I’ve long promised a post on Austrian economics. To organise my thoughts and minimise the risk of attacking a straw man, I’ve taken as my starting point this encylopedia article by Peter Boettke. Boettke sets out ten claims and derives some claimed conclusions. I’ve responded point by point, and then given my own summary.
As I’ve had trouble with various fringe adherents of Austrianism, I’m setting out some strict ground rules for discussion here. Comment should stick strictly to discussion of economics. Anyone making personal attacks of any kind will have their comments deleted and be barred from this thread. Avoid anything that might be seen as insulting other participants in the discussion
Boettke’s points follow, with my responses in itals
The Science of Economics
Proposition 1: Only individuals choose.
Man, with his purposes and plans, is the beginning of all economic analysis. Only individuals make choices; collective entities do not choose.
The primary task of economic analysis is to make economic phenomena intelligible by basing it on individual purposes and plans; the secondary task of economic analysis is to trace out the unintended consequences of individual choices.
So far so good. Methodological individualism seems like a good starting point. But it’s important to remember that individual choices are very much affected (sometimes, effectively determined) by the collective entities of which they are a part.
Proposition 2: The study of the market order is fundamentally about exchange behavior and the institutions within which exchanges take place.
The price system and the market economy are best understood as a “catallaxy,” and thus the science that studies the market order falls under the domain of “catallactics.” These terms derive from the original Greek meanings of the word “katallaxy”—exchange and bringing a stranger into friendship through exchange. Catallactics focuses analytical attention on the exchange relationships that emerge in the market, the bargaining that characterizes the exchange process, and the institutions within which exchange takes place.
Markets are places where exchange takes place, so this is more or less self-evident. But there is more to economics than markets. The extensive attention given to Robinson Crusoe in economic textbooks is evidence of this, as is the huge amount of activity that takes place within firms, households, governments and so on. The absence of any real theory of the firm, or of the household, is a major weakness of Austrian economics, partly reflecting the very limited work done in this framework in recent decades, a period which has seen huge developments in mainstream analysis of contracts, asymmetric information and so on
Proposition 3: The “facts” of the social sciences are what people believe and think.
Unlike the physical sciences, the human sciences begin with the purposes and plans of individuals. Where the purging of purposes and plans in the physical sciences led to advances by overcoming the problem of anthropomorphism, in the human sciences, the elimination of purposes and plans results in purging the science of human action of its subject matter. In the human sciences, the “facts” of the world are what the actors think and believe.
The meaning that individuals place on things, practices, places, and people determines how they will orient themselves in making decisions. The goal of the sciences of human action is intelligibility, not prediction. The human sciences can achieve this goal because we are what we study, or because we possess knowledge from within, whereas the natural sciences cannot pursue a goal of intelligibility because they rely on knowledge from without. We can understand purposes and plans of other human actors because we ourselves are human actors.
The classic thought experiment invoked to convey this essential difference between the sciences of human action and the physical sciences is a Martian observing the “data” at Grand Central Station in New York. Our Martian could observe that when the little hand on the clock points to eight, there is a bustle of movement as bodies leave these boxes, and that when the little hand hits five, there is a bustle of movement as bodies reenter the boxes and leave. The Martian may even develop a prediction about the little hand and the movement of bodies and boxes. But unless the Martian comes to understand the purposes and plans (the commuting to and from work), his “scientific” understanding of the data from Grand Central Station would be limited. The sciences of human action are different from the natural sciences, and we impoverish the human sciences when we try to force them into the philosophical/scientific mold of the natural sciences.
As an objection to naïve behaviorism this is fine. If you want to understand what people do, it’s important to understand what they think. But the facts economists try to explain are what people do.
Microeconomics
Proposition 4: Utility and costs are subjective.
All economic phenomena are filtered through the human mind. Since the 1870s, economists have agreed that value is subjective, but, following alfred marshall, many argued that the cost side of the equation is determined by objective conditions. Marshall insisted that just as both blades of a scissors cut a piece of paper, so subjective value and objective costs determine price (see microeconomics). But Marshall failed to appreciate that costs are also subjective because they are themselves determined by the value of alternative uses of scarce resources. Both blades of the scissors do indeed cut the paper, but the blade of supply is determined by individuals’ subjective valuations.
In deciding courses of action, one must choose; that is, one must pursue one path and not others. The focus on alternatives in choices leads to one of the defining concepts of the economic way of thinking: opportunity costs. The cost of any action is the value of the highest-valued alternative forgone in taking that action. Since the forgone action is, by definition, never taken, when one decides, one weighs the expected benefits of an activity against the expected benefits of alternative activities.
This can be read in two forms. The weak form, which Peter Boettke adopts in comments relies on the opening claim that “all economic phenomena are filtered through the human mind” and are in that sense subjective. This is true of the standard neoclassical theory as presented by Marshall, and it was equally true of the older labor theory of value. The strong form is the implication that a theory of value (different in some substantive sense from the Marshallian) can be developed without reference to objective conditions of production. The strong form is important, but wrong. The weak form consists of claims that are true, as Boettke says, “by definition”, and are therefore tautological. The problem I have with this kind of thing is twofold. First, you commonly get a rhetorical two-step where the strong form of the claim is put forward, then replaced by the weak form when it is challenged. Second, it seems to be supposed that purely tautological claims of this kind justify the kind of a priorist metholodogy favored by Mises and some (but not all) other Austrians, in which economics is supposed to consist of logically self-evident truths.
Proposition 5: The price system economizes on the information that people need to process in making their decisions.
Prices summarize the terms of exchange on the market. The price system signals to market participants the relevant information, helping them realize mutual gains from exchange. In Hayek’s famous example, when people notice that the price of tin has risen, they do not need to know whether the cause was an increase in demand for tin or a decrease in supply. Either way, the increase in the price of tin leads them to economize on its use. Market prices change quickly when underlying conditions change, which leads people to adjust quickly.
True and important, but not the whole truth, as witness the fact that people (including the managers of enterprises) so frequently choose to dispense with prices and rely on direct control to get things done.
Proposition 6: Private property in the means of production is a necessary condition for rational economic calculation.
