George Akerlof - Behavioral Macroeconomics and Macroeconomic Behavior (Introduction) lyrics

[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.