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Milton Friedman: "We Curtsy to Marshall But We Walk with Walras"

One of the greatest contributions Milton Friedman made to American economics was his insistence that we should be "Marshallians" rather than "Walrasians." Marshallians stay close to the data: are the theoretical mechanisms we are studying things that we can see? Are their predictions consistent with the gross features of reality? Supply curves slope up: if we say that demand has changed and pushed us along a supply curve, is it in fact the case that both quantities and prices have risen (or fallen)? Demand curves slope down: if we say that supply has changed and pushed us along a demand curve, is it in fact the case that quantities have risen and prices have fallen (or fallen and risen)?

If the first-order predictions of our theories are not visible in the first-order movements of the data--quantities, prices, asset values, and expectations--then, Friedman (and Marshall) would say, our theory is broken and we need to fix it.

As Kevin Hoover puts it:

Walrasian theory is itself highly abstract.... The Walrasian approach is totalizing. Theory comes first.... Empirical reality must be theoretically articulated before it can be empirically observed. There is a sense that the Walrasian attitude is that to know anything, one most know everything....

Walras started his intellectual life as an engineer. The Walrasian vision is an engineering vision. The Walrasian wants to articulate the causal structures of the economy. The modern Walrasian macroeconomist wants microfoundations for macroeconomics. Here the metaphor of foundations is seen through the eyes of the engineer. The foundations are where we start building. If we do not get them right, the superstructure will be shaky.

The Marshallian also wants microfoundations. But the metaphor is a different one. The Marshallian approach is archaeological. We have some clues that a systematic structure lies beneath the complexities of economic reality. The problem is to lay this structure bare. To dig down to the find the foundations, modifying and adapting our theoretical understanding as new facts accumulate, becoming ever more confident in our grasp of the superstructure, but never quite sure that we have reached the lowest level of the structure. The Marshallian approach is not atheoretical.... [But] eonomic theory is “not a body of concrete truth, but an engine for the discovery of concrete truth”... “systematic and organized methods of reasoning”... an account of “manner of action of causes”.... While theory is ideally universal – not unlike Lucas’s vision of a theory without free parameters – theory is, in practice incomplete and probationary. Theory must be supplemented with particular facts to be useful. This is not, as some modern economists would have it, invidious ad hockery; it is an inevitable part of the process of acquiring empirical knowledge...

I am thinking about this because of Mark Thoma's reflections on Robert Lucas's lecture at the University of Washington. Mark:

Economist's View: I mostly agreed with the outline of [Lucas's] talk until the bottom of page 35 where Lucas asks in regard to the slow recovery, "Is this because government isn't spending enough," and on page 36 where he answers....

Believe it is more accurate to say that the problem is government is doing too much:

  • Again, I see analogies to the U.S. of the 1930s
  • Likelihood of much higher taxes, focused on the “rich”
  • Medical legislation that promises large increase in role of government
  • Financial legislation that assigns vast, poorly-defined responsibilities to Fed, others

Are these conditions that foster a revival in business investment, consumer spending?

A Marshallian--a student of Milton Friedman--would then go on to say:

  • If businesses are unwilling to invest because they fear future taxes and government regulation, we should see this in prices and quantities: Are interest rates high because lenders expect their future earnings to be highly taxed?
  • If businesses are unwilling to invest because they fear future taxes and government regulation, we should see this in prices and quantities: Are stock prices low because government regulation is anticipated to cripple corporate earnings?
  • If businesses are unwilling to invest because they fear future taxes and government regulation, we should see this in expectations: Do businesses lack confidence because they are unusually fearful of government regulation and high taxes?
  • As the chances of Dodd-Frank's passage waxed and waned, did the economic outlook wane and wax?
  • As the chances of national Romneycare's passage waxed and waned, did the economic outlook wane and wax?

At this point a Marshallian--a Friedmanite--would then present evidence that these were in fact the case--or talk very fast to explain away the lack of empirical evidence that these theoretical mechanisms were the first-order drivers of real-world prices, quantities, asset values, and expectations.

By contrast, at this point a Walrasian would... lose interest. The microfoundation-based theoretical framework is not to be tested, but simply applied. It is not an "engine for the discovery of concrete truth" but rather a body of truth itself. Once a Walrasian has pointed out some not-wholly-implausible microfoundation-based mechanisms, his work here is done.

To a Walrasian, the facts that interest rates are low, that stock prices have recovered, that businesses surveyed report that their big problem right now is a lack of demand rather than high taxes or government regulation, that the economic outlook did not wane and wax as the prospects for Dodd-Frank's passage waxed and waned, that the economic outlook did not wane and wax as the prospects for nationwide RomneyCare's passage waxed and waned are not things that impinge on their mental radar screens.

This is what Paul Krugman calls the doctrine of immaculate crowding-out:

The Doctrine of Immaculate Crowding Out: If you believe that government spending has to crowd out private spending by actually changing incentives, namely by raising interest rates, you have to confront the fact that rates are historically very low.... But it’s now an article of faith on the right that government spending must crowd out private spending, no evidence is necessary. And one must say, alas, that this view has been promulgated by supposedly serious economists. And the thing is, at this point no amount of facts and logic will dislodge that article of faith. It’s pretty hard to kill a zombie.

For Paul Krugman--a Marshallian--demand curves slope down and supply curves slope up. If fear of future taxes and government regulation have shifted business demand for financing for investment projects to the left, investment will be low and asset prices will be low too, which means the stock market will be depressed and interest rates will be high. They aren't.

But Paul Krugman is a Marshallian--a Friedmanite.

Would that we all were...

What Friedman liked to say about Walrasian and Marshallian economists, from deVroey (2004):

[Oskar] Lange largely dispenses with the initial step  a full and comprehensive set of observed and related facts to be generalised  and in the main reaches conclusions no observed facts can contradict. His emphasis is on the formal structure of the theory, the logical interrelations of the parts. He considers it largely unnecessary to test the validity of his theoretical structure except for conformity to the canons of formal logic. His categories are selected primarily to facilitate logical analysis, not empirical application or test...

The important distinction between the conceptions of economic theory implicit in Marshall and Walras lies in the purpose for which the theory is constructed and used. To Marshall  to repeat an expression quoted earlier  economic theory is “an engine for the discovery of concrete truth”. ... Economic theory, in this view, has two intermingled roles; to provide “systematic and organised methods of reasoning” about economic problems; to provide a body of substantive hypotheses, based on factual evidence, about the “manner of action of causes”. In both roles the test of the theory is its value in explaining facts, in predicting the consequences of changes in the economic environment. Abstractness, generality, mathematical elegance  these are all secondary, themselves to be judged by the test of application. The counting of equations and unknowns is a check on the completeness of reasoning, the beginning of the analysis, not an end in itself. Doubtless most modern economic theorists would accept these general statements of the objective of economic theory. But our work belies our profession...

Of course, it would be an overstatement to characterise all modern economic theory as “Walrasian” in this sense. For example, Keynes’s theory of employment, whatever its merits or demerits on other grounds, is Marshallian in method. It is a general equilibrium theory containing important empirical content and constructed to facilitate meaningful prediction..