Source: An essay in Toward Liberty: Essays in Honor of Ludwig von Mises on the Occasion of his 90th Birthday, September 29, 1971, vol. 2, ed. F.A. Hayek, Henry Hazlitt, Leonrad R. Read, Gustavo Velasco, and F.A. Harper (Menlo Park: Institute for Humane Studies, 1971).
In the thickening gloom of our age, an age of declining standards, rampant inflation, and egalitarian ideology, it is perhaps too much to hope that the realm of economic thought alone will remain unscathed and at least this province of the human mind escape invasion by our contemporary follies. In fact, what we find to-day is very much what one might have expected. We see a few thinkers engaged in a valiant but desperate struggle to defend and strengthen the great tradition they have inherited. The large majority of economists have to-day adopted an arid formalism as their style of thought, an approach which requires them to treat the manifestations of the human mind in household and market as purely formal entities, on par with material resources. Not surprisingly, the adherents of this style of thought have come to find the mathematical language a congenial medium in which to give expression to their thoughts.
They are fond of referring to themselves as “neoclassical” economists. This label is, however, rather misleading. The classical economists, in their great day, were concerned with human action of a certain type, the forms it takes in varying circumstances and the results it is likely to produce. They took the market economy of their time as object of their thought and asked why it was what it was. Gradually they built up a formal apparatus of thought in order to deal with these problems.
The “neoclassical” economists of our time have taken over, developed and considerably refined this apparatus of thought. But in doing so they have taken the shadow of the formal apparatus for the substance of the real subject matter. It will not surprise us to learn that when confronted with real problems, such as the permanent inflation of our time, neoclassical economics has nothing to say. “Late classical formalism” appears to us a much better designation of the style of thought currently in fashion in these quarters.
A prominent economist of this school has recently told us, “Until the econometricians have the answer for us, placing reliance upon neoclassical economic theory is a matter of faith.” What a faith! Economics is by no means exclusively concerned with what happens, but also with what might have happened, with the alternatives of choice which presented themselves to the minds of the decision-makers. In fact, it is in terms of these alternatives alone that the decisions can be rendered intelligible, which is after all the main purpose of a social science. Statistics, as Mises has often explained, merely record what happened over a certain period of time. They cannot tell us what might have happened had circumstances been different.
Thirty years ago Mises warned us of the futility of late classical formalism. Characteristically he thrust his blade into his opponents' weakest spot. He showed the inadequacy of the main tool of the formalists, the notion of equilibrium. “They merely mark out an imaginary situation in which the market process would cease to operate. The mathematical economists disregard the whole theoretical elucidation of the market process and evasively amuse themselves with an auxiliary notion employed in its context and devoid of any sense when used outside of this context.”1 And he added “A superficial analogy is spun out too long, that is all.”
In voicing these strictures Mises gave pointed expression to that opposition to the work of the school of Lausanne in general, and its fundamental concept, the notion of equilibrium, in particular, which has for long been a characteristic feature of the whole Austrian School. From Menger's letters to Walras to the work of Hans Mayer and Leo Illy a succession of Austrian writers have expressed their distrust of the Lausanne approach and criticised the theory of general equilibrium. Schumpeter is the obvious exception, but in the sense relevant to our problem, as in several other senses, he may be said not really to have belonged to the “inner core” of the Austrian School. Mises, by contrast, established his claim to this title by his rejection of the equilibrium concept and thus showed himself to stand firmly in the true line of the Austrian succession. But he did not confine himself to criticism of the work of the School of Lausanne. He took an important step forward. He replaced the notion of equilibrium by the concept of the Market Process. We shall have more to say later on about this fundamental concept and its significance within the structure of Mises' thought. But there is another matter to which we must turn first.
In the 30 years which have now elapsed since Mises made his attack on the late classical formalism of our age and its notion of equilibrium a certain re-orientation of modern economic thought has taken place. Less is heard to-day of what Mises called the “evenly rotating economy” (Kreislauf) as the framework of the equilibrium concept. Instead the notion of “growth equilibrium” or “steady state growth” has come to acquire a place of prominence in contemporary thought. We shall therefore have to ask ourselves whether, and how far, this metamorphosis of the notion of equilibrium has affected the validity of Mises' criticism of 30 years ago.
