Lars Syll on the Gross Substitution Axiom

Actually, Lars quotes Paul Davidson in a succinct statement of the gross substitution axiom and why it is incompatible with Keynes’ General Theory here:

Lars P. Syll, “The Gross Substitution Axiom — The Backbone of Mainstream Economics,” 15 August, 2014.

This is a nice complement to my post here.

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/

More on the Gross Substitution Axiom

Post Keynesians reject the gross substitution axiom, an implicit assumption made by both Austrians and neoclassicals. In brief, money and financial assets have zero or near zero elasticity of substitution with producible commodities.

The operative concept is demand for liquidity. The most liquid asset is money, and, in varying degrees of liquidity, there follow various types of financial assets, which are nonproducible and held as a store of value:

“If the gross substitution axiom was universally applicable, however, any new savings that would increase the demand for nonproducibles would increase the price of nonproducibles (whose production supply curve is, by definition, perfectly inelastic). The resulting relative price rise in nonproducibles vis-a-vis producibles would, under the gross substitution axiom, induce savers to increase their demand for reproducible durables as a substitute for nonproducibles in their wealth holdings. Consequently nonproducibles could not be ultimate resting places for savings as they spilled over into a demand for producible goods ... Samuelson’s assumption that all demand curves are based on an ubiquitous gross substitution axiom implies that everything is a substitute for everything else. In Samuelson’s foundation for economic analysis, therefore, producibles must be good gross substitutes for any existing nonproducible liquid assets (including money) when the latter are used as stores of savings. Accordingly, Samuelson’s Foundation of Economic Analysis denies the logical possibility of involuntary unemployment as long as all prices are perfectly flexible.” (Davidson 2006: 189).

Neoclassical synthesis Keynesians and Post Keynesians part company on precisely this point: the gross substitution axiom is false, and even if all wages and prices were perfectly flexible, you would still have involuntary unemployment, for these reasons:

(1) with no truth in the gross substitution axiom, demand for liquid financial assets as a store of value, even when it raises the relative prices of nonproducible financial assets in relation to producible commodities will not necessarily spill over into demand for the latter;

(2) Say’s law does not hold in any economy where we face uncertainty, subjective expectations, and money and financial assets with a store of value function;

(3) Liquidity preference and the desire for increased liquidity apply not just to individuals but also to banks and other business institutions; indeed, in modern capitalist economies it is the liquidity preferences of banks that are particularly important.

BIBLIOGRAPHY

Davidson, P. 2006. “Samuelson and the Keynes/Post Keynesian Revolution,” in M. Szenberg, L. Ramrattan, A. A. Gottesman (eds), Samuelsonian Economics and the Twenty-First Century, Oxford University Press, Oxford and New York. 178–196.

Keynes on the Special Properties of Money

Keynes in the General Theory (1936) showed that fiat money and even commodity money have special properties:

“… money has, both in the long and the short period, a zero, or at any rate a very small, elasticity of production, so far as the power of private enterprise is concerned, as distinct from the monetary authority;—elasticity of production meaning, in this context, the response of the quantity of labour applied to producing it to a rise in the quantity of labour which a unit of it will command. Money, that is to say, cannot be readily produced;—labour cannot be turned on at will by entrepreneurs to produce money in increasing quantities as its price rises in terms of the wage-unit. In the case of an inconvertible managed currency this condition is strictly satisfied. But in the case of a gold-standard currency it is also approximately so, in the sense that the maximum proportional addition to the quantity of labour which can be thus employed is very small, except indeed in a country of which gold-mining is the major industry.
Now, in the case of assets having an elasticity of production, the reason why we assumed their own-rate of interest to decline was because we assumed the stock of them to increase as the result of a higher rate of output. In the case of money, however—postponing, for the moment, our consideration of the effects of reducing the wage-unit or of a deliberate increase in its supply by the monetary authority—the supply is fixed. Thus the characteristic that money cannot be readily produced by labour gives at once some prima facie presumption for the view that its own-rate of interest will be relatively reluctant to fall; whereas if money could be grown like a crop or manufactured like a motor-car, depressions would be avoided or mitigated because, if the price of other assets was tending to fall in terms of money, more labour would be diverted into the production of money;—as we see to be the case in gold-mining countries, though for the world as a whole the maximum diversion in this way is almost negligible” (Keynes 1936: 230–231).

Money has a zero or very small elasticity of production. This means that a rise in demand for money and a rising “price” for money (i.e., an increase in its purchasing power) will not lead to businesses “producing” money by hiring workers.

Even under the gold standard, when money was a type of producible commodity, production of gold or silver in significant quantities was severely limited to certain countries and brief times. For example, if the UK was hit by a deflationary depression in the 1880s, with a rising purchasing power for money as demand for it increased as a hedge against future uncertainty (that is, a rise in its value due to deflation), could UK businesses just hire unemployed workers to “produce” gold in the UK? They could not.

The property of zero or very small elasticity of production also applies to liquid financial assets. If consumers decide to buy less producible commodities and increase their holding of money or ownership of financial assets, unemployment will result in some sectors as demand for commodities declines. The price of financial assets will rise and it is possible that the price of money could also rise. But private businesses cannot hire the unemployed to “produce” or “manufacture” more money or financial assets to exploit profit opportunities in the high-price liquid assets (Davidson 2010: 255–256).

