Islands in the sun …

Late this afternoon I appeared on ABC Radio National Saturday Extra at a public forum on the future of coal that was held at Fort Scratchley which is near my favourite surf beach in Newcastle (Nobby’s). The site is near the mouth to the Newcastle Port which is the World’s largest coal export port. The program will be broadcast this coming Saturday (see link) but there was a public audience (to heckle the Minister!) present. They filmed the forum and it will be available via podcast sometime later. But that is not the topic of today’s blog. It is about another Nobel Prize winner.

In his 2003 presidential address to the American Economic Association, Robert E. Lucas, Jnr of the University of Chicago said:

My thesis in this lecture is that macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes, and has in fact been solved for many decades. There remain important gains in welfare from better fiscal policies, but I argue that these are gains from providing people with better incentives to work and to save, not from better fine tuning of spending flows. Taking U.S. performance over the past 50 years as a benchmark, the potential for welfare gains from better long-run, supply side policies exceeds by far the potential from further improvements in short-run demand management.

You might wonder what the current crisis is all about then. But these guys never let the facts get in the road of their models. One professor once said to me in all seriousness when I confronted him about the fact that his predictions didn’t accord with the data said .. “clearly the facts are wrong”.

Anyway, Lucas was given the Nobel Prize in 1995 “for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy.”

That single sentence should tell you why the Nobel Prize is a nonsensical award.

His earlier work was with Leonard Rapping and together they developed the concept of a natural rate of unemployment and set in place the foundations for real business cycle theory. it was work that Rapping lived to regret until his early death in 1991.

That article was Lucas, Robert E., Jr. and Rapping, Leonard A. (1969) ‘Price Expectations and the Phillips Curve’, The American Economic Review, 59(3), 342-50.

You might like to seek out the interview with Rapping in Arjo Klamer’s book “The New Classical Macroeconomics” Wheatsheaf Books, 1984.

On methodology, Rapping says of his Chicago days:

… we were in the Chicago tradition, so we assumed perfect competition and profit and utility maximisation. Every single proposition had to be consistent with those assumptions. There were certain rules of logic that had to be followed, and the discussions were very tight and logical. We would try to explain everything in terms of the competitive equilibrium models. (We had learned that from Friedman) …

Sometime later, Rapping became extremely disillusioned with the Vietnam War and saw that the logic of the war clashed with the training he had received at Chicago, and was, in turn, passing on to students himself. He said:

I discovered that the war was wrong: I came to the conclusion that it was an illegitimate war and America was an imperial power. That disillusioned me. In all my training at Chicago there was no serious mention of the global system. Chicago training, like training elsewhere, was closed economy training. I knew that the Chicago world vision was inappropriate for the problems I was concerned with … You cannot have democracy at home and an empire abroad … Friedman never mentioned anything about foreign policy or defense spending or an American system. So I did the only thing I could: I jettisoned Chicago economics …

This led Rapping to initially abandon his burgeoning career as one at the forefront of mainstream neoclassical thinking at Carnegie-Mellon University (Pittsburgh). He later turned to radical economics and took a post at Umass (Amherst). It was a major change in his thought processes and I always had a lot of respect for his dilemma.

He was very critical of Ronald Reagan’s pursuit of supply-side economics and said it was a policy that “transfers money from the poor to the rich.”

I had an interchange a few years ago with Arjo Klamer about Rapping which suggested he didn’t die all that happy.

Anyway, once he had made the transition his views on the work of Lucas and the rational expectations tradition changed signifantly. Klamer asked him: “What do you think about the current work of Bob Lucas?” He replied:

It is very abstract and formal model building … For me it’s too general, too removed from reality.

Further on in the interview (p.234), Rapping said that:

Frankly, I do not think that the rational expectations theorists are in the real world … People trained in his way …[Lucas] … of thinking will be applied mathematicians. Of-course, these people will not be convinced that less “precise” ways of thinking are appropriate. So what? Most of the economists who pick up this stuff are young; the older economists have not embraced it. The younger ones may drive the broad thinkers somewhere else, like to political science or sociology or law. That bothers me about American economics.

