Calculation and Knowledge: Recent Episodes
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Calculation and Knowledge has works on the socialist calculation argument, place of economic calculation, monetary calculation, and knowledge in the economy.
Despite what many elites believe, AI can do many things, but it cannot successfully plan an economy. It lacks the intelligence of an entrepreneur.
Original Article: "AI Lacks the Entrepreneurial Intelligence to Plan an Economy"
Much of government-owned transportation destroys rather than adds to wealth. The lack of a sound system of economic calculation is to blame.
Original Article: "The Problem with Public Transit"
Economic calculation is not an either-or proposition. Even in so-called market economies like that of the USA, there is plenty of government intervention that distorts market processes.
Original Article: "Economic Calculation Is Nonbinary"
Following the collapse of the USSR, many socialists pinned their hopes upon the development of a "market socialism" that would be economically efficient and create equality. Marxist philosopher G.A. Cohen wisely dissented.
Original Article: "What Marxists Say about "Market Socialism""
On this episode of Good Money, Tho is joined by Tate Fegley of Montreat College. Dr. Fegley talks about his lectures from Mises University on policing, AI, and the deep state, and the important topic of economic calculation that connects the three. In the final segment, Tho looks at the economics of college football in the aftermath of FSU's threat of secession from their conference.
Good Money listeners can order a special $5 book bundle that includes How To Think About the Economy and What Has Government Done to Our Money? with free shipping using promo code "GoodMoney" at Mises.org/Good
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Experienced entrepreneurs are Austrians.
Download the slides from this lecture at Mises.org/MU23_PPT_35.
Recorded at the Mises Institute in Auburn, Alabama, on 28 July 2023.
Game theory done the wrong way eliminates individual choice.
Download lecture slides at Mises.org/MU23_PPT_30.
Recorded at the Mises Institute in Auburn, Alabama, on 27 July 2023.
“Our civilization is inseparably linked with our methods of economic calculation. It would perish if we were to abandon this most precious intellectual tool of acting.”
Download lecture slides at Mises.org/MU23_PPT_28.
Recorded at the Mises Institute in Auburn, Alabama, on 27 July 2023.
In 1920, Ludwig von Mises destroyed the intellectual foundations of the case for socialist central planning.
Download lecture slides at Mises.org/MU23_PPT_12.
Recorded at the Mises Institute in Auburn, Alabama, on 25 July 2023.
Whether political elites promote outright socialism or interventionism, thanks to the reality of economic calculation, they are advocating a failed economy.
Original Article: "Why Mises’s Theory of Economic Calculation Still Is Relevant Today"
While F.A. Hayek's famous 1945 essay effectively critiques the "perfect information" hypothesis, it is an inadequate explanation of the issue of economic calculation.
Original Article: "The Market Process Is Not a Knowledge Problem"
Shoddy service, regular breakdowns, and overbudget to boot. There is a reason why government-funded projects always waste resources.
Original Article: "The Failure of Public Works and Public Funding"
Jonathan Newman joins Bob to critique a recent Twitter argument where some were claiming that supercomputers solved the socialist calculation problem.
The Twitter thread on AI and Socialism: Mises.org/HAP394a
Bob on Socialism and calculation vs knowledge: Mises.org/HAP394b
Karras Lambert and Tate Fegley on economic calculation and AI: Mises.org/HAP394c
Most socialists are not misguided about how to have a prosperous economy, for that is not their goal.
Original Article: "Socialism Isn't about Creating Economies. It Is about Amassing Political Power"
This Audio Mises Wire is generously sponsored by Christopher Condon.
The Need to Be Whole: Patriotism and the History of Prejudiceby Wendell BerryShoemaker and Company, 2022; x + 513 pp.
Wendell Berry, a poet, novelist, and philosopher well known for his protests against mechanized agriculture and for his defense of the “land ethic,” is not a thinker one would immediately associate with Ludwig von Mises, and indeed, in economic theory the two are far apart. But there is nevertheless a passage in Mises’s Socialism that is central to Berry’s concerns.
The passage I have in mind is this:
When society’s existence is threatened, each individual must risk his best to avoid destruction. Even the prospect of perishing in the attempt can no longer deter him. For there is then no choice between either living on as one formerly lived or sacrificing oneself for one’s country, for society, or for one’s convictions. Rather, must the certainty of death, servitude, or insufferable poverty be set against the chance of returning victorious from the struggle. War carried on pro aris et focis [for hearth and home] demands no sacrifice from the individual. One does not engage in it merely to reap benefits for others, but to preserve one’s own existence.
Berry uses a similar idea to explain and defend the South’s standpoint in the Civil War, but he does not do so in the way one might expect. Far from extolling the virtues of antebellum slavery, he condemns it as a grievous sin. In this connection, he makes an interesting criticism of John C. Calhoun, who deemed manual labor beneath the dignity of gentlemen, fit only for slaves. Berry argues that it was in part the unwillingness of elements among the Southern planter elite to acknowledge the virtue of work that led them to turn away from the Jeffersonian position that slavery is a great evil. In this connection, Berry quotes John Quincy Adams, a great opponent of slavery whom he admires: “I told Calhoun I could not see things in the same light—It is in truth all perverted sentiment—mistaking labor for slavery, and dominion for Freedom” (Adams, quoted on p. 298).
If slavery was wrong, why, then, does Berry defend the South’s position in the Civil War? His answer is that the great bulk of those who fought for the South did so not to entrench slavery but rather to protect their land and homes from invasion: “But from the point of view of the Confederate soldiers, the great fact of the war, once it had begun, was that their country had been, and was going to be invaded. They shared with [Robert E.] Lee a settled determination to defend their homelands and their people” (p. 203).
In arguing in this way, Berry agrees with Murray Rothbard, another thinker not usually coupled with him. Like Berry, Rothbard argues that the Southerners were defending their lands from invasion:
In 1861, the Southern states, believing correctly that their cherished institutions were under grave threat and assault from the federal government, decided to exercise their natural, contractual, and constitutional right to withdraw, to “secede” from that Union. The separate Southern states then exercised their contractual right as sovereign republics to come together in another confederation, the Confederate States of America. If the American Revolutionary War was just, then it follows as the night the day that the Southern cause, the War for Southern Independence, was just, and for the same reason: casting off the “political bonds” that connected the two peoples. In neither case was this decision made for “light or transient causes.” And in both cases, the courageous seceders pledged to each other “their lives, their fortunes, and their sacred honor.”
If it is objected that without the war, the end of slavery might have been indefinitely postponed, Berry admits that he has no easy answer but that he does know that the violence of war exacts tremendous costs. He reminds us that the “crusade” mentality led to later disasters:
[The Civil War] remains popularly credited as the solution, entirely good, of our worst national problem. So successful were we at solving our own great problem that we have generously undertaken to solve international problems and the problems of other nations also by force of war and with the same assurance of our goodness in doing so. If we have a sort of notion of preventability, we are not long detained by it. We appear never to bother with the question of net good. We went to war in Iraq and Afghanistan as if such questions could not be asked, as if no useless war had ever been fought, and in a nationalist confusion of pride, fear, moral certainty, and (never dismissible) the allure of profits in the war industries. (p. 85)
In condemning the stern moralism of the Northern aggressors, Berry again finds himself at one with Rothbard.
The Civil War seems to me to have been, to an extent sufficiently noticeable, a conflict of patriotism, which is to say love for one’s actual country or the land under one’s feet, against nationalism, which is to say allegiance just short of worship to a political idea or ideal and to a government. The difference is well illustrated by the anthems of the two sides: the jaunty “Dixie,” which celebrates the “land where I was born,” versus “The Battle Hymn of the Republic,” a hymn sure enough of a sanctified nationalism, in which the misfortunate Jesus once again shows up in uniform. (p. 250)
In like fashion, Rothbard says:
The Northern war against slavery partook of fanatical millennialist fervor, of a cheerful willingness to uproot institutions, to commit mayhem and mass murder, to plunder and loot and destroy, all in the name of high moral principle and the birth of a perfect world. The Yankee fanatics were veritable [Isabel] Patersonian humanitarians with the guillotine: the Anabaptists, the Jacobins, the Bolsheviks of their era. This fanatical spirit of Northern aggression for an allegedly redeeming cause is summed up in the pseudo-Biblical and truly blasphemous verses of that quintessential Yankee Julia Ward Howe, in her so-called “Battle Hymn of the Republic.”
We have much to learn from Berry’s profound defense of the local and particular against militarism and fanaticism.
In 1920, Ludwig von Mises destroyed the intellectual foundations of the case for socialist central planning.
Download the slides from this lecture at Mises.org/MU22_PPT_12.
Recorded at the Mises Institute in Auburn, Alabama, on 26 July 2022.
Bob has Steve Patterson back on the show, to concede that Steve’s skepticism of higher mathematics was right all along. Specifically, Bob explains how his recent discovery of a theorem from Riemann showed that something is indeed rotten in the way mathematicians typically handle infinite sets.
Mentioned in the Episode and Other Links of Interest: The YouTube version of this interviewSteve Patterson’s website and YouTube channelSteve’s interview with NJ WildbergerA great summary of Riemann’s Rearrangement TheoremThe BMS episodes on Godel’s Incompleteness Theorems and Arrow’s Impossibility TheoremSteve’s previous appearance on the Bob Murphy Show For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Google Podcasts, Stitcher, Spotify, and via RSS.
In the past few weeks, I’ve been involved in an email exchange about the differences in methodology between the Austrian school and the Chicago school. The correspondence has revealed some surprising misunderstandings of a key Austrian view, demonstrated preference, and what I hope to do in this week’s article is to give an account of that view and some of the misunderstandings about it.
The best account of demonstrated preference is in Murray Rothbard’s essay “Towards a Reconstruction of Utility and Welfare Economics” (1956). Essentially, the doctrine is this. When you make a choice, it’s usually among a few options. The choice is an action, and the action demonstrates, or reveals, that the option, or preference, that you choose ranks higher than the competing options. As Rothbard puts it,
Human action is the use of means to arrive at preferred ends. Such action contrasts to the observed behavior of stones and planets, for it implies purpose on the part of the actor. Action implies choice among alternatives. Man has means, or resources, which he uses to arrive at various ends; these resources may be time, money, labor energy, land, capital goods, and so on. He uses these resources to attain his most preferred ends. From his action, we can deduce that he has acted so as to satisfy his most highly valued desires or preferences.
The concept of demonstrated preference is simply this: that actual choice reveals, or demonstrates, a man’s preferences; that is, that his preferences are deducible from what he has chosen in action. Thus, if a man chooses to spend an hour at a concert rather than a movie, we deduce that the former was preferred, or ranked higher on his value scale. Similarly, if a man spends five dollars on a shirt we deduce that he preferred purchasing the shirt to any other uses he could have found for the money. This concept of preference, rooted in real choices, forms the keystone of the logical structure of economic analysis, and particularly of utility and welfare analysis.
When we talk about “preferences” or “options” here, what is meant are the alternatives that an actor has in mind when he decides what to do. We aren’t assuming that these preferences remain constant over a substantial period of time, much less that the actor has “in his mind” a list of all possible actions he could take in all possible worlds and that this list also remains the same for a long period. Because we don’t assume these things, we also don’t assume “transitivity of preferences.” If you prefer A to B, B to C, and A to C, then your preferences are transitive; but if your preferences are A over B, B over C, and C over A, they are intransitive. Many people think that intransitive preferences are irrational, for reasons we won’t go into here.
In the Austrian view, this issue doesn’t arise, because we’re concerned only with someone’s choice at a particular time. If the actor now has to choose between A and B, we don’t assume that he considers how to choose in situations that involve other options, nor do we assume that his preference for A over B remains constant. As Rothbard puts it, “The prime error here is the assumption that the preference scale remains constant over time. There is no reason whatever for making any such assumption. All we can say is that an action, at a specific point of time, reveals part of a man’s preference scale at that time. There is no warrant for assuming that it remains constant from one point of time to another.”As Rothbard points out, there is a difference between constancy and consistency, and the former isn’t a requirement of reason.
[C]onstancy and consistency are two entirely different things. Consistency means that a person maintains a transitive order of rank on his preference scale (if A is preferred to B and B is preferred to C, then A is preferred to C). But the revealed preference procedure does not rest on this assumption so much as on an assumption of constancy —that an individual maintains the same value scale over time. While the former might be called irrational, there is certainly nothing irrational about someone’s value scales changing through time. Hence, no valid theory can be built on a constancy assumption.
One of the participants in the email exchange raised this objection:
It [demonstrated preference] at most reveals his higher preference, his preference between two alternatives he is free to choose between…. Consider a prude who is made unhappy by other people’s consumption of pornography. In the free market society he doesn’t have the option of forbidding it, even though his highest preference might be an otherwise free market plus a ban on pornography. If there were only two other people in the society he could offer to pay them to agree not to consume pornography, but in a society of millions transaction costs plus the public good problem—the ban is a public good from the standpoint of all the other prudes—make that impractical.
The mistake here is that demonstrated preference concerns only choices that face an actor at a time. It isn’t about how he ranks possible states of affairs. I’d “prefer,” in one sense of that word, a world in which everyone held the correct view (mine, of course) of how society should be organized, but that sense of preference isn’t relevant to Austrian economics.
Another comment about demonstrated preference didn’t aim to undermine it directly, but rather to show that the doctrine brought with it baggage Austrians wouldn’t welcome. Austrians are against logical positivism, but, the commenter said,
[t]here is actually something like logical positivism in Austrian economics. I mean the idea that one can’t make interpersonal utility comparisons, as well as the more fundamental idea that “preference” must mean “revealed preference”. This is very reminiscent of the positivistic idea that all meaningful statements must be testable by sensory observation. Good rationalists reject this assumption.
Maybe they do, but “demonstrated preference,” as Austrians use this concept, means that choice reveals the chooser’s highest preference. It isn’t a claim about the meaning of “preference.”
This objection, one must say, doesn’t “demonstrate” much acquaintance with Austrian economics. It’s good to have it anyway. As W.V.O. Quine once said, “Every knock a boost.
Bob reviews Mark Spitznagel's latest book, Safe Haven: Investing for Financial Storms, on which he was a consultant. Bob explains that Spitznagel rejects the alleged dichotomy between risk and return, and then gives a numerical example to illustrate the two schools of thought.
Mentioned in the Episode and Other Links of Interest: Bob’s appearance on Jordan Peterson‘s podcastBob’s surprisingly high ranking among influential economistsHis episode with Winston Ewert (who helped design the AI that produced the ranking)Mark Spitznagel’s new book Safe Haven: Investing for Financial Storms and his previous book, The Dao of Capital For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on Apple Podcasts, Google Podcasts, Stitcher, Spotify, and via RSS.
Fans of Austrian economics know hedge fund manager Mark Spitznagel as a brilliant thinker thoroughly steeped in Menger, Böhm-Bawerk, Mises, and Rothbard. His excellent 2013 book The Dao of Capital was rooted in Austrian capital theory and "roundaboutness," and his application of of that theory has proven highly beneficial for his investors.
Now Spitznagel is back with a new book that directly challenges our understanding of risk. Safe Haven asks, and answers, a fundamental question: Can mitigating risk actually add to the bottom line? Can safe havens be truly cost-effective, by adding to CAGR? Mises Institute Senior Fellow Robert Murphy, who consulted on the book, joins the show for a fascinating look at Spitznagel's penetrating and contrarian thesis. If you're interested in the intersection of investing and Austrian economics, don't miss this episode!
Mark Spitznagel's Safe Haven: Investing for Financial Storms on Amazon: Mises.org/SafeHaven
And, Spitznagel's 2013 book The Dao of Capital: Austrian Investing in a Distorted World on Amazon: Mises.org/Dao
Abstract: As employees are increasingly recognized as an important source of ideas and inspiration, contemporary leadership research finds that the central task of leaders is to empower employees to realize their skills and talents to achieve an organizations’ visions and goals. Drawing on this leadership premise, this study develops the concept of entrepreneurial empowerment (EE). EE has structural and psychological dimensions that empower employees to utilize their knowledge to solve the internal Hayekian knowledge problem. EE introduces an endogenous discovery process in which entrepreneurial leaders play a central role in empowering employees to use their localized knowledge. This entrepreneurial discovery process offers opportunities to adapt and innovate using the knowledge experiences of employees. This study underscores that a venture’s success is not tied to an entrepreneur’s inspirational ideas (or, more broadly, their asymmetric knowledge experiences), but to their ability to inspire ideas from all levels of their business hierarchy.
JEL Classification: B53, M12, M54 Desmond Ng (dng@tamu.edu) is associate professor of agribusiness and strategy management at Texas A&M University. The author would like to thank the special guest editor, Professor Bylund, and the two anonymous reviewers for their constructive comments and suggestions.
“No company, small or large, can win over the long run without energized employees who believe in the mission and understand how to achieve it.” – Jack Welch, General Electric
To succeed in an increasingly complex and changing market environment, ventures can no longer compete on the basis of their leader’s capabilities, knowledge, talents, and vision alone (e.g., Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering, Weitzel, and Muehlfeld 2019). Ideas to develop new products and services can come from anywhere, from loyal customers, blog spheres, supply chain partners, social media, and above all employees (Rigtering, Weitzel, and Muehlfeld 2019). For instance, 3M established a culture in which employees are encouraged to develop “home-grown” solutions to addressing their customers’ needs. These homegrown solutions transformed a small-scale mining venture into a leading material sciences company and have earned the company a spot on Fast Company’s Best Workplace for Innovators list (Rubinson 2009; FastCo Works 2019). Companies such as 3M underscore that in order to succeed entrepreneurs must be able to adapt to ideas that extend beyond their own (e.g., Lee, Lee, and Pennings 2001; Rigtering, Weitzel, and Muehlfeld, 2019; Sarasvathy 2001). Adaptation promotes an integration of different knowledge experiences that enables the venture to respond to changing market conditions and opportunities not previously considered (e.g., Hargadon and Sutton 1997; Sarasvathy 2001; Sullivan and Marvel 2011). Hence, although successful ventures are commonly attributed to an entrepreneur’s ideas, talents, and vision (e.g., Witt 1998, 1999), entrepreneurs today face increasing demands to adapt their ideas to the knowledge experiences of others (see Cowen and Parker 1997; Rigtering, Weitzel, and Muehlfeld 2019; Sarasvathy 2001).
Although the role of Austrian economics in contemporary entrepreneurship research remains a subject of much discussion and debate (Klein and Bylund 2014), Austrian economics is particularly suited to addressing the challenges faced by today’s entrepreneurs. According to the subjective tenets of Austrian economics, entrepreneurs operate in a sea of subjective experiences in which they adapt by mobilizing these knowledge experiences to address opportunities not currently met by the market. This adaption has been widely understood as the Hayekian knowledge problem: the problem of how to utilize knowledge experiences that are broadly distributed among the productive members of society. F. A. Hayek (1945) argued that the productive members of society, such as employees, have a knowledge of the “particular circumstances of time and place” (521). This knowledge involves an employee’s particular understandings of the special circumstances, challenges, and local conditions of their job. Hayek (1945) argued that a single mind, such as that of a centrally planner, cannot offer an adaptation that can utilize this “knowledge of particular circumstance of time and place,” because this knowledge is highly localized to an employees’ experiences. He instead argued that employees are in the best position to utilize this knowledge because their understandings of the special circumstances of their job offered employees or “arbitrageurs” (522) opportunities to exploit local price differentials not known by others. This arbitrage function was later formalized by Israel M. Kirzner’s (1979, 2009, 2019) concept of the alert entrepreneur. Alertness involves discovering price arbitrage opportunities by bringing into use factors of productions at a price less than their valued uses. Specifically, as employees are key factors of a firm’s production, alertness solves the Hayekian knowledge problem, because the alert entrepreneur is incentivized to bring into use their employee’s knowledge to discover the price arbitrage opportunities of the market.
Although Kirzner (1979) has been credited with solving the Hayekian knowledge problem (Elert and Henrekson 2019; Foss and Klein 2016), the concept of alertness implicitly assumes that an employee’s knowledge can be centralized under an entrepreneur’s leadership. This leadership involves a position of authority in which the entrepreneur has the power to institute their vision over their employees (Shamir, House, and Arthur, 1993; Witt, 1998). In this position, however, an entrepreneur cannot readily identify their employees’ knowledge, because the entrepreneur’s authority is removed from their employees’ day-to-day experiences. This is consistent with Hayek (1945), who argued that employees are best suited to making decisions on how to allocate their time, resources, and efforts in dealing with their daily operational challenges because employees are most familiar with the circumstances facing them in carrying out their tasks. Hence, the challenge facing the entrepreneur is that their inability to centralize their employees’ knowledge introduces an internal Hayekian knowledge problem (see also Elert and Henrekson 2019; Foss 1997; Foss, Foss, and Klein 2007) of: how an entrepreneur in a position of authority can utilize the different knowledge experiences of their employees when employees are in the best position to know their valued contributions?
This study’s objective is to develop a concept of “Entrepreneurial Empowerment” (EE) to address this internal Hayekian knowledge problem. Leadership research has widely recognized that employees are an important source of ideas and inspirations (Argyris 1998, Foss, Foss, and Klein 2007; Gagne and Edward 2005; Govindarajan and Srikanth 2013; Lee and Koh 2001; Lee, Willis, and Tian 2018; Rigtering, Weitzel, and Muehlfeld 2019). The task of the leader, then, is to empower employees to realize their skills and talents to achieve the organization’s mission and goals (Argyris 1998; Cowen and Parker 1997; Foss, Foss, and Klein 2007; Lee and Koh 2001; Lee, Willis, and Tian 2018). Drawing on this leadership premise, this article develops the concept of entrepreneurial empowerment (EE). EE involves a leadership task of organizing a firm’s internal decision-making process in which employees are delegated a decision-making authority that advances the entrepreneur’s mission. Specifically, EE has structural and psychological dimensions that empower employees to utilize their knowledge of particular circumstances of time and place to solve the internal Hayekian knowledge problem. By solving this problem, EE offers opportunities for the entrepreneurial leader to adapt to and innovate using the knowledge experiences of their employees in ways that cannot be achieved through centralized direction. Propositions surrounding this EE concept are offered. One major contribution of the concept of EE is that the entrepreneurial leader offers an internal organization that empowers employees to solve an internal Hayekian knowledge problem and thus advances an entrepreneur’s mission or goals. As result, this study offers a theory of internal organization that opens up the “black box” of Austrian economics (Foss and Klein, 2012 70).
I. UNITS OF ANALYSIS, DEFINITIONS AND ASSUMPTIONS Before developing this study’s conceptual model, it is important to outline its definitions, assumptions, and units of analysis. According to leadership research, empowerment is defined by an “increased individual motivation at work through the delegation of authority to the lowest level in an organization where a competent decision can be made” (Seibert, Silver, and Randolph 2004, 332). As entrepreneurs often hold positions of leadership, an entrepreneur’s leadership involves the power to delegate authority to the lower levels of their decision hierarchy (e.g., Cowen and Parker 1996; Foss, Foss, and Klein 2007; Shamir, House, and Arthur 1993; Witt 1998). In addition, this leadership also involves an ability to motivate and shape employees’ behavior and attitudes (Ashford and Sitkin 2019; Shamir, House, and Arthur 1993; Witt 1998), as well as empowering the psychological states or intrinsic motivations of their employees (Lee and Koh 2001; Lee, Willis, and Tian 2018). With these distinctions, entrepreneurial leadership is defined by structural and psychological dimensions that involve empowering employees through a delegation of authority to all levels of the decision hierarchy and an ability to appeal to employees’ intrinsic motivations. This definition assumes that employees’ empowerment is “influenced or caused” by an entrepreneur’s leadership. This assumption is consistent with Lee and Koh (2001), in which empowerment is understood as the “behavior of a supervisor who empowers his/her subordinates” (685). With this assumption, the unit of analysis is focused on the structural and psychological relationships that exist between the entrepreneurial leader and their employees (Lee and Koh 2001). Specifically, this study focuses on the leadership of senior members and not supervisory managers, because leadership studies find that hierarchically organized businesses are subject to social learning processes in which a leader’s actions can have a “cascading effect” that impacts the lowest-level employees of their decision hierarchy (Liu, Liao, and Loi 2012; Shamir, House and Arthur 1993; Witt 1998).
Empowerment and Hayek’s Libertarian View of Markets
Although the concept of empowerment is commonly explained in terms of a leadership function (e.g., Lee and Koh 2001, Spreitzer 2008), empowerment also shares a similar political economic orientation to the libertarian tenets of F. A. Hayek (1945, 1952). As in Hayek (1945), empowerment is a political exercise that rejects the “politics in command” of centrally planned/socialist economies (Mohanty 1995, 1434). Empowerment involves granting freedom and equality by transferring power from an upper level agency, such as a central planner or authority, to people below (Mohanty 1995). This empowerment involves affirming an individual’s freedoms by strengthening their capacity for self-governance, autonomy and self-determination and is an important economic and political goal of Western societies (Mohanty 1995). Similarly, Hayek’s notion of “true libertarianism” is founded on a political economic philosophy that celebrates the benefits of individual choice and freedom. This libertarianism appeals to the collective powers of a decentralized decision-making process, as Hayek (1952) shows:
many of the greatest things man has achieved are not the result of consciously directed thought, and still less the product of deliberately coordinated effort of many individuals, but of a process in which the individual plays a part which he can never fully understand. They are greater than any individual precisely because they result from the combination of knowledge more extensive than single mind can master. (84)
Although empowerment shares a similar political-economic orientation to Hayek’s true libertarianism, their motivations for rejecting the powers of a central authority differ. Empowerment rejects the “politics in command,” because of the corruptive tendencies of government (Mohanty 1995). Hayek’s true libertarianism (1945) rejects central planning on grounds of its limited ability to process decentralized information (see also Klein 1996). Hayek (1945) argued that the allocation of societal resources requires centralizing dispersed knowledge experiences that cannot be fully known by a central authority. This dispersed knowledge is held by the “man on the spot,” consisting of workers or employees. Each employee has a knowledge of the particular “circumstances of time and place,” or more simply put, knowledge of the particulars. This knowledge consists of the particular work challenges and local work conditions faced by an employee. For instance, a real estate employee’s ability to develop their clientele is dependent on their unique understandings of the amenities in a neighborhood (i.e., quality of schools, relative affluence of homeowners, crime rates, general history of the neighborhood, etc.). The man on the spot/employee is better suited to utilizing this knowledge of the particulars than a centrally planned actor, because the man on the spot is most familiar with the unique circumstances of their job (Hayek 1945). As a result, Hayek (1945) argued that the chief economic problem is not concerned with how a central planner can allocate the scarce resources of society, but rather a knowledge problem “of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know” (520).
II. ALERT ENTREPRENEURSHIP AND A SOLUTION TO HAYEK’S KNOWLEDGE PROBLEM In sharing Hayek’s (1945) commitments to freedom and liberty, Kirzner’s (1979) concept of alertness offered a mechanism key to solving the Hayekian knowledge problem (Foss and Klein 2016). Alertness is defined as “an attitude of receptiveness to available, but hitherto overlooked, opportunities” (Yu 2001, 51). This receptiveness involves a psychological predisposition for discovering price arbitrage opportunities not seen by others (Kirzner 1979). Alertness involves discovering price arbitrage opportunities where the entrepreneur assembles their factors of production at a price that is less than the prices received from the sale of their products / services; however, it does not entail a deliberate search (Kirzner 1979, 2019; Yu 2001). Deliberate search involves a commitment of resources (Kirzner 2019) in which the “agents already know enough of the territory that they know what kind of information they want and where to acquire such information” (Yu 2001 51). Yet Tony Fu-Lai Yu (2001) argued that agents search because they are dissatisfied with their current information. This dissatisfaction motivates a search for better knowledge involving the asymmetric knowledge experiences of the entrepreneur (Shane and Venkataraman 2001, Yu 2001). As employees’ knowledge of the particulars are distributed across an organization’s factors of production, an entrepreneur has an asymmetric knowledge that enables the entrepreneur to assemble these distributed experiences at a total price or cost that is less than their value uses (i.e., prices of the products or services received). Specifically, the task facing the alert entrepreneur is to draw on their asymmetric knowledge experiences in discovering those wage rates that will not only incentivize employees to utilize their knowledge of the particulars, but to also discover a wage rate that is less than the prices of their sold products or services. Hence, through this alert discovery of arbitrage opportunities, the entrepreneur engages in a nondeliberate search in which employees’ knowledge of the particulars is brought into use by the price system to solve the Hayekian knowledge problem.
Internal Hayekian Knowledge Problem
Yet in spite of Kirzner’s (1979) contributions to solving the Hayekian knowledge problem, the entrepreneur faces a distinct “internal Hayekian knowledge problem” (Elert and Henrekson 2019; Foss 1997). This internal Hayekian knowledge problem involves a use of knowledge in which employees’ knowledge of the particulars cannot be centralized under the direction of an entrepreneur’s authority (see also Cowen and Parker 1997; Elert and Henrekson 2019; Shane 2000). According to Hayek (1945), employees’ knowledge of the particulars cannot be centralized because this centralization requires aggregating an employee’s knowledge of the particulars in which differences in their local work conditions and special circumstances would be abstracted away. Due to the distributed nature of an employee’s knowledge of the particulars, this knowledge thereby cannot be conveyed to a central authority (Hayek 1945, 524). Since entrepreneurs are also tasked with allocating their firm’s factors of production (e.g., Klein 1996; Bylund 2016), this inability to centralize their employee’s knowledge of the particulars renders the entrepreneur unable to allocate their factors of production—employees—to their most valued uses. As result, unlike the traditional Hayekian knowledge problem, the internal Hayekian knowledge problem raises a distinct firm-level problem, because the challenges surrounding the centralization of a firm’s distributed knowledge impact a firm’s internal allocation of resources.
The internal Hayekian knowledge problem is closely tied to Ludwig von Mises’s economic calculation problem, and both can be used to elaborate on this firm-level distinction. According to Mises, a firm is tasked with an economic calculation problem of allocating a firm’s resources or factors of production that would satisfy the needs of its consumers (Foss and Klein 2010; Klein 1996). This allocation requires that the entrepreneur understand current factor prices as well as the anticipated prices of consumer goods sold (Foss and Klein 2010). An understanding of these current factor prices is critical, because in the absence of these factor prices, the entrepreneur cannot allocate their factor inputs into meeting the firm’s consumer needs (Klein 1996). Mises has used this economic calculation problem to challenge centrally planned governments, because the absence of property rights over factors of production limits a firm’s ability to discover the prices of their factor inputs (Klein 1996). In the absence of these factor prices, socialistic and, more generally speaking, centralized planned organizations, cannot offer an allocation of capital that solves the economic calculation problem (Bylund 2016; Klein 1996; Foss and Klein 2010). The internal Hayekian knowledge problem parallels the criticisms raised by Mises’s economic calculation problem. According to Hayek (1945), the distributed nature of an employee’s knowledge renders such knowledge unable to be aggregated into a price statistic (Hayek 1945). In the absence of these internal prices, an employee’s knowledge of particulars cannot be coordinated into discovering an allocation of resources that will meet the needs of the firm’s customers. As a result, like Mises, the internal Hayekian problem underscores that centrally planned organizations face limits in their ability to solve the economic calculation problem.
III. ENTREPRENEURIAL JUDGMENT To address limits in a firm’s central authority, an entrepreneur’s judgment has been offered as a response to Mises’s economic calculation problem (Bylund 2016; Klein 1996). Judgment refers “to the process of businesspeople forming estimates of future events in situations in which the relevant probability distributions are themselves unknown” (Foss, Foss, and Klein 2007, 1896). For instance, judgment can involve the formation of a business plan in which factor inputs are identified and coordinated with the purpose of earning future rents or profits (Foss, Foss, and Klein 2007). This judgment occurs by giving the entrepreneur ownership over the use of a firm’s factor inputs (Foss, Foss, and Klein 2007; Foss and Klein, 2010). According to Mises’s economic calculation problem, ownership over factor inputs creates an entrepreneurial incentive to reveal their prices such that factors of production can be allocated in ways that satisfy future needs or demand expectations (Klein 1996). This is because factor prices are influenced by the varied uses of an input, which gives owners of capital a strong incentive to reveal their factor input’s valued uses (see also Bylund 2016; Klein 1996). The challenge, however, is that these valued uses are known only by members who have an intimate or particular understanding of a factor’s varied uses (Hayek 1945). Hence, judgment suggests that owners of capital have a strong incentive to encourage their employees to utilize their knowledge of particulars to addressing their firm’s economic calculation problem (see also Klein and Foss 2010; Klein 1996). This is consistent with Per Bylund (2016), who noted, “the only basis for making decisions and attempting to identify room for improvement is entrepreneurial judgment: there are no market prices to guide the entrepreneur” (110). This judgment suggests that through ownership the entrepreneur exerts control over the firm’s internal allocation of resources that is distinct from those resource allocations determined by market prices (e.g., Foss, Foss, and Klein 2007).
Theory of the Firm: An Austrian Judgment Perspective
To understand this internal allocation, R. H. Coase’s theory of the firm is instructive to Austrian explanations of judgment (see also Bylund 2020; Klein and Foss 2010).In that, while Kirznerian (1979) and Hayekian (1945) explanations would argue that market prices would incentivize employees to utilize their knowledge of the particulars, Coase (1937) had long recognized that there is a transaction cost in determining these relevant prices. Coase (1937) argued that if there are no transaction costs, an employee’s knowledge can be readily coordinated through a series of market-based exchanges. These contractual exchanges would do away with the need to transmit any knowledge to a central authority, and thus an organization—as defined by Coase (1937) an authority would cease to exist. The fact, however, remains that authority exchanges exist in all types of organizations, including entrepreneurial ones. The existence of these exchanges suggests that the price system is not a sufficient mechanism to incentivize the use of knowledge within an organization (see also Elert and Henrekson 2019; Shane 2000). This is particularly the case when considering an employee’s knowledge of the particulars, because such knowledge is tacitly known to the employee. With this tacitness, external prices cannot readily reveal the valued uses of an employee’s knowledge of particulars (see also Bylund 2016; Foss and Klein 2010), because there is a transaction cost in organizing this tacit knowledge through a market-based exchange. Thus, according to a Coasian explanation, a firm’s existence can be attributed to an entrepreneur’s judgment because judgment offers an alternative to market prices in allocating a firm’s internal resources (Bylund 2016, 2020).
For instance, Bylund (2020) draws on a Coasian argument to explain a firm’s existence. Bylund (2020) attributes a firm’s existence to the entrepreneur/manager’s ability to “actively directs factors of production instead of the price mechanism” (10). Through an entrepreneur/manager’s authority, external market exchanges are internalized in the firm, avoiding the transaction costs of the market (Bylund 2020). These transaction or marketing costs involve costs in determining factor prices and organizing factor inputs. Bylund (2020) argues that a firm exists when the entrepreneur/ manager directs an internal allocation of resources that avoids these marketing costs. Yet, due to limits in bounded rationality, an entrepreneur/manager’s internal allocation of resources is subject to diminishing returns. These diminishing returns limit an entrepreneur/manager’s ability to replicate the resource allocations of the market. Hence, Bylund (2020) argues that a firm’s existence depends on developing an internal allocation that not only avoids marketing costs (MktgCost) but also avoids the relative inefficiency of an entrepreneur/manager’s internal allocation (As) to a market efficient allocation (Ae).According to Bylund (2020), a firm’s existence is explained by a simple rearrangement of his terms where Mktg Cost > Ae−As. By drawing on this marginal analysis, Bylund (2020)It should also be noted that Bylund’s (2020) work is based on an interpretation of Coase’s original insights. This work involves formulizing Coase’s theory and this formulization should not be conflated with Coase’s original or seminal contributions. An alternative to Coase’s theory is offered by Bylund (2016) also argues that the entrepreneur/manager can increase the size of their firm’s operation when their internal allocation of resources (As) exceeds the difference between the market efficient allocation (Ae) of resources and the market costs associated with this allocation (MktgCost).
Although Bylund (2020) does not directly examine the role of entrepreneurial judgements, an entrepreneur’s judgement is implicit in its explanations (see Bylund 2016). Since the entrepreneur/manager plays a “directive” role in the firm’s internal allocation of resources (Bylund 2020), an entrepreneur’s judgments surrounding the prices of factor inputs can offer an internal allocation of resources (As) that avoids Bylund’s (2020) marketing costs. For instance, since an entrepreneur’s judgment encourages employees to utilize their knowledge of the particulars (see also Foss, Foss, and Klein 2007), such knowledge offers an internal allocation of resources that is not readily known through external market prices. This judgment thereby offers an internal allocation (As) that avoids marketing costs and thus impacts a firm’s reason to exist. Furthermore, since an entrepreneur’s judgment is also subject to limits in bounded rationality, there are diminishing returns to an entrepreneur’s judgments. Such diminishing returns can reduce the efficiency of an entrepreneur’s internal allocation of resources (As) and thus impact the boundary conditions described in Bylund’s (2020) marginal analysis.
Entrepreneurial Judgment and a Firm’s Internal Organization
Although the concept of judgment offers important insights for explaining a firm’s existence and boundaries (e.g., Bylund 2016, 2020), Foss, Foss, and Klein’s (2007) theory of economic organization argues that an entrepreneur’s judgment can also impact a firm’s internal organization. According to Foss, Foss, and Klein. (2007), judgment involves a leadership role in which a firm’s human and capital assets are organized under the direction and control of the entrepreneur. This internal organization involves judgments surrounding the design of a firm’s formal and informal communication structures and system of rewards that would secure the control and support of a firm’s employees (Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering, Weitzel, and Muehlfeld 2019). This internal organization has been historically described by an authoritarian decision-making structure in which the entrepreneurial leader has direct control and influence over their employees’ behaviors (Bylund 2020; Coase 1937; Cowen and Parker 1997). Yet, due to the increasing complexity of markets, modern organizations face increasing pressures to organize this internal decision-making structure in ways that best respond to these external changes (Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering, Weitzel, and Muehlfeld 2019). This internal organization involves delegating a leader’s decision-making authority to all levels of the firm’s decision-making hierarchy (see also Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering et al 2019).
