Debunking Economics Part 15

Hicks's critical epiphany about the IS-LM model came far too late to stop the revisionist juggernaut he had set in motion by reinterpreting Keynes as a Walrasian back in 1937. His recantation in 1981 was generally ignored by economists, who if they were aware of it at all would have been more inclined to put his views down to approaching senility than to any blinding logical revelation. In any case, the gradual demolition of IS-LM by economists was substantially advanced by 1980.

This demolition began back in the 1950s with the 'strong reductionist' critique that Hicks's 'Keynesian' model did not have good microeconomic foundations, by which neocla.s.sical economists meant that it was not possible to derive results that IS-LM could generate such as the economy settling into a less than full-employment equilibrium from standard microeconomics.

Of course, in making this critique they were profoundly ignorant of the aggregation errors in the theory itself that I have outlined in preceding chapters. Properly understood, it is possible to derive results like involuntary unemployment from a neocla.s.sical model. A properly derived market demand curve can have any shape at all (Chapter 3), leading to a market marginal revenue curve that would therefore intersect the constant or falling marginal cost curve (Chapters 4 and 5) in its market in multiple locations. Complexities in distribution and production covered in Chapters 6 and 7 would complicate the outcome even further, while price-setting would have to be done in dynamic disequilibrium, raising the specter of nonlinear dynamics and chaos (Chapter 9).

A macroeconomic model derived properly from neocla.s.sical foundations would probably be more chaotic than the real world itself, even without introducing the complications the neocla.s.sical model omits by improperly excluding money and debt from its a.n.a.lysis.26 However, all this was unknown to the neocla.s.sicals, who continually chipped away at the IS-LM model and its cousin the AS-AD model ('Aggregate Supply-Aggregate Demand'), and even to the many defenders of these models. Non-orthodox economists, who were aware of these issues, watched on in bemused horror as a model that was already a b.a.s.t.a.r.dization of Keynes's a.n.a.lysis27 was further emasculated over time. The extent to which this was an agenda driven by ignorance rather than wisdom can be seen in the memoir of n.o.bel laureate Robert Lucas, one of the key actors in this process, when he delivered the keynote address to the 2003 History of Political Economy conference.

He began by a.s.serting stridently that he was once a Keynesian: My credentials? Was I a Keynesian myself? Absolutely. And does my Chicago training disqualify me for that? No, not at all [...] Our Keynesian credentials, if we wanted to claim them, were as good as could be obtained in any graduate school in the country in 1963.

Then he continued: I thought when I was trying to prepare some notes for this talk that people attending the conference might be arguing about Axel Leijonhufvud's thesis that IS-LM was a distortion of Keynes, but I didn't really hear any of this in the discussions this afternoon. So I'm going to think about IS-LM and Keynesian economics as being synonyms.

I remember when Leijonhufvud's book came out and I asked my colleague Gary Becker if he thought Hicks had got the General Theory right with his IS-LM diagram. Gary said, 'Well, I don't know, but I hope he did, because if it wasn't for Hicks I never would have made any sense out of that d.a.m.n book.' That's kind of the way I feel, too, so I'm hoping Hicks got it right. (Lucas 2004: 1314; emphases added) This was over twenty years after Hicks himself said that he had got it wrong! And Lucas had the hide to call himself a Keynesian, when he admits that 'if it wasn't for Hicks,' both he and fellow n.o.bel laureate Gary Becker 'never would have made any sense out of that d.a.m.n book'? This is one reason I bridle when I hear the comment that 'Keynesian economics has failed'; what most self-described Keynesians in economics mean by the word 'Keynesian' is the economics of Hicks and Samuelson, not Keynes.

Starting from the false belief that Hicks had accurately summarized Keynes, Lucas then conformed to the unfortunate rule within economics, that poor scholars.h.i.+p is built upon poor scholars.h.i.+p. He played a crucial role in undermining IS-LM a.n.a.lysis itself in the early 1970s, first with the development of 'rational expectations macroeconomics' and then with what became known as 'the Lucas critique' an attack on using numerical macroeconomic models as a guide to policy. These developments led to the final overthrow of any aspect of Hicksian, let alone 'Keynesian,' thought from mainstream macroeconomics. In the ultimate fulfillment of the program of strong reductionism, macroeconomics was reduced to no more than applied microeconomics and based on the premise that all the concepts that I have shown to be false in the preceding chapters were instead true.

Lucas's a.s.sault on IS-LM28 With Hicks's IS-LM model accepted as providing a mathematical expression of Keynes, Lucas (Lucas 1972) focused on models that economists had constructed using Hicks's model as a foundation, which concluded that macroeconomic policy could alter the level of economic activity. He began by conceding that most economists believed that the 'Phillips Curve' accurately described the 'trade-off' society faced between inflation and unemployment. He also conceded that the statistical evidence certainly showed a negative relations.h.i.+p between inflation and unemployment: when: 'It is an observed fact that, in U.S. time series, inflation rates and unemployment are negatively correlated' (ibid.: 50).

10.5 Unemployment-inflation data in the USA, 196070.

The 'Phillips Curve trade-off' interpretation of these statistics turned an empirical regularity into a guide for policy. Since the statistics implied that unemployment and inflation moved in opposite directions, it seemed that the government could choose the level of employment it wanted by manipulating aggregate demand (so long as it was willing to tolerate the inflation rate that went with it). This 'rule of thumb' policy conclusion was also consistent with the results of the large-scale econometric models derived from Hicks's IS-LM model.

However, Lucas put himself in the skeptics' camp, and argued instead in favor of what he called the 'Natural Rate Hypothesis,' that there was no such trade-off instead, that the economy had a natural rate of employment towards which it tended, and any attempt to increase employment above this rate would simply increase the rate of inflation, without altering employment. He defined the 'Natural Rate Hypothesis' as: 'the hypothesis that different time paths of the general price level will be a.s.sociated with time paths of real output that do not differ on average' (ibid.: 50).

This, in a convoluted way, a.s.serted the pre-Great Depression neocla.s.sical belief that the economy tended toward an equilibrium in which relative prices were stable, and any attempt to increase the number of people employed would simply cause inflation. Lucas's problem, in a.s.serting this belief, was the evidence. He presented this paper before the 'stagflation' of the 1970s, when inflation and unemployment both rose at the same time, and the evidence of the period from 1960 to 1970 showed a clear trade-off between inflation and unemployment see Figure 10.5.

