The Nature of an Economy

1. The Nature of an Economy Axel Leijonhufvud UCLA and University of Trento INET Budapest Conference September 6 - 8, 2010

2. Response to conceptual failure • 1) Deny it (preferred option) • 2) Go through the assumptions. Find out which ones need to be changed • (Problem: How many are there? How count the ones you are not aware of?)

3. Looking back…. • Keynesian IS-LM: stable with frictions • Stagflation: Phillips curve unstable • Friedmanian Monetarism • Lucas and RatExp • Money abandoned: RBC theory • 2007-09 DSGE: stable with frictions(?) • Correcting assumptions one-by-one… • BACK TO GO!

4. Transcendental realism (no less!) • Tony Lawson, Economics and Reality (1997) • Ontology: need to “grasp the nature of the reality” that is the object of study – and to adapt methods to it

5. Open systems • TL: an economy is an “open” system but economists deal with it as if “closed” • Our mathematical representations require closure for models to have determinate solutions • TL critical of math econ and more generally of deductivism in economics • Compare “getting the assumptions right”

6. Closed systems • The impetus for “closure” in modern macro stems from the commitment to represent all behavior as optimal • … which also implies that all states are equilibria • Rational expectations were necessary to generalize this program to intertemporal transactions • Another factor: drive to endogenize “practically everything”

7. Reflexivity and RatExp • Soros’ reflexivity: current beliefs about the future induce present actions which create the future • Lack of correspondence between public’s beliefs and outcomes presents opportunities for profit (and loss) • RatExp is the very special case of the fixed point correspondence between current beliefs and future outcome • In which case – no profit, etc.

8. Muth and the Cobweb • Two quite special conditions make RatExp reasonable in Muth’s original case • (1) the weather of the crop year “is drawn from” an objectively given and knowable distribution • (2) supply (production) and demand (consumption) equalized over the year (an exogenously fixed period) • These conditions are rarely satisfied

9. RatExp • In the reality of Muth’s case, it is reasonable to assume that most farmers will learn not to make systematic mistakes and thus will learn the RatExp equilibrium • When the conditions are not fulfilled we cannot assume a systematic tendency for (1) all to learn the same thing, where (2) the same thing is an objective “truth”

10. Lack of Synchronicity • Unexamined assumptions of GE models: In any given market, S and D equilibrated over given, fixed unit period • … and this period is the same for all markets • Consider,for ex., markets for oil or natural gas. There is no such “natural” unit period • Lack of it is a sufficient condition for persistent heterogeneity of expectations

11. RatExp revolution • Nonetheless, RatExp generalized in every direction – infinite dimensional cases, etc. • The math representation of the system closed by RatExp produced proofs of various proposition that seemed counterintuitive (or at least counter to received “wisdom”) • Great intellectual excitement back then!

12. Unknowable future • The future is not and cannot be known with certainty, even as a probability distribution. This makes an economy an “open” system. • Most behavior has to be represented as adaptive [11 eds of Trento Summer School] • In periods of prolonged tranquility may be approx. by intertemporal optimization • In volatile times, reaction to current data • Behavioral time horizons vary • But also: innovations introducing novelty

13. Budget Constraints • The most difficult analytical problems arise when we cannot assume that budget constraints are binding • (Difficult do GE unless BC violations obey a known probability distribution) • Distinguish two cases of violations of equal-value-in-exchange: • 1) in private sector, and 2) by sovereign

14. Nature of an Economy • What macroproperties does the complex, adaptive dynamical system have? • Imagine a state space for the private sector of three regions: • PR1: stable, negative feedbacks dominate • PR2: some narrowly bounded instabilities • PR3: several interacting positive feedback loops – “black hole” = debt deflation

15. Finances of the Sovereign • State space for central government • SR1: budget surpluses or sustainable deficits • SR2: deficits but fair measure of control: expected inflation, Fisher premia, etc. • SR3: Control of deficit lost. Inflation expectations very volatile. System will not support intertemporal markets with maturities longer than a few weeks

16. Contrast recent DSGE • “Frictions”, not instabilities, the sources of problems • Balance sheets have evolved along equil. paths and remain “on track” • Private sector budget constraint violations of little consequence

17. Double Jeopardy • Widespread default in private sector & fear of counterparty insolvency plus solvency of sovereign in doubt • Action to offset private sector deleveraging risks sovereign insolvency (Latin American cases) … and high inflation • Channel between Scylla and Charybdis can become too narrow for safe navigation • US benefitting from global shortage of safe assets and lack of substitutes for $

18. Prospects for Macroeconomics • Our ability to predict is inherently limited when dealing with open systems • For macroeconomics, (theoretically not very ambitious) extrapolations will be useful in tranquil times • ... which, in fact, is what forecasters actually do

19. Prospects, cont. • The important task is not prediction but improving our understanding of the conditions marking he boundaries between stable and unstable regions • For policy: How to reduce the risks of sliding over into Region 3. How to claw your way back from there… etc. • Deductive theorizing will not be of much help….