Conventional and more recent theories of the balance of payments with special regard to the Danish capital account

WITH S P E C I A L REGARD TO THE DANISH CAP I T A L ACCOUNT A Thes i s in Economics

Al

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382 . 17309^ 89 JES C20727I

W h e n I took up thè c h a l l e n g e of joining thè first brood of post- guraduate students at thè EUI, I did it wi t h some r e s e r v a t i o n s .

P a r t l y beca u s e I left an interesting job at thè Council of Economie A d v i s o r s in C o p e n h a g e n a nd p a r t l y because of m y total u n c e r t a i n t y a b o u t wh a t thè E u r o p e a n U n i v e r s i t y Institute was to prove.

In thè beginning, everyt h i n g was a bit chaotic and, if I may state thè m a t t e r s t r a i g h t f o r w a r d l y , some of us felt as "lonely riders", w ho had to rely m a i n l y upon ourselves and thè very pos i t i v e a t m o s p h e r e w i t h i n thè department. On thè other hand, such a s i t uation gave us m u c h m o r e liberty to fili out thè frame- wo r k of thè study on o ur own.

I c o n s i d e r thè aim of a thesis as twofold: One is to show thè a udience that thè r elevant liter a t u r e has been read and p r operly digested* thè o t h e r is to c o n t r i b u t e wi t h an

in d ependent p iece of wo r k w i t h i n one's field. Regarding thè former, this c a n n o t be of m u c h interest in itself, but, as far as thè two aims are interwoven, thè thesis is to be c o n s i d e r e d as a single, co h e r e n t p r e s e n t a t i o n of m y research.

The thesis has been u n d e r t a k e n under Professor L. Duquesne de la Vi n e l l e ' s kind supervision. I also wish to m e n t i o n thè help and e n c o u r agement w h i c h I r e ceived from Professor Pierre Salmon, EUI, and P r o f e s s o r Niels T h y g e s e n of thè U niversity

of Copenhagen. W h i l e work i n g on thè empirical part of m y disser- tation, I stayed at thè latter University, and I want to express m y g r a t itude to thè Institute of Economics which, w i t h o u t h e s i t a —

cations.

The c o m p u t a t i o n s are car r i e d out at RECKU with thè use of thè e c o n o m e t r i e p r o g r a m pack a g e ' TSP' i m p lemented by cand. polit. T o r b e n W a r n i c h - H a n s e n and stud.polit. Ar n e Facius. T he d r a w i n g s are ma d e by cand.polit. Tyge V o r s t r u p Rasmus- sen's plotter-program, w h i c h I am grateful for having got access to.

Efnglish is not m y native language a nd w i t h o u t thè help of Mrs. Jo An n M e r e d i t h this thesis w o u l d h a rdly have been readable.

Finally, a g r a n t from K j 0 b e n h a v n s H a n d e l s b a n k 's Studierejse- legat e a s e d m y financial c o n s t r a i n t w h i l e staying abroad, which is g r a t e f u l l y acknowledged.

CONTENTS PREF A C E i CONTENTS i C H A P T E R 1 I n t r o d u c t i o n 2 C H A P T E R 2 THE T H E O R E T I C A L F R A M E W O R K SECT I O N 2.1. M E T H O D O L O G I C A L REFLECTIONS 2.1.1. I n t r o d u c t i o n 5 2.1.2. The C h a l l e n g e to N e o c l a s s i c a l M a c r o e c o n o m i c s 6 2.1.3. T he A n a t o m y of D i s e q u i l i b r i u m 9 2.1.4. Walras' L a w Relconsidered 12 2.1.5. The C o n c e p t of E q u i l i b r i u m 14 2.1.6. T e n d e n c y towards E q u i l i b r i u m 19 2.1.7. The C o n c e p t of U n c e r t a i n t y 20 2.1.8. Stock ctr. F l o w S p e c i f i c a t i o n of M o dels 23

2.1.9. Speeds of A d j u s t m e n t and Mark e t

Cl e a r i n g 26

2.1.10 Stock ctr. F l o w S p e c i f i c a t i o n of

M a r k e t s 27

2.1.11. C o n c l u s i o n 29

SECTION 2.2.

C O N V E N T I O N A L MODE L S USED FOR B A L A N C E OF PAYMENS ANALYSES

2.2.1. I n t r oduction 31

2.2.2. A n a l y t i c a l M o dels and T i m e Periods 32

2.2.3. P o r t f o l i o Model 34

2.2.4. The F l o w or Short Run Model 39 2.2.5 The long run or General E q u i l i b r i u m

Model 43

SECT I O N 2.3. THE F I N A N C I A L F R A M E W O R K 2.3.1. In t r o duction 49 2.3.2. The A g g r e g a t i o n of thè Econ o m y 50 2.3.3. The S u p p l y of M o n e y 51 2 . 3 . 3 . a. Some Cruciai P r o p e r t i e s of M o n e y 51 2 . 3 . 3 . b. Control of thè M o n e y Supply 53 2 . 3 . 3 . c . The S u pply of Secondary L i q u idity 55

2.3.4. The D e m a n d for M o n e y 58

2 . 3 . 4 . a A D i s e q u i l i b r i u m Concept 58 2.3.4 . b. The P r e c a u t i o n a r y M o tive 59 2 . 3 . 4 .c. The F i n a n c e M o t i v e 59 2 . 3. 4 . d . A C e r t a i n Store of Value 60 2.3.5. The S u p p l y of other F i n a n c i a l Claims 62 2 . 3 . 5 . a . The P r i v a t e N o n - f i n a n c i a l Sector 62 2.3.5.b. F i n a n c i a l Interm e d i a r i e s 64

2 . 3 . 5. c . The Public Sector -65

2 . 3 . 5. d . C l aims D e n o m i n a t e d in F o r e i g n

C u r r e n c i e s 66

2.3.6. The D e mand for Fi n a n c i a l Asse t s 68

2 . 3 . 6 . a. The T otal Yield 70

2 . 3. 6 . b. The H o l d i n g P e riod 71 2 . 3 . 6 . c . Expe c t a t i o n s 73 2 . 3 . 6 -d. S p e c u l a t i o n 75 2 . 3 . 6 . e. Capi t a l G a i n s / L o s s e s 76 2.3.7. Summary 78 SECTION 2.4. C O N V E N T I O N A L AND MO R E RECENT T H E O R I E S OF THE BALANCE OF P AYMENTS A D J U S T M E N T

2.4.1. Introduction 79

2.4.2. The S u b d i v i s i o n of thè Bala n c e

of Payments 81

2.4.3. Purch a s i n g Power P a r i t y 83

2.4.4. E l a s t i c i t y A p p r o a c h 88

2.4.5. Income Power Parity 94

2 . 4 . 5 . a. Di f f erent Kinds of Income Effects 94 2 . 4 . 5 . b. The A b s o r p t i o n A p p r o a c h 97 2 . 4 . 5 . c . A S y n t hesis of thè E l a s t i c i t y and

A b s o r p t i o n Appro a c h e s 98 2.4 .5.d. T e m p o r a r y E q u i l i b r i u m Ana l y s i s of

