Akerlof’s AEA lecture

In his presidential address to the American Economics Association, Nobel laureate George Akerlof points to a new agenda for macroeconomics, rooted in more realistic assumptions about human behaviour. Below is the abstract and introduction. The full paper is here. Economist’s View’s coverage also includes a New York Times article that interviews Akerlof about his views (here).

The Missing Motivation in Macroeconomics, George A. AkerlofABSTRACT The discovery of five neutralities surprised the economics profession and forced the re-thinking of macroeconomic theory. Those neutralities are: the independence of consumption and current income (given wealth); the independence of investment and finance decisions (the Modigliani-Miller theorem); inflation stability only at the natural rate of unemployment; the ineffectiveness of macro stabilization policy with rational expectations; and Ricardian equivalence. However, each of these surprise results occurs because of missing motivation. The neutralities no longer occur if decision makers have natural norms for how they should  behave. This lecture suggests a new agenda for macroeconomics with inclusion of those norms.

I. Introduction

Macroeconomics changed between the early 1960’s and the late 1970’s. The macroeconomics of the early 1960’s was avowedly Keynesian. This was manifested in the textbooks of the time, which showed a remarkable unity from the introductory through the graduate levels.[1] John Maynard Keynes appeared, posthumously, on the cover of Time Magazine.[2] Even Milton Friedman was famously—although perhaps misleadingly—quoted, “We are all Keynesians now.”[3] A little more than a decade later Robert Lucas and Thomas Sargent (1979) had published “After Keynesian Macroeconomics.” The love-fest was over.

The decline of the old-style Keynesian economics was due in part to the simultaneous rise in inflation and unemployment in the late 1960’s and early 1970’s. That occurrence was impossible to reconcile with the simple non-accelerationist Phillips Curves of the time.

But Keynesian economics also declined because of a change in economic methodology. The Keynesians had emphasized the dependence of consumption on disposable income, and similarly, of investment on current profits and current cash flow.[4] They posited a Phillips Curve, where nominal—rather than real—wage inflation depended upon the unemployment rate, which was used as an indication of the looseness of the labor market. They based these functions on their own introspection regarding how the various actors in the economy would behave. They also brought some discipline into their judgments by estimating statistical relations.[5]

But a new school of thought, based on classical economics, objected to the casual ways of these folks. New Classical critics of Keynesian economics insisted instead that these relations be derived from fundamentals. They said that macroeconomic relationships should be derived from profit-maximizing by firms and from utility-maximizing by consumers with economic arguments in their utility functions.

The new methodology had a profound effect on macroeconomics. Five separate neutrality results overturned aspects of macroeconomics that Keynesians had previously considered incontestable. These five neutralities are: the independence of consumption and current income (the life-cycle permanent income hypothesis); the irrelevance of current profits to investment spending (the Modigliani-Miller theorem); the long-run independence of inflation and unemployment (natural rate theory); the inability of monetary policy to stabilize output (the Rational Expectations hypothesis); and the irrelevance of taxes and budget deficits to consumption (Ricardian equivalence).[6] These results fly in the face of Keynesian economics. They undermine its conclusions about the behavior of the economy and the impact of stabilization policy.

The discovery of these five neutrality propositions surprised macroeconomists. They had not suspected that radically anti-Keynesian conclusions were the logical outcome of such seemingly-innocuous maximizing assumptions.

II. Neutralities and Preferences

How did macroeconomists react to the discovery of the five neutralities? On the one hand, the New Classical Economists viewed their neutrality results as a tell-tale: that Keynesian economists of the previous generation had been thinking in the wrong way. In their view, scientific reasoning was producing a newer, leaner, more precise economics.

On the other hand, Keynesian economists, for the most part, reacted differently. In due course they came to view the neutralities as logically impeccable. These New Keynesians accepted the methodological dictums of the New Classical economics: that constrained maximization of profit and utility functions is the appropriate microfoundation for macroeconomics. They also viewed the neutralities as having a certain sort of generality. The neutralities do commonly describe equilibria of competitive economies with complete information irrespective of people’s preferences—as long as those preferences correspond to economists’ typical descriptions of them. The Keynesians then resurrected some—but not all—of the Keynesian conclusions by adding a variety of frictions to the New Classical model. Those frictions include credit constraints, market imperfections, information failures, tax distortions, staggered contracts, uncertainty, and bounded rationality. This formulation preserves many (but not all) Keynesian conclusions regarding cyclical fluctuations and macroeconomic policy.

