(uplifting music) - This is a course of lectures
and discussions on economics. This is the first of two sessions in which I explore the claims
of economics to be a science, like physics or chemistry. And crucial to that claim is that economic systems can be modeled, or explained as equilibrium systems. In other words, equilibrium is crucial to the claim of economics to be a science, like gravity, in the natural sciences. But why should economic systems
tend towards equilibrium? I mean, what's the equivalent of gravity that keeps markets in order? And when we look into that, we find many, many difficulties
because it's not clear. We understand that it's a force of nature in the natural sciences, but we're not absolutely sure what the equivalent is in economics, but nevertheless, that is the claim of economics, that it is governed by laws
which are essentially similar to the laws of gravity in physics. (dramatic music) Is economics a science
like physics or chemistry? Well, I would say no and perhaps most people here would say no, but most economists do think
of economics as a science. The economic world, they say, is a predictable system
just like the natural world. This is because it's governed by reliable, measurable motives, which
can be treated as causes. This means that the test of
a successful economic model is its predictive power. It's because of its ability to
make quantitative predictions that Paul Samuelson called
economics "the queen "of the social sciences." Numbers are its tools. Most of today's economics is mathematical. That is, it tells its story
in equations and statistics. This is because most economists think that reality can only be precisely stated in mathematical form. That this cuts economics off from most people's understanding, does not faze most economists. Mainstream economists believe that a story which cannot be told in maths, is not part of economics, but of some other scientifically
inferior discipline, like history, or sociology, or literature. (laughs) Maths enables economics
to look like a science, but is it actually a science? If so, what kind of science is it? You can put on the uniform of a policeman, but does that make you a policeman? The main idea economics shares
with the natural sciences, is the idea of equilibrium. If equilibrium is a groundless idea, then economics's claim to
be a hard science collapses. Equilibrium is absolutely
crucial to economics's claim to be a hard science. The economist Schumpeter
described equilibrium as the "magna carta of economic theory." The general idea is, that there exist forces in
nature which balance each other. Any disturbance to the balance
will set up an opposing force to rebalance the system. It comes out of natural science, this thinking about the world. Galileo glimpsed the
operation of equilibrium in the curved line drawn by the moon, as it circled the earth. Kepler was then able to describe accurately the path it took, from which Newton deduced
the concept of gravity, a field of force which
pulls matter together. No one has ever seen gravity. It was a hypothesis to
explain Kepler's observation, and many others since. A reliable hypothesis, as it turned out. Mainstream economists believe that the economic world
exhibits something like the principle of gravity. As the economist Alfred Marshall wrote, "If a stone hanging by
a string is displaced "from an equilibrium position, "the force of gravity will
at once tend to bring it back "to its equilibrium position." Now, he wrote that about economics, he was using an analogy, the analogy of the natural world, to explain the concept of
equilibrium in economics. Economic equilibrium is
secured by the forces of supply and demand. The elementary supply and demand diagram shows the quantity of a
good which will be demanded, and the quantity supplied
at different prices. Price of something goes up, the quantity sold goes down, price goes down and the
quantity sold goes up. Now, that seems straightforward and probably quite
reasonable you might think, in a single market, in a local place, although why that should
be so is something we need to talk about. But economists have extended the notion to the equilibrium of the whole system of interdependent markets, and that is General Equilibrium, the theory of Leon Walras, a 19th century French mathematician, who reasoned that if the
whole economy consisted of perfect auction markets, which would include all
markets for future contracts, as well as present contracts, supplies and demands would always be balanced throughout the system, always, instantaneously, the whole time, there'd never be any slumps. There couldn't be. I could shown it, arithmetically, that this was so, it must be right. In Walrasian General Equilibrium, each market establishes
its market clearing price, through a process he called "groping". I'm sure he'd use that word today. At the point of trade, all prices in the economy
have been perfectly adjusted to the supply and demand
conditions in each market. That's equilibrium. Is a state in which the market
has allocated resources so that all the participants, producers and consumers, have got what they set out to get. They have no motive to
change their position. Marshall's pendulum does not swing. Well, despite all these sort
of mathematical scaffoldings, equilibrium in economics is a minefield which can easily blow up in your face. So there are many problems with it, but I just want to concentrate on, say, three of them. Open them up for discussion. First, what is actually
meant by equilibrium, other than just a sort