2.4.6. The Capital Acc o u n t 104 2.4.7. The P o r t f o l i o Model 105 2.4.8. D i r e c t I nvestment 109 2.4.9. The A s s e t A p p r o a c h 110 2 . 4 . 9 . a. A Simple M o d e l 110 2.4.9.b. W e a l t h Effects 112 2 . 4 . 9 . c. A s s e t Model w i t h a Forward M a r k e t 114 2.4.9.d. The I mportance of E x p e c tations 116 2 . 4 . 9 . e. C o n c l u d i n g Remarks 117

2.4.10. M o n e y Power P a r i t y 118

2.4.11 Sum m a r y 121

C H A P T E R 3

THE E C O N O M I C AND I N S T I T U T I O N A L B A C K G R O U N D

3.1. A Brief S u r v e y of Internai and

Ex t e r n a l D e v e l o p m e n t 12 5 3.2. Ins t i t u t i o n s in thè F i n a ncial Sector 130 3.3. M o n e t a r y Policy: 1967-1976 131 3.4. The E x c h a n g e R e g u l a t i o n s 134 3.4.1. F o r w a r d C o n t r a c t s for F o r e i g n Exc h a n g e 136 3.5. T he In s t i t u t i o n a l E x c h a n g e Rate Regime 137

C H A P T E R 4

PREVIOUS STUDIES OF T HE DANISH C A P I T A L A C C O U N T 14 0

C H A P T E R 5

P R E S E N T A T I O N OF DATA

5.1. The Ideal Case 146

5.2. The Relation between Stocks

F lows in Pra c t i c e 147

5.4. D i s a g g r e g a t i o n into Sectors 14 9 5.5. The C o m p u t a t i o n of thè Net Fi n a n c i a l W e a l t h of thè Priv a t e Sect o r 151 5.6. E x p l a n a t i o n of thè Statistical F i g u r e s > 153 5.6.1. Stocks 153 5.6.2. Flows 154 5.6.3. Prices 157 5.6.4. Ti m e Peri o d s 157

5.7. Balance Sheet of thè Sectors 158

5.8. L i s t of V a r i a b l e s 160 5.8.1. A s s e t s 160 5.8.2. L i a b i l i t i e s 162 5.8.3. I n terest Rates 163 5.8.4. E x c h a n g e Rates 16 3 5.8.5. Bala n c e of P a yments 164 5.8.6. M i s c e l l a n e o u s 165 A p p e n d i x 5.1: Sources of thè Data 16 6 C H A P T E R 6 TH E E M P I R I C A L ANA L Y S I S OF C A P I T A L A C C O U N T FIGURES F O R DENM A R K 6.1. I n t r o duction 173 6.2. The S t a t i s t i c a l B a c k g r o u n d 173 6.2.1 The Ti m e Period 176 6.2.2. D i s a g g r e g a t i o n of thè Capital Acc o u n t 177 6.3. The T h e o r e t i c a l M o d e l s Used for thè

E m p i r i c a l Ana l y s e s 177

6.3.1. The P o r t f o l i o Model 177

6.3.2. An A l t e r n a t i v e A p p r o a c h 179

6.4. Em p i r i c a l Results 182

6.4.1. Total p r i v a t e net capi t a i import 183 6.4.2. T o t a l pri v a t e capitai flows

dis-a g g r e g dis-a t e d into e x port dis-and import 189 6.4.3. Priv a t e long term capitai flow 189 6.4.4. Priv a t e short term capitai flows 190

6.5. Co n c l u d i n g Remarks 190

6.6. A s e p a r a t e a n alysis of thè trade credit rela t e d to thè Fore i g n T r a d e on a m o n t h l y

C H A P T E R 6 ( C o n t ’d)

6.6.1. Data and M e t h o d of C a l c u l a t i o n 196

6.6.2 T he P r o p o s e d Mode l s 198

6.6.3. A T e s t of thè M o d e l s 200 6.6.4. The A u t o m a t i c Credit Term 2 02 6.6.5. C h a n g e i Payments Habits 2 05

6.6.6. Import related trade credit 2 06

6.6.7. Total import c r edit 211

6.6.8. E x port r e l a t e d credit 212

6.6.9. Ex post forecast 214

6.7. A Suiranary of thè Resulta Related

to T r a d e Cred i t 216

6.8. R e g i s t e r e d T rade C r e d i t 220

A p p e n d i x 6.1. D o m i n a t i n g C u r r e n c i e s in Danish

foreign t r a n s actions 226

A p p e n d i x 6.2. Mean, S t a n d a r d deviation, and c o r r e l a t i o n of thè Q u a r t e r l y

F i g u r e s for Capital Flows 227

A p p e n d i x 6.3. M o r e D e t a i l e d i n f ormation concerning thè mo s t important regre s s i o n

equa-tions 228 C H A P T E R 7 TH E D E T E R M I N A T I C I OF THE F O R W A R D P R E M I U M 7.1. I n t r o d u c t i o n 24 9 7.2. A T h e o r e t i c a l M o d e l of thè Market for F o r w a r d E x c h a n g e 24 9 7.2.1. Pure Trad e r s 250 7.2.2. S p e c u l a t i o n 2 52 7.2.3., A r b i t r a g e u r s 254 7.3. A Geom e t r i c a l E x p o s i t i o n of thè

Spot and Forw a r d M a r k e t s 255 7.3.1. The Interaction between thè Spot

and Forward Mark e t s 259

7.3.2. Intervention 261

7.3.3. Leads and Lags 263

C H A P T E R 7 (Cont'd)

7.5. The A p p l i c a t i o n of thè T h e o r e t i c a l Model for an E m p irical Ana l y s i s of

thè F o r w a r d M a r k e t for F o r e i g n E x c h a n g e 2 66 7.5.1. D e mand and Supply F u n ctions 266 7.5.2. Ex c h a n g e Rate E x p e c t a t i o n s 2 67

7.6. The Danish Case 272

7.7. Em p e r i c a l F i ndings 273 7.7.1. A Q u a r t e r l y Study 273 7.7.2. A M o n t h l y Study 279 7.7.3. T he S i g n i f i c a n c e of thè E x change Rate 280 7.7.4. Ex post Fo r e c a s t 283 7.8. C o n c l u d i n g Remarks 2 86

A p p e n d i x 7.1. A Comm e n t on F. McCormick, "Forward

Exchange" 290

C H A P T E R 8

CON CLU SION S

8.1. Intr o d u c t i o n 293

8.2. M o n e t a r y P o l i c y 294

8.2.1. T he C h o i c e between C r e d i t R a t ioning vs.

I n terest Rate Poli c y 296

8.2.2. Em p i r i c a l Evi d e n c e of M o n e t a r y Impact 299

8.3. Fiscal Poli c y 301

8.4. P u blic E x t e r n a l B o r r o w i n g 301 8.5. R e s t r i c t i o n s on E x t e r n a l Capital Flows 302 8.6. Inte r v e n t i o n in thè M a r k e t for Forw a r d

E x c h a n g e 304

8.7. The Choi c e of E x c h a n g e Rate Policy 3 05 8.7.1. F l e x i b l e Exc h a n g e Rates 305

8.7.2. Doublé Exc h a n g e Rates 306

8.7.3. F ixed E x c h a n g e Rates 307

8.8. C o n c l u d i n g Remarks on E c onomie Policy 3 08

A n n e x 1 :

LIST OF V A R I A B L E S A ND DATA

1.1) Q u a r t e r l y Figures used for R egression Ana l y s e s

1.2) Balance Sheet figures

1.3) M o n t h l y Fig u r e s used for Regression Ana l y s e s

The overall aim of this d i s s e r t a t i o n is to i n v estigate from a theoretical a nd empirical point of v i e w thè d e t e r m i n a n t s of thè c apitai account of thè balance of payments w i t h special regard to a small, op e n economy. As an empirical case study, I have

c h o s e n Denmark, w h i c h I k n o w p a r t i c u l a r l y well, but, u n f o r t u n a t e l y , D e n m a r k is somewhat atypical to thè textbook models, b e c a u s e of its rather tight capitai Controls.

