Keynes and the Stockholm School

27 Aug, 2014 at 18:40 | Posted in Economics | 1 Comment

The Stockholm method seems to me exactly the right way to explain business-cycle downturns. In normal times, there is a rough – certainly not perfect, but good enough — correspondence of expectations among agents. That correspondence of expectations implies that the individual plans contingent on those expectations will be more or less compatible with one another. Surprises happen; here and there people are disappointed and regret past decisions, but, on the whole, they are able to adjust as needed to muddle through. There is usually enough flexibility in a system to allow most people to adjust their plans in response to unforeseen circumstances, so that the disappointment of some expectations doesn’t become contagious, causing a systemic crisis.
But when there is some sort of major shock – and it can only be a shock if it is unforeseen – the system may not be able to adjust. Instead, the disappointment of expectations becomes contagious. If my customers aren’t able to sell their products, I may not be able to sell mine. Expectations are like networks. If there is a breakdown at some point in the network, the whole network may collapse or malfunction. Because expectations and plans fit together in interlocking networks, it is possible that even a disturbance at one point in the network can cascade over an increasingly wide group of agents, leading to something like a system-wide breakdown, a financial crisis or a depression.

But the “problem” with the Stockholm method was that it was open-ended. It could offer only “a wide variety” of “model sequences,” without specifying a determinate solution. It was just this gap in the Stockholm approach that Keynes was able to fill. He provided a determinate equilibrium, “the limit to which the Stockholm model sequences would move, rather than the time path they follow to get there.” A messy, but insightful, approach to explaining the phenomenon of downward spirals in economic activity coupled with rising unemployment was cast aside in favor of the neater, simpler approach of Keynes …

Unfortunately, that is still the case today. Open-ended models of the sort that the Stockholm School tried to develop still cannot compete with the RBC and DSGE models that have displaced IS-LM and now dominate modern macroeconomics. The basic idea that modern economies form networks, and that networks have properties that are not reducible to just the nodes forming them has yet to penetrate the trained intuition of modern macroeconomists. Otherwise, how would it have been possible to imagine that a macroeconomic model could consist of a single representative agent? And just because modern macroeconomists have expanded their models to include more than a single representative agent doesn’t mean that the intellectual gap evidenced by the introduction of representative-agent models into macroeconomic discourse has been closed.

Uneasy Money

1 Comment

  1. The ‘ceteris paribus’ assumption seems to have taken hold. Hayek mentions that money is neutral when the markets are at equilibrium, even though this stipulation ignores the much wider realm of exchange that is not necessarily identified by transactions and agreements in the financial or economic sense. It would be great if human society simply expected to reach equilibriums and maintain homeostasis. But, such is not the case.

    It should be clarified that economic crises like the Depression and the Great Recession and other scandals are the effect of illegal and unethical behavior, even if the culprits do not know what they are doing or are simply following policy.

    But, Hayek notes that monetary policy faces two “”ratio”” (my paraphrase from Adorno) problems: when supply cannot meet demand, when demand is weak and supply has overproduced. Monetary policy addresses these situations by changing the money supply. However, the effects of economic transactions that expect to reach equilibrium is usually not addressed because the economic system drives towards expanding markets, not merely an equilibrium or homeostatic evenness,

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