Arrow on flawed markets, involuntary unemployment and rational expectations

15 Aug, 2014 at 16:29 | Posted in Economics | Comments Off on Arrow on flawed markets, involuntary unemployment and rational expectations

Arrow: I think the idea that a society has to be responsible for all of its citizens, those who do well and those who do not, is really a precondition of a good society. Let me say that from the time I first understood economic principles, I was always concerned also that any system be operated on an efficient basis, which meant decentralization because knowledge is not concentrated anywhere …

On the other hand, markets are not, in my opinion, a full solution to any problem. The obvious problem they don’t meet is the concerns of the welfare of individuals who may get lost in the operation of the system — the distributional question. We’ve seen this growing as we go further and further toward a market ideology in the United States and the United Kingdom. We’ve seen a decline in the welfare of the working poor, leaving aside any other pathologies, just the working poor, a very distinct increase at the very top levels …

I think on the efficiency level, not only the distribution level, capitalism is a flawed system. It probably has the same virtues as Churchill attributed to democracy: It’s the worst system except for any other. And I think that’s right, but it cannot be thought that some unmitigated belief in free markets is a cure even from the efficiency point of view …

Region: Recent macroeconomic research in Minnesota — both at the Federal Reserve Bank and at the University of Minnesota — has been greatly influenced by your work in the 1950s in the theory of general equilibrium. At the time, did you think that your work would contribute to a better understanding of the macroeconomy?

Arrow: I did, but not in the way it’s turned out. The vision I had that wasn’t articulated in my articles exactly was that the macroeconomy was the disequilibrium phenomenon. The idea that we could interpret economic fluctuations as an equilibrium phenomenon was something that did not cross my mind. And I’m still not sure that the disequilibrium interpretation isn’t more appropriate …

I do think the interpretation of unemployment specifically is not well represented in the equilibrium models. I don’t believe that unemployment is all voluntary, by anticipation of future wage movements or this sort of thing. I know you can modify the models by taking into account the indivisibilities, but I don’t really think that people are voluntarily unemployed …

Region: So you’re not going to buy into the argument that these are just people in search?

Arrow: No, because I can’t see why search should vary that much …

Region: The Nobel Prize in Economics has recently been given to Robert E. Lucas Jr. for the influence that he has had in macroeconomics and, in particular, for his contributions to the theory of Rational Expectations … Do you think that the current theories of learning will prove more successful than the theory of Rational Expectations for certain questions? And if so, which questions?

Arrow: I think the answer is yes, that learning models will turn out to be more accurate. More useful is another question, because usefulness depends on tractability …

October ’87 is a wonderful example. Rational expectations would suggest that prices would change when news changes. In October ’87 there was no news that anybody could identify even in retrospect as relevant. There was a 20 percent drop in the day. Now that’s a kind of internal dynamics of the market. And part of it undoubtedly is that investors have a model of the future which says that if prices start falling they’re going to continue to fall for a while, and therefore one ought to get out of it now and then buy at a lower price later. So one rushes to get out. That’s oversimplifying it, but it’s built into the computer programs. Now that’s not based on a rational expectation.

It struck me when this thing started that it’s perfectly obvious that prices were to get back up again. I held on. It seemed to be quite obvious that they were going to come back because there was no reason why they shouldn’t. But the fact is that people didn’t behave that way. The fact is you have these periods of alternating volatility and lack of volatility. So it seems to me that at least as far as the financial markets are concerned, there is increasing evidence against rational expectations, even at the macro level. When you look at any experimental work not directly related to economics, but trying to test rational behavior in other ways, experiments have conspicuously failed to show rational behavior … Finally, there aren’t enough repetitions to justify rational expectations. The world is changing. We’re not really proceeding on a stationary basis.

The Region