Continual Erosion and the "General Equilibrium"

The onslaught against the market economy in the first half of the 20th century was launched on two flanks, micro and macro.1 The micro attack was itself based on the proposition that perfect competition was a necessary condition for markets to work satisfactorily, and that equal distribution was a necessary condition for markets to be just. This led to the conclusion that, since perfect competition was nowhere to be found and just distribution could only be defined by social choice, the free market should not be trusted to maximize welfare. This conclusion was shared both by anti-market ‘literary’ economists (as Paul Samuelson called them), and by mathematical economists partial to planning.

The macro attack was led by John Maynard Keynes, after the Great Depression had thoroughly undermined confidence in the free market system. Indeed, a few years before he had proclaimed “The End of Laissez Faire” (1926) [emphasis modified]. As was to be expected, in his General Theory of Employment, Money, and Interest (1936) he would propose the theory that modern economies tended to find themselves in the doldrums of unemployment equilibrium, and that the remedy lay in the hands of governments, in their role as saviors of bourgeois civilization.

The two forces, micro and macro, were finally gathered under the banner of the neo-classical synthesis, championed by Samuelson. Thus the last nail was planted into the coffin of classical liberalism… or was it?

To answer this question I now intend to arraign a representative group of three economists who had a hand in the hibernation of economic liberalism in the first half of the 20th century. Of the literary sort I will take on Arthur Pigou and leave aside Joseph Schumpeter for I have written a past column on this seductive anti-bourgeois socialist.2 Of the mathematical planners I will concentrate my fire on Oskar Lange, who tried to establish ‘market socialism’ in Soviet Poland. Finally, I will dare take on Paul Samuelson, the supremely gifted eclectic, the mathematician who helped dress soft liberalism in scientific garb. In my column next month I will play State’s Attorney and try to censure their ideas with the help of the luminaries of the great scientific revival of liberalism of the second half of the 20th century.

Arthur Pigou’s The Economics of Welfare3 (1924) is one of the most successful books in political economy and one of the most harmful. Pigou followed in the footsteps of John Stuart Mill, who had been the first to classify market failures as derived from imperfect knowledge, defective market mechanisms and capital indivisibilities. 4 It was logical for Pigou to show that these three kinds of failures resulted in positive and negative ‘social’ effects and to propose state interventions to correct them. In Part II, chapter VIII of his work he made the crucial distinction between the social net product and the private net product of a nation and proposed diverse public interventions to bring them together.

By the “social net product” is meant the aggregate contribution made to the national dividend; by the “private net product” the contribution (which may be either greater or less than the above) that is capable of being sold and the proceeds added to the earnings of the person responsible for the unit of investment.

Pigou posited the inequality between the social and the private product as the norm. Only public intervention could fill this chasm.

It is evident that, in general, industrialists are interested, not in the social, but only in the private net product of their operations. Clearly, therefore, self-interest will not tend to bring about equality between the values of the marginal social net products of investment in different industries. (Page 151)

Pigou then proceeds to list a number of cases in which private net product falls short of social net product “because incidental services are performed to third parties from which it is technically difficult to exact payment”. His examples were, among others, light-houses, private parks in cities, roads and tramways, private forests, smoke abatement, scientific research. Then he listed investments whose private product is larger than the social, such as game feeding on neighbours’ lands, nuisance from factories in residential quarters, overcrowding in cities, financing wars abroad or having women work in factories before or after childbirth. He finally mentioned the psychological loss of consumers from seeing others consume better or newer goods than they. For Pigou, almost any production or consumption had a public dimension that needed correction with “bounties and taxes”. (Page 170) Pigou nowhere mentioned competition as a possible corrective force to equate social and private net product, in contrast with later economists of the mathematical school who posited that these unwelcome phenomena would disappear with perfect competition. Barring this, the reader will be struck by how modern Pigou’s list is and how up to date the suggestion that taxation and subsidies be ready to hand to correct the failings of the market. Except for the mention of the possible failures of the state which a present day interventionist might add, the Pigovian doctrine has become the accepted doctrine of the profession (until Ronald Coase proved it wrong, as I will show in my next column).

Let me now turn to the mathematical school of economists, who tried to be neutral with regard to the respective advantages of the free market and the command economy and so in effect undermined the system of economic liberty.

