Peter Cooper — One of the Fundamental Differences Between Modern Monetary Theory and New Keynesian Economics

Independent economist Peter Cooper addresses the "we-knew-it-all-along" claim and shows, not really.

heteconomist
One of the Fundamental Differences Between Modern Monetary Theory and New Keynesian Economics
Peter Cooper

Equilibrium in Economic Theory

Everything you may have wanted to know about equilibrium in economics.

Post Keynesianism generally dismisses the neoclassical assumption of equilibrium in economic theory, but these posts serve to clarify the concept and the debate around it. David Glasner explores the history, while Jason Smith comments on the concept for the POV of physics and explains it in terms of information equilibrium.

Uneasy Money
On Equilibrium in Economic Theory
David Glasner | Economist at the Federal Trade Commission

Information Transfer Economics
An agnostic equilibrium
Jason Smith

See also

The Undercover Historian
What is the cost of ‘tractable’ economic models?
Beatrice

Peter Cooper — Disequilibrium Dynamics of Output and Demand

Theoretical studies of output and growth often focus on the behavior of equilibrium output. The usefulness of this approach depends on there being a tendency for actual output to converge on equilibrium output. With such a tendency present, studying the behavior of equilibrium output will tell us something about the behavior of actual output. It is therefore of interest to spell out the process by which an economy in disequilibrium is thought to tend toward equilibrium.

A first step is to consider the disequilibrium behavior of an economy that, for simplicity, is taken to be stationary (non-growing) when in equilibrium. This approach is adopted in the present post. The exercise is really preparation for considering a continually growing economy – a task that is left for a possible future post.…

The material in this post is somewhat technical but hopefully not difficult. Even so, the post is long (about 4000 words) and, for readers not already familiar with similar material, possibly a stretch to read all in one go. I considered separating the post into numerous shorter ones but felt that the loss of continuity would require too much repetition in setting up the discussion each time.

The post is divided into sections that provide natural stopping points for readers who wish to take breaks. The section titles are:

1. Macroeconomic Equilibrium
2. Disequilibrium Behavior
3. Adjustment Process
4. Adjustment in Simple Algebra
5. Convergence as a Power Series: λ = 1
6. Convergence as a Power Series: λ < 1
7. Adjustment of Growth Rates

heteconomist

Disequilibrium Dynamics of Output and Demand
Peter Cooper

Erica Klarreich — In Game Theory, No Clear Path to Equilibrium

Game theory in math and economics.

Quanta Magazine
In Game Theory, No Clear Path to Equilibrium
Erica Klarreich

Ramanan — What Is Equilibrium?

The new paper by Gennaro Zezza and Michalis Nikiforos for the Levy Institute, surveying the literature on stock-flow consistent models has a discussion on the concept of equilibrium:

In neoclassical economics the concept of equilibrium is based on Say's law, which implies that in the long run there are no market gluts since free markets adapt to changing conditions through the operation of the law of supply and demand. This means that all markets tend to clear in the long run, including not only capital and consumer goods markets, but also labor markets and financial markets.

Gluts and shortages are temporary deviations in specific markets that are removed by the law of supply and demand. Therefore, a general glut can only result from an exogenous shock, and left to itself the market as whole will tend to general equilibrium "in the long run" as efficiently as possible.

Heterodox economists can be broadly defined as those rejecting the key fundamentals of the neoclassical approach, the assumption of rational utility maximization and general equilibrium.

Gennaro Zezza and Michalis Nikiforos set forth the SFC approach, and Ramanan summarizes it.

The Case for Concerted Action

What Is Equilibrium?
V. Ramanan

Mark Buchanan — The Misunderstanding at the Core of Economics

The theorem shows -- in a highly abstract model -- that producers and consumers can match their desires perfectly, given a particular set of prices.... 

... it worked only in a perfect world, far removed from the one humans actually inhabit....

This perversion isn’t Arrow’s fault. He merely helped to prove a mathematical theorem, and was no blind advocate for markets. Indeed, he actually thought the theorem illustrated the limitations of capitalism, and he was prescient in understanding how economic inequality might come to impair the workings of democratic government. 