Anyway, back to Lucas. One of his most quoted pieces of work related to his island model of inflation – Lucas, R.E. Jr. (1972) ‘Expectations and the Neutrality of Money’, Journal of Economic Theory, 4, 103-124.

This was his best known model and it was used to assert that money supply changes are inflationary and will not have real effects in the long-run. It was the vanguard paper of those who eschewed the use of government intervention which they claimed would not be able to improve the employment situation but would just be inflationary.

Lucas built on Phelps work which had been criticised for assuming adaptive expectations.

Under adaptive expectations people make a forecast of the future on the basis of their last forecast plus some fraction of the forecast error they made in the last period. So when inflation is rising continuously they will always be wrong.

The mainstream economists thought this was suggestive of irrational behaviour. The addition to Phelps’ natural rate of unemployment that Lucas made was to add what is called rational expectations (RATEX).

This was an extraordinary development. Accordingly, all people generate rational expectations which means that they know the true underlying economic model in the world and on average make the correct forecast of the future only varying randomly due to informational deficiencies.

It was once pointed out at a workshop I attended with some really well-known economists who were pushing this notion that if it was remotely true then there would be no need for economists. If everyone understood the true nature of the economy then the person delivering the mail in the morning was as well qualified to talk about the economy as one who had a PhD in economics.

The person challenging the panel then asked that they all resign – on the basis of their obvious self-professed redundancy. I don’t believe a single mainstream professor resigned! So they didn’t believe in their own theories.

Anyway, Lucas built RATEX into a model of islands. What he was trying to come to terms with was the short-term positive relationship between output and inflation (the so-called ‘Phillips curve’) which was an empirical fact. But this was contrary to the thrust of the mainstream that long-run money growth could not affect real output and the economy would settle at a real equilibrium and any attempts by the government to improve on this (lower unemployment) would be inflationary.

So he used the islands model to pursue that question. His economic model had N islands each with an individual resident. So a lonely life but at least the waves wouldn’t be crowded! Every person produces an amount of output Q and money is used to buy the output. Trade occurs by people moving between the islands in search of output.

Lucas just asserts the Quantity Theory of Money which in symbols is MV = PQ but means that the money stock times the turnover per period (V) is equal to the price level (P) times real output (Q). The mainstream assume that V is fixed (despite empirically it moving all over the place) and Q is always at full employment!

So then they say that M -> P (that is, the basic Monetarist claim that expanding the money supply is inflationary). It beggars belief that anyone would still believe this stuff but they do.

One of the contributions of Keynes was to show the QTM could not be correct. And with high rates of capacity and labour underutilisation at various times (including now) one can hardly seriously maintain the view that Q is fixed.

But the modern belief in the QTM is behind the hysteria about the level of bank reserves at present – it has to be inflationary they say because there is all this money lying around and it will flood the economy. Crazy stuff.

Anyway, back to the islands. So all these lonely islanders make stuff and sell it to other islanders. They will only work if the real wage is equivalent to their marginal productivity (which is the last unit of output they make per hour) and that is diminishing (major assertion of mainstream economics).

This was expressed in the form of a supply function such that a person would increase their output if the price they received for it was greater than the aggregate price in the economy. The fudge that Lucas introduced was to assume that each person only knows their own price but is uncertain of the price ruling across all islands.

The difference between any island’s price and the aggregate price was assumed to be random although specific prices might alter due to better techniques etc which would change the relative price and invoke output changes.

If all prices are rising proportionally the islander would not change production because his/her real income was unchanged. The problem then was that an islander would get confused because they only knew their own price and may not know this rise is general. In those cases, they will think their real income is better and supply more labour and produce more output.

So the story went that if the government tried to increase output (to reduce unemployment) and increased the money supply growth the resulting inflation would in the short-run trick people into thinking their own circumstances were better than they are – in which case they would increase output. So you get the positive relationship between inflation and output (negative between inflation and unemployment).

But as soon as the islander does some skipping between islands, he/she soon discovers they have been tricked and immediately withdraws the extra (tricked) labour and the supply swing reduces output again back to the initial (natural) level.

