Conversation with Prof. Axel Leijonhufvud

This conversation with  G. Bracci, G. Caterini and L. Pederiva took place between 2017 and 2018. Special thanks to Earlene C. Leijonhufvud. 

Axel Leijonhufvud is a Swedish economist and a key figure in the economic profession. During his career, he ha has addressed a wide range of economic topics, spanning from the correct understanding of Keynes’ General Theory(GT) to the rise of DSGE models.

For almost 30 years after the publication, orthodox economists merely considered the Keynesian representation of the system with its pathologies as a special case of the classical frame in which prices fail to adjust and thus the economic system does not recover after a shock as envisaged by a Walrasian general equilibrium framework. The “Great Depression” raised doubts as to economists’ ability to understand how the system works: the fall of  consumption and wages and the rise of unemployment were too wide and persistent to be consistent with the adjustment mechanisms that prices are supposed to operate.

Keynesians (that is, those economists belonging to the “majority school macroeconomics which has evolved out of the debates triggered by Keynes’s General Theory”[1]) basically misunderstood the message of the General Theory and focused on maladjustments due to price rigidities. A classical re-interpretation of Keynesian model was given by Hicks in 1937 with his paper originating the so-called IS-LM model. In the late 60’s, realizing that Keynes’s main lesson wasn’t clearly learnt, A.L. gave a fundamental contribution to the debate and to the understanding of Keynes, stressing the role of information and markets’ coordination. As A.L. pointed out, Keynes didn’t reject the general equilibrium model and didn’t exclude a priori the existence of a market clearing vector of prices. Rather, the situation in which such a vector exists and is perfectly known by agents is itself a special case and not the general one. In order to move from Walras to Keynes, we only need to remove the hypothesis that an imaginary auctioneer routinely informs the market about the “correct” price vector. It means that transactions can actually occur at prices that are not the “right” ones and adjustments mechanisms work on quantities. Keynes focused on the “wrong” level of the interest rate rather than on price rigidities; paradoxically, Keynes’s argument was in favor of less price flexibility.

With the belief that the main insight in the GT was about the role of inter-temporal uncertainty, between the ‘70’s and the 90’s Prof. Leijonhufvud’s production addressed the main sources of uncertainty, especially in hyperinflation episodes in South America.

In subsequent years, he investigated the switch towards a market economy in former socialist countries and the role of division of work in the aggregate production A.L. published articles on VOX and CEPR before and after the recent financial crisis. In 2013 he was given by the University of Cordoba in Argentina his third honorary doctorate. His other honorary doctorates were given by the University of Lund and the University of Nice.

Two final remarks: 1) in Swedish “lejon” means “lion” and “huvud” means “head”; 2) Axel is a Professor Emeritus of the University of Trento. 

Interviewer: In your works, you challenge the idea, diffused among classics (and shared also by your mentor Franco Modigliani) according to which in the General Theory disequilibrium mainly depends on the rigidity of wages while Keynes had focused

A.L.: Well, on the level of interest rates, and in his theory, if wages were flexible they might fall very far and perhaps fast without finding an equilibrium so that I think is the basis, but Keynes did not argue for wage flexibility.

Interviewer: Keynes stressed that the interest rate is created on the monetary market and you stress the role of the bond market, the stock market. Can you clarify this concept?

A.L.: I was talking about long-term expectations so that puts us in the bond market and it would do that for Keynes too: he talked a lot about the money market when he talked about the limits of monetary policy, and the reason for that was that under the conditions of the 1930s he came to doubt the ability of operations of the central bank on the money market to do something about long-term interest rates. So these are not inconsistent positions, but the argument about the weakness of monetary policy is one that’s historically contingent, it’s about the situation late in the 1930s.

Interviewer: In your 1968’s book On Keynesian Economics and the Economics of Keynes you conveyed the impression that Keynes was misunderstood. Keynes is often represented as a person willing to dig in the land and fill up the holes in the morning, but the policies he advocated were different. Is Keynes still surrounded by an aura of misunderstanding or is there any bad faith behind these mockeries?

A.L.: I think people have stopped considering him. Twenty years ago, people were still quoting Keynes and invoking Keynes as a motivation for doing this or not doing that: I think this is not happening anymore and one reason is we hadn’t had any long-lasting depression. But I don’t think Keynes and Keynes’s ideas are much talked about in central banks nowadays or in the finance ministries. In a recession, someone automatically looks for deficit spending and doesn’t try to balance the budget: so that’s a lasting Keynesian influence. However, people don’t go back to reading Keynes himself.