Perhaps it would be best to use his own words: “In a system where virtually all resources are available for a price, economic power can be translated into political power by channels too obvious for mention. In a capitalist society, economic power is very unequally distributed, and hence democratic government is inevitably something of a sham.”

As I have been saying, capitalism (economic liberalism) is antithetical to democracy (political liberalism).

Bloomberg View
The Misunderstanding at the Core of Economics

Mark Buchanan
ht Mark Thoma at Economist's View

Rajiv Sethi — Reigns of Error

Not only does [the great sociologist Robert K. Merton (father of the Nobel-winning economist)] provide a very clear account of equilibrium beliefs, but goes on to point out that even when these beliefs are correct in a narrow sense, they can hold in place an incorrect understanding of the social world. To translate this into the contemporary language of economics, Merton points out that the play of equilibrium strategies can go hand in hand with a deeply erroneous understanding of the game....

The economic method, for all its flaws, has one very important virtue: it shines a bright light on interests and incentives, and in doing so can challenge essentialist interpretations of social reality. But if this potential is to be realized, it is important to focus not just on the characterization of equilibrium behavior, but also on the reigns of error that distort our mental models of the underlying game.

Rajiv Sethi Blog
Reigns of Error
Rajiv Sethi | Professor of Economics, Barnard College, Columbia University, & External Professor, Santa Fe Institute

Brian Romanchuk — Equilibrium And Steady State In SFC Models

Noah Smith had already observed that "equilibrium" is an ambiguous term in economics. Brian delves into specifics.

Bond Economics
Equilibrium And Steady State In SFC Models
Brian Romanchuk

Jason Smith — One more physics analogy

Continuing the debate.

David Glasner found a back-and-forth between me and a commenter (with the pseudonym "Avon Barksdale" after the character on The Wire who ends up taking an economics class) on Nick Rowe's blog who expressed the (widely held) view that the only scientific way to proceed in economics is with rigorous microfoundations. "Avon" held physics up as a purported shining example of this approach.

I couldn't let it go: even physics isn't that reductionist.

Is the assumption of stable equilibrium based on rationality taking a special case for a general one?

Information Transfer Economics
One more physics analogy
Jason Smith

Claudio Borio and Piti Disyatat — The Interest-Rate Enigma

...interest rates are not determined by some invisible natural force; they are set by people. Central banks pin down the short end of the yield curve, while financial-market participants price longer-dated yields based on how they expect monetary policy to respond to future inflation and growth, taking into account associated risks. Observed real interest rates are measured by deducting expected inflation from these nominal rates. 

Thus, at any given point in time, interest rates reflect the interplay between the central bank’s reaction function and private-sector beliefs. By identifying the evolution of real interest rates with saving and investment fundamentals, the implicit assumption is that the central bank and financial markets can roughly track the evolution of the equilibrium real rate over time.

But this is by no means straightforward. For central banks, measuring the equilibrium interest rate – an abstract concept that cannot be observed – is a formidable challenge....

Moreover, central banks’ policy frameworks may be incomplete. By focusing largely on short-term inflation and output stabilization, monetary policy may not pay sufficient attention to financial developments. Given that the financial cycle is much more drawn out than the business cycle, typical policy horizons may not allow the authorities to account adequately for the impact of their decisions on future economic outcomes....

With financial-market participants as much in the dark as central banks, things can go badly wrong. And so they have....

Monetary policy cannot overcome structural impediments to growth. But the actions that central banks take today can affect real macroeconomic developments in the long term, primarily through their impact on the financial cycle.

Minsky.

Project Syndicate
The Interest-Rate Enigma
Claudio Borio, Head of the Monetary and Economic Department at the Bank for International Settlements, and Piti Disyatat, Director of Research at the Bank of Thailand

Peter Radford — Some thoughts on economics

My instinctive entry point into economics is through business....
Economics as it exists today in its mainstream form is of no use whatever to anyone seeking to understand the reality of business. Our extant theories of the firm are failures in that they attempt to see the world through a neoclassical lens whilst that lens obscures anything remotely real from view in an effort to retain the equilibrating perfection of the closed system envisaged by Walras. The contradiction between the pursuit of equilibrium explanations and the open ended nature of the real world defeats neoclassicism at the starting gate and dooms it to subsequent nonsensical irrelevance....