Though the inflation-unemployment data at the precise date at which he spoke had a much higher unemployment level than had been experienced at a comparable rate of inflation in the 1960s, shortly after he spoke (in October 1970) the inflation rate plunged in an apparent lagged response to the rise in unemployment during the 196970 recession.

10.6 Unemploymentinflation data in the USA, 195072 How then to justify skepticism about what seemed an obvious reality? He argued that the 'Phillips Curve' was simply an artifact of how 'agents form and respond to price and wage expectations,' and that attempting to exploit this curve for policy reasons would destroy the apparent trade-off, because agents would change their expectations: 'The main source of this skepticism is the notion that the observed Phillips curve results from the way agents form and respond to price and wage expectations, and that attempts to move along the curve to increase output may be frustrated by changes in expectations that s.h.i.+ft the curve' (ibid.: 50).

Lucas thus accepted the empirical evidence of the negative relations.h.i.+p between inflation and unemployment in that a higher level of inflation was statistically correlated with a lower level of unemployment. However, he argued that this could not be used as a policy tool, alleging that attempts to drive unemployment down by driving inflation up would simply result in higher inflation at the same rate of unemployment.

This was not an entirely new argument Friedman had made a similar a.s.sertion two years earlier (Friedman 1968), using what became known as 'Adaptive Expectations' (Friedman 1971: 331). But Milton's model wasn't good enough for Lucas though not for the reasons you might expect.

Helicopter Milton Ben Bernanke copped the nickname 'Helicopter Ben' for his observation that a deflation could always be reversed by the government 'printing money': the U.S. government has a technology, called a printing press, that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation under a fiat (that is, paper) money system, a government should always be able to generate increased nominal spending and inflation [...] and sufficient injections of money will ultimately always reverse a deflation. (Bernanke 2002a) However, the 'Helicopter' part of the nickname alluded not to work by Bernanke, but by his intellectual mentor Milton Friedman, who, more than any other neocla.s.sical, was responsible for the overthrow of the IS-LM model and its replacement by a resurgent neocla.s.sical orthodoxy.

In any sane discipline, Friedman's starting point for his dismantling of the then Keynesian orthodoxy would have been good enough reason to ignore him completely if not recommend he see a psychiatrist. A key aspect of the neocla.s.sical model is the proposition known as 'money neutrality': that the nominal quant.i.ty of money has no effect on the real performance of the macroeconomy, apart from causing inflation. Friedman rea.s.serted that belief, but also clearly stated the condition required for it to operate in reality. The condition was that, if the quant.i.ty of money in circulation increased by some factor, then all nominal quant.i.ties including the level of debts was also increased by the same factor: It is a commonplace of monetary theory that nothing is so unimportant as the quant.i.ty of money expressed in terms of the nominal monetary unit dollars, or pounds, or pesos. Let the unit of account be changed from dollars to cents; that will multiply the quant.i.ty of money by 100, but have no other effect. Similarly, let the number of dollars in existence be multiplied by 100; that, too, will have no other essential effect, provided that all other nominal magnitudes (prices of goods and services, and quant.i.ties of other a.s.sets and liabilities that are expressed in nominal terms) are also multiplied by 100. (Friedman 1969: 1; emphases added) This condition is so clearly not fulfilled in reality that the opposite conclusion therefore applies: since the value of a.s.sets and liabilities is not adjusted when inflation occurs, therefore the nominal quant.i.ty of money in circulation is important. However, Friedman, who had already given us the 'a.s.sumptions don't matter' methodological madness, continued straight on as if it didn't matter that this condition was not fulfilled in reality.

Friedman's next counterfactual a.s.sertion was that, left to its own devices, a free market economy with no growth and a constant stock of money would settle into an equilibrium in which supply equaled demand in all markets, and all resources including labor were fully employed (where full employment was defined as supply equaling demand at the equilibrium real wage):29 'Let us suppose that these conditions have been in existence long enough for the society to have reached a state of equilibrium. Relative prices are determined by the solution of a system of Walrasian equations' (ibid.: 3).

He then considered what would happen to money prices in such a situation if there was a sudden increase in the money supply: 'Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated' (ibid.: 45).

If you are gobsmacked by this absurd vision of how money is created dropped from the air like manna from heaven brace yourself: ideas even more absurd that this are about to come your way.

Friedman's 'helicopter' is of course a parable for the behavior of a central bank (which is not a market actor) that injects money into the system as Bernanke has himself done twice already, though during the Great Recession rather than when the economy was in 'a state of equilibrium.'30 But it is a parable which takes for granted that the money supply is completely under the Fed's control that it is 'exogenous' in the parlance of economics. In contrast, the empirically derived 'endogenous' theory of money I'll outline in Chapter 14 argues that the money supply is largely outside the Fed's control.

However, with his simplistic model of money creation, Friedman decided that the consequence of doubling the money supply would be that nominal prices would ultimately double. Relative prices and real output would be unaffected in the long run, but in an important qualification compared to Lucas's later a.n.a.lysis Friedman conceded that in the interim there could be disturbances to relative prices and the levels of output and employment: It is much harder to say anything about the transition. To begin with, some producers may be slow to adjust their prices and may let themselves be induced to produce more for the market at the expense of non-market uses of resources. Others may try to make spending exceed receipts by taking a vacation from production for the market. Hence, measured income at initial nominal prices may either rise or fall during the transition. Similarly, some prices may adjust more rapidly than others, so relative prices and quant.i.ties may be affected. There might be overshooting and, as a result, a cyclical adjustment pattern [...]. (Ibid.: 6) Friedman then extended this 'one-off' thought experiment to a theory of inflation by a.s.suming that this 'helicopter drop' of money becomes a continuous process: Let us now complicate our example by supposing that the dropping of money, instead of being a unique, miraculous event, becomes a continuous process, which, perhaps after a lag, becomes fully antic.i.p.ated by everyone. Money rains down from heaven at a rate which produces a steady increase in the quant.i.ty of money, let us say, of 10 per cent per year. (Ibid.: 8; emphasis added) The highlighted phrase in the preceding quote is what Friedman later called 'Adaptive Expectations': people form expectations of what will happen in the future based on experience of what has happened in the recent past. He also considered that there could be disturbances in the short term in this new situation of a permanent 10 percent per annum increase in the money supply: 'If individuals did not respond instantaneously, or if there were frictions, the situation would be different during a transitory period. The state of affairs just described would emerge finally when individuals succeeded in restoring and maintaining initial real balances' (ibid.: 10).