In this essay we set ourselves two tasks: in the first place, to examine the question whether the new notion of equilibrium growth may be regarded as exempt from the criticism of the old variety of static equilibrium which Mises has presented. In the second place, Mises' hints about the Market Process as an alternative to equilibrium as a fundamental concept will have to be worked out more fully. We shall have to ask what are the conditions of the continuous existence of such a process. We shall also have to ask, what is, within the framework of the market process as a whole, the status of those equilibrating forces which tend to produce at least partial adjustments.
In this section we propose to show that the new notion of “growth equilibrium” which has come into fashion in the last quarter of a century is even more inadequate than was the older version which Mises so trenchantly criticised. Though the new variety acquired fame and came into fashion as a feature of the Harrod-Domar model of economic growth, its origin has to be sought in Cassel's work in the second decade of this century. Cassel was critical of Wicksell's work, and in particular of the latter's attempts to analyse dynamic processes in terms of concepts, such as the “natural rate of interest”, which can be given little meaning outside an unchanging world. He realised that economic processes in an industrial society subject to continous change could not possibly be analysed with the help of such instruments of thought. But he remained enough of a Walrasian to want to retain the notion of general equilibrium and the static method. So he proposed the “uniformly progressive economy”, the model of an economy in which output of all goods and services increases at a uniform rate all over the system while relative prices and the relative marginal products of the factors of production remain unaffected. Thus our economic system can remain in a state of general equilibrium all the time while output, population and the stock of capital grow steadily. We now have equilibrium persisting in a world of steady change. The static method remains applicable to a world which is not stationary. In a sense we might say that here we have another type of an “evenly rotating economy”, only that the economic system as a whole achieves motion while it is rotating. Harrod and Domar, when they worked out their model, appear to have been quite unaware of Cassel's contribution.1)
It is noteworthy that the protagonists of modern growth theories appear to believe that their models bear at least some resemblance to reality. Professor Solow asks, “What are the broad facts about the growth of advanced industrial economies that a well-told model must be capable of reproducing?” and, following Kaldor, then proceeds to state six “stylized facts”. The first of them is according to him: “Real output per man (or per man-hour) grows at a more or less constant rate over fairly long periods of time. There are shortrun fluctuations, of course, and even changes from one quarter-century to another. But at least there is no clear systematic tendency for the rate of increase of productivity in this sense to accelerate or to slow down. If, in addition, labour input.... grows at a steady rate, so will aggregate output....”. The second is stated as “The stock of real capital, crudely measured, (our italics) grows at a more or less constant rate exceeding the rate of growth of labour input”.2)
That some fascinating games can be played with “macro-economic” aggregates, and the size of the capital stock in particular, is not a new discovery. When Cassel presented his model, at a time when macro-economics had not been thought of, he had to stress the need for a uniform rate of progress in all sectors. In our age this implication is conveniently forgotten together with the Cassellian original.
If the equilibrium of a stationary economy is an unsatisfactory tool of analysis for an industrial economy, growth equilibrium of the kind we described above is readily seen to be even less satisfactory. When real incomes per head increase, income recipients do not spend them in the same proportion as before. They will begin to buy some goods which previously had been entirely beyond their reach, buy more of some other goods, but less than in proportion to their higher incomes, and may actually reduce their consumption of some other goods they have come to regard as “inferior”. The pattern of relative demand will certainly change. For the pattern of relative supplies to adjust itself INSTANTANEOUSLY we at once have to assume that producers foresaw this change correctly as well as the time pattern of the change. We also have to assume that costs are constant over the relevant ranges of output in all industries affected and that wage rates do not change, otherwise relative prices will change. Such assumptions about constant costs and wages when relative output changes must be regarded as being already somewhat unrealistic. But the degree of lack of realism inherent in such assumptions pales into insignificance when compared with that of perfect foresight on the part of the producers without which we can have no instantaneous adjustments of supply to demand. In fact it is this assumption of perfect foresight that deprives the model of growth equilibrium of any resemblance to the market processes of the real world.
