On Peter Howitt's Other Work
Yes, his work on growth is great and deserving of a Nobel. But that is not all!
The winners of the Nobel Memorial Prize in Economics were announced this past Monday. Brian wrote a post summarizing the authors’ work that earned them the award. Being on the inside of the economics profession, one’s reaction to an award can be different than it is for those who have a more casual interest in economics and economic ideas. From the inside looking out, we economists tend to have our own opinions of the work prior to the award. As a result, sometimes the award feels more deserving than others.
In this case, I must echo Brian’s sentiment that this year’s winners are excellent choices to receive the award. When I teach economic growth to my students, I often emphasize two aspects of the growth literature. There is a mechanism approach, which focuses on the process by which growth occurs. In other words, what economic mechanism can explain how you get sustained growth? But this necessarily leads you to the second aspect. Economic growth is a modern phenomenon. Sustained economic growth is not the norm throughout human history. As a result, one needs to determine what changed to bring about this unprecedented, sustained economic growth. The thing that I like about this award is that Aghion and Howitt provide the framework for thinking about the economic mechanisms and Mokyr provides an understanding of what created the preconditions for these mechanisms to kick in. Undergraduates who have taken my course on economic growth have worked their way through Aghion and Howitt’s textbook (my favorite, challenging as it might be for undergrads) and Mokyr’s arguments.
Nonetheless, I don’t want to write another post about how much I appreciate their work on growth. Brian already wrote a great summary and you should read that if you haven’t already. Instead, I want to devote this post to writing about Peter Howitt and some of his other work, which focused on issues related to monetary theory and business cycles. I think this work is deserving of discussion and his recent award gives me an excuse to write about it.
Some Background
Peter Howitt’s work on monetary theory and business cycles comes out of an older tradition. Howitt received his Ph.D. at Northwestern. His dissertation advisor was Robert Clower. What is particularly unique about this is that Howitt received his Ph.D. in 1973, but Robert Clower left Northwestern for UCLA in 1971. According to David Laidler, Howitt followed Clower to Los Angeles. While there, Howitt was exposed to people like Axel Leijonhufvud, Joseph Ostroy, and Armen Alchian. (You had to know we would tie this award back to UCLA price theory somehow.)
What is most important here is that Clower and Leijonhufvud were known for having a unique approach to macroeconomics. To some degree, you could argue that they were interested in the economics of John Maynard Keynes, but they didn’t see Keynes as a Keynesian. In other words, their view was that what was called Keynesian economics had developed in a way that was distinct from Keynes’s writings in his General Theory. In particular, Keynesians seemed to attribute business cycles to the slow speed at which wages and prices adjust to macroeconomic shocks. Clower and Leijonhufvud not only recognized that Keynes explicitly ruled this out as an explanation of business cycles, but that empirically this didn’t seem to make sense. The Great Depression was a period of significant deflation and only ended when the deflation ended. Thus, it seems odd to attribute slow adjustment of prices for the severe and prolonged economic downturn when prices adjusted quite a bit — and even more odd to attribute such an argument to Keynes.
Clower and Leijonhufvud were also critical of Walrasian general equilibrium approaches to monetary economics and business cycles. In particular, in Walrasian models, equilibrium exists when there is a vector of prices that clear all markets. The price adjustment process takes place in the background of the model. The process by which markets clear is via an auctioneer that costlessly identifies the relevant vector of prices that will eliminate excess demand across all markets. The critique they made of this approach is that it ignores any process of exchange. The difficult task of buyers and sellers finding one another and agreeing upon prices is absent from the model. Without any explicit account of exchange, there is no role for money to play in the model. Furthermore, the Walrasian approach seemed to rule out by assumption the sorts of coordination failures that Clower and Leijonhufvud saw at the core of Keynes’s arguments.
Macroeconomics and Coordination
Early in his career, Howitt was profoundly influenced by these arguments. In 1990, he collected some of his early publications together in a book entitled, The Keynesian Recovery. This book featured work that had drawn on the insights of Clower and Leijonhufvud. Much of this early work focused on macroeconomic coordination. Howitt recognized that Keynesian-style arguments had to rest on some idea of disequilibrium coordination. In other words, the main claim of Keynesian was (is?) that either one can end up in an equilibrium with less than full employment or perhaps in a state of disequilibrium in which there is no tendency to converge to the full employment equilibrium. But conventional economic arguments view prices as the equilibrating force. Furthermore, when we look around, we see a lot of evidence in favor of supply and demand and market-clearing and the equilibrating role of prices in allocating resources. This posed a serious challenge to Keynesian ideas.
