Perspectives on equilibrium
The extent to which an economy moves naturally towards equilibrium without the interference of government, is the subject of intense debate in economics and has been so since its origins. Although there are many different views, these are often classified as the Classical, Neo-Classical, and Keynesian perspectives.
The Neo-classical view
The
Neo-classical era of economics
sits between two great periods
of economic theory, the
Classical era (1770’s – 1870’s) and the
Keynesian era (1940’s – 1970’s). Neo-Classical economics can be
summarised as the general belief that a market economy will
automatically adjust towards equilibrium and there is no need for
government intervention – in short, markets are said to work effectively, both at
the micro and the macro-economic level.
Each sector
is brought into equilibrium through automatic adjustments in product,
labour and financial markets. All the markets clear because of the
effectiveness of the price mechanism. The Neo-Classical economists
argued that any problem with markets not
clearing is the result, of
government failure of some sort, or the activities of interest groups
and other third parties not directly involved in market
transactions. For example, economists from the Classical tradition would
tend to argue that unemployment exists because government welfare
payments are too generous and artificially distort the effectiveness of
labour markets.
If the
price
mechanism is free to work, the economy will always be moving towards
equilibrium such that full employment will occur. The Neo-Classical line
of argument is that wages will
adjust to ensure that the labour market clears; so if an
economy experiences a downturn in the business cycle, wages would fall, and the same number of workers would be employed, but at a lower wage
rate.
Classical
economists also argued that, in the financial market for loans,
savings
would always equate with investment because
interest rates will naturally
adjust to bring them into balance. If savings are greater than
investment at the current interest rate then the rate will fall, as
financial institutions have excess funds, and this will encourage
investment and deter savings. In the next time period savings will fall
and investment rise.
Similarly, imports and exports will always move towards equilibrium through adjustments in the exchange rate. If imports are greater than exports, the supply of currency will increase, and the exchange rate will fall. In the next time period, exports will increase, because the lower currency makes exports more price competitive, and imports will fall, because they are less price competitive.
The New-classical view
Classical economics became influential again during the 1980s with the work of New Classical economists like Robert Lucas, who revived interest in Classical macro-economic theory.
The Keynesian View
The alternative view – that markets do not always self correct - is based largely on the ideas and work of British economist, John Maynard Keynes. Keynes’s work culminated in the publication of The General Theory of Employment, Interest and Money (1936), commonly known as The General Theory, which became the most influential book on economics of the 20th Century. Keynes argued that a market economy is not always effective at creating full employment equilibrium, and there are likely to be times when governments should compensate for the failure of free markets. Full employment equilibrium is simply a ‘special case’ of equilibrium, and not a ‘general’ case.
In particular,
Keynes argued that savings and investment would not always respond to
changes in interest rates in the way the neo-Classical economists
assumed. This is because the connection between savings and investment
is weak. Savings are more directly affected by national income
than interest rates.
Keynes was
also critical of the Classical assumption that wages and prices are
flexible downwards as well as upwards. According to Keynes, the
inflexibility of wages downwards created the possibility of
unemployment.
At a deeper
level, Keynes also saw that self interest, regarded as the key driver
for market interaction, was potentially harmful. From Adam Smith
onwards, the orthodox view was that the economic welfare of everyone is
maximised when individuals pursue self-interest. In his paradox of
saving Keynes was able to demonstrate that the self interest associated
with increased saving could be harmful to others because saving would
lead to a fall in spending, and to a fall in other people’s income.
Eventually, even the saver suffers as economic activity in the economy
collapses.
The Classical
and Keynesian perspectives represent two opposing views of how
and whether equilibrium is established.