Thursday, September 07, 2006

Disconnect Of Monetary And Price Theory In Neoclassical Economics

Friedrich Hayek, John Maynard Keynes, and Gunnar Myrdal found themselves in the 1930s addressing the same problem in price theory. I refer not to the practical difficulty in accounting for the Great Depression, but the lack of integration between monetary theory and the theory of value and distribution:

Here's Hayek:
"What I complain of is not only that this theory [Fisher's monetarism] in its various forms has unduly usurped the central place in monetary theory, but that the point of view from which it springs is a positive hindrance to further progress. Not the least harmful effect of this particular theory is the present isolation of the theory of money from the main body of general economic theory.

For so long as we use different methods for the explanation of values as they are supposed to exist irrespective of any influence of money, and for the influence of money on prices, it can never be otherwise." (Hayek 1935, p. 2-3)
Here's Keynes:
"So long as economists are concerned with what is called the Theory of Value, they have been accustomed to teach that prices are governed by the conditions of supply and demand; and, in particular, changes in marginal cost and the elasticity of short-period supply have played a prominent part. But when they pass in volume II, or more often in a separate treatise, to the Theory of Money and Prices, we hear no more of these homely but intelligible concepts and move into a world where prices are governed by the quantity of money, by its income-velocity, by the velocity of circulation relative to the volume of transactions, by hoarding, by forced saving, by inflation and deflation et hoc genus omne; and little or no attempt is made to relate these vague phrases to our former notions of the elasticities of supply and demand. If we reflect on what we are being taught and try to rationalize it, in the simpler discussions it seems that the elasticity of supply must have become zero and demand proportional to the quantity of money; whilst in the more sophisticated we are lost in a haze where nothing is clear and everything is possible. We have all of us become used to finding ourselves sometimes on the one side of the moon and sometimes on the other, without knowing what route or journey connects them, related, apparently, after the fashion of our waking and our dreaming lives.

One of the objects of the foregoing chapters has been to escape from this double life and to bring the theory of prices as a whole back to close contact with the theory of value. The division of Economics between the Theory of Value and Distribution on the one hand and the Theory of Money on the other hand is, I think, a false division..." (Keynes 1936, p. 292-293)
And here's Myrdal:
"It is a peculiarity of all systematic treatises on orthodox economic theory that there is no inner connexion and integration of monetary theory with the central theory of prices. Usually the monetary theory is only a rather loose appendix to the theory of price formation. The central economic problems - according to the classical theory, those of production, of barter-exchange and of distribution - are treated, without exception, as problems of exchange value, or, in other words as problems of relative prices. Obviously, by regarding the central economic problems in this way one entirely detaches their fundamental treatment from any monetary considerations." (Myrdal 1939, p. 10)

I put the above quotes into my latest iteration of this paper.

I think that, despite later work by, for example, Don Patinkin or Eugene Fama or with models of overlapping generations, mainstream economists still fail to satisfactorily integrate monetary and price theory. I an influenced in this view by a Frank Hahn paper and comments of various Post Keynesians, such as Paul Davidson.

  • Hahn, F. H. (1965). "On Some Problems of Proving the Existence of an Equilibrium in a Monetary Economy" in The Theory of Interest Rates (Ed. by F. H. Hahn and F. Brechling), Macmillan.
  • Hayek, F. A. (1935). Prices And Production, Second Edition, London: George Routledge and Sons.
  • Keynes, J. M. (1936). The General Theory of Employment Interest and Money, New York: Harcourt, Brace and Co.
  • Myrdal, G. (1939). Monetary Equilibrium, New York: Sentry Press.


Blissex said...

«mainstream economists still fail to satisfactorily integrate monetary and price theory.»

Oh is this surprising? Money is about time, e.g. concepts like velocity don't make sense otherwise.

But ''mainstream'' theory of distribution (because price theory as you well know is in effect a theory of distribution) is not about time, because if one introduces time then the unicity and marginal productivity results disappear. And the purpose of mainstream economic is to prove the unicity and optimality of income distribution, and that simply cannot be renounced.

So never shall the two meet...

Anonymous said...

But is there a satisfactory theory of value that also integrates money in ways other than an afterthought?

Blissex's conspiratorial theory does not make much sense if the difficulty of such an integration is extraordinary.

By the way, do you think that the mistakes related to “roundaboutness” in Austrian Business cycle theory really affect the substance of said theory? The main point of the theory is that government manipulation of interest rate leads to ‘malinvestment’ – a monotonic relation between the interest rate and roundaboutness is not crucial for this conclusion.
I know that Hayek rejected the concept of roundaboutness in his debate with Knight if I remember correctly.

radek said...

I agree with anonymous that the adjective 'neoclassical' in the title of the post should be removed, unless you can point me to a unified treatment that avoids the obvious problems. I think this is an area where mainstream economists would happily admit that a lot of problems exist. It's a conceptually difficult subject (which is sort of the running theme in all your criticisms, since the alternatives don't exist or have their own particular problems). Which is sort of why 'monetary theory', at least as pure theory is somewhat out of favor at the moment (at least in my understanding). Folks are happy with just slapping on some ad-hocery and proceeding to the empirical work. Which of course isn't what you want, but sometimes you have to take what you've got.

These comments and discussions would be a lot more enjoyable if there wasn't so much smugness and snide-ness involved.

Robert Vienneau said...