In this context I have to attribute a great honor to the Arrow-Debreu effort to complete the Walrasian episode. Arrow-Debreu deserves our constant indebtedness. It shows, definitively, how the Walrasian tradition cannot be an explanation for a real economy. It achieves completion by imposing such horrendously, and obviously, unreal constraints on itself that it proves Walras wrong. It is thus great science. It is the falsification of a tradition shown to be worthless.

On another matter: mainstream economists have never adequately, in my opinion, responded to Coase’s challenge of 1937. He asked simply: if markets do what classical economists and their followers say they do, why do firms exist? They ought not. That they do suggests something is very wrong at the heart of orthodox thinking. So I add the ‘Coase conundrum’ to Arrow-Debreu as adding weight to the critique. Mainstream economics is alchemy....

Asymmetrical information is another challenge to orthodoxy that is too often ignored. Information about things is patchy in the real world. Very patchy. It is non-existent with regard to the medium and long term future. Yet this never deters the neoclassical theorists. They march along as if asymmetry was an inconvenience that can be assumed away for simplicity’s sake, rather than a dagger in the heart of their work....

Uncertainty and complexity characterize the real world. Certainty and simplicity characterize neoclassical economics. Hence it irrelevance. It is complicated though, as Arrow-Debreu shows. It has to be. Its epicycles weigh it down. But no amount of clever formalism can turn unreality into reality, just as lead is pretty tough to turn into gold. This doesn’t mean that neoclassical economist aren’t very bright. They are. They have to be to to tend to those epicycles. Newton, after all, spent more time on alchemy than on recognizable physics. No indeed, they are very bright. Just wrong. 

Real-World Economics Review Blog

Some thoughts on economics
Peter Radford

This is a seminal article. Not much that we haven't said hundreds of time on this blog and in the comments, but Peter Radford ties it together very nicely — concise, precise and clear.

Note also that what is said about economics, order and entropy wrt to management also applies wrt to governing, and as Norbert Weinberg observes in naming cybernetics. It's also the basis of general system theory developed by economist Kenneth Boulding and others from related fields who understood the fundamental role of information in imposing order and overcoming entropy. See A Curriculum for Cybernetics and Systems Theory by Alan B. Scrivener for a summary of the basics.

Why don't conventional economists read this stuff, or if they do, why don't they use it?

Where I would quibble with Radford is over his assertion,

"The substitution of labor for capital or vice versa tells us that neither if fundamental. The energy and skill are. Energy and knowledge deployed to order resources for subsequent disordering. That’s the economic process." 

Is he forgetting that capital goods are also produced by labor? Labor is basic until capital goods can produce capital goods and innovate while doing so. That level of AI is still  in the dream stage of development, and even then it seems that knowledge workers will still be required in the Age of Artificial Intelligence.

Antoine Reverchon — The Dogmas of the Market Economy under Critical Scrutiny

About Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State by Roman Frydman and Michael D. Goldberg and what the authors call "imperfect knowledge economics."

INET Blog
The Dogmas of the Market Economy under Critical Scrutiny
Antoine Reverchon (translated from French), Le Monde

PDF of the epilogue here.

From the epilogue:

Keynes ... shared Knight’s profound doubts concerning the usefulness of standard probability theory for understanding change in individual decisionmaking and market outcomes: we “cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist” .... The importance that Keynes attached to the role of uncertainty concerning both outcomes and probabilities played a key role in his analysis of financial markets and their influence on the broader economy, particularly investment.

But

Hayek’s admonition was directed at the post- (1945) Keynesian econometric models, which grew out of the purported formalization of Keynes’s ideas and were estimated by statistical methods on the basis of historical data. Around the time of Hayek’s Nobel lecture, the applicability of these models for policy analysis had come under severe criticism, either for portraying market participants’ forecasting behavior with mechanical rules, which did not take into account contemplated changes in policy, or for disregarding such behavior’s eff ects on aggregate outcomes altogether.

