At the crossroads between economic theory and policy: ‘Misplaced concreteness’ and ‘disguised politics’ within the formulations of PPP as a theory of exchange rate equilibrium in Gustav Cassel’s economic thought
The concept of equilibrium lies at the heart of economic analysis since its inception, being a central organising concept of economic theorising in both Classical and Neoclassical schools of thought. However, the jump in use of the concept of equilibrium from a methodological device in the development of abstract theory, models, to a characterisation of concrete historical situations as one of equilibrium, which is key to transform the theoretical concept into an operational concept for economic policy, has always been characterized by tensions and controversy. The determination of real exchange rate equilibrium at a theoretical level and its operationalization as empirical tool is no exception. In this paper I will illustrate that this underlying tension in the use of the concept equilibrium in exchange rate theory has been present since its inception in the formulation of Purchasing Power Parity (PPP) theory, and in its application, by Swedish economist Gustav Cassel. When the Gold Standard was abandoned by European countries after the outbreak of the 1st World War, exchanges rates fluctuated erratically to the bewilderment of many. In this context, the formulation of PPP theory provided an explanation for the movement of exchange rates based on inflation rate differentials between countries would bring international recognition to Cassel. In the years after the war, Cassel participated actively, as an expert, in different conferences organized by League of Nations to discuss the return of the gold standard, in which he argued in favour that new gold parities should be settled by countries at levels determined by PPP theory. However, when trying to translate the concept of equilibrium from abstract theory to concrete historical situations, I claim that Cassel would fall into the fallacies of “misplaced concreteness” and “disguised politics”, long highlighted by Machlup (1958). This eventually led him to a continuous process of change and adjustment in his exposition of PPP theory, introducing an increasing number of auxiliary assumptions and necessary conditions, which needed to be fulfilled to sustain his defence of PPP as a theory of real exchange rate equilibrium. Hence, overall, I argue that the contrasting definitions of PPP theory present in Cassel’s economic thought stems from the crossroads between developing economic theory and trying to influence policy-making that he found himself in the years after the First World War. A tension that was inherited in later formulations of the real exchange rate equilibrium in the literature.
Area: Eshet Conference
Keywords: Purchasing Power Parity, PPP, Gustav Cassel, Exchange Rates, Equilibrium