However, in the long run, these disturbances dissipate and the economy settles into a long-run equilibrium where all 'real magnitudes' (relative prices, output, employment) are the same as before, but the absolute price level is rising at 10 percent per annum. This occurs not because markets are in disequilibrium with demand exceeding supply, causing prices to rise, but because of the expectations all agents have formed that prices always rise by 10 percent per annum. It is thus expectations which cause prices to rise, rather than disequilibrium: 'One natural question to ask about this final situation is, "What raises the price level, if at all points markets are cleared and real magnitudes are stable?" The answer is, "Because everyone confidently antic.i.p.ates that prices will rise"' (ibid.).

This was the basis for Friedman's argument against Keynesian demand-management policies, which attempted to exploit the apparent negative relations.h.i.+p between unemployment and the rate of inflation: though a higher rate of growth of the money supply could in the transition cause employment to rise, ultimately the economy would return to its equilibrium level of employment, but at a higher rate of inflation. This was characterized as the 'short-run Phillips Curve' 'moving outwards' the temporary trade-off between higher inflation and lower unemployment in the transition involved higher and higher levels of inflation for the same level of unemployment while the 'long-run Phillips curve' was vertical at the long-run equilibrium level of unemployment.

Though Friedman's model was highly simplistic, his vigorous promotion of his 'monetarist' theories just preceded the outbreak of stagflation during the 1970s, giving an apparent vindication of his position. There did indeed seem to be an outward movement of the negative relations.h.i.+p between unemployment and inflation, while there appeared to be a 'long-run' rate of unemployment the economy kept tending towards, at about a 6 percent rate of unemployment compared to the level of below 4 percent that had been achieved in the 1960s.

10.7 Unemploymentinflation data in the USA, 196080 Friedman's monetarism thus defeated Keynesian demand management both inside the academic profession, and in public policy, with central banks trying to limit the growth of the money supply in order to reduce the inflation rate.31 The period of 'stagflation' rising unemployment and rising inflation thus sounded the death-knell for 'Keynesian' economics within the academic profession. However, monetarism's defeat of 'Keynesian' theory wasn't enough for Lucas, since monetarism still implied that the government could alter the level of employment.

'Improving' on Friedman The problem with monetarism, as Lucas saw it, was Friedman's admission that in the short run, a boost to the money supply could have real effects. Lucas began by stating the paradox for a neocla.s.sical economist that in neocla.s.sical theory there should be no relations.h.i.+p between inflation and employment: changes in aggregate demand caused by changes in the money supply should simply alter the price level while leaving supply unchanged: 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. This point of departure leads to something of a paradox, since the absence of money illusion on the part of firms and consumers appears to imply a vertical aggregate supply schedule, which in turn implies that aggregate demand fluctuations of a purely nominal nature should lead to price fluctuations only. (Lucas 1972: 51; emphasis added) Lucas's comment about 'money illusion' shows that, though he criticized Friedman, it was because Friedman was not neocla.s.sical enough for him Friedman's macroeconomics was not sufficiently based upon neocla.s.sical microeconomic theory. Since microeconomics predicted that changing all prices and incomes wouldn't affect the output decision of a single consumer, macroeconomics had to conclude that the aggregate rate of unemployment couldn't be altered by monetary means: On the contrary, as soon as Phelps and others made the first serious attempts to rationalize the apparent trade-off in modern theoretical terms, the zero-degree h.o.m.ogeneity of demand and supply functions was re-discovered in this new context (as Friedman predicted it would be) and re-named the 'natural rate hypothesis.' (Lucas 1976: 19) After discussing models used to explain the perceived inflationunemployment trade-off based on adaptive expectations, Lucas observed that under Adaptive Expectations, it was possible that actual inflation (which was driven by the actual rate of growth of the money supply at a given time) might differ from expected inflation (which was based on people's experience of past inflation that adjusted 'after a lag' to the current rate of inflation). This in turn would mean that, if actual inflation exceeded expected inflation, then there could be 'unlimited real output gains from a well-chosen inflationary policy. Even a once-and-for-all price increase, while yielding no output expansion in the limit, will induce increased output over the (infinity of) transition periods. Moreover, a sustained inflation will yield a permanently increased level of output' (Lucas 1972: 53).

But herein lay a dilemma: Lucas's logic had revealed that the only way to conclude that there was a natural rate of employment was to a.s.sume that expected inflation always equaled actual inflation, which in turn means a.s.suming that people can accurately predict the future.

Obviously Lucas couldn't a.s.sume this.

Well, obviously, if he wasn't a neocla.s.sical economist! Because that's precisely what he did a.s.sume. His way of stating this was obtuse, but nonetheless unmistakable: In the preceding section, the hypothesis of adaptive expectations was rejected as a component of the natural rate hypothesis on the grounds that, under some policy [the gap between actual and expected inflation] is non-zero. If the impossibility of a non-zero value [...] is taken as an essential feature of the natural rate theory, one is led simply to adding the a.s.sumption that [the gap between actual and expected inflation] is zero as an additional axiom [...]. (Ibid.: 54; emphasis added) Such an 'axiom' is transparently nonsense something that might have led a sensible person to stop at this point. But instead Lucas immediately moved on to an equivalent way of stating this 'axiom' that wasn't so obviously absurd: 'or to a.s.sume that expectations are rational in the sense of Muth' (ibid.).

Thus neocla.s.sical macroeconomics began its descent into madness which, thirty-five years later, left it utterly unprepared for the economic collapse of the Great Recession.

Expectations and rationality Decades before, when the Great Depression also forced economists to consider reality rather than their largely verbal models of equilibrium, Keynes made a similar point to Lucas's, that expectations about the future affect decisions today, and he pilloried the neocla.s.sical theorists of his day for ignoring this.

Keynes welded the role of expectations in economics with uncertainty about the future, and considered how people still manage to make decisions despite uncertainty. Thirty-five years later, Lucas reintroduced expectations into macroeconomics, but with the a.s.sumption that people could accurately predict the future and thus eliminate uncertainty an even more absurd position than that of his pre-Great Depression predecessors, whom Keynes merely accused of 'abstracting from the fact that we know very little about the future.'

