi Galí and Olivier Blanchard on the future of DSGE modeling. Here, I was disappointed by the inability of either Jordí or Olivier to acknowledge the body of knowledge developed over the past three decades by researchers in the sunspot/multiple equilibrium program. Neither Jordí nor Olivier are unaware of these ideas. Jordi has written sunspot papers and Olivier was the discussant on the Animal Spirits paper I wrote for the new Phelps volume where I showed how models with indeterminate steady state equilibria can explain hysteresis, a topic after Olivier’s heart.

Saïdi and Cherrier speculate that sunspot ideas did not capture the hearts of the profession because the researchers involved in the program failed to develop a common language and engaged in territorial disputes over property rights. There was no single leader to push the agenda. There is certainly an element of truth to that. Sunspots, self-fulling prophecies, animal spirits and confidence were all used interchangeably by different groups of authors to mean the same thing. Now there is yet another emergent power play by George-Marios Angeletos and Jennifer La’o to take the mantle. Rather than use sunspots, self-fulfilling prophecies or animal spirits, Angletos and La’o substitute yet another term ‘sentiments’ to mean the ability of non-fundamental shocks to influence economic activity.

There will always be turf battles over intellectual ideas. The stakes are high, particularly when these ideas are once more gaining prominence. It is a personal view, expanded on here, that the entire MIT inspired New Keynesian edifice is built on sand. It is hard to read the General Theory without recognizing the role of multiple equilibria. Not just multiple paths, as in the first generation sunspot models, but multiple indeterminate steady states, as in the second generation models based on search theory that I survey here.  By marginalizing that idea and building their models on ‘frictions’, the New Keynesians sold their collective soul.

In some circles, DSGE is a four-letter term of abuse. That is a pity and here, I am on the side of Gürkaynak and Tille. To quote from my 1993 book, The Macroeconomics of Self-Fulfilling Prophecies, [page 1]  “… the future of macroeconomics is as a branch of applied general equilibrium theory.”  For forty years or more, Post-Keynesian economists clung to the idea that, whatever Keynesian economics is about, it is not about sticky prices. I agree.   But unlike the Post-Keynesians, I am also a fan of DSGE modelling. As I argue here, by adopting the ideas of second generation models of indeterminacy and sunspots, it becomes possible to be a Post-Keynesian, as opposed to a New-Keynesian, and a DSGE fan, at the same time. 

I am optimistic, perhaps in vain, that David's sling-shot will one day, bring down Goliath.

Cách Nên Kinh Tê Vân Hành

For all my Vietnamese readers: the Vietnamese edition of my book, How the Economy Works, is now available.  You can order it here. My apologies to all those of you who read Vietnamese: Apple has not yet figured out how to add all of the accents used in Vietnamese.

You can now order How the Economy Works in hardback, paperback,  audio and on Kindle. Its also available in Hungarian and Vietnamese. 

Here is what one reviewer said about the book on Amazon

This is a timely book to spark debate & reflection following the September 2008 financial crisis that is still with us in 2010...   In this book ...   leading economist professor Roger E. A. Farmer dissects the current economic meltdown ; suggesting how the economics must change to get out of the doldrums. Professor Roger E. A. Farmer traces the swings between classical & Keynesian economics since the early twentieth century, explaining the elements of both theories. ... He adopts the principle that markets do not always work well & that capitalism needs some strategic guidance to improve. ...A highly recommended reading, clear & accessible to the general public to hopefully spark debate on this current important issue.  M. Mariba