I

Capital flows have to be seen as just one partial element in thè entire economy. I have, therefore, devoted quite a number of pages to a d e s c r i p t i o n of h ow I think capitai flows fit into a small, o p e n economy. One aspe c t involves thè finaneial sector, w h e r e In t e r n a t i o n a l capitai flows are an unav o i d a b l y integrated part of its functioning. T he o ther a s pect concerns capitai flows as a part of thè balance of payments, and one cannot analyze

balance of p ayments a d j u s t m e n t w i t h o u t taking into co n s i d e r a t i o n thè curr e n t account as well as thè capitai account. In fact, this integ r a t i o n has not until r ecently been m a d e in analytical m o d e l s , w h e r e f o r e a g r e a t deal of p r e v i o u s d i s cussions concerning

balance of payments a d j u s t m e n t was partial in a doublé sense.

Before going into a m o r e d e t a i l e d d i s c u s s i o n of thè theory of c apitai flows, I have felt it n e c e s s a r y to initiate this thesis w i t h a m e t h o d o l o g i c a l chapter. Wh e n reading balance of payments theory, I am struck by thè fact that, broadly speaking, all con- tributions are held w i t h i n thè generai e q uilibrium framework and have m a n y n eoclassic traits. It is as if thè n e o - K e y n e s i a n re­ vol u t i o n had left no m a r k on that field of economie thinking. To c l a r i f y thè cruciai d i s t i n c t i o n between thè n eoclassic and neo - K e y n e s i a n research p r ograms (cf. L e i j o n h u f v u d , 1974), w e have to c o n s i d e r some of thè m o r e basic c o ncepts in economie m e t h o d - ology, w h i c h also gives m e a w e l c o m e o p p o r t u n i t y to present my g e s t a l t c o n c e r n i n g how I rega r d thè functioning af thè economie system.

Unfortunately, this m e t h o d o l o g i c a l d i g r e s s i o n will leave thè reader somewhat frustrated, because I have not been able to set up a s a t i s factory n e o - K e y n e s i a n a l t e r n a t i v e — neither in thè theoretical sectìon nor in thè empirical s p e c i f i c a t i o n s . The n e a r e s t I have b e e n able to provide is a s o mewhat dynamic p r o c e s s-description, w h i c h is rather h a l f b a k e d and has a grop- ing appearance.

It is e s p e c i a l l y u n s a t i s f a c t o r y that I have been so c o n v e n t i o n a l in thè empirical section. But there is not enough support from thè l iterature to o b t a i n a basis for a discussion of thè pr o b l e m s

involved wh e n e s t i m a t i n b e h avioural

equa-tions related to a m a r k e t in d i s e q u i l i b r i u m * . I believe thè p r o b l e m s are of f u n damental c h a racter and even q u e s t i o n thè p o s s i b i l i t y of o b t aining r e liable data at all. Mo r e regarding this later, but thè in c o n s e q u e n c e is apparent.

The empirical sect i o n begins w i t h a short survey of thè develop-m e n t of thè Danish econodevelop-my w i t h i n thè a n a l y z e d period: 1967-1976. O ne c h a r a c t e r i s t i c feature has b e e n that thè capitai flows were subject to rath e r firm r e g u l a t i o n at thè beginning of thè period. T hese have g r a d u a l l y been eased, e s p e c i a l l y in relation to thè

2

Danish p a r t i c i p a t i o n in thè EEC from 1973 .

Quite a number of r e s ources have been u t i l i z e d in thè construc- tion of data on a q u a r t e r l y basis. The m o s t ambitious and

a u d a c i o u s p r o j e c t has been thè c o n s t r u c t i o n of figures for private financial wealth.

The r egression a nalysis can be divi d e d into three parts:

First, I i n v estigate total capitai im- a nd export a g g r e g a t e d as well as d i s a g g r e g a t e d into 5 or 6 subcomponents.

Second, I have taken out thè m o s t important and least regulated

Fair & Jaffe, 1972 and Jaffe, 1978 are a few e x c e p t i o n s .

This gives rise to anot h e r fundamental question: W h e t h e r a b a s i cally free m a r k e t o r i e n t e d theory can form a r easonably f oundation for thè empirical tests and to what extent regula- tions are simply c o r rectives w h i c h can be handled by d u m m i e s .

part of thè cap i t a i flows — thè trade c r edit — and m a d e a m o n t h l y study.

T h i r d , t h e forward pre m i u m on foreign e xchange has been analyzed, and somewhat m o r e success has been o b t a i n e d insofar as exchange rate expectations are concerned.

All thè e s timations have b e e n c a r r i e d out w i t h thè m e t h o d of O r d i n a r y L e a s t Squares (OLS), w h i c h does not c o r r e c t thè simul- t aneity bias. This is, of course, a we a k point in thè analysis which, on thè o t h e r hand, c an be defended by reference to thè short peri o d of estimation, espec i a l l y wh e n m o n t h l y data are used.

As a final point, I have drawn some conclusions. They c o mprise an ap p r a i s a l of thè lack of c o r r e s p o n d e n c e between theory and real i t y as well as some p o l i c y recom m e n d a t i o n s derived from thè e m p irical results. T hese point at thè fact that thè m o n e t a r y p o l i c y has be e n m o r e aus t e r e than wh a t can be e x p l ained by thè n e e d of priv a t e capi t a i import only.

C H A P T E R 2 : T HE T H E O R E T I C A L F R A M E W O R K .

SEC T I O N 2.1: M E T H O D O L Q G I C A L REFLECTIONS

2.1.1. I n t r o duction

Wh e n reading thè e s t a b l i s h e d literature on thè theory of thè b alance of payments, I have been struck by thè ap p a r e n t generai c o n s ensus of a n alysis w i t h i n thè framework of a g e n e r a i e q u i l i ­ brium m o d e l (which, for convenience, I will cali thè n eoclassic approach). For instance, at thè 1975 St o c k h o l m conference, o r g a n i z e d by thè Institute for International Economie Studies, on flexible exc h a n g e rates and s t abilization policy, two of thè p a r t i c i p a n t s in thè gene r a i d iscussion concluded^ that thè rele- v a n t model was o ne of gene r a i e q u i l i b r i u m with i n w h i c h Walras' L a w and c e r t a i n h o m o g e n o u s postul a t e s were contained. This con- c lus i o n was u n q u e s t i o n e d and should be re g a r d e d as one chara c t e r - istic of thè p r e s e n t m e t h o d of a n a lyzing international economics.