In response to this decentralization of decision tasks, Foss, Foss, and Klein (2007) argue that an entrepreneur’s leadership role involves organizing the firm’s decision-making authority such that employees are engaged in a “derived judgment” that acts on behalf of the entrepreneur’s original judgments (see also Cowen and Parker 1997; Rigtering, Weitzel, and Muehlfeld 2019; Witt, 1998, 1999). An entrepreneur’s original judgment, or simply judgment, refers to the “formation and execution of a business idea” (Foss, Foss, and Klein 2007, 1896), such as a firm’s mission or goals. A derived judgment involves “utiliz[ing] the knowledge best known to” the employee (Foss, Foss, and Klein 2007, 1894) in responding “to new circumstances or situations that may be unknown to the employer.” (Foss, Foss, and Klein 2007, 1894). These derived judgments draw on the employee’s knowledge to develop “productive” activities that advance an entrepreneur’s mission or judgment (Foss, Foss, and Klein 2007; see also Rigtering, Weitzel, and Muehlfeld 2019). Yet since this derived judgment is predicated on giving employees greater discretionary powers, employees can also draw on their knowledge to advance their personal goals (Foss, Foss, and Klein 2007). An employee’s derived judgment can thereby result in “unproductive” activities that undermine the entrepreneur’s mission or judgment (Foss, Foss, and Klein 2007). Hence, the challenge surrounding an entrepreneur’s judgment is in organizing a decision-making structure in which employees utilize their knowledge to serve the entrepreneur’s judgment and not their own (see also Cowen and Parker 1997; Witt, 1998).
For instance, Ulrich Witt’s (1998, 1999) concept of entrepreneurial leadership reflects this type of judgment. According to Witt (1998), entrepreneurial leadership involves a judgment surrounding an entrepreneur’s “imaginations” about the future prospects of a firm’s business concept or mission. Such imaginations or judgments are realized by inducing the support of the firm’s employees (Witt 1998). As in Foss, Foss, and Klein (2007), this support operates within a decentralized organizational setting. With this decentralization, there are limits on a leader’s bounded rationality that preclude the leader from directly controlling and influencing their employees’ behavior. Witt (1998) argues that this decentralization requires a leadership that appeals to the social and psychological aspects of a firm’s internal organization (Witt 1998). The social aspects of a firm’s internal organization involve instituting a social consensus among employees in order to realize an entrepreneur’s imaginations. In addition, while financial renumeration is important to inducing the support of employees, Witt (1998) argues that leadership must also appeal to an employee’s psychological motivations. This may involve relating an entrepreneur’s imaginations to an employee’s personal values. Hence, according to Witt (1998), judgments involve a leadership role of instituting a social and psychological decision-making process that seeks the support of employees. Such judgments are central to an entrepreneur’s leadership, because they allow the entrepreneurial leader to utilize their employees’ decentralized knowledge experiences in fulfilling the entrepreneur’s imaginations or judgments (see also Cowen and Parker, 1997).
IV. ENTREPRENEURIAL EMPOWERMENT Yet although the organization of a firm’s decentralized experiences is implicit to the internal Hayekian knowledge problem, an entrepreneur’s leadership role in empowering employees to address this knowledge problem remains largely undeveloped in theories of economic organization (Cowen and Parker 1997; Foss, Foss, and Klein 2007; Witt 1998). A concept of entrepreneurial empowerment (EE) is proposed. EE appeals to a judgment in which the decision task of the entrepreneurial leader is to institute “structural and psychological” forms of empowerment that encourage employees to draw on their knowledge of the particulars to realize an entrepreneur’s mission or judgment. Specifically, since judgment involves an ownership stake, the entrepreneurial leader is defined as an individual who has an ownership stake in their business and/or holds a senior leadership position in the organization (i.e., CEO). With this ownership stake, the entrepreneurial leader has the incentive and decision-making power to institute structural and psychological forms of empowerment practices on their employees (see also Cowen and Parker 1997; Witt 1998).
With this characterization of the entrepreneurial leader, EE approaches the internal Hayek knowledge problem not by viewing the entrepreneur as a central planner, but as a collaborator who cultivates a greater sense of autonomy in their employees. In particular, although giving employees greater decision-making autonomy can offer a means to utilize their knowledge of the particulars (e.g., Foss, Foss, and Klein 2007), this decentralization is only a partial solution. As Hayek (1945) described,
We must solve it by some form of decentralization. But this answers only part of our problem. We need decentralization because only thus can we ensure that the knowledge of the particular circumstances of time and place will be promptly used. But the “man on the spot” cannot decide solely on the basis of his limited but intimate knowledge of the facts of his immediate surroundings. There still remains the problem of communicating to him such further information as he needs to fit his decisions into the whole pattern of changes of the larger economic system. (524–25; author’s emphasis)
In response to this form of decentralization (see also Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering, Weitzel, and Muehlfeld 2019), EE offers a structural and psychological source of empowerment that addresses the “communicative” and “man on the spot” requirements of Hayek’s decentralization. Structural empowerment consists of the communicative systems of a firm’s internal organization. This communication involves the provision of “opportunities, information and support” that empower employees to realize their latent skills and experiences (Spreitzer 2008, 55). Psychological empowerment involves an appeal to the “man on the spot’s” intrinsic motivations. These intrinsic motivations involve cultivating a psychological state “in which an individual wishes and feels able to shape his or her work role and context” (Spreitzer 1995, 1444).
The structural and psychological components of EE, it is argued, solve the internal Hayekian knowledge problem by empowering employees to utilize their knowledge of the particulars in addressing the unique or circumstantial challenges of their job tasks. Yet, as employee can utilize their knowledge for their own benefit (Foss, Foss, and Klein 2007), the solution to the internal Hayekian knowledge problem also requires that the entrepreneurial leader empower employees to utilize their knowledge of particulars in ways that realize an entrepreneur’s mission or judgment. In addition to examining the individual components of the EE concepts—structural empowerment and psychological empowerment—this study argues that an examination of their joint impact can empower employees to utilize their knowledge of the particulars to advance an entrepreneur’s mission or judgment. In this fashion, the concept of EE offers a distinct firm-level solution to the internal Hayekian problem. To develop this argument, each of the structural and psychological components of the EE concept are first examined.
Structural Empowerment (SE)
Based on a social structural perspective, structural empowerment (SE) is defined by a “sharing power (i.e., formal authority or control over organizational resources (Conger and Kanungo 1988)) through the delegation of responsibility throughout the organizational chain of command” (Spreitzer 2008, 55). To institute this redistribution of authority, structural empowerment (SE) consists of practices that make efforts to develop in employees a greater: 1) autonomy to develop goals, a system of rewards, work procedures, and responsibilities in regard to employees’ assigned job tasks, 2) transparency of information where strategic goals and direction are communicated in ways relevant to their job performance, and 3) training practices that build their knowledge, skill, and ability to perform their assigned job tasks well (Spreitzer 2008).
The goal of the empowered entrepreneur is to develop SE practices that provide employees with the “opportunity, information, support, and resources” (Spreitzer 2008 55) to fully realize their latent skills and experiences in addressing the changing circumstances of their job (Spreitzer 2008). An entrepreneur can provide opportunities by developing resource forums and centers that promote the sharing of ideas among employees (Hargadon and Sutton 1997). For instance, in their study of the product design firm IDEO, Hargadon and Suttons (1997) pointed out that IDEO created a resource forum that pooled the design solutions used in previous projects. Engineers could draw on this pool to solve the current problems they faced in their job tasks. Entrepreneurs can also provide financial support to promote the development of new product ideas. Companies such as Google have provided millions in seed capital to help commercialize products developed by their project teams (Gagne and Deci 2013). Lastly, the entrepreneur can promote a sharing of information, for example through their organization’s policies on risk taking. Jeff Bezos and Elon Musk recognize that their organizations’ success rests on a policy that failure is a necessary part of the innovation process. This policy of failure can promote greater risk taking in employees and thus promote a greater willingness to experiment with new ideas (Henao-Zapata and Peirὀ 2018).
By providing employees with such opportunities, information, and support, SE practices offer an important communicative structure that demonstrates an entrepreneur’s commitment to an employee’s autonomy (see also Argyris 1998). Leaders need to communicate to their employees that they have made a personal commitment to empowering them (see also Argyris 1998; Bendahan et al. 2015). Developing this commitment is important, because leaders can engage in empowerment practices with politically correct motivations and not with a genuine commitment in promoting the autonomy of their employees (Argyris 1998). A communicative structure involving the provision of opportunities, information, and support signals a leader’s commitment to empowering their employees and thus assures employees that their leader’s empowerment efforts are genuine.
Exhibiting this genuine commitment, this communicative structure increases an employee’s willingness to exploit their knowledge of the particulars in that it reduces an employee’s fear that the use of their knowledge of the particulars will threaten the power and authority of the entrepreneur. For instance, studies find that leaders face difficulties giving up their positions of authority (Argyris 1998; Bendahan et al. 2015). This difficulty arises, because authority offers leaders the power to influence their subordinates in ways that advance a leader’s self-interest (Bendahan et al. 2015; Lubit 2002; Schyns and Schilling 2013). Hence, by providing employees the opportunities, information, and support to more fully utilize their knowledge, an entrepreneur not only demonstrates a clear commitment to relinquishing their control over their employees but also places trust in employees to utilize their knowledge of the particulars to advance their job task. This commitment as a result reduces the entrepreneur’s potential for retaliatory action and reduces an employee’s fear that utilizing their knowledge of particulars will threaten the entrepreneur’s authority (e.g. Bendahan et al. 2015; Lubit 2002; Schyns and Schilling 2013). This is consistent with empowerment studies that find that employees are hesitant to engage in greater decision-making autonomy because they fear the repercussions this may have for a leader’s authority (Spreitzer 1996). Therefore, in order to empower employees, their leaders must give their commitment to this, because in its absence employees do not want to be held accountable for decisions that are not supported by their leaders. SE offers a communicative structure that alleviates such concerns, because the provision of opportunities, information and support signals an entrepreneur’s commitment to empowering employees to make decisions.
Proposition 1: SE involving the provision of opportunities, information, and support positively influences an employee to utilize their knowledge of the particulars in their job tasks.
Psychological Empowerment (PE)
Unlike the communicative aspects of SE, PE appeals to an empowerment that is experienced by the employees themselves (see also Spreitzer 2008). Psychological empowerment (PE) is defined as a “psychological state of a subordinate [i.e., employee] perceiving four dimensions of meaningfulness, competence self-determination and impact, which is affected by empowering behaviours of the supervisor [i.e., entrepreneur]” (Lee and Koh 2001, 686). Each of these psychological states is described as follows:
Meaning involves a fit between the needs of one’s work role and one’s beliefs, values and behaviours….Competence refers to self-efficacy specific to one’s work, or a belief in one’s capability to perform work activities with skill….Self-determination is a sense of choice in initiating and regulating one’s actions….It reflects a sense of autonomy or choice over the initiation and continuation of work behaviour and processes (e.g., making decisions about work methods, pace, and effort). Impact is the degree to which one can influence strategic, administrative, or operating outcomes at work. (Spreitzer 2008, 57)
Studies have found that meaning, competence, self-determination, and impact increase an employer’s ability to achieve the objectives and challenges of their job (Lee and Koh 2001; Spreitzer 2008). For instance, an employee who finds meaning in their job develops greater motivation in fulfilling the requirements of their job (Henao-Zapata and Peirὀ 2018). Furthermore, competence or self-efficacy has been associated with improvements in an employee’s productivity (Henao-Zapata and Peirὀ 2018; Spreitzer 1996, 2008). Self-determination in which the employee takes on greater personal responsibilities in defining their job goals has been found to improve an employee’s goal achievement (Eva et al. 2019, Henao-Zapata and Peirὀ 2018; Spreitzer 1996, 2008). Lastly, impact has been found to increase an employee’s feelings of control over the workplace and promotes a greater commitment to pursuing organizational goals (Spreitzer 2008).
Since leadership is central to the empowerment of employees (Argyris 1998; Lee and 2001; Spreitzer 2008), the goal of the entrepreneur is to PE an employees’ sense of meaning, competence, self-determination, and impact in their jobs. This PE involves developing a vision that provides a sense of meaning and purpose to employees. For instance, Truett Cathy, the founder of the immensely successful Chick-fil-A restaurants, developed a vision based on Christian principles in which the glorification of God involved the provision of “second to none” service to his customers. This vision deeply resonated with the personal beliefs of his employees, and this greater sense of meaning and purpose has resulted in a commitment to service that is unrivalled in the food industry (Kruse 2015; Petrone 2014). An entrepreneur can promote self-determination by offering their employees the freedom to explore their personal talents and skills. Companies such as 3M and Google allow their employees to use up to 15 percent of their time to pursue projects of their own choice (Govindarajan and Srinivas 2013). Empowerment studies find that this self-determination can increase an employee’s sense of competence that they have the skills and experiences necessary to complete their jobs (Spreitzer 2008). Lastly, entrepreneurs who believe that their products and services have an impact on society can encourage their employees to develop job tasks in realizing such impacts. For instance, Toyota has made a commitment to producing cars that meet its environmental sustainability goals. To realize such goals, Toyota’s engineering specialists developed a solvent to clean the robots used in painting vehicle bumpers. The use of hazardous chemicals and water was significantly reduced as well as the number of defective bumpers.See https://www.toyota.com/usa/environment/.
By engaging in such forms of PE, entrepreneurs will not only develop a greater sense of meaning, competence, self-determination, and impact in their employees, but employees will also be more likely to utilize their knowledge of the particulars in ways not recognized by Hayek (1945). Hayek (1945) writes that “every individual has some advantage over all others in that he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active cooperation” (521–22). Austrians (Cowen and Parker 1997; Hayek 1945; Kirzner 1979, Foss, Foss, and Klein 2007) would argue that an extrinsic reward system would incentivize employees to engage in this active cooperation, to utilize their knowledge of the particulars. Yet various studies find that financial or extrinsic rewards (i.e., wage rates) can undermine an individual’s intrinsic motivation (Argyris 1998; Judge et al. 2010; Kuvaas et al. 2017; Ryan and Deci 2000). Judge et al. (2010, 158) explains
that extrinsic rewards are ultimately demotivating and dissatisfying to individuals. Because they have a negative effect on intrinsic interest in a task or job, extrinsic motivations tend to undermine perceived autonomy…. Moreover, goals for financial success have been argued to undermine well-being, because these goals represent a controlled orientation that interferes with the fulfillment of more enduring needs such as self-acceptance or affiliation.
Since PE involves an appeal to an employee’s intrinsic motivations, the use of financial, or extrinsic, rewards cannot psychologically motivate an employee to utilize their knowledge of the particulars. The reason is that financial rewards incentivize employees on the basis of achieving performance goals set by their supervisors and not on the basis of goals that advance their personal long-term growth (Judge et al. 2010). Stated differently, extrinsic, financial rewards only incentivize employees to take on initiatives when financial rewards are increased (Argyris 1998; Judge et al. 2010) and thus tend to undermine an individual’s autonomy to fulfill their high-order needs. In contrast to financial rewards, studies have shown that intrinsic motivations are positively related to greater levels of employee persistence and proactiveness (Judge et al. 2010; Kuvaas et al. 2017) and a greater ability to internalize the specific conditions of their work climate (Gagne and Deci 2005). These findings suggest that a PE employee will utilize their knowledge of the particulars in their job task because this knowledge offers them a greater sense of control in their work and the ability to proactively shape their tasks. This increased autonomy allows them to perform their jobs in ways that advance their personal goals and identities. Hence, PE increases an employee’s use of their knowledge of the particulars by empowering them to realize their higher-order or self-actualizing needs in ways that cannot be realized by the extrinsic financial rewards of Hayek (1945; see also Spreitzer 2008).
Proposition 2: a PE involving the development of a sense of meaning, competence, self-determination, and impact increases employees’ intrinsic motivation to utilize their knowledge of the particulars in their job tasks.
V. DECENTRALIZATION BENEFITS OF ENTREPRENEURIAL EMPOWERMENT By utilizing an employee’s knowledge of the particulars, SE and PE not only offer a means to solve the internal Hayekian knowledge problem, but also offer opportunities to exploit the benefits of decentralization. Austrian economists recognize that decentralization introduces intrafirm learning opportunities that increase an organization’s ability to adapt to and innovate in changing market conditions (Elert and Henrekson 2019; Foss, Foss, and Klein 2007; Henao-Zapata and Peirὀ 2018; Rigtering, Weitzel, and Muehlfeld 2019). These benefits of decentralization stem from the greater autonomy given to an organization’s subunits to engage in local problem-solving behaviors (Cowen and Parker 1997; Kollman, Miller, and Page 2000; Richardson et al. 2002; Rigtering, Weitzel, and Muehlfeld 2019). For instance, by offering employees greater autonomy in their decision-making, employees can draw on their day to day operational experiences to adapt to the problems faced in their job tasks. Furthermore, this greater autonomy comes with a lower resistance to change and thus increases employees’ freedom to pursue new ideas and innovations (Henao-Zapata and Peirὀ 2018; Rigtering, Weitzel, and Muehlfeld 2019). Hence, as structural and psychological empowerment offer employees a greater decision autonomy, these different forms of empowerment enable employees to exploit the adaptive and innovative benefits of decentralization.
Yet since the task of the entrepreneurial leader is to empower employees in ways that realize the entrepreneur’s mission or judgment, the structural and psychological components of EE cannot individually accomplish this leadership task. This is because the structural and psychological components operate at different levels of analysis in which neither considers the influences of the other (Siebert, Silver, and Randolph 2004). Empowerment studies have argued that a joint consideration of these components is needed because a firm’s internal communication structure has been shown to influence an employee psychological motivations (Siebert, Silver, and Randolph 2004). In the context of entrepreneurial leadership, a leader who jointly leverages the structural and psychological components of the EE concept not only empowers their employees to exploit the adaptive and innovative benefits of decentralization but can also empower employees to utilize their knowledge of particulars to advance an entrepreneur’s judgment or mission.
Bounded Autonomy
To explain this aspect of entrepreneurial leadership, EE exploits the adaptive benefits of decentralization by leveraging the relationship between a firm’s “bounded autonomy” and an employee’s “self-determination” (Siebert, Silver, and Randolph 2004; Spreitzer 2008). Bounded autonomy refers to the structural empowerment aspects of EE and is defined by “organizational structures and practices that encourage autonomous action, including the development of a clear vision, and clarity regarding goals, work procedures, and areas of responsibility” (Seibert, Silver, and Randolph 2004, 333; see also Spreitzer 1996). In the Austrian economics literature, this bounded autonomy has been described as a “nested hierarchy” (Foss, Foss, and Klein 2007, 1897) or “polyarchy” (Cowen and Parker 1997, 59). Common to these descriptions is that the firm is organized around a number of decentralized/partly autonomous units, each of which is delegated a decision authority that operates within the context and constraints of a greater decision-making authority (Cowen and Parker 1997; Foss, Foss, and Klein 2007; Witt 1998).
Although a firm’s bounded autonomy is organized in a fashion similar to other studies or economic organization (Cowen and Parker 1997; Foss, Foss, and Klein 2007; Rigtering, Weitzel, and Muehlfeld 2019; Witt, 1998), this study adds that the depth / width of this bounded autonomy is influenced by limits in entrepreneurs’ judgment. Due to limits on bounded rationality, transaction cost explanations would argue that an entrepreneur’s judgment faces increasing costs in coordinating an increasing specialization of tasks within its decision hierarchy. The depth of an organization’s bounded autonomy is influenced by the extent to which these specialized tasks can be vertically integrated within the bounded autonomy (see also Bylund, 2016). With limits on an entrepreneur’s judgement, entrepreneurial leaders face increasing difficulties in understanding the specialized decisions made by lower or deeper members of its decision hierarchy because these employees’ tasks are highly specialized to the unique circumstances and challenges of their local work environment. As result, an entrepreneur’s efforts to institute a bounded autonomy are subject to diminishing returns that limit the depth of specialized activities that can be integrated into this bounded autonomy. Furthermore, limits in an entrepreneur’s judgment also impact the width or scope of activities in a firm’s bounded autonomy. The width or scope of a bounded autonomy consists of the diversity of specialized activities in a firm’s decision hierarchy. Bylund (2016) argues that this diversity of specialized activities can exhibit interdependencies or synergies that are difficult for the entrepreneur to know. The width of scope of these experimented activities is thus limited by an entrepreneur’s ability to discover the interdependencies or synergies among them. Hence, as an entrepreneur’s EE is impacted by their judgment, an entrepreneur’s efforts to institute a bounded autonomy are subject to cognitive limitations that restrict the depth / width of this bounded autonomy.
By recognizing such limits in an entrepreneur’s structural empowerment efforts, a bounded autonomy is distinct from other decentralized forms of organization, such as Oliver E. Williamson’s (1975) M-form organizational structure. Williamson’s (1975) M-form organization emphasizes a highly diversified knowledge structure in which units are unrelated to the activities of others. With this autonomy, employees in each unit compete against others for corporate funds. While such competition offers a means to replicate the external market process, unit goals are prioritized over corporate goals (Cowen and Parker 1997). In contrast, the units in a bounded autonomy are guided and directed by the limits of an entrepreneur’s judgment. In order to conserve an entrepreneur’s bounded rationality, the entrepreneurial leader institutes a bounded autonomy in which the depth and width of unit activities are limited to those activities that are related to an entrepreneur’s mission or judgment. Hence, consistent with Cowen and Parker (1997), limits in an entrepreneur’s judgment result in a bounded autonomy in which the depth /width of a unit’s activities exhibit a coherence or relatedness that is absent from Williamson’s M-form structure.
Bounded Autonomy and Self-Determination
Under a bounded autonomy, employees engage in a self-determination that exploits the adaptive benefits of decentralization in ways consistent with an entrepreneur’s mission or judgment. Specifically, bounded autonomy reduces the ambiguities surrounding the expectations and scope of an employee’s decision-making authority (Spreitzer 1996). This reduction of ambiguity is important, because “if people do not know the extent of their authority and what is expected of them, they will hesitate to act (i.e. lack of self-determination) and thus feel unable to make a difference (i.e. lack impact)” (Spreitzer 1996, 487). This reduction of ambiguity offers employees a clear delineation of their decision-making authority, promoting a greater sense of self-determination that avoids the resistance to change typically found in organizational bureaucracies (Spreitzer 1996) by giving employees greater authority to draw on their knowledge of the particulars to address the challenges and expectations of their jobs. Studies find that such self-determination can increase an employee’s resiliency in their decision-making and promote a greater resourcefulness to seek local resources and experiences (Henao-Zapata and Peirὀ 2018; Spreitzer 1996). This resiliency and resourcefulness suggest that employees will draw on their knowledge of the particulars to gain an intimate understanding of their local work conditions. This localized understanding in turn increases an employee’s ability to adapt to the changing circumstances of their job. Unlike the unproductive behaviours described by Foss et al. (2007), an employee’s self-determination is constrained by a firm’s bounded autonomy. That is, a bounded autonomy offers a clear delineation of an employee’s delegated decision-making authority in which their self-determination is limited to their local conditions.
For instance, the joint influences of bounded autonomy and self-determination can be explained in terms of Koch Industries’ “market-based management” strategy (Cowen and Parker 1996; see also Klein 1996). This management strategy involves communicating the corporate mission to each business unit and delegating a decision-making authority to each unit in support of this corporate mission. This delegated decision-making offers a type of “bounded autonomy” in which units are given discretion to determine unit-level missions that guide their employees to make daily decisions that support the corporate mission (Cowen and Parker 1997). With respect to the self-determinative aspects of psychological empowerment, Koch’s market-based management also involves adopting a matrix management structure in which employees report to the senior managers of different units. With this matrix management, employees are “ultimately accountable to the consumer of the firm’s products and to the firm’s mission rather than to some specific individual known as a “boss” (Cowen and Parker 1997, 50–51). While we cannot directly assess the psychological aspects of an employee’s self-determination, Koch’s matrix structure offers a means for employees to assert their self-determination in responding to the needs of the firm’s customers. Furthermore, Koch Industries also offers compensation that rewards employees for developing products and services that advance the firm’s mission. These resources provide opportunities that affirm an employee’s self-determination. As a result, by jointly leveraging the bounded autonomous and self-determinative aspects of EE, these empowerment practices enable employees to exploit the adaptive benefits of decentralization in ways that also advance the entrepreneur’s mission or judgment (see also Cowen and Parker 1997).
Proposition 3: entrepreneurial empowerment involving a SE practice of bounded autonomy positively influences an employee’s PE by developing a self-determination that adapts to an entrepreneur’s mission or judgments.
Broad Sharing of Information and Competence
In addition, EE offers a structural and psychological empowerment that exploits the decentralized benefits of innovation. Specifically, a SE policy involving a broad sharing of information can psychologically empower employees to institute new ideas in their job tasks by promoting a sense of competence. This broad sharing of information involves sharing an organization’s strategy to all members of its decision hierarchy (Spreitzer 1996). For instance, Kellogg’s CEO, Carlos Gutierrez, instituted a value-added strategy that differentiated Kellogg’s products from an increasingly competitive cereal market. Mr. Gutierrez was successful in implementing this value-added strategy, because he was able to relate this differentiation strategy to the specific job demands and goals of every employee in his organization (Boyle 2004). Empowerment studies find that this broad sharing of information increases an employee’s sense of meaning and purpose, because employees can see the “big picture” and gain a better understanding of how their job fits within their organization’s broader vision or mission (Siebert, Silver, and Randolph 2004; Spreitzer 1996). Furthermore, studies find that this greater sense of meaning and purpose can increase an employee’s feelings of competence (Gagne and Deci 2005; Siebert, Silver, and Randolph 2004; Spreitzer 1996). This competence is important to instituting new ideas and innovations, because it increases employees’ perception that their implemented ideas will succeed and will have a meaningful impact on their organization’s future goals (Gagne and Deci 2005; Henao-Zapata and Peirὀ 2018; Seibert et al. 2004).
As entrepreneurs are often admired for their vision, an EE involving a broad sharing of information psychologically empowers an employee’s competence to engage in innovations that realize this vision. Specifically, a broad sharing of an entrepreneur’s vision offers employees a greater context in which to understand how their knowledge of the particulars can help realize an entrepreneur’s vision. This communication is important, because an employee who fails to understand how their knowledge of the particulars fits within the entrepreneur’s vision can create coordination problems (Witt 1998). Each employee will seek to utilize their knowledge of the particulars without considering their impact on others. As a result, such autonomous decision-making introduces conflicts in implementing innovations that would realize an entrepreneur’s vision (see also Foss, Foss, and Klein 2007). In order to avoid such conflicts, employees must develop a shared understanding of the entrepreneur’s vision (Spreitzer 1996; Witt 1998). This shared understanding is consistent with the communicative aspects of Hayek’s (1945) decentralization which posits that an employee’s knowledge of the particulars need to be understood within the context of a larger information system (see also Witt 1998). However, since Hayek (1945) relies on the price system to communicate the goals of this larger system, he does not consider those communication systems that appeal to an employee’s intrinsic motivations. EE addresses this shortcoming. An EE involving the broad sharing of an entrepreneur’s vision with all members of their organization (such as Gutierrez’s strategy at Kellogg’s), psychologically empowers an employee’s feeling of competence. This empowerment occurs, because a shared understanding aligns an employee’s knowledge of the particulars with their entrepreneur’s vision (Witt 1998) and thus increases an employee’s feelings of competence—that their knowledge of the particulars can have an impact in realizing the entrepreneur’s vision. This competence energizes an employee’s creativity to utilize their knowledge of particulars to develop new ideas in their jobs.
For instance, 3M started a new product that started with a complaint in their customer care division. The employee sought a solution by conducting his own research and then recontacted the customer to see if the solution was a suitable remedy (Rubinson 2009). This is consistent with studies’ finding that empowered employees tend to engage in greater creativity and innovation (Gagne and Deci 2005; Henao-Zapata and Peirὀ 2018; Kuvaas et al. 2017; Zhang and Bartol 2010). However, unlike these studies, which focus on the psychological aspects of empowerment, this study argues that a broad sharing of entrepreneur’s visions empowers employees competence to utilize their knowledge of the particulars to discover novel solutions that would realize an entrepreneur’s vision. This is consistent with J. P. C. Rigtering, G. U. Weitzel, and K. Muehlfeld (2019), who argue that lower-level managers and employees draw on their domain-specific knowledge to implement new business ideas. Hence, they argue, the task of corporate leaders is to “contextually frame” these lower-level innovative efforts to align with the corporate vision. This study argues that a SE practice of broad information sharing and its influence on an employee’s competence can contribute to a contextual framing in which the entrepreneur is able to exploit the decentralized benefits of innovation.
Proposition 4: entrepreneurial empowerment involving a SE practice of broad information sharing positively influences an employee’s PE by developing their competence to innovate in activities that advance an entrepreneur’s mission or judgment.
DISCUSSIONS AND CONCLUSIONS As entrepreneurs’ success is often attributed to their ability to identify unnoticed market opportunities, the discovery of opportunities within a firm’s internal organization remains largely underexamined in Austrian economics and mainstream entrepreneurship research (see Alvarez, Barney, and Anderson 2013). Yet leadership research has widely recognized that employees are central to an organization’s success and thus the task of a leader is to empower their employees to realize this success. This distinction was recognized earlier by Chester I. Barnard’s (1938) seminal work on leadership. He argued that the quintessential task of a leader is to communicate and empower a common purpose to their employees. A concept of entrepreneurial empowerment has been developed in which opportunities for employee empowerment are used to solve an internal Hayekian knowledge problem. In this solution to the internal Hayekian problem, the entrepreneur’s task as a leader is to structurally and psychological empower their employees in order to unleash their latent potential. EE’s structural and psychological dimensions motivate employees to use their knowledge of the particulars to discover the adaptive and innovative benefits of decentralization. EE has three implications for Austrian economics and entrepreneurship research.
First, according to Austrian economic explanations, adaptation and innovation are largely explained in terms of market-level processes. As result, an organization’s adaptive and innovative processes remain generally understood as a “black box” (Kirzner 2019). EE offers a direction for Austrian economists to “open” up this black box in which a venture’s ability to adapt and innovate is attributed to the structural and psychological aspects of the EE concept. EE introduces an adaptive and innovative process that is endogenous to an employee’s knowledge of the particulars. This endogenous process underscores that although the success of a venture is widely attributed to its entrepreneur’s inspirational ideas, a venture’s success can also come from those involved in executing these ideas. This is because employees have the most familiar understandings of the challenges surrounding the implementation of their leader’s ideas. More broadly speaking, this knowledge of the particulars offers employees a unique position to adapt and innovate activities that reconcile the challenges of their job tasks with the ideas and goals of the entrepreneur. The utilization of this knowledge opens up the black box of Austrian entrepreneurship, in which an organization’s adaptation and innovation is explained by a decentralized process that cannot be centralized by an entrepreneur’s leadership (see also Shane 2000).
More fundamentally, EE’s utilization of an employee’s knowledge of the particulars offers a decentralization that appeals to Mises’s open-ended view of entrepreneurship (Salerno 1993). By solving the internal Hayekian problem, EE offers an economic calculation in which the employee’s knowledge of the particulars is used in determining an allocation of internal resources that meets the needs of a firm’s consumers. Since consumer needs will continually evolve, EE’s solution to the internal Hayekian problem offers an economic calculation that evolves with the changing needs of the consumer. Consistent with Mises, EE will result in an economic calculation in which this changing allocation of internal resources may not converge toward an equilibrium outcome (see also Salerno 1993). EE thereby offers an alternative to alert explanations of the market process.
Second and relatedly, since the concept of EE has a distinctly proactive orientation, EE introduces a “deliberateness” not found in alert entrepreneurial explanations (Kirzner 2019). Unlike with Kirzner (2019), the structural and psychological dimensions of EE involve a search that requires a deliberate commitment of an entrepreneur’s time and efforts. Structural empowerment requires that the entrepreneur institute practices that provide employees the opportunity, information and support to realize their latent potential. As these policies involve redistributing the power in an organization’s hierarchy, supervisory members of this hierarchy are likely to resist such policies, because they undermine their position of power and influence (Argyris 1998; Bendahan et al. 2015). Hence, an entrepreneur who institutes such SE policies is likely to expend considerable time and effort in overcoming this resistance.A reviewer has noted that once an entrepreneur has instituted such structural and psychological forms of empowerment this resistance to change will not likely persist. That is, the ultimate goal of EE is to empower employees to act in accordance to an entrepreneur’s mission or judgment. Hence little resistance by employees will be expected once the individual and joint efforts of EE are instituted by the entrepreneur. With this commitment of effort, EE introduces a deliberateness that is particularly relevant to addressing recent debates surrounding an entrepreneur’s claims to the wealth creation process. For instance, a NY representative, Alexandria Ocasio-Cortez, argued that wealthy business owners did not deserve their wealth because they “sat on couches, while thousands were paid modern day slave wages.” EE argues that due to the commitment of resources required by the structural and psychological empowerment process, entrepreneurs have a direct claim to such wealth. Stated differently, EE argues for a Friedman system of ethics (see also Bylund 2019, Kirzner 2019) that justifies an entrepreneur’s wealth on the basis that they have contributed resources in empowering their factors of production (i.e., employees). Hence unlike Kirzner’s (2019) rejection of Friedman’s system of ethics, EE argues that entrepreneurs have a legitimate moral claim to the wealth creation process, because this wealth creation is based on an entrepreneur developing a deliberate relationship to their factors of productions (see also Bylund 2016).
Third and lastly, the concept of EE offers a type of judgment that is important to explaining a firm’s internal organization. EE appeals to a judgment that is not principally concerned with developing an internal allocation of resources that reduces the transactions cost of the market. Instead, EE appeals to a judgment in which the task of the entrepreneurial leader is to organize a firm’s internal decision-making structure in which employees utilize their knowledge of particulars to advance their entrepreneur’s judgment. In addition, entrepreneurs are often viewed as visionary leaders. But entrepreneurs have a leadership responsibility to not only articulate a compelling vision to their employees, but also to empower their employees to realize this vision. The concept of EE offers a type of judgement in realizing entrepreneurial visions. This judgment involves efforts to organize a firm’s internal communication structure and to provide appropriate psychological motivations that empower employees to realize their entrepreneur’s vision. The implication of this wealth creation process is that EE favors a more creative explanation of entrepreneurial opportunities (Alvarez and Busenitz 2001) in which opportunities are brought into existence by the empowerment efforts of the entrepreneur. EE, however, does not imply a rejection of the price arbitrage opportunities of alert entrepreneurship, because alert entrepreneurship and EE are concerned with solving different knowledge problems. EE emphasizes a distinctly firm-level approach to solving the internal Hayekian problem. This firm-level approach argues that an employee’s inherent potential cannot be fully realized by the external price system. In contrast, alertness emphasizes the discovery of price arbitrage opportunities at the market level and therefore relies on prices that cannot reveal an employee’s latent potential. An important direction for Austrian economics research is to examine both forms of entrepreneurship, because they address different aspects of the entrepreneurial discovery process.
Contra Marx, Mises understood that human desires and needs are not determined merely by biology.
Original Article: "Why Marx Never Figured Out How to Distribute Goods in a Socialist Society".
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Professor Per Bylund of Oklahoma State University is the author of The Seen, The Unseen, and the Unrealized. 2020 is the year social scientists failed to show us the unseen, namely the staggering and still unfolding economic, social, medical, and human costs of Covid lockdowns. Dr. Bylund and Jeff Deist discuss Covid and government responses against the backdrop of ripple effects, Say's law, "market failure," and the inability of bureaucrats to make rational tradeoffs. They also discuss Dr. Bylund's upcoming project for the Mises Institute: an Austrian economics primer, under 100 pages, available as a very inexpensive paperback.
Find Dr. Bylunds book at mises.org/Unrealized
And follow him on Twitter @PerBylund
Abstract: This paper expands Fuller’s (2013) analysis of the net present value and interest rate changes in the context of the Austrian business cycle theory. During the boom phase of the business cycle, the economy shifts to a more risky position as the result of entrepreneurs’ profit targeting. To quantify this risk the duration, defined as the number of periods that elapse before the average present value dollar is received from a stream of cash flows, can be used. The new risk-adjusted net present value is created after applying the duration to capital asset pricing model determining the discount rate that should be used to calculate the present value of the project.
JEL Classification: B53, E22, E40, E52, G31, G32 Joanna Kruk (jkruk67@gmail.com) is a recent graduate of the Cracow University of Economics and Jagiellonian University.
- INTRODUCTION The Austrian business cycle theory (ABCT) gained the interest and endorsement of non-Austrians as a valid theory shortly after the outbreak of the 2007/08 crisis. Then, major focus was placed on macrolevel aggregates such as the volume of loans, the threat of large scale bankruptcy or the supply of money. Little attention was paid to the analysis of corporate finance and the causes of companies’ erroneous decisions about initiating and carrying out unprofitable undertakings. One direct cause of the collapse was identified as cheap credit, which engenders a reallocation of resources between stages of production. That is inconsistent with the intertemporal preferences of consumers. In particular, lowering the interest rate below its natural level causes production to become more future-oriented. Artificially low interest rates are not only the cause of incurring new debts by companies, but are also the reason why less efficient companies enter the market. Due to the poor quality of their projects, these less efficient companies are more likely to mobilize necessary funds if funds are less limited, which is the result of expansionary monetary policy. Correspondingly, there are numerous entrepreneurs that will receive investment funds only when credit is “easy.” (Engelhardt, 2013) Moreover, erroneous decisions to engage more resources to projects which cannot be successfully completed are implemented, making the situation worse than it otherwise would be.
