Mises’s Three Concepts of Equilibrium

Equilibrium can be a tricky subject, as different economists have different definitions of the concept. Mises employs 3 different concepts, as follows:

“[sc. Mises] posits not one, but three notions of equilibrium that he claims underlie his analysis. The first, the ‘plain state of rest,’ is a temporary state in which all currently desired transactions have been made and, for the moment, no one wants to trade. His example of such a state is the close of the trading day in the stock market ....

The second equilibrium notion Mises employs is the “final state of rest,” the state toward which the market tends if there is no change in the data. This apparently is Mises’ analogue to general equilibrium. Whereas the plan state of rest is a phenomenon that is routinely found in markets, the final state of rest is an “imaginary construction” in that it can never be achieved in reality, although it is a necessary analytic tool for understanding the direction of price changes.

Finally, Mises posits yet a third equilibrium notion, the “evenly rotating economy,” or the “ERE.” This, too, is an imaginary construction of what the market would be like if there were no changes in the data. In this construction, however, people continue to be born, to live and to die, and capital is accumulated at a rate just sufficient to maintain current patterns of consumption and investment. It is a condition in which the same products are consumed and produced over and over again, and all prices equal the prices established in the final state of rest .... Whereas the first two notions have their analogues in contemporary economics, the ERE seems to be unique to Mises.” (Vaughn 1994: 81–82).

Mises describes the nature of money in the ERE:

“Then there is a second deficiency. In the imaginary construction of an evenly rotating economy, indirect exchange and the use of money are tacitly implied. But what kind of money can that be? In a system without change in which there is no uncertainty whatever about the future, nobody needs to hold cash. Every individual knows precisely what amount of money he will need at any future date. He is therefore in a position to lend all the funds he receives in such a way that the loans fall due on the date he will need them. Let us assume that there is only gold money and only one central bank. With the successive progress toward the state of an evenly rotating economy all individuals and firms restrict step by step their holding of cash and the quantities of gold thus released flow into nonmonetary—industrial—employment. When the equilibrium of the evenly rotating economy is finally reached, there are no more cash holdings; no more gold is used for monetary purposes. The individuals and firms own claims against the central bank, the maturity of each part of which precisely corresponds to the amount they will need on the respective dates for the settlement of their obligations. The central bank does not need any reserves as the total sum of the daily payments of its customers exactly equals the total sum of withdrawals. All transactions can in fact be effected through transfer in the bank’s books without any recourse to cash. Thus the ‘money’ of this system is not a medium of exchange; it is not money at all; it is merely a numeraire, an etheral and undetermined unit of accounting of that vague and indefinable character which the fancy of some economists and the errors of many laymen mistakenly have attributed to money. The interposition of these numerical expressions between seller and buyer does not affect the essence of the sales; it is neutral with regard to the people’s economic activities. But the notion of a neutral money is unrealizable and inconceivable in itself. If we were to use the inexpedient terminology employed in many contemporary economic writings, we would have to say: Money is necessarily a ‘dynamic factor’; there is no room left for money in a ‘static’ system. But the very notion of a market economy without money is self-contradictory.” (Mises 1996: 249)

The ERE was not used by Hayek as his equilibrium model in Prices and Production, although there are of course similarities (and the ERE does appear in later Hayekian versions of ABCT). I do not think Wicksell’s model in his monetary equilibrium theory is an ERE either (if readers think I am wrong, I would like to hear why).

Hayek makes it clear in Prices and Production that he working in the general equilibrium tradition, which would be Mises’s “final state of rest”:

“it is my conviction that if we want to explain economic phenomena at all, we have no means available but to build on the foundations given by the concept of a tendency toward an equilibrium. For it is this concept alone which permits us to explain fundamental phenomena like the determination of prices or incomes, an understanding of which is essential to any explanation of fluctuation of production. If we are to proceed systematically, therefore, we must start with a situation which is already sufficiently explained by the general body of economic theory. And the only situation which satisfies this criterion is the situation in which all available resources are employed.” (Hayek 2008: 225).