The only way the government can keep the output levels higher is to keep pushing monetary growth and tricking the islanders. But of-course over time this just becomes more and more inflationary with no real output gain.

So Lucas advanced a policy ineffectiveness proposition which says that in the long-run, governments cannot induce extra output by expanding monetary growth (so there is no trade-off between real output (unemployment) and inflation).

In other words, fiscal policy of the sort we are seeing now is ineffective and all that will result once everybody adjusts their expectations is inflation.

The more extreme versions of this model lead to the conclusion that rational agents soon work out what the government is doing and are no longer able to be tricked.

The point of this article was to buttress the assertion that anticipated changes in the money supply do not influence real output whereas unanticipated shocks to the money supply can have real effects. So the people on the islands see an increase in prices but don’t know whether it is local or applicable to all islands. They initially respond to the unanticipated shock believing it to be local and so output increases. But this cannot be systematically exploited by monetary authorities.

But over time, trend output is unaffected so monetary policy is neutral – it cannot shift the natural rate of output.

He won a Nobel Prize and built a very well paid career on that rubbish. Students are still subjected to it. The view pervades the current thinking of central banks including the RBA. That is why the RBA thinks that interest rate rises have no real effects in the long-run.

In a major symposium on rational expectations in 1980, which was the basis of a special edition of the Journal of Money, Credit and Banking (Vol. 12, No. 4, Part 2, November) there was vigorous debate about this sort of modelling.

Famous (Keynesian) economist Arthur Okun (who died in that year and never saw the publication) wrote (p. 819-820):

Operating on my own intuition, I find it implausible that important information is sufficiently costly to outweight its value to rational agents on a timely basis. For one thing, by reading the newspapers, market participants obtain a virtually costless flow of information from the reporting on the monthly indices of cosnurer and producer prices. Even more significantly, firms and households operate in both product and factor markets at essentially the same time. How much of a communciation gap or lag can rationally be maintained between the personnel manager and the sales manager of a given firm? How much of an effort is required within the family to ensure communications between the workers and the shoppers?

How long can a rational agent collect wage offers in various labor markets and still maintain a serious misperception in the face of his actual experience?

He then listed a series of “stylized cyclical facts which do not seem to be explicable by rational-expectations-with-misperceptions”. An easy one to understand is that in the real world – without any doubt at all – that quits are procylical and layoffs are countercyclical.

I could have gone into chapter and verse in a highly technical way as to why this sort of model is logically-inconsistent and worthless. But the quits example is sufficient to destroy it and easy to understand.

In the neo-classical model of the type Lucas builds and teaches, the real wage is considered to be determined ‘in the labour market’ at the intersection of the (downward-sloping) labour demand function and the (upward-sloping) labour supply function. The ‘equilibrium’ employment level is constructed as full employment because it suggests that every firm who wants to employ at that real wage can find workers who are willing to work and every worker who is willing to work at that real wage can find an employer willing to employ them.

This concept of full employment is consistent with both ideas of equilibrium noted above being satisfied. Frictional unemployment is easily derived from the classical labour market representation, as is voluntary unemployment.

Holding technology constant (and hence the labour demand curve fixed), changes in employment (and hence unemployment) are driven by labour supply shifts. Various theoretical constructs have been developed to explain how business cycles are driven by labour supply shifts.

For example, the Friedman and Lucas’s misperceptions hypothesis considers that workers possess less short-run information than the employers about the relationship between relative and absolute price levels. Accordingly, the workers can be induced to supply more labour than is optimal given their preferences for as long as they are confused about their real wage level.

In other words, they believe that a nominal wage rise is a real wage rise and supply more labour accordingly. Once they learn the truth they withdraw this supply and equilibrium is restored. The essence of all these supply shift stories is that quits are constructed as being countercyclical despite all evidence to the contrary.

This induced famous institutional economist Lester Thurow to once ask (tongue in cheek):

… why do quits rise in booms and fall in recessions? If recessions are due to informational mistakes, quits should rise in recessions and fall in booms, just the reverse of what happens in the real world.