A further point is that 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).

The gross substitution axiom is a fundamental assumption of neoclassical economics and the Austrians appear to tacitly assume the axiom as well. But the gross substitution axiom is wrong, and all inferences made from it in economic theories are also wrong.

This is also one of the reasons why Say’s law, in its various forms, does not work.

BIBLIOGRAPHY

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

Davidson, P. 2010. “Keynes’ Revolutionary and ‘Serious’ Monetary Theory,” in R. W. Dimand, R. A. Mundell, and A. Vercelli (eds), Keynes’s General Theory after Seventy Years, Palgrave Macmillan, Basingstoke, England and New York. 241–267.

Keynes, J. M. 1936. The General Theory of Employment, Interest, and Money, Macmillan, London.

Why Are So Many Economists Wrong?

The question is posed by a commentator on the last post, with respect to the New Keynesian N. Gregory Mankiw. The answer is that he, like the New Classical and monetarist economists, starts from fundamentally wrong assumptions about the world and the economy. In fact, these assumptions are basically the following axioms:

(1) the ergodic axiom
(2) the neutral money axiom (at least neutral in the long run)
(3) the gross substitution axiom.

These axioms are all wrong. A mainstream economist would have to reject them and start from scratch to come to the same conclusions independently as Keynes or Post Keynesians.

For why these axioms are wrong, see Paul Davidson, Financial Markets, Money, and the Real World (Cheltenham, 2002), p. 43ff.

As I noted in the last post, these are the traits of real world capitalist economies:

(1) a monetary production economy,
(2) fundamental uncertainty;
(3) subjective expectations;
(4) contracts which do not normally allow flexibility if economic variables change;
(5) inflexible or “sticky” wages;
(6) money with a zero or very small elasticity of production, and
(7) money and financial assets with zero elasticity of substitution with producible commodities.

If someone starts from principles that do not describe the real world, then one’s deductive arguments will go badly wrong and will not apply to the real world.

F. H. Hahn in a Candid Moment on Neo-Walrasian Equilibrium

The neo-Walrasian economist Frank H. Hahn is a respected neoclassical economist. Unlike other neoclassicals, however, he has been rather more honest in admitting the limitations of neo-Walrasian general equilibrium theory.

John Maynard Keynes stressed that money has special properties. Money has a zero or very small elasticity of production, and money and financial assets have zero elasticity of substitution with producible commodities. Keynes and modern Post Keynesians thus reject the “gross substitution axiom,” an idea held by neoclassicals and probably by many Austrians as well.

As Paul Davidson has noted (Davidson 2010), Frank H. Hahn in 1977 came to a similar conclusion about money and financial assets:

“there are ... resting places for saving other than reproducible assets. In our model this is money. But land, as Keynes to his credit understood, would have just the same consequences and so would Old Masters. It is therefore not money which is required to do away with a Say’s Law-like proposition that the supply of labour is the demand for goods produced by labour. Any non-reproducible asset will do. When Say’s law is correctly formulated for an economy with non-reproducible goods it does not yield the conclusions to be found in textbooks. As I have already noted Keynes was fully aware of this and that is why he devoted so much space to the theory of choice amongst alternative stores of value” (Hahn 1977: 31).

Furthermore, Hahn also questioned the role that flexible money wages are supposed to play in clearing markets and reducing unemployment:

“One can certainly now see that the view that with ‘flexible’ money wages there would be no unemployment has no convincing argument to recommend it … Even in a pure tatonnement in traditional models convergence to an equilibrium cannot be generally proved. In a more satisfactory model matters are more doubtful still. Suppose money wages fall in a situation of short-run non-Walrasian unemployment equilibrium. The argument already discussed suggests that initially this will lead to a redistribution in favour of profit. The demand for labour, however, will only increase on the expectation of greater sales since substitution effects in the short run can be neglected. If recipients of profit regard the increase as transient (as they sensibly might) their demand for goods will not greatly increase. On the other hand, if wage-earners have few assets their demand will decrease. But that means that producers get a signal to reduce output. Wages continue to fall and prices begin to fall also. Real cash balances increase but expectations about future prices may give a positive rate of return to money. There may be many periods for which falling money wages go with falling employment. Where the system would end up in the ‘long run’ I do not know” (Hahn 1977: 37).

Hahn (1977: 39) also noted that in any economy “which is not a barter economy … any non-reproducible asset allows for a choice between employment inducing and nonemployment inducing demand.” Hahn was right, but Keynes knew this long before Hahn.

BIBLIOGRAPHY

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

Davidson, P. 2010. “Keynes’ Revolutionary and ‘Serious’ Monetary Theory,” in R. W. Dimand, R. A. Mundell, and A. Vercelli (eds), Keynes’s General Theory after Seventy Years, Palgrave Macmillan, Basingstoke, England and New York. 241–267

Hahn, F. H. 1977. “Keynesian Economics and General Equilibrium Theory: Reflections on Some Current Debates,” in G. C. Harcourt (ed.), The Microeconomic Foundations of Macroeconomics, Macmillan, London. 25–40.