A l t h o u g h we are n o w in 1979, thè s i t u ation has chan g e d little and disc u s s i o n s are stili c e n t e r e d a r ound thè differences between thè three ”classical" approaches: 1) thè e l a s t i c i t y approach,

2 3 2) thè a b s o r p t i o n approach, a nd 3) thè m o n e t a r y approach

In searching for an a l t e r n a t i v e theoretical basis to thè con- ve n t i o n a l a n alysis of external relations, we m ay turn our atten- tion to thè d i s c u s s i o n of d i s e q u i l i b r i u m economics.

See Sca n d i n a v i a n J o u r n a l of E c o n o m i c s , 1976, no. 2, p. 389 and p. 397.

As long as there is n ow an estab l i s h e d c onvention of meaning, I find it often m o r e m i s l e a d i n g than clarifying to use these labels: neoclassic and Keynesian. Thus, I will take thè liberty of using thè pr e d i c a t e neoclassic for equil i b r i u m economics.

For a few exceptions, I will refer back to this in section 2.4. below.

2.1.2. The C h a llenqe to Neocla s s i c M a c r o e c o n o m i c s

The economie analysis of a c l o s e d e c o n o m y has u n d e r g o n e remark- able d e v e l o p m e n t in thè last decade. Until thè m i d 60's, thè e s t a b l i s h e d m a c r o e c o n o m i c s of a closed — and for that matter, an op e n — e c o n o m y was held w i t h i n an e q u i l i b r i u m model.

B r o a d l y speaking, there we r e two such m o d e l s (thè ISLM^ an d thè P a t i n k i n (1965) m o d e l ) , bo t h of w h i c h were c h a r a c t e r i z e d by

c o n c e n t r a t i n g on thè e q u i l i b r i u m values. Sometimes thè a nalysis of thè e q u i l i b r i u m was s u p p l emented by a stability a n alysis

following thè C o r r e s p o n d e n c e p r i nciple (Samuelson, 1947) , w h i c h was then c a l l e d a dynamic analysis.

>

This a p p r o a c h to m a c r o e c o n o m i c theory was c h a l l e n g e d by a number of writings, w h i c h m o r e or less d r e w their inspiration from a r e i n t e r p r e t a t i o n of Keynes' works. T he d i s c u s s i o n was o p ened by C l o s e r ’s n ow c l a ssical article, "The Ke y n e s i a n C o unter-revo- lution: a T h e o r e t i c a l A p p r a i s a l ” , w h e r e i n he showed that Walras' L a w was not as gene r a i as h i therto assumed. In fact, .it only seems to ho l d go o d in cases of generai equilibrium; when thè eco n o m y is ou t of equilibrium, there c an be e.g. excess labor supply w i t h o u t excess d e m a n d in an y o t h e r market. Th e n we can- not rely on an a d j u s t m e n t m e c h a n i s m in thè m a r k e t , w h i c h will a u t o m a t i c a l l y bring thè e c o n o m y back into equilibrium. This analysis inspired and stimulated a number of researchers to re- read Keynes' c o n t r i b u t i o n s m o r e c a r e f u l l y and give them an up- to-date i n t e r p r e t a t i o n d e t a c h e d from thè generai e q u ilibrium framework.

Two c o r n e r s t o n e s should be v e r y b r i e f l y mentioned: Leijonhufvud, "Keynesian Ec o n o m i c s and thè E c o nomics of Keynes," 1968, and P. Dàvidson, "Money and thè Reai World," 1972.

Hicks, "Mr. Keynes a nd thè Classics," 1937. I will include a m o r e rigorous cri t i q u e in section 2.2.

By "Keynesian Economics" L e i j o n h u f v u d refers m a i n l y to thè con- v e n t ional ISLM m o d e l d e v eloped by Hicks in 1937, w h e r e i n he g a v e thè theme of "thè General Theory" an e q u i l i b r i u m interpre- tation — and e.g. u n e m p l o y m e n t c o u l d on l y be e x p l a i n e d by so- c a l l e d imperfections: Upper and lower bounds for

thè i n terest rate, rigid wages c a used by thè m o n o p o l y p ower of trade unions, a nd m i n i m u m wages or unwilli n g n e s s to work.

In "Keynesian economics", thè m a i n c o n c l u s i o n is that because of 1) lack of information, 2) uncertainty, 3) constraints, 4) imperfect markets, it is illogical to a s sume that m a r k e t c l e a r i n g forces will secure gene r a i equilibrium. This a p p r o a c h is d i s c u s s e d m o r e t h o r o u g h l y below, in an attempt to see wh a t èlements have r e l e v a n c e for thè theory of thè balance of

pay-i

m e n t s .

Leijonhufvud, 1977 (and C l o w e r & Leijonhufvud, 1975) has given a m o r e exp l i c i t f o r mulation of w h a t he thinks is thè fundamental theme of economie analysis, w h i c h is thè c o o r d i n a t i o n of economie ac t i v i t i e s w i t h i n a d e c e n t r a l i z e d economie system. This, of

course, p o ints do thè m a r k e t as thè pivotal element in understand- ing thè f u n ctioning of a m o d e r n m i x e d economy. Ho w are thè

di f f e r e n t m a r k e t s o r g a n i z e d ? Wh a t types of agents participate, and h o w to they react w h e n enc o u n t e r i n g one or mo r e constraints? H o w is info r m a t i o n transmitted, an d how are expectations forxned?

D avidson stresses three themes in his book: 1) The market, 2) Uncertainty, and 3) The special role of money. Concerning thè market, he drives home thè p o i n t that thè functioning of a m a r k e t can differ widely, so one can never speak of a common m a r k e t adjus t m e n t m e c h a n i s m (e.g. flex-price or f i x - p r i c e ) . For each m a r k e t thè specific reaction pat t e r n of thè agents has to be analyzed. This ideal is in a c c o r d a n c e w i t h Leijonhufvud, and both have to some extent r e v i v e d thè M a r s h a l l i a n m a r k e t a d j u s t m e n t theory , w h e r e i n thè driving force consists of thè

Davidson, "D i s e q u i l i b r i u m M a r k e t Adjustment, M a r s h a l l Re- v i s i t e d " , 1974 (and Leijonhufvud, "Maximization and

Marshall", w h i c h he refers to several times but w h i c h has not yet been p u b l i s h e d ) . In a D a n i s h context H . E s t r u p , 1977 should be m e n t i o n e d as one w ho has revived thè interest for M a r s h a l l i a n price theory.

d i s c r e p a n c y betw e e n thè supply a nd d e m a n d prices, co n t r a r y to thè W a l r a s i a n auctioneer.

