Thursday, September 29, 2016

Summary on "The Use of Knowledge in Society– F.A Hayek"

For the problems that society face, due to lack of the fullest information/data, the calculus way of thinking, might not help often . In reality, existing information/knowledge are very dispersed, incomplete and even contradictory in nature. These create dispute between economic theory and economic policy. To resolve such, the problem of society should NOT be "How to allocate given resources?" but indeed should be "How to secure the best use of the known resources?" Having said so, the problem of society  is then finding a system (either centralized or decentralize) which can perform fuller use of the existing knowledge. 

Further, Hayek stressed that economic problem arises due to the consequence of changes and adaption to change. But the change itself gradually occurs, but often economist apt to forget about such constant small change (which make up the economic picture) and focus more into statistical aggregates. The central planning based on these statistical information by nature cannot take direct account of the circumstances of time and place. But the decentralized system (by those who are familiar with rapid adaptation to changes in the particular circumstances of time and place) can make better ultimate decision and not by the central board of planning with limited information. 

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Having said so, the problem still arises on how the communication of information occurs in such decentralized system, such that one fits his decision into the whole pattern of changes of larger economic system, even thou, one might not have the fullest information. In fact, all that is significant for him (any i-th agent) is the relative importance of particular things which he is concerned based upon the difficulty level of procurement and his level of urgency of need/want. Hakey states, here in this case calculus is helpful. Such problem is solved via the price system. Fundamentally, in a system where the knowledge of the relevant facts is dispersed among many people, prices can act to coordinate the separate actions of different people. Therefore, the price system is a mechanism for communicating information and price system as a kind of machinery for registering change.

Hayek, F. (1945). The use of knowledge in society. The American Economic Review, 35(4), 519–530.


Sunday, September 25, 2016

The Rise and Fall of Keynesian and Sweet Smell of Revenge– the Post 1929 History of Macroeconomics

After the great depression of 1929, unemployment was escalating and deflationary policy backfired. Keynes in 1936 with his "The General Theory" expounded that such involuntary unemployment was triggered from a demand deficiency and lack of investment injection. This gave a solid ground to desert "laissez faire doctrine'. Later, Hicks (1937) transcribed Keynes verbal presentations graphically into IS-LM graphs and simultaneous equations (which later became the workhorse for Keynesian macroeconomics). While Jan Tinbergen (1939) developed the econometric model for such (for which Keynes was dismissive and stated–"little can be gained from trying to test theoretical models empirically"). Fueled with the zeal of IS-LM, later in 1955, Klein and Goldberg developed an econometric model with 15 structural equations and 5 identities with the dual objective of: predicting economic activities; and simulating the effects of policy change. Yet it lacked a dynamic framework, capital accumulation and technological progress, but was undoubtedly pragmatic. Brookings model with ~ 400 equations in 1960 reigned over the economic profession with IS-LM workhorse. The IS-LM euphoric success roots on its simplicity, intuitiveness and plasticity, however, was contaminated by conceptual sloppiness– the castle of IS-LM was built without the microeconomics foundation (how economic agents are making choices) – and failed to explicate the involuntary unemployment (proclaimed aim of Keynesian theory), however, via Philip curve, it suggested the government can buy decrease level of unemployment in the cost of increase inflation. As Leijonhufvud states, it seems till then, Keynesian revolution got off on the wrong track and continued on it. The ship of macroeconomics needed a micro foundational anchor. 

Don Patinkin in 1956 and 1965 with his book “Money, interest and price” staged Walrasian general equilibrium framework and cast Keynes involuntary unemployment as the period of adjustment toward equilibrium. Clower 1965 and 1984 floated with the dual decision hypothesis which suggests rationed labors evince constrained/effective demand, which is lower than notional/walrasian demand. (General demand/notional demand (ability and willingness to purchase) comprise effective demand (actual purchase) and latent demand (willing to purchase)). Leijonhufvud (1968) with a Marshallian equilibrium approach (which focus on equilibrating process rather that end state of the economy) put forward his astonishing discernment on possibility of market failure as a failure of inter-temporal coordination of the rate of interest on saving and investment. While parturient efforts of Robert Barro and Herschel Grossman (1971, 1977), Jcques Derze (1975), Benassy (1975) and Edmond Malinvaud (1977) were noteworthy to trigger 'non-walrasian equilibrium' approach to ratify the Keynes acumen of "market may experience market failure" via rigorous mathematical demonstration of agent optimizing behaviors under special constraints. These were the reappraisal of Keynesian theory but meanwhile Lucas critique was coeval daunting rival with the domain of relevance of the business cycle (discussed later). On confrontation, Lucas won and dethroned Keynesianism while "Non-Walrasian macroeconomics was a collateral victim of this (temporary) fall" (Vroey and Malgrange, 2011). 