The aim of this paper is to analyze corporate finance from an ABCT perspective with a focus on the excessive risk-taking by companies. While the main literature about the business cycle focuses on the effects of certain policies on the aggregate and general shift of the economy to more risky positions, the motivation of financial decisions on a micro-level can shed new light on the foundations of the emergence of the business cycle. The vast difference between the profitability of an investment project relative to the interest rate change was previously discussed by Fuller (2013) using the net present value and the marginal efficiency of capital to show how interest rates affect the intertemporal allocation of capital and shift the resources to more roundabout projects. Enriching the analysis in risk assessment could lead to a further conclusion regarding the subject. One of the frequently used risk measures is duration, used in capital budgeting and precisely described by Blocher and Clyde (1979) and Johnson (2005).
In this paper, we plan to analyze previous work on the cycle effects on the microenvironment from the Austrian perspective, along with financial literature research on risk assessment, in order to try to capture the impact of interest rates changes based on financial decisions of firms with on numeric examples.
- THE CORPORATE APPROACH TO THE AUSTRIAN BUSINESS CYCLE THEORY The Austrian business cycle theory was developed in the first half of the 20th century, mostly by Ludwig von Mises and Friedrich von Hayek. The main focus of the theory was placed on the intertemporal coordination and allocation of resources. In the market economy, the role of price signals was emphasized, as it is the major indicator of entrepreneurs’ success in fulfilling their clients’ demands. Special attention was paid to interest rates since the core of the ABCT is how artificially low-interest rates, which are falling below their natural level, influence the economic activity of agents.
As formulated by Rothbard (1978), the unhampered market interest rate is determined only by the “time-preferences” of the agents. People choose money right now over a promise made in the present to receive the same amount of money in the future, which means that their time preference is positive. Time preference also indicates the distribution of people’s income between savings and consumption. When the interest rate falls as the result of government intervention, rather than as a change in people’s preferences, an artificial boom starts. Agents are deceived into thinking that there is a greater amount of savings available for their investment projects, so they begin to engage more capital, particularly in lengthy and time-consuming undertakings, which previously were unprofitable due to the higher cost of financing them.
The main focus of Austrian economists is placed on emphasizing the disruption of intertemporal resources allocated between stages of production, resulting in malinvestments. At the later stage, these projects turn out to be impossible to complete since there are not enough resources to finish all undertakings initiated during the boom episode. This argument was originally formulated by Ludwig von Mises: “Projects which would not have been thought profitable if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found profitable and can be initiated.” (Mises 1912, 26)
In the microscale during the expansionary phase of the business cycle, firms will prefer to expand production. Since the interest rate is regarded not only as a cost factor but also as a factor of capitalization, decreasing the interest rate creates an incentive for investments in fixed capital by way of capitalization of future yields (Machlup 1935). This is the effect of the increased present value of future return, which is capitalized at the new, lowest interest rate. This reasoning applies to both lowering interest rates directly by the central bank and to credit expansion. In the second scenario, the newly available funds push down the interest rate and create the impression that there are more resources available for investment in lengthy projects. At the same time, the decreased interest rate is the reason people are less willing to keep their income as savings, thus the further discrepancy between real and natural interest rate is created (Engelhardt 2012).
The main reason for keeping interest rates low is to boost the economic activity of agents. As a direct consequence, on a corporate finance level, it causes an increase in debt to capital ratio but also has an effect on capital budgeting decisions as described by Cwik (2008). Firms tend to not only increase the volume on investments but also replace investment in working capital with investment in fixed capital, widening the distance between real-time preference and the one imposed by the nominal interest rates. After the boom ends, these projects are abandoned as they are no longer able to generate positive cash flows. Some of the fixed capital used in undertaking can be moved to other projects, which was described by Wood (1984) as the illusion of depression: when companies decide to quit unprofitable undertakings, thus causing a decline in economic activity, but releasing the necessary resources for more effective projects. The resources which cannot be engaged in another project due to their specifics are considered sunk costs.Mises (1949) used the distinction for convertible and partially or nonconvertible capital: “It is expedient to substitute the notion of the convertibility of capital goods for the misleading distinction between fixed and free or circulating capital. The convertibility of capital goods is the opportunity offered to adjust their utilization to a change in the data of production.”
- INFLUENCE OF INTEREST RATE CHANGES ON THE NPV OF THE INVESTMENT PROJECT Net Present Value is an indicator used in order to compare projects realized in different periods of time and with different lengths. It uses the discounted cash flow generated by the activity. The present value of delayed payoff can be found by multiplying the payoff by a certain discount factor, which is less than 1. If the value of the discount factor was greater it would mean that the dollar tomorrow is worth more than a dollar today, which denies positive time preference. Net present value is defined as follows:
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where:
CFt = a cash flow to be received in a period of time t,
r = discount rate.
Ludwig von Mises and Irving Fisher suggest using the present value approach to economic calculation since the price of an investment project is moving towards the present value of the project’s expected cash flows.Both values are equal in equilibrium or in the Evenly Rotating Economy. Present value approach was also advocated by Rothbard (1962, 62–63):
It is clear that the higher the rate of discount, the lower the present value of the future good will be, and the greater the likelihood of abstaining from the investment. On the other hand, the lower the rate of discount, the higher the present value of future goods will be on the actor’s value scale, and the greater the likelihood of its being greater than the value of present goods forgone, and hence of his making the investment.
The consequences of interest rate changes and their effect on the valuation of projects were examined by Fuller (2013) and can be presented graphically:
Figure 1. Net Present Value Profile
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Diagram from Fuller (2013).
There are three indications of the NPV profile shape: the NPV of the project increases as the interest rate falls, the chart is curved, so the NPV profile becomes flattened as the interest rate falls, meaning that the change in interest rates causes not proportional change in NPV and this dependence is explicit in long term investment projects in particular, since the longer stream of cash flows is discounted. Third, the NPV profile intersects the interest rate axis at the point where NPV is zero, indicating the positive NPV area on the right from the vertical axis (Fuller, 2013).
If the present value is used as an indicator of a project’s profitability, then the expected reinvestment rate should be used as a discount factor, since comparing two projects of a different outlays requires comparing in relative, rather than absolute terms. In that case, it is necessary to compare “present value per dollar of outlay” (Solomon, 1956). The valid comparison can be made not only with similar projects but also with two different courses of action, which can be brought to the same measure using NPV.
Wealth maximizing investors use NPV to rank their investment projects while competition in the market creates a tendency for the price of an investment project to equal the present value of expected cash flows. This is because investors will bid up the price when it is below the present value and bid it down when it is above, a simple arbitrage process. In the wooden and steel bridge example first described by Hansen (1953, 118) and later developed by Fuller (2013), there is presented the disproportionate effect of the change of the interest rate on the short-term and long-term projects. Since the lowering of interest rates favors longer projects, it is intuitive that these projects are usually associated with greater uncertainty, since they absorb resources for a longer period of time. The risk of the interest rate change may be one of the components that has an impact on how safe the particular investment is. For the purpose of expanding and quantifying this intuition, risk measures such as duration can be used.
- DURATION AS A RISK MEASURE One of the reasons for the 2007 crisis was aggressive profit targeting. As a result, agents tended to focus on the higher return from their investments, neglecting the difference in risk associated with their decisions. Since they were acting in the low rates environment, in the long term, more risky projects seemed more attractive as there was a possibility to achieve higher profits by engaging in these. That is the reason we cannot exclude risk from its role in the profitability of the investment projects, and this factor should be included in further analysis. It is not surprising that risk is positively correlated with higher potential profit. As a result of entrepreneurs being more likely to forecast consumers’ demand in the near future, they generate greater errors in forecasting longer periods. Therefore, on average, there is a higher probability of erroneously forecasting more distant cash flow than those forecasts of cash flows to be received in the relatively near future.
In the short run, if we examine the wealth generated by the project without adjusting the forecasted values for risk, the output of the economy appears better when it is associated with an incipient boom. Consequently, in the medium or long run, collapse starts when this risk taken by the entities materializes.Materialization of risk may be explained by an example: when a large number of companies engage in similar ventures, with a 70 percent probability of success each, it means that, on average, this will end up as a loss for about 30 percent of companies. In the beginning, the projects generate positive cash flows and investments pay off, but eventually at least part of the risky investments will not succeed and the bust phase of the business cycle begins. Generally, the lower the interest rate, the more profitable investments in more roundabout projects appear. At the same time, the risk grows. This implies shifting the economy to a more risky position with higher potential returns (Cowen, 1997).
To quantify this risk, the risk-adjusted NPV as a measure of profitability should be used. Since wealth maximizing investors are evaluating projects only using risk-free NPV they may underestimate the risk associated with their investment decisions. One of the risk measures for the purpose of adjusting NPV for risk can be the duration measure. It was discovered and developed by Frederic Macaulay (1938) for the purpose of measuring the average time an investor waits to retrieve his money from an investment. Hicks independently derived “average period,” an equivalent measure of elasticity, with respect to a discount ratio (Hicks 1939, 186). Although it has other applications, duration has been successfully used in problems regarding the reduction of basis risk, and even Macaulay himself was primarily focused on “the risk-proxying properties of his measure, despite the assigned name duration.” (Cox, Ingersoll, and Ross, 1979) Although it was originally designed for bonds, it was later developed to be used effectively in capital budgeting (Blocker and Stickney, 1979). The duration is represented as follows:
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where:
CFt = a cash flow to be received units of time from today, beginning with t=1 period from today,
r = an appropriate discount rate for determining the present value of the cash flow,
t = units of time.
The formula represents a weighted average of the stream payments, where the maturity of each payment is weighted by the proportion of the total value of an asset accounted for by the payment (Haugen 1990), so the duration, in a way, represents an average life of an asset.
For the purpose of capital budgeting, the duration can be measured as the duration of the net cash inflows and the duration of the net cash outflows (Durand 1974, 25). The properties of this measure, as Blocher and Stickney (1979) pointed out, are as follows:
The duration of a stream of cash flows is always less than the time of the last cash flow (unless the stream is single cash flow, in which case duration is equal to the number of periods which elapse until that last cash flow).The difference between a project’s life and its duration is relatively small for shorter-lived projects but increases as the life of the projects is increased.Duration varies inversely with the discount rate used. The higher the discount rate, the shorter will be the time until the average present value dollar is received.For a project with a zero or positive net present value at the certain discount rate used, duration increases at a decreasing rate as the foreseen life of the project is increased, but it is bounded.Duration is relatively insensitive to the discount rate used for shorter-lived projects but becomes more sensitive to the discount rate as life is increased. (pp. 3–4) When used in predicting bonds’ prices, duration assumes a linear relationship between price and changes in interest rates. In reality, however, prices rise more than proportionally as interest rates fall and decrease at an increasing rate as interest rates rise. As a result, the duration will underestimate the price increase, meaning that the risk can still be undervalued.
To illustrate the calculation of duration we will use the following example:
Table 1. Duration Calculation[[{"fid":"93415","view_mode":"image_no_caption","fields":{"alt":"table 1","class":"media-element file-default media-wysiwyg-align-center","data-delta":"4","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 1","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"4":{"alt":"table 1","class":"media-element file-default media-wysiwyg-align-center","data-delta":"4","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 1","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"table 1","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"4"}}]]
For this project, the duration is 1.74 and this is the number we receive by dividing the sum of the column (5) by the sum of the column (4).
Duration is also used as a measure of expected changes in market prices of bonds after a change in interest rates. The relation between duration (D), price (P) and interest rate (r) is described by the equation:
(3) [[{"fid":"93416","view_mode":"image_no_caption","fields":{"alt":"kruk03","class":"media-element file-default","data-delta":"5","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk03","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"5":{"alt":"kruk03","class":"media-element file-default","data-delta":"5","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk03","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"kruk03","class":"media-element file-image-no-caption","data-delta":"5"}}]]
Meaning, ceteris paribus, the greater the duration, the more sensitive will be a bond’s price to changes in the interest rate. The elasticity aspect of duration ensures its usefulness in capital budgeting decisions for the purpose of a measurement of a loss in the net present value of a project suffered from a change in required rates of return. In two comparable projects the shorter the duration, the less net present value of the project is vulnerable for interest rate changes (Blocher and Stickney, 1979) and the safer the investment, since the investors are waiting for the return, on average, for a shorter period of time. There is, however, a side effect of this approach: when investors expect the interest rate to fall, the investment in projects with a longer duration will experience a larger increase in their value than others, meaning that investors may shift to those projects if NPV valuation is not supported by further risk analysis. It may be perceived as the proper investment decision as long as the low interest rate environment is controlling. The problem is that longer investment projects are considered more attractive. But it is probable that the interest rate will increase during the project’s life. That will change profitability drastically.
Since duration reflects the average length of time consumed waiting for receipt of the cash flow generated by the project, it also demonstrates the liquidity of the project. It competes in that area with a conventional payback method,Payback period is the amount of time it takes to recover the cost of an investment. but duration surpasses payback period in that function since only duration can be incorporated in the analysis of NPV, and not as a supporting indicator alone.
- DURATION EFFECTS ON NPV Since, as explained in the above analysis, investors after lowering interest rates are switching their preferences to more capital-intensive, longer-term investments, at the same time, on average, they turn to projects with a longer duration. This means that during the phase of the boom of the business cycle economy shifts to a more risky position. Since the agents are targeting profit, there is a little attention paid to the risk exposure, measured by duration, of their projects.
Taking into the examination the example presented by Fuller (2013) of the two alternative projects, the further analysis of two investment projects will be carried out: a wooden bridge requiring a lower financial expense of 2,000 units and providing a constant cash flow of 1,000 in the next 3 years, and a steel bridge requiring the expense of 5,000 units and providing 0 units cash flow for the next 2 years, and a constant 1,000 units for the following 8 years, which is presented in the following table:
Table 2. Cash Flows Schedule[[{"fid":"93417","view_mode":"image_no_caption","fields":{"alt":"table 2","class":"media-element file-default media-wysiwyg-align-center","data-delta":"6","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 2","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"6":{"alt":"table 2","class":"media-element file-default media-wysiwyg-align-center","data-delta":"6","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 2","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"table 2","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"6"}}]]
The interest rate for which these projects generate the same net present value, meaning that they should be indifferent in the investors ranking, is approximately 5.48 percent. Discounted by this rate, the net present value of the projects is around 699.10 units. Calculating the duration for both provides more information about the expected returns. Since the duration for wooden bridge equals 1.96, and for the steel bridge it is 6.22, investors have to wait for returns from invested capital more than three times longer if they decide to invest in the steel bridge, which is associated with a higher risk for their income. But further assume that the investors demand a higher return and the interest rate increases from 5.48 percent to 7 percent. In this scenario, the net present value of the wooden bridge decreases only to 624.32 from 699.10, which is about an 11 percent decrease, while the steel bridge net present value decreases from 699.10 to just 215.56, which constitutes a 61 percent decrease, showing how sensitive projects with a large duration are to changes in interest rates.
This may explain why even a slight change in the interest rates may cause a dramatic change in the profitability of a project. Since in the present low rate environment, we expect that the average undertaken project has a longer duration, the expected vulnerability to the discount rate changes also increases.
Table 3. NPV and Duration Schedule[[{"fid":"93418","view_mode":"image_no_caption","fields":{"alt":"table 3","class":"media-element file-default media-wysiwyg-align-center","data-delta":"7","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 3","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"7":{"alt":"table 3","class":"media-element file-default media-wysiwyg-align-center","data-delta":"7","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 3","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"table 3","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"7"}}]]
To fully understand the duration’s significance in NPV analysis we present selected values in the table. The first conclusion is that the greater the interest rate, the smaller the duration is. It is the result of the NPV profile. When we increase the discount factor used for future cash flows, the more advanced payments are getting a lower share in the total NPV sum compared to prior payments. As a result, using the duration interpretation, we do not wait as long for future cash generated by the project as we do when using the same payment with a lower interest rate, due to the fact that later payments are given less significance. It also must be noted that the duration changes associated with interest rate changes are not substantial and are even small for the shorter projects.
The second conclusion which we can derive from the values in the table is that the greater the duration, the greater NPV loss from the increase of the interest rate. It is worth noting that this is only true for nominal values.
Figure 2. Duration Profile[[{"fid":"93419","view_mode":"image_no_caption","fields":{"alt":"figure 2","class":"media-element file-default media-wysiwyg-align-center","data-delta":"8","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"figure 2","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"8":{"alt":"figure 2","class":"media-element file-default media-wysiwyg-align-center","data-delta":"8","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"figure 2","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"figure 2","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"8"}}]]
In Figure 2, different duration values for different interest rates are presented. Although changes are not significant, it can be easily seen that the values for duration for the shorter project, the wooden bridge, are steady. Despite the fact that the NPV and the returns from investment are changing, the average waiting period for the investor to recover his money from the investment is not. In case of the longer, more deferred project, we see a steady drop in duration value as the interest rate increases. Although, as we mentioned, generally shorter projects are less risky, in this case the decline in duration is associated with decreasing share of later payments in overall value. That means that the greater weight is given to the less distant payments, which is decreasing the duration, but at the same time NPV values are decreasing on a larger scale.
If the interest rate is artificially reduced by a central bank, the duration gap between shorter-lived and longer projects increases. This causes a greater hazard for the second type of projects as their payment is not only subject to interest rate risk, which can be measured by duration, but is also subject to the uncertainty associated with changing economic conditions of business.
Longer-term projects are more information sensitive and are subject to profitability changes due to uncertainty. Even though this is unquantifiable, the entrepreneurs have to make a prediction about the forecasted cash flows generated by the company investment decisions. As described by Ludwig von Mises (1951, 27): “There is no certainty about the future state of the market and about the height of these earnings. They can only be determined by speculative anticipation on the part of the entrepreneur.”
The duration may prove useful to quantify at least some risks regarding the previously estimated profit not being realized. The duration may show that not every long term project is equally risky—e.g., risk may also depend on how flat the yield curve is for a particular project.The flat yield curve indicates that there is almost no difference between short-term and long-term rates for bonds and notes of similar quality.
- RISK-ADJUSTED THE NET PRESENT VALUE Since the net present value is sensitive to interest rate changes, especially long-term projects should not be discounted with a nominal interest rate. Expanding the analysis for the illiquidity risk-adjusted interest rate could further develop the analysis. For projects in which annual cash flows constitute an annuity, the algorithm for the duration is reduced to:
(4) [[{"fid":"93420","view_mode":"image_no_caption","fields":{"alt":"kruk04","class":"media-element file-default","data-delta":"9","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk04","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"9":{"alt":"kruk04","class":"media-element file-default","data-delta":"9","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk04","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"kruk04","class":"media-element file-image-no-caption","data-delta":"9"}}]]
Where r is the value which equates the present value of the inflows to the price of the investment. For project analysis it can be the yield rate, the cost of capital rate, a risk-adjusted rate, or any rate that an investor may use as a required rate of return (Brown and Kulkarni 1993).
To perform the NPV analysis, the company can estimate the discount rate for each project using the Capital Asset Pricing Model (CAPM) method.CAPM defines the relationship between systematic risk and expected return for assets. While it is not the method consistent with the Austrian theory, it is still one of the most popular tools used by large companies on the market, which is the reason we cannot neglect its importance. Graham and Harvey (2001) surveyed 392 CFOs about the cost of capital, capital budgeting, and capital structure. The results indicate that “the CAPM is by far the most popular method of estimating the cost of equity capital: 73.5% of respondents always or almost always use the CAPM. The second and third most popular methods are average stock returns and a multibeta CAPM, respectively” (Graham and Harvey 2001). CAPM is also popular among academics. Research conducted by Welch (2008) revealed that about 75 percent of finance professors still advocate using the CAPM to estimate the cost of capital. Furthermore, there is evidence that while the CAPM deliberately fails to predict asset prices, it is more useful for the purpose of estimating the cost of capital (Da, Guo, Jagannathan 2012). Even if we do not fully acknowledge the prediction made using the CAPM model including the duration in the equation may reduce the entrepreneurial mistakes caused by the non-risk-adjusted version of it, which is the reason the model is included in the paper.
The model determines the required rate of return for an investment as the sum of the risk-free rate (Rf) and a premium, which is the product of beta and the difference between the market rate of return (Rm) and the risk-free rate:
(5) [[{"fid":"93421","view_mode":"image_no_caption","fields":{"alt":"kruk05","class":"media-element file-default","data-delta":"10","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk05","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"10":{"alt":"kruk05","class":"media-element file-default","data-delta":"10","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk05","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"kruk05","class":"media-element file-image-no-caption","data-delta":"10"}}]]
In order to obtain beta coefficients for investments, the method requires regressing the returns of the projects against the market returns, if available. In the case of the wooden and steel bridges, the most reasonable assumption is the beta coefficient for both projects moving in exactly same direction and having the same impact of changes on required return as a market,Beta belonging to the interval (0,1) means that the investment is reacting slower than the market, and beta greater than 1 means that every time the market rate changes the required rate of return changes more than the market rate. meaning that beta equals 1 and using the market return of 5 percent (for which the steel bridge is a more attractive investment using net present value as an indicator). The risk-free rate is usually described as the government bonds’ rate since they are currently considered the safest investment. We further make a conservative assumption that the risk-free rate is at 2 percent, meaning that 3 percent is the risk premium.The greater the risk premium, the greater impact duration will have on the risk-adjusted net present value. Since private investments usually have a few times higher return than the risk free rate, the 3 percent risk premium is a safe assumption.
We will now try to adjust the net present value of the wooden and steel bridges from the example using the following equation presented by Brown and Kulkarni (1993):
(6) [[{"fid":"93422","view_mode":"image_no_caption","fields":{"alt":"kruk06","class":"media-element file-default","data-delta":"11","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk06","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"11":{"alt":"kruk06","class":"media-element file-default","data-delta":"11","format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"kruk06","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"kruk06","class":"media-element file-image-no-caption","data-delta":"11"}}]]
where:
i = the rate of return adjusted for duration and timing of the cash flows
r = the required rate of return on a project,
D(i,n)= duration of a project with periodic cash flow over n years discounted at the rate appropriate for the duration of that project
D(r,n)= the duration of a project with equal periodic returns over the project life of n years discounted at the r rate
The equation derives from the standard CAPM equation with inclusion of liquidity adjustment coefficient (Di,n/Dr,n). A justification for including this ratio in the equation is that the “the ratio of duration of any project of n years life to the duration of a uniform series project of the same life, when multiplied by the risk factor should produce a close approximation to what the rate should be to correct for duration” (Brown and Kulkarni 1993). Since Dr,n is the function of only the project’s life and rate and it assumes equal periodic returns over the life of the project, it can be calculated using equation (4) using r just as in the CAPM model.
The values of i and Di,n remain to be calculated. We know that for a project with a higher earlier duration, the risk is decreased, so adjusting for the duration of the projects also decreases the discount rate. This is analogous to the case of the projects with lower earlier cash flows. Therefore we know that if the duration of the project is less than Dr,n, then i will be less than r, and i will be greater than r if the duration of the project is greater than Dr,n, as in this case. We find values of i and Di,n in the following way: first, we assume i = r and compute Di,n using (2). Then we find the difference between the left and right sides of (6). Therefore, we know whether our i lies in the interval [0, r] or [r, ∞]. Finally, we may use any method for finding roots, such as the bisection method, to find the value of i that makes both sides of (6) equal, again using (2) for finding Di,n.
For a steel bridge the proper discount rate i equals 5.65 percent with duration Di,n 6.21. Since the wooden bridge generates stable cash flows every year Di,n=Dr,n for this project, this means that the discount rate for this project is the same as the initially used 5 percent.
Table 4. NPV and Risk-Adjusted NPV Comparison[[{"fid":"93423","view_mode":"image_no_caption","fields":{"alt":"table 4","class":"media-element file-default media-wysiwyg-align-center","data-delta":"12","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 4","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"12":{"alt":"table 4","class":"media-element file-default media-wysiwyg-align-center","data-delta":"12","format":"image_no_caption","alignment":"center","field_file_image_alt_text[und][0][value]":"table 4","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"table 4","class":"media-element file-image-no-caption media-wysiwyg-align-center","data-delta":"12"}}]]
Even though the steel bridge seemed the more attractive investment at the 5 percent discount rate and was higher in the NPV ranking, after adjusting the discount rate for the risk, the new risk-adjusted NPV changed the valuation, and in the effect the safer investment: the wooden bridge project is preferred.
- CONCLUSION Since the net present value is a frequently used indicator of the profitability of projects, when we consider its disadvantages—volatility resulting from even subtle interest rate changes—enhancing this measure for quantification of this risk can provide further information for investors. Since the duration of a project captures the impact of both uncertainty of future income and sensitivity for interest range changes in low rate environments, it can be used as a measure for interest risk changes and as a factor in determining the risk-adjusted NPV value. As presented in this paper, adjusting for risk can produce a different order of profitability of projects, enriching the analysis and preventing more risk-averse investors from taking excessive risk, which inextricably linked with longer investment projects.
It is worth noting that using such models for the purpose of making future predictions may constitute a part of the entrepreneur’s verstehen. In order to forecast future conditions of economic activity, entrepreneurs must use qualitative forecasts that are supported by his judgment. This was also the view emphasized by Rothbard (1997): “Misesian Man knows a lot; but he does not know everything and he must try to estimate the future, given various quantitative and qualitative estimates of change.” Duration is definitely among important parameters which have to be taken under consideration by entrepreneurs.
Previous research on corporate finance was focused on the liquidation phase and depression (Cwik 2008) or the focus was placed on the roundaboutness of projects (Cachanosky, Lewin 2014). A deeper understanding of financial foundations of the business cycle can increase knowledge of the effects of an easy monetary policy along with a better understanding of causal relations between companies’ decisions and any emerging crisis. While there is a common agreement about the wrong valuation of risk by companies throughout the business cycle, there is little evidence about the foundations of this factor underestimation. One of the reasons may be using measures that are not risk-adjusted and which may create an illusion of profitability in a current low rate environment.
Why don't corporations just get bigger and bigger until they take over the whole economy? Unlike states, firms aren't necessarily better off as they get bigger.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Michael Stack.
Original Article: "Why the Economy Isn't Controlled by One Big Corporation".
Syndicalism is a method of attack by organized labor for the attainment of certain political ends. It requires widespread acts of destruction on "capitalist" institutions as a means of ushering in a socialist regime.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "Mises on Syndicalism".
The case for the privatization of roads has much to recommend it if only in terms of how it would affect the power of the police to detain us, search us, and seize our property.
This Audio Mises Wire is generously sponsored by Christopher Condon. Narrated by Millian Quinteros.
Original Article: "How Government Roads Expand Police Power in America".
Download the slides from this lecture at Mises.org/MU20_PPT_09.
Recorded at the Mises Institute in Auburn, Alabama, on 14 July 2020.
Download the slides from this lecture at Mises.org/MU21_PPT_12.
Recorded at the Mises Institute in Auburn, Alabama, on 20 July 2021.
Abstract: Leigh Phillips and Michal Rozworski’s The People’s Republic of Walmart entered the scene in 2019 with the remarkable idea that mammoth firms such as Walmart and Amazon, by being able to direct huge volumes of resources—sometimes with the capacity of entire countries—without an inner market to signal prices, are living evidence of the viability of a collectively planned economy. Moreover, they argue that the nondemocratic command system that often accompanies the structure of firms is due to their operation in a profit-seeking market system. Using the Austrian arguments propounded during the economic calculation debate, this essay shows that not only are firms, like other organizations, unable to substitute the market in coordinating their economic plans, but that their nondemocratic elements arise precisely from their function as “miniature planned economies,” demonstrating that the authors have misunderstood the nature of economic planning in a market economy. It is further argued that the problems that a planned economy would face without market signals would no less obstruct the efficient and successful operation of private firms if they ever tried to eliminate the market creating them.
JEL Classification: P21
Márton Kónya (marton.konya@stud.uni-corvinus.hu) is a BA student of applied economics at the Corvinus University of Budapest.
I would like to thank everyone who aided me in writing this paper, especially Dr. Karl-Friedrich Israel of the University of Leipzig and my good friend Bálint Madlovics.
INTRODUCTION The People’s Republic of Walmart contains many ideas that are truly provocative to someone with Austrian views. In some everyday political circles, the book is cited as exposing how many neoclassical scholars’ objections to the high ideas of socialism are in fact unsubstantiated. It would seem that this book has become one of the fundamental “weapons” of today’s socialists. While reading it, the possible sources of its ideas became ever more apparent and its errors in economic theory showed themselves, which with a more careful study of Mises’s works would not have occurred.
The book’s argument, grossly simplified, is the following: socialist governments of the past failed to produce an efficient planned economy that could rival the market system, but this failure is almost entirely due to technological constraints that have since disappeared. Not only is a modern planned economy not impossible, but capitalism is partially operating it right before our very eyes. Megacorporations, such as Amazon and Walmart, are working at an economic capacity far greater than that of most of the former socialist countries. They are not only afloat, but can supply millions upon millions of consumers and arrange their production processes without having an inner market, which would need a price system based on private property to operate. These companies are the living evidence that the fears and objections of Austrian thinkers such as Ludwig von Mises and F. A. Hayek are wrong and that we have a system that can coordinate human efforts without a market.
This critique revives, in their accurate forms, the thoughts of Austrian school thinkers, mainly Ludwig von Mises, for he refuted the errors in the book long ago. Although this might be true for other arguments in the book as well, those elements which are not strictly connected to economic calculation will be avoided. Some of the book’s other fundamental ideas often appear in socialist works: for example, the exploitation theory of capital, the robber baron myth, the denial of the tragedy of the commons, the linking together of anarchism and the command economy, the idea that overproduction causes depressions, etc. These questions have been dealt with in countless books and essays. Instead, this essay’s purpose is to show that Mises and Hayek’s writings, if read correctly, already refute Phillips and Rozworski’s arguments and that Austrian economics provides more insight into the workings of large corporations than the book’s authors claim to.
This essay will first consider the book’s main terminological confusion, followed by a short restatement of the basic problem of economic planning. The second section applies these findings of the Austrian thinkers to the cases of large corporations. The final chapter briefly discusses the relation between planning as it occurs in a market economy, and in a collectivist economy.
I. PLANNED ECONOMY AND ECONOMIC PLANNING The central error of the book is that it uses two fundamentally different terms synonymously, economic planning and planned economy, and views both as incompatible with the market. But one of them is not only compatible with market economies, but is one of their foundational tools: economic planning. In order to make a clearer distinction between the two phrases, they need to be defined first. Simply put, economic planning is the process by which the various participants in the economy make calculations about the economic steps they must take in the future. In contrast, a planned economy is an entirely centralized system in which the allocation of everything from raw materials to capital goods, to consumer goods is implemented by a central authority, without the market mechanism.
To a naïve reader the only difference may be the scale of the planning operation, but the distinction is much more fundamental. To briefly summarize and illustrate the problemThe illustration here used is heavily influenced by an example given in a YouTube video by the Learn Liberty channel (2015) called “What If There Were No Prices?” that Mises originally pointed out in Economic Calculation in the Socialist Commonwealth ([1920] 1990) and later elaborated in Socialism ([1922] 1981) and Human Action (1949), let us take a planned economy. There are no profit-oriented firms or capitalists, and all means of production (including labor) are under central control. Let us suppose that the board of directors is tasked with building a railroad connecting two cities between which there is a high mountain. Let us suppose further that somehow the board of directors knows that the routes going through and around the mountain would increase social welfare to the same degree, and that their goal is to use the society’s resources in the most economical way (meaning that they must only use up resources that are not needed by an enterprise that promises a higher increase in social welfare). In short, we have simplified the scenario so that the directors only have to wrestle with the problem of finding the lowest cost possible. For the sake of simplicity, let us say that only two means of production are necessary to build a railroad, engineering and steel, and let us establish that the route through the mountain requires a lot of engineering work but less steel, and that the route around it takes more steel and less engineering. The problem, then, is to determine whether the society needs steel or engineering more. How can this be discovered? The other uses of the two factors must be known.
Consider engineering. It is the foundation of modern industry. There are immeasurable known uses for it (and even more that are unknown!). What if, it might be asked, more tractors are made instead of the railroad, as they might be more beneficial? How can this be known? With more tractors, there could be a larger output of goods that require the use of tractors. But these are usually not final goods, but various crops in their raw forms, so it is not known how much these would increase the utility of people. We have to go further down the chain of production: it must be known how much the increased crop yield would benefit the industries that use them (such as livestock farms, canning factories, restaurants, mills, etc.). It needs to be realized that an increase in the quantity of tractors affects a huge number of processing industries that serve the consumer in a wide variety of ways. In the end, what the consumers think about these alternative uses of more tractors, manifested as final products, would need to be known. The citizens would presumably have to be asked for their preference between the railroad route and every existing and potential food and drink item whose production at some point involves a tractor. But in this case, the same process would have to occur with every existing and potential use of engineering as a means of production, not just tractors, since engineering can also has many other applications. (Of course, this assumes that collecting the data of people’s preferences is technically feasible, despite the known fact that there are various obstacles that prevent the acquisition of some basic information. It would be wrong to assume that a person expresses the same pattern of preferences under surveying conditions as he would when acting under real circumstances. He might answer carelessly, just to get the survey over with. It may even be in his interest to falsify a survey.)
The same exercise can be done with steel. Social welfare might be increased in millions of ways using steel, not just by laying down rails. For example, frying pans might be made out of it. But how important are frying pans? In order to know this, we would have to know how much every consumer (and potential consumer) of frying pans would value more pans. If, for example, the people have various kinds of frying pans, they might want the railway between the two cities more than an additional pan. But if they have nothing to cook scrambled eggs in but would happily go from city A to city B on foot, they would probably want the pans more. And we must consider not only consumer goods, but the staggering multitude of production goods made of steel (machinery, for example), not to mention those consumer goods that can be created with production goods made of steel.
Add technology to this problem, which, although in a free market society is a blessing, in this case appears to be a great problem. In Human Action, Mises writes: “It is permissible to say that the present state of technological knowledge makes it possible to produce almost anything out of almost everything” (p. 695). A couple of lines later he gives the example of tap water: in modern society, we gain drinkable water by cleaning local water deposits or by using expensive aqueducts to transport spring water to the cities. But with modern technology it is equally possible to produce drinkable water synthetically. Today, of course, people smile at such a suggestion, but only because they cannot even imagine a world without sensible economic planning. Water-supplying companies (mostly government owned in Europe) can choose these efficient means of “producing” and transporting clean water, because market prices make these solutions the most economical for them. Without such guidance, they would have no idea whether to build huge cleaning facilities or synthetic water “factories,” or which option deprives society of the most precious resources relative to the “value” of output. There would be real chaos of production.
It is easy to see that even in this elementary example, with just two nonhuman factors of production, the examination of all their possible involvement in production would require that we know (1) who the possible consumers are and (2) whether they would prefer that a new railroad route be built or some other use of the factors and their resulting consumer goods. Here the problem is not, as the authors of The People’s Republic of Walmart wish to present it, to have a sufficiently accurate method of linear programming that could process the available data and solve the optimization problems before the data becomes obsolete. Rather, the problem is that in order to make just one economic decision we need to know all the preferences of all the participants in economic life. Just in the case of steel and engineering, we can say that we have to know all the latest thoughts of every consumer about every existing and potential consumer good. Due to the intertwining of production processes, almost all factors of production affect almost every other factor of production (and we have not even mentioned human labor, which is part of every production process and must be economized as well, since it is also a scarce resource). As a result, just to assess the extent of a few costs, we would have to be aware of all the thoughts of all the economic participants.
And here it is not enough, contrary to the authors’ assertion, to find partial solutions.As the authors write: “That’s the trick: to find the best possible, even if partial, approximations. Amazon’s modelers work to bring intractably complex problems down to size, to build plans that neither stretch into infinite time, nor respond to all the possible random events that could happen at every step, but that simply work. This means coming as close as possible to the true answer of a planning question within a realistic time frame and with the use of available computing power. When it is impossible to use an ‘algorithm of algorithms’ to mechanically find the algorithm that best approximates the original problem, creativity then comes into play” (Phillips and Rozworski 2019, 34). As will be seen later, a planning unit in a market economy can resort to such simplifications, but in our example, which is a genuine planned economy, what can be simplified? There is nothing precise to approach. In the case of a railway project, wasting a bit of steel or wasting a bit of engineering skill might not seem drastic, but if the methods and inputs are chosen randomly, or just without precision, in every conceivable line of production, soon society will find itself with shortages of resources that can have catastrophic consequences.
The book is noticeably quiet about the failures of socialist attempts at solving this problem. We can read about Otto Neurath’s brave revolutionary deeds (Phillips and Rozworski 2019, 10), but his central “calculation in kind” idea, which has long been debunked, does not appear. Marx’s and Engels’s critiques of capitalism rage though the pages (ibid., 27), but the “labor theory of value” that they advocated is not discussed. In fact, all these previous failures point to the central distinction between economic planning and a planned economy: money prices.