It is ironic that the more elaborate proposals for collectivist planning were based on the General Equilibrium theory of Léon Walras (1834-1910), a theorem that showed how right Adam Smith was in his intuition that all the different parts of an economy continually tended to be in harmony.5

Walras was himself a man of deep socialist convictions. Once he was able to model a purely competitive economy in equilibrium, that is to say an economy at its optimum because there was a perfect fit of all demands and supplies, he concluded that one did not need a real market to reach a social optimum—a lesson soon learnt by Walras’s disciples, including Oskar Lange.

The great discovery of Adam Smith was that in human societies a most improbable and unintended order emerged, with nobody designing it or governing it. This elevates him to the same scientific level as Charles Darwin, who generalized this idea of emerging order by applying it to nature as a whole.6 Smith sees self-interest as giving the necessary impulse: “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from the regard to their own interest”.7 (I, ii) Thereby and unknowingly,

[… ] every individual necessarily labours to render the annual revenue of the society as great as he can. [Though he] generally, indeed, neither intends to promote the publick interest, nor knows how much he is promoting it […] he is in this, as in many other cases, led by a hidden hand to promote an end which was no part of his intention. (IV.ii).

Not only is the individual mostly unaware of the general order that he and his likes are promoting; but he cannot follow how this order functions in detail because the division of labor and the use of money hide the connecting pathways from his sight. Given the immense complexity of the economic system, it seems a miracle that we live in societies so improbably ordered: for Smith’s intuition implies that demands and supplies should tally, that investments should find the necessary savings, that the institution of money should help tide people over when their planned income does not arrive in time for their planned expenditure—all this spontaneously.

Smith’s vision, however, was not based on the belief that there was a metaphysical harmony in society, as say some of the critics of classical liberalism. Dr. Smith was not Dr. Pangloss. What would have been the point of writing the An Inquiry into the Nature and Causes of the Wealth of Nations if everything was for the best in the best of all possible worlds?

In 1926 Keynes wrote an essay tellingly titled “The End of Laissez-Faire”. He there wanted to set aside ‘the metaphysical principles’ on which laissez- faire had been grounded.

It is not true that individuals possess a prescriptive ‘natural liberty’ in their economic activities. There is no ‘compact’ conferring perpetual rights on those who Have or those who Acquire. The world is not so governed from above that private and social interests always coincide. It is not so managed here below that in practice they coincide. It is not a correct deduction from the principles of economics that enlightened self-interest always operates in the public interest. Nor is it true that self-interest generally is enlightened; more often individuals acting separately to promote their own ends are too ignorant or too weak to attain even these. Experience does not show that individuals, when they make up a social unit, are always less clear-sighted than when they act separately. (1926, pages 287-288)

A passage less in accordance with Adam Smith (and with the reality of markets) could scarcely be imagined.

Let me leave Keynes’s anti-market metaphysics aside and see in what way General Equilibrium theory can contribute to a Smithian view of the economy. Order in market economies is far from perfect, but it would be a great advance to show that it was possible in principle and at the limit. It was Léon Walras (1834-1910) who opened the way to proving mathematically that such a system was indeed consistent. With the help of a model based on the assumption of perfect competition, he showed that a market economy could reach a state of general equilibrium, where all those Smithian equalities (demands and supplies, savings and investments, money in measure and transaction) held stably.8

Now, out of this Walrasian model and its proofs two very different traditions developed. One was to use the idea of perfect competition, unrealistic though it was, as a foil to discover real life distortions: the model helped diagnose unexpected repercussions and feedbacks of any policy change or institutional reform if restrictions in the rest on the economy subsisted and could make the change or reform backfire. For example, not every removal of a tariff on imports would make overall trade freer, because this partial liberalization could increase the degree of protection of the rest of the economy.9 This line of tradition, known today as ‘applied general equilibrium’, follows the Popperian methodology of making observable predictions and falsifying them by observation or experiment. It has been used by Milton Friedman, Gary Becker and their many disciples of the Chicago School. Thus, Friedman (1957) presented a statistical model which falsified Keynes’s theory of the consumption function; and Becker (1981) was able to devise economic explanations of demographic changes that set aside the usual sociological musings.