Would value and monetary theory be better integrated today if more economists picked up on Townshend's “Liquidity-Premium and the Theory of Value” (1937) or Colin Rogers’ Money, Interest and Capital: A Study in the Foundations of Monetary Theory (1989)? Does the development of economics in a culture in which, say, Lorie Tarshis’ textbook The Elements of Economics (1947) could be attacked with McCarthyite foulness have anything to do with the choices of research directions on my topic? I don’t claim to have definitive answers for either question. But the first one indicates where I would look for an alternative theory. Suppose someone directed me instead to Robert Clower’s work or to Joseph Stiglitz on the implications for macroeconomics of asymmetric information. I don’t feel I know enough about either to offer a convincing opinion.

Anyways, my original post, being about neoclassical theory, is correctly titled. My subject is not whether those wanting to modernize classical theory should study up on arguments between the banking and currency school. Nor is it on why Marx put so much emphasis on money in the first chapter of the first volume of Capital. As usual, alternatives can be looked for in quite a few places, whatever one may think about the applicability and state of development of those alternatives.

I think that Hayek rejected the possibility of a single measure of capital-intensity. I am not sure that he ever rejected the idea of a tendency to reallocate, in response to a lower interest rate, resources from producing low order goods to producing high order goods. But this is the part of my paper I have yet to write, and I cannot complain about reading suggestions. I would like to see Roger Garrison or somebody produce a statement of Austrian Business Cycle theory that isn’t in error from my perspective. I think you need more than mistakes in investment to explain cycles. The incorrect theory, as I understand it, claims that the mistakes are systematic in a way that could lead to cycles.

I think I get too few comments to even bother worrying about whether discussion has already broken down.

Anonymous said...

Of course there are alternatives if one is looking for inspiration rather than for fully developed satisfactory theories. One can do much worse than searching for inspiration in Austrian economics. I was just making the simple observation that until a theory that on various metrics is more satisfactory than the neoclassical value theory is presented, it is unlikely that criticisms will lead to the abandonment of neoclassical theory. (I'm not saying that you would necessarily disagree.)

As for why monetary theory is not well integrated with value theory, I think the main reason is the difficulty that (neoclassical?) economic theory has in dealing with disequilibrium. In an imaginary economy with permanent equilibrium, money simply has no purpose. If all possible situations are covered by contracting from the present until the end of time, what role is there for money to play? It is only by integrating disequilibrium behaviour that money can have a purpose.
I don't think that neoclassical economics doesn't deal with disequilibrium for ideological reasons -- rather, it does not deal with such behaviour because the subject is extremely difficult. It is not hard to find instances of neoclassical economists calling for attention on disequilibrium economics -- for instance Martin Shubik's piece here -- but it is harder to find satisfactory treatments of the subject. Franklin Fisher's book length treatment in "Disequilibrium Foundations of Equilibrium Economics" seems to be the best available -- but the author candidly admits the shortcomings of his research.

This situation is compatible with my claim that the subject is avoided because of its difficulty and I don't think it's compatible with ideological bias.

I would go further and say that all serious problems with neoclassical theory have a common root in the theory's inability to deal with disequilibrium. Even the CCC criticism can be truly damaging only to the extent that it sheds light or focuses attention on the shortcomings of the treatment of disequilibrium. The fact that changes in the (exogenous) quantity of an endowed good can lead to changes in (endogenous) variables such as wealth and/or employed technology in such a way that the price of the mentioned good does not bear a monotonic relation with its quantity does not necessarily mean that the neoclassical vision is invalidated. As long as the relative scarcity of goods (and utility) still play an important role in determining prices, the neoclassical vision remains valid.
It is much harder to deal with criticisms that point out the problems neoclassical theory has in dealing with disequilibrium -- whether this criticism comes from the CCC or from other sources.

Returning to the Austrian Business Cycle (ABC) theory, I don't have any references to the exposition of ABC that doesn't use the classification of capital goods into several orders. I was just suggesting that this classification does not seem to be essential to the arguments underlying the boom-bust cycle. The 'artificial' and unexpected change in the interest rate determines entrepreneurs to make correlated mistakes in their evaluation of the capital structure that the economy can sustain (note that here there doesn't seem to be any need for elucidating in which 'orders' the investments goes, the fact that there is general 'malinvestment' rather than 'overinvestment' or 'underinvestment' in particular 'orders' of capital seems sufficient). As the mistakes become clear, due to the specificity of capital, the process of boost in which certain investments have to be abandoned and others begun starts.
The classification of capital goods into several orders seems to me to be just an attempt at providing intuition for what happens in the boom-bust cycle, but not really necessary for the argument. A 'natural rate of interest' does seem necessary for the ABC theory to hold though.

Robert Vienneau said...

I agree that Franklin Fisher's book is well worth considering, and am grateful to have Shubik's paper called to my attention. I agree, and I think that Blissex would too, that a good theory of money will need to deal with disequilibrium.

I still think that those drawing on my favorite approaches, that is, Keynesianism and Post Keynesianism, have been subject to ignorant political attacks. I may blog sometime in the future on political interference in academic economics.

I see how Anonymous explains the compatibility of Austrian Business Cycle theory with a rejection of the existence of a tendency for more capital-intensive techniques to be adopted at lower interest rates. He thinks that it is enough for mistakes in investment to be correlated. That’s an interesting point. I intend to end my paper by challenging Austrians either to reject the ABC theory or restate it in a way not vulnerable to the critiques, the capital-theoretical one and ones more focused on money.