One
might find it peculiar that economists, professionals whose primary focus is on
models of equilibrium, expend a tremendous amount of intellectual effort in
attempt to explain the occurrence of non-equilibrium phenomena known as
business cycles. Jason Potts observes that “it is widely held that bubbles are
inconsistent with the theory of stable general equilibria in markets, and
conventionally argued that bubble formation disrupts the natural efficiencies
of market capitalism.”[1]
Nor was he the first to make this observation. John Maynard Keynes, Gustav
Cassel, Joseph Schumpeter, and Friederich Hayek, to name only a few, were all
aware of the contradiction between equilibrium models and the persistence of
business cycles. I suggest that our understanding might be improved by
revisiting their arguments and connecting their ideas to a modern research
program.
We start with the gloomiest of views which come from John
Maynard Keynes. In his General Theory
Keynes argues that high unemployment levels are inherent in the free market
system. In the words of David Glasner and Ronald Batchelder, “Instead of
attributing high unemployment to monetary mismanagement, as he and Hawtrey had
previously, Keynes saw high unemployment as deeply rooted in the structure of
modern economic systems regardless of monetary policy or the exchange rate.”[2]
Keynes’s theory of business cycles was that, not only were they inherent in
markets, but that they lacked mechanism for a timely self-correction.[3] In
his analysis, Keynes ignored the cause of the Great Depression and instead
posited solutions to it. The only problem with this was that the cause of the
Great Depression, destructive central bank policies, were ongoing even as he
promoted expansionary fiscal policy as a solution for unemployment.[4]
The dark side of disequilibrium that Keynes presented was
not accepted by many of his experienced peers, whom also acknowledged that
bubbles cannot be fully analyzed by equilibrium models. Gustav Cassel, far from
condemning the business cycle, wrote, “Anyone who complains of trade cycles,
and condemns a social order that facilitates or tolerates their existence, is
really complaining of the advance of our material civilization.”[5]
For Cassel, the business cycle was the price of progress, a “progress [which] cannot
be absolutely uniform.”[6]
This cycle was too significant to ignore, but too complex to analyze with
simple equilibrium models. Cassel and his contemporaries understood that the
business cycle emerged from social interaction that steered the economy away from equilibrium, and “such
divergencies can, of course, only be established by a study of actual facts.”[7]
Ralph Hawtrey echoed this sentiment, noting that “The trade cycle was an
empirical discovery” and that theories of it had “been invented to fit the
statistical evidence.”[8]
The best that economists can do is to tell a story about the recurring cycle of
economic growth and disturbance that fit the data at their disposal. Their stories
indicted the cyclical nature of the interest rate as a lagging economic
indicator. Its rise only occurred after profits dwindle, thus leading to a
contraction precisely when business tend to lack liquidity. This increases
demand for money, thus lowering the price level and can spark a credit crisis.[9]
To refer to theories about the trade cycle as “stories” is
no exaggeration. If a feature of the macroeconomy is for it to deviate away
from equilibrium to great extents, economists must identify an actor whose job
it is to push the economy away from equilibrium. Enter Joseph Schumpeter’s
entrepreneur. Having realized that the business cycle does “not lend itself to
description in terms of a theory of equilibrium”, Schumpeter suggested that
economists include the entrepreneur in their analysis.[10] Entrepreneurs
“destroy any equilibrium that may have established itself or been in process of
being established” and in doing so create “cyclical ‘waves’ which are
essentially the form ‘progress’ takes in competitive capitalism.”[11] They
discover and implement new technologies and reorganized commercial society.
They cannot be described in the terms of the physics mimicking worldview of
equilibrium models because the results of their actions are of “discontinuous
character.”[12]
In other words, not only is the entrepreneur disincluded from neoclassical
equilibrium analysis, the very nature of the entrepreneur is antithetical to
it.[13]
Of course Austrian economists like Frederich von Hayek knew
that macroeconomics in general, and the business cycle in particular, cannot be
analyzed by the tool set of equilibrium
analysis:
Any theory
which limits itself to the explanation of empirically observed interconnections
by the methods of elementary theory necessarily contains a self-contradiction.
For Trade Cycle theory cannot aim at the adaptation of the adjusting mechanism
of static theory to a special case; this scheme of explanation must itself be
extended so as to explain how such discrepancies between supply and demand can
ever arise.[14]
Much like Schumpeter, Hayek told a story to explain the
recurrence of business cycles, only instead of praising entrepreneurs for their
disruptive efforts, he condemns central banks. These privileged financial
organs expand the money stock “under the pressure of an inflationist ideology.”[15]
Due to the nature of the gold standard, this first causes prices to rise,
though unevenly, and then fall as an inevitable monetary contraction follows
due to gold outflows. This process distorted relative prices – the ratio of
prices between goods and services – causing miscalculations by entrepreneurs.
Each of these stories of the business cycle clearly break
away from the physics-mimicking framework that thoroughly saturates modern
economics. It is for this reason that these early theories ought to be
reconsidered. Each theory essentially acknowledges that disequilibrium is a
feature of the market system (though Hayek’s theory less so) and that
equilibrium theory is ill-suited for analysis of business cycle. If we construct a representative story that includes time and micro level interaction – as opposed
to aggregation of micro-level agents, which is nothing more than positing a single macro-level
agent – we will have a starting point for a model that includes these details.
[1]
Jason Potts, “Liberty Bubbles” Policy
20 no. 3 (Spring 2004): 2.
[2]
Glasner and Bathchelder, “Pre-Keynesian Monetary Theories of the Great
Depression: What Ever Happened to Hawtrey and Cassel?” SSRN (April 2013): 42.
[3]
John Maynard Keynes, General Theory (Orlando,
Florida: Harcourt, Brace, & World Inc., 1965): 314, 320.
[4]
John Maynard Keynes, Treatise on Money
vol. 2, 376.
[5]
Gustav Cassel, The Theory of Social
Economy (New York: Augustus M. Kelley, 1967): 645.
[6]
Ibid., 646.
[7]
Ibid., 533.
[8]
Ralph Hawtrey, “The Monetary Theory of the Trade Cycle and Its Statistical
Test,” The Quearterly Journal of
Economics 41, no. 3 (May 1927): 471,72.
[9]
Cassel, The Theory of Social Economy,
649.
[10]
Joseph Schumpeter, “The Instability of Capitalism,” The Economic Journal 38, no., 151 (September 1928): 378
[11]
Ibid., 383.
[12]
Ibid., 378.
[13]
This did not stop Israel Kirzner from trying. See Market Theory and the Price System.
[14]
F. A. Hayek, Monetary Theory and the Trade Cycle (New York: Sentry Press): 43.
[15]
Ibid., 150.
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