While unnamed, the most prominent author of "the post- (1945) Keynesian econometric models" was Paul Samuelson, who integrated some Keynesian principles with neoclassical general equilibrium.

Hayek fared no better.

Rational Expectations models, which were becoming highly influential at the time, were proposed by their advocates as a way to remedy this fl aw in Keynesian econometric models. But the Rational Expectations models were as mechanical as their Keynesian predecessors.

Because their portrayal of individuals' forecasting behavior is woefully inadequate, Rational Expectations models were unsuitable for analyzing how market participants would respond to the contemplated changes in economic policy. Remarkably (given that they were developed by Hayek's successors at the University of Chicago), these models were, moreover, fully predetermined, and thus perpetuated "the pretense of exact knowledge" that Hayek criticized so scathingly in his Nobel lecture.

Behavioral economics, often credited with overturning this did nothing of the sort, since it carried over previous assumptions.

Faith that better fully predetermined models hold the key to
adequately predicting all future changes and their consequences is
puzzling not only with respect to adherents of the Rational Expectations Hypothesis. When behavioral economists, who uncovered
many important empirical failures of Rational Expectations models,
formalized their insights, they followed their conventional predecessors by doing so with fully predetermined models

The authors then outline their approach as qualitative and contingent.

Imperfect Knowledge Economics stakes out an intermediate position between erratic animal spirits and the contemporary presumption that change and its consequences can be adequately prespecifi ed with mechanical rules. In contrast to the contemporary approach, the mathematical models of Imperfect Knowledge Economics explore the possibility that change and its consequences can be portrayed with qualitative and contingent conditions. h ese conditions are context-dependent, and as discussed in Chapter 9, the qualitative regularities that they formalize become manifest—or cease to be relevant—at moments that no one can fully predict.

Imperfect Knowledge Economics therefore does not adopt the extreme view, often associated with Knight, that uncertainty is so radical as to preclude economists from saying anything useful and empirically relevant about how market outcomes unfold over time. Indeed, departing from the position of Knight and Keynes, we make nonstandard use of probabilistic formalism.

This approach facilitates the formalization of qualitative conditions that make up Imperfect Knowledge Economics models and the mathematical derivation of their qualitative and contingent implications. However, Imperfect Knowledge Economics recognizes the importance of early modern arguments that market participants (and economists) have access to only imperfect knowledge of the causal factors that may be useful for understanding outcomes.

Noah Smith — What is an economic equilibrium?

I get asked about this one a lot. And it's also a source of controversy...on one hand you have some econ critics who say "Econ models wrongly assume that the economy is always in equilibrium," and on the other hand you have economists responding that "No, economics models are defined to always be in equilibrium." So I thought I'd try to clear things up...hopefully I don't just end up muddling them further. But anyway:

"Equilibrium" can mean many different things.

There are many different types of equilibria in economics. This may sound intellectually dishonest, but it's not; the same is true in biology, physics, or any other science. "Equilibrium" just means "balance", and there are lots of different kind of things that can balance. In fact, any equation you write down that isn't true by definition can be interpreted as an "equilibrium" relationship, or "equilibrium condition" - the equation is simply a statement that whatever's on the left-hand side of the equation is balanced with whatever's on the right-hand side.

Different economic models have different kinds of equilibria, so it's not like there's one kind of "equilibrium" that is all-important to modern economics....

Noahpinion
What is an economic equilibrium?
Noah Smith | Assistant Professor of Finance, Stony Brook University

Andrew Lainton — Keen's Modification of Walras’s Law, Applied to Walras’s Theories

I have long argued on this blog that Steve Keen needs to be taken seriously as an economic theorist and he had made a number of contributions that help solve key theoretical puzzles.

I will posit that one of these contributions is a major modification, indeed correction of Walras’s law. But if he is to be taken seriously then we have to see what economic theory looks like with these changes ‘plugged in’ -does it become more or less coherent? Here I look at his correction of Walras’s law and its implications for general equilibrium theory, a track I wonder if Professor Keen is interested in going down as, rightly, he sees the rigid and dogmatic approach to equilibrium theory in the current lucasian hegemony in economics as a major weakness.

