Thursday, August 14, 2014

The Three Axioms at the Heart of Neoclassical Economics

As identified by Paul Davidson, they are as follows:
(1) the neutral money axiom;

(2) the ergodic axiom, and

(3) the gross substitution axiom (Davidson 2002: 40–45; Davidson 2009: 26–31).
While Fazzari (2009) argues that the neutral money axiom is more a consequence of unrealistic models rather than a real axiom (Fazzari 2009: 6), the concept of neutral money holds that changes in the money supply will only affect nominal values (e.g., prices, money wages, etc.), not real variables (such as production, employment, and investment).

While most neoclassical economists are of course willing to concede that money is non-neutral in the short run, nevertheless most do think money is neutral in the long run (Davidson 2002: 41).

Keynes and Post Keynesians, by contrast, reject the view that money can ever be neutral even in the long run (Davidson 2002: 41).

The ergodic axiom holds that the probability of future events can be predicted objectively by means of statistical analysis from past data (Davidson 2002: 43). But the world contains many non-ergodic processes and phenomena where statistical data simply does not yield probabilities of this sort: that is, fundamental uncertainty is a real, frequent and ineradicable aspect of economic life.

The gross substitution axiom is the idea that every good can in theory be a substitute for any other good (Davidson 2002: 43). In essence, this means that the law of demand can be applied to all goods, assets (even financial assets on secondary financial markets) and money.

This is unrealistic. As the blogger “Unlearning Economics” puts it rather pithily,
“economic theory assumes there is a price at which all commodities will be preferred to one another, which implies that at some price you’d substitute beer for your dying sister’s healthcare.”
“The Illusion of Mathematical Certainty,” Unlearning Economics, July 10, 2014.
http://unlearningeconomics.wordpress.com/2014/07/10/the-illusion-of-mathematical-certainty/
But the problems with the law of demand actually run far deeper than this, as pointed out by Steve Keen.

The gross substitution axiom is also not realistic for a much more profound reason as pointed out by Keynes: when applied to both financial assets and newly produced goods, it does not necessarily work (Davidson 2002: 44).

Fundamentally, money and financial assets have zero or near zero elasticity of substitution with producible commodities:
“The elasticity of substitution between all (nonproducible) liquid assets and the producible goods and services of industry is zero. Any increase in demand for liquidity (that is, a demand for nonproducible liquid financial assets to be held as a store of value), and the resulting changes in relative prices between nonproducible liquid assets and the products of industry will not divert this increase in demand for nonproducible liquid assets into a demand for producible goods and/or services” (Davidson 2002: 44).
And once we see that money and secondary financial assets (as demanded as a store of value) have a zero or very small elasticity of production, it follows that a rise in demand for money or such financial assets (and a rising “price” for such assets) will not lead to businesses “producing” money or financial assets by hiring unemployed workers (Davidson 2002: 44).

All this is sufficient to damn the gross substitution axiom.

All in all, the three axioms that form the basis of neoclassical economics cannot be taken seriously.

Further Reading
“The Law of Demand in Neoclassical Economics,” June 1, 2013.

“What is the Epistemological Status of the Law of Demand?,” September 19, 2013.

“Steve Keen on the Law of Demand,” September 20, 2013.

“Keynes on the Special Properties of Money,” May 8, 2011.

“F. H. Hahn in a Candid Moment on Neo-Walrasian Equilibrium,” January 29, 2011.

“More on the Gross Substitution Axiom,” July 28, 2011.

“Gold as Commodity Money and its Elasticity of Production,” November 18, 2011.

BIBLIOGRAPHY
Davidson, P. 2002. Financial Markets, Money, and the Real World. Edward Elgar, Cheltenham.

Davidson, Paul. 2009. John Maynard Keynes (rev. edn.). Palgrave Macmillan, Basingstoke.

Fazzari, Steven M. 2009. “Keynesian Macroeconomics as the Rejection of Classical Axioms,” Journal of Post Keynesian Economics 32.1: 3–18.

“The Illusion of Mathematical Certainty,” Unlearning Economics, July 10, 2014.
http://unlearningeconomics.wordpress.com/2014/07/10/the-illusion-of-mathematical-certainty/

8 comments:

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  2. "..the resulting changes in relative prices between nonproducible liquid assets and the products of industry will not divert this increase in demand for nonproducible liquid assets into a demand for producible goods and/or services."

    I'm not sure I understand Davidson's point here.

    If a change in the relative price involves a fall in the dollar price of goods, that increases the real value of liquid asset holdings. When Davidson talks about the demand for liquid assets, do you think he is talking about the demand for a dollar amount or for a real amount? If the former, then is he simply arguing that people suffer from some form of money illusion? If the latter, why does he think that the increase in demand would not be satiated by the increase in actual real balances?

    I think there are various reasons why falling prices might not prompt further demand for goods, but I'm not sure how those relate to what Davidson is saying here.

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    1. " When Davidson talks about the demand for liquid assets, do you think he is talking about the demand for a dollar amount or for a real amount?"

      It is not stated which he has in mind, but the argument works either way.

      He's saying the law of demand does not apply to both goods and financial assets.

      People demand money and liquid finanical assets as a hedge against uncertainty. When expectations are uncertain and pessimistic, people won't suddenly buy goods instead of holding money/liquid assets just because goods prices have fallen. The law of demand does not apply. Goods cannot satisfy the role that liquidity can.

      Regarding the so-called "money illusion", it is not an illusion at all: if nominal contracts are fixed (above all, debt contracts), it is not an illusion to worry about nominal wage cuts.

      If they go deep enough nominal income/wage cuts cause bankruptcy to people with fixed nominal debt.

      Also, the real balances effect is rejected as not being an effective mechanism by Keynes and Post Keynesians. E.g., Keynes in chapter 19 of the GT:

      http://socialdemocracy21stcentury.blogspot.com/2014/01/the-general-theory-chapter-19-changes.html

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    2. It may be that it works either way, but I don't think it can work both ways at the same time. If, say, prices fall and demand for real money balances does not change, then demand for nominal money balances must have fallen. If one elasticity is zero, the other must be one (or minus one). So, as far as I can see, Davidson must believe that one is true and the other is not true. It would be interesting to know which.

      But I like the post you linked on the impact of money wages - this largely conforms with how I see things.

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  3. Great Piece LK. One question I do have is on the 'gross substitution demand.'

    Don't NCers agree there are 'elastic' and 'ineslastic' goods? Like gasoline is quite inelastic whereas luxury cruises are quite elastic?

    Again, I'm not on their side but I got to understand this stuff to do battle with it properly. LOL

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  4. I see after posting my above comment that you do touch on elasticity. However, my point is that a NCer might argue that they don't believe that all goods will always be perfect substitutes for any other goods.

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  5. " money and financial assets have zero or near zero elasticity of substitution with producible commodities"

    Makes sense to me but don't Monetarists always tell us that 'money is special?'

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/08/money-prices-and-coordination-failures.html#more

    Certainly not trying to defend Monetarists-Market Monetarist or other-just trying to get it all straight.

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    1. Interesting you should mention monetarism here, as there seems to be some connection between this question of the elasticity of substitution and the quantity theory. We can call the demand for money Md, the demand for producibles Y, and the relative price of each (being the general price level) P. The elasticity of substitution can then be seen as a question of how Md / Y varies with respect to P (or how Md / PY varies if we are considering demand for real money balances).

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