It is one of the greatest abuses of language committed by neocla.s.sical economists that a proposition which in any other discipline would be deemed as insane that on average, people's expectations about the future are accurate goes under the name of 'rational expectations' in economics. That the idea could even be countenanced shows the extent to which neocla.s.sical economics is driven by a teleological desire to prove that capitalism is fundamentally stable, rather than by a desire to understand the empirical record of the actual economy.

10.8 The hog cycle (hog/corn price) The paper that initially developed the concept of 'rational expectations' (Muth 1961) applied it to microeconomics, to develop a critique of a simplified theory of price cycles in agricultural markets known as 'the Cobweb model.' Agricultural products like pork were subject to irregular cycles in prices see Figure 10.8 and one explanation that microeconomists developed was that time lags in production generated the cycles.

The Cobweb cycle model argued that suppliers would take prices one season as a guide to how many hogs to breed in the next season. When prices were high, many hogs would be raised the subsequent season, which would cause prices to crash the season after; while when prices were low, few hogs would be raised the next season, which would cause prices to rise. Prices thus fluctuated in disequilibrium over time, overshooting and undershooting the equilibrium price.

The Cobweb a.s.sumed the existence of standard Marshallian supply and demand curves something we have debunked in Chapters 35 and also had a hard time explaining the lengthy cycles that could occur, which were measured in multiples of the breeding cycle itself.32 Seizing on the latter weakness, Muth proposed that farmers' price expectations were not simply that last year's prices would be next year's, but that they would be to some degree informed by experience a sensible observation in itself. However, he extrapolated from this to the following hypothesis: 'I should like to suggest that expectations, since they are informed predictions of future events, are essentially the same as the predictions of the relevant economic theory' (ibid.: 316).

That is, he a.s.sumed that farmers formed their expectations of next year's price by a.s.suming that it would be the equilibrium price as given by the Marshallian model of supply and demand, and that these expectations were correct they were what would happen because the model itself was accurate: 'The hypothesis can be rephrased a little more precisely as follows: that expectations of firms (or, more generally, the subjective probability distribution of outcomes) tend to be distributed, for the same information set, about the prediction of the theory (or the "objective" probability distributions of outcomes)' (ibid.).

Not only did Muth believe that the predictions of the theory were that price would equal marginal cost in equilibrium (erroneously, as we saw in Chapter 4), he also a.s.sumed that the producers had implicit knowledge of the market's supply and demand functions, and would form their expectations accordingly and therefore correctly antic.i.p.ate the future.

Muth's rationality was thus rationality on steroids not only did people know of and behave in their own best interests, they also knew how the system in which they were bit players actually behaved. This is not mere utility-maximizing rationality with respect to one's own interests (something I showed was computationally impossible in Chapter 3), but 'meta-rationality' knowledge of how the entire system in which we are embedded works which is so good that the average expectation of the future will be correct.

This is the opposite of the realistic concept of uncertainty that Keynes had tried, unsuccessfully, to introduce into economic theory. Muth introduced expectations into his model in a manner that neutralized uncertainty.

Though there were some nuances later in the article which made it somewhat less unrealistic including that expectations might 'consistently over- or under-discount the effect of current events' (ibid.: 321), the impact of inventories, speculators and so on33 the impact of this 'rational expectations hypothesis' on the model of price fluctuations in an agricultural market was that the expected market price was the equilibrium price, and all fluctuations about this price were caused by random shocks.

This is a familiar tune in neocla.s.sical economics: whenever an attempt to incorporate a more realistic vision of how the economy functions results in a need to think in a disequilibrium way, economists dream up ways of relegitimizing equilibrium a.n.a.lysis once more. This is accepted within neocla.s.sical economics itself, even if it involves doing severe damage to realism as the a.s.sumption that the future can be (on average) accurately predicted surely does and even if it involves an obvious contradiction of other parts of neocla.s.sical economics.

Muth committed such a contradiction when he put forward as a justification for a.s.suming rational expectations at the market level the proposition that: 'Information is scarce, and the economic system generally does not waste it' (ibid.: 316).

Leaving aside the very concept of information about the future, this a.s.sertion within neocla.s.sical economic theory leads to the conclusion that expectations should be less than rational.

If information is scarce, then it should have a price, and a rational agent should purchase information (about the future ...) up until the point at which the marginal cost of this information equals the marginal benefit from acquiring it. This would necessarily occur before enough information (about the future ...) was purchased to allow completely rational expectations (about the future ...) to be formed, so that actual expectations should be less than fully 'rational.'

No such limit occurred to Muth, however, let alone to Lucas, who appropriated this concept from the model of a single market to apply it at the level of the entire economy.

The macroeconomics of Nostradamus The argument that producers in a given market have at least some idea of how that market works, and can therefore produce slightly informed predictions of what next season's price might be, given this season's outcome, is not entirely unreasonable. But the argument that agents in a macroeconomy can know how the macroeconomy works and therefore correctly antic.i.p.ate the future course of macroeconomic variables like inflation is simply absurd.

However, this absurdity was in fact a necessity for neocla.s.sical economics. If it were to maintain the belief that the economy was fundamentally stable, then expectations of the future had to be either ignored or tamed.

In Keynes's day, as he himself noted, neocla.s.sical economics did the former. After Keynes, expectations were again ignored in Hicks's development of the IS-LM model, and then the numerical forecasting models derived from it. Then, in one of the greatest travesties in the history of economic thought, Muth and Lucas could claim that they were introducing expectations into economic theory, because they were clearly unaware of Keynes's earlier insistence on the importance of expectations in the context of uncertainty about the future.

However, here they were constrained by the dilemma that Keynes observed afflicted his neocla.s.sical contemporaries, when he noted that they attempted 'to deal with the present by abstracting from the fact that we know very little about the future' (Keynes 1937: 215). Neocla.s.sical economics could only maintain its belief that the economy was in equilibrium if actions today, taken on the basis of how conditions were expected to be in the future, were correct. So the choice that neocla.s.sical economics faced was between ignoring the future, or pretending that it could be accurately foreseen.