Decisions, Decision, Decisions
Keen's Modification of Walras’s Law, Applied to Walras’s Theories
Andrew Lainton

Lainton disagrees with the view that excess reserves don't affect bank lending and has put forward argument for it.

Growth in bank accounts do have an effect on economic activity if it leads to an increase in excess reserves which banks try to offset by increasing lending.  Capital plus excess reserves is the banks budget constraint (we have covered this point, and the fallacy that reserves don’t matter in endogenous money theory, on this blog many times, and we are agreement here with all of the banking theory textbooks written from an endogenous money perspective).  Of course if banks do not lend we get a seizing up of the monetary circuit.

Lars P. Syll — Foundations of Paul Samuelson’s Revealed Preference Theory

Wonkish but important in taking down the foundations on which the neoclassical assumption of equilibrium based, positing a representational rational agent using utility maximization as the driver. The problem lies in defining "utility" in a way that provides a connection between the theory and the world it purports to explain through a general description. The problem with "utility" is that it is subjective, hence, non-descriptive. Samuelson tried to overcome this bias using revealed preference, which is behavioral, hence, can be described, e.g., through indifference curves. The post is why this approach is also deficient. Neoclassical economics presumes a downward sloping demand curve, and this cannot be shown convincingly using revealed preference as Paul Samuelson had attempted.

Lars P. Syll
Foundations of Paul Samuelson’s Revealed Preference Theory

Bill Mitchell — A chicken in every pot!

Bill takes down the foundation of neoclassical economics, equilibrium at full employment. Neoclassical economics posits equilibrium at full employment, while Keynes posited equilibrium at less than full employment under capitalism unless government intervenes to increase effective demand.


Bill Mitchell — billy blog
A chicken in every pot!
Bill Mitchell

Lord Keynes — Kaldor on Economics without Equilibrium

If one were state the difference between Post Keynesianism and mainstream neoclassical theory, it might be summed up with the idea that Post Keynesian theory is “economics without (Walrasian) equilibrium.”

Social Democracy For The 21st Century
Kaldor on Economics without Equilibrium
Lord Keynes

Kaldor understood how business works and how firms actually respond to signals rather in the highly idealized way of price being the equilibrium between perfectly elastic supply and demand "curves" (behavior) that economics generally assumes as intuitively true. That behavior of firms is just not factual, as every business person knows from experience, much along the lines that Kaldor describes.

Ramanan elaborates with an extended Kaldor quote:

The Case for Concerted Action
The Heavenly Walrasian Auctioneer

Lord Keynes — Philip Pilkington on Hayek and the Origins of Neoliberalism

When Hayek’s economics essentially failed, he turned to a different program: social and political theorising.

While Hayek's economics may have failed his own expectations, his social and political theorizing lead to the dominant contemporary narrative, likely wildly beyond his expectations. It was an idea whose time was right, even though it was not a right idea. Now we are experiencing it's failure.

Social Democracy for the 21st Century
Philip Pilkington on Hayek and the Origins of Neoliberalism

Lord Keynes

James K. Galbraith — How the Economists Got It Wrong

An oldie but goodie from Jamie Galbraith, hat tip to Philip Pilkington.

The deeper problem is the nearly complete collapse of the prevailing economic theory--of the structure of thought that supports their policy ideas. It is a collapse so complete, so pervasive, that the profession can only deny it by refusing to discuss theoretical questions in the first place.


The prevailing theory is the idea that price and quantity are set in free competitive markets through the interaction of supply and demand. It is this idea, and no other, that lies at the core of the economist's way of thinking. And it is also the source of the profession's problem in getting almost anything important right.



The notion of supply and demand as the organizing principle for everything is a few decades more than a century old. (It was not so for Smith, Ricardo, Malthus, Marx, or Mill.) The key player in the Anglo-Saxon tradition is Alfred Marshall; in the continental tradition, no doubt, Leon Walras. In the twentieth century, great economists including Keynes, Joseph Schumpeter, and John Kenneth Galbraith have tried to break the grip of this notion on the professional imagination. But they have not succeeded.