The other tradition is that of the abstract mathematical school. The paradoxical conclusion of the General Equilibrium economists of this school is that Adam Smith’s intuition of emerging order is inapplicable to the real world because perfect competition is missing; hence unceasing intervention is necessary to have the market work for the welfare of the people and indeed to function at all. Those economists suffer from tunnel vision. The point of Adam Smith’s idea of the ‘invisible hand’ had been that decentralized markets, even in the context of imperfect competition, resulted in a more orderly and more efficient organization than that imposed by centralized control.10 So I find it downright depraved (to coin a word favored by Samuelson)11 that General Equilibrium theory should be used to show that real world markets will prove inferior to a planned economic system. According to that theory, the social optimum can only be reached via perfectly competitive markets with equality of income distribution. Given that real markets are neither perfectly competitive nor egalitarian, it follows that they must either be replaced by a designed and purified replica or at least continually invigilated, so as to maximize some social welfare function favored by the critic. The theorists of planning, like Lange, would have some Planning Authority use a model economic market to facilitate their calculations and to help impose an equal distribution. Non-socialist soft liberals like Samuelson would allow the market to subsist but continually regulate it and correct it. They all see the market as a mere planning mechanism, rather than as a self-standing social institution; and they enthrone perfect competition as an attainable goal instead of seeing it as a mere analytic instrument. When it comes to judging the free market from the point of view of organization or results, the General Equilibrium chapel of the mathematical school turns out to be full of true red socialists or at best Pontius Pilate agnostics.

I am no Luddite. The formalistic advances of ‘scientific’ economics in the 20th century associated with the names of John Hicks, Paul Samuelson, Kenneth Arrow, Amartya Sen and many other distinguished theoreticians, do afford us instruments to avoid common theoretical or logical mistakes. However interesting their negative results, their positive results are limited, mainly because they dwell in an atmosphere of mathematical abstraction and philosophical neutrality fundamentally averse to Adam Smith’s “system of natural liberty”.

Oskar Lange, a Polish mathematical economist of communist persuasion, got all the mileage he could from these excogitations and advanced even further. In his article “On the Economic Theory of Socialism (1936-7) he expressed not a doubt that a socialist economy would be far superior to a capitalist one.

Lange’s opening shot was a heavy attempt at humor. He named Ludwig von Mises the advocatus diaboli in the cause of socialism for having posed the problem of “economic accounting to guide the allocation of resources socialist economy” and proposed a statue should be erected in his honor “in the great hall [… ] of the Central Planning Board of the socialist state.” (Page 53) Mises had explained in (1920, 1935) that without money prices and private property, it was virtually impossible for the socialist commonwealth to take decisions about what mix of consumption goods to supply, let alone how to value and apply production goods, given the different possible combinations of productive services for the supply of consumption. So he contended “that a socialist economy cannot solve the problem of the rational allocation of resources”. Lange saw the need to face these objections of Mises to prove that socialism was a workable social arrangement.

He started with an explanation of “the determination of equilibrium on a competitive market”. As one can see, he used the Walrasian ploy of a situation of perfect competition to explain how in a free economy all markets emptied, i.e. all demands and supplies tallied. That is because consumers maximize their total utility; producers minimize costs to obtain a profit; and owners of productive resources auction their services. The prices that result in equilibrium prices are found by a process of trial and error.

A planned economy, he says, can function quite like a market economy.

The rules of consistency of decisions and of efficiency in carrying them out are in a socialist economy exactly the same as those that govern the actual behavior of entrepreneurs on a purely competitive market. (Page 123)

The Central Planning Board would initially set a schedule of accounting prices, which would be corrected at the end of the accounting period if there were a surplus or a shortage of whatever commodity. (If the accounting period is a year, the system would move rather cumbersomely!) But it is not consumer choice that guides production: the preference scale is “fixed by the Central Planning Board while the price system is used to distribute the consumers’ goods produced”. (Page 70) For instance, the Board would assign

… to a hat the valuation of ten monetary units, when 100,000 hats are produced monthly, whereas it would assign a valuation of eight monetary units to a hat when 150,000 hats per month are produced. (Page 68)

(Bowlers or trilbies? For women or for men?)