Economists and social thinkers had long recognized that private ownership provides powerful incentives for the efficient allocation of scarce resources. But those sympathetic to socialism believed that socialism could transcend these incentive problems by changing human nature. Ludwig von Mises demonstrated that even if the assumed change in human nature took place, socialism would fail because of economic planners’ inability to rationally calculate the alternative use of resources. Without private ownership in the means of production, Mises reasoned, there would be no market for the means of production, and therefore no money prices for the means of production. And without money prices reflecting the relative scarcities of the means of production, economic planners would be unable to rationally calculate the alternative use of the means of production.
As with P4, this has a strong and a weak form. The strong form suggests that rational economic calculation is impossible in enterprises where the means of production are publicly owned. This is false, unless the term ‘rational’ is stretched so as to make the claim meaningless. Publicly owned enterprises have operated successfully for decades, sometimes in competition with private firms and sometimes as monopoly providers. There’s a case to be made that, on balance, private ownership yields better performance, but even if you accept this case, this does not sustain the claim above. The weaker view, defended by Boettke in comments, is that an economy needs at least some private ownership to produce informative money prices. This obviously leaves open the question of how large the publicly-owned sector can be without inducing economic collapse. Experience here and elsewhere suggests that substantial public ownership is compatible with continued economic growth. Determining the optimal balance is a matter of empirical assessment not abstract arguments of the kind put forward by Mises.
Proposition 7: The competitive market is a process of entrepreneurial discovery.
Many economists see competition as a state of affairs. But the term “competition” invokes an activity. If competition were a state of affairs, the entrepreneur would have no role. But because competition is an activity, the entrepreneur has a huge role as the agent of change who prods and pulls markets in new directions.
The entrepreneur is alert to unrecognized opportunities for mutual gain. By recognizing opportunities, the entrepreneur earns a profit. The mutual learning from the discovery of gains from exchange moves the market system to a more efficient allocation of resources. Entrepreneurial discovery ensures that a free market moves toward the most efficient use of resources. In addition, the lure of profit continually prods entrepreneurs to seek innovations that increase productive capacity. For the entrepreneur who recognizes the opportunity, today’s imperfections represent tomorrow’s profit.1 The price system and the market economy are learning devices that guide individuals to discover mutual gains and use scarce resources efficiently.
This is probably the most distinctive and valuable point of the Austrian school. But it’s important to remember that discovery is ultimately a public good, and that markets only reward some kinds of discovery
Macroeconomics
Proposition 8: Money is nonneutral.
Money is defined as the commonly accepted medium of exchange. If government policy distorts the monetary unit, exchange is distorted as well. The goal of monetary policy should be to minimize these distortions. Any increase in the money supply not offset by an increase in money demand will lead to an increase in prices. But prices do not adjust instantaneously throughout the economy. Some price adjustments occur faster than others, which means that relative prices change. Each of these changes exerts its influence on the pattern of exchange and production. Money, by its nature, thus cannot be neutral.
This proposition’s importance becomes evident in discussing the costs of inflation. The quantity theory of money stated, correctly, that printing money does not increase wealth. Thus, if the government doubles the money supply, money holders’ apparent gain in ability to buy goods is prevented by the doubling of prices. But while the quantity theory of money represented an important advance in economic thinking, a mechanical interpretation of the quantity theory underestimated the costs of inflationary policy. If prices simply doubled when the government doubled the money supply, then economic actors would anticipate this price adjustment by closely following money supply figures and would adjust their behavior accordingly. The cost of inflation would thus be minimal.
But inflation is socially destructive on several levels. First, even anticipated inflation breaches a basic trust between the government and its citizens because government is using inflation to confiscate people’s wealth. Second, unanticipated inflation is redistributive as debtors gain at the expense of creditors. Third, because people cannot perfectly anticipate inflation and because the money is added somewhere in the system—say, through government purchase of bonds—some prices (the price of bonds, for example) adjust before other prices, which means that inflation distorts the pattern of exchange and production.
Since money is the link for almost all transactions in a modern economy, monetary distortions affect those transactions. The goal of monetary policy, therefore, should be to minimize these monetary distortions, precisely because money is nonneutral.
With a handful of dogmatic new classicals, all economists agree that money is non-neutral. And with a similar handful of exceptions, all economists agree that inflation is undesirable (if sometimes unavoidable)
Proposition 9: The capital structure consists of heterogeneous goods that have multispecific uses that must be aligned.
Right now, people in Detroit, Stuttgart, and Tokyo City are designing cars that will not be purchased for a decade. How do they know how to allocate resources to meet that goal? Production is always for an uncertain future demand, and the production process requires different stages of investment ranging from the most remote (mining iron ore) to the most immediate (the car dealership). The values of all producer goods at every stage of production derive from the value consumers place on the product being produced. The production plan aligns various goods into a capital structure that produces the final goods in, ideally, the most efficient manner. If capital goods were homogeneous, they could be used in producing all the final products consumers desired. If mistakes were made, the resources would be reallocated quickly, and with minimal cost, toward producing the more desired final product. But capital goods are heterogeneous and multispecific; an auto plant can make cars, but not computer chips. The intricate alignment of capital to produce various consumer goods is governed by price signals and the careful economic calculations of investors. If the price system is distorted, investors will make mistakes in aligning their capital goods. Once the error is revealed, economic actors will reshuffle their investments, but in the meantime resources will be lost.3
Again, no one disagrees with this. I was waiting for a claim that capital markets always do a better job of allocating capital than any alternative, or that they would do better in the absence of government regulation, but it hasn’t been made, so I won’t impute it. I will note that the price system may be distorted by all sorts of factors, including systemic biases in capital markets. The dotcom bubble/bust is a prime example of capital market failure in the leadup to the GFC.
Proposition 10: Social institutions often are the result of human action, but not of human design.
Many of the most important institutions and practices are not the result of direct design but are the by-product of actions taken to achieve other goals. A student in the Midwest in January trying to get to class quickly while avoiding the cold may cut across the quad rather than walk the long way around. Cutting across the quad in the snow leaves footprints; as other students follow these, they make the path bigger. Although their goal is merely to get to class quickly and avoid the cold weather, in the process they create a path in the snow that actually helps students who come later to achieve this goal more easily. The “path in the snow” story is a simple example of a “product of human action, but not of human design” (Hayek 1948, p. 7).
The market economy and its price system are examples of a similar process. People do not intend to create the complex array of exchanges and price signals that constitute a market economy. Their intention is simply to improve their own lot in life, but their behavior results in the market system. Money, law, language, science, and so on are all social phenomena that can trace their origins not to human design, but rather to people striving to achieve their own betterment, and in the process producing an outcome that benefits the public.