Wicksell had already used Walras’ theory of general equilibrium and combined it with Bohm Bawerk’s theory of interest, to try and establish the conditions of monetary equilibrium (Loasby 1998: 54). Hayek developed an intertemporal equilibrium theory in 1928 in his paper “Intertemporal Price Equilibrium and Movement in the Value of Money” (Hayek 1984 [1928]), but did not use this in Prices and Production. Instead, “he reverted to the stationary equilibrium approach, by adopting the simple stationary-equilibrium model put forward by Wicksell in Interest and Money as the starting point for his analysis” (Donzelli 1993: 57). This was a stationary equilibrium model:

“Wicksell’s theory of monetary equilibrium, whose influence was to be crucial, was built on the foundations of his critique of the Quantity Theory. He effectively believed that the velocity of circulation of money proper was unstable since, under certain institutional conditions, it is possible to reduce the use of money through control of credit and thus to affect its velocity of circulation. The demand for credit of the banking system is governed by the difference between two rates: the supply price of bank credit, or money rate of interest, and a rate which Wicksell defined first as a ‘natural rate’, which would equalise savings and investment in an economy without money, and then as a ‘normal’ rate: the equilibrium interest rate on loanable funds in a monetary economy …. Hayek retained the idea of a disparity between these rates as a driving force behind the processes of expansion and contraction, as well as the role of credit in allowing a demand for produced and non-produced investment goods in excess of voluntary savings. Demand is then pushed above the value of goods supplied, leading to increased prices and a rationing of consumers – a forced saving. Equality of these interest rates represents monetary equilibrium.” (Hénin 1986: 39)

BIBLIOGRAPHY

Donzelli, F. 1993. “The Influence of the Socialist Calculation Debate on Hayek’s view of general equilibrium theory,” Revue Européenne des Sciences 31.96.3: 47–83.

Hayek, F. A. 1984 [1928]. “Intertemporal Price Equilibrium and Movement in the Value of Money,” in R. McCloughry (ed.), Money, Capital and Fluctuations. Early Essays, Routledge & Kegan Paul, London.

Hayek, F. A. von, 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, Ludwig von Mises Institute, Auburn, Ala.

Hénin, P.-Y. 1986. Macrodynamics: Fluctuations and Growth: A Study of the Economy in Equilibrium and Disequilibrium, Routledge & Kegan Paul, London.

Loasby, B. J. 1998. “Co-ordination Failure: Economic Theory in the 1930s,” in P. Fontaine and A. Jolink (eds), Historical Perspectives on Macroeconomics: Sixty Years After the General Theory, Routledge, London. 53–64.

Mises, L. 1996. Human Action: A Treatise on Economics (4th revised edn), Mises Institute, Auburn, Ala.

Vaughn, K. I. 1994. Austrian Economics in America: The Migration of a Tradition, Cambridge University Press, Cambridge and New York.

Mises’s “Evenly Rotating Economy” (ERE) and ABCT

Mises’s early work on the Austrian business cycle theory (ABCT) uses the Wicksellian natural interest rate concept and Wicksell’s monetary equilibrium analysis. This can be seen here:

“[Mises] surely made use of the natural and market rate concepts, developing Wicksell's analysis of the upward price spiral caused by a too low market rate into a theory of the business cycle” (Horwitz 2000: 77).

“Wicksell distinguishes between the natural rate of interest (natürliche Kapitalzins), or the rate of interest that would be determined by supply and demand if actual capital goods were lent without the mediation of money, and the money rate of interest (Geldzins), or the rate of interest that is demanded and paid for loans in money or money substitutes. The money rate of interest and the natural rate of interest need not necessarily coincide, since it is possible for the banks to extend the amount of their issues of fiduciary media as they wish and thus to exert a pressure on the money rate of interest that might bring it down to the minimum set by their costs. Nevertheless, it is certain that the money rate of interest must sooner or later come to the level of the natural rate of interest, and the problem is to say in what way this ultimate coincidence is brought about.
Up to this point Wicksell commands assent; but his further argument provokes contradiction. According to Wicksell, at every time and under all possible economic conditions there is a level of the average money rate of interest at which the general level of commodity prices no longer has any tendency to move either upwards or downwards. He calls it the normal rate of interest; its level is determined by the prevailing natural rate of interest, although, for certain reasons which do not concern our present problem, the two rates need not coincide exactly. When, he says, from any cause whatever, the average rate of interest is below this normal rate, by any amount, however small, and remains at this level, a progressive and eventually enormous rise of prices must occur ‘which would naturally cause the banks sooner or later to raise their rates of interest.’ Now, so far as the rise of prices is concerned, this may be provisionally conceded. But it still remains inconceivable why a general rise in commodity prices should induce the banks to raise their rates of interest ... ” (Mises 2009 [1953]: 355).