By induction from consumer prices resulting from trial and error, the prices of productive services would be set so that the hat factory had enough machines, felt and bands. Lange did not say how the Board would prove to have the requisite knowledge of technology to relate resources to final production. Also, as Mises (1935) points out, there would be complicated technical interconnections between resources in a production process that have to be chosen; and there will also need to be choices as to where to apply multiple-use resources, such as whether to building a bridge or a canal or digging a coal mine.12 Finally there was the problem of the interest rate. In the short run it would be set by supply and demand for credit at the socialized banking system. In the long run, the Board would decide how much it wanted capital to accumulate and so deduct the requisite savings before meting out the disposable income to the citizens. (Is the accumulation of capital the main engine of growth?)

These questions are scarcely answered by saying that

[… ] the Central Planning Board has a much wider knowledge of what is going on in the whole economic system than any private entrepreneur can ever have; and consequently, may be able to reach the right equilibrium prices by a much shorter series of successive trials than a competitive market actually does. (Page 67)

I must say that the more I hear about this kind of market socialism the less attractive it is compared with our homely market, with all its blemishes. But Lange seems to be satisfied that they are of the same family and so he asks the obvious question:

Why change the whole economic system if exactly the same result can be attained with the present system, if only it could be forced to maintain the competitive standard? (Page 123)

(Not perfect competition, I hope.) The answer is: “Only a socialist economy can distribute incomes so as to attain the maximum social welfare” by establishing real equality. The Authority would be right to assume “the marginal utility curves of income to be the same for all individuals”. The ground for such an extraordinary supposition is that “differences in ‘sensitiveness’ existing in present society are chiefly due to social barriers between classes”. Equality of income without affecting efficiency would be achieved by paying all citizens an equal money income and then charging a price for “leisure, safety, agreeableness of work, etc.” for jobs having those advantages.

Also, the socialist system can set prices so that private cost converges with social cost, to the satisfaction of Professor Pigou; it can fine-tune the propensity to save so as to leave room for consumption, to allay Mr. Keynes’s worries; it is capable in a depression of restoring employment via a “a bold programme of public investment”; and “the business cycle theorist would lose his subject of study in a socialist economy.”

On one point Lange did accept a possible argument against socialism: that “the efficiency of public officials” would not compare with “private entrepreneurs as managers of production”. He dismissed these fears by saying that “this argument belongs to the field of sociology rather than of economic theory”.

I hope the reader will have formed an opinion not too dissimilar from mine on the feasibility of proposals for a socialist commonwealth. Lange was unfazed by any possible difficulties and confidently concluded that there is only one policy that an “economist who is called to advise a socialist government can commend: “a policy of revolutionary courage.”

Seen from today, the respect with which the profession treated Lange is astounding. Lange taught not only in Poland but also in some of the most prestigious universities of Europe and America. His technical ability blinded him and his admirers to the real world effects of his doctrines. At the end of his life Lange did advise the Communist government of his native Poland in the application of his kind of market socialism. It did not work well. He could always say that it was not carried out to his specifications. But there is no hiding the fact that this benighted and supremely intelligent economist was complicit in the sufferings imposed by Communism on his poor native country.

It is with some trepidation that I undertake criticism of the political economy of Paul Samuelson, a giant among the cultivators of economic theory. His work in the field of high theory, especially in mathematical economics, will leave a permanent mark on our subject.13 He did very little work in applied economics: apart from a number of non-scientific debatable obiter dicta, he concentrated his practical efforts on writing and revising his Economics textbook, the supreme introductory textbook of the 20th century. The general appreciation for his life-work was crowned with the Nobel Prize in Economics in 1970.

His call to arms was Foundations of Economic Analysis (1947). The quotation on the frontispiece of the book, “Mathematics is a language” indicates his approach to economic theory: mathematics not only allows a succinct presentation of economic theorems but also helps guarantee internal consistency, discover analogies, and generalise results.

In chapter VIII on “Welfare Economics” Samuelson tried to solve the problem of how to base welfare policy on economic theory with the help of mathematics. His starting point was that most economists felt that “in some sense perfect competition represented and optimal situation”. By ‘optimal’ he meant ‘being in a state of equilibrium’. But perfect competition was not enough: one had to see that “perfect competition is optimal when the distribution of income is appropriate”.

