11

On the microfoundations of money

Walrasian and Mengerian approaches reconsidered in the light of Richard Rorty’s critique of foundationalism

Randall Kroszner

Many philosophers have endeavoured to find a foundation for knowledge —that is, to outline a well-defined reliable scientific method which provides access to the facts of the matter under study. While operating on a less grand scale, economists have adopted a parallel style of inquiry. When the traditional models were gradually revealed to shed only a dim light on many aspects of macroeconomic and monetary phenomena, the hue and cry went up for foundations. The problem, many economists believe, is that these models are ad hoc and at odds with other approaches in the body of economic thought. Economists turned to the elegant and relatively recently ‘perfected’ Walrasian ‘general equilibrium’ framework (to be discussed below) as the saviour from the difficulties attributed to the ad hoc approach. Grounding our inquiry in this highly regarded model of microeconomic interaction would thus be the way in which to structure our study of macroeconomic and monetary phenomena.

Richard Rorty has boldly attacked the parallel demand for foundations of knowledge in philosophy as nothing more than a strait-jacket on inquiry. By employing themes developed by Rorty in his critique of foundationalism, we will try to illuminate some of the current controversies within economics which revolve around the microfoundations of macroeconomics, focusing on monetary phenomena.

PHILOSOPHIC BACKGROUND

Before embarking upon the analysis of the discussion of foundations in economics, I will attempt in this section to give a flavour of Rorty’s argument, highlighting the aspects that are most directly applicable to the problem at hand.1 Developing a theme from the work of Hans-Georg Gadamer, Rorty takes a radical stand on what constitutes hermeneutics. In contrast to Wilhelm Dilthey and his followers—including Charles Taylor and Hubert Dreyfus—Rorty sees it not as ‘the method of the social sciences’ but rather as an ‘attitude’ or ‘intellectual position one arrives at when one puts aside the idea of “method” and the cluster of other Cartesian and Kantian ideas within which it is embedded’ (Rorty 1980, p. 39). Rorty comes to this ‘radical’ Gadamerian perspective by

236 HERMENEUTICAL REASON

way of a critique of the philosophic enterprise as a foundational discipline. He sees this enterprise inevitably as an attempt to put blinders on discussion rather than open it up. In Rorty’s view, an epistemology-based philosophic enterprise has tyrannized systematic inquiry by trying to legislate what can and cannot be done in the so-called scientific acquisition of knowledge. From Plato to Descartes to Kant to the logical positivists, the notion that the mind or our reason has a ‘privileged access’ to an objective external reality has formed a core of philosophy. The objective has thus been to delineate the method we can follow in order to gain this access to reliable ‘scientific’ knowledge. Drawing on criticisms by W.V.O.Quine, Wilfred Sellars, and the pragmatists William James and John Dewey, Rorty (1979) disposes of this approach to knowledge and foundationalist philosophy itself, thereby undermining the dictatorship of philosophy or any particular method over enquiry.2

The work of the pragmatists and the compelling attacks on necessity and essence by these thinkers, Rorty argues, render the ‘privileged access’ position— of access to the world independent of human interpretation untenable: ‘We can only make sense of accounting for [the world] in terms useful for this or that human purpose, but we cannot make sense of describing it “in its own terms”’ (Rorty 1980, p. 40). We are not able to step outside of the world and observe it from a ‘god’s-eye’ point of view. Our models or ways of speaking should not be construed as representation of some external realm, the essence of which we wish to capture in a model. The goal of a correspondence between our model and ‘the world out there’ is illusory, for we cannot know what is out there without employing some human filter. Since we are unable to step outside and look in, we can focus instead upon coherence and usefulness, rather than correspondence, in judging our models and theories.

The ‘scientific method’ has been dethroned as the ruler of the realm of knowledge acquisition, and no new leader need take its place. The usefulness of mechanical and formal ways of speaking in fields such as physics and engineering is no reason to insist that other disciplines adopt a similar vocabulary in order to achieve success. The demarcation of science from non-science has been used as an obstacle to inquiry rather than as an epistemological way by which to separate the wheat from the chaff. As Rorty explains:

[i]t may be that the only people who still care deeply about the distinctions between science and art, between the cognitive and the noncognitive, are the bureaucrats who give out grants, the educational administrators, and us professors of philosophy.

(Rorty 1980, p. 45)

The ideas that Rorty develops are in response to the attempts to ground the whole enterprise of knowledge acquisition and not simply to ground the structure of inquiry within a particular discipline. The offending attitudes that Rorty identifies, however, also affect discussion within individual disciplines, as our

THE MICROFOUNDATIONS OF MONEY 237

examination of the general-equilibrium microfoundations of macroeconomics will demonstrate. The application of Rorty’s insights to these issues—in particular to the microfoundations of money—helps to illuminate the debates and dissolve some of the controversies.

