February 2, 2014

Nominal and real distribution

Comment on 'Pareto-efficiency, Hayek’s marvel, and the invisible executor'


The crucial point is this. General equilibrium models are “real” in the sense that money and nominal magnitudes play no role. In a more critical vein it can be said that these models cannot deal with a monetary economy at all. Yet, as we all know, that is the economy we live in. Hence the “real” core of standard economics has, as a matter of principle, nothing to say about the real reality.

You correctly point out that the example I have taken from Cassidy is odd because the criterion of Pareto-efficiency applies in the strict sense exclusively to a “real” model.

This, however, is forgotten when it comes to the discussion about efficient markets and optimal allocation. For a monetary economy the efficiency results have never been proven. It is only by analogy that people think that, admittedly under idealized conditions, the price system works also in a monetary economy towards Pareto-efficiency. Cassidy's example is a case in point. But Cassidy is only echoing Hayek.

The really odd thing is that you have readily identified the weak spot but that Cassidy himself and the referees, proofreaders, consultants and whoever was involved in producing his qualitatively outstanding book overlooked it. It seems that Cassidy never got a critical comment from a neoclassical economist about the misrepresentation of the Pareto criterion.

My idea of resolving the problem is simply not to apply the Pareto criterion to the monetary economy. It was not designed for this environment and it is positively misleading in any discussion about the working of the price system. If you accept Pareto-efficiency as a benchmark then most real-world markets “fail”. Is a thunderstorm a “failure” of an otherwise optimal weather system? Definitively not. The Pareto criterion establishes an unacceptable frame of reference.

In sum: The marvel of the price system consists not so much in informational and allocative efficiency, which is not defined for the monetary economy with flexible nominal prices, but in smooth real redistribution.

Egmont Kakarot-Handtke