This lecture will suggest a new stance in regard to each of the five neutralities. Like New Classical and New Keynesian economics, it will derive behavior from utility and profit maximization. That captures the purposefulness of economic decisions. But this lecture will also question the generality of the preferences that lead to the five neutralities. There is a sense in which those preferences are very narrowly defined. They have important missing motivation—since they fail to incorporate the norms of the decision makers. Those norms reflect how the respective decision makers think they and others should or should not  behave even in the absence of frictions. Preferences reflecting such norms yield a macroeconomics with important remnants of the early Keynesian thinking. They also yield a macroeconomics that, in important details, cannot be obtained only with frictions.

We shall see that with such preferences, even in the absence of frictions, each of the five neutralities will be systematically violated. Specifically:

—a realistic norm regarding consumption behavior will make consumption directly dependent on current income, in violation of the neutrality of consumption given wealth;

—a realistic norm will make investment directly dependent on cash flow, in violation of Modigliani-Miller;

—a realistic norm will make wages and prices dependent on nominal considerations and thus violate natural rate theory;

—a realistic norm will make income and employment dependent on systematic monetary policy, and thus violate rational expectations theory; and

—a realistic norm will make current consumption dependent on the current generation’s social security receipts, in violation of Ricardian equivalence.

Additionally, insofar as the behavior assumed by the early Keynesians differed from the behavior that produces the neutralities, there is likely to be a bias in favor of the Keynesians. The Keynesians based their models on their observation of motivations, rather than on abstract derivations. If there is a difference between real behavior and behavior derived from abstract preferences, New Classical economics has no way to pick up those differences. In contrast, models with norms based on observation will systematically incorporate such behavior — although, of course, as with any method, there is the possibility for error.

Inclusion of the “missing motivations in macroeconomics” then combines the observations of the Keynesians with the intentionality of economic decisions in New Classical economics. Such a synthesis yields the best of the two approaches.

Two disclaimers. Before beginning in earnest, let me offer two brief disclaimers. First, none of the behavior revealing of the norms that are introduced in this lecture will be new. On the contrary, I have purposefully chosen phenomena that have been emphasized since The General Theory by macroeconomists, who have followed Keynes in voicing their continuing doubts about classical interpretations of macroeconomic behavior.

Second, this lecture will discuss different norms that respectively correspond to the five neutralities. I shall assume that these norms are exogenous. Such assumptions of exogeneity are standard in economic analysis. In a given problem in a given time frame, some terms are assumed constant, while others are allowed to vary. I ask you, at least to the end of the lecture, to withhold your doubts regarding whether such exogeneity is a correct assumption or not. The incorporation of such endogeneity is the next step—not the first step—in the study of the effect of norms on macroeconomics, especially since such endogeneity may sometimes dampen, but will rarely nullify, the conclusions of this lecture.

3 comments

  • I think this is great.

    From what I can tell, Akerlof (& Stiglitz and others) are mounting a challenge on neoclassical economics that is far more effective than the post-autistic economics challenge. They are keeping some things (the math, the utility-based framework) but are asking “what does a world of ubiquitous market failures look like?” and what do we do about it?

    They are still a bit stuck in the false dichotomy of markets vs. state, but still, I think it’s fine.

  • LUCAS AND SARGENT DID NOT PRESENT THE CORRECT METHODOLOGY. THEY IGNORED THE FACT THAT WE CAN DERIVE THE TRUE CONCLUSION FROM THE FALSE PREMISE. THE TRUE THEORY IS DERIVED FROM THE TRUE PREMISE. FOR EXAMPLE, THE CONCLUSION OF POLICY INEFFECTIVENESS MUST BE DERIVED FROM THE FACT IF THE POLICY INEFFECTIVENESS WORKS IN OUR DAILY LIFE.

    THE INCORRECT METHODOLOGY IS THE REASON WHY LUCAS AND SARGENT REJECTED THE CRITIQUE THAT THE RATIONAL EXPECTATION IS UNREAL (I.E., A FALSE PREMISE TO EXPLAIN THE REAL WORLD BECAUSE THE RATIONAL EXPECTATION DOES NOT EXIST IN OUR LIFE) IN “AFTER KEYNESIAN…”

  • ….There is room for hope however. In the 2007, AEA Presidential Address, Akerlof demonstrated the existence of identity (the objectiveness of subjectivity–existence if you like). Let us hope it does not take Paul the same amount of time it took him to finally digest Storper-Samuelson 1941.

    As an aside, I look forward to the AEA Presidential Address of 2050 wherein some bright aging orthodox economist will discover society exists: then we will really be cooking with gas.

    http://rppe.wordpress.com/2007/05/31/hey-krugman-it-just-ain%e2%80%99t-so-get-unreal/

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