U n c e r t a i n t y is o ne of thè keywords in u n d e r s t a n d i n g d i s e q u i l i b r i u m economies. F o r thè sake of clarification/ one c an say that u n ­ c e r t a i n t y is related to those events w h i c h are u n m e a s u r a b l e . U n c e r t a i n t y is c a u s e d by thè lack of perfect knowledge^" of thè e c onomie agents, and, if thè b ehavior of thè agents is d o m i n a t e d by this uncertainty, Davidson concludes that it is extremely d i f f i c u l t to rely on thè a s s u m p t i o n of stable b e h a v i o r a l equa- tions for thè economie analysis. In fact, he c hallenges thè app r o a c h of using a f ormalized model as long as thè factors of U n c e r t a i n t y r e main unexplained. The c r itique goes to thè heart of e m p i r i c a l ana l y s i s bec a u s e if reaso n a b l y good results cann o t be obtained, then thè i m m e a surable unce r t a i n t y is, perhaps, thè e x p l a n a t i o n for this.

One q u a l i t a t i v e m e a s u r e of thè state of u n certainty is thè li q u i d i t y preference. The best prote c t i o n against thè unknown is m o n e y (or other financial assets w i t h high m a r k e t a b i l i t y and a p r e d i c t a b l e price) or, to put it positively, thè best way of being able to take a d v a n t a g e of favorable future events (e.g. in­ v e s t m e n t opportunities) is to be l i quid (money at h a n d ) . There-

fore, thè d e mand for liquidity will increase in a period of m o r e p r o n o u n c e d uncertainty, even in periods wi t h significant infla- tion rates.

This is a very signi f i c a n t o b s e r v a t i o n in relation to thè i n t e r ­ play between u n c e r t a i n t y and money. But there is an enormous jump between this and thè s t a tement that m o n e y is thè m a i n cause of uncertainty, and I find that Davidson wide l y o v e r plays thè r o l e o f m o n e y wh e n searching for thè origins of disequilibrium. It is, of course, c o r r e c t to underline thè fact that a shift in

1

In this context perfect k n o wledge includes cases where it is on l y thè p r o b a b i l i t y d i s t r i b u t i o n of a c e r t a i n event w h i c h is known, whereas thè exact oute o m e is unknown. (Cf.

thè d e mand from p r o d u c i b l e goods to m o n e y will c h o k e off thè effective demand, but this effect will take place w h e n e v e r thè d e m a n d for g o o d s w i t h a v e rtical supply curve increases at thè expense of goods w i t h a p r i c e elastic supply^-.

The above m e n t i o n e d reai w o r l d o b s t acles to a s m o o t h - f u n c t i o n ­ ing of thè gene r a i e q u i l i b r i u m model are simply m e a n t to in­ d i cate wh a t this d i s c u s s i o n w i l l be c e n t e r e d around. But, it is remar k a b l e that no such t h orough d i s e q u i l i b r i u m a p p r o a c h in I n ternational economics has been ma d e until now. E v e n thè m o s t recent a p p r o a c h — "thè Monetary" — is ve r y conv e n t i o n a l in thè sense that it uses thè equi l i b r i u m m o d e l as thè framework for its analysis.

«

In a following section, we shall see to wh a t extent thè

e s t a b l i s h e d the o r i e s of thè balance of payments can be recon- sidered w i t h i n this f r a m ework in w h i c h thè d i s e q u i l i b r i u m factors are stressed.

2.1.3. The A n a t o m y of Di s e q u i l i b r i u m

It w o u l d be m u c h easier if we c o u l d assume that thè adjustment m e c h a n i s m works quite well, so that thè transitory period b e fore a n e w e q u i l i b r i u m is reac h e d is of an i n s i g n ificantly short

du-2

ration. In thè W a l r a s i a n w o r l d thè a d j ustments take place in a s a l esroom w h e r e thè a u c t i o n e e r shouts a price and then counts offers for sale and demand. If they differ, no trade takes p lace and a n ew price is shouted. This process continues until demand and supply are equal for all g oods and, at this point

I shall come to this later on, but one m i s u n d e r s t a n d i n g

m u s t be avoided, namely, that money should be thè cause of disequilibr u m.Without money, thè functioning of thè m a r k e t s will be

m u c h m o r e impeded and thus increase thè number of imperfec- tions and constraints, m a k i n g thè prob i e m of d i s e q u i l i b r i u m even m o r e serious (Hahn, 1977).

To a void a n o t h e r m i s u n d e r s t a n d i n g , it should be empha s i z e d that by W a l r a s i a n economics, I refer m a i n l y to thè generai e q u i l i b r i u m m odel of thè neoclassic economists, i.e., Arro w - Debreu model. There m i g h t be some m i s i n t e r p r e t a t i o n com- pared to thè o r iginai c o n t r i b u t i o n by Walras. This theme of thè history of theories will not be dealt wi t h here.

trade s upposedly takes place. W h e n this process is assumed to take no time, we have instantaneous e q u i l i b r i u m , a n d a d j u s t ­ m e n t is u n i m p o r t a n t .

However, except for v e r y few mark e t s of financial assets and raw materials, thè aucti o n e e r does not exist and some kind of trial and error p r o c edure has to be assumed. The i n stantaneous eq u i l i b r i u m will only be a relevant d e s cription of thè m a r k e t if thè economie units possess perfect knowledge regarding future e q u i l i b r i u m prices. F u r t h e r m o r e , it should be a s s u m e d that this k n o w l e d g e can be o b t a i n e d in a costless manner, i m m ediately a nd i ndepen d e n t l y of thè actual prices.

»

U n d e r p e r f e c t competition, thè supply and demand curves for each economie unit are i nfinitely elastic, since thè prices are r e garded as p a r a m e t r i c a l l y given. In this case, thè above

m e n t i o n e d a s s u m p t i o n s seem to be fulfilled, but then nobody will have thè i n c e ntive to c h ange thè price. Once again, we are c a u g h t by thè m i s s i n g auctioneer.

As early as 1959, A r r o w o b s e r v e d that p e r f e c t c o mpetition with one p rice on each m a r k e t is o n l y pos s i b l e in equilibrium. Else- where, buyers and sellers have some m o n o p o l i s t i c power, because thè p rice is not p a r a m e t r i c a l l y g i v e n by thè market, but w i t h ­ in limits is a r e sult of optimal p l anning by thè agents. As a r ough g e n e r a l i z a t i o n one m a y a s s u m e that it is thè side of thè m a r k e t wi t h less p a r t i c i p a n t s that is m o s t likely to be thè

p rice setter a nd thè m o r e at o m i s t i c side adjusts thè quantity. Accordingly, firms have o f t e n thè price setting function, and

imperfect k n o wledge regarding thè future demand, òne cannot expect that thè flow of goods bétween thè firm and thè customers will clear thro u g h price v a r i a t i o n s only. If no common price for goods is established, then searching becomes a rational action.

So, in practice, there is no befor e h a n d perfect k n o w ledge c o n c e r n ­ ing equil i b r i u m prices. The transactors have to react to thè actual prices because they are one of thè m a i n sources of i n f o r ­ m a t i o n c oncerning thè state of thè m a r k e t a nd thè other t r a n s ­ actors ' plans. This information can be o b t a i n e d neither cost- lessly nor be independent of thè actual prices. In addition,

thè a d j u s t m e n t process takes time, w h i c h m e a n s that states of d i s e q u i l i b r i u m are not thè exception, but thè rule.