So here we have three elements for a maximum of social welfare in a (closed) economy: perfect competition, stable equilibrium, and ethical distribution—all of them highly artificial conditions in any conceivable situation. Of course, the improbability of these conditions being achieved in any real market situation led Samuelson quickly to demand correction, intervention, regulation.

1. 1. Perfect competition implies: that no dealer can influence prices, that goods and resources are perfectly divisible, and that there is perfect information. (In fact, the construct of perfect competition was not observed in reality but slowly defined as an analytical instrument along the years.) 14
2. 2. Maximum welfare will be attained when the economy is in stable equilibrium. (The last thing we want is an economy in stationary state. For the explanation of social phenomena, it is actors tending towards equilibrium that is interesting.)
3. 3. A just distribution is difficult to define even for Samuelson. We saw Lange get into the most peculiar contortions trying to devise a method of equalising incomes without affecting efficiency. (Samuelson used another construct to solve it: A Social Welfare Function.)

Let me look at condition 3. A social welfare function (SWF) that would embody a general ethical view of the kind of welfare a society should aim at—given a number of economic and non-economic variables desired, and subject to real world restrictions such as the limitation of resources. Different people will give the SWF different forms or shapes: for example, one should aim at the greatest possible equality among the members of the society. Now, the idea that there must be a SWF so that the justice of the arrangements of a society can be evaluated from the outside by an ethical observer is objectionable for a true individualist. (In my next column we shall see James Buchanan insist that ‘playing God’ is not the role of an economist.)

If we take a look at Samuelson’s practical politics, the dangers of his eclecticism become obvious, not so much because I may disagree with his beliefs and opinions as because I do not see the connection between his scientific analyses and his political conclusions. There is a wealth of articles to choose from in the seven volumes of the monumental Collected Scientific Papers of Paul A. Samuelson. Let me name a few, since I will have occasion to delve more deeply in them in my next column. In volume 2, in an essay called “Modern Economic Realities and Individualism” he just dismissed the “principle of unanimity” as “of course, completely impractical”. (The free market is a unanimous process). In volume 3 we find a long essay on “Personal Freedoms and Economic Freedoms in the Mixed Economy” where he presents Friedrich Hayek’sRoad to Serfdom as a “grossly oversimplified view” between the lack of economic freedom and the future of political freedom. (He may have been over-optimistic as to the future of our Welfare democracies). In volume 4, in an essay titled “Liberalism at Bay” he implies that Adam Smith was wrong in stating that “a competitive market system, concerned with atoms only pursuing their own narrow self-interest, would be led ‘as if by an invisible hand’ to achieve the good of all”. (He obviously had not read The Theory of Moral Sentiments, 1759). In the 1948 edition of his Economics textbook still presented a Lange-like explanation of ‘market socialism’ with a straight face. And I will say nothing (now) of the egregious assertion that the Soviet centralised economy could function nearly as well as the capitalist economies of the world—until just before the Berlin Wall was demolished.

My kind readers will have to wait until next month to see how, in their different ways, these five economists helped reestablish the philosophy of economic freedom on a more solid basis than in classical times and thereby undo some of the harm caused by the nay-sayers of the first half of the 20th century.

Becker, Gary (1981): A Treatise on the Family. Harvard.

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Mitchell Resnick (1997), “On the Economic Theory of Socialism (1936-7)

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Schwartz, Pedro (1979): “Second Best and Welfare Economics. Some Partial Solutions”. Working Paper 1979-1, Instituto de Econom’a de Mercado. Madrid.

Smith, Adam (1759): The Theory of Moral Sentiments. Glasgow Edition of the Works and Correspondence of Adam Smith. Oxford.

Smith, Adam (1776): An Enquiry into the Nature and Causes of the Wealth of Nations. Glasgow Edition of the Works and Correspondence of Adam Smith. Oxford.

Stigler, George J. (1965): “Perfect Competition Historically Contemplated”, in Essays in the History of Economics. Chicago.

Walras, Léon (1926, 1953): Elements of Pure Economics. Translated by William Jaffe. George, Allen and Unwin.