We begin with a consideration of the Walrasian ‘general equilibrium’ (GE) model, and the debate among economists over the purposes it may serve. This is the construct in which economists attempt to ground such phenomena as money. Rather than providing a basis for ‘representation’ of economic phenomena, the GE construct may be more usefully considered as a moneyless comparison point which is used to sharpen other approaches. We then apply the insights arising from this reconsideration of the purposes of the GE model, and its putative foundational role in economics, to some studies of non-Walrasian theories that attempt to integrate disequilibrium processes. The focus will be upon the interpretation of Carl Menger’s notion of marketability in his theory of the origin and evolution of money. Our purpose is to illustrate how interplay, rather than ‘communion’, of theories furthers our understanding of monetary phenomena. The ‘confrontation’ of the Mengerian and Walrasian approaches helps to illuminate the strengths and weaknesses of each, and to avoid the pitfalls of attempting to render them commensurable. We finally turn to Menger’s evolutionary approach itself and examine how certain essentialist biases in the standard interpretation may have unnecessarily limited the range of questions it can usefully address.

THE USES AND PURPOSES OF ‘GENERAL

EQUILIBRIUM’

The incompatibility of micro and macro theorizing can be salubrious to both ways of thinking without needing to declare one the victor. Through a study of contrasts, practitioners in each sub-discipline may come to understand their own efforts more clearly without feeling that legitimacy is lost if one’s theories are not a direct lineal descendant of others’ mental handiwork. If one really does desire a unified approach, then attempting to graft one framework on top of another will not be adequate. Focusing on how economic activities, institutions, and plans cohere, instead of narrowly searching for the prime mover, may be a more fruitful way of generating insights in economics.

The search for underpinnings of macroeconomic theorizing stems as much from the disappointments in applying macroeconomics in the policy realm as from failures in theory. Economists have sought comfort, or perhaps refuge, in the GE model. Great strides have been made during the past half century in developing the structure and implications of this model. There is hope that by grounding macroeconomic and monetary theory in this model, the success of the GE approach in the ‘micro’ realm would rub off. In this way, for many economists, the GE approach fulfils the role of the ‘language of unified science’ which would provide the key to all economic understanding.3 It is precisely the reshaping of

238 HERMENEUTICAL REASON

all inquiry in the form of one successful line which ‘blocks the road of inquiry’ (Rorty 1979, pp. 349 and 367).

The elegant edifice of GE theory had been erected without reference to money (see Arrow and Hahn 1971, and Weintraub 1979, for detailed discussions). The GE model attempts to provide an account of how the market allocates resources among atomistic individuals through the price mechanism. The economy is characterized in formal mathematical terms, and conditions for existence, optimality, and other properties of equilibrium are derived. Speaking loosely, the allocation is accomplished through a central auctioneer who calls out a set of prices for everything in the economy and then costlessly gathers information from market participants to discover what demand and supply would be for each good at the announced prices. The auctioneer then calculates a new set of prices aimed at eliminating disparities between supply and demand: when the total quantity demanded of a good exceeds the total quantity supplied, the price of that good will rise; conversely, prices fall for those goods in excess supply. These calculations underscore the interdependence of markets for the different commodities. The auctioneer then calls out a new price structure, and the adjustment process continues through successive rounds until equilibrium is achieved where supply and demand are exactly balanced for all commodities. Actual trading occurs only at the final equilibriumprices stage and not during the tâtonnement, or ‘groping’ process.

Theorists have expended much effort in an attempt to integrate money into this framework, but the theory has stubbornly rejected it. Any good may serve as the numéraire accounting unit to express the commodity ratios declared by the auctioneer. Since all trades costlessly take place in the blink of an eye (or the rap of an auctioneer’s gavel) at known equilibrium commodity ratios in perfectly organized markets, there is no use for a medium of exchange and money has no role.

What are the conclusions to be drawn from this tension between GE theory and money for monetary theory? The implications depend upon the purpose to which one wishes to put the theory and what one demands from a theory.

If the purpose of GE theory is to illuminate directly the way in which the economy operates, then this approach is a failure—as Janos Kornai (1971), for example, has convincingly argued. Prices are not formed by a central figure dutifully taking account of the preferences and incomes of atomistic individuals in order to ensure simultaneous market clearing for all goods. Furthermore, the technical mathematical requirements for the results of GE theorizing are also inapplicable to most, if not all, functioning markets. Responding to such assaults upon GE, the eminent theorist Frank Hahn questions the standard for theory evaluation in these ‘realism’ criticisms: ‘It is Kornai’s besetting sin that he writes as if such a lunatic claim [that GE models describe the economy] had ever been entertained’ (Hahn 1973b, p. 329).

There is a quite different and more useful conception of the GE enterprise. If, following Friedrich Hayek (1941, pp. 21 and 23), one believes that GE theory is

THE MICROFOUNDATIONS OF MONEY 239

of a ‘purely fictitious character’ and so may serve as ‘a kind of foil’, the absence of money (and many other important features of the economy) need not be a strike against the approach. On the contrary, Hayek (1941, p. 28) argues: ‘it seems to be a weakness of the traditional use of the concept of [general] equilibrium that it has been confined to cases where some specious “reality” could be claimed for it’.