The conc e p t of "false prices" (and, for that matter, "false quantities") has be e n tied to thè price of disequilibrium^. Basically, thè K e y nesian m u l t i p l i e r process can be r e garded as c a u s e d by thè lack of instantaneous price adjustment, w h i c h g ives space for "false trading". A fall in reai d e mand should be m a t c h e d by a chan g e in relative prices w h i c h c o u l d i m m ediately restore thè initial level of demand. But price adjustments are not so quick, and false prices will prevail and a g g ravate thè fall by thè der i v e d effects: Falling reai income, de p r e s s e d e x p e c tations and further u n e m p l o y m e n t .

Instead of c o r r e c t i n g and establishing changes in thè relative prices, we o b s e r v e a d e s t a b ilizing fall in q uantities and, hence, in reai income. This happens because thè i n f ormation available concer n i n g thè actual a nd future events is ambiguous and creates expe c t a t i o n s that c o n t r i b u t e to m a k i n g thè state of disequilibriun even m o r e pronounced. This is not to say that all price changes will be destabilizing, but that thè lack of instantaneous a d j u s t ­ m e n t m a k e s thè r e l e vance of c o n t i n u o u s e q u ilibrium analysis

rather restricted.

One m o r e factor should be observed. A g iven series of events can c r eate v e r y di f f e r e n t e x p e c t a t i o n s w h i c h ma k e thè k n o w l e d g e about thè intentions of o t h e r transactors, even w i t h i n one market, very limited, e.g. how will other producers react to a 300 per cent rise in oil prices?

See H i c k s , 1939, p. 128-129. He does not, however, a t t a c h any importance to this con c e p t of false trading for thè e q u i l i b r i u m a djustment process — on l y a second order ma g - nitude.

2.1.4. W a l r a s 1 Law R e c o n sidered

T h r o u g h o u t thè 1 9 5 0 ' s a long d i s c u s s i o n co n t i n u e d about Walras' L aw (W.L.) and Say's Law (S.L.). In short, W.L. says that, by definition, thè sum of excess demands on all m a r k e t s is zero, wher e a s S.L. states that this sum is zero for all reai m a r k e t s — thè old "money is a veil" discussion. I will on l y c o n c e n t r a t e on W.L. in an att e m p t to show that this "Law" is also clos e l y

c o n n e c t e d to thè state of equilibrium, if not m e r e l y a tautology^. It is essential to d i s t i n g u i s h between planned demand and supply

2

and ef f e c t i v e d e m a n d and supply . Taking a single economie

agent, it is reaso n a b l e to assume that he acts rationally in thè sense that he will n e v e r pian an expense w i t h o u t also planning thè source w h i c h will finance it. This m e a n s that if we cum u l a t e all p l a n n e d d e mand a nd supply of this agent, it will sum zero. Furthermore, if we cum u l a t e ov e r w e l l - d e f i n e d sectors, we will ob tain thè sanie result, in that Walras' Law is valid insofar as plan n e d q u a n t i t i e s are concerned. However, wh e n one considers effective d e mand and supply, thè situation changes. By effective, we m e a n that t h è ,excess) d e m a n d can influence thè m a r k e t clearing variable. If two sectors have ma d e m u t u a l l y inconsistent plans, then we can no longer e x pect thè sum of thè excess demands to be zero. To take C l ower's example, for instance: If thè household sector plans to buy m o r e g oods a nd supply m o r e labor than thè business sector has pla n n e d to prod u c e a nd employ, then thè plan n e d excess d e m a n d for g o o d s c a nnot be effective because there is no finance to back it. T he firms wil not be aware of this potential excess d e mand for goods and, therefore, receive no stimulus to increase employment. W e see that there is no effective excess d e mand at thè goods market, but we will obs e r v e e f f e ctive excess supply at thè labor m a r k e t (unemployment — people w i l l i n g to work at thè ruling wage level) and thè sum of effective excess demand will diff e r from zero.

Ex post dema n d is equal to supply at each market, a nd then thè cumulateti suin of excess demands is identical equal to zero

Planned v a r iables are derived from individuai experi:.;ents, i n d epencenc of an event ;nutual i n c o n s i s t e n c y , v.-hereas

Accordingly, Walras' L aw is not v alid for e f f e ctive quanti t i e s outs i d e equilibrium. One m i g h t ask if this state of d i s ­

e q u i l i b r i u m can c o ntinue unchanged, but n a t u r a l l y it cannot. The e f f ective excess supply will influence thè m a r k e t c l e a r ­ ing mechanism, i.e., thè (reai) wage, but, for a number of reasons, thè a d j u s t m e n t process will be slow. One of these is that thè firms do not feel inclined to c h ange as long as they b e l i e v e that they are m a x i m i z i n g p r ofit (they do not k n o w thè p l a n n e d demand, only rea l i z e d q u a n t i t i e s ) . The w o r k e r s wi l l hes i t a t e before accepting a fall in wages. Furthermore, there is thè d a nger of setting off a w a g e - p r i c e spirai (cf. Keynes* w a r n i n g a g a i n s t wa g e de f l a t i o n in "thè General Theory". Dur- ing thè 1 9 6 0 's and e arly 1 9 7 0 's a parallel war n i n g aga i n s t wage inflation w o u l d have been u s e f u l ) . To give a m o r e thorough pic t u r e of thè dynamic process c h a r acterizing thè state of d i s ­ equilibrium, w e have to w a i t for thè d iscussion of thè "Corridor Model", section 2.2.6. below.

Looking at thè single individuai agent, thè raain obs t a c l e he encounters in an att e m p t to m a k e thè planned demand effective is w h e n he tries to break thè actual budget constraint. In thè short run, this c o n s t r a i n t is p r i m a r i l y related to thè liquidity position. W h a t e v e r thè a gent p o s s esses in liquid assets (money, d e mand deposits, short term bonds, etc.) a nd automatical credit lines can back thè p l a n n e d demand. Thus, in thè short run, it is re l e v a n t to talk a b o u t a l i q u idity c o n s t r a i n t ^. In thè m e d i u m run, thè liquid funds will be ex h a u s t e d (even if thè liquidity con c e p t is br o a d e n e d in this time perspective) and d e mand m u s t be b a cked by income (or new b o r r o w i n g ) . Thus, we find an income

(flow) c o n s t r a i n t . In thè long run, thè agent will experi e n c e a c r e d i t a b i l i t y crisis if his w e a l t h continues to stay in thè red; sooner or later thè cr e d i t o r s will ask for their m o n e y back and

2 thè w e a l t h const r a i n t becomes reai .

Clower, 1967, holds a p a r t i a l l y parallel view, but he stresses thè point that effective demand has to be b a c k e d by money.

The analogy of a single cou n t r y in thè international m o n e t a r y environment seems quite obvious.