This is true, but so is the converse: social institutions are often the result of human design.
The implications of these ten propositions are rather radical. If they hold true, economic theory would be grounded in verbal logic and empirical work focused on historical narratives.
This is a gigantic non-sequitur, which reflects the cultural predilections of the Austrian tribe. If anything, the outline above supports an axiomatic and mathematical approach of the type favored by the neoclassical school. Prices are numbers after all, and information is a mathematically precise concept. Why would you throw all that away and stick to verbal methods, except for lack of capacity to do it right? And the claimed focus on empirical work seems to be the exact opposite of the a priori methodology espoused by Mises and supported above.
With regard to public policy, severe doubt would be raised about the ability of government officials to intervene optimally within the economic system, let alone to rationally manage the economy.
Not many people these days would claim optimality for government intervention. But there’s nothing so far to show that government intervention can’t improve outcomes in the standard cases of microeconomic market failure and macroeconomic co-ordination failures.
Perhaps economists should adopt the doctors’ creed: “First do no harm.” The market economy develops out of people’s natural inclination to better their situation and, in so doing, to discover the mutually beneficial exchanges that will accomplish that goal. Adam Smith first systematized this message in The Wealth of Nations.
The first sentence seems entirely inconsistent with the general policy stance of the Austrian school, which involves a wide range of radical policy measures, based on untested hypotheses. “First do no harm” would suggest cautious incremental changes to the existing mixed economy. It’s true that markets develop out of natural inclinations to better our situation, but then so do governments.
In the twentieth century, economists of the Austrian school of economics were the most uncompromising proponents of this message, not because of a prior ideological commitment, but because of the logic of their arguments.
Sorry, but I can’t agree. Maybe this was true at the beginning of the 20th century, but in recent decades, the Austrian school of economics has been a dogmatic sect, characterised by extreme ideological views on all subjects. About the only thing I agree with in this point is that the Austrian message is based primarily on a priori logic and not on openness to empirical evidence.
Summary. The main thing I find useful in Austrian economics is captured by Proposition 7, which encapsulates the limitations of neoclassical general equilibrium theory, where all possible states of nature are assumed known, so that discovery is not really possible. Unfortunately, this is wrapped up with both some misconceived methodological views (for example, the commitment to verbal logic) and a set of ideological blinkers which guarantee in advance that the policy conclusions will be those of laissez-faire.
Final point. Boettke doesn’t talk explicitly about Austrian Business Cycle Theory, which is obviously of some interest. I’ll treat this topic in a later post.
Update I advertised this in comments over at the Austrian Economics Blog. I got a couple of comments from Greg Ransom (thanks!), but I was hoping for a bit more of a response from serious Austrian economists, while avoiding the lunatic fringe. Is there anywhere else I should be looking?
Further update I’ve edited this a bit in response to comments from Peter Boettke. In particular, I’ve changed my treatment of Props 4 and 6. As clarified Prop 4 doesn’t reveal any substantive difference between Austrian and mainstream economics, and Prop 6 is much weaker than it appears.
John Quiggin 
Andrew at 86 says
“As part of your answer please incorporate excess and deaths due to war.”
and Sean at 85 says
“I want your definition of it”. (Sean wants my definition for the word “common good”.) “I understand what it is but what is your view of the common good – what does it mean? How does it come about?”
What is this??? – do I get any pay for taking instructions from you two?
There was an elephant at Taronga Park Zoo in the 1930s. Her name was Jesse. She carried children around on her back for rides. If you two dont mind, please dont mistake me for Jesse. In exchange I wont mistake you for Jesse, for both having such thick hides.
Alice – I would like to hear your definition because you refuse to argue using facts but rather make wild assertions. Such as that I am a fundamentalist libertarian-type person.
Note that I wrote (#83) a long reply to your post and you ignore it. There is very little logic in what you are talking about so I thought that instead of discussing things with you; finding your personal definitions would be able to decipher why you go to extremes in debate.
Sean G #102
Isnt it your view I have individual “freedom of choice” .
Then Ill take it in terms of who I respond to and how.
Oh and Sean – I dont go to extremes. I believe in the public sector and the private sector. I dont believe in people who suggest an all or nothing approach to the management of economic policy and I dont like extremism (I dont subscribe to ideology for ideology sake) I dont beleive that private markets are the sole creators of wealth. I dont beleive everything boils down to an emphasis on “individuals being free to choose”. I dont beleive individualism should be the sole focus. We have a public sector (and a legal framework) to prevent market failure. As we speak there are republican senators in the U.S who are outraged by the payments to AIG executives from public bailout monies. So am I. This is clearly morally wrong and is evidence that CEO self reward and market systems of remuneration have failed us utterly. They have had almost perfect market freedoms over their salary processes and have abused it. Yet some remain persistently unwilling to see the flaws and weaknesses of the unregulated market model.
Sean you have seen the waste in government. I do not deny that there can be waste in government but you would deny the government an existence to a greater extent than I would deny the market a place (and indeed I do not – I object to market abuses and market failures, not the market itself as you may well object to government abuses and not the government itself).
If you see any place for the government, then you must see a need for public actions toward the common good and you are well aware of the meaning of the word.
So what role do you see for the government Sean?
(unless you want to exercise your freedom of choice not to answer my question of course).
Yes, me also.
Ben, its funny how a comment challenging the view that governments are basically good for nothing parasites all of a sudden bears the burden of proof. The original proposition however bears no such burden. The rules of the exchange appear to be heavily weighted to one side.
Lets start with the health system, that there is only limit scope for genuine competition in health is fairly self evident. The private hospital sector runs largely on public money.
If there is true competition in public transport in any city anywhere I would be very happy to follow up the lead. This in fact goes for any of my examples. Privately run public transport services in Australia run largely on public money.
Cable networks? I really can’t see how else they can be run. Even if we did get competition are we to have multiple networks? That strikes me as over-investment.
You may say wireless, but I think this also eventually runs into the same problem, its called economies of scale.
Water distribution, same problem.
How about roads, are we to build multiple roads along the most efficient routes in a city? Sure you may say well they have a choice and go the long way, but if they choose to take the most direct and efficient route they are forced to deal with a monopoly. You could almost call that coercion.
Airports – need I say more.
So you think the local GP doesn’t compete for clients by trying to have a nice office, convienient operating hours and friendly service?