Keynes's contemporaries chose the former route; Lucas and modern neocla.s.sicals instead embraced the latter and had the hide to call such a view 'rational.' In reality, 'rational expectations' was a device, not to introduce expectations into economic modeling, but to keep time and uncertainty about the future out of it. In place of dealing with the present 'by abstracting from the fact that we know very little about the future,' rational expectations deals with the present 'by pretending that we can predict the future.'

Microeconomic macroeconomics The concept that agents in a complex system like the macroeconomy can accurately predict its future should have been rejected on first sight. Not only does it ignore uncertainty, even prediction of what a model itself will do in the future is only possible if the model is 'erG.o.dic' meaning that the past history of the model is a reliable guide to its future behavior.

The complex dynamic models we considered in Chapter 9, such as Lorenz's model of atmospheric turbulence, are non-erG.o.dic.34 The past history of a complex model is not a reliable guide to its future behavior, because where the model will evolve to is dependent on where it starts from the so-called 'b.u.t.terfly Effect' applies. Two situations with differences in initial conditions that are too small to be distinguished from each other will have drastically different outcomes in the future: they will be similar for a short while (which is why weather forecasting is accurate only about a week in advance) but then diverge completely.

Only if models of the economy are not of this cla.s.s are 'rational expectations' possible even within the model. The easiest way to make rational expectations work within a model is to make it linear and this is what Muth did in his first model: For purposes of a.n.a.lysis, we shall use a specialized form of the hypothesis. In particular, we a.s.sume: The random disturbances are normally distributed.

Certainty equivalents exist for the variables to be predicted.

The equations of the system, including the expectations formulas, are linear.

These a.s.sumptions are not quite so strong as may appear at first because any one of them virtually implies the other two. (Muth 1961: 317) Though some subsequent 'rational expectations' models used in macroeconomics had nonlinearities, they continued to make Muth's second a.s.sumption that the 'exogenous shocks,' which are the only explanation these models have for cyclical behavior, are 'normally distributed' and as Muth observes, this is effectively the same as having a linear model.

However, 'rational expectations' makes no sense in non-erG.o.dic models: any predictions made from within such a model about the model's future behavior would be wrong (let alone predictions made about the economy the model is alleged to simulate). Crucially, the errors made by agents within that model would not be 'normally distributed' they would not be neatly distributed around the model's mean as in the cla.s.sic 'Bell Curve.' Instead the distribution would be 'chaotic,' with lots of what Na.s.sim Taleb labeled 'Black Swan events' (Taleb 2007). It would be futile to have 'rational expectations' in such a model, because these would be misleading guides to the model's future. The model's future would be uncertain, and the best thing any agent in such a model could do would be to project forward its current trajectory, while also expecting that expectation to be wrong.

What applies to a model applies in extremis to the real world, and parallels Keynes's observations about how people in a market economy actually behave: they apply conventions, the most common of which is to extrapolate forward current conditions, even though 'candid examination of past experience' (Keynes 1937: 214) would show that these conditions did not persist.

Keynes remarked that superficially this might appear irrational, but there is no better course of action when the future is uncertain. One of Keynes's observations, highlighted in the next quote, directly contradicts the key a.s.sumption of rational expectations, which is that on average people's expectations about the future will be correct: It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain. It is reasonable, therefore, to be guided to a considerable degree by the facts about which we feel somewhat confident, even though they may be less decisively relevant to the issue than other facts about which our knowledge is vague and scanty.

For this reason the facts of the existing situation enter, in a sense disproportionately, into the formation of our long-term expectations; our usual practice being to take the existing situation and to project it into the future [...]

The essence of this convention [...] lies in a.s.suming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation.

Nor can we rationalize our behavior by arguing that to a man in a state of ignorance errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the a.s.sumption of arithmetically equal probabilities based on a state of ignorance leads to absurdities.

We are a.s.suming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematical expectation [...]

In abnormal times in particular, when the hypothesis of an indefinite continuance of the existing state of affairs is less plausible than usual even though there are no express grounds to antic.i.p.ate a definite change, the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation. (Keynes 1936: 148, 152, 154; emphasis added) The concept of rational expectations should therefore have died at birth, but because it let neocla.s.sical economists return to their pre-Keynesian practice of arguing that the economy was self-regulating and always either in or tending toward equilibrium, rational expectations was instead embraced. Lucas and his colleagues Thomas Sargent, Neil Wallace, Edward Prescott, Leonard Rapping, and several others produced a series of papers that developed models of the macroeconomy that extrapolated directly from the alleged behavior of a single utility-maximizing and profit-maximizing agent who was endowed, via 'rational expectations,' with the capacity to accurately predict the future.

One of these predictions was that increasing the money supply would cause inflation. In a model without 'rational expectations,' if the government increased the money supply in order to reduce unemployment, there would be a lag between when the money supply was increased, and when the inflation actually occurred. In the meantime, the increased money supply would have the impact desired by the government, of increasing economic activity and hence reducing unemployment. This was Friedman's adaptive expectations, leading to the undesirable result from the point of view of neocla.s.sical economists that the government could reduce the unemployment rate below equilibrium via a policy of permanent accelerating inflation.

The twist of adding expectations into the model, when expectations were identical to the prediction of the model, was that inflation would occur instantly, rather than with a lag. This is because, since everyone expects an increased money supply to cause inflation, everyone instantly puts their prices up as soon as the money supply rises. The lag between an increase in the money supply and an increase in prices is eliminated, and with it disappears any temporary impact of the money supply on unemployment. In one of the pivotal papers in this literature, Sargent and Wallace put it this way: The public knows the monetary authority's feedback rule and takes this into account in forming its expectations [... therefore] unantic.i.p.ated movements in the money supply cause movements in [output], but antic.i.p.ated movements do not [...]

[R]emoving the a.s.sumption that the authority can systematically trick the public eliminates the implication that there is an exploitable tradeoff between inflation and unemployment in any sense pertinent for making policy. The a.s.sumption that the public's expectations are 'rational' and so equal to objective mathematical expectations accomplishes precisely this.