Fo l l o w i n g Streissler, 1977, m a r k e t imperfe c t i o n s also put c o n ­ straints on thè p a r t i c i p a n t s . He m e n t i o n s that lack of price v a r i a t i o n m a k e s thè quantities rationed. The instance he cites is thè ave r s i o n of banks to raise and l ower thè lending rate to thè e x tent that neither u n s a t i s f i e d d e mand for loans no r excess reserves arise. This bank behavior can be e x p l a i n e d by some long run optimalization, but in thè short run, it crea t e s const r a i n t s on i n v e s t o r s 1 activities.

Similarly, thè partial situation of thè i nvestor pr e v e n t s him from being aware of thè m u t u a i i n t e r d ependence existing between thè c r e a t i o n and thè f u l fillment of expectations. Wh e n entre- pr e n e u r s expect a rise in reai dema n d and, therefore, begin some inves t m e n t plans, thè first step in increasing thè effective dema n d is realized. This could be c a l l e d thè c o n s t r a i n t of p a r t i a l i t y .

This d i s c u s s i o n of c o n straints shall be c l osed by stating that " un c e r t a i n t y leads to a cascade of constraints," (Streissler, 1977, p. 101), a generai but, nonetheless, ve r y important obser- v a t i o n .

C o n s t r a i n t s are active in disequilibrium, so there is no neces- sary c o m p a t i b i l i t y between thè real i z a t i o n of individuai plans. This leads, at thè ag g r e g a t e level, to thè knowledge that thè nth m a r k e t is not m e r e l y a m i r r o r of (n-1) other markets. Thus, thè conv e n t i o n a l p r o c edure i n •neoclassic m a c r o e c o n o m i c s of

suppressing thè analysis of one market, wi t h reference to Walras' Law, seems inconsistent w i t h thè d i s e q u i l i b r i u m assumption.

2.1.5. The Conc e p t of E q u i l i b r i u m

W i t h time, I am m o r e and m o r e coming to doubt w h e t h e r thè c o n ­ cept of equil i b r i u m is relevant to p ositive economie analysis. M a c r o e c o n o m i c s was at thè time of Walras a g g r e g a t e d m i c r o e c o n o m i c relations, so thè concept of equi l i b r i u m steals easily upon this a r e a .

The use of equi l i b r i u m in m a c r o e c o n o m i c s is stili defended. One line of arg u m e n t follows thè postulate: "sure we all k n o w that thè economy is never in equilibrium; but this is thè least a r b itrary assumption w h i c h c an m a k e our economie theory (as a logicai and c o n s i s t e n t system) o p e r a t i o n a l . " A n o t h e r school of thought stubbornly continues to a s sert

that "thè full emplo y m e n t economy is thè only r elevant f r a m e ­ w o r k for analysis." This school is pr o b a b l y blin d e d by thè e xper i e n c e s of thè fifties and sixties.

E q u i l i b r i u m as such seems to be a very large abst r a c t i o n when a p p l i e d to thè reai world. The mea n i n g of thè conc e p t has so m e w h a t d e v e l o p e d but one common feature is that equi l i b r i u m can be d e s c r i b e d by thè solution of a m a t h e m a t i c a l model. In its m o r e p r i m i t i v e form it is a state of economics wher e i n all p a r t i c i p a n t s are s a t isfied and m e r e l y w a n t to endlessly repeat their transactions, and all economie v a r i a b l e s are unchanged or p r e d e t e r m i n e d w i t h time. This is a long term stationary state^-. In g r o w t h theory, thè concept of e q u ilibrium is e l a b o r a t e d to imply constancy of g r o w t h rates rather than

levels, but this is su b s t a n t i a l l y thè same kind of abstraction. Ma n y refi n e m e n t s have been proposed: For instance, thè very p o l i s h e d A r r o w - D e b r e u model, wher e i n e q u i l i b r i u m is extended into thè future. Here, thè m a r k e t cle a r i n g values are given thè p o s s i b i l i t y of differing over time in a ccordance wi t h thè change in exogenous variables; yet stili, all transactions and eq u i l i b r i u m values are assumed to be esta b l i s h e d thè v e r y first day through a system of perfect spot a nd future markets.

T h e r e are a number of explanations as to how and w hy this concept of e q u i l i b r i u m penet r a t e d economie theory and thought. Looking at thè rural society of thè Eight e e n t h Century, when economie thought began, thè idea of every- thing repeating itself year after year was not so far- fetched. Later, thè idea of equi l i b r i u m survived in thè mi c r o e c o n o m i c analysis — espec i a l l y good examples were m a r k e t s for a g r i c ultural or m a s s p roduced goods.

Hahn has, w i t h time, changed his v i e w on thè c o n c e p t of equilibrium, m o v i n g from an A r r o w - D e b r e u c o n c e p t i o n to: "an economy is in equi l i b r i u m wh e n it g e n e r a t e s m e s s a g e s w h i c h do not c a u s e agents to change their t h eories w h i c h they hold or thè politics w h i c h they pursue". (Hahn, 1973, p. 25). This seems to be a great improvement because here thè e q u i l i b r i u m conc e p t is not rela t e d to a c e r t a i n state of thè economy but related to thè s t a bility of thè behavioral

(or structural) functions.

Sometimes a seemingly d i f f erent a p proach is employed, w h e r e b y thè long run e q u i l i b r i u m is dressed up w i t h leads and lags a c c o rding to thè c o r r e s p o n d e n c e principle. In this case, thè m o d e l is g i v e n some a r b i t r a r i l y c h o s e n initial values and thè q u e s t i o n of thè stability of thè equi l i b r i u m is w a t c h e d wi t h g r e a t earnestness. One should be aware that thè work i n g of such a m o d e l is d e t e r m i n e d by thè p o s t u l a t e d e q u ilibrium con- ditions in c o n n e c t i o n wi t h thè a s s u m e d m a r k e t adjustment

variables. W i t h i n thè n eoclassic tradition, it is always thè p r i c e va r i a b l e s (e.g. Patikin's price, rate of interest diagram. In K e y n e s i a n "une m p l o y m e n t equilibrium", one of thè adjustment v a r i a b l e s is reai output. C f . thè ISLM d i a g r a m ) .

In theo r e t i c a l economics, thè m o v e m e n t away from this stereo- typed i n t e r p r e t a t i o n of thè e q u i l i b r i u m concept has mo r e or less fo l l o w e d two ve r y dis t i n c t lines. One is an attempt to redefine thè c o n c e p t ' s content by relaxing thè a ssumption of g e n e r a i m a r k e t c learing w i t h i n each period, and thè level of a b s t r a c t i o n of thè long run state is reduced by introducing thè

i n stantaneous (short run) or intermediate (longer run) equilibria. The so-called te m p o r a r v e q u i l i b r i u m m e t h o d is de v e l o p e d in this background. The o t h e r line implies a rejection of thè generai e q u i l i b r i u m concept, a nd partial e q u i l i b r i u m is c o n s i d e r e d only as a p r a ctical tool in some cases.