If a railway company is in the hands of a private entrepreneur, he has every incentive to choose the method of construction with the lowest monetary costs, assuming the same utility to the consumers (the total income of the project in monetary terms), in order to achieve the highest degree of profit. However, this also serves society best. What does it mean that engineering is too expensive? It means that other participants in the market (for example, farmers) are willing to pay engineers more. The reason for this is most probably that the farmers’ consumers (producers of foodstuffs) are willing to pay them more for their goods (crops). These producers of lower-order goods, in turn, are willing to pay more, because their own customers are willing to pay more for their final goods (foodstuffs). In accordance with the marginalist theory of value elaborated by the founders of the Austrian school, such as Carl Menger ([1871] 2007, 114–65), a change in consumer demand (at whichever stage of production it may occur) creates a signal for producers at higher stages that tells them which needs are to be satisfied more and which less urgently. A rise in the price of engineering means that engineering is being used in production processes that are creating goods which the consumers urgently need, and thus only producers satisfying even more urgent needs may acquire it.
The price system, based on the maximization of profit and utility, seemingly coordinates economic participants without any planning. Looking at the big picture, this is certainly true. Yet planning as such not only does not disappear, but is only possible in a free market environment. The Austrian thinkers, such as Hayek (1945), were right in calling the price system a system of information sharing. The price system does nothing more than divide a kind of mental labor between several miniature “planned economies,” mental labor that could not be carried out by a single, publicly owned planned economy. Its tool for this task is money. Money provides the common denominator which the socialist thinkers were unable to invent. It is the tool which enables market participants to use accounting methods to compare the incomes and costs of their activities, and to plan their future steps accordingly (Mises 1949, 230). It is at this level that the important act of economic planning happens. Accounting is how corporations, governmental organizations, nonprofit organizations, the army, the police, the nationalized schools and hospitals, every level of human organization is able to solve its planning problems: via money prices established by the market process based on the private ownership of the means of production. This holds true, of course, only if the preconditions of the formation of a market price are satisfied. In the case of the armed forces, police, and other governmental monopolies, the consumers do not get to decide the price which they would be willing to pay for these services, and as a result prices of production factors employed in these branches (such as policemen’s and soldiers’ wages or the prices of various weaponry) can’t accurately reflect their value relative to other resources, leading to waste. (Later the reason such a monopoly (be it governmental or private) on factors of productions would impede the economic actor’s ability to determine their prices will be explored.) It is fair to say, therefore, that although governmental monopolies can calculate with money prices, their presence in the economy in fact obstructs the economic calculus (on a long-term basis, as opposed to private monopolies, whose errors in calculation are not compensated by taxation).
The authors fell into the same trap as earlier socialists. The difference is that while the authors discuss large firms, earlier thinkers spoke about governmental bodies, since earlier in history those organizations were the largest economic units without an inner market. Mises ([1922] 1981, 136), however, showed that government institutions’ ability to calculate is only due to the market surrounding them:
State and municipal enterprises calculate with those prices of the means of production and of consumption goods which are formed on the market. Therefore it would be precipitate to conclude from the fact that municipal and state enterprises exist, that socialist economic calculation is possible.
The same principle applies to the modern case: considering that large corporations, however great the volume of their activity, plan in terms of market prices, corporate planning on a huge scale is not sufficient evidence for the feasibility of a planned economy without market prices. It would still be “just groping about in the dark,” using Mises’s (1949) words.
II. SCALE AND DEPTH Before it can reach the consumer (especially with today’s refined technology), a consumer good must go through several long stages of production. From the extraction of raw materials from nature through the various steps of manufacturing, time-consuming and complex processes are connected so that in the end some member of society may receive the final good or service. As has been shown above, the central management of the whole process would require complete knowledge—a supernatural if not impossible condition. But the reason for this is not the size of the economy or the greatness of cash flows occurring in it, nor the number of consumers. The constraint of a planned economy is not volume, but the complexity of alternatives.
Let Amazon and Walmart be as large as possible, even the sole monopolists of their industry on the entire globe. Still they could only coordinate their activities with market prices. True, their size would be gigantic, but this is not what makes economic calculation difficult. They are wide but thin slices of the entire system. And it is depth that really matters in calculation. Here it is worth mentioning the irony that the main activity of both Amazon and Walmart is the distribution of final goods. Mises (1981 [1922], 118) himself has pointed out in his works that the prices of (already available) consumption goods may be asserted even by a planned economy. Simply, the central planner should give money to the citizens and then hand out the final goods to the highest bidders. This is the farthest a socialist community (with available final goods) may go as far as gathering information is concerned, and only because the prices are expressed in terms of privately owned money and this process is still permitted by our definition of a collectivist society (producer goods still remain common property, but money is private property).Mises’s example goes as follows: “True, a socialistic society could see that 1000 litres of wine were better than 800 litres. It could decide whether or not 1000 litres of wine were to be preferred to 500 litres of oil. Such a decision would involve no calculation. The will of some man would decide. But the real business of economic administration, the adaptation of means to ends only begins when such a decision is taken. And only economic calculation makes this adaptation possible. Without such assistance, in the bewildering chaos of alternative materials and processes the human mind would be at a complete loss. Whenever we had to decide between different processes or different centres of production, we would be entirely at sea.” It is clear from what has been said above that the real problem only starts with the possible uses of the available production goods, and with finding production methods that are yet unknown. The latter point is illustrated by Ericson (1991, 21) when he writes about the Soviet Union’s tendency to only replicate the methods of production already used by capitalist firms and its inability pioneer such methods.As he wrote: “The [Soviet] system has been particularly effective when the central priorities involve catching up, for…the problems of what to do, when and how to do it, and whether it was properly done, are solved by reference to a working model, by exploiting what Gerschenkorn…called the ‘advantage of backwardness.’”
Knowing this, the book’s lengthy discussion about how complex and high-level technology is used by these corporations to find out the demand for different goods, seems only to be the knocking on an already open door. Moreover, the authors’ description precisely backfires: trading with final goods is just the ending move of the process of production, and this already requires a huge and costly computing system based on complex mathematics from these mammoth firms. Yet all this is only one function. We must not be deceived by the multitude of products these firms are selling, because Walmart and Amazon fundamentally produce only one good: they link the producers with the final consumers. Huge scale, little depth. And in order to carry out this function they must align their activity with market prices, much like every other corporation. Every step toward the complete ownership of the market would make their tasks exponentially more complex, since, as the example above showed, at every stage the number of different real and potential alternative uses of the factors multiplies until the point at which they would need complete knowledge. The need for calculation arises from the variety of alternative uses of the means of production. As long as this is solved by the market, Walmart can calculate how much income it has received from the suppliers who want to sell their goods at its stores (how high a need the members of society have expressed for the service rendered by Walmart), how much it had to spend on wages, capital goods, public utilities (how important the resources used up by its activity are to society), and how much profit these two leave (the difference between the valuation of its services and the resources used up). If all these were the property of Walmart, its efforts toward an efficient economic plan would also be in vain, since it would be unable to decide the most economical way of employing its production goods.
This problem is greatly elaborated in many relevant sections of Rothbard’s Man, Economy, and State ([1962] 1970, 547–48), especially those highlighted by Klein (1996) concerning the constraints economic calculation imposes upon the possible size of business units. Here Rothbard shows that firms require markets in order to efficiently calculate and plan their methods of production and operation. If a firm integrates stages of productions, it is required to conduct transfers within its divisional units without the market. If the managers want to know how profitable the operations of and transfers between the various units were, they have to use some kind of reference price in the accounts of the units. When a market of the transferred factor exists outside the firm, they can use its price as a “substitute price,” which helps them determine costs and thereby the most efficient methods of production. But if such a market does not exist, if, for example, the firm in question is the sole owner of the factors of production, then the managers have a very small chance of accurately determining the opportunity cost of the factors. This would result in gross misallocation of factors of productions, meaning not only losses on the firm’s accounts but also a wasteful, inefficient management of society’s resources. Rothbard argues that this problem forms an upper boundary on the size of the firm. The greater its share in the ownership of a factor of production, the less accurately it will be able to determine the factor’s opportunity cost, and the greater its losses will be on existing markets.In Rothbard’s words: “The force of this law multiplies as the area of the economy increases and as islands of noncalculable chaos swell to the proportions of masses and continents. As the area of incalculability increases, the degrees of irrationality, misallocation, loss, impoverishment, etc., become greater. Under one owner or one cartel for the whole productive system, there would be no possible areas of calculation at all, and therefore complete economic chaos would prevail.”
There is no doubt that this is true in the case of Amazon and Walmart. It may well be, as the authors have noted, that Walmart is able to utilize the huge volume of its capital equipment without an inner market. As they write, “[t]he different departments, stores, trucks and suppliers [of Walmart] do not compete against each other in a market; everything is coordinated” (Phillips and Rozworski 2019, 12). But if Walmart were the only owner of trucks in the world (or if it were somehow isolated in a such way as to be oblivious of the costs of transportation determined on the market), the only way of vaguely deciding the costs of trucking in order to plan the feasible amount of capital used for this purpose would be to approximate based on some other mode of transportation that does have a market price—and this would still lead to great inaccuracies. The fewer the reference points for this approximation are, the more inaccurate the calculation will be and the greater the amount of wasted resources will be.
III. ISLANDS OF TYRANNY As it is evident from the first sentences of their introduction, the authors more or less had to explain themselves in front of their fellow socialists. After all, writing a revering book about two corporate giants is quite a foreign thought in the circles to which the book is mainly addressed. To avoid confusion, after every admiration of planning comes an establishment of the fact that both Amazon and Walmart use planning for profit-induced reasons characteristic of capitalist corporations. We can read at length about how the firms, after buying the time and energy of the working class (Phillips and Rozworski 2019, 26–27), use them as they please, and that the workers are forced into this dictatorial system because they would starve to death without a salary. The working conditions, the authoritarian methods of force, the strict inner bureaucracy, the tools for the surveillance of workers are well detailed (Phillips and Rozworski 2019, 38). All this, of course, is attributed to the fact that despite being the living evidence of the possibility of planning, in a capitalistic environment all this efficiency benefits the capitalist class and oppresses the working class, which is forced into an autocratic system. They use the words of Noam Chomsky, who claims that firms, contrary to the “black box” concept of standard microeconomics and the cooperation models of business economics, are indeed “Islands of Tyranny.”
These are perhaps the most ironic parts of the book. The book’s main idea is that large corporations prove the viability of a planned economy, but its authors are forced to accuse these very examples of “planned economy” of using autocratic methods. And this, most ironically, they blame on the market economy surrounding these corporations. For those familiar with the ideas of Austrian economics it might be obvious that the case is just the other way around. It is easy to derive from what has been said above that the whole point of a market economy is to minimize the amount of planning necessary for an efficient economy. This is the “mental division of labor” of the market. It coordinates personal and organizational plans the central and complete coordination of which would take supernatural powers. However, the top-down organized hierarchal structure is an indispensable element of every planned economic process.
It seems expedient to mention here one of the most crucial chapters in The Road to Serfdom, “Planning and Democracy” (Hayek [1944] 2001, 59–74). In this chapter, Hayek clearly explains that in every planning process only one plan may exist and that it has to be one concrete aim. In such a process we are looking for a democratic element in vain. Every participant who opposes the plan constructed by the experts is sabotaging its realization. And if we want to plan the entire economy, there is no room for coexisting inner plans, either. There cannot be a separate steel industry plan, which contradicts the agricultural plan or the infrastructural plan. This leads to the centralizing nature of planning: in the end, only one plan can prevail. Under such conditions, it is impossible to create a consensus between people’s different motives, aims, and moral judgments. At most we can create an outcome which would not satisfy anyone. As Hayek explains:
That planning creates a situation in which it is necessary for us to agree on a much larger number of topics than we have been used to, and that in a planned system we cannot confine collective action to the tasks on which we can agree, but are forced to produce agreement on everything in order that any action can be taken at all, is one of the features which contribute more than most to determining the character of a planned system. (Hayek [1944] 2001, 65)
Speaking of “islands of tyranny,” the authors only listed those attributes of planning that are required for the realization of a certain goal. We know from business economics that the nonmarket inner world of a firm necessitates a high degree of harmony among its workers. If the experts at the top of the company have set a goal of opening a new plant, lessening administrative costs, installing a new technical system, changing some aspect of production, or anything else, every employee has to adjust his activity according to the company’s plan. Otherwise, they would sabotage the plan. In such a case, the leadership may choose to penalize lack of cooperation through the withdrawal of certain grants or privileges, by firing the employees or even starting lawsuits against them. But none of this originates from the profit motive of capitalism: it is inherent in planning as such. Profit only tells the managers how they can serve best the consumers as far as profit in a competitive industry represents the difference between the high valuation of the produced good and the low valuation of the factors of production used up. This profit system is not, however, what requires the centralized command structure, but firms have to employ undemocratic means precisely because they are the only effective way of carrying out a plan.
It would be mistaken to think that a completely planned economy would have not less but more democratic elements. The intertwining of production processes demands the cooperation of every part with every other:
A complex whole where all the parts must be most carefully adjusted to each other, cannot be achieved through a compromise between conflicting views. To draw up an economic plan in this fashion is even less possible than, for example, successfully to plan a military campaign by democratic procedure. As in strategy it would become inevitable to delegate the task to the experts….But the ends of an economic plan, or of any part of it, cannot be defined apart from the particular plan. It is the essence of the economic problem that the making of an economic plan involves the choice between conflicting or competing ends—different needs of different people. But which ends do so conflict, which will have to be sacrificed if we want to achieve certain others, in short, which are the alternatives between which we must choose, can only be known to those who know all the facts; and only they, the experts, are in a position to decide which of the different ends are to be given preference. It is inevitable that they should impose their scale of preferences on the community for which they plan. (Hayek 2001 [1944], 68)
It must not be denied that in the final sentences of the book, the authors themselves gave voice to the concern that the idea of a planned economy arouses in people:
It is not enough to say, ”Nationalize it!” We have to think hard about how to ensure that the already enormous amounts of information controlled by large, unaccountable corporate bureaucracies do not become the basis for new unaccountable bureaucracies (state-run or otherwise). As the two twins of undemocratic planning, Soviet Union and Walmart, show, planning on its own is no synonym for socialism. (Phillips and Rozworski 2019, 103)
However, all these concerns are naively set aside as the matter for some other book. After this paragraph, a remarkably humorous quotation (at least for an Austrian scholar) follows by Friedrich Engels, who expresses his deep contempt against all those who call every planned system “socialistic.” He says that if this were so, then “Metternich and Napoleon would be counted as the founding fathers of socialism,” and “the Royal Maritime Society and the nationalized Royal Porcelain Manufactures could all be called chief socialist institutions.” To the advocates of a free market economy, the elaboration of the irony surrounding these sentences is not necessary.
CONCLUSION The economic calculation debate was perhaps the most important debate of the entire history of economic science. It has moved such brilliant minds that it is safe to say that the problem has been processed to such an extent that practically everything has already been said about it. Neurath, Böhm-Bawerk, Lange, Hayek, Lerner, Mises, and Dickinson have examined this area in such detail that the following generations only have to pull one of their works from the shelves in order to come across an answer for almost any question about it. In order to counter every collectivist supposition, it is enough to find out where in the twentieth-century debate we have to “look closer.”
To The People’s Republic of Walmart we can assign several such dates, but certainly to its early sections, since in them even the necessity of money prices is missing, which neosocialists (such as Oskar Lange and Abba P. Lerner) have already discovered. The ideas in Hayek’s The Road to Serfdom about economic planning, well-trodden ground, are also absent. But implicitly we can find the tendency characteristic to the economic calculation debate, namely that in every one of its stages the debate has approached step by step the triumph of the market economy. It is a history of constant concessions: first the collectivist idea of the common ownership of consumer goods had to be discarded, then the untenable ideas of the labor theory of value and the elimination of the market, and finally the entire idea of the public ownership of the means of production. It is a slow awakening from a deep slumber, in which during every doze we have to shake the dreamers awake. In the words of Ludwig von Mises:
The socialists cannot help admitting their crushing final defeat. They no longer claim that socialism is matchlessly superior to capitalism because it brushes away markets, market prices, and competition. On the contrary. They are now eager to justify socialism by pointing out that it is possible to preserve these institutions even under socialism. They are drafting outlines for a socialism in which there are prices and competition. (Mises 1949, 702)
Abstract: This paper extends subjective expectations theory to form a new approach called the discovering markets hypothesis (DMH). Market participants form expectations on the basis of subjective knowledge and communicate with each other through narratives to improve their understanding of factual information before acting in markets. Thus, market prices are shaped by the subjective interpretation of emerging facts and shared narratives. To understand how new narratives replace existing ones, we refer to the theory of scientific revolutions. Winning narratives shape market prices until their victory is confirmed by the facts or they are discredited by facts and replaced by new narratives.
JEL Classification: B53, D84, E71 Marius Kleinheyer (marius.kleinheyer@fvsag.com) is a research analyst at the Flossbach von Storch Research Institute in Köln, Germany and PhD candidate at the University Rey Juan Carlos, Madrid. Thomas Mayer (thomas.mayer@fvsag.com) is the founding director of the Flossbach von Storch Research Institute and honorary professor at the Universität Witten-Herdecke.
INTRODUCTION Prices fluctuate, and especially in financial markets, where they are heavily influenced by expectations of the future. Some economists have explained price fluctuations with the myopia of market participants. For instance, bid and ask prices are based on prices observed in the past, and when supply and demand do not match, prices are adjusted. Other economists have replaced myopia with perfect foresight in their models. According to them, all market participants always have all the necessary information to agree on a price equating supply to demand so that prices change only when they receive new information. However, actual price behavior is neither consistent with complete myopia nor perfect foresight among market participants. Sometimes, prices move as if market participants were myopic, sometimes as if they were forward looking. This has prompted another theory, according to which price fluctuations reflect market participants’ collective oscillation between rational and irrational behavior.
This paper argues that there is a better way to explain price fluctuations in financial markets. Market participants form their price expectations on the basis of information that they collect and interpret with their individual skills and knowledge of economic relations. They act in the market or communicate with others through narratives to improve their understanding of their factual information before acting. Thus, market prices are shaped by the subjective interpretation of emerging facts and shared narratives. The resulting price movements in return influence narratives and the subjective interpretation of facts.
First, the theories of adaptive and rational expectations and the concept of adaptive markets will be discussed. These theories will then be connected to the theory of subjective expectations and an extension to the latter suggested, the discovering markets hypothesis (DMH). Empirical evidence is presented to support this approach, and finally, its utility in making predictions.
OBJECTIVE THEORIES OF EXPECTATIONS Economist John Hicks took issue with the idea put forward by Léon Walras that transactions take place at prices where demand is equal to supply. Since traders generally could not know what would be supplied and demanded at certain prices, they could only guess. Hence, Hicks (1939) argued, transactions would generally occur at prices which did not equate supply and demand. Following Hicks, we could describe the market as a mechanism that matches expectations and prices, but not necessarily potential supply and demand.
John Maynard Keynes raised the question of how expectations about the future are formed. Where they could, people would rationally calculate subjective probabilities for different outcomes and choose the most likely. But they would also often fall back on whim, sentiment, or chance. The latter was especially the case in capital markets, where participants were driven by “animal spirits.” There, it was often necessary to forecast “what average opinion expects average opinion to be” (Keynes 1936). Keynes left the formalization of his macroeconomic expectations theory to his disciples, which often led to a mechanistic reduction of his arguments. An example of this is the theory of adaptive expectations.
In the adaptive expectations model an expected market price depends on the expected price of the previous period and an “error correction” term that is given as a fraction of the difference between the expected and the actual price in the previous period. This model is not only intuitively appealing but benefits also from the advantage that expected prices can be expressed as a weighted average of past prices. Given its user friendliness the adaptive expectations theory has been built into many macroeconomic models and has been used by many econometricians. However, even its most enthusiastic users have had to admit that it describes the formation of expectations in a very mechanical way that falls far short of Keynes’s more sophisticated view (see also Gertchev 2007).
In the early 1960s, the US economist John Muth contradicted the theory of adaptive expectations. He argued that the expectations of economic agents were nothing more than predictions, which could be made with the appropriate economic theory (Muth 1961). In the formation of rational expectations only the future counted, which would be fathomed with the help of economics. If people used all available information efficiently and knew how the economy really worked, then realized prices would differ from expected prices only as a result of random influences. And if the expected value of random influences were zero, market prices would over the longer run equilibrate supply and demand.
Muth’s theory, originally intended to explain price formation in specific markets, was incorporated into an economy-wide, dynamic general equilibrium model by Robert Lucas. According to Lucas, economic agents form their expectations of the future with full knowledge of all economic relations and using all available information. Based on these expectations they maximize their utility over their lifetime. With his work Lucas not only solved Hicks’s problem of imperfect information but also challenged established Keynesian macroeconomics. He argued that robust economic predictions could be made only with models founded in microeconomic theory because macroeconomic relations observed in the past were unstable over time.Lucas‘s challenge to Keynesian macroeconomics went down in the history of economics as the "Lucas Critique." Economic agents would change their behavior in response to economic policy. For instance, the famous relationship between unemployment and inflation proposed by the Phillips Curve would go up in smoke once people realized that the gains in purchasing power afforded by higher nominal wages were subsequently eroded by higher inflation.
Eugene Fama applied the concept of rational expectations to financial markets and hypothesized that financial prices contained all available information. At a minimum, it should not be possible to use past prices to predict future prices, and at best there would be no difference between market prices and fair prices of financial assets (Fama 1970). Thus, if markets are “weakly efficient,” future prices cannot be predicted on the basis of past prices. Already this rather restrained statement contradicts the theory of adaptive expectations, which assumes that past prices contain valuable information for future prices. Markets are “semi-strongly efficient” when prices reflect all publicly available information. In this case, forecasting on the basis of past price movements as well as by considering new publicly available information is impossible. Finally, Fama classifies markets as “strongly efficient” when prices not only reflect all relevant public information but also proprietary insider knowledge. In this case, market prices and fair values of assets would be identical.
Rational expectations theory and the efficient markets hypothesis (EMH) were not only very successful academically—Robert Lucas and Eugene Fama were both awarded Nobel Memorial Prizes for their work—but also highly influential in business and politics. EMH provided the theoretical foundation for “passive investing” through index funds. If no single fund manager could reliably beat the market, why pay fees for active portfolio management? Greater returns could surely be obtained by investing in the entire market at lower costs. And EMH also had a strong influence on government policies. If the market always knew best, why let government bureaucrats regulate it? “Light” regulation was in this case surely better than heavy-handed intervention.
However, Ricardo Campos Dias de Sousa and David Howden (2015), among others, have shown that EMH suffers from logical contradictions. If, as it stipulates, all market participants have all relevant information and interpret it in the same way, all would agree on a price and there would be no incentive to sell or buy. On the other hand, if only a sufficiently critical mass of market participants interpreted relevant information in the same way, transactions could take place, but the price allowing this transaction would be seen as efficient by one and inefficient by the other group. Thus, “efficient prices for one group requires inefficient prices in the eyes of the other” (Campos Dias de Sousa and Howden 2015, 396).
Rational expectations theory and EMH suffered their first practical setback in the early 2000s, when the “technology stock bubble” burst. Apparently market participants were not just cool-headed homines oeconomici but could get carried away by emotions. The experience gave a big boost to behavioral economics and finance. Until that point, behavioral economics had largely been an experimental science confined to the laboratories of a few universities—its key protagonists, Daniel Kahnemann and Amos Tversky, were Israeli psychologists. US economist Robert Shiller (2000) applied behavioral economics to finance, publishing a book in which he diagnosed the wild rally of technology stocks towards the end of the 1990s as a bubble just as it was peaking. Not least because of the excellent timing of the release of his book, a serious challenge to the EMH had emerged in science and financial business.
Rational expectations and EMH suffered another setback with the Great Financial Crisis of 2007–08. The systematic mispricing of risk, which became apparent when the credit bubble burst, was inconsistent with the idea that people would base their financial decisions on all available information and with a full knowledge of the true “economic model.” Obviously people in the credit markets had based their actions on inadequate information and a false economic model that indicated risk reduction through asset pooling when risks in fact accumulated as a growing number of people acted on this model.
Despite its obvious failure, EMH has remained the predominant theory of market behavior in academics and large parts of the business world simply because there has been no other theory in mainstream economics to displace it.The confusion in academics about how markets work became evident with the awarding of the 2013 Nobel Memorial Prize to both Eugene Fama and Robert Shiller. In 2017, however, the US financial economist Andrew Lo came up with another challenger to EMH. Conscious of the difficulty of dethroning a theory taught widely at universities and perhaps with the ambition to follow in the footsteps of Nobel Prize winners Fama and Shiller, he named his theory the adaptive market hypothesis (AMH) (Lo 2017).
Lo’s intention was not to scrap EMH entirely, but to restrict its validity to times of continuous market development. During those times people act rationally, based on a wide knowledge of facts and a good understanding of the valid economic model. But when markets are disrupted for whatever reason, people turn from rational analysis to instinctive behavior. They join others in either rushing into markets for fear of missing out or fleeing them for fear of losing their fortunes. Lo (2017, 188) summarizes his theory in five key principles:
We are neither always rational nor irrational, but we are biological entities whose features and behaviors are shaped by the forces of evolution.We display behavioral biases and make apparently suboptimal decisions, but we can learn from past experience and revise our heuristics in response to negative feedback.We have the capacity for abstract thinking, specifically forward-looking what-if analysis; predictions about the future based on past experience; and preparations for changes in our environment. This is evolution at the speed of thought, which is different from but related to biological evolution.Financial market dynamics are driven by our interactions as we behave, learn, and adapt to each other, and to social, cultural, political, economic, and natural environments in which we live.Survival is the ultimate force driving competition, innovation, and adaptation. Thus, during normal market conditions reward increases with risk. But at times of negative disruption people may shun risks irrespectively of the associated reward. The Capital Asset Pricing Model may work in normal times but fail in other market environments. Similarly, portfolio optimization according to Markowitz may work in good times but fail in bad times. When there is contagion among different markets, asset diversification may no longer reduce risk (Lo 2017, 282).
Lo’s AMH is an intriguing effort to overcome the contradiction between EMH and behavioral finance and connect them by making them state dependent. However, why should “rationally” acting professional investors suddenly turn “irrational” in market downturns, and why should “irrationally” acting retail investors suddenly turn “rational” in normal markets? And why do environments change from “normal” and continuous to “abnormal” and discontinuous? Perhaps we can get a better idea of how markets behave when we study more closely the way that market participants process information.Lo’s auxiliary assumption of shifting market environments to retain the EMH could be interpreted, in Lakatos’s (1976) words, as a “degenerative problem shift” in a descending research program (see below).
A SUBJECTIVE THEORY OF PRICE AND EXPECTATIONS FORMATION Like Hicks, Austrian economists in the tradition of Carl Menger and Eugen von Böhm-Bawerk acknowledged that people act with imperfect knowledge. However, these economists claimed that although prices realized in transactions may not equilibrate potentially available supply and demand they always cleared the market (in the sense that actual supply matches actual demand). The early Austrian economists introduced real-world outcomes as “points of rest” (Menger) or “momentary equilibria” (Böhm-Bawerk), where market exchanges are carried out without the adjustment of buyers´ and sellers´ preferences (Klein 2008, 172). Mises coined the term plain state of rest (PSR) as opposed to the imaginary construct of the final state of rest (FSR) (where all supply equals all demand). He explains: “When the stock market closes, the brokers have carried out all orders which could be executed at the market price. Only those potential sellers and buyers who consider the market prices too low or too high respectively have not sold or bought” (Mises 1949, 245). As an analytical tool, the FSR serves as a hypothetical scenario in which basic data of the market are frozen and market participants have perfect information and knowledge. In the FSR all feasible gains from trade are exhausted (Klein 2008, 173). But in reality the FSR never materializes, because market participants have imperfect knowledge that they continuously seek to improve. Thus, during the market process entrepreneurs shuffle and reshuffle resources and capital combinations in response to new knowledge to take advantage of profit opportunities and avoid losses (Salerno 2006). Hence, realized prices generally can be characterized as representing an “equilibrium with error” (Manish 2014). Since the errors of actors with superior knowledge are smaller than those of others, their profits from transactions are larger. As more profitable actors attract more capital at others’ expense, their influence on the exchange process increases. Thus, competition improves the functioning of markets and the economy at large.
Without perfect information and knowledge about the workings of the economy, prices are based on expectations, which are derived from the subjective interpretation of information (Manish 2017). Mises points out: “As action necessarily is directed toward influencing a future state of affairs, even if sometimes only the immediate future of the next instant, it is affected by every incorrectly anticipated change in the data occurring in the period of time between its beginning and the end of the period for which it aimed to provide” (Mises [1949] 1998, 253) From this it follows, according to Mises (1962), that “Every action is a speculation, i.e. guided by a definite opinion concerning the uncertain conditions of the future.” That is—in short—expectations. Thus, expectations “form a crucial component of every act” (Manish 2007, 209). The knowledge used to form expectations is somewhat different in each individual mind, because it reflects the individual’s experience and the specific and unique ability to collect and interpret information. The knowledge is often implicit. Actors may not be able to articulate it, and it certainly cannot be objectively measured. Mises coined the term thymology to describe a method that allows historians to “understand” a complex historical event (Mises [1985] 2007). In the same way that historians look into the past, market participants look into the future. This means that just as thymological experience serves as the basis for the historian´s interpretative understanding of past events (so far as they depend on social and not natural causes), it also conditions the actor's “specific understanding of future events” (Salerno 1995, 309).
After the Austrian revival in the 1970s, debates about expectations and the market process’s possible convergence towards equilibrium took on a central role. For Lachmann (1976), expectations are radically subjective and as such radically unpredictable. In consequence, he states: “Expectations must be regarded as autonomous, as autonomous as human preferences are” (Lachmann 1976, 130). This radicality has been criticized as nihilistic (Hülsmann 1997, 25). Of course, experience-based knowledge is fundamentally different from experimentally established facts of the natural sciences, but it is still real knowledge (Salerno 1995, 312). As Mises puts it: “To know the future reactions of other people is the first task of acting man.” (Mises [1985] 2007, 311). Kirzner (1973) argued that the alertness of entrepreneurs for profit opportunities leads to a general systematic tendency toward equilibration.
Thus, the market is in a state of continuous disequilibrium but moving toward an equilibrium. Although Mises sees a theoretical final state of equilibrium resulting from the exploitation of profit opportunities from disequilibria by capable entrepreneurs (see above), in reality continuously emerging new facts are changing this equilibrium so that it can never be attained.
THE DISCOVERING MARKETS HYPOTHESIS In order to shed more light on the formation of expectations, subjective expectations theory will be extended by including two further observations: (i) The subjective reception of complex contents is communicated in narratives, and (ii) shared narratives shape prices and are shaped by them.
The Role of Narratives
Before they act, individuals communicate with each other to cross-check their subjective knowledge against the knowledge of others. Complex knowledge is difficult to communicate. When expressed in the form of narratives it is easier to “get across ideas” (Shiller 2017). Robert Shiller has launched a research program (dubbed ”narrative economics”) to study the influence of popular narratives on seminal events such as the depression of 1920–21 or the Great Depression of the 1930s (Shiller 2019). Among other things he has found that narratives can spread like epidemics and influence people’s behavior, which can feed back into the narratives. While Shiller traces the effects of “big” narratives on historical economic developments, the focus of this text is on the effect of “narrow” narratives on financial market prices. As market participants share narratives and act on them in the market, prices move. In turn, the movement of prices feeds back into the narratives. The legendary stock market trader Jesse Livermore (alias Larry Livingston) explains in the classic book Reminiscences of a Stock Operator: “Observation, experience, memory and mathematics—these are what the successful trader must depend on…He must bet always on probabilities—that is, try to anticipate them,” (Lefevre 1922, 416).
Battles of Narratives
Shiller explains the emergence and disappearance of narratives in terms of contagion and recuperation. This can be well applied to “big” narratives evolving and fading with time. The “small” narratives in financial markets, however, do not die of old age but are replaced by other “small” narratives. To understand how new narratives replace existing ones in financial markets, we recur to the theory of scientific revolutions developed by Thomas Kuhn (1970). He argues that scientific knowledge normally increases around a widely accepted paradigm. In normal times, the paradigm itself is not challenged but is fleshed out more by new insights. However, when a critical mass of new facts emerges that is inconsistent with the ruling paradigm a scientific revolution may occur. Previously widely shared and accepted beliefs are questioned and overturned. Uncertainty and confusion may reign until a new paradigm is found that better explains the new facts. After a turbulent period (“extraordinary science”), scientific work returns to its normal state of work (“ordinary science”).
Imre Lakatos (1976) speaks of research programs that have a paradigm at their core. According to him, however, the paradigm shift is not abrupt, but a tough struggle between the defenders of the old paradigm in the old research programs and the challengers who question it. When new facts put pressure on a paradigm, defenders find supporting auxiliary hypotheses to save it, but the original core of the paradigm is weakening. Lakatos calls this “degenerative problem shift.” The challengers, on the other hand, find new explanations for the facts and develop a theory with a higher explanatory value. This leads to a “progressive problem shift.” In contrast to Kuhn, who combines paradigm shifts with radical breaks, Lakatos sees continuous gains in knowledge through the problem shifts in research programs.
The insights of Kuhn and Lakatos into the creation of new scientific knowledge are valuable guides for understanding the effects of the emergence of new knowledge in the market. Participants acting on a new shared narrative influence market prices. For some time, there may be a battle of the ruling and the new narratives. The new narrative may change or bear new narratives during this battle. And eventually the argument will be settled, and a new narrative will rule until the process begins anew. It is possible that the battle of narratives is intense and the victory of the new one absolute, as Kuhn has described the revolutionary paradigm change in science, or that it is drawn out and the new narrative displaces the old one gradually, as Lakatos has argued.
Continuity and Discontinuity in Price Discovery
When knowledge improves incrementally narratives change only little and the process of price discovery proceeds gradually. Financial markets are then characterized by relatively small spreads between offer and demand prices (or “bid-ask spreads”) for securities and by moderate price volatility. This notwithstanding, market clearing prices are being found through a process of trial and error and may move around until all participants agree on the price that best reflects their shared narrative. A market “equilibrium with error” (or “plain state of rest” according to Mises [1949] 1998)At the “plain state of rest” markets are cleared, but not necessarily in an equilibrium free of all market participant error. This is the “final state of rest,” towards which the market is pushed by competition but which may never be reached in reality. has then been established, only we don’t see much of these movements.
One way to illustrate the search process for a market clearing price is the old-fashioned cobweb model shown in Figure 1. The suppliers want to supply quantity Q0 at price P0. However, the price they get when they offer Q0 is much lower than P0. Consequently, many cut their offer so that supply now falls below demand. Excess demand brings suppliers back into the market, but at the new price there is excess supply. They cut back again, only to face excess demand again. The process of trial and error continues until the market clearing price is found.
Figure 1. Finding the Market Clearing Price in a Cobweb[[{"fid":"90046","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"3":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Market Clearing Price","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"3"}}]]
In this graph, the market clearing price is found, because the supply curve is more elastic than the demand curve. In consequence, suppliers adjust their prices by large amounts in response to excess supply or demand. But what if suppliers react less and demanders more elastically to excess supply and demand than before? In this case, excess demand and supply grow with each step and a market clearing price cannot be found (Figure 2). This is, incidentally, also true when both sides react with the same elasticity.
Figure 2. Searching for the Market Clearing Price in Vain in a Cobweb[[{"fid":"90048","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"4":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Market Clearing Price","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Market Clearing Price","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"4"}}]]
Let’s now assume that the combination of a fairly inelastic demand with an elastic supply curve characterizes a market where the demanders represent the “wisdom of the crowd” in the eyes of suppliers. This is how people intending to sell securities probably would look at the market. They would adjust their intentions relatively strongly in response to the feedback they get from the market. This is how markets normally behave, when most people share similar knowledge about market circumstances. New knowledge emerges gradually, and prices converge to clear the market.
However, when new and disturbing knowledge drops like a bombshell into the market there will probably be determined (or even forced) sellers in the market and many demanders will be very unsure about what to make of this. In this case, the demanders overreact to sales by the suppliers, and the suppliers in turn underreact to the demand changes by the demanders. No new equilibrium can be found. Bid-ask spreads widen and price volatility increases, because suppliers and demanders are out of synch with each other. Only when the new knowledge has been absorbed and evaluated by everyone can the market return to its “normal” mode of operation.
Battles of Narratives and Fractal Geometry
Can we identify patterns in the emergence of gradual and revolutionary new narratives in the markets? Fractal geometry, developed by the mathematician Benoit Mandelbrot, may help (Mandelbrot and Hudson 2004). According to Mandelbrot smoothness and roughness alternate in nature and financial markets. There are long periods when little happens and short periods of high turbulence. To borrow from Kuhn, markets are calm when an accepted narrative is not seriously challenged, and they experience heavy turbulence when an accepted narrative is overturned by a radically new one. Or, to borrow from Lakatos, markets shift as new narratives gradually displace old ones. We call the evolution of prices in response to the spread of narratives the discovering markets hypothesis (DMH).
AMH and DMH Compared
Although Lo’s adaptive markets hypothesis and the DMH start with the same insight that markets may alternate between continuity and discontinuity, there are important differences. First, AMH takes the change in states as given while DMH explains it as the way in which knowledge emerges and spreads in the form of narratives. Second, AMH assumes schizophrenic minds in market participants and employs psychology to explain alternating behavior while DMH assumes psychologically stable market participants who act continuously and consistently—in a subjectively rational way. By focusing on the process of augmenting subjective knowledge in a battle of narratives, DMH provides a more consistent framework for analyzing and predicting market behavior.
EMPIRICAL SUPPORT FOR THE DMH Can we relate market price movements to the emergence of new facts and the spread of new narratives? In this section, DMH is applied to explain a few highly visible market movements, although this does not constitute a test of the theory in the spirit of Karl Popper, in which researchers aim to establish a numerically quantified causal relationship between exogenous and endogenous variables. In view of the complexity of the object of research, F. A. von Hayek’s (1974) “pattern recognition” method is employed. Hayek has argued that numerical predictions based on causal relationships between endogenous and exogenous variables are less reliable the more complex the system to which these variables belong is. The complexity of social systems in particular is such that the establishment of causal relationships between variables and their quantification are next to impossible. But this does not mean that falsifiable hypotheses cannot be created and that predictions are unable to be made (Hayek 1974).
