Equilibrium is a core idea of neoclassical economics, but...
Appears to be a persistent fiction
Economic equilibrium as a core idea
Economic equilibrium is accepted as a core idea of neoclassical economics, but where did this idea come from?
Adam Smith?
The word equilibrium does not appear in either of the major works of Adam Smith, The Theory of Moral Sentiments (1759) or The Wealth of Nations (1776).
He did however write a chapter in The Wealth of Nations titled “Commodities’ natural and market prices” which includes such gems as:
“These ordinary or average rates may be called the natural rates of wages, profit and rent at the time and place in question.”, and…
“The actual price at which a commodity is commonly sold is called its ‘market price’. It may be the same as its natural price or above or below it.”, and…
“So the natural price is, as it were, the central price to which the prices of all commodities are continually gravitating. Various events may sometimes keep them suspended a good deal above it, and sometimes force them down somewhat below it. But whatever the obstacles to their settling in this centre of repose and continuance, ·the natural price·, they are constantly tending towards it. . . .”.
It sounds like his use of “natural” describes “equilibrium” but it may be other people came along later and created that equivalence for us. Either way, I’ve heard economists talk as if Smith believed in equilibrium.
David Ricardo?
David Ricardo also never used the word “equilibrium” in his books either.
However in Principles of Political Economy and Taxation (1817), he included a chapter titled “On Natural and Market Price”, which includes:
“In making labour the foundation of the value of commodities, and the comparative quantity of labour which is necessary to their production, the rule which determines the respective quantities of goods which shall be given in exchange for each other, we must not be supposed to deny the accidental and temporary deviations of the actual or market price of commodities from this, their primary and natural price.”, and…
“Let us suppose that all commodities are at their natural price, and consequently that the profits of capital in all employments are exactly at the same rate, or differ only so much as, in the estimation of the parties, is equivalent to any real or fancied advantage which they possess or forego. Suppose now that a change of fashion should increase the demand for silks, and lessen that for woollens; their natural price, the quantity of labour necessary to their production, would continue unaltered, but the market price of silks would rise, and that of woollens would fall; and consequently the profits of the silk manufacturer would be above, whilst those of the woollen manufacturer would be below, the general and adjusted rate of profits.", and…
“It is then the desire, which every capitalist has, of diverting his funds from a less to a more profitable employment, that prevents the market price of commodities from continuing for any length of time either much above, or much below their natural price.”.
Again, Ricardo seems to be talking about what we now call equilibrium without using the word equilibrium.
Others?
An article on the website of the Institute for New Economic Thinking titled Theories of Economic Crises1 contains nineteen instance of the word “equilibrium”:
“…as an unexpected shock that moves (transiently) away from an equilibrium position…”, and…
“…as oscillations around a long-term trend and as a transitory deviation from a position of equilibrium.”, and…
“…to equilibrium levels of production and employment corresponding to the full use of the productive forces,”,
You can click the footnote link above to read the other sixteen, but you get the general idea.
Then why are we constantly monitoring and adjusting?
Various entities are constantly monitoring and adjusting “economic levers” in an attempt to “move the economy” where they feel it needs to go.
I’ll use US entities here as the US is still the 800 pound economic gorilla in the global economy, but these ideas are not unique to the US.
Here is a partial list of various entities who monitor economic data and make adjustments that are both within their legal purview and which they deem to be necessary:
Banking System: Monitoring and interventions by the Federal Reserve
Congress has delegated specific monitoring and interventions to the federal reserve banks.
The word “reserves” appears a few times below. Reserves are nothing more than money in an account at the federal reserve. For banks, they serve two main purposes:
Interbank payment settlements. If I pay you $100 and my account is at one bank while your account is at another, three things have to occur. 1) My bank takes $100 out of my account. 2) They give that money to your bank. 3) Your bank puts that money into your account. Step 2 is done with reserves.
They are money banks can draw upon to satisfy depositor withdrawals.
NOTE: Contrary to a popular belief, banks do not, and can not, lend out reserves2.