The American Prospect (December 19, 2001)
How the Economists Got It Wrong
James K. Galbraith | Lloyd M. Bentsen Jr. Chair in government-business relations at the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin, a senior scholar of the Levy Economics Institute, and chair of the Board of Economists for Peace and Security.

Lars P. Syll — Robert Lucas and the intellectual collapse of freshwater economics

Robert Lucas is at is again. The invisible hand will return the economy to equilibrium at full employment to the degree that it is allowed to operate by eliminating government interference. And as Lars points out, without a shred of evidence in the face of massive failure of that paradigm to foresee the crisis, which it explains as either resulting from governmental intervention or an unforeseeable shock.

The presumption of equilibrium in neoclassical economics is derived from a 195y century view of physics that contemporary economists have attempted to save using DSGE. That is is say, the assumption is that equilibrium is the guiding principle in analysis of "free" markets and distribution by price discovery.

This is reminiscent of past presumptions that affected thought in the West. The Greeks had that cosmos (order) is imposed on the original chaos (randomness) by logos (rational principle or cause – Greek αἰτία). The Greek term logos is the root of English "logic." The ancient Greeks held that the universe (cosmos) is rational. Logic is the rational structure underlying human cognition of invariant principles that order change iaw law (causality). Mathematics is an aspect of logic. The lintel of Plato's Academy was inscribed with the words, "Let no one ignorant of geometry come under my roof." Given this presupposition the discovery of irrational numbers was an earth-shaking event that initially concealed from the uninitiated lest they lose faith. Subsequently, it led to a bifurcation between arithmetic and geometry that persisted until the beginning of the modern period.

The discovery of irrational numbers caused a break in Greek mathematics between arithmetic and geometry. The Greeks could not accept the fact that some lengths were incommensurable with rational numbers. Therefore, they decided that numbers could not be associated with lengths. Unfortunately, this decision led to a division between arithmetic and geometry that was not reconciled until the time of Descartes. (Math Lair)

Similarly, Aristotle had posited that the motion of heavenly objects must be circular because of the perfect form of the circle. This presupposition was at the root of the resistance to change in astronomy from a Ptolemaic system of epicycles to the simpler heliocentric Copernican system, later explained by Kepler, who was the first to use elliptical orbits.

Modern physics also presents a parallel. Classical physics presents the universe as realistic and deterministic. The discovery of quantum mechanics shook that foundation by suggesting the bedrock on which classical physics is built is probabilistic. Einstein famously objected to this interpretation with "God does not play dice," and engaged in a running debate with Bohr for decades over this. The debate was finally resolved by time, and now a majority of physicists accept that "reality" is probabilistic at ground.

The discipline of economics is affected by a similar presumption — equilibrium. Keynes rejected the neoclassical view, but Keynesians were not able to hold the fort. Samuelson capitulated and "bastardized" Keynesianism with his neoclassical synthesis. Now mainstream economists, who call themselves "orthodox" and everyone else "heterodox," which is a euphemism for "heretical," have largely prevailed and imposed equilibrium as the "normal" paradigm in Kuhn's sense.

Until this lock on the discipline is broken, economics will be theology and lag its sister science in adherence to a dogma that has been widely discredited.

As Robert Vienneau wrote recently:

If you want to argue against mainstream economics, a mainstream economist can dismiss you as ignorant of some model variation and as attacking a strawperson. Furthermore, this dismissal could be "justified" by just checking whether you have a degree from a small number of schools, and, if you do, just mocking you as not having fully learned what they are teaching. Thus, your time can be taken up with argument about whether you know what you are talking about. The mainstream economist never need get to the point of engaging a critique.

The economics profession is broken and it cannot be fixed without replacing those who adhere religiously to discredited dogma, which looks suspiciously like a conservative preference for government as an adjunct to business rather than the ordering mechanism of society as a complex system in which emergence presents challenges that markets alone are not suited to address.

Lars P. Syll's Blog
Robert Lucas and the intellectual collapse of freshwater economics
Lars P. Syll | Professor, Malmo University