“In conformity with Wicksell’s terminology, we shall use ‘natural interest rate’ to describe that interest rate which would be established by supply and demand if real goods were loaned in natura [directly, as in barter] without the intermediary of money. ‘Money rate of interest’ will be used for that interest rate asked on loans made in money or money substitute.” (Mises 2006 [1978]: 107–108).

“The ‘natural interest rate’ is established at that height which tends toward equilibrium on the market. The tendency is toward a condition where no capital goods are idle, no opportunities for starting profitable enterprises remain unexploited and the only projects not undertaken are those which no longer yield a profit at the prevailing ‘natural interest rate’” (Mises 2006 [1978]: 109; from Monetary Stabilization and Cyclical Policy [1928]).

So as late as 1928 in Monetary Stabilization and Cyclical Policy (1928), Mises is still using the Wicksellian natural interest rate concept.

I have recently seen this attempt to defend Mises’ early versions of ABCT, by invoking his later concept of the “evenly rotating economy”/stationary economy concept:

“The point Mises is making in the [sc. quotes] ... is that the natural interest rate is the rate of interest that would arise in the [“evenly rotating economy”]... It is the value towards which interest rates in the real world economy tend though there are real world factors that take the interest rate away from the natural interest rate.”

But a reading of the earlier work of Mises in works cited above does not support this:

(1) There is not one reference to the concept of the “evenly rotating economy” (ERE) in The Theory of Money and Credit (trans. J. E. Batson; Mises Institute, Auburn, Ala. 2009 [1953]). On pages 349–366 where Mises sets out his trade cycle theory, he uses the Wicksellian natural interest rate concept and Wicksellian monetary equilibrium analysis.

(2) There is not one reference to the concept of the “evenly rotating economy” in Monetary Stabilization and Cyclical Policy (1928), and again Mises is still using the Wicksellian natural interest rate (p. 99ff.).

The “evenly rotating economy” just like the “originary interest rate” appears in Human Action, not in these earlier works. The concept of the “evenly rotating economy” needs clarification:

“In Human Action, Mises advanced the Austrian theory of money by delivering a shattering blow to the very concept of Walrasian general equilibrium. To arrive at that equilibrium, the basic data of the economy—values, technology, and resources—must all be frozen and understood by every participant in the market to be frozen indefinitely. Given such a magical freeze, the economy would sooner or later settle into an endless round of constant prices and production, with each firm earning a uniform rate of interest (or, in some constructions, a zero rate of interest). The idea of certainty and fixity in what Mises called “the evenly rotating economy” is absurd, but what Mises went on to show is that in such a world of fixity and certainty no one would hold cash balances. Everyone’s demand for cash balances would fall to zero. For since everyone would have perfect foresight and knowledge of his future sales and purchases, there would be no point in holding any cash balance at all.” (Rothbard 2011: 697).

“The Evenly Rotating Economy is a fictitious system in which there are no price changes whatever – i.e., there is perfect price stability. The concept is used to illustrate the function of entrepreneurship and to demonstrate meaning of profit and loss by hypothesizing a system where they are absent.”
http://wiki.mises.org/wiki/Evenly_Rotating_Economy

“… this line of argument makes it necessary to clarify the precise meaning of general equilibrium, as well as its role in economic analysis. Mises argued that general equilibrium—which he called the stationary economy (stationäre Wirtschaft)—is a purely methodological device. It is an imaginary construct (Gedankenbild) that has no counterpart in the real world. Its only purpose is for the definition of profit and loss.” (Hülsmann 2007: 773).

If Mises really believed that “the natural interest rate is the rate of interest that would arise in the ERE. It is the value towards which interest rates in the real world economy tend though there are real world factors that take the interest rate away from the natural interest rate,” then ABCT has no application to real world capitalism. Why?

In the real world, economies are growing, and there can never be an “endless round of constant prices and production.” This would require an economy without growth, frozen in time, for a single natural rate of interest to even exist. As Sraffa showed, even in a barter economy with growth, there can be as many natural rates of interest as there are commodities.

Yet ABCT requires a single natural rate of interest in the real world for the market/bank rate to coincide with, in order that we can avoid the cycle effects allegedly caused by ABCT.

BIBLIOGRAPHY

Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. 1998. Human Action: A Treatise on Economics, Mises Institute, Auburn, Ala.

Mises, L. von. 2006 [1978]. The Causes of the Economic Crisis and Other Essays Before and After the Great Depression, Ludwig von Mises Institute, Auburn, Ala.

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala.

Rothbard, M. 2011. Economic Controversies, Ludwig von Mises Institute, Auburn, Ala. p. 697.