Peter Howitt on Coordination

His version of the microfoundations of macroeconomics

Peter Howitt, one of the 2025 Nobel laureates in economics, earned his award for his work on long-term economic growth. But as I pointed out, I liked his ideas on the causes of fluctuations in output and employment.

Josh Hendrickson writes,

Howitt followed Clower to Los Angeles.

…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.

Pointer from Tyler Cowen.

Clower/Leijonhufvud/Howitt never caught on, because it required economists to think in terms of many, many different markets. And in terms of trading taking place outside of equilibrium. How difficult! The profession decided to look for its lost watch under the lamp post, instead.

What I call “folk Keynesianism” says that spending creates jobs and jobs create spending. That is how every journalist who covers the economy describes things. But it makes no sense from the standpoint of microeconomics.

In microeconomics, the supply curve and the demand curve intersect. If there is a single market for labor, as there is in folk Keynesianism (and in most mainstream macro), then the supply and demand should intersect at the point where the wage is such as there is neither excess demand nor excess supply.

If you insist that you can treat the labor market as a single market, then the only way that you can have excess supply (i.e., unemployment) is if the wage gets stuck too high. That is where most macroeconomists landed, and that is where many of them still are. When I was in graduate school, and in the decades that followed, macroeconomists tied themselves in knots over the issue how the wage could get too high and stay stuck there, and under what conditions the central bank could unstick the labor market by printing more money. The resulting late-twentieth-century macro has no redeeming social value.

Howitt tried something different. Hendrickson writes,

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.

…Howitt was wrong about where the profession was headed.

What Hendrickson calls “the general trend in macroeconomics” was set by Stanley Fischer, who I call the Genghis Khan of macro, because just about every tenured macroeconomist is one of his descendants. It relied heavily on modeling the economy in terms of a single representative agent solving a mathematically rich optimization problem.

Hendrickson writes,

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.

Think of multiple goods, each with its own trading post. Groceries are traded here, televisions are traded there, cars are traded somewhere else. A typical firm is not just producing output. It is also a trading post, where workers come to trade their efforts for money and buyers come to obtain what the firm sells.

Some economists have claimed that if a worker were paid in the form of output, there would not be any unemployment. Marty Weitzman even wrote a paper suggesting that something like that could be put into practice.

To understand why, imagine an agricultural economy in which every farm produces food. Rather than face unemployment, an apple picker can always give the owner owner of an apple orchard an offer to pick apples, allowing the worker to take home a fair share of his output to eat or to sell himself.

In fact, when the economy was mostly rural, it did not experience anything like Keynesian unemployment. Bad times consisted of bad harvests, not general gluts.

But when we introduce a more complex economy, with a large manufacturing sector, it is not feasible for workers to be paid in output. If the steel manufacturer cannot sell steel, how is a steel worker supposed to do so? There is no choice but to pay workers in money. And if the steel manufacturer cannot afford to pay its workers, the workers have to be laid off.

The problem of getting all of the trading posts in a complex market economy synched up is what Tyler Cowen once called “the dual of the socialist calculation problem.” Howitt’s story (originally from Leijonhufvud) is that they are only synched up within a “corridor,” in which relative prices are close enough to equilibrium values. In that case, workers in each occupation can go to a “trading post’ (employer) and exchange labor for money. But when a shock knocks the economy out of the “corridor,” a lot of trading posts all at once are only able to clear a low volume of sales. When the worker comes to a trading post where he would have been able to make a trade when the economy was inside the corridor, he instead gets sent away, unemployed and empty-handed.

My wrinkle is to think of firms not as static trading posts but as dynamic firms in Schumpeterian competition. When they have established sustainable patterns of specialization and trade, offers to work consist of incumbent workers coming to their usual place of work, where their offers are automatically accepted. That is, you go to work every day, knowing that your job will still be there. But when the dynamics of creative destruction cause enough patterns to break, workers must wait for entrepreneurs to discover the new profit opportunities that can lead to more hiring.

Clower and Howitt used agent-based modeling to demonstrate how unemployment could persist in a multi-market economy. With AI’s, agent-based modeling could be more popular. Further analysis of a multi-market economy could finally free macroeconomics from Stan Fischer’s descendants.

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On Peter Howitt's Other Work