[Introduction]
Think about Richard Scarry's Cars and
Trucks and Things That Go. Think about what
that book would have looked like in sequential
decades of the last century had Richard Scarry
been alive in each of them to delight and amuse
children and parents. Each subsequent decade
has seen the development of ever more specialized
vehicles. We started with the Model T
Ford. We now have more models of backhoe
loaders than even the most precocious fouryear-old
can identify.
What relevance does this have for economics?
In the late 1960's there was a shift in the
job description of economic theorists. Prior to
that time microeconomic theory was mainly
concerned with an*lyzing the purely competitive,
general-equilibrium model based upon
profit maximization by firms and utility maximization
by consumers. The macroeconomics
of the day, the so-called neocla**ical synthesis,
appended a fixed money wage to such a generalequilibrium
system. “Sticky money wages” explained
departures from full employment and
business-cycle fluctuations. Since that time,
both micro- and macroeconomics have developed
a Scarry-ful book of models designed to
incorporate into economic theory a whole variety
of realistic behaviors. For example, “The
Market for ‘Lemons' ” explored how markets
with asymmetric information operate. Buyers
and sellers commonly possess different, not
identical, information. My paper examined the pathologies that may develop under these more
realistic conditions.
For me, the study of asymmetric information
was a very first step toward the realization of a
dream. That dream was the development of a
behavioral macroeconomics in the original
spirit of John Maynard Keynes' General Theory
(1936). Macroeconomics would then no longer
suffer from the “ad hockery” of the neocla**ical
synthesis, which had overridden the emphasis in
The General Theory on the role of psychological
and sociological factors, such as cognitive
bias, reciprocity, fairness, herding, and social
status. My dream was to strengthen macroeconomic
theory by incorporating a**umptions
honed to the observation of such behavior. A
team of people has participated in the realization
of this dream. Kurt Vonnegut would call
this team a kera**, “a group of people who are
unknowingly working together toward some
common goal fostered by a larger cosmic influence.”
In this lecture I shall describe some of
the behavioral models developed by this kera**
to provide plausible explanations for macroeconomic
phenomena which are central to Keynesian
economics.
For the sake of background, let me take you
back a bit in time to review some history of
macroeconomic thought. In the late 1960's the
New Cla**ical economists saw the same weaknesses
in the microfoundations of macroeconomics
that have motivated me. They hated its
lack of rigor. And they sacked it. They then held
a celebratory bonfire, with an article entitled
“After Keynesian Macroeconomics.” The new
version of macroeconomics that they produced
became standard in the 1970's. Following its
neocla**ical synthesis predecessor, New Cla**ical
macroeconomics was based on the competitive,
general-equilibrium model. But it differed
in being much more zealous in insisting that all
decisions—consumption and labor supply by households, output, employment and pricing
decisions by producers, and the wage bargains
between both workers and firms—be consistent
with maximizing behavior. New Cla**ical
macroeconomics therefore gave up the a**umption
of sticky money wages. To account for
unemployment and economic fluctuations, New
Cla**ical economists relied first on imperfect
information and later on technology shocks.
The new theory was a step forward in at least
one respect: price and wage decisions were now
based upon explicit microfoundations. But the
behavioral a**umptions were so primitive that
the model faced extreme difficulty in accounting
for at least six macroeconomic phenomena.
In some cases, logical inconsistency with key
a**umptions of the new cla**ical model led to
outright denials of the phenomena in question;
in other cases, the explanations offered were
merely tortuous. The six phenomena are:
[1. The existence of involuntary unemployment]
In the New Cla**ical model, an unemployed
worker can easily obtain a job by
offering to work for just a smidgeon less than
the market-clearing salary or wage; so involuntary
unemployment cannot exist.
[2. The impact of monetary policy on output and employment]
In the New Cla**ical model,
monetary policy is all but ineffective in changing
output and employment. Once changes in
the money supply are fully foreseen, prices and
wages change proportionately; real wages and
relative prices are constant; and there is no
impact on the real economy whatsoever.
[3. The failure of deflation to accelerate when
unemployment is high]
The New Cla**ical
model produces an accelerationist Phillips
curve with a unique natural rate of unemployment.