In this system, there is no sense in which the authority has the option to conduct countercyclical policy. To exploit the Phillips Curve, it must somehow trick the public. But by virtue of the a.s.sumption that expectations are rational, there is no feedback rule that the authority can employ and expect to be able systematically to fool the public. This means that the authority cannot expect to exploit the Phillips Curve even for one period. Thus, combining the natural rate hypothesis with the a.s.sumption that expectations are rational transforms the former from a curiosity with perhaps remote policy implications into an hypothesis with immediate and drastic implications about the feasibility of pursuing countercyclical policy. (Sargent and Wallace 1976: 173, 176, 1778; emphases added) Not surprisingly, this doctrine was termed the 'policy ineffectiveness proposition.' If anything that was consciously done by policymakers to manipulate the economy led instantly to countervailing behavior by people in the economy, then nothing the government could do would alter the rate of unemployment. Instead, all the government could do was cause inflation.

This doctrine also provided a basis on which to attack the strongest edifices of macroeconomics at the time, the large-scale numerical simulations of the economy derived from Hicks's IS-LM model.

The Lucas critique These numerical simulations had two roles: providing a means to organize economic statistics from the past, and providing a means to forecast what might happen to the economy if a new government policy were implemented. Lucas's critique focused on this second role, by arguing that the parameters in the models' equations reflected the expectations that agents in the economy had under past policies. A new policy would evince new reactions from agents within the economy, thus altering the parameters and rendering projected economic outcomes based on them invalid. As Lucas put it: The thesis of this essay is that [...] the 'theory of economic policy' [...] is in need of major revision. More particularly, I shall argue that the features which lead to success in short-term forecasting are unrelated to quant.i.tative policy evaluation, that the major econometric models are (well) designed to perform the former task only, and that simulations using these models can, in principle, provide no useful information as to the actual consequences of alternative economic policies. (Lucas 1976: 1920) Leaving aside the absurdity of using this critique to justify the a.s.sumption of rational expectations, Lucas's general point was valid: one of the many things that an economic model should incorporate is the possibility that the behavior of the economy could alter in response to a change in government policy.

However, it is a wild extrapolation to then argue that the change would be sufficient to completely neutralize the policy, as rational expectations exponents contended. It is also committing the fallacy of strong reductionism to believe that this justifies overthrowing explicitly macroeconomic models and replacing them with ones in which macroeconomics is directly extrapolated from microeconomics.

The applicability of the Lucas critique to the existing IS-LM-based macroeconomic modeling tradition was also a matter of degree, as Gordon argued at the same conference: While I am prepared to grant the validity of the proposition that the mechanical extrapolation of a model with fixed parameters cannot provide useful information on the effects of all policy changes, on the other hand the effects of some policy changes can be determined if parameter s.h.i.+fts are allowed and are either (a) estimated from the response of parameters to policy changes within the sample period or (b) are deduced from a priori theoretical consideration. (Gordon 1976: 47) However, Lucas and the Rational Expectations Mafia35 weren't interested in nuances: their objective was the elimination of macroeconomics as a separate discipline, and the replacement of IS-LM-based macroeconomic models with models that extrapolated the neocla.s.sical microeconomics to an a.n.a.lysis of the entire economy. Manifestos to this effect are spread throughout the economic literature.

The microeconomic manifesto The belief that macroeconomics should be applied microeconomics was an article of faith for neocla.s.sical economists, and this faith was radiantly on display at Lucas's keynote speech to the History of Political Economy conference in the year in which he became president of the American Economic a.s.sociation. In this memoir, he reiterated the view that macroeconomics had to be based on Walrasian microeconomics: I think Patinkin was absolutely right to try and use general equilibrium theory to think about macroeconomic problems. Patinkin and I are both Walrasians, whatever that means. I don't see how anybody can not be.

I also held on to Patinkin's ambition somehow, that the theory ought to be microeconomically founded, unified with price theory. I think this was a very common view [...] n.o.body was satisfied with IS-LM as the end of macroeconomic theorizing. The idea was we were going to tie it together with microeconomics and that was the job of our generation. Or to continue doing that. That wasn't an anti-Keynesian view. You can see the same ambition in Klein's work or Modigliani's. (Lucas 2004: 16, 20) Today, macroeconomic textbooks start from the presumption that macroeconomics must have microeconomic foundations. Ljungqvist and Sargent's 2004 text gives a typical justification for this: This book is about micro foundations for macroeconomics. [There are] two possible justifications for putting microfoundations underneath macroeconomic models. The first is aesthetic and pre-empirical: models with micro foundations are by construction coherent and explicit. And because they contain descriptions of agents' purposes, they allow us to a.n.a.lyze policy interventions using standard methods of welfare economics. Lucas [...] gives a distinct second reason: a model with micro foundations broadens the sources of empirical evidence that can be used to a.s.sign numerical values to the model's parameters [...] We don't think that the clock will soon be turned back to a time when macroeconomics was done without micro foundations. (Ljungqvist and Sargent 2004: xxvixxvii) The problem for early would-be neocla.s.sical macroeconomists was that, strictly speaking, there was no microeconomic model of macroeconomics when they began their campaign. So they developed a neocla.s.sical macro model from the foundation of the neocla.s.sical growth model developed by n.o.bel laureate Robert Solow (Solow 1956) and Trevor Swan (Swan 2002). They interpreted the equilibrium growth path of the economy as being determined by the consumption and leisure preferences of a representative consumer, and explained deviations from equilibrium which the rest of us know as the business cycle by unpredictable 'shocks' to technology and consumer preferences.

This resulted in a model of the macroeconomy as consisting of a single consumer, who lives for ever, consuming the output of the economy, which is a single good produced in a single firm, which he owns and in which he is the only employee, which pays him both profits equivalent to the marginal product of capital and a wage equivalent to the marginal product of labor, to which he decides how much labor to supply by solving a utility function that maximizes his utility over an infinite time horizon, which he rationally expects and therefore correctly predicts. The economy would always be in equilibrium except for the impact of unexpected 'technology shocks' that change the firm's productive capabilities (or his consumption preferences) and thus temporarily cause the single capitalist/worker/consumer to alter his working hours. Any reduction in working hours is a voluntary act, so the representative agent is never involuntarily unemployed, he's just taking more leisure. And there are no banks, no debt, and indeed no money in this model.

