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The Nature of an Economy Axel Leijonhufvud UCLA and University of Trento INET Budapest Conference September 6 - 8, 2010

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Response to conceptual failure 1) Deny it (preferred option) 2) Go through the assumptions. Find out which ones need to be changed (Problem: How many are there? How count the ones you are not aware of?)

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Looking back…. Keynesian IS-LM: stable with frictions Stagflation: Phillips curve unstable Friedmanian Monetarism Lucas and RatExp Money abandoned: RBC theory 2007-09 DSGE: stable with frictions(?) Correcting assumptions one-by-one… BACK TO GO!

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Transcendental realism (no less!) Tony Lawson, Economics and Reality (1997) Ontology: need to “grasp the nature of the reality” that is the object of study – and to adapt methods to it

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Open systems TL: an economy is an “open” system but economists deal with it as if “closed” Our mathematical representations require closure for models to have determinate solutions TL critical of math econ and more generally of deductivism in economics Compare “getting the assumptions right”

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Closed systems The impetus for “closure” in modern macro stems from the commitment to represent all behavior as optimal … which also implies that all states are equilibria Rational expectations were necessary to generalize this program to intertemporal transactions Another factor: drive to endogenize “practically everything”

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Reflexivity and RatExp Soros’ reflexivity: current beliefs about the future induce present actions which create the future Lack of correspondence between public’s beliefs and outcomes presents opportunities for profit (and loss) RatExp is the very special case of the fixed point correspondence between current beliefs and future outcome In which case – no profit, etc.

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Muth and the Cobweb Two quite special conditions make RatExp reasonable in Muth’s original case (1) the weather of the crop year “is drawn from” an objectively given and knowable distribution (2) supply (production) and demand (consumption) equalized over the year (an exogenously fixed period) These conditions are rarely satisfied

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RatExp In the reality of Muth’s case, it is reasonable to assume that most farmers will learn not to make systematic mistakes and thus will learn the RatExp equilibrium When the conditions are not fulfilled we cannot assume a systematic tendency for (1) all to learn the same thing, where (2) the same thing is an objective “truth”

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Lack of Synchronicity Unexamined assumptions of GE models: In any given market, S and D equilibrated over given, fixed unit period … and this period is the same for all markets Consider,for ex., markets for oil or natural gas. There is no such “natural” unit period Lack of it is a sufficient condition for persistent heterogeneity of expectations

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RatExp revolution Nonetheless, RatExp generalized in every direction – infinite dimensional cases, etc. The math representation of the system closed by RatExp produced proofs of various proposition that seemed counterintuitive (or at least counter to received “wisdom”) Great intellectual excitement back then!

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Unknowable future The future is not and cannot be known with certainty, even as a probability distribution. This makes an economy an “open” system. Most behavior has to be represented as adaptive [11 eds of Trento Summer School] In periods of prolonged tranquility may be approx. by intertemporal optimization In volatile times, reaction to current data Behavioral time horizons vary But also: innovations introducing novelty

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Budget Constraints The most difficult analytical problems arise when we cannot assume that budget constraints are binding (Difficult do GE unless BC violations obey a known probability distribution) Distinguish two cases of violations of equal-value-in-exchange: 1) in private sector, and 2) by sovereign

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Nature of an Economy What macroproperties does the complex, adaptive dynamical system have? Imagine a state space for the private sector of three regions: PR1: stable, negative feedbacks dominate PR2: some narrowly bounded instabilities PR3: several interacting positive feedback loops – “black hole” = debt deflation

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Finances of the Sovereign State space for central government SR1: budget surpluses or sustainable deficits SR2: deficits but fair measure of control: expected inflation, Fisher premia, etc. SR3: Control of deficit lost. Inflation expectations very volatile. System will not support intertemporal markets with maturities longer than a few weeks

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Contrast recent DSGE “Frictions”, not instabilities, the sources of problems Balance sheets have evolved along equil. paths and remain “on track” Private sector budget constraint violations of little consequence

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Double Jeopardy Widespread default in private sector & fear of counterparty insolvency plus solvency of sovereign in doubt Action to offset private sector deleveraging risks sovereign insolvency (Latin American cases) … and high inflation Channel between Scylla and Charybdis can become too narrow for safe navigation US benefitting from global shortage of safe assets and lack of substitutes for $

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Prospects for Macroeconomics Our ability to predict is inherently limited when dealing with open systems For macroeconomics, (theoretically not very ambitious) extrapolations will be useful in tranquil times... which, in fact, is what forecasters actually do

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Prospects, cont. The important task is not prediction but improving our understanding of the conditions marking he boundaries between stable and unstable regions For policy: How to reduce the risks of sliding over into Region 3. How to claw your way back from there… etc. Deductive theorizing will not be of much help….

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