The defence of GE theorizing on this basis is consistent with a hermeneutic and pragmatic enterprise. It explicitly rejects the positivist and foundationalist belief that the scientist’s job ‘is a matter of conforming to, copying, mirroring a supposedly “objective” nature’ (Madison 1987, p. 4). This position emphasizes that we may well be able to gain valuable insight into a problem through a model which has no pretensions to correspond in any direct way to the phenomenon under study. In his inaugural lecture at Cambridge, Hahn (1973a, p. 8) is quite explicit on this point: an ArrowDebreu equilibrium is not representative of and should not be conceived of as a ‘termination of actual processes’. ‘Indeed,’ Hahn (1973a, p. 21) believes, ‘one of the reasons why an equilibrium notion is useful is that it serves to make precise the limits of economic analysis’.

As Hahn (1973a and 1973b) develops his argument, however, he abandons a hermeneutic approach and falls prey to foundationalist traps. In his defence of the GE construct, Hahn outlines what he considers to be the three most valuable functions in its role as a foil. We can classify the first two as ‘therapeutic’ and the third as ‘positive’.

The first therapeutic use of GE theory is to clarify policy debate. Hahn argues that GE theory provides a neat framework in which to unearth unstated assumptions upon which policy recommendations may rest, and to identify unintended effects that come about due to the interrelatedness of economic activities. The GE enterprise has unquestionably heightened economists’ awareness of many ‘indirect’ or so-called GE effects of policies, and has underscored the limited validity of theoretical results that ignore these feedback processes.

It is not clear, however, whether these benefits could not have been obtained from systematic economic analysis based upon something other than Walrasian GE theory (see Hausman 1981, pp. 152–3).4 Even if GE theory were able to identify effects that other perspectives could not, the model rarely gives us any hint of their relative magnitude and importance.5 In addition, since important policy-relevant aspects of the economy may be absent from the model, the use of GE theory in policy analysis may confound rather than clarify debate. The model’s virtues as a foil for economic theory may become its drawbacks for policy analysis. Its often valuable role in sharpening the arguments in certain types of inquiries does not justify making it the touchstone for all economic debate.

Hahn offers a second therapeutic f unction of GE theory. He argues that:

Arrow and Debreu show what the world would have to look like if the claim [that the ‘invisible hand’ operates efficiently to coordinate the

240 HERMENEUTICAL REASON

actions of purely self-interested individuals] is to be true. In doing this they provide the most potent avenue of falsification of the claims.

(Hahn 1973b, p. 324)

The great contrast of the Arrow-Debreu world with our own, Hahn believes, has served to shake the profession of the belief in the applicability of Adam Smith’s metaphor. Hahn’s claim, however, fails on two levels. In a technical sense, the assertion that the Arrow-Debreu GE model describes the only possible structure in which an invisible hand effectively operates is incorrect. As Daniel Hausman (1981, p. 152) has pointed out: ‘If GE models were needed for this purpose, they would not help anyway, since the existence proofs the models present do not show what conditions are necessary, but only what conditions are sufficient for competitive equilibrium.’

Even if the claim were technically valid, it assumes that the processes Adam Smith considered are translatable into the GE model. To limit the conception of the invisible hand to the mathematical formulation of the GE world, as Hahn has done, shows how the emphasis on a restrictive set of techniques can eliminate fruitful paths of inquiry.6 The notion of invisiblehand processes has proved to be an effective device in the social sciences and philosophical inquiry without reference to Arrow-Debreu techniques or a GE setting (see, for example, Hayek 1973, Nozick 1974, and UllmannMargalit 1978). The spontaneous ordering of selfinterested individuals cannot be captured fully in terms of the formal equations of the GE model. An attempt to do so robs the notion of its power to illuminate economic and social processes because its purpose is to shed light on the adaptation and co-ordination of individuals under ever-changing circumstances known to no central figure. Since a perfectly informed auctioneer construct is central to GE theory, there is little scope for the operation of an invisible-hand process. An invisible hand interpreted in a non-mechanistic manner is unlikely to be associated with the Arrow-Debreu world, and so not ‘falsified’. Hahn’s interpretation of the Smithian process reveals a faith in commensurability of all forms of economic theorizing with GE modelling, hence a faith in the GE framework as the language of a unified economic science.

Hahn directly compromises the hermeneutic argument in favour of GE work with his third and ‘positive’ role for GE. He claims that it provides a ‘starting point from which it is possible to advance towards a descriptive theory’ (Hahn 1973b, p. 324). The weaknesses of current models should not be used to criticize the merit of the whole enterprise, that is, the theorems of Debreu are only an early stage in the development of GE theory (Hahn 1973b, p. 329). Is there a persuasive argument for refining GE for descriptive theory rather than looking to an alternative? Beyond simple assertion, Hahn does not explain ‘how general equilibrium models help economists advance toward an adequate economic theory’ (Hausman 1981, p. 153). The promise that Hahn held out in 1973 for extensions entailing ‘sequence economies, stochastic equilibria, and equilbria relative to information structures’ has yet to be fulfilled (see Hahn, 1973b, p.