Jonathan Catalán Puzzles over the Hayekian ABCT

In a curious post here Jonathan Catalán looks over the classic Hayekian Austrian business cycle theory (ABCT) and proposes a puzzle:

Jonathan Catalán, “A Thought on the Business Cycle, Economic Thought,” Economic Thought, 8 March, 2013.

My immediate question is: in previous posts, Catalán implies that he does not think that there is a real world tendency towards a general equilibrium (GE) sstate, whether towards a Walrasian GE or Mises’s “final state of rest” (although the actual equilibrium state is never attained, of course).

Yet the Hayekian ABCT requires a “transition between equilibria” - that is, a real world tendency towards an equilibrium state for the theory to work.

But there is a gaping hole here: if you do not think that real-world market economies have a tendency towards a general equilibrium state, then what is the use of the theory?

The Hayekian ABCT is just another equilibrium theory, and once one accepts that equilibrium theory is irrelevant for the real world, it follows logically that any ABCT that requires and posits a “transition between equilibria” in real market economies is also irrelevant.

Léon Walras and General Equilibrium

Léon Walras, whose photo appears below, was the founder of the neoclassical Walrasian economics tradition.



There are obviously differences between what Alfred Marshall meant by equilibrium and what neoclassicals like Walras meant by it, but general equilibrium can be defined as a situation where all markets, including the labour market, clear at the same time. It can also be called a “full employment equilibrium.”

A question that immediately occurs is this: did Walras think general equilibrium is ever attained in the real world?

Apparently not:

“Equilibrium in production, like equilibrium in exchange, is an ideal and not a real state. It never happens in the real world that the selling price of any given product is absolutely equal to the cost of the productive services that enter into that product, or that the effective demand and supply of services or products are absolutely equal. Yet equilibrium is the normal state, in the sense that it is the state towards which things spontaneously tend under a régime of free competition in exchange and in production.” (Walras 1954: 224–225).

“Such is the continuous market, which is perpetually tending towards equilibrium without ever actually attaining it, because the market has no other way of approaching equilibrium except by groping, and, before the goal is reached, it has to renew its efforts and start over again, all the basic data of the problem, e.g. the initial quantities possessed, the utilities of goods and services, the technical coefficients, the excess of income over consumption, the working capital requirements, etc., having changed in the meantime. Viewed in this way, the market is like a lake agitated by the wind, where the water is incessantly seeking its level without ever reaching it. But whereas there are days when the surface of a lake is almost smooth, there never is a day when the effective demand for products and services equals their effective supply and when the selling price of products equals the cost of the productive services used in making them. The diversion of productive services from enterprises that are losing money to profitable enterprises takes place in various ways, the most important being through credit operations, but at best these ways are slow. It can happen and frequently does happen in the real world, that under some circumstances a selling price will remain for long periods of time above the cost of production and continue to rise in spite of increases in output, while under other circumstances, a fall in price, following upon this rise, will suddenly bring the selling price below cost of production and force entrepreneurs to reverse their production policies. For, just as a lake is, at times, stirred to its very depths by a storm, so also the market is sometimes thrown into violent confusion by crises, which are sudden and general disturbances of equilibrium. The more we know of the ideal conditions of equilibrium, the better we shall be able to control or prevent these crises.” (Walras 1954: 380–381).

A point that emerges is this: the differences between those Austrian economists who adhere to the view of a strong tendency to general equilibrium in the real world (even if it is never attained) and neoclassicals are greatly exaggerated, for even Walras himself believed the same thing: the state of general equilibrium is an ideal, not “a real state.”

I think important conceptual distinctions should be made between the following:

(1) the state of general equilibrium (which never exists in the real world);

(2) a strong tendency to general equilibrium in the real world. This means market processes are moving in that direction normally and consistently as a natural condition. These processes are “equilibrating mechanisms,” and it is their combined effective operation that creates a strong tendency to general equilibrium;

(3) The “equilibrating mechanisms” or “coordinating mechanisms” should not simply be identified with the actual tendency to general equilibrium in the real world. The latter is a distinct phenomenon, whose existence Post Keynesians would deny.

The “equilibrating mechanisms” for Austrians and neoclassicals are regarded as things such as an equilibrium rate of interest clearing the loanable funds market, equilibrium prices, Say’s law, the tendency of the rate of profit to become uniform, entrepreneurship seeking profit, speculative arbitrage, significantly and quickly flexible wages and prices, and so on.

It can be seen that some of these alleged “equilibrating mechanisms” do not even exist: the equilibrium rate of interest and Say’s law, for example. Others do not actually happen in the real world, such as rapidly adjusting wages and prices.

Of course, even Post Keynesians would not deny that there do exist certain coordinating mechanisms. But the issue is whether the ones that do exist really work in the way imagined by neoclassicals and Austrians.

The alleged combined effective operation of these “equilibrating mechanisms” is really a myth, and so is the strong tendency to general equilibrium.

The fundamental insight of Keynes was that, even if we had perfectly flexible wages and prices, market economies would still not necessarily converge to full employment equilibrium. Significant unemployment could still exist even with perfectly flexible wages and prices.

The insight of Irving Fisher and Hyman Minsky was that price deflation in an environment of high private debt causes debt deflation.

Post Keynesians argue that there is nothing in market systems that ensure that the economy will converge automatically to full employment equilibrium (Davidson 1993: 436). This does not mean that free market economies are inherently disequilibrating, however (Davidson 1993: 436). For Keynes, the most serious flaws in capitalism were as follows:

“The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.” (Keynes 1936: 372).

No doubt there are more radical criticisms that could be made of capitalism, but it is important to make clear what Keynes thought.

Keynes regarded the “unemployment equilibrium” (which is better called an “unemployment disequilibrium”) as capitalism’s natural state:

“our actual experience … [sc. is] that we oscillate, avoiding the gravest extremes of fluctuation in employment and in prices in both directions, round an intermediate position appreciably below full employment and appreciably above the minimum employment a decline below which would endanger life.” (Keynes 1936: 254).

Keynes’s view was that real-world capitalist systems have a tendency to fluctuate around a state well below full employment: this is a major and serious problem of market economies.


BIBLIOGRAPHY

Davidson, P. 1993. “Austrians and Post Keynesians on Economic Reality: Rejoinder to Critics,” Critical Review 7.2–3: 423–444.

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

Vienneau, Robert. “One Generation Passes and Another comes, but the World Forever Stays,” Thoughts on Economics Blog, August 12, 2007.

Walras, Léon. 1954. Elements of Pure Economics, or, The Theory of Social Wealth (trans. W. Jaffé), Allen & Unwin, London.

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.