Hayekian Macro
…Hayek argued that no individual is capable of understanding the full complexity of a market system. Instead, individuals only understand small bits of the total information. The main function of markets consists in aggregating this diverse information. If there were individuals capable of understanding the whole picture, we would not need markets. This was in fact Hayek’s criticism of the “socialist” economists who took the view that the central planner understood the whole picture and would therefore be able to compute the whole set of optimal prices, making the market system superfluous.
Rational expectations models as intellectual heirs of central planning
My contention is that the rational expectations models are the intellectual heirs of these central-planning models. Not in the sense that individuals in these rational expectations models aim at planning the whole, but in the sense that, as the central planner, they understand the whole picture. These individuals use this superior information to obtain the “optimum optimorum” for their own private welfare. In this sense, they are top-down models.
In a recent paper, I contrast the rational expectations top-down model with a bottom-up macroeconomic model (De Grauwe 2009). The latter is a model in which agents have cognitive limitations and do not understand the whole picture (the underlying model). Instead, they only understand small bits and pieces of the whole model and use simple rules to guide their behaviour. I introduce rationality in the model through a selection mechanism in which agents evaluate the performance of the rule they are following and decide to keep or change their rule depending on how well it performs relative to other rules. Thus agents in the bottom-up model learn about the world in a “trial and error” fashion.
Loop of Financial Doom
For the authorities, [excessive risk-taking by the financial sector] poses a dilemma. Ex-ante, they may well say “never again.” But the ex-post costs of crisis mean such a statement lacks credibility. Knowing this, the rational response by market participants is to double their bets. This adds to the cost of future crises. And the larger these costs, the lower the credibility of “never again” announcements. This is a doom loop.
Banking on the State, Piergiorgio Alessandri & Andrew G Haldane
Samizdata auto-critique
Over at Samizdata, the UK’s favourite libertarian gated community, Paul Marks–finding time between predicting the financial crisis, alerting the world to Obama’s incipient Marxism (thanks Paul!), and explaining why WH Smith is threatening our liberty–engages in 检讨–jiǎntǎo, or Maoist self-criticism:
The enemy do not try and refute our arguments, they just sneer.
Quite.
Escaping the Liquidity Trap
Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others, Lars E.O. Svensson
Abstract
Existing proposals to escape from a liquidity trap and deflation, including my “Foolproof Way,” are discussed in the light of the optimal way to escape. The optimal way involves three elements: (1) an explicit central-bank commitment to a higher future price level; (2) a concrete action that demonstrates the central bank’s commitment, induces expectations of a higher future price level and jump-starts the economy; and (3) an exit strategy that specifies when and how to get back to normal. A currency depreciation is a direct consequence of expectations of a higher future price level and hence an excellent indicator of those expectations. Furthermore, an intentional currency depreciation and a crawling peg, as in the Foolproof Way, can implement the optimal way and, in particular, induce the desired expectations of a higher future price level. I conclude that the Foolproof Way is likely to work well for Japan, which is in a liquidity trap now, as well as for the euro area and the United States, in case either would fall into a liquidity trap in the future.
In which we learn about the relationship between profits and bonuses on Wall Street…
Hat-tip: Nancy Folbre, Economix