The taxi industry seems to entail competition. And it does so in spite of barrier to entry costs of around $400,000 just in the government imposed vehicle license fee. And in spite of blanket price regulation. And of course in Sydney we had private buses until routes were regulated and then the services were ultimately bought out under compulsory government acquisition. And when it comes to intra city public transport all the airlines in Australia are privately owned and competitive.
Japan privatised it’s urban railways back in the 1980s. Apparently they now have some of the best commuter rail services in the world.
Alice @ 104 –
My view on the economic role of Government is to create the right structure and framework to allow the private sector and the marketplace to operate as efficiently and productively as possible.
This requires high amounts of physical and social capital – transport and energy infrastructure; a good education system that is not based on socioeconomic background; the rule of law; maintenance of public spaces to improve our quality of life.
Government must provide a light-touch regulation focusing on areas that matter and enforcing high standards of behaviour.
Not very in depth but it is a broad view on the role of the government. Do you require any more info?
Terje,
Don’t forget London up to the point where it was all nationalised. Same applied for many cities around the world – public transport was started by private companies and then it was nationalised.
Markets are perfect.
TerjeP
“The taxi industry seems to entail competition. And it does so in spite of barrier to entry costs of around $400,000 just in the government imposed vehicle license fee”.
Re your suggestion on taxi de-regulation – they tried that in the Northern Territory. It churned, and it churned as every layabout from Alice Springs North went off to NT with vehicle to be a taxi driver…rides from hell, drunken drivers, assaults in taxis….flood of angry customer complaints didnt stop. Sufficient to reverse it – a dismal failure.
Your proposition that Austrian economics is a crude form of reductionism is false and misleading. Your attempting with your simplistic reductionist argument to undermine gentelman such as Mises, Hayek, Schrumpter, Menger and Smith whose wisdom and ideas have taken economics from its simplistic classical Newtonian form to something closer to a unified theory of economics.
“Austrian economics adopts a humanistic perspective on the world. It is the socialist / marxist principles that are fundamentally reductive in its understanding of human action, displacing the human subject from the center of its concerns and turning instead to vast, impersonal forces to explain historical and social pattern.Hence socialist /communist ideas are reductionist – trying to understand higher more complex phenomena in terms of alower or less complex phenomena, it loses sight of what is fundamentally distinctive about human action.”
“Bruce Littleboy Says:
March 20th, 2009 at 1:45 pm
Sdfc 70
You seem to think that there may be a rational way to break into the Austrian mindset. They argue, with some plausibility, that markets promote competition; monopolies are transitory — technological artificacts– unless governments protect them from new entrants and technologies.
“Optimal” suggests “efficient”, but they reject static neoclassical “efficiency” based on perfect competition in favour of the dynamic efficiency resulting from creative destruction.”
Bruce raises an important point about the Austrians, It is difficult freeze the Austrians into a corner, as the view of there world is not classical Newtonian in nature.
I will quote Paul Cantor here:
Click to access asc8-cantor.pdf
“Austrian School respects the heterogeneity of phenomena and hence of a variety of methods of studying them. The Austrians do not accept the idea of a master science, one method of knowing that provides the key to understanding all phenomena. Far from being reductionist,
Austrian economics refuses to study the human in terms of the non-human.”
“The Austrian School views economics as the realm of freedom; indeed it regards economic behavior and above all the central act of choice as the defining manifestation of human freedom. Austrian economics is the very opposite of a deterministic doctrine. In addition to resting on the axiom of human freedom of choice, it stresses the role of chance and contingency in human affairs.”
The precise reason I discovered economics, had a lot to do with the ubiquitous offering Austrian economic thought brings to the table of life. It reminds me of a book I read years ago “Zen and the Art of Motorcycle Maintenance” by Robert Prisig, the primary message I took away from this book was that no set of instructions was ever a watertight guarantee of providing a practical solution to a problem, as Robert discovered whilst trying unsuccesfully to mend his bike.
The Socialist mindset reminds me of the Quantum Zeno effect (QZE) or Zeno’s arrow paradox
http://en.wikipedia.org/wiki/Quantum_Zeno_effect
The QZE is reductionist in nature. It can be likened to Keynesian economic thought. Keynesian policies are currently being applied in many parts of the world. They are deterministic in nature, only address immediate consequences and deliberatley neglect the long term consequence of short sighted reductionist policies. In fact Kenyenesian eonomics is the perfect tool for the state, its short term populist solution tends to make the future consequences of its actions forgotten.
Icono Austrian economics is far from as simplistic as you have labelled it. The fact you see it as reductionist implies you have as yet not grasped the full extent of its offering.
Jim Birch @67
Your views are flawed. I no it is attractive to put us all in separate baskets and put labels on us to explain your world. But it is not a realistic proposition. It is awfully reductionist don’t you think.
Sukrit. Thanks for drawing my attention to this: it wasn’t where I looked for it. My response to the response.
On the subjective nature of costs, it seems that Boettke’s claim is much weaker than it appeared to me, and much closer to the view that Don Arthur imputes. If so, I don’t disagree, but I also don’t see anything distinctively Austrian about it.
On #6, again, the claim as explained seems much weaker than as originally stated. It now looks as if all that is being said is that a perfectly socialist economy will not function because of the absence of the price information generated by property rights, but that a mixed economy can do fine, since the public sector can use price information generated by the private sector. Conversely, as I note, the private sector depends heavily on public goods, including information generated in the public sector. So, a mixed economy looks pretty good here.
Finally, I agree that some version of ABCT is implicit in #10, and I will come back to that.
On mathematical theory and econometrics, there seems to be a lot of disagreement within the Austrian school. My view is that, while a fair degree of scepticism is appropriate, it is a mistake to reject these methods outright.
This paper by “New Austrians” seems to put the case pretty well
Click to access An%20Appeal%20from%20New%20to%20Old%20and%20Middle-Aged%20Austrian.pdf
Feel free to repost this over at the Austrian blog.
Bruce – you state the esteemed of the Austraian view “They argue, with some plausibility, that markets promote competition; monopolies are transitory”
If Monopolies are so transitory why do we still have the excessively large pharmas, M’soft and numerous others and why is AIG too big to fail? The CEOS at the top these mountains like to flex their political muscles and keep their monopolies intact by exerting pressure on governments to protect them (whether through less regulation or whether through taxpayer subsidies). Transitory – hardly. Efficient – hardly. AIG, Merrill Lynch and whole lot of others may be transpiring right now but they are showing strong resistance to the idea of being transitory.