Yet, without such foresight the adjustment of supply to changes in demand will certainly be delayed, and during the delay there will be disequilibrium in the markets affected. If any transactions take place during the period of disequilibrium (and, in a continuous market, how could this fail to happen?) the conditions of our moving equilibrium will be changed for the very same reasons for which Edgeworth and Walras had to introduce “re-contract” to safeguard the determinate character of their final equilibrium position. To our knowledge, however, none of the many economists who have presented to us equilibrium growth models in recent years has attached the condition of re-contract for transactions during periods of disequilibrium. They have all, of course, assumed continuous and uninterrupted existence of equilibrium. It is this which, without instantaneous adjustments of supply to changes in demand, is impossible.
Similar problems arise in connection with the composition of the stock of capital. The maintenance of a constant capital—output ratio (whatever this vague notion may mean and imply) is, of course, not a sufficient condition of the maintenance of general equilibrium in a growing economic system. The actual composition of the capital stock in terms of the various capital resources must be appropriate to the composition of total output demanded. The capital stock must contain no single item which its owner would not wish to replace by a replica, if he suddenly lost it by accident, otherwise the stock cannot be in equilibrium. Such changes in demand for consumer goods as we discussed above must therefore be at once accompanied by a corresponding change in the composition of the capital stock, otherwise this stock cannot retain its equilibrium composition and we confront a new source of disequilibrium. Of course, so long as we regard all capital as homogeneous the problem does not arise. As soon as we face the fact that most durable capital goods, even if not actually specific to the uses for which they were originally designed, have at least a limited range of versatility, the continuous maintenance of the equilibrium composition of the capital stock in a world in which relative demand and technology are bound to change in quite unpredictable fashion, emerges as a serious problem.
It is instructive to look at the whole problem from the point of view of the convergence of expectations. A society in which economic progress occurs is part of an uncertain world. Nobody knows the future. In a stationary world it is possible to appeal to the constancy of the “data” and the continuous recurrence of events to justify the belief that all members of such a society will sooner or later become familiar with them and their expectations will converge on the recurrent pattern of events. In an uncertain world this is impossible. Experience shows that different people will entertain widely divergent expectations. This will be so not merely because some men are, by temperament, optimists and others pessimists. Differences in knowledge are here often of fundamental importance. The diffusion of new knowledge is not a uniform and not often a continuous process. Some sources of knowledge are only available to some, but not to others, while the ability to make use of new knowledge is most unequally distributed among men.
For all these reasons expectations in an uncertain world are bound to diverge. But divergent expectations cannot all be fulfilled. Some are bound to be disappointed. The plans based upon them will fail. Some plans will be even more successful than their makers had expected. In either case the planners will not be in equilibrium over time. At the end of the period they will wish they had pursued different plans, and this will apply to those whose plans failed as well as to those whose plans succeeded better than expected. They will thus have to revise their plans in the light of an unsatisfactory experience. But continuous equilibrium requires continuous success of plans. We have to conclude therefore that in an uncertain world in which expectations diverge and the plans based upon them cannot be consistent with one another the particular type of dynamic equilibrium known as “growth equilibrium” is impossible.
Mises rejects the notion of equilibrium and proposes to replace it by that of The Market Process. In following him we confront a number of difficulties. Not the least of them stems from a fact of history which none of us can eschew. The ascendancy which the school of Lausanne has gained in this century has created a situation in which for most of us it has become difficult even to conceive of a world without equilibrium. It nowadays requires quite an effort to do so. So much of what we have learnt and thought seems to depend on it that without it we appear to be drifting helplessly on an uncharted sea without a possibility of taking our bearings. But the inadequacy of the Lausanne notion of general equilibrium has been established. We have to tackle the uncomfortable task of substituting for it something else, something at once more akin to reality and more congenial to praxeological thought.
Fortunately we have Mises' work to guide us in this task. In ridding our minds of the domination of the equilibrium notion the market process presents itself as a better alternative. Perhaps such a conception came more naturally to somebody who shaped his fundamental conceptions in the Vienna of the first decade of this century, the decade in which the reputation of the Austrian School was at its peak.1 No doubt the young Mises, imbibing the “pure atmosphere” of the school of Vienna, not as yet contaminated by alien particles, found himself able to conceptualize, with little effort, the essence of the market economy in the form of the market process. For us, as we explained, an effort is here required. We should make a start by looking at different meanings of the notion of equilibrium.