If unemployment falls below this natural
rate, inflation accelerates. With unemployment
above the natural rate, inflation continually
decelerates. 4. The prevalence of undersaving for retirement:
In the New Cla**ical model, individuals
decide how much to consume and to save to
maximize an intertemporal utility function. The
consequence is that privately determined saving
should be just about optimal. But individuals
commonly report disappointment with their
saving behavior and, absent social insurance
programs, it is widely believed that most people
would undersave. “Forced saving” programs are
extremely popular.
[5. The excessive volatility of stock prices relative
to their fundamentals]
New Cla**ical theory a**umes that stock prices reflect fundamentals, the discounted value of future income streams.
[6. The stubborn persistence of a self-destructive
undercla**]
My list of macroeconomic questions
to be explained includes the reasons for
poverty because I view income distribution as a
topic in macroeconomics. Neocla**ical theory
suggests that poverty is the reflection of low
initial endowments of human and nonhuman
capital. The theory cannot account for persistent
and extreme poverty coupled with high incidence
of drug and alcohol abuse, out-ofwedlock
births, single-headed households, high
welfare dependency, and crime.
In what follows I shall describe how behavioral
macroeconomists, incorporating realistic
a**umptions grounded in psychological and sociological
observation, have produced models
that comfortably account for each of these macroeconomic
phenomena. In the spirit of Keynes' General Theory, behavioral macroeconomists are rebuilding the microfoundations that were sacked by the New Cla**ical economics. I shall begin my review by describing one of my earliest attempts in this field, which led to the
discovery of the role of asymmetric information
in markets.
I first came upon the problems resulting from
asymmetric information in an early investigation
of a leading cause for fluctuations in output
and employment—large variations in the sales
of new cars. I thought that illiquidity, due to
the fact that sellers of used cars know more than
the buyers of used cars, might explain the high
volatility of automobile purchases. In trying to
make such a macroeconomic model, I got diverted.
I discovered that the informational problems
that exist in the used car market were
potentially present to some degree in all markets.
In some markets, asymmetric information
is fairly easily soluble by repeat sale and by
reputation. In other markets, such as insurance
markets, credit markets, and the market for labor,
asymmetric information between buyers
and sellers is not easily soluble and results in
serious market breakdowns. For example, the
elderly have a hard time getting health insurance;
small businesses are likely to be creditrationed;
and minorities are likely to experience
statistical discrimination in the labor market
because people are lumped together into categories
of those with similar observable traits. The failure of credit markets is one of the major
reasons for underdevelopment. Even where
mechanisms such as reputation and repeat sales
arise to overcome the problem of asymmetric
information, such institutions become a major
determinant of market structure.
To understand the origins of the economics of
asymmetric information in markets, it is useful
to reflect on the more general intellectual revolution
that was occurring at the time. Prior to the
early 1960's, economic theorists rarely constructed
models customized to capture unique
institutions or specific market characteristics.
Edward Chamberlin's monopolistic competition
and Joan Robinson's equivalent were
taught in graduate and even a few undergraduate
courses. However, such “specific” models
were the rare exception; they were presented not
as central sights, but instead as excursions into
the countryside, for the adventurous or those
with an extra day to spare. During the early
1960's, however, “special” models began to
proliferate as growth theorists, working slightly
outside the norms of standard price-theoretic
economics, began to construct models with specialized
technological features: putty-clay, vintage
capital, and learning by doing. The
incorporation into models of such specialized
technologies violated no established pricetheoretic
norm, but it sowed the seed for the
revolution that was to come. During the summer
of 1969, I first heard the word model used as a
verb, and not just as a noun. It is no coincidence
that just a few months earlier “The Market
for ‘Lemons' ” had been accepted for
publication.11 The “modeling” of asymmetric
information in markets was to price theory
what the “modeling” of putty-clay, vintage capital,
and learning by doing had been to growth theory. It was the first application of a new
economic orientation in which models are constructed
with careful attention to realistic microeconomic
detail. This development has
brought economic theory much closer to the fine
grain of economic reality. Almost inevitably,
the an*lysis of information asymmetries was the
first fruit of this new modeling orientation. It
was the ripest fruit for picking. In the remainder
of this essay I shall discuss the payoffs of this
new orientation for the new field of behavioral
macroeconomics.