of banal description? Secondly, is the tendency to
equilibrium a good description of actual behavior in markets, and third, what in human
behavior is the equivalent to the force of gravity which
brings equilibrium about, in the natural world? What is it that pushes down the price of a good in excess supply, or pushes up the price of
a good in excess demand? What causes the market
to behave like a see-saw? Well first, the problem of equilibrium. There are so many so-called equilibria, that it's very hard to know
which one is being used there, the short-run equilibria, long-run equilibria, static equilibria, temporary equilibria, bootstraps equilibria, Nash equilibria, expectational equilibria, real equilibria, and they all seem to be, we seem to, they're used rather promiscuously. The word equilibrium
encompasses the whole lot, and we need to be very, very clear about which equilibria we are talking about, in any particular topic of interest. But at least we, I think have to distinguish
between three types. First of all, an Optimal Equilibrium. I think that situation, in
which everyone's profit, or utility, is maximized, so no one can do better
than they are doing, by changing their behavior. And I think that really only applies to a situation, not just created by the market, but the general potential
of the economic activity, it is fully realized. That would be an optimal equilibrium, we can discuss it a bit more. Then there's the Keynesian
Under-Employment Equilibrium, in which a labor surplus coexists with a deficiency of demand. Supply and demand are out of phase, but there's nothing that
can be done about it, within the market, and therefore it's a static situation. Here, the equilibrium is not
a point of optimal deployment of resources, but a point of rest. It's just a point of rest. No one has any incentive to change it within the market
system, within that market. A Keynesian equilibrium
arises when the business class can do no more investment then it's doing, because of the state of affective demand. In other words, Keynes makes the quality
of the equilibrium dependent on the quantity
of demand in the economy. It's a macroeconomic concept. There's a lot of argument, by the way, about whether the Keynesian equilibrium is temporary equilibrium, or whether it can persist and if it's temporary, for how long. So that's the argument about that. Then there's a third type of equilibrium, which is Dynamic Equilibrium, in which all the quantities
which determine the equilibrium are changing at the same speed, or the same rate, so the relative ratios of prices and quantities are unaffected. So three types of equilibria, many more, now, a second problem, is this. Does the notion of pendulum swings have any part to explain the
actual movement of economies through time? Is the idea of movement
more accurately explained by the notion of dis-equilibrium, than by transitions between
two points of equilibrium? That needs to be talked about. As for the third question, what is the economist's
equivalent to the law of gravity? The answer is contained in a
single powerful hypothesis, and that is self interest. Self interest is the gravitational force which makes economic
behavior as predictable as the behavior of the planets. You can always on X's self interest to achieve the result, you know, that you perhaps are aiming for. If you can assume that market participants are reliably governed by self interest, then, so the argument goes, you can reliably predict what
they will pay for a quantity of something. Self interest isn't just
greed, it's rational greed. And to achieve a good equilibrium, markets have to be fully decentralized, or competitive, and the rational greed, I mean rational greed is of course, you can apply that concept
to a monopolistic market, but still, in a monopolistic market, that's not the best
possible state of affairs for everyone, but it can be quite stable, with the monopolist
being a rational agent. If Marshall's Pendulum is set in motion by unexpected shocks, how long does it swing
before it stops swinging? In other words, how long are deviations from
equilibrium supposed to last? Most mainstream economists would say that given the conditions of rationality, assumed conditions of rationality, and perfect information
and those sort of things, the swings would be short and shallow. That was, of course, the
assumption after 2008-2009. There'd be a V-shape, very, very brief, economy collapses, within a month, it's up again. You know, something like that. Therefore, you know,
didn't have to do anything. It was a great surprise when it seemed that wasn't happening. But how long are these deviations? The idea that equilibria, once disturbed, take time to establish themselves, has given rise to the crucially
important idea of frictions. Gravitation in physics
depends on the existence of a vacuum. The law of gravitation
has high predictability because frictions are very small. But nothing like a vacuum
exists in economic life. There's always a lot of friction. These frictions are
caused by human beings. Their existence, unfortunately, is something that can't be ignored, even by economic theory. So, the existence of
frictions then seems crucial to the defense of equilibrium. This word, taken from physical
and engineering sciences, signifies a resistance to the
efficient sliding together of parts of the market system. Frictions do a huge amount of work in maintaining the grand theory of equilibrium economics, by explaining the possibility