First of all, we have to note that what has happened to the notion of equilibrium is that the economists of Lausanne and their successors to-day have stretched the meaning of equilibrium to such an extent that a notion, in its original meaning useful and indeed indispensable, has been applied far outside the borders of its natural habitat.
The Austrians were concerned, in the first place, with the individual in household and business. There is no doubt that here equilibrium has a clear meaning and real significance. Men really aim at bringing their various actions into consistency. Here a tendency towards equilibrium is not only a necessary concept of praxeology, but also a fact of experience. It is part of the logic inherent in human action. Interindividual equilibrium, such as that on a simple market, like Böhm-Bawerk's horse market, already raises problems but still makes sense. “Equilibrium of an industry” à la Marshall is already more precarious. “Equilibrium of the economic system as a whole”, as Walras and Pareto conceived of it, is certainly open to Mises' strictures. “Growth Equilibrium”, as we have tried to show, the equilibrium of a system in motion, is simply a mis-conception.
The vice of formalism is precisely this, that various phenomena which have no substance in common are pressed into the same conceptual form and then treated as identical. Because equilibrating forces operate successfully in the individual sphere of action, we must take it for granted, so the formalists tell us, that they will also do so outside it. From Walras to Samuelson we find the same manner of reasoning, the same arbitrary assumptions, the same unwarranted conclusions.
What, then, are we to do? If, with Mises, we adopt the Market Process as our fundamental ORDNUNGSBEGRIFF, how much of equilibrium can we embody in it? We suggest that we envisage a world in which millions of individuals attempt to reach their individual equilibria, but in which a general equilibrium that would embrace all of these is never reached. The Market Process derives its RATIONALE from, and has its place in, a world in which general equilibrium is impossible. But to deny the significance of general equilibrium is not to deny the existence of equilibrating forces. It is merely to demand that we must not lose sight of the forces of disequilibrium and make a comprehensive assessment of all the forces operating in the light of our general knowledge about the formation and dissemination of human knowledge.
If, with Mises, we reject the notion of general equilibrium, but, on the other hand, do not deny the operation of equilibrating forces in markets and between markets, we naturally have to account for those disequilibrating forces which prevent equilibrium from being reached. In other words, to explain the continuous nature of the market process is the same thing as to explain the superior strength of the forces of disequilibrium.
The market process is kept in permanent motion, and equilibrating forces are being checked, by the occurrence of unexpected change and the inconsistency of human plans. Both are necessary, but neither is a sufficient condition. Without the recurrence of the first, i.e. in a stationary world, it is indeed likely that plans would gradually become consistent as men came to learn more and more about their environment including one another's plans. Without the inconsistency of plans prompted by divergent expectations, on the other hand, it is at least possible that all individuals would respond to exogenous change in such a manner that general equilibrium can really be established. A good deal would here, of course, depend on the speed of such adjustments. Where this is high, each adjustment may have been completed before the next unexpected change occurs. What, however, will in reality frustrate the equilibrating forces is the divergence of expectations inevitable in an uncertain world, and its corollary, the inconsistency of plans. Such inconsistency is a permanent characteristic of a world in which unexpected change is expected to recur.
Within the general framework of the market process, prompted by the two permanent forces whose MODUS OPERANDI we have just attempted to describe, equilibrating adjustments in individual markets, both price and quantity adjustments, will, of course, take place. The equilibrating forces will be found to do their work. But we can never be sure that the spill-over effects which an equilibrating adjustment in one market has on other markets will always be in an equilibrating direction. They may well go in the other direction. Equilibrium in one market may be upset when the repercussions of the equilibrating adjustments in other markets reach it. There is therefore no reason why the effects of such intermarket repercussions must always on balance be equilibrating. But our inability to assess the net result of this interplay of equilibrating forces in different markets does not amount to the discovery of another permanent force which keeps the market process in motion. It is a process within the market process.