Howitt was therefore influenced by Axel Leijonhufvud’s idea of a “corridor.” The basic idea is that as long as macroeconomic shocks were small enough, economic activity would remain within a corridor in which the price mechanism was sufficient to push economic activity back toward equilibrium. However, a large enough macroeconomic shock could potentially push economic activity outside this corridor. Outside the corridor, other economic forces might be pushing in the opposite direction of prices. If these other forces were strong enough, they might prevent prices from serving their role of coordinating economic activity when markets are in disequilibrium.
Leijonhufvud’s argument was largely conceptual, but Howitt formalized this idea in his paper “The Limits to Stability of a Full-Employment Equilibrium.” Although many had expressed skepticism about Leijonhufvud’s idea, Howitt argued that the idea was really just the claim that the economy is locally stable, but not globally stable. He pointed out that such claims were similarly at the core of ideas like Irving Fisher’s debt-deflation theory of depressions. An adverse macroeconomic shock will push the economy below its potential and away from full employment. Ordinarily, prices serve as an equilibrating force. Wages and prices ultimately adjust downward and push output back toward potential. However, those declines in wages and prices also increase the real value of debt. A large enough shock might induce bankruptcies. This will tend to push output in the opposite direction. If the shock is big enough, falling prices not only might not help the system move toward a full employment equilibrium, but they might actually amplify these countervailing forces.
The papers collected in that book represented Howitt’s belief that models of multiple equilibrium and coordination had the potential to push macroeconomics in a different direction. In fact, he called his book The Keynesian Recovery because he thought that these tools might revive a more meaningful re-evaluation of Keynes’s ideas, focusing mainly on fundamental questions about how markets work, the role of expectations, and the coordination of economic activity across time. Despite being wrong about the general trend in macroeconomics, these themes continued throughout his work.
Microfoundations
Howitt was wrong about where the profession was headed. The profession continued to push in the direction of rational expectations and microeconomic foundations of macroeconomics. The coordination problems that could have been an implication of the microeconomic foundation of macroeconomics remained a relatively small subset of the work being done on business cycles. Nonetheless, what stands out the most about Peter Howitt is how different he was from many others in his camp. Many others who wrote skeptically about rational expectations and microeconomic foundations. In some cases, this seemed to be the result of the fact that such directions led to skepticism about the effectiveness of macroeconomic stabilization policy. In some cases, this seemed to be motivated by a belief that microfoundations were either superficial or unnecessary.
Howitt, on the other hand, took a different approach. He tended to argue that microeconomic foundations didn’t go far enough. In the mid-1990s, he wrote a paper with Robert Clower entitled “Taking Markets Seriously: The Groundwork for a Post-Walrasian Macroeconomics.” The premise of the article is that traditional Walrasian-type model has no role for money. Economists have therefore tended to create what Clower and Howitt viewed as convoluted assumptions in order to fit money into the model. In doing so, this tends to undermine an analysis of the nature of exchange. Furthermore, it becomes hard to determine what results come from the nature of exchange or the convoluted assumptions.
Their argument is really that Coase’s discussion of the firm — or how Coase’s discussion was framed subsequently by other economists — didn’t go far enough. Most people frame Coase’s discussion as a choice between allocation in a market and an allocation by planning (allocation within a firm). They argue that this doesn’t take the discussion far enough. Such a framing takes for granted that the firm is the available alternative to markets. However, firms emerge amidst the same process of specialization and exchange as money. Yes, firms allocate some resources internally and some through markets, but firms themselves are responsible for creating markets that help to facilitate exchange. Thus, what is necessary for thinking about both money and the theory of the firm is the fundamental institutional underpinning of exchange.
Although that paper was mainly a critique of the profession that highlighted issues that needed to be resolved, Howitt worked on developing alternative approaches. In a subsequent paper with Robert Clower, they used agent-based modeling to show that some basic rules of thumb could spontaneously turn an autarkic system into market economy with a medium of exchange. In another paper, Howitt developed a model along the lines described by he and Clower in their critique that provides a microeconomic foundation for what are otherwise known as “trading-post” models.