You think I'm joking? I wish I was. Here's Robert Solow's own summary of these models initially called 'real business cycle' models, though over time they morphed into what are now called 'Dynamic Stochastic General Equilibrium' models: The prototypical real-business-cycle model goes like this. There is a single, immortal household a representative consumer that earns wages from supplying labor. It also owns the single price-taking firm, so the household receives the net income of the firm. The household takes the present and future wage rates and present and future dividends as given, and formulates an optimal infinite-horizon consumption-saving (and possibly labor-saving) plan [...] The firm looks at the same prices, and maximizes current profit by employing labor, renting capital and producing and selling output [...] (Solow 2001: 23) In the ordinary way, an equilibrium is a sequence of inter-temporal prices and wage rates that makes the decisions of household and firm consistent with each other. This is nothing but the neocla.s.sical growth model [...]

The theory actually imagines that the model economy is disturbed from time to time by unforeseeable shocks to the technology and the household's tastes [...] There is thus nothing pathological or remediable about observed fluctuations. Unforeseeable disturbances are by definition unforeseen; after one of them has happened, the economy is already making optimal adjustments, given its technology and the inter-temporal preferences of its single inhabitant or identical inhabitants. There is no role for macroeconomic policy in this world [...] the best it [the government] can do is to perform its necessary functions in the most regular, predictable way, so as not to add unnecessary variance to the environment. (Ibid.: 234) If you get the feeling that Solow a neocla.s.sical economist par excellence and, as noted, the author of the growth model from which real business cycle models were derived is not happy with the microeconomic takeover of macroeconomics, you'd be right. Though microeconomics masquerading as macroeconomics took over PhD programs across the USA, and it is all the current crop of neocla.s.sicals really knows, there has always been opposition to this approach to macroeconomics from within the neocla.s.sical school itself. Solow's own reactions are the most notable, since Solow's growth model is acknowledged by Finn Kydland and Edward Prescott, the originators of these models, as its fountainhead (Kydland and Prescott 1991: 1678).

Solow's reaction to the fact that his growth model was used as the basis of modern neocla.s.sical macroeconomics was one of bewilderment: The puzzle I want to discuss at least it seems to me to be a puzzle, though part of the puzzle is why it does not seem to be a puzzle to many of my younger colleagues is this. More than forty years ago, I [...] worked out [...] neocla.s.sical growth theory [...] [I]t was clear from the beginning what I thought it did not apply to, namely short-run fluctuations in aggregate output and employment [...] the business cycle [...]

[N]ow [...] if you pick up an article today with the words 'business cycle' in the t.i.tle, there is a fairly high probability that its basic theoretical orientation will be what is called 'real business cycle theory' and the underlying model will be [...] a slightly dressed up version of the neocla.s.ssical growth model. The question I want to circle around is: how did that happen? (Solow 2001: 19) Solow inadvertently provided one answer to his own question when he discussed the preceding IS-LM model: For a while the dominant framework for thinking about the short run was roughly 'Keynesian.' I use that label for convenience; I have absolutely no interest in 'what Keynes really meant.' To be more specific, the framework I mean is what is sometimes called 'American Keynesianism' as taught to many thousands of students by Paul Samuelson's textbook and a long line of followers. (Ibid.: 21) How bizarre! Solow is decrying that poor scholars.h.i.+p led to his growth cycle model being used for a purpose for which it was not designed, and yet he is blase about whether or not the models of the economy he helped develop, and which he labels Keynesian (albeit with the qualifier 'American'), have anything to do with Keynes's ideas.

The old saying 'As ye sow, so shall ye reap' applies here. The poor scholars.h.i.+p that let American economists delude themselves into believing that they were Keynesians, when in fact they were extending models originated by and later disowned by John Hicks, now let them use Solow's growth model as a foundation for models of the business cycle, even though Solow himself disowned the enterprise on two very valid grounds.

The first is that the limitations of IS-LM modeling pointed out in the Lucas critique did not justify modeling the entire macroeconomy as a single representative agent. Unlike many neocla.s.sicals, Solow was aware that the Sonnenschein-Mantel-Debreu conditions discussed in Chapter 3 invalidate attempts to model the entire economy by extrapolating from microeconomic theory about the behavior of individual consumers: the main argument for this modeling strategy has been a more aesthetic one: its virtue is said to be that it is compatible with general equilibrium theory, and thus it is superior to ad hoc descriptive models that are not related to 'deep' structural parameters. The preferred nickname for this cla.s.s of models is 'DSGE' (dynamic stochastic general equilibrium). I think that this argument is fundamentally misconceived [...] The cover story about 'microfoundations' can in no way justify recourse to the narrow representative-agent construct [...]

He also supplied a simple a.n.a.logy as to why the valid criticism of IS-LM models that they don't consider that economic agents may change their behavior when government policies change does not justify the strong reductionist approach of reducing macroeconomics to applied microeconomics: The nature of the sleight-of-hand involved here can be made plain by an a.n.a.logy. I tell you that I eat nothing but cabbage. You ask me why, and I reply portentously: I am a vegetarian! But vegetarianism is reason for a meatless diet; it cannot justify my extreme and unappetizing choice. Even in growth theory (let alone in short-run macroeconomics), reasonable 'micro-foundations' do not demand implausibility; indeed, they should exclude implausibility. (Solow 2007: 8; emphasis added) Solow's second point is a practical one: the standard fare of macroeconomics booms and slumps, inflation and deflation, unemployment rising as people are sacked during recessions cannot occur in pure DSGE models. They are therefore a particularly useless foundation from which to a.n.a.lyze such phenomena. In a paper tellingly ent.i.tled 'Dumb and dumber in macroeconomics,' Solow observed that, though 'The original impulse to look for better or more explicit micro foundations was probably reasonable [...]'

What emerged was not a good idea. The preferred model has a single representative consumer optimizing over infinite time with perfect foresight or rational expectations, in an environment that realizes the resulting plans more or less flawlessly through perfectly compet.i.tive forward-looking markets for goods and labor, and perfectly flexible prices and wages.

How could anyone expect a sensible short-to-medium-run macroeconomics to come out of that set-up? My impression is that this approach (which seems now to be the mainstream, and certainly dominates the journals, if not the workaday world of macroeconomics) has had no empirical success; but that is not the point here. I start from the presumption that we want macroeconomics to account for the occasional aggregative pathologies that beset modern capitalist economies, like recessions, intervals of stagnation, inflation, 'stagflation,' not to mention negative pathologies like unusually good times. A model that rules out pathologies by definition is unlikely to help. (Solow 2003: 1; emphases added) In typical neocla.s.sical fas.h.i.+on, Solow's legitimate complaints about 'micro-foundations-based representative agent macroeconomics' have been ignored. The accepted wisdom within neocla.s.sical economics remains that macro models had to have 'good microeconomic foundations,' and the only dispute, prior to the Great Recession, was over what const.i.tuted good foundations. This led to a bifurcation within neocla.s.sical macroeconomics into two camps, one of which preferred to model the entire economy as a single agent existing in a perfectly compet.i.tive general equilibrium, the other of which modeled the economy as one (and occasionally more than one) agent existing in a state of imperfectly compet.i.tive general equilibrium.