Interviewer: Keynes argues that people are more apt to protest against a reduction in monetary wage rather than real wage. In your 1969’s lecture at the LSE, you provided a list of topics addressed by Keynes: monetary illusion is not discussed in the General Theory. What distinguishes monetary illusion from protests for monetary wages reduction?

A.L.: Workers are paid in money so the two variables are the price of consumer goods and the money wage that they have been paid: the money wage is the one thing that they can negotiate about, they can’t do much about prices. You can’t strike, you don’t go to work and tell your employer you’re doing it because you didn’t like the prices in the supermarket.

Interviewer: Students study the IS-LM thinking they are learning the model of Keynes.

A.L.: Yes, a lot of teachers don’t agree with me, I suppose, so they still teach Keynes the way it’s been going on for many years now. There are lots of textbooks out there.

Interviewer: Most undergraduate students are taught that the fundamental economic problem is the allocation of scarce resources for alternative uses which are often mutually exclusive. How would you restate the fundamental economic problem in light of your work on coordination problems? Are biological metaphors useful in promoting a deep understanding of coordination problems?

A.L.: If the coordination is not solved, efficiency obviously cannot be maximized. So, the coordination problem is prior to that of efficiency. Metaphors from other fields can stimulate theoretical understanding. But one has to be cautious in relying on them.

Interviewer: A cruel question: are neo-Keynesians closer to classics or to Keynes?

A.L.: I don’t know what metric to put on that, they’re their own breed of animals, and they stress unemployment of course which is not classical, but their explanation is not the same since they focus on rigidities.

Interviewer: Another issue you’ve been dealing with in your research is the concept of the corridor. According to this notion, there are upper and lower bounds for fluctuations, and as long as we are inside the corridor, prices adjust and we can go back to an equilibrium. However, if we find ourselves out of the corridor, then the situation gets worse.

A.L.: Well, the ability of the system to find a path back to an equilibrium neighborhood gets very much weaker out of the corridor and you can’t depend on it, you can’t just leave it alone hoping it will happen.

Interviewer: Can we also apply this framework to the last crisis? We probably went outside the corridor…

A.L.: Well, the Great Depression of the 1930s is of course the greatest example: not only there was huge unemployment all through the decade of the 30s, but eventually what got us back to full employment was not monetary policy, or the adjustment of markets. War financing did the trick.

Interviewer: And in the light of the last crisis? agents should learn to adapt to the new disequilibrium context as time goes by. However, this learning process has been very slow this time.

A.L.: Well, I’m not saying that they should learn to find equilibrium, I’m saying that they’re learning from current experience and that learning, if disequilibrium is severe, will take them further away from equilibrium, which makes things worse.

Interviewer: At the beginning of your career you said that you were planning to work on debt/deflation but then you discovered that Fisher already did it.

A.L.: Quite a while before. Nobody told me Fisher did it because he was quite forgotten. The reason is sort of interesting because Fisher ruined his own reputation during the depression: he kept saying “it’ll turn around next month, it’ll turn around next month” until nobody listened to him anymore. When in graduate school you read Fisher on the theory of interest rates, you had no idea of his role at the time as an economic prognosticator and political advisor.

Interviewer: But he probably didn’t understand what Keynes thought, that when people invest in the stock market is not because they judge a project or a plan or they consider future expectations about profits: it’s just animal spirit, just intuition, more in the US than in the UK he argues.

A.L.: What he says about the US is just prejudice, he didn’t much like Americans. Lots of people were in panic and Fisher probably thought he could have some influence on the panic, but I also think that he did not fully understand what was happening so he still had in his head the image of the self-regulating economic system. He thought that the further away you were, the stronger the rebound had to be at some point and so Fisher and Keynes were probably the two greatest economists of the period and they ended up being completely opposite in this regard. Fisher clung to the whole idea of the self-regulating system and Keynes said “what is happening now is the one way that the system can fail”.

Interviewer: Nowadays Amazon, Facebook and other gigantic companies operating on the internet are gathering tons of information from consumers. Consumers’ preferences can be mapped to some extent and this could allow companies to discriminate. Do you have the impression that those phenomena are creating more oligopolistic power, departing from a perfectly competitive scenario, or can the information gains reduce asymmetries?

