Are We Ever Really in Equilibrium?

One mistake made frequently by economists is to focus on the destination rather than the journey. We like setting two sides of an equation equal, solving for a variable and focusing on that neat and tidy result. But a little common sense shows that even the most canonical equation in the field, “supply equals demand,” requires a process to become true. Firms don’t know the magical market clearing price, they must experiment to find it, and every time there’s a shock an adjustment process must ensue. If shocks are frequent enough, that process would never end—a complex real-word economy might be all journey and no destination.

Alexander Salter has an interesting post at the Sound Money Project about nominal versus real interest rates that echoes the scenario above. Economists like to think central banks can only influence real variables in the short-run. An unexpected increase in the money supply, for example, will lower interest rates in the short run, but expectations about inflation will cause the nominal rate to rise, restoring the real rate to its pre-intervention level. But as this process unfolds, economic actors are making decisions based on the nominal variables they see in front of them. This may provide some support for Austrian Business Cycle Theory, where fluctuations arise in part from business people being misled by nominal variables in the short-run. I discussed similar ideas in the context of inflation distorting decisions made by consumers and businesses.

Salter finds the argument interesting but not fully persuasive. But beyond the relative importance of nominal and real interest rates, it’s undeniable that economic variables don’t adjust to their “equilibrium” values instantaneously. Our economy is a complex network of millions or billions of actors. Even if we believe prices, incomes or interest rates tend toward equilibrium values, it isn’t much of a leap to believe that shocks to our system are so frequent that our economy is in a state of constant dynamic movement. Economists at the Santa Fe Institute and elsewhere who study complex adaptive systems believe that equilibrium is the wrong paradigm with which to view economy. Complexity has a way of making those equations not so tidy.

It’s fascinating how much Austrian Business Cycle Theory anticipated the field of complexity economics many decades before the latter entered the scene. Both paradigms see transmission of information through networks, adjustment processes and agents with human limitations on their ability to calculate as critically important. Both schools of thought can inform each other and how we view economic issues of critical importance.