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Post Keynesian Dynamic Stochastic General Equilibrium Theory

Last year, I was invited to present a keynote address to the 20th annual conference of the FMM Research Network on Macroeconomics and Macroeconomic Policies, “Towards Pluralism in Macroeconomics”, held in Berlin on October 20th – 22nd 2016. Due to unforeseen circumstances, I was  unable to attend in person but the organizer, Torsten Niechoj, kindly invited ...

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Last year, I was invited to present a keynote address to the 20th annual conference of the FMM Research Network on Macroeconomics and Macroeconomic Policies, “Towards Pluralism in Macroeconomics”, held in Berlin on October 20th – 22nd 2016. Due to unforeseen circumstances, I was  unable to attend in person but the organizer, Torsten Niechoj, kindly invited me to submit a paper for the conference volume. That paper is now available as an NBER working paper here, and as a CEPR discussion paper here. In it, I make the case that Post-Keynesians and New-Keynesians have much to learn from each other and I invite the next generation of macroeconomists to help develop a fresh approach to our subject: Post-Keynesian Dynamic Stochastic General Equilibrium Theory.

Image from: The Rocky Horror Picture Show

Image from: The Rocky Horror Picture Show

Here is an extract from the paper, that reports a conversation overheard between Janet, a North American economist from the Great Lakes region, and Brad, a Post Keynesian graduate student who has read my book, Prosperity for AllJanet seems a bit confused over Gene Fama's use of the word 'efficiency' in the efficient markets hypothesis. Brad explains that Fama is talking about informational efficiency and that this is distinct from Pareto Efficiency. Janet thinks that these are the same thing. Brad disagrees.

Janet:      The distinction between informational efficiency and Pareto efficiency is a distraction. If people trading in the financial markets cannot make money, nor can the government. There is no such thing as a free lunch. 

Brad:    I disagree. The fact that a market is in equilibrium does not mean that it is efficient.

Janet:    Well OK, I know that you Post-Keynesian types are willing to make all sorts of assumptions about market frictions. Those assumptions don’t seem credible to me. As a first approximation, I am willing to assume that prices are perfectly flexible.

Brad:    You seem to be confusing me with a New-Keynesian. I’m happy with the flexible price assumption.  I’ll give you that one.

Janet:    Well perhaps you think that there are missing financial markets. I know that Kenneth Arrow has argued that transactions costs preclude the existence of all the financial instruments necessary to generate market efficiency. But I don’t buy that. If there are big potential gains from trade, there are big incentives for private agents to create new markets. Just look at all the derivatives that were created over the last few decades. They came about because of lower transactions costs. I’m willing to assume, to a first approximation, that there is a complete set of financial markets.

Brad:    While that seems like a stretch; I’ll give you that one too. Let’s assume that there is a complete set of financial markets and that everyone participating in the financial markets can make any conceivable trade in the futures markets at zero cost.

Janet:    Is it the assumption of perfect knowledge you’re uncomfortable with? I know that Frank Knight  drew a distinction between risk and uncertainty and that you Post Keynesian types keep harping on about radical uncertainty. Although you may have a point there, I just don’t see how we can make any progress if we assume that nobody knows anything about the future. I’m willing to go with the assumption that we live in a stationary world because it’s the best chance we have of saying something about the behavior of short-run macroeconomic variables. And that means that we should also assume that people have rational expectations.

Brad:    Well I’m not entirely on board with that. But, for the sake of argument, let’s agree to model the way that human beings would act if they did live in a world where all uncertainty is generated by a known stationary probability distribution and where the people in our model have rational expectations. If we can agree on the answer to what an equilibrium would look like in that world, then perhaps we can extend our equilibrium concept to a more complicated world where the future is characterized by radical uncertainty.

Janet:    Hmmm… If you accept all of these assumptions, I’m having trouble understanding why you don’t understand, that if private agents can’t make money in markets, then, neither can the government. Maybe you’re one of those Marxist types who thinks that product markets are characterized by monopolists and we need unions to defend workers’ rights. In my view, that’s a load of poppycock. Product markets are contestable and, to the extent they’re not, the solution is limited regulation. I don’t see what that has to do with the distinction between informational efficiency and Pareto efficiency. 

Brad:    Wow: you really have drunk the Kool-Aid. But no; that’s not my point either. Let’s suppose you’re right that the labor market and the product markets are well approximated by the assumption of perfect competition. I’m willing to give you flexible prices, complete markets, rational expectations, and perfect competition. But there’s one little fact you can’t get around.

Janet:    What’s that Brad?

Brad:    The Grim Reaper. People die and new people are born. Even if everyone present today could make trades with each other contingent on every conceivable future event, the unborn cannot participate in markets that open before they are born. Government, on the other hand, is present in every period and it can intervene on behalf of our children and our grandchildren.

Janet:    Nonsense. We don’t need government for that; we need the family. Robert Barro showed that all we need to correct the inefficiency in an overlapping generations model is for parents to love their children. The representative household is a useful fiction because each of us is connected by a chain of operative bequests. 

Brad:    You’re wrong Janet. Overlapping generations models have not one, but two kinds of inefficiencies. Robert Barro’s argument applies to dynamic inefficiency, which is the fact that, in overlapping generations models, interest rates can be too low. There is a second kind of inefficiency that was pointed out by David Cass and Karl Shell . And Costas Azariadis (Azariadis, 1981) showed that overlapping generations models can lead to volatile fluctuations in asset markets that have nothing to do with fundamentals. In his book, Prosperity for All Farmer argues that a large fraction of the fluctuations we see in stock markets are caused by this second kind of inefficiency. And this second kind of inefficiency cannot be eliminated by the family because it would require that our parents leave positive bequests in some states of nature and negative bequests in other states of nature.

My imagined conversation between Janet and Brad is meant to illustrate the idea that we can accept the tenets of a version of general equilibrium theory while rejecting the first welfare theorem.

It is my hope that the shock of the Great Recession will catalyze interbreeding between new-Keynesian and heterodox economists. If I am right, more of my neo-classical contemporaries will need to listen to the drum beat that post-Keynesians have been sounding for sixty years. And Post-Keynesians will need to explain to neo-classical and new-Keynesian economists, in their own language, what they are doing wrong. General equilibrium theory, broadly interpreted, like mathematics, is a language.

If you are young enough to have not yet been corrupted by establishment elites of either subspecies, I urge you to think hard about joining me in establishing Post-Keynesian DSGE theory as the future of macroeconomics. 

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Roger Farmer
ROGER E. A. FARMER is a Distinguished Professor of Economics at UCLA and served as Department Chair from July 2008 through December 2012. He was the Senior Houblon-Norman Fellow at the Bank of England, January-December 2013.

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