May 10, 2016

The market economy is inherently unstable and economists never grasped it

Comment on Lars Syll on ‘Frank Ackerman on general equilibrium theory’


The core of the familiar narrative is: supply and demand interact over all markets with the result that (I) the system as a whole is stable, and (II), the outcome of the adaptation process is optimal in a well-defined sense. This implies that the labor market is cleared, in other words, full employment obtains.

Lars Syll critically summarizes: “Almost a century and a half after Léon Walras founded general equilibrium theory, economists still have not been able to show that markets lead economies to equilibria. We do know that — under very restrictive assumptions — equilibria do exist, are unique and are Pareto-efficient.” (See intro)

The claim ‘We do know that ... equilibria do exist’ is provably false. Economists are in a state of severe self-delusion. The proof is straightforward.

Standard economics is built upon this set of foundational propositions, a.k.a. axioms:
HC1 economic agents have preferences over outcomes;
HC2 agents individually optimize subject to constraints;
HC3 agent choice is manifest in interrelated markets;
HC4 agents have full relevant knowledge;
HC5 observable outcomes are coordinated and must be discussed with reference to equilibrium states. (Weintraub, 1985)

Methodologically, these premises are forever unacceptable but economists swallowed them hook, line and sinker from Jevons/Walras/Menger onward to DSGE.

One obvious blunder consists of taking equilibrium into the premises. HC5 is what is known since antiquity as petitio principii. Generally speaking, it has to be DEMONSTRATED that a system converges toward a well-defined state, and because of this, it is methodologically INADMISSIBLE to take this end state into the premises. At the very beginning of the analysis, we simply do NOT KNOW whether an equilibrium exists or not. Joan Robinson ridiculed the senselessness of the so-called existence proof: “After putting the rabbit into the hat in the full view of the audience [with HC5], it does not seem necessary to make so much fuss about drawing it out again.” (quoted in Harcourt, 2010, p. 48).

What has to be done is to fully replace the whole set of Walrasian microfoundations with methodologically correct macrofoundations. The paradigm shift is achieved as follows.
(A0) The objectively given and most elementary configuration of the (world-) economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm.
(A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L,
(A2) O=RL output O is equal to productivity R times working hours L,
(A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

For the graphical representation of the ABSOLUTE formal MINIMUM see link #1. A1 to A3 asserts: At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the ADDED preliminary conditions of (i) budget balancing, i.e. C=Yw, and (ii), market clearing, i.e. X=O.

Under the conditions (i)|(ii) the price is derived in each period as P=W/R (1), i.e. the market-clearing price is in the most elementary case equal to unit wage costs. This is the simplest form of the macroeconomic Law of Supply and Demand.

The first point to notice is that the real wage W/P is invariably equal to the productivity R according to (1). So, for the economy as a WHOLE, the marginal principle does NOT hold. This explodes the welfare theorems which ultimately depend on HC2.

The second point to notice is that monetary profit, i.e. Qm≡C−Yw, in the most elementary case of the pure consumption economy is zero because of (i). For profit/loss to emerge this condition has to be lifted.

Note that the product market is cleared due to condition (ii), and it has been left open so far HOW this is done in practical detail. We focus here on the labor market and not on the product market.

It is assumed now for a start that actual employment L is below full employment Lf. There is no need to define Lf at this stage in greater detail.

Now, the usual behavioral assumption is added that the wage rate W falls as long as there is unemployment, i.e. as long as L−Lf is less than 0. What happens then? From (1) follows that the price falls and that the real wage is invariably equal to the productivity R. The profit of the business sector is again zero. Hence, the wage reduction does NOT increase profit.

For the firm/business sector, there is no motive to move in any direction. All employment levels are INDIFFERENT with regard to profit. There is no such thing as equilibrium/ disequilibrium. The wage reduction can be repeated for an arbitrary number of periods, the only result is deflation. The flexible fall of the wage rate cannot clear the labor market.

This holds for the elementary case of the pure consumption economy. Perhaps things change when the business sector is differentiated? So, in the next step, the investment economy has to be investigated.

To cut the meticulous formal derivation short (2015; 2014; 2012), the most elementary version of the Employment Law for the economy as a whole is shown on Wikimedia: #2

From this equation follows:
(i) An increase of the expenditure ratio ρE leads to higher employment L (the letter ρ stands for ratio).
(ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
(iii) An increase in the factor cost ratio ρF≡W/PR leads to higher employment.

The complete Employment Law is a bit longer and contains in addition profit distribution, public deficit spending, and import/export. Employment is now the dependent variable, the price is among the independent variables.

Item (i) and (ii) are familiar since Keynes. What is missing in the Keynesian employment multiplier, though, is the ratio ρF as defined in (iii). This variable embodies the price mechanism. It works such that overall employment INCREASES if the average wage rate W INCREASES relative to average price P and productivity R and vice versa.

This is the very OPPOSITE of what economics teaches. “We economists have all learned, and many of us teach, that the remedy for excess supply in any market is a reduction in price. If this is prevented by combinations in restraint of trade or by government regulations, then those impediments to competition should be removed. Applied to economy-wide unemployment, this doctrine places the blame on trade unions and governments, not on any failure of competitive markets.” (Tobin, 1997, p. 11)

The general adaption rule for competitive markets DESTABILIZES the system. This is what happened during the Great Depression. The explanation of unemployment is given by the fact that the price mechanism does NOT work as the representative economist hallucinates. Economists are PROVABLE wrong with regard to the two most important features of the market economy: (a) the profit mechanism, and (b), the price mechanism. This holds for Walrasians, Keynesians, Marxians, and Austrians.

Egmont Kakarot-Handtke

Harcourt, G. C. (2010). The Crisis in Mainstream Economics. real-world economics review, (53): 47–51. URL
Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Disaster. SSRN Working Paper Series, 2130421: 1–19. URL
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL
Tobin, J. (1997). An Overview of the General Theory. In G. C. Harcourt, and P. A. Riach (Eds.), The ’Second Edition’ of The General Theory, volume 2, pages 3–27. Oxon: Routledge.

#1 Wikimedia AXEC31
#2 Wikimedia AXEC62