of deviations from it, without endangering the core doctrine. The existence of frictions, such as, one of the most famous frictions, of course, is sticky wages. It might explain persisting unemployment. To the fervent globalist, national frontiers are frictions to the more perfect
integration of markets. When humans are shown not to
possess the properties needed for perfect deficiency, they, too, become frictions. Now, the prescription for frictions, is to try and minimize them, so as to maximize market efficiency. Neoclassical economists
see no great difficulty about doing this. To minimize the length
and severity of frictions was the main aim of the
rational expectations revolution of the 1970s. The promise of continually
fulfilled expectations gives neoclassical economics
a lot of its crusading zeal. I think this whole way of
thinking about economies, their tendency, natural
tendency to equilibrium, the shallowness of the frictions, has a baleful effect on policy. It leads to the unthinking
belief in the automatic tendency of a market system to an optimal, or at least satisfactory equilibrium, provided it's not interfered with. Therefore, the best policy, is laissez-faire. Let things be. That sort of persists, really, all the way through the
history of economics, despite all the exceptions. In conclusion, what is the status of
equilibrium theory today? It's still implicit, I would argue, in neoclassical reasoning, even if not literally believed in, it is clung to as a sort of benchmark needed to judge imperfect performance, rather like, you need a model answer if
you have an exam question, you need a model answer, you set the, then you say well,
that's seven out of ten. Or that's, you know. But you could do better
if you have this model. Heterodox economists
have abandoned the notion of a natural tendency of markets towards an optimal equilibrium. Keynes pointed out that the economy doesn't
self-correct itself, through relative price adjustment, as equilibrium theory claims. All prices tend to move
one way or another, as a consequence of production
decreasing or increasing. It's important, in understanding
the Keynesian system, to understand that he
didn't abandon the idea of equilibrium in his model, only he thought that the equilibria, that most equilibria weren't optimal. Since then, others have abandoned the idea of equilibrium entirely
as self-contradictory, an economy in motion
can't have points of rest. Well, it can, but I mean, why should it? Kaldor, Lachman, Robinson, Shackle, have all argued that
ignorance excludes the use of equilibrium models. Ignorance, but of the future, will bring. Schumpeter is a tormented soul. He clings to the idea of equilibrium, but of course his famous
notion of creative destruction, is quite contrary to it. Equilibrium refers to an
economy of given known and constant external conditions, such as tastes and technology, and Schumpeter proves that
these are always in flux. So, he wants to be a
neoclassical economist, but his genius keeps breaking through, and he can't do it. But apparently, in the
last days of his life, he was doing simultaneous equations and all kinds of things, just to sort of prove to himself that he could do some maths. In the Schumpeterian analysis
that's come down to us, external conditions not only change, but such change is fundamental
to a capitalist economy. "Entrepreneurs try out innovations, "which in a process of
creative destruction "replaces tried methods." "Increasing destruction
of age old relationships "for the sake of progress." That's how Schumpeter described. Where is equilibrium in this? It's going on the whole time. Marx said exactly the same thing. Capitalism is constantly
revolutionizing the means of production, and the social relationships
of each productive stage. So, just to end, how do we explain the continued hold of equilibrium thinking? First, it's explained by
the longing of economists for the certainty of the natural sciences. Second, is the conviction
that underneath the messiness of appearances, there exists an underlying order which can be captured by logic and maths. This goes all the way back to Descartes. Equilibrium is thus a
mental construct designed to explain a feature of nature, which is not evident
when you first see it, when you look at it, namely, the principle of orderliness. I have one final
reflection on equilibrium. Just reverting to it
as a notion of balance. If a principle of balance
exists in social life, it's something much wider than
the balance of the market. The market is just part
of that wider balance. It lies in the natural tendency of an excess in one direction, producing its opposite. And I think that is the
basis of historical cycles. The cycles that have
interested historians, not just economists, I'm not just talking
about con gratia cycles, or eugla cycles, or the cycles that economists
do recognize as deviations, or exceptions from their
general notion of equilibrium. I'm talking about, you know,
full-blooded historical cycles. The rise and decay of
certain civilizations. The autonation between democracy and authoritarianism dictatorship. The autonation between
puritanism and excess, puritanism and licentiousness, I mean these things go
on all through history. And they do tend to, in the end, produce some balance, as one excess is canceled out and leads to the pendulum swinging back. But these cycles are far too loose to have the precision required for the prediction of specific events. So, I wouldn't repudiate
the idea of equilibrium, and the pendulum swinging, but it's a much broader idea
than the economists notion of equilibrium.
