Friday, February 7, 2014

Away from an Equilibrium Approach to Business Cycle Theory: A Search for Intellectual Roots

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

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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