Kenneth Arrow versus Robert Lucas

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Thomas Sargent, one of the most determined anti-Keynesians, once contrasted the core macro views of Kenneth Arrow and Robert Lucas, each broadly recognized as a titan of postwar economic thinking (Journal of Economic Literature, 2015, pp.43–64). Arrow (with Debreu) figured out how to root general market equilibrium (GME) in rational behavior. Nobody questions his preeminence. In Sargent’s telling, Arrow’s musing about macro theory in 1967 “identified the relation between micro and macroeconomics as ‘one of the major scandals of price theory.’ He doubted that the problem had been resolved ‘by what Samuelson has called the neoclassical synthesis, in which it is held that achievement of full employment requires Keynesian intervention but that neoclassical theory is valid when full employment is reached.’ Arrow asserted that ‘the mutual adjustment of prices and quantities represented by the neoclassical model is an important aspect of reality worthy of the serious analysis that has been bestowed on it’ but that to understand depressions and economic development ‘something beyond, but including, neoclassical theory is needed’.”

Sargent allows Robert Lucas to make his perhaps surprising case in more detail, centrally placing Samuelson’s neoclassical synthesis at the core of a Keynesian economics that he believes to be a failed research program. Focusing on Keynes, Lucas writes: “… what do we mean by ‘managing’ an economy? Prior to Keynes, “managing” was taken to involve a good deal of governmental intervention at the individual market level—socialism in Russia, fascism in Italy and Germany, the confusion of early New Deal programs in the United States. It meant a fundamental shift away from market allocation and towards centralized direction. The central message of Keynes was that there existed a middle ground between these extremes of socialism and laissez faire capitalism. (Actually, there is some confusion as to what Keynes really said—largely Keynes’s own fault. Did you ever actually try to read the General Theory? I am giving you Keynes as interpreted by Alvin Hansen and Paul Samuelson.) It is true (Keynes argued) that an economy cannot be left to its own devices, but all we need to do to manage it is to manipulate the general level of fiscal and monetary policy. If this is done right, all that elegant nineteenth century economics will be valid and individual markets can be left to take care of themselves. . . . These were hard times, and this was too good a deal to pass up. We took it. So did society as a whole. (Conservatives were a little grumpy, but how bad off could we be in a country where Paul Samuelson is viewed as a leftist?)

“This middle ground is dead. Not because people don’t like the middle ground any more but because its intellectual rationale has eroded to the point where it is no longer serviceable. . . . the problem in a nutshell was that the Keynes–Samuelson view involved two distinct, mutually inconsistent theoretical explanations of the determinants of employment.” (Lucas’s Collected Papers on Monetary Theory, 2013, Chapter 21, section titled “The Death of Keynesian Economics”.) As readers of this Blog know, one explanation requires flexible labor pricing which GME rooted in rational behavior. The other is constructed on market wage stickiness for which Samuelson and other Keynesians could not provide rational foundations, causing the failure of their research program.

The GEM Project has resolved the titans’ differences. Important guidance for constructing rational-behavior workplace equilibrium came from the genuinely brilliant Kenneth Arrow. The Project accepts his conclusion that the “neoclassical [GME] model is an important aspect of reality worthy of the serious analysis that has been bestowed on it”. The workplace-marketplace synthesis assigns a substantial role to market centricity, which calls the tune in its small-firm venue.. But recall that Arrow’s assessment came with a caveat, which the Project also accommodates: “to understand depressions and economic development ‘something beyond, but including, neoclassical [GME] theory is needed’.” The Project’s second venue of rational exchange provides Arrow’s “something beyond” market analysis. i.e., rational employer-employee interaction in workplaces restricted by asymmetric information. Once rational exchange has been generalized from the marketplace to information-challenge workplaces, powerful labor-price rigidities are made consistent with optimization and general decision-rule equilibrium. The real work on modeling instability in the wake of aggregate-demand disturbances can begin.

Meanwhile, understanding Lucas’ inability to  explain crucial evidence is more tricky. I believe that the failure is rooted in his admirable insistence on macro modeling being rooted rational behavior. Prior to the GEM Project, such modeling was market-centric, Consequently there has always been a pile of inconvenient, albeit important, evidence (notably including Keynes’ central problem of  involuntary job loss) that Lucas would never be able to explain. But, unlike most mainstream theorists who pretend that layoffs and job downsizing will someday be made rational in the neoclassical GME context, Lucas is honest. He openly recognizes that involuntary job loss cannot exist in general market equilibrium, concluding that macroeconomists working within that framework must ignore forced unemployment. The GEM Project can work with that honest assessment of market centricity. It is unsurprising that nothing in his insightful comments quoted above is inconsistent with the need for workplace  modeling to adequately explain macro instability after the Second Industrial Revolution. Indeed, it is not much of a stretch to interpret Lucas’ macro perspective as an invitation to incorporating rational-behavior nonmarket exchange into rigorous, stabilization-relevant macroeconomics.

If this narrative needs a loser, let it be Tom Sargent, not Arrow or Lucas. Sargent’s stubborn anti-Keynesian mindset prevents recognition that rational-behavior nominal wage rigidity, the central instability-relevant contribution of the market-to-workplace generalization of rational exchange, is both feasible and a crucial object of useful research. That is especially true now that foundational workplace-equilibrium analysis has already been constructed.

Blog Type: Wonkish

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