Uneasy Money

As an addendum to yesterday’s post I will merely quote the first three paragraphs of Franklin Fisher’s entry in The New Palgrave on “Adjustment Processes and Stability.” The whole article merits careful attention and study as does his great book Disequilibrium Foundations of Equilibrium Economics. See also a previous post of mine on Fisher’s work

Economic Theory is pre-eminently a matter of equilibrium analysis. In particular, the centerpiece of the subject — general equilibrium theory — deals with the existence and efficiency properties of competitive equilibrium. Nor is this only an abstract matter. The principal policy insight of economics — that a competitive price system produces desirable results and that government interference will generally lead to an inefficient allocation of resources — rests on the intimate connections between competitive equilibrium and Pareto efficiency.

Yet the very power and elegance of equilibrium analysis often obscures the fact that it rests on a very uncertain foundation. We have no similarly elegant theory of what happens out of equilibrium, of how agents behave when their plans are frustrated. As a result, we have no rigorous basis for believing that equilibria can be achieved or maintained if disturbed. Unless one robs words of their meaning and defines every state of the world as an “equilibrium” in the sense that agent do what they do instead of something else, there is no disguising the fact that this is a major lacuna in economic analysis.

Nor is that lacuna only important in microeconomics. For example, the Keynesian question of whether an economy can become trapped in a situation of underemployment is not merely a question of whether underemployment equilibria exist. It is also a question of whether such equilibria are stable. As such, its answer depends on the properties of the general (dis)equilibrium system which macroeconomic analysis attempts to summarize. Not surprisingly, modern attempts to deal with such systems have been increasingly forced to treat such familiar macroeconomic issues as the rule of money.

We do, of course, have some idea as to how disequilibrium adjustment takes place. From Adam Smith’s discussion of the “Invisible Hand” to the standard elementary textbook’s treatment of the “Law of Supply and Demand”, economists have stressed how the perception of profit opportunities leads agents to act. What remains unclear is whether (as most economists believe) the pursuit of such profit opportunities in fact leads to equilibrium — more particularly, to a competitive equilibrium where such opportunities no longer exist. If one thinks of a competitive economy as a dynamic system driven by the self-seeking actions of individual agents, does that system have competitive equilibria as stable rest points? If so, are such equilibria attained so quickly that the system can be studied without attention to its disequilibrium behaviour? The answers to these crucial questions remain unclear.