Set the federal funds rate
Everyone knows the Fed sets interest rates, but there are lots of interest rates. Mortgages, car loans, credit cards, etc. all have different interest rates. The Fed sets ONE of these and it’s what is called the federal funds rate3. The federal funds rate is the interest rates banks pay for short terms loans of reserve balances they make to each other4. All other interest rates are set, by lenders, relative to this rate.
Change collateral eligibility rules
The Fed loans reserves to banks using various forms of collateral. Ordinarily the Fed loans reserves for treasury securities, so when a bank needs more reserves, the bank transfers ownership of some treasury securities to the Fed, which they plan to buy back later.
However, they are allowed to accept other forms of collateral5, and they can add to their list in times of market stress or emergency situations6.
After the 2008 financial crisis, the Fed established an Agency Mortgage-Backed Securities (MBS) Purchase Program, where they bought (not borrowed) “toxic assets” (mortgages that would never be paid back) from banks in exchange for reserves.
Bank supervision
Banks have two primary functions: hold deposits and make loans.
A standard “business equation” is “assets - liabilities = equity”. And while other types of business are legally allowed to operate with negative equity, banks are not.
A bank with negative equity is insolvent and goes into a formal receivership shutdown7.
The Fed monitors the banks in the federal banking system, and if and when a bank becomes insolvent, it supervises the shut down process.
This may involve paying depositors out of the Federal Deposit Insurance Corporation (FDIC) fund and may involve the sale of the insolvent bank to another bank.
The US dollar valuation: The Exchange Stabilization Fund (ESF)
The US Department of the Treasury contains the ESF and they stabilize the value of the US dollar by buying and selling US dollars on the foreign exchange market8.
This occurs on a massive scale
To give you some perspective on the scope of this, the foreign exchange market (ForEx) is the largest market, by transaction volume, on earth.
Check out these daily transaction volumes:
The NY stock exchange: $2.4 B per day for the first four months of 20249.
NASDAQ: Around $300 B to $400 B per day10.
Chicago options exchange: For 2024, the average daily trading volume has been $2.7 T per day.
ForEx: For 2024, daily transactions volumes were between $4.5T and $6.5T11. The US dollar was involved in 88% of daily transactions12.
If currencies is what we buy things with, what do we buy currencies with?
Other currencies.
Calling currency swaps buying and selling does seem to be stretching the meaning of those words as it’s always a currency swap, but we do call it buying and selling.
This is in fact how nations devalue their currencies
I’m sure you’ve heard that county X has devalued their currency. As near as I can tell, the way they do it is:
Within their institutions, they create more of their currency.
They take that currency to the ForEx and swap it for some others currency.
This reduces the value of their currency relative to that other currency.
Of course if they took some of the others currency and used it to swap for some of theirs, they would increase the value of their currency relative to other currencies.
The US Department of the Treasury Exchange Stabilization Fund does this for the US dollar
I can’t find specific transaction volumes, so I don’t know if they buy and or sell US dollars every day, every week, etc., but we know this function exists within the US treasury and they buy and sell US dollars relative to other currencies to maintain a stable value for the US dollar relative to those other currencies.
Does constant interventions contradict equilibrium?
In other words, if economic equilibrium is a thing, why do we need to constantly monitor and intervene? If markets return to equilibrium, why not just let them?
It seems to me the obvious answer is because the powers that be, the ones doing all the monitoring and intervening, know that idea of economic equilibrium is not true.
We simultaneously promote two ideas that seem contradictory to each other. The first idea is that markets have rules (which ALL markets do) and the second idea is that markets return naturally to equilibrium when some external shock pushes them out of equilibrium.
This can only make sense when the rules of the markets “just are” and are not created and periodically changed. But of course the rules are markets ARE created and periodically changed.
I present two specific examples from history, where holding those two contradictory ideas at the same time had disastrous consequences.
Ireland: 1845 to 1852: Markets have rules vs markets self correct
Prior to 1845, a variety of factors (including British commercial interests and Irish land management practices) created a dominant crop in Ireland, potatoes, and they grew a fairly small variety of species with high yields.