The temporary e q u i l i b r i u m a p p r o a c h has redefined thè conc e p t of e q u i l i b r i u m in thè sense that situations w here trade takes place in thè m a r k e t are c a l l e d states of equilibrium even if

agents are constrained. Depending on thè scope of thè analysis m a r k e t s m a y be a s s u m e d to be exogenous a n d u n d i s t u r b e d by thè d e v e l o p m e n t on thè endogenous markets. The d i s t i n c t i o n between endog e n o u s and exogenous m a r k e t s is p r i m a r i l y r e l a t e d to thè length of thè p e riod of thè analysis.

If prices are p e r f e c t flexible (for instance on some financial m a r k e t s ) , thè m a r k e t clears i n s t a n taneously and no quant i t i e s are kept i n v o l u n t a r i l y . The r ealized price m a y entail revisions of thè e x p e c t a t i o n s c oncerning thè future prices w h i c h will

c a u s e a chan g e in thè price thè next period.

A n o t h e r r e p r e s e n t a t i v e of thè temporary equil i b r i u m m e t h o d is Malinvaud, 1977. He defines a m a r k e t e q uilibrium where, at

fixed prices, thè short end of thè m a r k e t determines thè trade (equilibrium) quantity"^. Then, thè plan n e d quantities will be c h a n g e d in thè next p e r i o d in accor d a n c e wi t h thè realized sales and thè d e v e l o p m e n t of stocks. W i t h i n that analysis, thè above d i s c u s s e d u n e m p l o y m e n t d i s e q u i l i b r i u m m a y be regarded as a c o n ­ s t rained e q u i l i b r i u m w h i c h is part of a generai e q u ilibrium model. This a p p r o a c h seems to m e to be very similar to thè

" insta n t a n e o u s equilibrium" method, only w i t h fixed prices and r a t i oning instead of fixed q u a n t i t i e s a nd d i s a p pointed price

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exp e c t a t i o n s .

So, w i t h a very m o d e s t intellectual effort, but with heavy m a t h e m a t i c a l c o m p l i c a t i o n s , these m o d e l s of instantaneous e q u i l i b r i u m c an form a synthesis by letting both types of v a r i a b l e have some degree of f l e xibility according to thè di f f e r e n t c h a r a c t e r i s t i c s of thè m a r k e t s u n d e r c o n s i d e r a t i o n . This will r e sult in very tough expe c t a t i o n a d j u s t m e n t functions • an adv a n c e d c l c c k w o r k system. But basically, it is stili an e q u i l i b r i u m model. It is assumed that some kind of m a r k e t

clear-Cf. section 2 . 1 . 9 . for a discussion of thè d i f ferent a d ­ justment behavior behind thè assump t i o n of flexible prices ctr. quantities

For other criticai comments on M a l i n v a u d ' s method, see A ndersen & Nielsen, 1977 and Kahn, 1978

ing takes p lace during each p e riod and thè a d j ustments are towards a w e l l - d e f i n e d state of long run e q u i l i b r i u m where perfect foresight and lack of u n c e r t a i n t y reign.

The second line can be identified by thè w a y in w h i c h thè post- K e y n e s i a n — C a m b ridge (UK) — school uses thè c o n c e p t of

e q u i l i b r i u m in its theoretical writings. " (To) use thè e q u i l i b r i u m concept one has to keep it in its place, and

its place is strictly in thè prel i m i n a r y stages of an analy t i c a l argument, not in thè framing of hypotheses to be test e d agai n s t thè f a c t s , for we k n o w p e r f ectly well that we shall no t find facts in a state of equilibrium", (J. Robinson, 1961, p. 78, m y i t a l i c s ) .

»

Gene r a l e q u i l i b r i u m is rejected^, espec i a l l y as a basis for empirical work, but partial e q u i l i b r i u m is kept as a useful tool for showing a nd analyzing specific phenomena. The m o s t p r o m i n e n t example is Keynes' use of a comp a r a t i v e static picture of thè goods m a r k e t to show thè i mportance of effective demand

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for thè level of p r o d u c t i o n . This is, of course, not to i n ­ timate that K e ynes should have c o n s i d e r e d perf e c t foresight or u n c e r t a i n t y as unJLmportant. On thè contrary, on l y for a few chapters of "thè General Theory" these state of things are a s s u m e d to be u n c h a n g e d — no t to confuse thè analysis of ef f e c t i v e d e m a n d at a p r e l i m i n a r y stage. The fundamental

p r o b l e m is, so to speak, to "tame" thè economy and, at thè same time, to a v o i d employing both inco n s i s t e n t and too unrealistic assuinptions.

In summary, m y o p i n i o n is that thè conc e p t of generai e q u i l i b r i u m is irrelevant in empirical a nalysis and an undue constr a i n t

on m a n y t h e oretical models. On thè other hand partial equil i b r i u m

Cf. Kaldor, "The Irrelevance of E q u i l i b r i u m Economics", where he refers to generai equilibrium, 1972, p. 1237. See Kregel, 1976.

2.1.6. T e n d e n c y towards E q u ilibrium

From our p revious discussions of how thè economy functions w ith- out an auctioneer, imperfect information about o ther t r a n s a c t o r s 1 plans c o n c e r n i n g price and quantity, and thè costs of transaction, it hard l y seems useful to assume that thè economy is in i n stan­ taneous equilibrium, or to a c cept thè statement: "Actual dis- equilibria n e v e r occur" (Mussa, 1976, p. 134). Instead, one

should perhaps talk about thè t e ndency towards equil i b r i u m (Hicks, 1965, pp. 17-18). If there is a theoret i c a l l y w e l l - d e f i n e d

e q u i l i b r i u m w h i c h thè automatic m a r k e t forces are driving thè e c o n o m y towards, then it seems m e a n i n g f u l to use thè con c e p t of a te n d e n c y towards equilibrium^. F or instance, in analyzing thè f inancial markets, one could apply this partial m e t h o d when thè short run d e v e l o p m e n t of thè rates of interest is described. If thè d e mand for one k i n d of financial assets rises and causes a fall in thè own rate of this asset, there will later be a chain of adjus t m e n t s which, g iven thè institutional framework, will result in a tendency to equalize thè own rates.

In m acroeconomics, as di f f e r i n g from partial- og1 m i c r o e c o n o m i c s , it is d i f f icult to employ this conc e p t because 1) no w e l l - d e f i n e d e q u i l i b r i u m exists — thè t a rget is, at best, c o ntinually mov- ing a n d 2) thè a d j u s t m e n t m e c h a n i s m s would, in any case, be o b s c u r e d by lack of s ufficient information. "No one w o u l d deny that to speak of a te n d e n c y towards e q u ilibrium that itself shifts thè pos i t i o n towards w h i c h it is tending is a contr a d i c

-P r o f e s s o r Garegnani, 1977, p. 382, uses thè term "a c e ntre of gravitation" which, alt h o u g h tempting for m e t a p h o r i c a l

reasons, has thè asso c i a t i o n of a c l o ckwork system of (naturai) science.

Lindbech, 1976, in his m e t h o d o l o g i c a l introduction to thè

* above m e n t i o n e d S t o c kholm c o n f e r e n c e touched upon this theme w it h o u t taking into c o n s i d e r a t i o n thè full cons e q u e n c e s of thè c ritique for thè usefulness of thè generai e q u i l i b r i u m framework.