Applying Hayek’s theory to the analysis of markets, it is possible to establish whether or not the DMH can explain the pattern of market price movements. What cannot be expected is to find a theory with which market outcomes can be predicted. Below a number of cases in which existing narratives were suddenly overturned by new ones (cases 1–2) is examined. This is followed by a study of two cases in which new narratives emerged after a battle of narratives (cases 3–4). A look at two cases in which the narrative shifted more gradually (cases 5–6) concludes the analysis.
Case 1: Diesel Shock
On September 22, 2015, the German car company Volkswagen AG (VW) published a profit warning acknowledging that Diesel engines had been manipulated so as to disguise the true level of NO2 exhaust. As Chart 1 shows, this attracted a lot of public attention and news coverage of Volkswagen surged (measured by the number of queries including the term “Volkswagen,” Chart 1).
Chart 1. News Concerning “Volkswagen,” 2014–19[[{"fid":"90043","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"5":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"5"}}]]
Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. The share price plunged on the news and then moved along with other share prices represented by the DAX30 stock market index (Chart 2). The observed share price movement is consistent with one-off repricing in response to unexpected news as postulated by the efficient markets hypothesis. It is also consistent with a radical shift of the narrative about the profitability of Volkswagen. From the analysis of the share price development, it is not evident which theory gives a better explanation of the observed pattern.
Chart 2. VW Shares Compared to the DAX30 Equity Price Index, 2015–19 (100 = 01.06.2015)[[{"fid":"90050","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"7":{"format":"image_no_caption","alignment":"","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","style":"float: left;","class":"media-element file-image-no-caption","data-delta":"7"}}]]
Source: Bloomberg, Flossbach von Storch Research Institute. However, things become clearer by looking at a corporate bond of the company. Until the release of the news the bond fluctuated around the bond price index iBOXX (Chart 3). In response to the release the price plunged in a way similar to the movement of the share price (though somewhat less) and volatility increased. Both markets seemed to follow the same narrative. Thereafter, however, the price of the bond recovered and returned to the level of the bond price index while volatility declined again. The narrative of a company in deep trouble was superseded by the narrative that the company would survive and creditors were fairly safe. If the market was “efficient,” the bond price should have reacted much more calmly than the stock price. But market participants needed to digest the news and differentiate the new narrative in the stock market from that in the bond market before prices in both markets settled.
Chart 3. Price of VW 4.625 Percent Perpetual Bond and iBOXX, 2015–19[[{"fid":"90051","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"8":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"8"}}]]
Source: Bloomberg, Flossbach von Storch Research Institute. Likewise, the cost of insuring Volkswagen debt against default rose significantly (Chart 4) in September 2015, but it fluctuated at a lower level in the aftermath of the crisis outbreak.
Chart 4. Price of a Credit Default Swap for Volkswagen (in Basis Points), 2015–18[[{"fid":"90052","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"9":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Volkswagen","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Volkswagen","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"9"}}]]
Source: Bloomberg, Flossbach von Storch Research Institute. Case 2: Brexit
On June 23, 2016, for many people unexpectedly, the British people voted in favor of the country’s exit from the European Union. Unsurprisingly, news coverage surged (Chart 5). The exchange rate of sterling against the US dollar took a dive and volatility surged (Chart 6). Following the nosedive, the exchange rate of sterling continued to weaken as it had done before the unexpected news. After some time, however, the initial shock faded and the exchange rate recovered part of the lost ground. Volatility also fell, suggesting that the initially high level of uncertainty gave way to a more stable pattern of views. The observed pattern is consistent with a weakening of the new Brexit narrative over time. As the debate about the terms of Brexit dragged on and the eventual outcome became ever more obscure, the exchange rate flattened. The confusion prevented any narrative from dominating the market.
Chart 5. News Concerning “Brexit,” 2014–19[[{"fid":"90053","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"10":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Brexit","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"10"}}]]
Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Chart 6. Price Quotation USD/GBP and Volatility, 2014–19[[{"fid":"90055","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit Prices Currency Pound Dollar","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"11":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Brexit Prices Currency Pound Dollar","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Brexit Prices Currency Pound Dollar","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"11"}}]]
Source: Bloomberg, Flossbach von Storch Research Institute. Case 3: Eurocrisis
Following Greece’s debt restructuring in early 2012 markets moved their focus to Italy. While the Greek debt crisis had posed only a limited threat to the survival of the euro an Italian debt crisis could spell its end. Hence, news reports mentioning a “euro crisis” increased (Chart 7). At the same time, Italian bond yields rose (Chart 8). On July 26, 2012, however, European Central Bank President Draghi said that the ECB would do “whatever it takes” to protect the euro. As a result, the Italian bond yields plunged. However, it took the rest of the year for the new narrative of the ECB’s survival guarantee to find its way fully into market prices. The pattern observed here is consistent with a new narrative (“whatever it takes”) replacing an old one (“euro crisis”) in the market.
Chart 7. News Concerning the “Euro Crisis,” 2004–18[[{"fid":"90057","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Euro Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"12":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Euro Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Euro Crisis","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"12"}}]]
Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Chart 8. Ten-Year Italian Government Bond Yields, 2004–13[[{"fid":"90059","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Italian Bonds","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"13":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Italian Bonds","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Italian Bonds","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"13"}}]]
Source: Bloomberg, Flossbach von Storch Research Institute. Case 4: Subprime Crisis
In early 2007 defaults in a segment of the US mortgage market—called “subprime”—received public attention. Initially the events were described as problems caused by the mis-selling of mortgages to financially weak debtors and hence as a limited problem in a relatively small market segment (Chart 9). Money markets in the US and Europe were affected as banks lost trust in each other’s solvency, but the stock market remained calm (Chart 10). The narrative changed with the default of Lehman Brothers, causing news on the subject to surge again (Chart 9). Through the remainder of the year and into 2009 stock prices fell and volatility increased. However, by the end of the first quarter of 2009 the crisis narrative had weakened sufficiently to be superseded by a more positive one, first along the lines of “the worst is over” and then of the recovery beginning. The fear of missing out by sticking to the old narrative was a key motivation in the skeptics becoming optimistic.
Chart 9. News Concerning “Subprime,” 2005–18[[{"fid":"90061","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Subprime Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"14":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Subprime Crisis","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Subprime Crisis","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"14"}}]]
Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Chart 10. S&P 500 Price and Historical Volatility, 2006–09[[{"fid":"90062","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"15":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"SP500","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"15"}}]]
Source: Bloomberg, Google, Flossbach von Storch Research Institute. Case 5: Recession
Although during the Great Recession of 2007/08 money markets were already experiencing severe tensions as of mid-2007, recession fears in the US gained momentum only in August 2007 and peaked in December 2007 (as measured by the number of queries for the word “recession” on Google and Bloomberg, Chart 11). Fears subsided during the first half of 2008 but surged again in August 2008, peaking in October 2008, one month after the bankruptcy of Lehman Brothers. Recession fears eased again during the second quarter of 2009.
The absolute peak of Google recession queries in the observation period occurred just at the beginning of the recession in the US in the first quarter of 2008. The return to a more normal level of recession fears in mid-2009 coincided with the (later proclaimed) official end of recession in the US. At the beginning of 2008 the stock market (as measured by the S&P 500 price index) broke below its 2007 trading range but remained in this range until the end of August. Only after the news of the Lehman bankruptcy on September 15 did stock prices plunge. They reached a nadir in early March 2009, coinciding with the easing of recession fears (measured by the number of Google and Bloomberg queries).
Chart 11. News Concerning “Recession” and Year-on-Year Percent Change of S&P 500 (Inverted)[[{"fid":"90064","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500 Recession","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"18":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"SP500 Recession","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"SP500 Recession","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"18"}}]]
Source: Bloomberg, Google Trends, Flossbach von Storch Research Institute. Case 6: Austrian Economics
Conventional New Keynesian economists had not seen the financial crisis and recession coming. This created renewed interest in the explanation of credit and investment cycles in Austrian economics, an explanation which became a narrative of its own. Chart 12 shows queries for “Austrian economics” worldwide. Queries surged in October 2008, the month after Lehman Brothers’s bankruptcy. They jumped to an even higher level in January 2012, when fears rose that Italy would crash out of the European Monetary Union (EMU). As central banks flooded the banking sector with money and Mario Draghi, president of the ECB, effectively guaranteed the existence of the EMU by promising to do “whatever it takes” to preserve the euro, the narrative of “Austrian economics” lost some of its attraction. Past experience suggests that interest will increase again when the financial system comes under renewed pressure in the next economic downturn.
Chart 12. Queries for “Austrian Economics”[[{"fid":"90065","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Austrian Economics","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"17":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Austrian Economics","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Austrian Economics","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"17"}}]]
Source: Google Trends. PATTERN PREDICTIONS WITH THE DMH Having found the DMH to explain the pattern of market movements as a competition between different narratives, its use in making “pattern predictions” can now be discussed. Hayek uses the example of a ball game to illustrate what can and cannot be predicted: if we knew precisely the skills and fitness of the opposing teams in addition to the rules of the game, we should in principle be able to predict the outcome with a relatively high degree of certainty. However, the closer the teams come in skills and fitness, the greater will be the role of chance in determining the outcome (Hayek 1974).
The legendary German coach Sepp Herberger once said: “People go to soccer games because they don’t know how the game ends.” In reality, no one has precise information about the skills and fitness of the players at the time of the game, so that not only pure chance but also a lack of information will prevent a reliable anticipation of the outcome. Nevertheless, knowing the rules of the game helps observers focus their attention on what is important to the result. Moreover, as people observe the game they acquire more information about players’ ability and can improve their prediction of the outcome. It is obviously easier to correctly predict the result of a soccer match at halftime than at the beginning, but even then a lot of uncertainty remains.
All this implies that one should not expect to be able to predict market outcomes. But by understanding how markets move we can better focus on what is important to the outcome. Observation of the important drivers of market developments can then help us narrow down the possible range of outcomes. Specifically, the discovering markets hypothesis suggests that we focus on how new facts influence narratives, which shape prices and are themselves reshaped by them. By identifying narratives shared by a large number of people and by finding out whether they are ascending or descending, we may be able to assess the persistence of market price movements. In some cases, narratives that precede price movements may even be identifiable. This is illustrated in Figure 3.
Figure 3. Formation of Prices[[{"fid":"90068","view_mode":"image_no_caption","fields":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Price Formation","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""},"type":"media","field_deltas":{"19":{"format":"image_no_caption","alignment":"left","field_file_image_alt_text[und][0][value]":"Price Formation","field_file_image_title_text[und][0][value]":false,"field_caption_text[und][0][value]":"","field_image_file_link[und][0][value]":""}},"attributes":{"alt":"Price Formation","class":"media-element file-image-no-caption media-wysiwyg-align-left","data-delta":"19"}}]]
Facts create subjective knowledge, which may induce financial market participants to act. More likely, however, they will exchange this knowledge with other participants with a view to identifying shared narratives, which have a more powerful influence on prices than individual action does.
SUMMARY AND CONCLUSION Expectations of the future shape the movement of prices, which clear markets, although not necessarily at the point where potential supply is equal to potential demand. This paper followed the argument of Lachmann and Mises that market participants form their expectations on the basis of their ability to collect information and interpret it. In keeping with Shiller, it was observed that market participants tend to communicate their views about the future in the form of narratives and that they learn by listening to the narratives of others. Narratives compete, and winners emerge by knocking out or gradually wrestling down competitors. Winning narratives shape market prices until the facts confirm their victory or until they are discredited by the facts and replaced by new narratives. When we understand how market prices form we can predict the way they adjust to changing economic conditions.
Could artificial intelligence and machine learning replace human actors in financial markets? Those who believe in more mechanical models of expectations—assuming “rational,” “irrational,” or state-dependent “rational/irrational” behavior—may be inclined to say yes. However, if market participants indeed act subjectively rationally and interdependently based on proprietary knowledge accumulated through experience and incomplete information transmitted through narratives—as described in the discovering markets hypothesis—the hurdle to clear for artificial intelligence to beat human intelligence seems fairly high.
Ryan McMaken, an economist and editor of Mises.org, joins the show to consider Part Five of Human Action: "Social Cooperation without a Market." This section of the book provides Mises's updated exposition of socialism, the impossible project of substituting 'One Will' for the subjective actions and preferences of everyone in society. Mises gives us the history behind support for socialism, and the enduring appeal of ascribing the best intentions and omniscience to the central state.
Can a socialist system really operate using the division of labor? Can mathematical equations lead us to equilibrium, the final and static price for any good or factor? Can the managerial state make the impossible possible? This is a rewarding discussion of socialism from Mises's brilliant and radical point of view.
Use the code HAPOD for a discount on Human Action from our bookstore: Mises.org/BuyHA.
Additional Resources Human Action: Mises.org/HumanAction
Bob Murphy's Study Guide to Human Action: Mises.org/Study
We continue our series on Human Action with Professor Per Bylund of Oklahoma State University.
Dr. Bylund and Jeff Deist consider Part Three of the book, "Economic Calculation," considering Mises's conception of value and the folly of attempting to define a "unit of value" in a highly subjective world. They discuss socialism and the elementary theory of value and prices; inputs and outputs in barter vs. under monetary exchange; prices as exchange ratios; why change is constant and price "stabilization" efforts fail; why mathematical calculation of money prices may rival the wheel as among the most important human inventions; and why Mises thought praxeology emerged when man started thinking about monetary calculation.
Use the code HAPOD for a discount on Human Action from our bookstore: Mises.org/BuyHA.
Additional Resources Human Action: Mises.org/HumanAction
Bob Murphy's Study Guide to Human Action: Mises.org/Study
In the second installment of our series on Mises's Human Action, Dr. David Gordon joins the show to walk us through Part One. The beginning of the book is considered its most "philosophical" material, where Mises lays out the basics of praxeology and epistemology as fundamental to understanding economics.
Dr. Gordon and host Jeff Deist consider each of the book's first seven chapters, with topics including: Mises's categories of action and causality, a priori disciplines, polylogism, "felt uneasiness," value and preferences, praxeology as it relates to time and uncertainty, probability and its application to human action, and the nature of production.
If you've wanted to read Human Action, this is your opportunity to hear it explained by great economists and scholars!
Use the code HAPOD for a discount on the pocket edition of Human Action from our bookstore: Mises.org/BuyHA.
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I. INTRODUCTION The complex issues relating to the interpretation and meaning of different concepts of probability and to the legitimate scope of their useful application in the social sciences and in economics belong to the more controversial topics within the subfield of economic methodology. Several of the most influential economists have expounded outspoken views about the matter. Thus it is probably no exaggeration to assert that John Maynard Keynes’s second-best-known book—after his The General Theory of Employment, Interest, and Money—is his A Treatise on Probability. Ludwig von Mises’s views about probability have been no less influential within the context of the Austrian school and even beyond. In this respect some commentators have claimed that Ludwig von Mises basically embraced the frequency interpretation of probability of his brother Richard von Mises,See, for instance, Hoppe (2006), who assumes that Ludwig von Mises is a representative of the frequency interpretation of probability. Whether or not this author’s views on probability are defensible, it is not quite correct to impute these same views to Ludwig von Mises.Moreover we are unable to detect any essential or exclusive connection between Keynes’s economics and Keynes’s views on probability; therefore a rejection of Keynesian economics—see e.g., Hoppe (1992)—need not entail a rejection of Keynes’s views on probability. Attempts to forge a supposedly essential connection between a particular philosophical (ideological) or economic Worldview on the one hand and a particular interpretation of probability on the other, are not new.Thus, as is also pointed out in Lad (1983), the objective interpretation of probability seems to have been rather influential in Marxist-Leninist philosophy and in Soviet thought under the influence of the mode of thinking of the Russian probabilist B. V. Gnedenko, who wrote about the subjective characterization of probability that “(t)he final outcome of consistently using such a purely subjectivistic interpretation of probability is inevitably subjective idealism” (2005 [1962], 25; also quoted in Lad [1983, 286]). Against this interpretation, Lad (1983) argues that an operational subjective construction à la de Finetti is free of Gnedenko’s charges and fits Marxist philosophical presuppositions better. thus suggesting that Ludwig von Mises’s views on probability are no less antagonistic to those of John Maynard Keynes than his views on economic theory and public policy. This latter view will here be challenged. While it is not contended that any historical evidence points to any direct historical influence between the views on probability of these two authors, it will be argued that in some relevant respects Ludwig von Mises’s views with respect to the meaning and interpretation of probability exhibit a closer conceptual affinity with the views of John Maynard Keynes about probability than with the views concerning probability of his brother Richard von Mises.
As regards the views about probability of Ludwig von Mises, it is undeniably true that these display considerable nuance and that they can be considered as being of a sui generis variety. Even if Ludwig von Mises’s views on probability exhibit a closer conceptual affinity with Keynes’s philosophy of probability than with the frequency interpretation espoused by his brother Richard von Mises, an important difference between the views of Ludwig von Mises and those of John Maynard Keynes in this respect will nevertheless be acknowledged.
II. THE SUMMA DIVISIO IN THE PHILOSOPHY OF PROBABILITY: EPISTEMIC VERSUS OBJECTIVE INTERPRETATIONS OF PROBABILITY Interpretations of probability are commonly divided into (1) epistemological (or epistemic) and (2) objective. Epistemological interpretations of probability take probability to be concerned with the knowledge (or belief) of human beings. On this approach, any probability assignment describes a degree of knowledge, a degree of rational belief, a degree of belief, or something of this sort. The approaches of both Ludwig von Mises and John Maynard Keynes belong to this category. Objective interpretations of probability, by contrast, take probability to be a feature of the objective material world, which has nothing to do with human knowledge or belief. The theory of Richard von Mises belongs to this category.The logical, subjective and intersubjective interpretations are all epistemological. The frequency and propensity interpretations are objective. For a survey and discussion of the different interpretations, see Gillies (2000).
Despite the fact that Ludwig von Mises himself clearly embraced what must be considered an epistemic view regarding the interpretation of probability, the objectivist view has been propounded by several Austrian economists, especially among those belonging to the praxeological camp. These authors apparently take it for granted that Ludwig von Mises had simply adopted the philosophy of probability of his brother Richard von Mises. Thus in a characteristic passage of Man, Economy, and State M. N. Rothbard wrote:
The contrast between risk and uncertainty has been brilliantly analyzed by Ludwig von Mises. Mises has shown that they can be subsumed under the more general categories of “class probability” and “case probability.” “Class probability” is the only scientific use of the term “probability,” and is the only form of probability subject to numerical expression.Rothbard (2004, 553).
In the two footnotes accompanying this passage M. N. Rothbard refers both to Ludwig von Mises’s discussion in Human Action, and to Richard von Mises’s Probability, Statistics, and Truth, thus conflating the views of the two brothers.Rothbard’s interpretation is questionable for at least two reasons. First, Ludwig von Mises embraces an epistemic interpretation of his concept of numerical class probability whereas Richard von Mises’s interpretation of the concept of frequency probability is objective. Second, whereas for Richard von Mises there is indeed only one scientific use of the term probability, from the perspective of Ludwig von Mises both the concept of class probability and the concept of case probability are scientifically legitimate. See further. For other references by Prof. Rothbard to Richard von Mises’s theory, see in particular Rothbard (1997, 24n, 24-27, 122n, 229n).
Views like the ones expressed by M. N. Rothbard are often, if not always, accompanied, and rather consistently, by a rejection of quantitative methods for the conduct of applied research in economics. Again M. N. Rothbard tells the story of how he came to decide to leave the world of statistics in rather dramatic terms:
After taking all the undergraduate courses in statistics, I enrolled in a graduate course in mathematical statistics at Columbia with the eminent Harold Hotelling, one of the founders of modern mathematical economics. After listening to several lectures of Hotelling, I experienced an epiphany: the sudden realization that the entire “science” of statistical inference rests on one crucial assumption, and that that assumption is utterly groundless. I walked out of the Hotelling course, and out of the world of statistics, never to return.Rothbard (1995, 38).
According to Professor Rothbard the questionable assumption is the following:
In the science of statistics, the way we move from our known samples to the unknown population is to make one crucial assumption: that the samples will, in any and all cases, whether we are dealing with height or unemployment or who is going to vote for this or that candidate, be distributed around the population figure according to the so-called “normal curve.”Rothbard (1995, 38).
Statements like these have been both severely criticized and misunderstood. Thus David Ramsey Steele, in his review of Justin Raimondo’s An Enemy of the State: The Life of Murray N. Rothbard writes:
If the young Rothbard really had found something that refuted all statistical theory, this would be a momentous discovery, and a great consolation to tobacco producers. But, sixty years on, the edifice of statistics has not registered any tremors.
In the Rothbard-Raimondo account, statisticians accept the bell curve because of a single example, the distribution of hits around the bull’s eye on a target. In fact, statisticians don’t view the bell curve as sacrosanct. Since a great many phenomena are, as a matter of fact, so close to normally distributed that the assumption of normal distribution will yield correct predictions, normal distribution can be treated as an empirical generalization and a useful instrument.
Alternatively, normal distribution can be strictly derived by the Central Limit Theorem, which shows that where some variable is influenced by a large number of unrelated random variables, that variable will be normally distributed. This result holds subject to certain conditions, which are very widely, but not universally, encountered. Statisticians are open to the possibility of non-normal distributions where these conditions don’t apply. It doesn’t seem likely that Rothbard successfully debunked all of statistics around 1942.See Steele (2000). The Central Limit Theorem (in the classical sense) is the generic name of a class of theorems which give, in precise mathematical terms, conditions under which the distribution function of a suitably standardized sum of independent random variables is approximately normal. This theorem is one of the most remarkable results in all of mathematics. For an introduction to the Central Limit Theorem from a historical perspective, see also W. J. Adams (1974).
This interpretation of Rothbard’s position is certainly questionable. It doesn’t seem likely after all that Rothbard was intent upon questioning the mathematical validity of the Central Limit Theorem or of any other theorem of formal probability calculus. It may still remain true, however, that in contexts where random collectives do not exist (that is, contexts characterized by lack of independent repetitions), as will often be the case in economics, objective probabilities cannot be used. Given that Rothbard embraced an objective, frequency interpretation of numerical probability, his rejection of statistics is a defensible and logically consistent corollary. Moreover the rejection of the use of objective probabilities in economics is in agreement with the conclusions of some of the most recent research about these matters, and with general arguments for interpreting probabilities in economics as epistemological rather than objective.See Gillies (2000, 187 ff.). The main reason why objective probabilities cannot be validly introduced in economics is not too difficult to grasp and can be related to the impossibility of introducing a satisfactory notion of independent repetitions of conditions and of random and homogeneous samples. In a typical experimental situation in physics, a sequence of independent repetitions of the experiment is perfectly possible. The experiment can be performed in the same laboratory on different days, or in different laboratories on the same day etc., and these repetitions will typically be independent. The conditions necessary for the introduction of objective probabilities are satisfied. It might seem as if there exists a certain structural similarity between a typical situation in economics and the typical experimental situation in physics. The two cases nevertheless differ in important respects. Could we not conceivably use observations of the behavior and performance of economic systems as samples of independent repetitions of conditions similar to the ones present in the typical experiment in physics? The different samples could be taken from either (1) data related to the same economic system at different times, or (2) data related to different economic systems at a similar stage of development. One author who recently re-examined these questions aptly summarizes his answer to this question as follows: “In the first case, if the samples refer to ‘snapshots’ of the economy which are too close together in time, it is hard to maintain that the more recent performance is not influenced by that of the previous periods; thus the independence of the samples cannot be maintained. If the samples relate to historical periods far enough from each other to render the assumption of independence plausible, one is unlikely to get homogeneous samples; thus invalidating the ‘experiment’. In the second case the use of a sample of cross-section data would still not give independence as economic systems tend to be integrated in terms of trade and production, and particularly as the flow of information from one country is likely to affect the behavior of agents in others.” See Gillies (2000, 192). This view with respect to the interpretation of probability is thus apparently dictated by the fundamentally different nature of the phenomena under study in the realm of human action, when compared with physical phenomena. Acting individuals in a market economy are very different from, say, the molecules of a gas. Since an economic system is composed of acting individuals, who have thoughts and beliefs, an independent repetition of any situation becomes difficult if not impossible.
It is worth pointing out that for quite some time the objectivist view had also been rather influential in certain Marxist-Leninist circles. Whereas the objectivist view had indeed been dominant in statistical theory and practice throughout most of the previous century, it was in particular in certain Soviet writings that attempts had been made to provide the objectivist view with supposedly Marxist-Leninist philosophical underpinnings, and to dismiss the subjective characterization of probability as inevitably leading to subjective idealism.In this respect attention can be drawn to the influence of B. V. Gnedenko, author of the often revised and reprinted Theory of Probability containing an objective characterization of chance and at once the most complete statement of the Soviet Marxist understanding of probability. See also footnote 1 above and the discussion in Lad (1983).
The critical issue we want to examine here, however, is whether the precepts of praxeological methodology and epistemology indeed entail an exclusive commitment to the objectivist viewpoint. An examination of Ludwig von Mises’s viewpoint in this respect has not convinced us that this is actually the case.
In fact, and as mentioned briefly already, Ludwig von Mises’s views with respect to the interpretation of probability, are more akin to Keynes’s views than to the philosophy of probability of his brother Richard von Mises. In order to substantiate this view, we will compare Ludwig von Mises’s position concerning this matter with the positions both of John Maynard Keynes and of Richard von Mises. The two main approaches to the interpretation of probability theory which will be considered here are thus the frequency interpretation, as developed systematically by Richard von Mises, and the logical interpretation, as developed systematically by John Maynard Keynes.These correspond by and large—although not exactly—to Carnap’s two concepts of probability: probability as used in logic (degree of confirmation) on the one hand, and probability as used in statistical and physical science (relative frequency), on the other. See Carnap (1945). Keynes’s views on probability are contained in Keynes (2004 [1921]); for our analysis of Richard von Mises’s views we will use Richard von Mises (1981 [1957]) and (1964).
In the third and fourth sections hereafter I present a general characterization of the views on probability of these two authors. In section V I argue that the thesis that Ludwig von Mises embraced the objective frequency interpretation of probability of his brother Richard von Mises is disputable in view of a number of Ludwig von Mises’s own statements with respect to this subject matter.
In the sixth section I examine further whether and in what respects Ludwig von Mises’s views on probability indeed exhibit a conceptual affinity with John Maynard Keynes’s interpretation of probability. In the seventh section an important difference between the respective views about probability of Ludwig von Mises and of John Maynard Keynes is highlighted.
III. RICHARD VON MISES’S OBJECTIVE APPROACH TO PROBABILITY: THE FREQUENCY INTERPRETATION The principal goal of Richard von Mises was to make probability theory a science similar to other sciences. According to the frequency view probability theory is considered a science of the same order as, say, geometry or theoretical mechanics. He criticizes the view that probability can be derived from ignorance:
It has been asserted—and this is no overstatement—that whereas other sciences draw their conclusions from what we know, the science of probability derives its most important results from what we do not know.Richard von Mises (1981 [1957], 30).
Probability should be based on facts, not their absence. The frequency theory relates a probability directly to the real world via the observed objective facts (or the data), in particular repetitive events. As Richard von Mises wrote:
By means of the methods of abstraction and idealization (…) a system of basic concepts is created upon which a logical structure can then be erected. Owing to the original relation between the basic concepts and the observed primary phenomena, this theoretical structure permits us to draw conclusions concerning the world of reality.Richard von Mises (1981 [1957], v).
In the logical approach to be examined in the next section, probability theory is seen as a branch of logic, as an extension of deductive logic to the inductive case. In contrast to this view, the frequency approach sees probability theory as a mathematical science, such as mechanics, but dealing with a different range of observable phenomena. Probability should thus not be interpreted in an epistemological sense. It is not lack of knowledge (uncertainty) which provides the foundation of probability theory, but experience with large numbers of events.
A probability theory which does not introduce from the very beginning a connection between probability and relative frequency is not able to contribute anything to the study of reality.Richard von Mises (1981 [1957], 63).A key question raised by this view relates to how mathematical sciences relate to the empirical material with which they are concerned. Since Richard von Mises was an empiricist, the starting point for him was always some observable phenomenon such as an empirical collective. In fact, according to the random frequency definition it is possible to speak about probabilities only in reference to a properly defined collective. Probability has a real meaning only as probability in a given collective. The basis of Richard von Mises’s theory of probability is thus the concept of a collective. The rational concept of probability, as opposed to probability as used in everyday speech, acquires a precise meaning only if the collective to which it applies is defined exactly in every case. Essentially a collective consists of a sequence of observations which can be continued indefinitely. Each observation ends with the recording of a certain attribute. The relative frequency with which a specified attribute occurs in the sequence of observations has a limiting value, which remains unchanged if a partial sequence is formed from the original one by an arbitrary place selection.On the concept of collective, see also Mises (1964, 11–15). As explained further, a collective is a mass phenomenon or an unlimited sequence of observations fulfilling two conditions, the convergence condition and the randomness condition. According to Richard von Mises, many types of repeatable experiment generate collectives, or at any rate would do so if they could be continued indefinitely. The task of statistics is to identify which experiments have this collective-generating property and to elicit the associated probability distributions over their class of possible outcomes. The task of probability calculus in mathematical statistics consists in investigating whether a given system of statistical data forms a collective, or whether it can be reduced to collectives. Such a reduction provides a condensed, systematic description of the statistical data that may properly be considered an “explanation” of these data. See Richard von Mises (1981 [1957], 222).
To deal with such phenomena, we obtain by abstraction or idealization some mathematical concepts, such as, in this instance, the concept of mathematical collective. We next establish on the basis of observation some empirical laws which the phenomena under study obey. Then again by abstraction or idealization we obtain from these empirical laws the axioms of our mathematical theory. Once the mathematical theory has been set up in this way, we can deduce consequences from it by logic, and these provide predictions and explanations of further observable phenomena.
Applying this scheme to the case of probability theory, there are, according to Richard von Mises, two empirical laws which are observed to hold for empirical collectives. The first of these can be named the Law of Stability of Statistical Frequencies; it refers to the increasing stability of statistical frequencies and is designated by Richard von Mises as “the ‘primary phenomenon’ (Urphänomen) of the theory of probability.”Richard von Mises (1981 [1957], 14). In fact, the expression “Stability of Statistical Frequencies” is Keynes’; see Keynes (2004 [1921], 336).
As Mises explains:
It is essential for the theory of probability that experience has shown that in the game of dice, as in all the other mass phenomena which we have mentioned, the relative frequencies of certain attributes become more and more stable as the number of observations is increased.Richard von Mises (1981 [1957], 12).
The first law of empirical collectives was fairly well known before Richard von Mises. The second law, however, is original to him and it relates to a decisive feature of a collective. This feature of the empirical collective is its lack of order, that is, its randomness.
Richard von Mises’s ingenious idea is that we should relate randomness to the failure of gambling systems.
As he wrote:
The authors of such systems have all, sooner or later, had the sad experience of finding out that no system is able to improve their chances of winning in the long run, i.e., to affect the relative frequencies with which different colours or numbers appear in a sequence selected from the total sequence of the game.Richard von Mises (1981 [1957], 25).
In other words, not only do the relative frequencies stabilize around particular values, but these values remain the same if we choose, according to some rule, a subsequence of our original (finite) sequence. This second empirical law can be called the Law of Excluded Gambling Systems.
The next step in Richard von Mises’s programme is to obtain the axioms of the mathematical theory by abstraction (or idealization) from these empirical laws. The first axiom can be easily obtained from the Law of Stability of Statistical Frequencies:
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One of the main objections to this theory is that it is too narrow, for there are many important situations where we use probability but in which nothing like an empirical collective can be defined. In particular this definition is too narrow in the context of economics. This was the viewpoint of important economists such as Ludwig von Mises, John Maynard Keynes and John Hicks.
Nevertheless Richard von Mises considers this alleged disadvantage to be a strong point in favour of his theory. We can, according to Richard von Mises, start with the imprecise concepts of ordinary language but when we are constructing a scientific theory we must replace these by more precise concepts. Thus we can of course start with the vague ordinary language concept of probability, but for scientific purposes it must be made precise by a definition. This is done by the limiting frequency definition of probability. This definition excludes some ordinary language uses of probability for which a collective cannot be defined, but this is no bad thing. On the contrary, it is positively beneficial to exclude some vague uses of probability which are unsuitable for mathematical treatment. Summing up this line of argument, he writes:
‘The probability of winning a battle,’ for instance, has no place in our theory of probability, because we cannot think of a collective to which it belongs. The theory of probability cannot be applied to this problem any more than the physical concept of work can be applied to the calculation of the ‘work’ done by an actor in reciting his part in a play.See Richard von Mises (1981 [1957], 15). Regarding his positivist ideas Richard von Mises was much influenced by E. Mach whom he greatly admired. See Richard von Mises (ibid., 225) where he writes: “The point of view represented in this book corresponds essentially to Mach’s ideas.” See in this connection also Richard von Mises (1951, passim).
The limiting frequency definition of probability is supposed to be an operational definition of a theoretical concept (probability) in terms of an observable concept (frequency). It could be claimed, however, that it fails to provide a connection between observation and theory because of the use of limits in an infinite sequence. It is well known that two sequences can agree at the first n places for any finite n however large and yet converge to quite different limits. A similar objection relates to the question of whether the representation of a finite empirical collective by an infinite mathematical collective is legitimate.
Richard von Mises’s answer to this difficulty is that such representations of the finite by the infinite occur everywhere in mathematical physics, and that his aim is only to present probability theory in a fashion which is as rigorous as the rest of mathematical physics. In mechanics, for example, we have point particles to represent bodies with a size, infinitely thin lines to represent lines with a finite thickness, and so on. Richard von Mises argues that he is trying to present probability theory as a mathematical science like mechanics, but it is unreasonable to expect him to make it more rigorous than mechanics. As he wrote:
the results of a theory based on the notion of the infinite collective can be applied to finite sequences of observations in a way which is not logically definable, but is nevertheless sufficiently exact in practice. The relation of theory to observation is in this case essentially the same as in all other physical sciences.See Richard von Mises (1981 [1957], 85). The practical difficulty arises from the fact that a collective is defined for an infinite sequence. A collective is an idealization. Strictly speaking, no relative-frequency probability statement says anything about any finite event, group of events or series. In other words, any calculated frequency is perfectly consistent with any probability attribution from zero to one. Combined with the injunction that there is no such thing as a probability of a “singular” event, it would appear that any definitive empirical attribution of numerical probabilities is a chimera. A statement about the limit of a sequence of trials hypothetically continued to infinity contains by itself absolutely no information about any initial segment of that sequence. Any initial segment of a collective—and we are, of course, only ever capable of observing initial segments—can be replaced with any arbitrary sequence of the same length without affecting any of the limits in the collective. Richard von Mises acknowledges that “[i]t might thus appear that our theory could never be tested experimentally.” (ibid. 84) His probabilistic solution to this problem is a pragmatic one. The empirical validity of the theory does not depend on a logical solution, but is determined by a practical decision. This decision should be based on previous experience of successful applications of probability theory, where practical studies have shown that frequency limits are approached comparatively rapidly. Moreover the idealization of the collective is comparable with other wellknown idealizations in science, such as the determination of a specific weight (perfect measurement being impossible), the existence of a point in Euclidean space, or the concept of velocity.The velocity of an accelerating object at a moment in time is the ratio of the change in distance to the change in time, ds/dt. Supposing the motion is not uniform, as in the case of a freely falling body whose velocity increases as it falls, to obtain the velocity we calculate the “instantaneous rate of change” of the distance with respect to the time by taking the limit as follows:i.e., v = lim ds/dt.dt ⇒ 0It is impossible to verify that this limit exists. It does not follow, however, that the concept of velocity is nonoperational. This criticism would duplicate the criticism of probability as the limit of a sequence, but it would not be considered a serious objection, because the definition of velocity as a limit has proven itself to be applicable to many different instances of motion, in just the same way the frequency theory has been successfully applied to many instances. The relation of theory to observation in the latter case is essentially the same as in all other physical sciences. It is reminded here that Ludwig von Mises’s definition of class probability, which is discussed further, is finitist in the sense that it dispenses entirely with any reference to the concept of a limit. In that limited sense it can be considered that Ludwig von Mises’s definition of class probability constitutes an improvement upon the definition of a collective offered by Richard von Mises.
To complete Richard von Mises’s programme, it must be examined how the second mathematical axiom—the axiom of randomness—can be obtained from the empirical Law of Excluded Gambling Systems. It turns out that the formulation of the axiom of randomness does involve some rather considerable mathematical difficulties. Even if these were eventually overcome, the quite subtle mathematical developments which finally gave Richard von Mises’s theory a rigorous mathematical foundation, are of little relevance in the present context. The main idea is reminded here, however:
Randomness condition:
The fixed limits to which the relative frequencies of particular attributes within a collective tend are not affected by any place selection, that is, by choosing an infinite sub-sequence whose elements are a function of previous outcomes. That is, if we calculate the relative frequency of some attribute not in the original sequence, but in a partial set, selected according to some fixed rule, then we require that the relative frequency so calculated should tend to the same limit as it does in the original set. In this respect Richard von Mises made the following stipulation:
The only essential condition is that the question whether or not a certain member of the original sequence belongs to the selected partial sequence should be settled independently of the result of the corresponding observation, i.e., before anything is known about this result.See Richard von Mises (1981 [1957], 25). As indicated already, the fulfillment of the second condition, insensitivity to place selection, is also described by Richard von Mises as the Principle of the Impossibility of a (successful) Gambling System. (ibid.)