The Howitt Principle
An often overlooked contribution, especially in comparison to the subsequent literature, is Howitt’s discussion of interest rate rules. In a 1992 paper entitled, “Interest Rate Control and Non-Convergence to Rational Expectations,” Howitt examined a problem that had been previously brought up by Milton Friedman in his 1968 Presidential Address to the American Economic Association.
Friedman’s point was that if the central bank set the nominal interest rate “too low,” this would lead to accelerating rates of inflation. The basic argument is as follows. Given expected inflation, suppose the central bank sets the nominal interest rate too low and keeps it there. This implies that the real interest rate is lower than the natural rate of interest. This causes higher inflation, which in turn causes people in the economy to increase their expectations of inflation. Higher expected inflation with a constant nominal interest rate pushes the real interest rate down further below the natural rate and causes inflation to rise even more. This process of accelerating inflation continues as long as the real interest rate remains below the natural interest rate.
At the time he was writing, this argument wasn’t taken particularly seriously in the profession. The reason it wasn’t taken seriously is that the common assumption of rational expectations assumes that people do not make systematic errors. At a certain point, if inflation kept rising above people’s expectations, surely they would eventually adjust their expectations such that they didn’t continue to make the same mistake.
Howitt challenged this notion. He took a fairly standard macroeconomic model and showed that under rational expectations, there is a unique constant rate of inflation in equilibrium. However, he considers what happens if one departs from rational expectations to determine whether people would learn how to adjust their expectations over time.
What he found is that when one departed from the assumption of rational expectations, the constant nominal interest rate would result in accelerating inflation. But more importantly, no one would ever learn how to get to the rational expectations equilibrium.
For example, suppose that people incorrectly expect inflation to be high. For a given nominal interest rate, this would imply that the actual real interest rate is below the natural interest rate. This would not only cause inflation to rise, but it would cause inflation to rise even faster than expectations.
In this scenario, inflation is not only a self-fulfilling prophecy, but there is also no means by which people can learn to correct their previous error. The reason is that when they mistakenly expect inflation to be high, this expectation not only leads to higher inflation but the feedback that they get is that their expectation of inflation was too low. Thus, unless you start with the idea that people have rational expectations, you would never converge on the rational expectations equilibrium. Instead, you would end up in a world of accelerating inflation.
What is important about this insight is that it assumes that one simply pegs the nominal interest rate at a particular level. One might wonder if there is anything that policymakers could do in the conduct of monetary policy to prevent these sort of dynamics.
Howitt showed that policymakers could mitigate these accelerating inflation dynamics if they committed to raising the nominal interest rate more than 1-for-1 in response to realized inflation. By doing so, they would ensure that higher inflation resulted in a higher real interest rate. As a result, whenever the real interest rate fell below the natural rate of interest, policy would push the real interest rate back in the direction of the natural rate and eliminating the dynamics of accelerating inflation. In other words, central banks must lean against the wind to prevent self-fulfilling inflationary dynamics.
Today, the idea of increasing the nominal interest rate greater than 1-for-1 in response to realized inflation is know as the “Taylor principle.” This is largely the result of the widespread use of the Taylor Rule in monetary policy analysis. According to the Taylor rule, the central bank should adjust the nominal interest to deviations of inflation from its target and output from its potential. A sufficient condition in linearized models to generate a unique, rational expectations equilibrium in these models (thereby ruling out multiple equilibria and self-fulfilling equilibria) is for the coefficient on inflation in the Taylor Rule to be greater than 1.
Although this sufficient condition is generally referred to as the “Taylor principle,” it really should be called the “Howitt principle” given that Howitt seems to have been the first person to have this insight.
Conclusion
As an economist and an economics professor, one often has opinions about the work of others. The profession consists of a lot of smart people. Thus, there is a sense in which you can argue that a lot of people that you meet and learn from are brilliant. And, in fact, some people do refer to a lot of people as brilliant. Of course, since economics is often tied up in policy and political debates, the description of someone as brilliant can also be assigned to those one agrees with on these issues and withheld from others whose views one doesn’t share.
To me, the term “brilliant” is best reserved to a select few. These tend to be people with unique ideas or insights. Often brilliant people can change the way that you think about something or force you to tighten up your own arguments or just to think more deeply about a particular topic. These can also be people who can articulate an idea in a way that after they say it, the insight seems obvious — and yet no one else was able to articulate or explain it. The uniqueness of their perspective is one factor that makes them brilliant. Peter Howitt is brilliant. I’m happy to see him share in this award.