A.L.: Of course, the economy is changing, but the economy was far from being “neoclassical” in the 60’s. I think economics does have trouble now in keeping up with the structural changes in the global economy. While so much is happening, people in economics sit and think with big models. That can’t capture it all or they don’t know how to incorporate events and so on: this causes problems for economists and for our big model builders in particular.

Interviewer: Behavioral economists have shown that human beings are only partially rational, that they are time inconsistent, and that there is no transitivity in their choices. It was also shown that the negative slope of the demand curve comes from aggregation; moreover, the empirical soundness of the Cobb-Douglas production function is disputed. What else do we need to put aside the neoclassical model?

A.L.: In the first instance there’s the question: what do you replace it with?

Interviewer: That’s where I want to go. According to you, at which point are we with the alternative contribution to the economic theory from the non-orthodox economists?

A.L.: Where we are is that they have not provided fully fledged alternatives. Their critiques are of course a healthy thing, they have shown that here and there naïve application of the neoclassical model is wrong and that makes the profession most skeptical about our tools.

Interviewer: And they could reply “we don’t care about the alternative”.

A.L.: Yeah, I’m sure they don’t care but as long as they cannot provide a valuable alternative their influence will still be limited, even though it’s increasing.

Interviewer: You also addressed the role of organization and division of work on returns to scale. What about the conversation between management theorists and economists?

A.L.: The way production is organized matters and there is no conversation. For institutional reasons, management theorists are in business schools…

Interviewer: I don’t remember I heard many economists emphasizing the role of organization.

A.L.: Well, I don’t think I have either, but for many years I ran a course at UCLA that was not Macro or Money, but it was European Economic History and it dealt with methods of production. If we consider graduate schools, there is a repertory of models that aren’t learned, that aren’t discussed, and some of them are so routine to the teachers that they are not seriously discussed anymore and I think production functions in general are suspect. But the major deficiency that I can point out is the neglect of economies of scale.

Interviewer: You didn’t use much mathematics in your 1960s book. Nowadays we are observing the increasing role of mathematics and econometrics in economics. Now, do we really need so much maths, are we really trying to turn economics into an exact science?

A.L.: I’m sure they’re overdoing it in various areas. There are some, well not perhaps fanatics, but some eager people whose skills are in mathematics rather than economics and that are advocating for this. At some point some use of mathematics I think helped clarify a number of issues. Certainly, when I had macroeconomics with Franco Modigliani he made modest use of some math and it was helpful.

Interviewer: More intuition than formalization?

A.L.: Well, I wouldn’t say intuition, he was carefully reasoning through the problems and here and there he found that it was useful to employ a bit of mathematics. But on the other end of the spectrum, we have these gigantic models, which haven’t done any good yet in my opinion, his enterprise now has gone on for decades.

Interviewer: An example of the misuse of mathematics and econometrics in economics is the fact that fiscal multipliers were underestimated after the crisis.

A.L.: The alternative to try and estimate would be what…just guessing? It’s a difficult problem, it depends on experience to put limits on the possible values. You try some econometrics and hope that it narrows down the possibilities: I’m not against trying it, just critical of over-optimistic views on this development.

Interviewer: What is your assessment of the proposal of a “split euro”, that was advanced by Stiglitz among others? According to many economists, the euro would be too strong for some economies such as Italy and too weak for some economies such as Germany.

A.L.: First, of course, such a project undermines the whole political motivation behind the Euro, which is a cost. Secondly, I’m not sure that it makes sense to divide up the countries in two groups – strong currencies and weak currencies – and try to create different systems. Dividing the weak countries into two groups will create a process of fragmentation. I belong to a generation that put a lot of hope in the European project and I would be sorry to see the Euro fail.

Interviewer: But we should have expected it because according to the theory we were not an optimal currency area.

A.L.: The optimal currency areas is a nice theoretical idea but if you take a look at the map of the world and ask yourself where you can define one…

Interviewer: Maybe such theory was elaborated just by looking at the US…

A.L.: I mean the US and China. They’re strong states, large areas with a single currency, but I don’t think you can look at the political situation and say, let’s exclude this and that country and thereby you obtain an optimal currency area. It is not desirable.

Interviewer: Should we go in the direction of more integration rather than exclusion?

A.L.: Yes, but what some people are thinking is this currency area is “Hmm, if we didn’t have these weaker countries we could have a single currency area in some subset”. Now, I’m not a political expert but I don’t think that’s a way to go. If you do it once, you get into problems a few years down the road and questions come up again to kick out some other country. 

[1]A. Leijonhufvud (1967): Keynes and the Keynesians: a suggested interpretation