An important implication of Richard von Mises’s frequency theory is that, when dealing with unique events, statistical or stochastic methods will be essentially useless. Where collectives do not exist, probability theory and the calculations based on it will add nothing to our knowledge concerning the world of reality. Only where previous experience has established that events can be considered as belonging to a collective, can statistical methods play a role. The calculations of insurance companies for instance demonstrate that stochastic methods play a legitimate role in certain kinds of business decisions, namely when dealing with events belonging to a collective. The theory of probability starts with certain given frequencies and derives new ones by means of calculations carried out according to certain established rules. In other words, each probability calculation is based on the knowledge of certain relative frequencies in long sequences of observations, and its result is always the prediction of another relative frequency, which can be tested by a new sequence of observations. The task of the theory of probability is thus to derive new collectives and their distributions from given distributions in one or more initial collectives.The derivation of a new collective from the initial ones consists in the application of one or several of the four fundamental operations of selection, mixing, partition and combination. See Richard von Mises (1981 [1957], Second Lecture; 1964, 15–35).As regards the frequentist solution to the problem of inference given by Richard von Mises, it consists of a combination of the frequency concept of a collective with Bayes’s theorem, a result known as the ‘Second Law of Large Numbers’. (ibid. 125) Bayes’s formula shows a relationship between prior and posterior probability functions. If knowledge of the prior distribution does exist, there is no conceptual problem with the application of Bayes’s theorem. Often the prior probability function will not be known, however, and it is then an important part of probability theory to know what influence the prior probability function has in the calculation of the posterior distribution. In general the following will hold: no substantial inference can be drawn from a small number of observations if nothing is known a priori, that is, preliminary to the experiments, about the object of experimentation. If the prior distribution is not known, and the number of observations, say rolls of a die, is small, then the posterior distribution will not allow to draw any conclusions accurately. On the other hand, a large number of observations limits the importance of knowing the prior distribution. As long as the number of experiments is small, the influence of the initial distribution predominates; however, as the number of experiments increases, this influence decreases more and more.Often the prior distribution will not be known. The actor will then have to guess at a distribution, sample the population, and then revise his guess according to Bayes’s formula. This means that actions of an individual will also be guided by the accuracy of his or her guess.
Richard von Mises’s limiting frequency definition of probability was clearly intended to limit the scope of the mathematical theory of probability, and, in fact, of the scientific concept of probability.As he wrote: “Our probability theory has nothing to do with questions such as: ‘Is there a probability of Germany being at some time in the future involved in a war with Liberia?’” See Richard von Mises (1981 [1957], 9).We can only, he claims, introduce probabilities in a scientific sense—which here also means: in a mathematical or quantitative sense—where there is a large set of uniform events, and he urges us to observe his maxim: “First the collective—then the probability.”Richard von Mises (1981 [1957], 18).Richard von Mises thus advocated a monist view of probability, that is, he asserts that there is only one concept of probability that is of scientific importance, in contradistinction to his brother Ludwig von Mises who espoused a dualist view of probability.
Despite controversy it can be expected that the frequency theory of probability will remain significant for the conduct of natural science.For recent testimony of this fact, see e.g., Khrennikov (1999). This author argues that certain problems in the foundations of quantum mechanics—such as the Einstein-Podolsky-Rosen paradox—are connected with the foundations of probability theory and thus have a purely mathematical origin. In particular, the pathological (or nonclassical) behaviour of “quantum probabilities”—in particular Bell’s inequality—is a consequence of the formal use of Kolmogorov’s probability model. This author uses the ensemble and frequency interpretations as the two fundamental interpretations of probability and arrives at surprising results. Bell’s inequality cannot be used as an argument for non-locality or nonreality. Historically, and although it has been argued that the philosophical background of subjective probability strongly resembles that underlying quantum mechanics (see Galavotti 1995), it is frequentism that became the “received view” of probability and seems to have been tacitly assumed also by the upholders of the Copenhagen interpretation of quantum mechanics (although the attribution of probabilities to the single case was generally admitted). In this context attention has often been drawn to Heisenberg’s viewpoint according to which “(t)he probability function combines objective and subjective elements. It contains statements about possibilities or better tendencies (“potential” in Aristotelian philosophy), and these statements are completely objective, they do not depend on any observer; and it contains statements about our knowledge of the system, which of course are subjective in so far as they may be different for different observers. In ideal cases the subjective element in the probability function may be practically negligible as compared with the objective one. The physicists then speak of a ‘pure case.’” See Heisenberg (1958 [1990], 41), and also the discussion in Galavotti (1995).
IV. JOHN MAYNARD KEYNES’S EPISTEMIC APPROACH TO PROBABILITY: THE LOGICAL INTERPRETATION The logical interpretation of probability considers probability as the degree of a partial entailment. Keynes’s Treatise is concerned with the general theory of arguments from premises leading to conclusions which are reasonable but not certain. Let e be the premises and h the conclusion of an argument. Keynes holds that the familiar relation ‘e implies h’ is the limiting case of a more general (probability) relation ‘e partially implies h.’ Keynes’s aim in the Treatise is to systematize statements involving such relations of partial implication. The logical theory uses the word “probability” primarily in relation to the truth of sentences, or propositions.
It aims at assigning truth values other than zero or one to propositions. In this process, that part of our knowledge which we obtain directly, supplies the premises of that part which we obtain indirectly or by argument. From these premises we seek to justify some degree of rational belief about all sorts of conclusions. We do this by perceiving certain logical relations between the premises and the conclusions. The kind of rational belief which we infer in this manner is termed probable (or in the limit certain), and the logical relations, by the perception of which it is obtained, we term relations of probability.See Keynes (2004 [1921], 111). Keynes mostly takes the empiricist line that knowledge acquired by direct acquaintance constitutes true and certain knowledge. Knowledge by argument, in contrast, proceeds through direct knowledge of relations of the form ‘e implies h’ or ‘e partially implies h.’
Comparisons are possible between two probabilities, only when they and certainty all lie on the same ordered series. Probabilities which are not of the same order cannot be compared. Only when numerical measurement of probabilities is possible, which is only occasionally possible and which is thus a matter for special enquiry in each case, algebraical operations such as addition and arithmetical multiplication, can be performed. The numbers zero and one figure as extreme cases. A probability of zero indicates impossibility, a probability equal to one indicates the truth of a proposition.
The idea of a logic of probability which should be the art of reasoning from inconclusive evidence was systematically developed by John Maynard Keynes although hints towards this approach had been expressed at least since Leibniz. Keynes regards probability theory, like economics, as a branch of logic. Although Richard von Mises calls Keynes “a persistent subjectivist,”Richard von Mises (1981 [1957], 94).Keynes makes it clear at the beginning of his book that his theory is, in an important sense, an objective one. For Keynes probability was degree of rational belief not simply degree of belief. The relevant passage is worth being quoted in its entirety:
The terms certain and probable describe the various degrees of rational belief about a proposition which different amounts of knowledge authorise us to entertain. All propositions are true or false, but the knowledge we have of them depends on our circumstances; and while it is often convenient to speak of propositions as certain or probable, this expresses strictly a relationship in which they stand to a corpus of knowledge, actual or hypothetical, and not a characteristic of the propositions in themselves. A proposition is capable at the same time of varying degrees of this relationship, depending upon the knowledge to which it is related, so that it is without significance to call a proposition probable unless we specify the knowledge to which we are relating it.
To this extent, therefore, probability may be called subjective. But in the sense important to logic, probability is not subjective. It is not, that is to say, subject to human caprice. A proposition is not probable because we think it so. When once the facts are given which determine our knowledge, what is probable or improbable in these circumstances has been fixed objectively, and is independent of our opinion. The Theory of Probability is logical, therefore, because it is concerned with the degree of belief which it is rational to entertain in given conditions, and not merely with the actual beliefs of particular individuals, which may or may not be rational.See Keynes (2004 [1921], 3–4). It is widely held that Keynes yielded to Ramsey’s (1988) critical arguments and that he abandoned the idea that rational beliefs are founded on logical relations of partial implication and accepted instead that they are closer to our perceptions and our memories than to formal logic. As Runde (1994) points out, Keynes’s theory of comparative probability emerges unscathed. On the one hand Ramsey’s theory embodies strong implicit presuppositions of its own and is in certain respects a considerably more idealistic construction than Keynes’s. On the other hand, Keynes’s emphasis is on incompleteness and on the fact that numerically definite probabilities can only be determined in situations which approximate games of chance.
It is important to acknowledge the point for point disagreement which exists between the theories of Richard von Mises and John Maynard Keynes.See also Gillies (1973, 14–15).For Richard von Mises probability is a branch of empirical science; for Keynes it is an extension of deductive logic. Von Mises defined probability as limiting frequency; Keynes as degree of rational belief. For von Mises the axioms of probability are obtained by abstraction from two empirical laws; for the other they are perceived by direct logical intuition. On one point there seems to be some agreement. Neither thinks that all probabilities have a numerical value, but the attitude of the two authors to this situation is very different. For Richard von Mises only probabilities defined within an empirical collective can be evaluated and only these probabilities have any scientific interest. The remaining uses of probability are examples of a crude prescientific concept towards which he takes a dismissive attitude. For Keynes on the other hand all probabilities are essentially on a par. They all obey the same formal rules and play the same role in our thinking. Certain special features of the situation allow us to assign numerical values in some cases, though not in general. Through the acknowledgement that frequency probability does not cover all we mean by probability, Keynes’s position is thus also closer to that of other economists such as Ludwig von Mises and John Hicks. Finally the position of statistics is different in the two accounts. For von Mises it is a study of how to apply probability theory in practice, similar to applied mechanics. For Keynes statistical inference is a special kind of inductive inference and statistics is a branch of the theory of induction.
The most striking differences between John Maynard Keynes and Richard von Mises are thus:
— according to Richard von Mises, the theory of probability belongs to the empirical sciences, based on limiting frequencies, while Keynes regards it as a branch of logic, based on degrees of rational belief; and
— Richard von Mises’s axioms are idealizations of empirical laws, Keynes’s axioms follow from the intuition of logic.
It is a quite remarkable fact that the practical significance of these differences in principles does not prevent the two authors from reaching nearly complete agreement on almost all of the mathematical theorems of probability, as well as on the potentially successful fields of application of statistics. Thus their complete disagreement on all the philosophical issues is accompanied by complete agreement on the mathematical side. Moreover an essentially similar conclusion can be drawn as regards the potential scope of successful application of numerical probability concepts.
Thus in Part V of the Treatise in the context of his discussion of statistical inference, Keynes has the great merit of noticing that the applicability of some of the essential parts of the classical doctrine assumes independence or irrelevance.As Keynes writes: “It is assumed, first, that a knowledge of what has occurred at some of the trials would not affect the probability of what may occur at any of the others; and it is assumed, secondly, that these probabilities are all equal à priori. It is assumed, that is to say, that the probability of the event’s occurrence at the nth trial is equal à priori to its probability at the nth trial, and, further, that it is unaffected by a knowledge of what may actually have occurred at the nth trial.” (2004 [1921], 344).As Karl Popper points out, the theory of independence or irrelevance is equivalent to the law of the excluded gambling system. See Popper (1983, 299).
Keynes also suggested renaming the law of large numbers the Law of Stability of Statistical Frequencies, which provides a clear summary of its meaning:
But the ‘Law of Great Numbers’ is not at all a good name for the principle which underlies Statistical Induction. The ‘Stability of Statistical Frequencies’ would be a much better name for it. The former suggests, as perhaps Poisson intended to suggest, but what is certainly false, that every class of event shows statistical regularity of occurrence if only one takes a sufficient number of instances of it. It also encourages the method of procedure, by which it is thought legitimate to take any observed degree of frequency or association, which is shown in a fairly numerous set of statistics, and to assume with insufficient investigation that, because the statistics are numerous, the observed degree of frequency is therefore stable. Observation shows that some statistical frequencies are, within narrower or wider limits, stable. But stable frequencies are not very common, and cannot be assumed lightly.Keynes (2004 [1921], 336).
According to the frequency view the successful application of probability theory, in particular for purposes of statistical inference, is conditioned by the fulfillment of a particular presupposition: in a particular domain of reality, one or more collectives exist as a matter of fact. This means that adequate applications of the laws of large numbers rest on a supposition of homogeneity with respect to the phenomena which are subjected to study.
Quite remarkably Keynes, when examining the validity and conditions of applicability of Bernoulli’s Theorem and its Inversion, arrives at similar conclusions.
As he wrote:
If we knew that our material world could be likened to a game of chance, we might expect to infer chances from frequencies, with the same sort of confidence as that with which we infer frequencies from chances.Keynes (2004 [1921], 384–85) Significantly, Keynes also wrote in connection with the application of Bernoulli’s formula: “In cases where the use of this formula is valid, important inferences can be drawn; and it will be shown that, when the conditions for objective chance are approximately satisfied, it is probable that the conditions for the application of Bernoulli’s formula will be approximately satisfied also.” (ibid. 290).
These reservations are similar to those expressed by several Austrian economists. For instance Ludwig von Mises clearly doubts whether the empirical Law of Stability of Statistical Frequencies is operative in social reality:
However, what the statistics of human actions really show is not regularity but irregularity. The number of crimes, suicides, and acts of forgetfulness (…) varies from year to year. These yearly changes are as a rule small, and over a period of years they often—but not always—show a definite trend toward either increase or decrease. These statistics are indicative of historical change, not of regularity in the sense which is attached to this term in the natural sciences.See Ludwig von Mises (1969 [1957], 84-5). See also (1978 [1962], 56) where Mises wrote: “There is no such thing as statistical laws.” According to this view, statistics is rather a sub-discipline, or an auxiliary discipline, of historiography.
V. RICHARD VON MISES VERSUS LUDWIG VON MISES, WITH RESPECT TO PROBABILITY In this section a certain amount of evidence is presented which is drawn from Ludwig von Mises’s writings and which is difficult to square with the thesis that Ludwig von Mises embraced what is basically the frequency interpretation of probability of his brother Richard von Mises.
It is remarkable that some of Ludwig von Mises’s most revealing statements about the nature and meaning of the concept of probability relate to a context which is alien to economic science proper. If there is one field of scientific enquiry where the nature and interpretation of the probability calculus have been the subject of much and reiterated debate, it is the domain of quantum mechanics and the philosophy of quantum mechanics. We have already noted at the end of section III that, controversy notwithstanding, the frequency interpretation remains highly significant for the conduct of natural science. Here we turn our attention more particularly to a comparison of Ludwig von Mises’s concept of class probability with Richard von Mises’s concept of frequency probability.
The writings of Ludwig von Mises contain many important insights with respect to the philosophy of the sciences and it is not quite surprising that he had an outspoken opinion about the matter. In Theory and History, in a section entitled Determinism and Statistics, he expressed his view with respect to quantum mechanics as follows:
Quantum mechanics deals with the fact that we do not know how an atom will behave in an individual instance. But we know what patterns of behavior can possibly occur and the proportion in which these patterns really occur. While the perfect form of a causal law is: A “produces” B, there is also a less perfect form: A “produces” C in n percent of all cases, D in m percent of all cases, and so on. Perhaps it will at a later day be possible to dissolve this A of the less perfect form into a number of disparate elements to each of which a definite “effect” will be assigned according to the perfect form. But whether this will happen or not is of no relevance for the problem of determinism. The imperfect law too is a causal law, although it discloses shortcomings in our knowledge. And because it is a display of a peculiar type both of knowledge and of ignorance, it opens a field for the employment of the calculus of probability.Ludwig von Mises (1969 [1957], 87–88).
Mises then provides the well-known definition of his concept of class probability:
We know, with regard to a definite problem, all about the behavior of the whole class of events, we know that A will produce definite effects in a know proportion; but all we know about the individual A’s is that they are members of the A class. The mathematical formulation of this mixture of knowledge and ignorance is: We know the probability of the various effects that can possibly be “produced” by an individual A.Ludwig von Mises (1969 [1957], 88).
Significantly Ludwig von Mises is also explicitly critical of the mainstream indeterminist interpretation of quantum mechanics since he pursues:
What the neo-indeterminist school of physics fails to see is that the proposition: A produces B in n percent of the cases and C in the rest of the cases is, epistemologically, not different from the proposition: A always produces B. The former proposition differs from the latter only in combining in its notion of A two elements, X and Y, which the perfect form of a causal law would have to distinguish. But no question of contingency is raised.Ludwig von Mises (1969 [1957], 88).
In Human Action Ludwig von Mises raised similar concerns when he wrote:
“The treatment accorded to the problem of causality in the last decades has been, due to a confusion brought about by some eminent physicists, rather unsatisfactory. (…)
There are changes whose causes are, at least for the present time, unknown to us. Sometimes we succeed in acquiring a partial knowledge so that we are able to say: in 70 per cent of all cases A results in B, in the remaining cases in C, or even in D, E, F, and so on. In order to substitute for this fragmentary information more precise information it would be necessary to break up A into its elements. As long as this is not achieved, we must acquiesce in a statistical law.Ludwig von Mises (1998, 22). In The Ultimate Foundation of Economic Science Ludwig von Mises also wrote: “There is always in science some ultimate given. For contemporary physics the behavior of the atoms appears as such an ultimate given. The physicists are today at a loss to reduce certain atomic processes to their causes. One does not detract from the marvelous achievements of physics by establishing the fact that this state of affairs is what is commonly called ignorance.” (1978 [1962], 23).
These passages are important and interesting because they clearly illustrate the fact that in the context of the well-known historical debate between physicists who believed that quantum mechanics is incomplete and who were tempted to assume that “God does not play dice,” on the one hand, and the physicists who, on the contrary, believed that the fundamental laws of nature are irreducibly probabilistic, on the other hand, Ludwig von Mises takes sides with the former.In particular quantum theory is irreducibly probabilistic. Unlike classical probabilities, quantum probabilities do not reflect our ignorance of the intricate details of some underlying physical reality. In particular Einstein disliked the element of chance implied by quantum theory. In a letter to Max Born, dated 4 December 1926, he wrote: “Quantum mechanics is very impressive. But an inner voice tells me that it is not yet the real thing. The theory produces a good deal but hardly brings us closer to the secret of the Old One. I am at all events convinced that He does not play dice.” Quoted in Baggott (2004, 34). Reference can in this context also be made to the confrontation between Einstein and Bohr over the interpretation of quantum theory, and to subsequent debates along similar lines, and which have often been portrayed in the past as a direct conflict between realism and positivism. For a good survey and discussion of these issues see also Baggott (2004). The issue for Einstein indeed seems to have been realism rather than determinism. Ludwig von Mises is apparently on the realist side. For a sophisticated analysis of Einstein’s views in this respect, see also Fine (1986); Einstein’s remark about the dice-playing God (“…ob der liebe Gott würfelt”) is also related in Bohr (1949, 218); see also Fine (1986, 29).Ludwig von Mises clearly associates the use of the probability calculus with partial knowledge, that is, with ignorance and the imperfections of our knowledge, and not with the existence of any contingency in re. Similarly Einstein believed, from the very beginning, that quantum theory lacked some key ingredients and that, in a very significant sense, it was “incomplete.” He compared it with the theory of light before the advent of light quanta. Quantum theory, he believed, was perhaps a “correct theory of statistical laws,” but it provided “an inadequate conception of individual elementary processes.”Einstein, Albert, letter to Sommerfeld, Arnold, dated 9 November 1927. Quoted in Fine, A. (1986, 29).
Thus Ludwig von Mises’s concept of class probability, in contradistinction to the frequency concept of his brother Richard von Mises, contains a reference to the deficiency of our knowledge, that is, to the idea that any probability assignment describes only a state of knowledge. A statement is probable if our knowledge concerning its content is deficient.Ludwig von Mises (1998, 107).According to this view the use of statistical laws signals partial knowledge and fragmentary information. There do not exist any statistical laws in an objective, physical sense.
As Popper reminds us too, the widely held view that whenever probability enters our considerations, this is due to our imperfect knowledge, is reminiscent of subjective interpretations of the probability calculus.Popper (1983, 295).The objective frequency interpretation does not have this connotation.
According to the mainstream view with respect to this matter, (nearly all) the probabilities appearing in theoretical quantum mechanics are indeed objective probabilities. That is to say, they inhere in the world and do not simply reflect the degrees of belief, or the degrees of knowledge, of an observer.See Hughes (1992, 218). The possible exceptions occur when a system is in a mixed state. Under the ignorance interpretation of a given mixture, a subjective probability is assigned to each of the pure states represented in it, and each of these in turn assigns objective probabilities to events. Not all mixtures can be given the ignorance interpretation, however. For a discussion of pure and mixed states, see also van Fraassen (1991, ch. 7). The interpretation of quantum states is a matter of much debate. For in-depth discussions of these and related matters, see in particular also Willem M. de Muynck (2002 passim).
These remarks are sufficient to establish the fact that Ludwig von Mises’s interpretation of numerical probability theory, and in particular his interpretation of the concept of class probability, is in a fundamental sense distinct from that of his brother Richard von Mises. Indeed, according to Richard von Mises, the point of view that statistical theories are merely temporary explanations, in contrast to the final deterministic ones which alone satisfy our desire for causality, is nothing but a prejudice which is bound to disappear with increased understanding.See Richard von Mises (1981 [1957], 223). As Richard von Mises writes: “The assumption that a statistical theory in macrophysics is compatible with a deterministic theory in microphysics is contrary to the conception of probability expressed in these lectures. Modern quantum mechanics or wave mechanics appears to be a purely statistical theory; its fundamental equations state relations between probability distributions.” (ibid. 223) The incompatibility with the views expressed by his brother Ludwig von Mises in this respect cannot be clearer. Therefore we do not share the view of an author who explains the absence of any reference in Ludwig von Mises’s Human Action to Richard von Mises’s frequency interpretation with reference to a supposed “estrangement” between the two brothers. See Hoppe (2006, 13). Clearly the two brothers disagreed on philosophical grounds.
The contrast between the views of Ludwig von Mises and of Richard von Mises in this respect can also be related to the fact that Ludwig von Mises’s worldview, in contradistinction to that of his brother Richard von Mises, apparently exhibited some leaning towards metaphysical determinism.See e.g., Ludwig von Mises (1978 [1962], 115). Turning back to quantum mechanics, it may be noted that the American-born physicist David Bohm has formulated in the 1950s an alternative interpretation of quantum mechanics that is fully deterministic (although non-local). The very idea of probability enters into this theory as some kind of an epistemic idea, just as it enters into classical statistical mechanics. Despite all the advantages of Bohm’s theory, an almost universal refusal even to consider it, and an almost universal allegiance to the standard formulation of quantum mechanics has persisted in physics throughout most of the past fifty years. For a summary introduction to Bohm’s approach, see David Z Albert (1994).
It is true that the contrast between Ludwig von Mises’s concept of class probability and Richard von Mises’s notion of a collective remains somewhat concealed and thus runs the risk of going unnoticed because of the fact that on a few occasions Ludwig von Mises uses terminology which is reminiscent of the idea of “frequency.”
In Human Action for instance Ludwig von Mises explicitly and unambiguously characterizes the notion of class probability as a variant of frequency probability.Ludwig von Mises (1998, 107).
Nevertheless this terminological issue cannot invalidate our thesis that, all things considered, Ludwig von Mises’s philosophy of probability exhibits a closer affinity with an epistemological view—such as Keynes’s logical theory—than with the frequency view of his brother Richard von Mises. The conclusion at which we have thus arrived is nuanced. On the one hand Ludwig von Mises clearly relates the idea of probability to the state of knowledge of the knowing subject. This is true both of class probability and of case probability. A statement is probable if our knowledge concerning its content is deficient. This view is shared by all adepts of an epistemological interpretation of the concept of probability, including John Maynard Keynes. Richard von Mises, to the contrary, very explicitly rejects the idea that the concept of probability refers to a state of partial or deficient knowledge. On the other hand, Ludwig von Mises clearly recognizes that the meaning of probability is different according to the field of knowledge in which it is used or according to the kind of phenomena to which it is applied. He thus embraces a dualist view in the philosophy of probability.Accordingly probability sometimes involves a reference to the notion of relative frequency, but relative frequency is not the general defining characteristic of the scientific concept of probability according to Ludwig von Mises.But in this respect his view is again clearly different from and opposed to that of his brother Richard von Mises who obviously embraces a monist theory of probability.
Moreover, from the perspective of the logical theory of probability too, the concept of probability sometimes refers to relative frequency. Contemporary adepts of the idea of probability theory as extended logic are confident that their approach can encompass frequentist methods, but merely as only one specialized application of probability theory.See Jaynes (2003, passim).
Apparently this was also Keynes’s view since he wrote that “the theory of this Treatise is the generalised theory, comprehending within it such applications of the idea of statistical truth-frequency as have validity.”Keynes (1921 [2004], 104).
In other words, on this view the problems that can be solved by frequentist probability theory form a subclass of those that are amenable to probability as logic; probability theory as logic, however, can also be applied consistently in many problems that do not fit into the frequentist preconceptions.
It would be premature to conclude that such concerns about the meaning of probability as are raised by Ludwig von Mises have now become obsolete and unambiguously belong to the history of the philosophy of probability. As one adept of the logical interpretation of probability explained recently:
Probabilities in present quantum theory express the incompleteness of human knowledge just as truly as did those in classical statistical mechanics; only its origin is different.
In classical statistical mechanics, probability distributions represented our ignorance of the true microscopic coordinates—ignorance that was avoidable in principle but unavoidable in practice, but which did not prevent us from predicting reproducible phenomena, just because those phenomena are independent of the microscopic details.
In current quantum theory, probabilities express our ignorance due to our failure to search for the real causes of physical phenomena; and, worse, our failure even to think seriously about the problem. This ignorance may be unavoidable in practice, but in our present state of knowledge we do not know whether it is unavoidable in principle; the ‘central dogma’ simply asserts this, and draws the conclusion that belief in causes, and searching for them, is philosophically naïve. If everybody accepted this and abided by it, no further advances in understanding of physical law would ever be made; indeed, no such advance has been made since the 1927 Solvay Congress in which this mentality became solidified into physics. But it seems to us that this attitude places a premium on stupidity; to lack the ingenuity to think of a rational physical explanation is to support the supernatural view.See Jaynes (2003, 328–29). In particular, this author’s views contrast sharply with those of Popper. With respect to the situation in physics, Popper, who argues for the compatibility of indeterminism with realism and objectivism, has gone so far as to blame the determinist interpretation of classical physics, or rather, what he characterizes as some unconscious determinist prejudice with respect to classical physics, for the subjective theory of probability and its consequence, the invasion of mysticism, irrationalism etc., into physics. See Popper (1982, passim).
Again a disagreement about the meaning of probability at the philosophical level need not preclude an approximate consensus regarding the legitimate scope of application of numerical probability theory. It is certainly doubtful whether the criterion of convergence and the conditions for the availability of a collective are ever satisfied in economic or econometric applications. Probabilities in economics are not the kind of physical entities that Richard von Mises seems to have had in mind in constructing his theory.
The empirical foundation for probability in this sense, that is to say for objective frequency probability, will typically be lacking. Richard von Mises himself seems to have suggested that the frequentist conception is not applicable to the moral sciences owing to the absence of events meeting the conditions of a collective. As he wrote:
The unlimited extension of the validity of the exact sciences was a characteristic feature of the exaggerated rationalism of the eighteenth century. We do not intend to commit the same mistake.See Richard von Mises (1981 [1957], 9).
On this point Ludwig von Mises and Richard von Mises seem to have agreed.
VI. MORE ABOUT LUDWIG VON MISES AND JOHN MAYNARD KEYNES, WITH RESPECT TO PROBABILITY Attention has already been drawn to the fact that both Ludwig von Mises and John Maynard Keynes embrace an epistemological rather than an objective interpretation of probabilities. Both of these authors also point to certain limits of the applicability of numerical probability, and in particular of the laws of large numbers. These authors’ respective views on probability have another important characteristic in common, however. Both authors recognize and acknowledge the epistemological and scientific legitimacy of qualitative, nonmeasurable probabilities.
With respect to the question of whether a numerical measurement of probabilities is always possible, John Maynard Keynes was critical of the tendency to interpret probabilities as being, in general, numerically measurable. Thus he wrote:
The attention, out of proportion to their real importance, which has been paid, on account of the opportunities of mathematical manipulation which they afford, to the limited class of numerical probabilities, seems to be a part explanation of the belief, which it is the principal object of this chapter to prove erroneous, that all probabilities must belong to it.Keynes (2004 [1921], 37).
In similar vein Ludwig von Mises wrote:
The problem of probable inference is much bigger than those problems which constitute the field of the calculus of probability. Only preoccupation with the mathematical treatment could result in the prejudice that probability always means frequency.Ludwig von Mises (1998, 107).
Ludwig von Mises, who distinguishes between two kinds of probability—class probability, which by and large corresponds to frequency probability, and case probability—accorded the second meaning of probability important scientific status.
In Ludwig von Mises’s words:
Case probability means: We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing.Ludwig von Mises (1998, 110).
Here too, however, the idea of probability relates to the general idea of partial or imperfect knowledge; in this respect, and only in this respect, case probability is indeed similar to class probability:
Case probability has nothing in common with class probability but the incompleteness of our knowledge. In every other regard the two are entirely different.Ludwig von Mises (1998, 110).
Keynes, while he does not adopt the terms case and class probability, believes, like Ludwig von Mises, that frequency probability does not encompass all we mean by probability. Clearly the random frequency definition of probability is too narrow to encompass what we mean when we use the term probability. We do say of unique events that they are more or less probable. Many decisions that people make daily are based on probability statements that have no frequency interpretation.
In Chapter VIII of A Treatise on Probability, while discussing Venn’s elaboration of the frequency theory, he wrote:
It is the obvious, as well as the correct, criticism of such a theory, that the identification of probability with statistical frequency is a very grave departure from the established use of words; for it clearly excludes a great number of judgments which are generally believed to deal with probability.Keynes (2004 [1921], 95).
While the frequency theory of probability is concerned with a cardinally measurable degree of probability, case probability is not open to any kind of numerical evaluation according to Ludwig von Mises.Keynes (2004 [1921], 95).
According to this view, case probability focuses on individual events which as a rule are not part of a sequence, and case probability is not measurable in any but an ordinal sense; there is no cardinal measure of case probability.
What is commonly considered as a numerical evaluation of case probability, Mises argues, exhibits, when more closely scrutinized, a different character, viz. that of a metaphor.See Ludwig von Mises (1998, 114). Ludwig von Mises’s view regarding this matter is thus distinct from the view of Bayesians such as Howson and Urbach who argue that choices of personal fair betting quotients can provide a basis for making numerical assessments of uncertainty. See Howson and Urbach (2006, 51 ff.).When we proceed to a numerical evaluation of case probability, this amounts to an attempt to elucidate a complicated state of affairs by resorting to an analogy borrowed from the calculus of probability. As it happens, this mathematical discipline is more popular than the analysis of the epistemological nature of understanding. As has been pointed out already, a distinctive feature of Keynes’s view too is that not all probabilities are numerically measurable, and in many instances, they cannot even be ranked on an ordinal scale.In the Treatise Keynes illustrates this point with the famous example of the “beauty contest.” (2004 [1921], 25 ff.)Keynes explains how one of the candidates of the contest sued the organizers of the Daily Express for not having had a reasonable opportunity to compete. Readers of the newspaper determined one part of the nomination. The final decision depended on an expert, who had to sample the top fifty of the ladies chosen by the readers. The candidate complained in front of the Court of Justice, that she had not obtained an opportunity to make an appointment with this expert. Keynes argues that the chance of winning the contest could have been measured numerically, if only the response of the readers (who sent in their appraisals and thus provided an unambiguous ranking of the candidates) had mattered. The subjective taste of the single expert could not be evaluated in a similar way. Hence, a rational basis for evaluating the chances of the unfortunate lady was lacking. Keynes concludes:Whether or not such a thing is theoretically conceivable, no exercise of the practical judgment is possible, by which a numerical value can actually be given to the probability of every argument. So far from our being able to measure them, it is not even clear that we are always able to place them in an order of magnitude. Nor has any theoretical rule for their evaluation ever been suggested. (ibid. 27–28)
Keynes’s views on the applicability of large number statistics to singular propositions are in this respect somewhat similar to those espoused by Ludwig von Mises. Keynes was clear on why one might adopt case probability judgments even where large number statistics are available:
In some cases, moreover, where general statistics are available, the numerical probability which might be derived from them is inapplicable because of the presence of additional knowledge with regard to the particular case.See Keynes (2004 [1921], 29). In similar vein, Hoppe (2006), analyzing the meaning of Ludwig von Mises’s concept of case probability, points out that the method of Verstehen can be characterized as a method of place selection, or a method of individualization.
VII. THE DISTINCTIVENESS OF LUDWIG VON MISES’S POSITION IN THE PHILOSOPHY OF PROBABILITY Acknowledging certain similarities between Ludwig von Mises’s and John Maynard Keynes’s respective positions in the philosophy of probability should not blind us to the fact that their respective views also exhibit some important differences. The most important of these relates to the fact that Ludwig von Mises advocates a pluralist, and in particular a dualist view of probability. According to a pluralist view of probability, there exist several different, though possibly interconnected, notions of probability which apply in different contexts, or with respect to different kinds of phenomena. Ludwig von Mises’s dualist position in the philosophy of probability is an aspect of his more general methodological dualism, which is based on a recognition of certain fundamental ontological, epistemological and methodological differences between the natural sciences on the one hand and the sciences of human action on the other, and between the natures of their respective subject matters. Moreover, in the particular case of Ludwig von Mises, his dualism in the philosophy of probability coincides with the distinction between measurable, numerical probability on the one hand and nonmeasurable, nonnumerical probability on the other, that is, with the distinction between class probability and case probability.It is not the case that according to Ludwig von Mises’s dualist (twoconcept) view with respect to probability, the different concepts of probability are conceived of as different interpretations of the same mathematical calculus, or as applications of the same mathematical calculus to different sets of phenomena, as is the case according to certain other dualist views of probability. The distinction between class probability and case probability is ultimately based upon the different kind of cognitive accessibility of human actors in contrast to noncommunicative entities. See Hoppe (2006).Ludwig von Mises’s view with respect to the meaning of probability may thus seem to occupy a truly unique place in the philosophy of probability. Another economist who adopted a nuanced viewpoint in this connection is John Hicks. This author wrote: “I have myself come to the view that the frequency theory, though it is thoroughly at home in many of the natural sciences, is not wide enough for economics.” (1979, 105) Hicks is contrasting two interpretations of probability—the frequency and the logical. The framework used here is wider since we distinguish objective theories of probability from epistemological theories.
Ludwig von Mises’s solution to the problem of defining the concept of probability remains, no less than Keynes’s, original and highly relevant. Where others have pleaded in favour of the introduction of operationalist procedures in the social sciences, as an alternative way of making the qualitative quantitative,See Gillies (2000, 200 ff.).Ludwig von Mises’s concept of case probability remains radically nonnumerical, geared to the needs of historical and entrepreneurial understanding.
VIII. CONCLUSION While certain fundamental differences between the natural and the social sciences and the consequent need for a nuanced solution to the problem of finding an adequate definition of the concept of probability have been recognized by various authors and schools of thought, the solutions to this problem offered by both Ludwig von Mises and John Maynard Keyes remain both interesting from a theoretical perspective and useful from a more practical viewpoint.
We have been entitled to conclude that Ludwig von Mises’s views concerning the interpretation of the concept of probability, as they can be ascertained from certain passages of his writings, are in some respects more akin to the logical interpretation of probability as developed by John Maynard Keynes than to the frequency view as developed by his brother Richard von Mises. Summarizing, it can be acknowledged that this conclusion is supported by the fact that the views of Ludwig von Mises and of John Maynard Keynes about the interpretation of probability—that is, their philosophy of probability—have two important characteristics in common which are not shared by the probability theory of Richard von Mises.
First, both Ludwig von Mises and John Maynard Keynes adopt an epistemological (or epistemic) interpretation of probability, whereas Richard von Mises clearly embraces an objective theory of probability. The viewpoints of Ludwig von Mises and John Maynard Keynes, in so far as they amount to an argument for interpreting probabilities in economics as epistemological rather than objective, are thus in agreement with the conclusions of recent research. Second, both Ludwig von Mises and John Maynard Keynes, in their respective ways, acknowledge the existence and the epistemological and scientific legitimacy of nonmeasurable (or nonnumerical) probabilities, besides the usual measurable probabilities having a definite numerical value in the interval [0, 1]. Although Richard von Mises did acknowledge that there was an ordinary language or common sense notion of probability which was not covered by his frequency theory, he asserts that there is only one concept of probability that is of scientific importance. In other words, according to this view there is, in a scientific approach to the subject matter, no room for a purely qualitative notion of probability.
While some authors have gone so far as to question the adequacy of the orthodox frequency theory even for the physical sciences, there is a somewhat greater amount of consensus in favour of the conclusions (1) that in any case an objective interpretation of probability such as the orthodox frequency theory is not wide enough for economics, and (2) that in economics a qualitative nonnumerical concept of probability is both needed and scientifically legitimate. Both of the aforementioned characteristics have much relevance for the conduct of social science in general and of economics in particular.