Friedman (1968) and Phelps (1967 and 1968) emerged as a veteran critic of Keynesian policy. Friedman critique two pillars of Keynes approach: a) pressing interest rate low and b) stable Phillips curve (trade off between inflation and unemployment) stating former policy doesn't sustain longer run, while for later, he stated, for short run, when money supply policy is unanticipated ensues real sector effect, but soon workers perceives their mistakes (differentiate on nominal and real wage) and integrate price hikes to their expectation and displace Phillip curve to the right side. To suppress unemployment, the money supply expansion to fool worker can be placebo but the threats of hyperinflation will sooner or later relinquish expansionary policy. The downward sloping Philip curve in this temporal dynamics transfigure to a curl in an axis– the natural rate of unemployment (Nairu) or Long run Phillip curve. Thus, Friedman concluded that, it's futile to reduce unemployment below Nairu. His claim indeed, justified the stagflation. Friedman shared similar apparatus with Keynesian thought (IS-LM and Marshallian lineage) and yet stays anti-Keynesian. The differences as per Friedman were only empirical– classical sub-system of IS-LM with wage flexibility was good comparing to a Keynesian sub-system of wage rigidity. 

Lucas parceled the rational behavior hypothesis induced by Muth (1961) into his "Expectation and the Neutrality of Money (1972, 1981) article, then, damned the Keynesian econometric models with faint praise (Contrary to Keynes, he praised Keynesian macroeconomics for having engaged in econometric model and empirical testing) as: not being derived via theory; estimates being/were independent with any changes in institutional regime; and missing structural linkage of agents rational behavior, preferences and technological constraints. Lucas paradigm shift inaugurated the emergence of real business cycle modeling (RBC) (dawn of a new-classical macroeconomics) under the Kydland and Prescott's lead, which later blossomed as dynamic stochastic general equilibrium (DSGE) model. The macroeconomics impression shifted from explaining unemployment (Keynesian central idea) to explain business cycle. Earlier business cycle was considered as market failure, but later these cycles were no longer perceived as market failure, but were expressed as the manifestation due to inter-temporal optimizing reaction of agents to outside shocks affecting economy (monetary shocks, agents’ imperfect information and or technological shocks) thus prescribed government to refrain. 

However, Lucas was also radically rejected by so called 'new Keynesian' economist– who flourished during 1970's and 80's– they refurbished Keynes insight by intermingle strong micro foundation and rational expectation hypothesis (when needed) but their models were static and RBC model was blooming toward DSGE. By mid-nineties, new Keynesian and RBC theorist concurred (Goodfriend and King 1997 apposite them as 'new neoclassical synthesis’) to adopt DSGE as new workhorse, and in exchange, they embrace RBC modeling, exogenous shocks, dynamic perspective, the equilibrium disciple, inter-temporal substitution, rational expectation and later integrated monopolistic competition from Dixit and Stiglitz's (1977) model of product differentiation. While Christiano, Eichenbaum and Evan's (2005) article enriched standard DSGE based on staggered wage and price contract and coalesce habit formation in consumer preferences, adjustment cost of investment, variable capital utilization and the need for firms to borrow working capital in order to finance their wage bill. 

However, quintessential DSGE in general didn't see Great Recession of 2008 coming and got spanked. The hard lighting great recession however showed blankness/failure of DSGE– in integrating financial sector and other about the possibility of working pathology of market system/trading system to some extent. All the virtues of RBC and DSGE were like a flash in the pan and to old Keynesians, that was the sweet smell of revenge and new voices (Skidelsky 2009 and Paul Krugman) reemerge trumpeting to return to Keynes theory. At this nick of the time, macroeconomics, either will fuse financial sector or will trigger more radical reorientation of macroeconomics.


Note: My writing is gist of following referenced paper. Anymistakes, errors and typos are my own. Read the following wonderful article.

Reference: Michel DE VROEY & Pierre MALGRANGE, 2011. "The History of Macroeconomics from Keynes’s General Theory to the Present," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales) 2011028, Universit√© catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).