Post at 115 meant to refer to Ubiquity’s comment at 113 (not Bruce).
post #113 was in regard to Iconoclast post @24
Alice @116
The markets Austrians argue for don’t currently exist. Thus comments like “AIG is to big to fail” are possible scenarios.
118# The markets Austraians argue for Ubiquity will never exist because it is an extreme view and extremes rarely work. Economists of all people should understand this (and the concept of equilibrium – it should also apply to economic policy decisions). I dont think I am alone in thinking this, but there now appears to be a backlash against policy direction that has swung unhealthily too far towards along the continuum towards the Austrian view…
I am pleased to see their is now a Bill that Obama has drawn up to impose a 90% tax surcharge on bonuses paid to executives at firms who have received 5 bill or more of bailout monies, for those executives who earn in excess of 250,000 (U.S.). Id like to see this imposed on all corporations, not just firms who have received bailout monies (and extend it to their usual remuneration – anything in excess of 250K U.S. is taxable at 90%. The use of off shore tax havens to launder taxable income into tax free income should be made an incarcerable offence).
It needs to be done. The plunder has been obscene.
“Proposition 6: Private property in the means of production is a necessary condition for rational economic calculation.
Obviously false, unless the term ‘rational’ is stretched so as to make the claim meaningless. Publicly owned enterprises have operated successfully for decades, often in competition with private firms. There’s a case to be made that, on balance, private ownership yields better performance, but even if you accept this case, this does not sustain the claim above.”
Well, I think that you need to think a little more when you respond to this king of claim.
First: The Austrians argue that socialism is irrational because there is no tendency for the means and ends structure with confront the central planner to be discovered. What this means is that without a social system based on private property we cannot have any systematic tendency towards the discovery of the structure of the problem with the central planner (or any planner) is confronted with. In the market there are millions of plans, each one of them is made based on a means and ends structure as perceived by each individual with is very small compared to the total “means and ends structure of society”. Each agent only needs to know his local data and anticipate the actions of other agents directly relevant to the completion of his action plan. The “total plan structure” of the economic system (made of millions of coordinated individual plans) becomes similar to the plan elaborated by an omniscient dictator.
However, since human beings have a limited capacity to perceive the structure of the problem with they are confronted, a system were the knowledge of millions of individual minds are mobilized is needed for the existence of rational economic planning. Now, if you assume equilibrium you are assuming that this knowledge problem with confronts every planning being is solved instantaneously, so the argument is essentially that without economic freedom no systematic tendency towards equilibrium can occur in the economic system.
Equilibrating tendencies exist in the market because the discrepancies in the price system permit the utilization of discoveries made by any agent participating in the market process. Or to put in other terms, it there is plan discoordination, then any agent can profit by discovering and coordinating these plans. With implies that the market utilizes the dispersed knowledge in the system in its totality. In central planning the central planner only utilizes his individual knowledge.
State enterprises are inserted in the market process and do not suffer from the type of problems related to socialism.
Rafael #120 Equilibriating tendencies and disequilibriating tendencies exist in the market or havent you noticed noticed lately? Unfortunately market abuse or abuse of market power tends to “disequilibriate”. Abuse of market power exists only because some have the wherewithall, the freedom and the power to choose to ignore the market or the price or demand (price control) – thus the Austrian design would appear to be fatally flawed – in that the implied freedoms of the market work to eventually concentrate power, permit greater, not lesser market power, and unravel the equilibriating tendencies of the Austrian model market. This is not new – Smith noticed the tendency for the growth of monopolies over time, so did Marx.
There is also as much hype surrounding the socialist view as there is surrounding the Austrian view or the communist view. They all have hype or are hype and none on its own a worthy solution. What is needed is a micro approach to macro policy management.
“With a handful of dogmatic new classicals, all economists agree that money is non-neutral. And with a similar handful of exceptions, all economists agree that inflation is undesirable (if sometimes unavoidable)”
Well, it is true that everybody knows that money is non neutral. What nobody seems to know is that there is no scientific theory of how money exists. Where is the chapter on money on my micro textbook? There is none. The answer to the absence of money in rational choice theory is simple: money cannot exist in equilibrium, and since equilibrium plans are represented in mathematical economics as the solution to the maximization problem with the agent confront itself, then rational maximizing agents do not utilize money. Note that money neutrality is equivalent to the inexistence of money. The new classicals are only the most rigorous of the mathematical economists and have taken the traditional neoclassical economics to the full logical implications of defining economics as the science of scarce means and unlimited ends. To most economists of the Austrian school the traditional neoclassical theory is a special case of the Austrian theory of the market process.
In Austrian economics money exists because of disequilibrium awareness. With means that since people become aware that they make spontaneous discoveries (they become aware that they do not know the means and ends structure with they are confronted and they become aware that, with the passage of time, they will discover opportunities to make better action plans), then they will demand the means necessary to explore these discoveries. Money is demanded because people expect it to be liquid. Since money does not have any value in itself, only as a means of exchange, monetary emission generates real effects because money is valued and since the cost of emitting money is zero, then in the short run people start believing that they are richer than they really are. Money them can disconnect (in the short run) the expectations of economic actors from the underlying reality of the market. In the long run money tends to be neutral because of the equilibrating tendencies of the market process.
The process of disconnecting the agents from economic reality in the short run to connect in the long run is explained by the ABCT.
Rafaal – my response to PB at #114 seems to apply also to your point @120
@122. The fact that there is no chapter on money (I assume that you mean “money in GE” or similar, since most micro texts do have a chapter on money) in your micro textbook does not imply that there is no economic theory of how money exists or how its existence affects general equilibrium. You might try Google scholar before making such assertions.
A combination of sweeping assertions about the superiority of school X on topic Y with obvious ignorance about mainstream work on the same topic is, unfortunately, a characteristic weakness of heterodoxy. I remember reading an econophysicist announcing triumphantly that, contrary to the foolish claims of mainstream economists that stock market prices can be predicted, they actually follow a random walk.
122# Ahh JQ. Stock market prices can be predicted – oh yes they follow a random walk (like “a drunk in a paddock” as one of my favourite lecturers explained it to me….).
I should get a bit more serious here, much as it is nice to tweak ‘market lovers’ noses.
When you don’t have reasonably accurate models, which are built on clear understandings (at least in the stochastic sense) of actions of components. Then you have to resort to (what I call at least) ‘1st order modelling’.