So when the potato blight showed up in 1845, the crop failures were so widespread, they stopped potato production in Ireland. As potatoes were the main source of calories for Irish people, the people in Ireland started to starve.
The British government adopted a policy of non interference in support of the idea of laisse-faire economics. This allowed food producers to store food for export in warehouses which were in view of starving people.
And somehow, the idea that the rules of the market were created by laws designed by people, and the idea that the market should be left alone to self correct, did not seem contradictory.
Yet, if economic equilibrium IS a thing, at all, it’s a thing within a defined set of rules for the market, which were not handed down by God on a set of stone tablets, but rather were arbitrarily created by men.
What seems to me to be an obvious reality, that the rules for markets are “just” made up, doesn’t seem to have occurred to anyone in charge during this crisis.
USA: 1929 to 1941: Again, markets have rules vs markets self correct
We know this period as the Great Depression.
Like most, if not all, major financial crisis’s, this was triggered by too many people having debts they had no chance of repaying, which in turn was triggered by a lot of people buying stocks on margin (with debt).
As long as the value of the stocks continued to rise, everything was great. But when the value of the stocks started to fall, the demand for immediate debt repayments (margin calls) that could not be met, made many banks insolvent overnight. A bank is insolvent when the simple equation “assets - liabilities = equity” results in equity being less than zero.
This resulted in a ripple effect of bank shutdowns and insolvencies and shutdowns and insolvencies, etc., which in turn resulted in a significant contraction of the amount of US dollars in circulation, which in turn resulted in a significant contraction of the economy.
The initial idea is that the market would return to equilibrium and full employment on its own.
Three plus years in this still had not happened, and the US Senate Committee on Finance conducted hearings on what to do.
Those hearings started February 13, 1933 and witnesses testified for 16 days. Witnesses were invited based on their business and business leadership experience and reputation.
The general tone of most witnesses seems to be that the economy would return to equilibrium and full employment on its own, so the best course of action was to take no specific actions.
However, a wealthy Utah banker named Marriner Eccles disagreed.
He was invited to testify as in the west he was a very well respected banker, in Washington DC he was unknown but vetted by people who were, and none of his banks in the west had failed.
His disagreement with his peers was NOT minor.
What’s really interesting, at least to me, is in Feb of 1933 he gave the US Senate Finance committee a lesson on what would later be known as Keynesian Economics, and he did so three years prior to Keynes publishing the book in which he laid out those ideas.
Eccles then proceeded to promote a series of government programs that would later become known as The New Deal.
To paint a fuller picture, Marriner Eccles was a millionaire Republican Mormon. As such, not your typical big government tax and spend liberal.
From his deep knowledge of how banking works, he inferred that the circular flow of money in the economy would not resume until ordinary people had money to spend.
Eccles knew banks create money when they make loans (something some economist today seem not to know), and without an increase in credit, the money supply would not expand, and without an expanding money supply firms would not sell more, and without firms selling more they wouldn’t increase hiring.
Firms sales were low because too many people had no money to buy with, but since firms were not hiring, too many ordinary people didn’t have incomes.
And no amount of equilibrium was going to change that.
Some economists now say economic equilibrium IS fiction
I had the following brief exchange with Richard Werner over Twitter.
And a quick search on Perplexity for papers that challenge the notion of economic equilibrium returns an article whose headline read “Study suggests a key assumption of economic theory may be wrong”13.
That article contains these gems:
“The concept of equilibrium, one of the most central ideas in economics and one of the core assumptions in the vast majority of economic models, may have serious problems, concludes a study from the Institute for New Economic Thinking at the Oxford Martin School.”, and…
“Pangallo [one of the researchers] concluded, “These findings suggest that in complex and competitive systems, new approaches to economic modelling are required that explicitly simulate behaviour and take into account the fact that real people are not good at solving complicated problems.”.
In closing
I would suggest that we have numerous examples of things happening, that would not have happened if economic equilibrium was real, and I’m encouraged to see some economists today reject the idea.
I’m not sure how long it will take for the lack of or absence of economic equilibrium to be recognized as a valid concept we need to incorporate into our economic modeling, but I personally think the evidence of overwhelming, so the sooner the better.