An important difference between the views of Ludwig von Mises and those of John Maynard Keynes in this respect has nevertheless been acknowledged. Whereas Keynes advocated a monist view of probability and claimed that his interpretation of probability applies to all uses of the concept, Ludwig von Mises, in accordance with his methodological dualism, embraced a dualist view, recognizing more emphatically the existence of important differences between the natural sciences on the one hand and the social sciences, including economics, on the other. The particular solution offered by Ludwig von Mises thus remains highly distinctive and sophisticated, even if in comparison with the Keynesian approach, it has until present received somewhat less attention.Those contemporary Austrian economists who acknowledge the usefulness of modern data analysis methods for the conduct of applied research in economics can be confident that the now more and more widespread practice of interpreting probabilities as merely epistemological is in general agreement with Ludwig von Mises’s approach to probability. Moreover, it is neither clear nor obvious why a recognition of the usefulness of modern data analysis methods would have to amount to a denial of the essential importance of the method of understanding or Verstehen.
Abstract: Rules and rule-following are becoming better understood as decision-making and coordination mechanisms. Further, that hierarchy is an under-appreciated element of natural spontaneous, rule-based, orders has caused confusion. The article argues firstly that the ability to meld rule-following and hierarchy in one theory of the firm presents an opportunity for a possible consistent Austrian theory of the firm. The paper then proceeds to discuss how rule-following is embedded in conventional theories of the firm and how a rule-based firm can create value in the larger spontaneous order of the extended market. The paper concludes by arguing that even though conventional views around hierarchy and the giving of orders within a firm may have a role, the conventional view may be under-privileging the role of rules, rule-following and the consequent natural emergence of hierarchy.
management authority emergent order coordination spontaneous order hierarchy JEL Classification: B53, D23, D83, L22, L26, M14 Aidan Walsh (aidan.walsh@ie.ey.com) is tax partner with EY, Dublin, Ireland. Malcolm Brady (malcolm.brady@dcu.ie) is associate professor at Dublin City University Business School.
“The enemies of liberty have always based their arguments on the contention that order in human affairs requires that some should give orders and others obey” (Hayek 1960, 159).
“We may only learn from the necessity of rules, wherever men have intercourse with each other” (Hume 1751, 38).
INTRODUCTION It is a universal feature of firms that they are hierarchical (Williamson 2009). Every firm, no matter how egalitarian, has a ‘boss’; even in Koch’s (2007, 130, 133) market-based management some individuals have more ‘decision-rights’ than others. It is a common view that firms are hierarchical in order to facilitate the flow of ‘orders’ and ‘commands’; hierarchy is equated to authority which inevitably is exercised through commands or orders (Schlicht 1998, 220).
The essential nature of command in conventional theories of the firm is clear from Coase’s seminal essay on the firm: “… the distinguishing mark of the firm is the supersession of the price mechanism…” (Coase 1988, 36, 38); he goes on to give a command as an example of such a supersession: an employee moving from department Y to department X “because he is ordered to do so” (Coase 1988, 35). This view of firms as command led hierarchies is strongly held because it is so intuitive.
The purpose of this article is to challenge this view that command is essential to the nature of the firm, to argue that we have misunderstood hierarchy and that rule-following, i.e. uncommanded, behaviour, may be a more important coordination mechanism for intra-firm activities than is generally recognised.
The article is divided into four parts. The first part looks at the emerging literature on hierarchy in naturally occurring spontaneous orders. The second part looks at the Austrian literature on the firm and the role of ‘command’ and ‘rule following’ in that literature and shows how understanding hierarchy as a natural feature of spontaneous orders resolves some difficulties in that literature. The third part looks at the conventional literature on the firm where rule-following has been a feature but where there is still recourse to command as being viewed as the primary coordination mechanism. The fourth section of the article argues that intra-firm coordination through rule-following extends the problem-solving power of the extended market order and allows different firms to create value in the larger market order in different ways. The paper concludes by suggesting that the role of rule-following within the firm has been under-appreciated and under-privileged.
- Hierarchy is a feature of natural spontaneous orders—an unexpected development. One of the difficulties for Austrian theorists of the firm is a general belief that spontaneous rule-bound orders are not hierarchical (Pongracic 2009, 92). This is not necessarily correct.
It is now generally agreed that rules are the foundation of coordinated behavior in animals (Hayek 1967, 66; Miller 2010, 175; Quera, Beltran, and Dolado 2010). With no leaders or external factors, order can emerge naturally from independent agents following common rules, the classic example being Reynolds’s flocking ‘boids’ (Reynolds 1987; Miller 2010, 174). However, Reynold’s simple computer program, where ‘boids’ following simple rules (fly at the same velocity as nearby birds, stay close to nearby birds, but avoid collisions) resulted in flocking-like behavior, has in some ways led us astray. As has Hayek’s focus on spontaneous orders where unthinking objects, iron-filings etc., are the basis of spontaneous orders (Hayek 1973, 40, 43).
Recent research has shown that flocking and herding rules include taking cues from ‘leaders’ and decision-makers, such as more experienced homing pigeons (Flack et al. 2012). Leaders have been observed to emerge within flocks of pigeons: ‘we found that stable, hierarchical pattern of in-flight leadership does not build upon the stable hierarchical social dominance structure evident in the same birds. Instead, in the case of pigeon flocks, the emergence of leadership and dominance hierarchies are each affected by different factors. By ignoring social dominance when in flight, flocks of pigeons potentially make better navigational decisions because leadership can emerge from relevant attributes, such as local experience and route fidelity’ (Nagy et al. 2013). Even tiny stickleback fish exhibit differences in behavior which drives leadership which results in particular forms of emergent shoal behavior (Jolles et al. 2017).With an almost Austrian emphasis on the diversity of abilities, Jolles et al. write:In recent years it has become apparent that across a wide range of animal taxa, individuals commonly differ consistently from one another in their behaviour (‘animal personalities’), often with large fitness consequences and wide-ranging ecological and evolutionary implications. Such variations could provide a level of heterogeneity within animal groups that may drive collective behaviour. Indeed recent studies have started to provide support for that notion and have shown that consistent behavioural differences can influence leadership, social network structure, collective dynamics and group performance…. Relatively simple interaction rules play an important role in the emergence of collective behaviour…. (Jolles et al. 2017)
According to Biro, “every [homing] pigeon has their own opinion on how to get home” (Biro 2016). Every homing pigeon is obviously committed to getting home but they will be guided, to some degree, by more experienced pigeons, better navigators and, of course, staying in the flock has advantages that outweigh acceptable deviations from a preferred course home. But sometimes the leader is wrong and the other pigeons will ignore him or her (Watts et al. 2016). Further, the flock will not follow the same route home that the leader would follow if flying solo—showing that the leader is influenced by the flock (Pettit et al. 2015).
Hierarchy is also a natural feature of human spontaneous orders. In the market order, participants will be influenced by (or it could appear, “follow the commands” given by) other market participants like Warren Buffett. The anthropologist E.E. Evans-Pritchard described the Nuer in the Sudan in the 1930s; he noted that their society was extremely egalitarian but that forms of hierarchy also existed:
The ordered anarchy in which they live accords well with their character, for it is impossible to live among Nuer and conceive of rulers ruling over them.... Wealth makes no difference... Birth makes no difference... [But] The words of some elders count for more than the words of others... Leadership in a local community consists of an influential man deciding to do something and the people of other hamlets following suit at their convenience” (Evans-Pritchard 1940, 179–81).
Another example would be the common-law legal system, an example given by Hayek of a spontaneous order (Hayek 1973, 81, 86). Here, again, hierarchy naturally emerges, with judges making decisions at various levels until there was an ultimate arbiter at the apex of this hierarchy—a king, a group of bishops and now supreme courts.
It is therefore not inconsistent even with pure spontaneous orders for there to be a hierarchical element. This hierarchical element may also be a feature of the larger market order but in a much less visible way. We may not feel that Warren Buffett is our superior, but we may avidly read his annual letter to investors and follow his advice just the same; we may not have a ‘boss’ in our market based activities but we may be a slave of some market or trend influencer, the economics of Snapchat or Instagram may have made this much clearer to us all. This also makes clearer how entrepreneurs play a leadership role, in, in Kirzner’s phrase (p. 18), the “mutual learning” that is the essence of the market process.
Further, we embed ourselves in the rules of different rule-based orders all the time, as employees, as customers, as suppliers and owners. For example, we will behave quite differently in a fast-food restaurant than in a fancy expensive one; we would not dream of clearing our own table in a white-linen restaurant but would ‘automatically’ in a burger joint. This is not us accepting ‘commands’ from a hierarchy, we have not fleetingly become employees as we empty our tray, but evidence of our innate ability to switch from one set of rules to another usually without conscious effort. The maître d’ may tell us what wine goes with what dish but we do not follow his or her commands, we bow to his or her superior knowledge of fine dining.
This is not a command hierarchy; this is not a hierarchy with commands cascading down but individuals happy to be guided by the advice, decisions or actions of others, however, inarticulately barked out (Brady and Walsh 2008). This does not mean that individuals can not try to give a command, after all what is the point of humans being able to speak if we cannot shout instructions at each other? However, just because we can shout, does not necessarily mean that what we shout is an order or a command. As Mary Parker Follett put it: “I may say to an employee, ‘Do so and so,’ but I should say it only because we have both agreed, openly or tacitly, that that which I am ordering done is the best thing to be done. The order is then a symbol” (Follett 1941, 65)See Kline and Martin (1958) and Pongracic (2009, pp. 38, 39) for further examples. Kline and Martin (1958) is particularly interesting. Hayek quotes from it in The Constitution of Liberty (1960, 427, n. 10) but only in relation to the loss of knowledge in relation to command. He makes no reference to the article’s use of rules as the solution to the knowledge problem of authority. Indeed, it is not until the early 1960s that he publishes works specifically on rules and rule-following (outside of his prior interest in the rule of law) as decision and coordination mechanisms. The article may have been part, if uncited, of Hayek’s realization of rules and rule-following as the basis for the classification system articulated in The Sensory Order that was then recast in rule terms in his writings in the 1960s (Hayek 1967, 43ff; Caldwell 2004, 296, 306, 307). We can say the same of Coase’s seminal ‘order’ that an employee should move from Department X to Department Y: is that a command or merely an inarticulate expression of the rule, if there is not enough work in Department X at any particular point in time then go to Department Y?Once we see that hierarchy is not inconsistent with rule-following, our eyes are opened to the possibility that many ‘orders’ that cascade down that hierarchy may not be commands at all; many instructions that individuals consider to be commands may be merely the articulation of a rule. Simon’s (1991) example, “repair this hinge,” can be rearticulated as a rule, (“If a hinge is broken, repair it”) and a piece of information (“This hinge is broken”). Coase’s example of a command (Coase 1988, 35), an employee moving from department Y to department X “because he is ordered to do so,” can be reinterpreted as a rule: if Department Y is quiet then move to Department X (Schlicht 1998, 222). Therefore, when there is an articulation of a rule or a piece of information (“Repair that hinge!”) and the rule is followed, it can appear that this demonstrates the power of the command and of the commander. We recall that Hayek originally argued that very specific rules could end up being close (“shade gradually into”) to command (Hayek 1960, 114, 148; Vanberg 1994, 266, n. 14). However, while this might look like the position when a command is compared to an isolated application of a rule (repair that hinge!) that cannot be the case generally: even the most specific rule like “if a room is dark, turn on the light,” informs every situation where one is in a dark room and also allows for unexpected situations like there is no electricity and the light switch does not work and you could use your mobile phone as a light. This is completely different from a command: Turn on that light! This tells you nothing about any other room, any other light, or any other situation. You can disprove there is command in organizations by asking yourself if you told someone to move from Department Y to Department X and on some other day, when circumstances were similar, you saw the person in Department Y and they said they were only there because noone had told them to go to Department X. You would be annoyed. Why? If they failed to follow a clearly articulated rule you would be right to be annoyed; if they were waiting until someone told them what to do then you should congratulate them on their understanding of the theoretical basis of intra-firm coordination.
This insight, that hierarchy emerges naturally from rule-following within a group as individuals look to others with more experience, skills, more or better knowledge or information and better knowledge of the rules, has major implications for theories of the firm. Conventional theories of the firm are largely focused on this visible hierarchy and this has allowed them to starkly contrast the firm with the larger market order. Williamson in his Nobel Memorial Prize-winning speech made this point explicitly contrasting the hierarchical firm with “spontaneous adaptations” in the market (Williamson 2009). In conventional theories of the firm, individuals in authority do not, obviously, have coercive power—they cannot kill or imprison you if you do not follow orders. But they are thought to have power because leaders in organizations have control over the resources of the firm (Roberts 2004, 103). However, this argument is obviously circular and cannot explain how individuals lose power, how CEOs end up being sacked; in fact, Turner argues that causation is the exact opposite, individuals get control of resources because the group has conferred power on them (Turner 2005).
What we see when we look at our pigeons flying home is a powerful vindication of the early management theorist, Mary Parker Follett. Follett argued that there is no command within organization just individuals following the “law of the situation.” She wrote: “The leader gets an order followed first, because men do really want to do things in the right way and he can show them that way, and secondly, because he too is obeying” (Follett 1941, 276). This seems so counterintuitive when we look at leaders in organizations barking out orders. But when we look at our pigeons flying in a coordinate flock, we cannot hear any commands, we cannot see any gestures, no pigeon has control of resources or any property at all but we do see hierarchy and leadership. But if we have discounted hierarchy in natural spontaneous orders because the leadership is largely invisible, have we over-privileged hierarchy in firms where leadership seems so visible and where the ability to secure coordination through being able to give orders and commands seems so clear?
This focus on hierarchy and the logical flaws in coordination through command and orders has been central to a dispute within Austrian theorists of the firm. We will explore this next.
- The illusory conflict within Austrian theories of the firm. In this section, we look at Austrian, effectively Hayekian influenced, theories of the firm. Hayek’s starting point was to look at the difference between a command and a rule. A command “aims at a particular result or particular foreseen results, and together with the particular circumstances known to him who issues or receives the command will determine a particular action” (Hayek 1976, 14); a command, by definition, must not be in accordance with the rules, otherwise the ‘command’ is merely rule articulation. Coase’s example given above meets Hayek’s definition of command. Hayek contrasts a command with a rule. He suggests that a rule “merely states certain attributes which any such action ought to possess” (Hayek 1976, 14). For example: “If {condition/situation} A, do B” is a rule (Becker, 2004) as is “If A, B is forbidden.” The complexity of the rules is somewhat overlooked in the simplicity of each individual rule; if A do B but if A1 do B1 or if A2 then do B2 can often require quite subtle thinking as to discover the correct situation, the correct rule or priorities of rules and to articulate the rule or the consequent action (Hayek 1967, 57).
Hayek’s key insight into the knowledge problem of central planning (Hayek 1948, 33ff) was the starting point for much of his later work on how the market order solved this knowledge problem. As is well known, Hayek argued that rules and rule-following behavior provided for the solution; rules are used by individuals to make decisions despite their constitutional ignorance, and the larger market order is a spontaneous order created by individuals following common rules.
On the other hand, Hayek considered that organizations (taxis in Hayek’s phrasing), as opposed to markets (cosmos), were coordinated by commands, but that there was also a role for rule-following. However, Hayek said that these rules of organization were a particular type of rule—rules, allowing the organization member to use some element of their knowledge, for the performance of assigned tasks to fill in the gaps in commands (Hayek 1973, 49; Vanberg 1994, 114). Generally, Austrian students of the firm are now agreed that Hayek, who “had little interest in organizations” (Foss and Klein, 2013), made unnecessary distinctions (with the larger market order) when he argued that organizations had to have a concrete goalIn some cases at least it may be an example of the post hoc ergo propter hoc fallacy applied to the theory of the firm. Barnard, himself, gave an example of this in a letter of 6 January 1956 to Hayek:Based upon my experience and observation I had arrived at conclusions consistent with yours before I had read any of your work or had heard of Michael Polanyi whose analysis of the situation [in The Logic of Liberty], I think, is correct and very valuable, but it is not sufficient. It seems to me that one has to be able to explain the illusion of successful planning…. In this city [New York] and its environment, in which there are millions of telephones, it is possible with almost complete certainty to make anyone of millions of possible connections merely by dialling correctly. The extreme degree of coordination of electrical and mechanical details to make this possible is almost incredible and an enormous amount of engineering work has gone into it and there is a blue print for nearly inch of the property concerned. It certainly looks as if the system as a whole has been meticulously planned to be what it is [by the New York Telephone Company]. Yet, this is absolutely false, as a whole it never was and never could have been planned (Barnard, F.A. Hayek papers, 1956). (Vanberg 1994, 142) and where he argued that the rules were necessarily subordinate to the command in an organization—in fact the opposite may have to be true (Ioannidis 2003a).
Despite this, Austrian economists have sought to apply Hayek’s knowledge problem and its solution to internal coordination within the firm. And the more recent Austrian focus on entrepreneurship and uncertainty has given us real insight into the limitations in the knowledge of entrepreneurs and managers; there is a knowledge problem not just within the larger market order but also within firms. Ioannides writes: “….the promotion of the entrepreneur’s business conception requires the information absorption capacity, the creativity and the problem solving capability of firm members. All these capabilities presuppose that the individual member acts within a framework of sufficiently abstract rules … In other words, the firm cannot but, at the same time, must not operate on the basis of commands” (Ioannides 2003b). “Cognitive constraints prevent the entrepreneur, as much as anyone else, from imaging all possible moves that unfold in the future” (Witt 2007).
However, despite these commonalities in the Austrian literature on the firm, there are now two quite different lines of thought on the role of hierarchy in intra-firm coordination: one line, taking a realistic view of the internal workings of the firm, notes the universal existence of hierarchies within firms and argues that this must result for some role for ‘command’ within the firm (Foss and Klein, 2013); we can call this the ‘realism’ line of thought. The other line focuses on the knowledge problem in any kind of central direction and proposes market-process type solutions like rule-following; we can call this the ‘logical’ Austrian line of thinking on the firm (Langlois 1995).
The realism line argues that rule-following is an important coordination mechanism within the firm, but that this does not affect the essential role of authority, hierarchy (Sautet 2000, 98) and the ability to give ‘orders’ and ‘commands’: that managers can get things done by merely telling people to do it. This line in the literature argues that the role of rules fluctuates in line with the degree of uncertainty and the amount of knowledge of the employees that must be used—the paradigm example being a new entrepreneurial firm with knowledgeable employees and a boss with cognitive and knowledge limits (Ioannidis 2003a, Witt 2007).
But despite what should be a natural antipathy to ‘command’, the Austrian perspective on the firm constantly returns to the obvious existence of hierarchy and, as they take it, its inevitable consequent coordination mechanism: command. Foss and Klein argue that command is essential to firm purpose. While they note that “knowledge causes authority (as a centralized decision-making system) to fail in all its forms” (Grandori 2002) they also write that: “consistent (or heavy-handed) application of Hayek’s decentralized argument leads to an apparent absurdity: if decentralization always and everywhere improves the utilization of dispersed knowledge, it would be hard to find any rooms [sic] for firms, and certainly for contemporary mega-sized firms… Yet (large) firms exist” (Foss and Klein 2013). Pongracic makes the same point: “…it should be obvious that most successful firms engage in some form of command-and-control, hierarchical operations. It seems highly unlikely that all these multitudes of entrepreneurs have been doing it wrong all along!” (Pongracic, 2009, p. 43).
The overall result of this stream in the literature is that the business firm is a “hybrid Hayekian order” (Ioannidis 2003a)—partly coordinated by rules and partly by command (in Hayekian terminology, neither a ‘cosmos’ nor a ‘taxis’)—with the mechanism mix fluctuating from firm to firm. Unfortunately, and paradoxically, as Pongragic has noted (2009, 72ff), this point that firms do not or should not emulate the larger market order, has morphed into an Austrian emphasis on the importance of hierarchy, authority and command (Cowen and Parker 1997, 75).
The second line of thought, building up logically from Austrian insights into market processes, also looks to rule following but is more sceptical of the power or abilities of hierarchy. The most direct application of that thinking is to argue that markets should be brought within the firm to solve the inherent knowledge problem with intra-firm coordination (Cowen and Parker 1997, Koch 2007). But if the problem was that simple to solve, why would firms have emerged at all? And, sure enough, we find, within for example the Koch companies which apply this market-process approach, all kinds of rules, like formal “decision rights” (Koch 2007, 126), that do not exist in that way within the market order.
Langlois argues that firms cannot plan in the conventional sense but instead must emulate to some degree a spontaneous order (Langlois 1995). Langlois draws on business history to demonstrate that firms move, in some form of coordinated way, from business to business without, inevitably given cognitive constraints and uncertainty, having a clear idea what they are doing but still being able to do it. But Langlois’s solution of firms relying on abstract rules to navigate this uncertain future also resulted in Langlois being “sceptical of hierarchy.” More recently Bylund (2016) takes a similar market process approach and comes to an even stronger conclusion: “we commonly perceive the firm as a hierarchy and that we as employees ‘follow orders’ from higher-ups in the workplace. But this perception is unfounded…. There is no reason to perceive of the firm as a hierarchy. Indeed we find no basis for authority….” (Bylund 2016, 88, 95).
Emerging in the Austrian literature of the firm are two different approaches to the firm—the logical approach that relies on the market process and denies that an authority relationship can exist, or is even desirable, and a realism school that argues that hierarchies are an observable feature of firms and so must have some function.
However, it is possible to square this logical-realism circle. If we appreciate that hierarchy can be a feature of rule-following orders, in fact that hierarchy can emerge naturally within any group of sentient rule-following agents, then we can see how an Austrian focus on rules, rule-following, uncertainty and cognitive constraints can be consistent with hierarchy. Especially, when we appreciate Follett’s point that many articulated commands or orders may be merely rule articulation.
On the other hand there is no need for acute observers of the firm like Langlois, to be “sceptical” of authority or hierarchy. The power of a spontaneous order to deal with the Hayekian knowledge-problem is not diluted by a hierarchical element that, in fact, may be an emergent feature of all spontaneous orders created by sentient agents following common rules.
- Rules and conventional theories of the firm. This insight in allowing us to integrate the different schools with the Austrian literature on the firm, by allowing for hierarchy to emerge naturally as a consequence of rule-following, also allows us to integrate the Austrian focus on rule-following with the more conventional literature on the firm as well.
Rules have become more central in general discussions about decision-making. In Risk, Uncertainty and Profit, Frank Knight noted that we all act in an environment of change and uncertainty: the problem of life is that we know so little and yet we manage to act. He argued that the manager in a business firm solves this problem through a process of ‘trained instinct’, ‘judgment’ or ‘intuition’ (Knight, 1921, pp. 211, 223); in other words he knew these decisions were made but had very little idea how they were made. Modern research in psychology and economics on how individuals make decisions has given us insights into the foundation of that ‘intuition’. We now know that individuals make judgments and decisions, not by elaborately generating and ranking options, but by following ‘heuristics’ i.e. rules. It is clear that this is also true for decisions made within business organizations. According to Kahneman, ‘[w]hatever else it produces, an organization is a factory that manufactures judgments and decisions’ (Kahneman, 2011, p. 418).
So we would expect the entrepreneur to attempt to coordinate through rule-following; articulated as such or not. An example of one entrepreneur using rules is when Henry Ford started the process of creating his “universal car;” he was trying to coordinate the activities of a number of individuals but without being able to articulate any concrete objective: “The plan which I then had in the back of my head but to which were then [1904] not sufficiently advanced to give expression....” (Ford and Crowther 1923, 56, 57). But even at that early stage Ford could articulate clear rules, from which the design of his car, he hoped but could not be sure, would emerge: “The universal car had to have these attributes: (1) Quality in material to give service in use; (2) Simplicity in operation—because the masses are not mechanics; (3) Power in sufficient quantity… (4) Absolute reliability….”
However, these insights into the power of rule-following have been missed because the emphasis on rule-following in the conventional literature on the firm had a different starting point and so a different focus. Max Weber in his writings about bureaucracy, and the rules that bureaucrats followed, wrote about the “regular,” “stable,” “methodical” characteristics of the modern bureaucracy (Weber 1968, 956). This early focus on rules in organizational studies has skewed the understanding of rules and rule-following in organizational theory and economic theories of the firm which have become focused on rules in routine situations (Becker 2004, Nelson and Winter 1982); ‘rules’ became synonymous with ‘rigidity.’
However, despite the “tendency for authors to slide between ‘rules’ and ‘routines’” (Loasby 2000), rules, more recent studies have shown, can also guide decisions in non-routine, novel or uncertain situations also (Gigerenzer and Gassmaier 2011, Gigerenzer 2007, Klein 1998, March 1997). Again, the conventional view has been inverted—it is following rules that provides for flexibility and following commands that is necessarily rigid. That rule-following allows for fast decision-making and that these quick decisions can be useful is a new development (Kahneman 2011). Eisenhardt and Sull (2001) make the point that rules are an appropriate coordination mechanism in “rapidly changing, ambiguous markets” where strategies are “constantly evolving.” Looking at actual company strategies, and without referring to any underlying theory or to management history, the authors had noticed the pervasiveness of rules in strategy formulation, articulation, and coordination.What is less well-known is recourse by the military to similar rules-based instruction. Arrow argued that (Arrow 1974, 68): ‘The purest exemplar of the value of authority is the military.... Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success’ (p. 69). And that putting in place rules for every eventuality is “highly costly.” This is a point repeated most recently by Foss and Klein (2012, 216). Contrary to expectations, the military and other military-like organizations such as the fire services, police and coast guard, do not rely on command even in non-routine circumstances (Klein 1998); even though senior military figures have the ultimate coercive power to make their soldiers do exactly what they want, they do not use it. These are the orders that the great Prussian general Moltke made at the outset of Prussia’s war with Austria in 1866 to the commanders of Prussia’s First and Second Armies, who within weeks would crush the Austrian army between them:.... With regards to distance, road connections and railroad, the direction [i.e. not a specific location] of Gitschin has been designated for eventual junction of both armies. By this it is not of course meant that the point must be reached under any and all circumstances, because that will depend entirely on the course of events ... [However] the convergence of all our armies for the main decision must always be kept in view (Moltke 1993, 245). Moltke’s orders can be easily expressed as rules: if there is a choice over direction, then choose the direction of Gitschin; if there is a choice between convergence and divergence with the other Army, then choose convergence; if there is a choice between direction and convergence, then choose convergence. (Note how there is no concrete goal.) The German army’s Field Service Regulations, dating back at least as far as 1887 (Samuels 2013) are almost Hayekian: “Every individual from the highest commander to the lowest private must always remember that inaction and neglect of opportunities will warrant more severe censure than an error of judgement in the action taken” (Halder et al. 1953, 7, 8; Creveld 1982). Articulated orders in this system were designed to give context and decision support premises to each individual soldier, so that when faced with the unexpected they knew what to do in a way that was coordinated with the rest of the soldiers in the army (Bungay 2011). This is the basis of current US Army military doctrine (United States Command and General Staff College 2014, 54). In developing his theories Hayek himself may have drawn on his own military experience: “his experience of the retreat [with the Austrian Army from the Piave River in Italy in 1918] first got Hayek thinking about spontaneous orders—the soldiers had no central direction, yet the retreat was more or less orderly” (Caldwell 2004, 135 n. 3; Leube 2003). This, of course, we now realize does not mean that the groups of men and boys were without leadership, there must have been individuals who had more local knowledge, better ability to find food etc. who would have emerged in the retreat.
If we take these insights into rule-following within the firm and apply them to existing theories of the firm we can see that many are writing about rule-following but, as with Knight, are struggling to articulate their insights in a clear way. Many existing theories are based on rules and rule-following behavior: routines (which are just rules to deal with regularly occurring situations) (Becker 2004, Nelson and Winter 1982), capabilities (the ability to make superior coordinated decisions, i.e., rule-following) (Loasby 1998), contractual relationships (that is, rule-bound relationships) with incentives for and monitoring of adherence to the rules (Alchian and Demsetz 1972), even hierarchies and authority (Williamson 2009, Coase 1988) (See Walker [2015] for a useful review).
But each theory has to introduce an artificial element that could be seen to fall away if a greater emphasis was given to rule-following. For example, if we look at Alchian and Demsetz’s paper, their logic, as Austrian writers on the firm have repeatedly pointed out, is impeccable: the employment relationship is just another market transaction, the employer has no more ability to ‘command’ the employee than the customer his or her grocer. However, to give their insight more realism, the authors introduced a centralized element:
… a special class of contracts…. Instead of multilateral contracts among all the joint inputs’ owners, a central common party to a set of bilateral contracts facilitates efficient organization of the joint inguts [sic] in team production.... We conclude with a highly conjectural but possibly significant interpretation… the firm can be considered a privately owned market….
They talk of the firm as a form of “specialised surrogate for a market” at the center of a nexus of contractual relationships with the firm as the central contractual hub. Rearticulating that description of the firm as a unique rule-bound order, with employees committing to following the rules, and agreeing to being sanctioned or excluded if they fail to follow them, eliminates the cumbersome, and completely artificial, requirement to have a complex system of ever-changing contractual relationships with a legal fiction as nexus. The requirement is now merely to follow different rules to the larger market order. This goes to the core of their analogy between the employee/employer relationship and the customer/grocer: as you wander around the grocery store looking for tins of tuna, you do not have, yet, any contractual relationship with your grocer—you have a market order in which you both will follow rules and within which you can predict each other’s behavior. Similarly, within a firm, the employees do not need a contractual relationship with each other or with a common artificial nexus. All they need are common rules and a mutual commitment to follow them. At the same time, the emergent feature of hierarchy within rule-following orders allows us to answer the most common criticism of Alchian and Demsetz’s article that there is a hierarchy within the firm but none in the larger market order. As we have pointed out rule-following within the larger market order and identical coordination mechanisms within the firm may result in more visible hierarchies in the latter than in the former but the mechanism is still the same.
Alghion and Tirole (1997) give a realistic view of the firm where decisions are delegated but they can only see this delegation as involving “a costly loss of control for” the superior. And they have no mechanism to explain how delegated decision can be coordinated; they very much imply they cannot and so only “relatively unimportant” decisions can be delegated. Again, a rule-following perspective from the Austrian literature would show how delegation exists within a hierarchy, both the hierarchy and the delegation are natural consequences of rule following, and how rule-following results in actions that can still be controlled and coordinated even in urgent and unforeseen circumstances.
- Rules and ‘Culture’ Hayek’s work on rules was an early example of an increasing focus on rule following in human behavior and coordination. It has become clear that rules are central to all human activities. Dopfer writes that “Homo sapiens can thus be viewed more generally as a rule-making and rule-using animal” (Dopfer 2004). But rules and rule-following are especially important in institutional settings. Social institutions are “nothing more than agents rationally following rules of action, and being believed by other agents to do so” (Rowe 1989, 5). Other authors note the usefulness of rules in coordinating behavior generally (Heiner 1983) and specifically within firms (Grant 1996). However, in many ways the conventional literature on firms and management is merely catching up earlier theorists, like Follett, and practitioners, like Henry Ford.
A neglected subject, however, is the interaction of rules with ‘orders’ and ‘commands’ in an institutional setting. A command is, by definition (Hayek 1973, 97, 99; Vanberg 1994, 129; Polanyi 1951, 141; Hayek 1976, 20), outside of any rule-system. If we return to Coase’s example of a command: an employee is told to move from Department Y to Department X because “he is ordered to do so.” The employee must think: is this a command or a rule (Schlicht 1998, 232)? Do I go to Department X just this once or every time or times when the factual situation is similar (like there is no work to do in Department X)? Without such clarification, there is a risk that an employee mistakes a rule for a command or vice versa—i.e. repeatedly carrying out an action where the original instruction was actually a once-off command but the employee thought it was rule-articulation. This is not a source of error that is identified or discussed in the literature, or even much in real life. Why is that? Perhaps because rule following and its hierarchical consequences are more pervasive than we thought?
Chester Barnard noted an “authority paradox” within organizations: activity is coordinated within firms even though we do not do as we are told. In Barnard’s words, “It is surprising how much that in theory is authoritative, in the best of organizations lacks authority—or, in plain language, how generally orders are disobeyed” (1938, 161, 162). However, understanding rules as the coordination mechanism within the firm easily allows us to resolve this paradox, as Barnard did: ‘orders’ are not followed where they conflict with the rules (maybe the wrong rule was articulated or maybe circumstances have changed and a different rule should be applied now), and thus, despite orders being disobeyed there is no loss of coordination. In fact, coordination is sustained only because ‘orders’ are disobeyed and this is why, as Barnard pointed out, “…obvious disobedience [is] carefully disregarded” (p. 162).
This feature of corporate life, that things continue in their own way despite the frantic efforts of senior management, is often identified as ‘corporate culture’; Hayek defined ‘culture’ as “the rules of conduct which govern the structure and functioning” of groups of people (Hayek 1978, 156)—“the brain is an organ enabling us to absorb but not to design culture.” What is now clear to everyone is that every company has its own unique corporate culture; in Schlicht’s vivid phrase: “Anthropologists may travel from island to island and observe that each harbours people with a particular custom. It is not necessary to go that far away, however. In modern economics, each firm forms an island of custom in the ocean of the market” (Schlicht 1998, 207). And the number of potential islands appears to be almost infinite; Vanberg (1994, 78) points out: the “cultural rules … appear to be exceptionally variable and it is the variability of these rules that accounts for the diversity of social orders.” We can thus explain why there can be an infinite number of different ‘corporate cultures’ in the larger market order, but what is not so clear is: what problem is that solving and what value does a firm extract from having a different culture to every other firm?
In much of management literature this culture thwarts and frustrates the efforts of leaders and management; Roberts refers to it as an “inert” element (2004, 28). What is also clear is that this culture is not completely ‘created’ by the firm founder or leading entrepreneur; even in the smallest firms, of only two or three people, the founder can feel that “control… slips away” (Ruef 2010); as early as 1980 Apple was making decisions that Steve Wozniak, one of the founders, did not understand or “like one bit” (Wozniak and Smith 2006, 230). A firm is not a “designed order;” as Ruef has pointed out: “Entrepreneurs… are defined by their intention to form a social group” (Ruef 2010, 7). Any social group is beyond the ability of any one person to create or concretely manipulate (Hayek 1952, 71).
The firm retains coordination, despite ‘orders’ being disobeyed and despite control, even knowledge of the current rules, slipping away from the founders, because the rules of the order are being adhered to—or as it is put colloquially, “culture eats strategy for breakfast”! (Groysberg, Price, Lee, and Cheng 2018).
However, the purpose of this article is to argue that this culture is not a by-product or even an unfortunate complication of firm creation but instead may be regarded as the essence of the firm—the rule-bound order, the ‘culture’ in other words, is the firm and that those rules, that culture, is different from every other firm is both inevitable and potentially valuable. The basic premise of anthropology is that every culture sees the world in a different way; in the words of Engelke, anthropology is “a way of seeing things, a way of thinking. Culture is a way of making sense” (Engelke 2017, 31, 32). Within organizations, culture has been defined as having a coordination role: the “social or normative glue that holds an organization together” (Smircich 1983), and a decision-making role, as Casson has pointed out: “’Learning by doing’ is an important aspect of problem solving and so learning effects will give each culture a distinctive type of problem-solving expertise” (Casson 1995, 89). In other words, we have described rules following in terms of ‘If A, then B’ but the rules also tell you which ‘A’ to pay attention to in the infinite number of potential problems that might be solved.
Perhaps an example may help. Steve Wozniak designed the Apple I and the Apple II and was clear on this from the start that he wanted to build a cheap computer. He worked as an employee of HP when he designed those computers—yet he did not feel he was competing with HP’s personal computer “[i]t wasn’t like ours—it was aimed at scientists and engineers and it was really expensive…. How could HP [build a cheap computer]? It couldn’t” (Wozniak and Smith 2006, 175, 176). He founded Apple Computers in 1975 with Steve Jobs and Ron Wayne and but even Wozniak initially thought of his machine of hobbyists and not for “regular people in regular homes”—this came later (p. 197).
In late 1979 Steve Jobs was given access to the Xerox research center, PARC. During that tour, an engineer, Larry Tesler, gave him a demonstration of a ‘mouse’ and a graphical user interface. Malcolm Gladwell describes what happened: “Tesler recalled. “He was very excited. Then, when he began seeing the things I could do onscreen, he watched for about a minute and started jumping around the room, shouting, ‘Why aren’t you doing anything with this? This is the greatest thing. This is revolutionary!’” (Gladwell 2011). It is one of the most celebrated moments in modern business history and Xerox is widely derided for not having exploited this intellectual property and instead, effectively, giving it away to Apple. But, as Gladwell points out, Xerox and Apple saw the problem in different ways: “PARC was building a personal computer. Apple wanted to build a popular computer.”
What was obvious to Jobs and employees in Apple was not at all obvious to employees in Xerox or HP; as Yu points out rules facilitate decision-making by limiting our choices (Yu 2005, 9)—for Xerox or HP, building a consumer or popular product was not within its realm of choices. For an employee in Xerox, focused on business customers, a mouse was a way of making technicians more efficient; for Jobs and other individuals in Apple it was a way of making everyone a computer technician; the same A but for Apple—If A then B and for Xerox If A then C. Apple in 2018 reached a market value of over $1 trillion but Xerox still has a market capitalization of over $6 billion; with different rules Xerox might have a different market capitalization, but the service it currently provides in the larger market order would not be provided in the same way, if at all. Seen in this light, we can see how the larger market order expands its problem-solving abilities as different rule-bound orders are created within it and how these rule-bound orders create value for customers, employees and investors. The rule in the market order may be: If A then B; the rule in other orders may be: If A then C, D, E, etc. It may be that the market throws up numerous failed orders before we get to set of rules that provide: If A then Z; this then solves a problem in a way that customers really appreciate and will pay for.