That is, a top down model based on empirical history, superior trend analysis basically. The limitations are obvious, you have limited analytic power (ie it explains what happens, not why), and it has poor (or non-existent) predictive power, because the future never quite follows the past, it sort of resonates.
If you do more research and you have the data then you might find 2nd order effects, that is components of the overall system you are analysing (basically correlations of sub-component). This give better analytic power and, sometimes better predictive power.
This is basically the only options in economics as we do not have:
(1) A good model of individual economic behaviour (though there is some great progress here).
(2) A good model of the firm as JQ noted, though this is strongly linked to small group behaviour as this is the dominant effect on decision making in medium/large organisations. Small group research has barely made progress since the 1st work decades ago.
(3) Large group behaviour. We have virtually nothing but rough guesses of mob behaviour. I was reminded of this today, watching a girl walk down the street with a bottle of water in her hand. This mob movement came out of nowhere and has made billions for some people out of frankly totally irrational and economically idiotic individual behaviour. Not long a ago the only people carrying water bottles were hikers … and we use tap or river water.
Therefore, we have to concentrate on top down, observationally based, data driven 1st and 2nd order models, hoping to find patterns and relationships that will give us some analytic and predictive power (this is the basis of Operations Research).
Used carefully these can be incredibly useful tools.
Take a practical example, Minsky’s Instability Model. This is 1st (perhaps 2nd order) model. it offers some analytic power (too much debt creates asset bubbles, plus reduction in loan standards happen, with mob behaviour driving it).
But the model tells us nothing about:
(1) When this might happen.
(2) What will trigger it.
(3) How it continues to grow
(4) What is the exact level that it will all fall over.
(5) etc.
So you can’t take this model and, plug in some observations, some assumptions and (say) predict that if current trends continue then in 15 years +- 3 years a debt deflation event will start.
Importantly this does not mean it cannot be used as a management tool. Because we know this is a danger, then we can say “we will watch for this”. Measures of debt growth and quality could be drawn up and monitored, if things started to grow too fast then measures could be put in place to slow it down.
Naturally this requires strongly empirical and rational minds. If you believe (that just about everyone did, including the RBA, Govt, etc) that rapidly rising house prices is a ‘good’ thing, then this is a blinkering ideology. It blinds you to risks and generates cognitive dissonance (that great enemy of rationality .. our own brain’s wiring).
So empirical analysis and model building is going to be the key, for the foreseeable future, of successful economics. And, once the ideological blinkers are torn away it will be an incredibly fruitful and useful time.
Most of the difficulties expressed here result from the confusion of discrete physical objects, individuals, with abstractions.
In the Austrian POV only individuals think, and therefore act.
Anything else are unthinking abstractions.
Louis #126
Then that is an abstraction, because individuals comprise groups and groups make joint and collective decisions and make collective decisions all the time, every day.
This Austrian POV really is entirely a bit other worldly or new agey for me – but do wake me up and tell me when the age of enlightened individualism arrives.
Ill try to use it work out which individual is going to decide to repair my back fence and which individual is going to pay for it.
And that is something that is lacking today.
Example:
Living in Glasgow in a tennement block. There was a simple, low variety rule (ref Stafford Beer) that everyone followed.
Wash the steps down from your level to the next (used to be one of my pocket money jobs). Each flat on a level (usually 3) took turns.
Because of that the steps were always clean, with minimal work.
Step forward 30 years. My old mum (80 year old no less), washing the steps every week, because no one else did. All the new people that had come in and the old ones died/left, never cleaned the steps. Who likes walking through filth?
Now we actually had ‘enlightened individualism’ then. We were all, in my personal case fierce, individuals, but it was logical to do what we did, the benefit outweighed the small amount of work/cost.
Are humans stupider now than then? Just ask my old mum.
Alice: “Stock market prices can be predicted – oh yes they follow a random walk (like “a drunk in a paddock” as one of my favourite lecturers explained it to me….).”
Not actually the case. It follows a chaotic series. A random walk can be estimated through gaussian statistics, but stock markets .. don’t.
This is the great fallacy of the Schoeles-Black (which is based on these assumptions), nice maths … completely wrong assumptions.
The practical effect is that ‘extreme points’ are FAR more probable than Guassian theory allows.
So all those people predicting 1:10,000 events were actualy dealing with 1:100 (or less) events.
Interesting ref: Richard Feynmen, the great physicist, look up his stuff on the Space Shuttle Challenger disaster.
#129 “It follows a chaotic series”
That’s a strong call Oldskeptic – what method would you use to tell that the market was chaotic?
Oldskeptic – the Scholes-Black model is for option pricing. But your point is correct. The Random Walk hypothesis assumes that past information is immaterial. This is wrong.
I think you might be interested in a book titled “The (Mis)behvaiour of Markets” by Benoit Mandelbrot.
One thing I would like to correct. The model is named “Black Scholes” not the other way around.
Dear me, Oldskeptic – I would have thought that someone capable of a comment like #125 would have known a bit more about behaviour of markets than you have subsequently and previously displayed.
To start, I would partially agree with you when you said
Problem is, of course, determining where the ideological blinkers are. As you have shown in your error-filled attempt at “disproving” the “Schoals-Black” model the blinkers may not be on those that believe that the freedom of the individual to transact should be limited as little as possible.
For example, time and again the random walk you disparage has stood up to tests of its correctness. The fact they do not obey a simple Gaussian normal distribution is well known – but then, little in nature does. The fact that it is not a Gaussian random walk does not falsify the whole concept of a random walk any more than the failure of a particular politician to be corrupt means that the whole lot are incorruptible.
Mandlebrot’s work (as SeanG has pointed out) shows clearly that a Lévy distribution random walk does work, with a D of 1.7 being commonly applicable – giving the fat tails that seem to cause you to disbelieve the whole thing.
If you need a version of the Mandlebrot paper that is written for a popular audience (and will not be too long), try Casti’s 1997 piece in the New Scientist (hotbed of Austrian thought there) no. 2078.
It should be simple enough to understand and you may be able to get it from your local library.
My argument was that it, and the many variants of course, were widely used. As was the cousin, VAR.
Thus a massive underestimation of risk was taken by many:
Banks, investment and trading.
Insurance companies, general and life.
Hedge funds.
Anyone else you can think of.
Partially, these ‘tools’ were used as psychological props to justify behaviour that was short term profitable, but long term disasterously risky.