It was a sham dichotomy, because they both shared the vision that, if the neocla.s.sical fantasy of perfect compet.i.tion applied, there would be no macroeconomic problems. They differed only on whether they believed that the neocla.s.sical fantasy could be a.s.sumed to apply in reality or not. As the end of the first decade of the twenty-first century approached, they had largely reached a rapprochement. And then the Great Recession crushed both their visions.

Much ado about almost nothing: freshwater versus salt.w.a.ter macroeconomics n.o.bel laureate Paul Krugman popularized the monikers 'freshwater' and 'salt.w.a.ter' economists for these two approaches to economics, and makes much of their differences (Krugman 2009a, 2009b). But the reality is that what they share is far more important than their slight differences, because they are both neocla.s.sical theories in which macroeconomic problems arise only if there are microeconomic 'imperfections,' and they both believe that a perfectly compet.i.tive economy with flexible prices is the definition of perfection.

As I explained in Chapters 35 of this book, this vision even of their own model is fundamentally wrong. Demand curves derived from aggregating the individual demand of 'perfectly rational' consumers could have any shape at all. Compet.i.tive firms would not produce where marginal cost equals price, but where marginal revenue equals demand, and set price above this level. Market demand curves would intersect with the marginal revenue curves of the industry's suppliers in multiple locations, making the very notion of an equilibrium price in a single market problematic. Incorporating the issues covered in subsequent chapters results in even more of a mess. Not even microeconomic a.n.a.lysis can be based on neocla.s.sical microeconomics let alone the a.n.a.lysis of an entire economy.

Both salt.w.a.ter and freshwater economists were therefore up Strong Reductionism Creek without a paddle when the Great Recession hit. I would prefer to leave them there, but since their squabbling and mea culpas dominate even today's debate about where macroeconomics should go from now, I have to detail how they got there in the first place, and why they remain lost in an irrelevant intellectual tributary of their own making when the real world is drowning in the flood of the Great Recession.

From Keynes to freshwater macroeconomics Both freshwater and salt.w.a.ter macroeconomics had their genesis in the pre-Keynesian belief that all dilemmas at the level of the overall economy must instead be signs of malfunctioning in particular markets and normally the labor market. As Coddington noted in the very early days of the neocla.s.sical revolt against Keynesian macroeconomics, Keynes's neocla.s.sical predecessors whom he labeled 'Cla.s.sical' had precisely the same view, and it was based on a reductionist vision of how economics should be done: Keynes attacked a body of theory that he designated 'Cla.s.sical.' [... and] called into question the method of a.n.a.lysis by which this system was constructed [...] this method consisted of a.n.a.lyzing markets on the basis of the choices made by individual traders [...] This method of a.n.a.lysis [...] I will refer to as 'reductionism,' on the grounds that the central idea is the reduction of market phenomena to (stylized) individual choices. (Coddington 1976: 1258) This pre-Keynesian vision was reconstructed by neocla.s.sical macroeconomists after Keynes. Their starting point was the key implication of 'The predominant theory of markets, namely the Walrasian or Arrow Debreu model of general compet.i.tive equilibrium,' which was that unemployment never appears and that economic policy never has universally good effects. First, it postulates that the supply and demand by price-taking agents equilibrates in the market for any commodity, including labor. Hence, no unemployment occurs. Second, Walrasian equilibria are efficient, as antic.i.p.ated by Adam Smith's 'invisible hand' [...] Thus, either economic policy has no effects or it hurts some group of citizens. (Silvestre 1993: 105) This pre-Keynesian att.i.tude was reborn with the development of what Coddington termed 'Reconst.i.tuted Reductionism,' because believers in neocla.s.sical economics could give Keynes's work any intellectual credence only if it were seen as a statement of what would happen out of equilibrium, since in general equilibrium, Walras's Law would apply and there could be no macroeconomic problems. As Robert Clower put it, Keynes either had such a hypothesis 'at the back of his mind, or most of the General Theory is theoretical nonsense' (Clower 1969: 290).

As I've explained above, Walras's Law itself is a theoretical nonsense that ignores the role of credit in a market economy. However, the belief that Walras's Law was a universal truth, and that any deviation from its fundamental result that macroeconomic crises were in fact manifestations of disequilibrium in individual markets must be a fallacy was shared by both sides of the neocla.s.sical salt.w.a.ter/freshwater divide. Coddington correctly noted that both salt.w.a.ter and freshwater economists a.s.sumed that economics had to be conducted from a reductionist perspective.

the claim that equilibrium theorizing must be abandoned in order to accommodate Keynesian ideas postulates that theorizing must be carried out in accordance with the reductionist program. (Coddington 1976: 1269) To ask this question, one needs a construction in which prices adjust less than instantaneously to economic circ.u.mstances, so that at any point in time the prices may be effectively providing incentives to act, but the information they reflect will not be appropriate for the equilibrium that is being approached. (Ibid.: 1270) Salt.w.a.ter economists were willing to abandon equilibrium (or at least perfectly compet.i.tive equilibrium) but still believed they had to reason in a reductionist way. Freshwater economists clung to modeling the economy as if it were always in equilibrium, which gave rise to the problem for them of the historical fact that unemployment occurred or, in their terms, that economic statistics reported that, on occasions, lots of people were not working. But according to their theory, if all markets including labor were in equilibrium apart from the impact of unexpected shocks, unemployment in general could not exist. How, then, to interpret past instances when high levels of unemployment were recorded like, for example, the Great Depression?

Their interpretation, in a nutsh.e.l.l, was that the Great Depression was an extended holiday: something happened that caused workers to decide to work less, and this increase in leisure was recorded by the statistical agencies as an increase in unemployment. This something was a change in government policy that made it rational for workers to voluntarily reduce their working hours in order to maximize their lifetime utility.

You think I