Given that quits are not countercyclical then the orthodox labour market model that constructs unemployment as being a supply-side phenomenon is plain wrong.

What this means is that Lucas-type models construct unemployment as being workers withdrawing their supply rather than there not being enough jobs.

But given it is not remotely what the data tells us, the orthodox explanation of unemployment trips up at the most elementary level. Labour supply shifts do not explain shifts in employment and unemployment.

Of-course, our Nobel Prize winner is not that much concerned with reality.

In one of his other famous articles (Lucas, R.E. (1972) ‘Econometric Testing of the Natural Rate Hypothesis’, in The Econometrics of Price Determination Conference, edited by Otto Eckstein, Washington D.C., Board of Governors of the Federal Reserve System, p.51), this is what he wrote:

It is natural … [to an economist] … to view the cyclical correlation between real output and prices as arising from a volatile aggregate demand schedule that traces out a relatively stable, upward-sloping, supply curve … The issue of whether we treat observed prices and quantities as market clearing arouses more controversy than it deserves. I prefer thinking of markets as cleared partly because of logical difficulties with the leading alternative view … and partly because it leads the theory into the crucial questions of intertemporal substitution and expectations and away from the mechanical “auctioneer” of the standard dynamics.

What does this mean? It means he just assumes perfect market clearing. The late James Tobin, who also developed an early stock-flow consistent model of the macroeconomy (in 1969) described Lucas’s assertion in this way (on page 789 of the special 1980 edition of the Journal of Money, Credit and Banking noted above):

… the market-clearing assumption is just that, an assumption. It is not justified by any new direct evidence that a Walrasian auctioneer process generates the prices observed from day to day or month to month or year to year, or by any new theory … In short, the long-time controversy about the degree of price inflexibility in the economy and its consequences is resolved by assuming … perfect price flexibility

The problem that these characters faced was that with rational expectations and continuous market clearly equilibrium there would be no fluctuations in real variables around their trend – that is, no business cycle. The equilibrium could shift because of new technology or new raw material discoveries but there would be continuous adjustment and continuous full employment.

So they had to come up with explanation of the business cycle – the observed positive associations of employment and output. This is where Lucas and others introduced, in an ad hoc manner the concept of “asymmetrical incompleteness of information”.

Tobin says (page 790):

… there are several stories about this, all of them contrived and arbitrary … Confined to our local island market, deprived of contemporaneous information about the money stock and prices on other islands, we misinterpret a positive money and price shock to be an opportunity to earn goods tomorrow by working hard today. We learn only later, on another isolated island, that prices were raised everywhere and permanently.

Another version assumes that the employer knows the correct information about the prices of the goods they supply and the nominal wages of the workers they employ. However, workers only know what their nomimal wage is and take time to translate that into real wages.

So when prices rise faster than nominal wages – that is, real wages fall, employers are alleged to employ more workers because it is rational to do so. But workers only see their nominal wages rise and think their real wage is rising so they supply more labour – because the theory alleges that there is a positive relationship between labour supply and real wages.

So workers overestimate their real wage and sacrifice leisure and overwork. Later on they realise that their real wage has actually fallen and they resign and labour supply falls – back to the natural employment level where for that moment everyone shares the same information set.

Believe any of this and you would believe anything. Unfortunately, I spent hours learning and mastering all the mathematical complexity that lay behind all this rubbish. Instead, I could have actually been on one of those islands surfing the waves and having fun.

Conclusion

This blog is a continuation of my demonstration of how students are being duped in their economics classes by all this nonsensical stuff they are forced to learn. The problem is that it remains influential and more and more graduates get pumped out with zero understanding of how the monetary system operates and, as Rapping suggests, little other knowledge about the greater scheme of things.

What these graduates have is a toolkit of mathematical models about nothing remotely like the real world and they bring with that toolkit an arrogance that is beyond belief. An arrogance that is assertive and intolerant.

These are the sort of characters that then get into Wall Street, our governments, and sometimes even become politicians. No wonder things are not all that hot!