You are quite right by the way, Mandlebrot was perfectly right, trouble was no one listened, (ditto, Minsky). But being a skeptic I wanted to prove it for myself, with hard numbers, it took about an hour to disprove one of the key assumptions of SB … on a spreadsheet. Another key assumption is so blidingly wrong that it remains amazing why anyone could ever believe it.
If you plug in some empirical distributions the difference in VAR calcs of extreme events is massive. 5 std deviation events actually look more like 1.5, or less, this is orders of magnitude of difference.
But no one wanted to listen, one reason being because that to do real calcs would mean needing huge amounts of capital for (say) Tier 1 and missing out on all those ‘investments’ and deals that made everyone so much money …. for a while.
I should add, it is not as simple as just changing a statistical distribution and then everything is ok again, you have to come up with a completely different model entirely.
“Rafaal – my response to PB at #114 seems to apply also to your point @120
@122. The fact that there is no chapter on money (I assume that you mean “money in GE” or similar, since most micro texts do have a chapter on money) in your micro textbook does not imply that there is no economic theory of how money exists or how its existence affects general equilibrium. You might try Google scholar before making such assertions.”
1- Well, my Mas-Colell does not have any chapter on money.
2- What I meant was that there isn’t any satisfactory theory of money in mathematical economics. I admit that I was a bit aggressive. Of course there are models that try to model money, but I think that these models are clearly unsatisfactory. As I explained why I think that models based on maximization from means and ends frameworks cannot model money by their nature.
“A combination of sweeping assertions about the superiority of school X on topic Y with obvious ignorance about mainstream work on the same topic is, unfortunately, a characteristic weakness of heterodoxy. I remember reading an econophysicist announcing triumphantly that, contrary to the foolish claims of mainstream economists that stock market prices can be predicted, they actually follow a random walk.”
Well, there are thousands of articles about the topic that is being discussed (and there are many articles about any topic that can be discussed in economic theory), but them nobody can speak about it, since it is impossible to read them all? You showed a very superficial understanding of Austrian economics in your post, them, by your own logic, I would have to tell you to read more about Mises, Hayek and Kirzner before criticizing them.
Not only heterodox economists show obvious ignorance about mainstream theories, but mainstream economists (well, I think that applies to all economists) show obvious ignorance about any theory outside their specialization.
“Conversely, as I note, the private sector depends heavily on public goods, including information generated in the public sector. So, a mixed economy looks pretty good here.”
Well, the point is that mixed economies function with less efficiency than free markets for the same reason that socialism does not work at all. The difference between mixed economies, free markets and socialism is only a difference in the degree of protection and respect for private property rights and contracts.
136 # Rafael
How do you measure efficiency?? – is that when execs can remunerate themselves more and there are no regulations to stop them. Is is when there isnt a build up of toxic assets on banks balance sheets because the toxic assets were overproduced? We have been trying “less regulation” for 30 years and under your logic the market should be more efficient? If you call our markets now more efficient, then its only an efficiency for some judging by the way they are throwing labour on to the streets and then just watch what people vote for….it wont be more “efficiency.”
Thats the trouble with these oh so pretty mathematical models that deliver “efficiency”. Efficiency means nothing and is highly over rated if the unemployment rate is insidiously rising. The underlying assumptions that people will be happy with that perfect efficiency in such circumstances, are all wrong…and short of dumping or disposing of the surplus labour into chain gangs so they dont object to the outcomes of the perfect mathematical model in the perfect world, I see these silly models and their proponents getting their marching orders from voters. You can fool some of the people etc
Thats the real world.
“Well, there are thousands of articles about the topic that is being discussed (and there are many articles about any topic that can be discussed in economic theory), but them nobody can speak about it, since it is impossible to read them all?”
No, but you pretty much disqualify yourself from the start by saying there are no such articles, then saying you mean none that you like. If you want to make the claim that the mainstream literature on this subject is useless, you ought to be able to nominate what you regard as the leading articles and point out their limitations.
As regards your suggestion that I haven’t read Hayek, Mises and Kirzner, what basis do you have for this claim?
I haven’t given them the complete, close and multiple readings appropriate for an Austrian true believer, but I’m confident that I am much more familiar with these writers than most Austrians are with (for example) the literature on money in general equilibrium.
Plus “what do you mean by efficiency” is a very profound quesion.
If you take a complex system, such as an economy or a body, then the key issue is the total efficiency of the overall system. Some components may be, on a reductionist basis, less efficient than they could be, but that is an important mechanism for maintaining total system efficiency.
Take a simple example, the electricity system. It may be efficient for that industry to work as close to failure as possible, with minimal redundancy of capacity, spare parts, etc. But this may not be efficient for the total economy.
Simply put, they may make a mistake in their calculations or a ‘black swan’ event happens, then blackout, with all the attendent costs for the whole economy. The recent example was Melbourne, we were within a hairs breadth of losing power to the majority of the city, several times, for possibly an extended time.
In this case, a less efficient sub-system, but with greater redundancy benefits the whole economy.
A trivial example is brakes on your car. Now the manufacturer may decide to shave the size of these. Cheaper to make, less weight. Normally this will make the car more efficient. Until a truck swerves on front of you at 100kph, then you are efficiently dead.
Take the human brain, this consumes 20% of your energy. Now this is clearly not efficient. What we need is too enginerr a brain that thinks a lot less and only consumes, say, 5% of your energy …. whoops this has already happened .. they are called neo-liberals.
Exactly Oldskeptic. That is my point – to ruthlessly search for efficiency in every firm, market, submarket, or government department is quite capable of generating overall inefficiecies.
(I wouldnt mind if CEOs had not been appropriating the surplus profits gained by the great efficiency hunt – and had not been exceptionally unentrepreneurial with those surplus profits).
Last paragraph of yours above – naughty Oldskeptic but I agree. So busy counting piffling sub departments for signs of inefficiency, which includes the inefficiency of labour, they dont realise they are completely lost in small rooms and corridors the middle of a metropolis where the unemployed are angry and walking around the streets. They just dont get the bigger picture.
An interesting study – I wonder how many unemployed financial sector workers, and other newly unemployed people will keep subscribing to the dream of a perfect market with no regulation, where CEOS can reward themselves and their mates seemingly unlimited amounts? I wonder how many of those unemployed will be changing their votes next time?