We have never been able to understand why in the discussion on Keynes' so-called “underemployment equilibrium” some economists, opposed to Keynesian teaching, should have regarded it as either necessary or desirable to argue that in a market economy the market process, if only left unhampered, would “in the end” tend to bring about full employment. In the light of the considerations presented above such a conclusion appears unwarranted. If the outcome of the contest between equilibrating and disequilibrating forces is at best uncertain, why should it be less so in the case of the labour markets, affected as they are by a variety of factors, many of them non-economic? If we have good reason not to believe in the generality of equilibrium, why should we want to assert that in the labour market alone equilibrium will always come about in the end? The cause of the market economy is not served by such assertions which a deeper understanding of the market process and the complex play of forces on which it rests will show to be fallacious. We have to learn to live with unemployment as with other types of disequilibrium.
It may be useful to elucidate the ideas presented above on market process and equilibrium by restating them in terms of the diffusion of information, somewhat in the manner in which Leijonhufvud has recently interpreted some ideas of Keynes.
We pointed out above that a good deal always depends on the speed of the adjustments following disequilibrium. Where these are made rapidly, equilibrium may be reached before the next unexpected change occurs. Most economists agree that the market is an agent for the diffusion of information, but we may well doubt whether this can be at all regarded as a rapid process. Equilibrium theory, in order to affirm the existence of a strong tendency towards it, has to assume that correct information about equilibrium prices and quantities is readily distilled from market happenings and available to all participants. Otherwise there can be no immediate adjustment. With slow adjustments a good deal may happen in the meantime before equilibrium is reached.
In reality, of course, information will spread slowly because not all participants have the same ability to assess the informative significance of the events they observe. But even apart from this fact, which in any case prevents equal knowledge by all market participants, we have to take note of two further facts which in reality cannot but impede the diffusion of information.
Firstly, nobody can be certain whether an event he has observed constitutes a “real change” or a random fluctuation. He has to wait for confirmation and this takes time. Secondly, nobody knows for how long the information provided by a market event will remain relevant to his plans. In a changing world information which is relevant knowledge to-day may have become obsolete by to-morrow. These two facts, pulling the individual in opposite directions, account for the divergence of expectations.
We thus have to conclude that the diffusion of information does indeed form an indispensable part of the market process and by itself constitutes an equilibrating force. But it is in reality bound to be a rather slow process, likely to be hampered by the divergence of expectations and overtaken by unexpected events.
Mises, as a critic of equilibrium theory and exponent of the Austrian tradition, assumed the rôle of an innovator when he presented his conception of the Market Process as an alternative. It is, however, noteworthy how slowly and gradually the Austrian school evolved these fundamental concepts which serve to unify economic action in society.
In the Walrasian system the notion of equilibrium is employed as a formal device to unify economic action on the three levels of individual, market, and system. This unification is apparently accomplished at one stroke on all three levels. Hence the formal elegance and architectonic unity which have so fascinated many of our contemporaries. But, as we saw, poverty of content is here the price to be paid for elegance of form. While we learn something useful about what governs and unifies individual action, we merely learn a few half-truths about the forces operating in the system as a whole.
The Austrian school presents a very different picture. Here conceptualization and unification are often painfully slow. Even on the level of the individual it took half a century and was not achieved until Schönfeld's WIRTSCHAFTSRECIINUNG of 1924. In the development of Mises' thought as we said above, the idea of the market process was probably conceived 60 years ago, but it was not formulated until the 1930's.
But the slow progress has now brought its reward. We are now able to gain an insight into the complex nature of the forces operating, in particular between markets, which was never dreamt of in the halls of the palace on the shore of the Lake of Geneva.
Mises has provided his disciples with an instrument of thought which promises to be of superb power. In years to come it will be for them to prove their worth by handling it with care and adroitness.
“Human Action”, 1949, p.352.
[1)]“Theoretische Sozialökonomie”, Leipzig 1918, I.Kapitel, para. 6.
[2)]R.M. Solow “Growth Theory. An Exposition”, Oxford 1970, p.2.
“These years, during which Böhm-Bawerk, Wieser and Philippovich were teaching at Vienna, were the period of the school's greatest fame.” F.A. von Hayek, “Economic Thought: The Austrian School.” International Encyclopedia of the Social Sciences, vol. 4, p.461.
Last modified April 10, 2014