Oldskeptic 134 –
I agree that the Black Scholes and VaR models are not perfect. They are, however, but bases for more complex models that banks, insurance companies and hedge funds use to value products or to test potential losses.
An example would be the use of Bayesian or binomial methods. The extensive use of stress tests are also examples of applying different methods of measuring impacts on a firm.
The problem is what you referred to as the desire not to hold Tier 1 capital. This acts as a dead weight for many firms. However it goes beyond Tier 1 or 2 capital but to how firms are funded, the government regulations surrounding debt origination and the monitoring by agencies of “systemic” market risk.
Alice 140 – there are not that many people who work in the financial sector who believe in the concept of a perfect market. There are many who see government regulations that achieve nothing or make problems worse.
Alice @118
Of course I am realist and accept the fact that Austrian economics is not likely to be implemented in its extreme form and I am not likely to defend an extreme version of it. But I would object to unsubstantiated ridicule of its ideas.
In regard to AIG for example, and I do not claim to be an expert on economic policy,the current economic commanders in hindsight have recognised that AIG bailout was taken advantage of in regard to executive bonuses and have introduced a new tax to circumvent those bonuses.
If you had applied Austrian principles to begin with, the benefit of Austrian foresight would have avoided executive bonuses being paid out of public funds and anothet tax law.
SeanG: Trouble is I’ve never seen one that is right!
Yep. Seen a lot of, for example DFA models (even created a few myself). With the exception of my own, never came across one that was even half right. Many are biased. Usually on very shakey assumptions and extremely dubious statistics.
Not that my own were great shakes, usually really crude. They had several advantages though, the maths were right, the assumptions were simple and tested and I could quantify the fuzziness. Based on actual data and real empirical distributions (or carefully tested and verified theoretical ones). Plus I always did the basic test “forecast the past”.
What I find these days is that a lot of people make basic mistakes, disobeying the first basic rule of model building:
“A simple model this is right, will always outperform a compex one that is wrong”. There is even a famous WW2 Operations Research story that emphasises this, taught to all newbies.
Just like the use of GLM’s (and their ilk), have I seen some stunning mistakes in this area, mostly because people don’t know the underlying maths and just use a program, without examining the data to see if it justifies the underlying assumptions or not (which they usually don’t even know). If one more person quotes the CLT to me, without them even having a clue what it realy means and the, often severe, limitations of it, I’ll scream (after I dismember them). Let alone misunderstadings of independence and correlations.
Blew a job a while back when I told them stright to their face “that all current credit models are wrong”. I must ring them up someday and say “I told you so”.
I was lucky, I came up in the old days, when if you wanted a GLM, you wrote it yourself. So you understood it properly.
Talib was right, and all the models in the world failed. Worse than that, they didn’t even give last minute warnings that everything was going belly up (which means that a lot of monitoring systems were even worse than their models).
SeanG: the idea that Tier 1 (etc) is a dead weight displays exactly the idiotic misunderstading of reserves that has got us into this mess (not you personaly of course).
Oh I know the attitude, met some people who, used to, express this. I find it breathtaking in its ignorance of how things work.
My feeling that anyone in senior position in (say) a bank who expressed this should be immediately fired on the basis of terminal incompetence. Plus their boss for hiring such an idiot. And their boss for hiring someone who was so incompetent to hire … you get the picture.
Oldskeptic – The problem with models is that they take on an assumption that we can diversify risk which turned out to be completely wrong when “diversified” products ended up with a correlation of 1.
Nassim Taleb is right when he states (and restates) that we underestimate the chances of catastrophic incidents. That is part of the Knightian uncertainty that comes into it – which can only be handled by good judgement and experience.
I think the financial markets lacked the experience. If you are working in capital markets and are 50 years old you would have experienced from the start of your working life severe recessions (1980-1982; 1991-1993), wild movements in equity and debt markets (’87, ’98 and ’00) as well as daily profits/losses. We do not have 50 year olds but people in their 20s who only experienced a bull market.
Oldskeptic
Could the computer be at fault for poor modelling – its one thing to be able to use one, another for the next generation to understand one (and the original in built faulty assumptions…)
We think computers saved our lives and gained us efficiencies, but once a program is invested in, faulty assumptions may get passed on to the next generation of modellers, so has the ease of computer modelling stopped some people actually thinking….??
Woulodnt surprise me at all. Did calculators stop high school kids doing long division in their heads? Yes, my elederly mother can do it in her head.
Seab=n #145
Let me tell you about a woman who experienced the great Depression. My grandmother referred to the seven years before 1929 as “the seven good years” of her entire married life and continued to do so for the rest of her life, with four young boys, an accountant husband and a housekeeper who helped with the boys. It all went (housekeeper and job) and he went selling door to door, despite qualifications. Took decades to recover but never ion front again. 1982, 1991 were not quite wild movements in equity. It took 14 years to 1942-43 to recover 1929 house prices in Sydney. 1982, 1991 no comparison. 2008 – 2009 could be on par with 1929. It has yet to play out. There are billions being poured in..
“No, but you pretty much disqualify yourself from the start by saying there are no such articles, then saying you mean none that you like.”
Well, I only thought that in the concept of economics as the science of rational utilization of means to achieve given ends, money cannot exist. In the mainstream articles about money that I have read, money is in the utility function (it cannot be more unsatisfactory than that), or it is only a numeraire, or it is demanded for future transactions because prices are expected to go down, that kind of sh*t. Some others have monetary theory without micro basis. None of them speaks about the money that we have in the real world, with exists because it is a mechanism that enables the utilization off the agent’s alertness.
“As regards your suggestion that I haven’t read Hayek, Mises and Kirzner, what basis do you have for this claim?”
Only this post.
“I haven’t given them the complete, close and multiple readings appropriate for an Austrian true believer, but I’m confident that I am much more familiar with these writers than most Austrians are with (for example) the literature on money in general equilibrium.”
I don’t know how familiar the Austrians are, on average, with mainstream monetary theory, but I do know that they had to study mainstream monetary theory in graduate school. While you (in my limited source of information in this post) has show that your understanding of austrian economics is less satisfactory than the understanding that any undergraduate student from a small college in Brazil that reads the Austrians for fun that I know has.
Alice
“How do you measure efficiency??”
Efficiency is determined by the “strength” of the equilibrating forces (dynamic efficiency) and by the incentives that would exist in equilibrium iff the incentive structure remains the same as in the present (static efficiency).
Thankyou Rafael – but you missed the irony alert.