- Tentative conclusions In this article we have repeated the, now commonplace, assertion that rule-following behavior occurs within organizations in both routine and non-routine, even unforeseen, situations. More novel, we have shown that the existence of rules and rule-following behavior can co-exist with hierarchy; that hierarchy can emerge naturally in groups following common rules.This may also allow us to take a further step to resolving a controversy between Hayek and some of his critics. Both Rothbard (2009, 62) and Bruno Leoni (Leoni 1961, 99, 110; Hayek 1973, 168) criticized Hayek for his failure to distinguish between rules voluntarily committed to and rules imposed by a coercive authority. The conventional economic view has been to use the firm as an exemplar of the power of ‘command’—perhaps the exact opposite is the case? If this were correct, the apparent tremendously effective coordinating power of ‘command’ in the firm would be seen as something different and there would be a different focus on the power of voluntary coordination in the larger market order. Or as Mary Parker Follett wrote of her insights into the law of the situation: “This gives, does it not, a slightly different aspect to the whole of business administration through the entire plant?” (Follett 1941, 59) This may allow for a greater role for rule-following within the firm. However, nothing in this theory prevents firms from having a dual nature, being coordinated by command as well rule-following; a hierarchy, once in place, may achieve coordination using many different mechanisms—commands, goals, rules.
Beyond Hayek’s insight into the division of knowledge in the larger market order and, by implication, within firms, Austrian insights into the firm have been relatively limited. It is submitted that this is because Austrian theorists of the firm have, following Hayek’s lead, conflated hierarchy with coordination by ‘command.’ This has led some Austrian theorists to dismiss hierarchy and others to under-privilege rule-following. The purpose of this article has been to attempt to return Austrian theories of the firm to a realistic, hierarchical, but rule-based theory of the firm.
It may be that Hayek’s core insights into the tremendous power of spontaneous orders and rule-following may have more general application than he envisaged.Chester Barnard wrote to Mary Niles in a letter of 13 August 1956 after he had read her The Essence of Management:I note one omission that surprises me. I did not find any quotation from Michael Polanyi nor is his name listed in the index, nor his writings in the bibliography. I think that his book The Logic of Liberty is one of the most important contributions to the theory of organization and management that I know, particularly relating to the limitations of the span of control and the necessity for autonomous behaviour in most organizations. If you don’t know the book I can certainly recommend it most highly.’ (Barnard 1956) These late letters of Chester Barnard, to Hayek, Polanyi, de Jouvenal, etc., essentially restating firms as Polanyi-ish spontaneous orders are a hitherto un-investigated alternative to the Williamson explicit contrast between Barnardian hierarchical firms and Hayekian spontaneous orders (Williamson 2009). If so, Austrian insights into entrepreneurship, coordination and knowledge, have been under-appreciated in the conventional literature on the firm and management theory and practice.
Quarterly Journal of Austrian Economics 22, no. 2 (Summe 2019) full issue. ABSTRACT: This paper discusses the epistemological status and potential scope of the discipline of sociology based on the writings of Ludwig von Mises. More specifically, it presents his epistemological distinction between theory and history, and argues that sociology can be integrated in this framework as a historical discipline. As such, it must be a praxeologically guided study of general or specific social phenomena that already occurred or are likely to occur. Additionally, this paper addresses the general insights provided by Mises to questions of interest to the field of sociology—the division of labor and the evolution of society, the social effects of socialism and capitalism, class analysis, and the role of ideas in social change—in order to infer from it the general tasks that sociology, as a historical discipline, can accomplish in its study of social phenomena.
praxeology — history — epistemology — mises — sociology JEL Classifications: B53, Y80 Ludwig von Mises’s contributions to economics are widely known. For instance, his application of Carl Menger’s subjective theory of value to money (Mises [1912] 1953), his description of the necessary economic failure of any socialist regime (Mises [1920] 1963; [1922] 1951), and his reconstruction of economics as a theory of human action (Mises [1949] 1998) all stand as important contributions to the development of Austrian economics. But Mises was more than an economist; he was also a philosopher and sociologist. However, many of his insights to these fields of study are less well known. There is the work of Salerno (1990), which identifies reason, ideology, and the division of labor as the main vectors for social change in the Misesian interpretation of history. There is also the more recent comparison between the social rationalism of Mises and that of the French Idéologue Destutt de Tracy by Dorobăţ (2015), as well as a comparison between the social theories of Mises and of French sociologist Raymond Boudon by Fillieule (2014). Finally, we can find studies in which Mises’s work is compared to Max Weber’s work (Schütz 1967; Boettke and Storr 2002; Anderson 2004; Callahan 2007; Zafirovski 2010). However, there still lacks a more general analysis linking Mises’s epistemology with his answers to the particular questions sociologists have attempted to address. This general analysis will allow us to see the extent to which the study of Mises’s work can help sociologists understand the social world.
This article is therefore guided by two different but interconnected goals. In the first section of this paper, I want to explain how sociology can be understood in light of Mises’s general epistemological distinction between theory and history. Second, I want to present an outline of the general answers he provided to some of the most important questions that sociologists sought to address. From this, it will become possible to understand how a Misesian sociological investigation can be conducted.
- ON SOCIAL THEORY AND HISTORY Ludwig von Mises’s distinction between theory and history is perhaps one of his most general and useful epistemological insights. In short, theory constitutes the set of all praxeological categories (and a priori laws) framing our knowledge whereas history constitutes the description and analysis of particular or general empirical events or trends (Mises 1962, 44–6).
Theory and history are complementary. Indeed, Mises writes: “The fullness of reality can be mentally mastered only by a mind resorting both to the conception of praxeology and to the understanding of history” (Mises [1949] 1998, 642–43). Without theory, social scientists cannot meaningfully grasp and understand the empirical data of historyOn the necessity of conceiving empirical knowledge as being praxeologically framed, see Hoppe (1995, 69–70).; without history, they are condemned to know what limits their knowledge of the social world without ever using (applying) those limits to understand specific empirical events. In other words, theory (praxeology) provides boundaries to the set of possible interpretations about historical (empirical) reality. One cannot make sense of history if one does not know how to frame one’s interpretations.On the necessity of a “common ground” to determine the validity or possibility of a claim or interpretation and, in particular, on praxeology as such a common ground, see Hoppe (1989). As Mises (1962, 2) puts it: “For epistemology there is something that it must take as unchanging, viz., the logical and praxeological structure of the human mind.” Indeed, “knowledge is a tool of action. Its function is to advise man how to proceed in his endeavors to remove uneasiness.” And “the pure search for knowledge, not motivated by the desire to improve the external conditions of life, is also an action, i.e., an effort to attain a more desirable state of affairs.” (Mises 1962, 35). Praxeology therefore provides the conditions of possibility of the understanding of history: “Experience concerning human action,” Mises writes, “presupposes the category of human action and all that derives from it. If one does not refer to the system of the praxeological a priori, one must not and cannot talk of action” (Mises 1962, 42). Also, “Understanding presupposes and implies the logical structure of the human mind with all the a priori categories.” (Mises 1962, 48).
As Hoppe (1995, 20, 81) indicates, following Mises, it is because action is both a mental and an external process that one can acquire theoretical (a priori) knowledge about what frames historical (empirical) understanding.The same applies for predictions about future empirical events. See Hoppe (1995, 43-46, 81; 1997). Mises (1962, 42) indeed writes: “Both, a priori thinking and reasoning on the one hand and human action on the other, are the manifestations of the human mind. […] Reason and action are congeneric and homogeneous, two aspects of the same phenomenon.” Indeed, action is external behavior guided by thinking and reasoning; and the structure of action is discoverable through thinking about action. It thus frames its real—external—manifestations and, thereby, also frames thoughts about these external manifestations. Historical data provide a record of these empirical events whereas praxeological concepts provide the boundaries within which one can think about what caused these external manifestations. And the usefulness of these concepts depends on the extent to which they allow us to understand real actions. For instance, the praxeological law according to which every voluntary exchange is mutually beneficial is only useful to our knowledge if in history there was indeed (or we expect that there will be in the future) actors proceeding to what we know to be a voluntary exchange. There would be no need for a theory of exchange if we lived in a world where no exchange ever occurs. Theory must thus address, frame, and impose limits on the understanding of phenomena that occurred (or are likely to occur) in order to be useful (Mises 1962, 41).
With this in mind, it is possible to address the question of the epistemological status of sociology according to Mises.
1.1 Theory, History, and the Epistemological Status of Sociology
Other than the quite trivial claim that sociology is the study of society, there is no epistemological consensus on what sociology is and on how it should be studied. In particular, over the past few decades, the discipline has mostly become, to borrow the words of Anderson (2000, 77), a research program that “openly assumes an ideological tone palatable to only the most liberal of scholars or ignorant of laymen.” But Mises—although it is safe to assume that he would have been vigorously opposed to the epistemological status (or lack thereof) that is assigned to sociology by the current postmodern and neo-Marxist sociologists—died before he could have been aware that such research programs constituted any threat to the social sciences. However, he often discussed the sociology of many of the founders of the discipline such as that of Auguste Comte, Émile Durkheim, and, in much greater length, of Max Weber. In short, there are three meanings of the term “sociology” that were addressed by Mises: 1) sociology as praxeology, 2) holistic sociology (Comte, Durkheim), and 3) interpretive sociology (Weber). It is by analyzing what Mises had to say about each one of these meanings that we will be able to understand whether he considered sociology as a theoretical or a historical discipline.
Mises himself first termed “sociology” the theoretical science of human action. But he later deemed this to be a mistake, and changed the name of this science to “praxeology.” The reason for this was that the name sociology became widely used in a different sense than that used by Mises (Hülsmann 2007, 720). Sociology, Mises tells us—referring in particular to Weber’s work—is practiced as a discipline of descriptive or general history (Mises [1949] 1998, 30 n.1), not as the theoretical study of the logic of action. In his Memoirs, he wrote:
[…] I made the mistake of using the term “sociology” to designate the theory of human action. I should have used the term “praxeology.” That which one generally calls sociology today is not theoretical, but historical knowledge. Max Weber was quite right in describing what he saw to be sociology in terms of the humanities. He observed that this was the sociology that worked with the formation of ideal types. His error lay in assigning to it many praxeological elements and in seeing economics as a field serviced by the intellectual methods of understanding. My essay [“Sociology and History”] was primarily directed against Max Weber’s epistemology, about which I raised two objections: its failure to comprehend the epistemological characteristics of economics, and its distinction between rational actions and actions oriented otherwise. (Mises 2009, 106–07).
We will discuss in greater details the sociology of Weber later on. Suffice it to say here that the meaning of sociology as praxeology has been abandoned by Mises, and that, therefore, each time he refers to the term “sociology” in his earlier work (up to his 1929 essay “Sociology and History”), he refers to something quite distinct from what Weber (and many others) meant by the term.
The second meaning of the term that was addressed by Mises is the holistic sociologies of Comte and Durkheim. To say the least, he did not consider them to be very promising. The research program of Comte—the attempt to reproduce the methods of the natural sciences to the study of the social world (earlier called physique sociale), which then becomes an analysis of the necessary stages of human history (human “progress”) allowing us to predict the future evolution of society (Comte 1839, 450–70)—is characterized by Mises ([1957] 2007, 241) as “so shallow and impractical that no serious attempt was ever made to realize it.” That of Durkheim and the Durkheimians—a study of the social world that assigns to society the status of an acting entity which imposes its will on the individuals (Durkheim [1895] 1982)—is described as the unsatisfactory result of “arbitrary metaphysical effusions about the recondite meaning and end of the historical process [...]” (Mises [1957] 2007, 242) Sociology is then—in the senses given by Comte, Durkheim, and their followers—not a legitimate field of study, and we cannot, therefore, pass judgment about its epistemological status; it simply does not convey any useful knowledge other than by mere accident.
The third meaning of the term addressed by Mises—Weberian sociology—is worth discussing in more details. On the links between the Misesian epistemology and Weber’s work, scholars such as Zafirovski (2010)One can also find similar claims in Lachmann (1990). have argued that Mises’s praxeology is in fact identical or quasi-identical with what Weber termed sociology; it is merely “the Austrian school’s version of, alternative to, or different name for, sociology in Max Weber’s sense.” (Zafirovski 2010, 76) Although this can already be rejected based on the evidence provided earlier, we should nonetheless address the specific arguments that are supposed to support such a claim.
To provide evidence for this claim, Zafirovski first quotes Mises when he writes that “[sociology] promised to substitute true science for the rubbish and empty gossiping of the historians in developing an aposteriori science of ‘social laws’ to be derived from historical experience.” (Mises [1957] 2007, 308). Zafirovski (2010, 83) then adds that Mises thought of praxeology as being this “true science.” Combined with the fact that Mises elsewhere indicates a correspondence between general sociology and Weberian sociology, this is supposed to imply that the terms “praxeology” and “Weberian sociology” are interchangeable. However, Zafirovski’s argument completely ignores what Mises wrote in the following paragraph of the same page, that is: “Their interpretations [that of the sociologists, including Weber] were in many regards unsatisfactory. They were deluded by many of the fundamental errors of historicism. All but Collingwood failed entirely to recognize the unique epistemological character of economics.” (Mises [1957] 2007, 308). In other words, their contributions to history notwithstanding, they failed to understand that history and sociology must be framed by praxeology (and, in particular, economics) in order to provide correct interpretations of empirical reality. The science of praxeology must thus be recognized as epistemologically distinct from history and Weberian sociology. This, in addition to Mises’s explicit rejection of Weberian sociology as theoretical in his Memoirs, is enough evidence to understand that the terms “praxeology” and “Weberian sociology” are not interchangeable.The confusion may lie in the previously mentioned fact that Mises used to term “sociology” what he then decided to call “praxeology” and on the other fact that Mises was appreciative of Weber’s work. This confusion is especially apparent throughout Zafirovski’s paper. After wrongly indicating that praxeology and Weberian sociology are identical or quasi-identical, he attempts to distinguish it from history in order to give to Weberian sociology the epistemological status of theory. To do so, he often cites Mises’s books Socialism and Epistemological Problems of Economics and the distinction between “sociology” and history that is presented in it (2010, 77, 82, 84–5). But this is an error of anachronism; the content of these books was written in the 1920s when Mises attempted to name “sociology” the general science of human action. As we have seen, Mises later distinguished sociology (including Weberian sociology) from this science. Weberian sociology is recognized as useful by Mises, but as a historical discipline and not as a theoretical one.
This terminological issue has implications about the way in which one is to understand the Misesian epistemology. For if the view of praxeology as sociology prevails, then one has to ignore or dilute Mises’s distinction between theory and history. Indeed, if Weberian sociology is identical to Misesian praxeology (or if there exists a mere difference in degree between them), there is no point in distinguishing between what would then be a quite trivial variation in method, i.e., between the analysis of history through the use of more general ideal types and through the use of less general ideal types.This is what Alfred Schütz (1967) attempted to do. Schütz’s conception of the ideal type is distinct from that of Weber in at least one major aspect. It takes into account the manner in which we choose the main characteristics to construct it. For Schütz, then, the “ideal types” of “pure economic theory” are constructed based on the universal invariants of human action (they have the highest possible degree of “anonymity”) and constitute, as such, necessary truths about action (244). In this sense, there should remain a distinction between the theorems of praxeology and the extra tools used in historical and sociological understanding. The problem is that by subsuming both under the concept of “ideal types” one can easily be confused as to whether there exists an epistemological distinction between the study of theory and that of history. Schütz himself, although agreeing with Mises on the universality of economic theory, seems to have failed to recognize its aprioristic and non-hypothetical character (Kurrild-Klitgaard 2001, 127–28), which therefore requires different tools of analysis than the a posteriori and hypothetical study of history. A similar—but even more problematic—confusion appears in Lavoie (1986), where it is argued that Mises did not really wish to “dichotomize” theory and history (194) since he thought both were complementary. This is a strange argument for 1) a dichotomy does not imply, as Block (1989, 219–20) correctly pointed out, an absence of complementarity, and 2) Mises was quite emphatic, as has already been shown, in claiming that such a dichotomy exists. The point of the Misesian distinction is precisely that the laws of action constitute necessary transhistorical knowledge about the social world whereas the additional tools of historical analysis are temporary, hypothetical (albeit often useful) constructions.
Indeed, praxeology provides us with a corpus of apodictic, non-hypothetical statements about human action and its logical consequences. True enough, this is often insufficient in order to study in depth an empirical event or trend. A historian or sociologist can then use additional tools or constructions to grasp the social world insofar as these tools do not lead him to reach any conclusion that enters in contradiction with praxeological laws (Mises [1949] 1998, 61). But it is clear that Weberian sociology and the study of history through the construction of temporary and hypothetical ideal types are fundamentally distinct from praxeology.
Now, keeping this in mind, there is no question that Mises was influenced by Weber. The question is: how? And the answer must be, in light of all the evidence, that Weber influenced Mises in his understanding of the proper methods for general historical studies. For, according to the Misesian framework, the Weberian method of sociological inquiry is indeed a useful and appropriate one in the study of history. It considers individuality and rationality as the central points of the understanding of social phenomena, as Mises (1962, 45–6) insisted it should. It tries to discover the commonalities and distinctions between various individuals or the reaction of individuals to various social contexts and organizes them into ideal types. In brief, it attempts to attribute a meaning to a historical event or trend. As such, from the point of view of Mises’s epistemology, ideal types constitute additional hypothetical tools for the understanding of history (Mises [1949] 1998, 60).
In light of all this, then, what is the epistemological status of sociology according to Mises? The methods of holistic sociology do not contribute to our knowledge; no epistemological status can thus be assigned to it. Weberian sociology, however, is acceptable when properly understood. This type of sociological research is a part of historical and thymologicalThymology refers to the study of the cognitive origins (or formation) of those elements that motivate action (values, beliefs, ideas, thoughts). See Mises ([1957] 2005, 271–72; 1962, 46–51). French sociologist Raymond Boudon (2003) refined Weber’s methods for the study of social phenomena by providing a typology for the rationality of beliefs and values (instrumental, axiological, and cognitive) which one can use in order to understand historical events or trends. This can be seen as an attempt to systematize the historical (thymological) study of values, ideas, and knowledge leading to action. studies aimed at providing an understanding of social phenomena. Thus, the epistemological status of sociology is that of general historical analysis such as what a properly understood Weberian sociology envisioned. As such, it must be based on ideal types, methodological individualism, and the actor’s rationality.
1.2. On Methodological Individualism and Rationality
The absence of methodological cohesion within the sociological profession is one of the key features characterizing the main debates in the discipline. Turner (2001, 3–4) has identified the problem as being a “micro-macro” problem, or an “agency-structure” problem. In short, the methodological debate is about whether social phenomena can be understood as the result of social forces constraining the individual (social structures determine the phenomena) or as the result of individual actions. If social structures are what determine the emergence of social phenomena, then methodological holism (social facts are considered real independent entities influencing one another) would be the correct method to understand the social world, whereas if we can only reconstruct social phenomena through individual actions, then methodological individualism would be the correct method to understand society.There exists a variety of solutions suggested to resolve the micro-macro problem. Turner and Boyns (2001, 354) identify eight solutions (ranging from what they call “microchauvinism” to “macrochauvinism,” and including many midway solutions). Turner’s own solution “involves recognizing that social reality does indeed unfold along micro, meso, and macro dimensions; that each of these levels reveals its own emergent properties; that these properties are driven by forces distinctive to each level; that theory is to be about the dynamics of the forces operating at each level; and that theoretical integration will always be about how the properties of one level load the values for the unique forces operating at other levels.” (Turner 2001, 6). But this heterogeneity in properties based on the level of analysis can only be considered as heuristically useful, depending on the question asked. It may be admitted that for the mere purpose of describing structural changes then it is sufficient to look at how two structures change together. But to explain it requires that we go deeper. One can describe how the state grows as a result of changes in the structure of central banking, but one certainly does not explain why the structure of central banking changed in the first place or why there would be a causal link simply by doing so. This would require an investigation of typical individual motivations and actions. And surely, if one can only explain macro phenomena by reducing them to (micro) individual actions and motivations, then the macro level is not, ultimately, a completely distinct realm of analysis. Tobe sure, how a structure (macro phenomenon) emerged is not always relevant to the question asked. Only in this sense is it permissible to argue that structures “constrain” the individual. But these structures, as Mises ([1922] 1951, 315; [1957] 2007, 326) argued—and Turner and Boyns (2001, 361) seem to agree—do not render deterministic explanations; and one must, therefore, still look at typical individual characteristics in order to understand how and why the structure impacted individual thoughts and actions leading to the social phenomena of interest.
It is quite clear that, for Mises, every historical (and therefore sociological) analysis must use methodological individualism. Every action is individual action, and its meaning must be thought as individual meaning (Mises 1962, 43–4). This does not imply, of course, that the individual is by necessity “temporally prior” to the collectivity or to various social structures. There exists a multitude of different collectives (built around different goals) to which individuals adhere (Mises [1949] 1998, 42–3). But one must keep in mind that “A collective operates always through the intermediary of one or several individuals […]” (Ibid.) It is thus only metaphorically that one can attribute an action to a social group: “society itself is neither a substance, nor a power, nor an acting being.” (Mises 1962, 78). Such metaphors are often useful. But a scientific analysis may fall into error if it fails to realize that they are indeed mere metaphors.
Weber and Weberians such as sociologist Raymond Boudon understood this. For Boudon, the individual is the ultimate origin of social explanation (Boudon 2010, 16, 27). To both Mises and Boudon, it is only possible to understand a “macrosocial” phenomenon by considering it as the result of a multitude of particular actions and by assembling these particular actions “step by step, part by part.” (Mises [1949] 1998, 46). This is what Mises called “methodological singularism.” It is only by understanding smaller, singular, phenomena that we can understand larger, more complex ones. Likewise, Boudon argued that it is necessary to aggregate typical micro-sociological facts in order to make sense of macrosocial data (Boudon 1986, 16). The macro data can only be heuristically useful in the formulation of enigmas and of hypotheses of investigation (Boudon 1986, 313 n. 11). A cathedral, to adapt one of Mises’s examples, provides an enigma: why was it built?; how was it built?; etc. This “macro” datum requires an explanation; we wish to understand something about the processes that made this achievement possible. But, as Mises pointed out, understanding it requires that we reconstruct the actions of the various individuals involved in the project of building this cathedral (Mises [1949] 1998, 45). In the words of Mises: “In studying the actions of individuals, we learn also everything about the collectives and society. For the collective has no existence and reality but in the action of individuals. It comes into existence by ideas that move individuals to behave as members of a definite group and goes out of existence when the persuasive power of these ideas subsides. The only way to a cognition of collectives is the analysis of the conduct of its members.” (Mises 1962, 81).
Such an analysis presupposes that we understand acting men as rational men. They have reasons to think what they think and to do what they do. Every action, according to Mises, is necessarily rational in that it always follows a process of thought about the adequation of means towards the achievement of ends. Although Weber allowed, in his typology of social actions, for actions non-rationally oriented (Weber [1922] 1978, 24–5), Weberians such as Boudon have argued that an action can be thus classified only “residually,” that is, when it is impossible to understand an action in another way than by classifying it as a result of “impulses” (Boudon 1986, 294 n. 14). To Mises, these “actions” are, of course, mere behaviors. But since Boudon insists on the residual classification of such “actions,” there is usually no major contradiction between his and Mises’s methods of understanding.
If it is quite clear, then, that—according to the Misesian framework—Weberian sociology proceeds to analyze historical social phenomena in a satisfactory manner, it is not the case for sociologists that deny the validity of methodological individualism and rationalism. For instance, Durkheim’s method of using aggregated statistical data or legal codes in order to explain collective phenomena (explaining “social facts” by other, temporally prior or concomitant, “social facts”)—his methodological holism (see Durkheim [1895] 1982, 162)—presupposes action without properly taking it into account, and is therefore inadequate to provide any explanation at all. It is not “society” that imposes its “will” to the individuals, as Durkheim would have it, thereby allowing for a methodology that merely attempts to describe how an aggregate phenomenon Y followed another aggregate phenomenon X and that somehow pretends to have thus provided an explanation of Y. This method simply cannot provide any explanation of Y, for it is only a study of individual actions reconstructing phenomena X and Y that can help us elucidate questions such as: why was X followed by Y?; must X necessarily be always followed by Y?; and so forth.
- TOPICS OF SOCIOLOGY Rationality and individuality, then, are at the center of Mises’s analysis of social evolution and devolution. Societies improve or decline based on the degree to which the individuals that compose them understand the benefits of increasing the division of labor.
Praxeology alone can teach us that increasing the division of labor is a process which allows for the maintenance and increase of material standards of living. But to claim that this process constitutes an improvement presupposes that we accept a few empirical assumptions. First, it must be accepted that individual actors generally seek to increase their material conditions of living (Mises [1949] 1998, 180). Indeed, if this were not the case, one could not talk of social progress when labor is further divided. Second, it must be accepted that these same actors tend to have a relatively low time preference, i.e., they do not seek to quickly, and for a short period of time, increase these standards of living at the cost of their long-run standards of living. For if this were not accepted, a society where there is just enough division of labor to have some wealth and where it is possible to fight and steal would still allow many individuals to improve their material wealth in the short-run while sacrificing the long-run process which allows material wealth to grow. Once these hypotheses are accepted, it is possible to better understand Mises’s analyses of how societies emerge, grow, and fall. The following section will contrast Mises’s social analyses to that of some of the major figures of early sociology and derive from them the distinct, praxeologically guided, sociology of Ludwig von Mises.
2.1. Division of Labor and the Emergence of Society
The question of the link between division of labor and the evolution of societies has been studied in depth by many sociologists. For instance, French sociologist Émile Durkheim argued that division of labor is the outcome—not the cause—of social development. Indeed, Durkheim criticized Herbert Spencer and the economists for their alleged failure to provide a rigorous explanation of the causes of division of labor. He accuses them of presenting a simplistic explanation, i.e., an explanation according to which isolated individuals suddenly recognize the productive advantage that it implies and that dividing labor will therefore make them happier (Durkheim [1893] 2013, 212).
His argument against this doctrine is, briefly put, that since division of labor has no known limit, if Spencer and the economists were right, then there would be also no known limit to happiness. But the science of psychology indicates that happiness is limited. Therefore, Spencer and the economists failed to explain why we still divide labor further (Durkheim [1893] 2013, 214–15). For Durkheim, the cause of the extension or intensification of the division of labor must thus lie outside of the individual. He finds it in the increases in the volume and density of the population (244). The increases in volume and density imply a larger market, which creates new needs, but also an increase in competition that forces the weaker members of society to specialize in order to survive (251–52). In other words, it is the “struggle to survive”It is unclear if Durkheim employed the terms “struggle to survive” in the usual sense of fighting for scarce resources or in the confused sense of competing for them (or if he subsumed both under the same category). There is, however, a clear distinction between fighting and competing in that the latter allows for the allocation of scarce resources to those who are inclined to provide consumer goods that are more highly valued, whereas the former seeks to deprive others of what they have. See Mises ([1922] 1951, 320–21; 1962, 88). that “forces” an expansion of the division of labor (248).This argument was supposed to contradict Spencer’s description of the extension of the division of labor. However, as noted by Perrin (1995, 793–94), Spencer did consider the influence of population pressures as one of the causes of the extension of the division of labor. For Durkheim, then, division of labor is a consequence of society rather than a cause (241).This theory is not completely shared by other sociologists. See for instance Georg Simmel ([1900] 1978, 175), who argues that social bonds and societies emerged from exchanges. It is imposed on the individual actors rather than chosen willingly as a means to prosper.
But these forces are not as “external” to the individual as Durkheim would like them to be. True enough, changes in man’s social environment can become problematic. An increase in scarcity (which can indeed be affected by population pressures) decreases the output per capita. This is the Malthusian law of population. But this in no way forces society to divide labor in the same sense that the law of gravitation forces earthly objects to fall when thrown.Durkheim indeed thought that his theory has the same status in the social world as the law of gravitation has in the natural world. See Durkheim ([1893] 2013, 330 n.1). Rather, as Mises ([1922] 1951, 293 n.1, 315–16) indicated, division of labor must first be recognized by individuals as a means to increase productivity for it to be extended in order to overcome or alleviate the effects of the struggle for existence that would otherwise prevail.
Far from being something which society imposes on the individual, the division of labor is something which he agrees to participate in because he recognizes it as a solution to a problem. This contradicts Durkheim’s classification of the division of labor as what he calls a “social fact,” and which he defines as “[…] manners of acting, thinking and feeling external to the individual, which are invested with a coercive power by virtue of which they exercise control over him.” (Durkheim [1895] 1982, 52). The increase of the division of labor, for Mises, is a deliberate means that men use in order to achieve their goals more efficiently (Salerno 1990, 28). It is also precisely because of the higher productivity of the division of labor that we can sustain growths in population density and volume, as Mises ([1922] 1951, 293 n.1) indicated, and that we can substitute cooperation for the war of all against all that characterizes the struggle to survive (Mises [1949] 1998, 159, 175, 663).
Therefore, according to Mises, although it is true that society pre-exists the individual and that man is not born in a cultural or social vacuum (Mises [1922] 1951, 315; [1949] 1998, 143, 164), it is incorrect to argue that society causes cooperation and the division of labor. On the contrary, it is cooperation that allows the creation of sophisticated social bonds such as friendship or love; it is the capacity of man to recognize the superiority of the division of labor as compared to autarky that creates a web of social links which we call civilized society (Mises [1949] 1998, 143–45). Indeed, Mises wrote: “Human society is an intellectual and spiritual phenomenon. It is the outcome of a purposeful utilization of a universal law determining cosmic becoming, viz., the higher productivity of the division of labor.” (145). And elsewhere: “Civilization is a product of leisure and the peace of mind that only the division of labor can make possible.” (Mises [1922] 1951, 305).
The sociological question of the causes of social evolution and devolution is therefore resolved by Mises. Although Durkheim is right in insisting on the fact that division of labor presupposes at least a primitive form of trust,On the loyalty that characterizes primitive tribes, and on how it is the outcome of ideas, see Mises (1962, 81). this is insufficient to demonstrate that social development is merely driven by pressures that are external to the individuals. Indeed, individuals are by no means forced to participate in the division of labor; they do so because they recognize that this is beneficial to the achievement of their various purposes.
It is the division of labor, then, which allows social scientists to distinguish society as the rational form of cooperation it has become from the mere impulses to associate such as what can be found in groups of animals (Mises [1922] 1951, 297). It is the variations in the extent and the intensity to which labor is divided that determine the evolution or devolution of society and which make it scientifically understandable (299–300; [1949] 1998, 160). Social evolution is therefore teleological (Mises [1922] 1951, 291; Salerno 1990), i.e., based on the rational thinking of individuals associating in order to overcome or alleviate natural or social problems—to “remove uneasiness,” as Mises would put it. It is not the necessary consequence of external sui generis social forces, as Durkheim and other sociologists have argued. Civilization, to Mises, is the purposeful result of an increase in the division of labor and the capital accumulation it allows, whereas social decline is the result of the reduction of the division of labor.
To understand social history, then, sociology must first identify whether and how the individuals are willing to extend the division of labor. It must describe how societies and civilization historically evolved or devolved by using this general criterion.
2.2. The Social Effects of Socialism and Capitalism
One of the effects of socialism, Mises ([1922] 1951, 458, 497) indicates, is to destroy the division of labor, and, therefore, civilization. The opposite is the case for capitalism. It is because the market economy is based on the division of labor that it is possible to “regard each other as comrades in a joint struggle for welfare, rather than as competitors in a struggle for existence.” (Mises [1922] 1951, 294–95) Thus, according to Mises, capitalism allows us to see our neighbor as a friend rather than a foe, for we do not see him as someone that will deprive us of scarce resources, but as someone with whom we can exchange and prosper. In other words, capitalism allowed for civilization to emerge because it presupposes a division of labor that bridges the potential divisions between men. As Mises pointed out, it is vain to try to preserve civilization without preserving capitalism because high culture and polite society rest on economic means that can only be obtained in a sufficient amount when the division of labor is unimpaired by state intervention (310). Thus, capitalism allows society to civilize itself whereas socialism dismantles it.
Indeed, for Mises, the erosion of civilization is inevitable under socialism. Dissenting opinions are to be prohibited, for only the central authority (not the consumers) has the power to decide what is allowed and what is not. With the socialist regime being in charge of the allocation of all scarce resources, it is impossible, for instance, for any scientist, artist or writer to seek funds in another way than to satisfy those who are in charge of this regime (Mises [1922] 1951, 188–89). Thus, socialism puts an end to some of the highest achievements of civilization—arts and sciences. In stark contrast, a capitalist society allows anyone to sell his artistic or scientific work to the public or to find a sponsor (189).
Indeed, Mises (194) writes, capitalism protects freedom. Not in the sense that it annihilates the costs of all actions of course, but rather in the sense that it allows individuals to be protected against arbitrary rules to a larger extent than any alternative system (192–94). One must not see freedom as the absence of rules, but rather as the absence of arbitrary rules. Indeed, some rules are unavoidable if one wishes to live in a society. If one desires to obtain the economic benefits of the division of labor and the social benefits of friendship, love, and cooperation, then one must adapt his actions in light of what the others desire.
But the rules imposed by the State are arbitrary. The State is not capable of meaningful economic calculation, and can therefore not adapt its action with the preferences of society. It is bound to make decisions and create rules that are merely based on the preferences of the ruling class (Mises [1922] 1951, 195). Indeed, economic calculation based on private property renders the cost of many actions more apparent than it would be otherwise (Mises [1949] 1998, 230); it allows for the estimation of how various actions will be profitable (Salerno 1990, 48). Hence capitalism, by making the satisfaction of consumers a condition of possibility for profit, makes it clear that there exists a bilateral dependency between the producer and the consumer: the producer depends on the consumer because he needs to sell goods in order to become a consumer himself and the consumer depends on the producer because he needs to obtain goods in order to maintain or improve his standards of living. The freedom to trade allows for this fact to be understood and for one to see one’s fellow men as allies in the achievement of his own goals. And this freedom, by favoring the increase of the division of labor, provides society with the means to evolve into civilization.
We can now be more precise as to how sociology must describe the evolution of societies. It is by observing how socialistic or capitalistic a society is that one can understand its evolution. Because capitalism is the economic system allowing for an extension of the division of labor and because socialism destroys it, a sociologist can analyze social evolution by looking at whether and to what extent capitalism prevails in a given society.
2.3. On Class Conflicts
Mises wrote quite a lot on group or class conflicts. To be sure, his analysis of class conflicts is very different from the most famous one (and one of the most widely used in sociological analyses), i.e., that of Karl Marx. True, Marx’s analysis of class conflicts stems from the identification of an important question: Why is it that several groups within society seem to dislike or fight one another? But this is already giving too much credit to Marx. Indeed, class analysis was already used by many economists and social scientists before him. For instance, the non-socialist French industrialists—in particular Charles Dunoyer—had already delineated a framework for class analysis before (Leroux 2016, 86). It thus comes as no surprise that Mises’s own class analysis is much closer to that of Dunoyer and other French classical liberals than to that of Marx and the Marxists.This has been pointed out by Murray Rothbard in his 1978 preface to Mises’s The Clash of Group Interests. See Rothbard (2011, ix).
The question that both Marx and Mises attempted to answer is: why are there clashes between groups within society? The Marxist answer to this question is based on historical material conditions of production and class consciousness (Lukács [1923] 1971). It is because a dominated class is composed of individuals who realize the singularity of their own class with respect to its links to the material conditions of their time that irreconcilable interests become conflicts with the other—dominant—class. Under capitalism, the capital owners are the oppressors and have a common interest to keep and extend their “domination” over those who do not own the means of production. The laborers (proletarians) are the oppressed and, once they realize their oppression, have an interest in destroying the capitalist system which captures the plus-value of their labor (Marx and Engels [1848] 2012). According to the Marxists, there is only one way to arrive to a general state of peaceful interactions within society: one class (the proletarians) must violently take control of society as a whole and impose its own will on it.Mises (1990, 210–11) writes: “The Marxians promise us peace for the time after the final victory of the proletarians, precisely, in the words of Marx, after the working class will have passed ‘through long struggles, through a whole series of historical processes, wholly transforming both circumstances and men’.” Mises calls it the “peace of the graveyard,” as opposed to liberalism’s “peace of progress” (Mises [1922] 1951, 85).
But, as Mises pointed out many times, Marx’s class theory is, at best, unconvincing. One can indeed proceed to class distinctions based on the economic concepts of labor or capital in order to scientifically establish the distinctions between what it is to be a laborer and what it is to be a capital owner (Mises [1922] 1951, 331–32). But, first, the mere fact that such a distinction can be done for scientific purposes is no proof that the interests of the laborers are homogeneous or that the interests of the capital owners are homogeneous; and second, even if this were the case, it is still no proof that the interests of the laborer and that of the capital owner are necessarily opposed (in fact, quite the opposite is the truth: the so-called “oppressed” accepts, under capitalism, to exchange his labor time for an immediate income, see Mises [1922] 1951, 334–35).
Instead, argued Mises, class antagonism is the result of state privileges. One needs to explain why, given the heterogeneity in values and interests between various groups, they cannot coexist peacefully. For a variation in values and interests is not a sufficient condition to explain why one group pursues its own interests at the expense of another group. One must also look at the social context which constitutes the vector translating this original heterogeneity of group interests to the resulting situation of conflict. And this social context, for Mises, is the lack of respect for private property rights and for the market economy. In other words, it is because of the state’s redistributive or restrictive policies that diverging interests become class conflicts (Mises [1945] 2011, 10). Class conflicts, then, can only occur between two broadly conceived (and internally changing) classes: those who obtain privileges through the state, and those who must pay the price of these privileges; the productive class and the expropriating class (Hoppe 1990, 83–4).
Without State privileges, despite the multiplicity of individual or group interests, no group can advance its own interests at the expense of another (Mises [1945] 2011, 7). For Mises, a more general kind of “interests,” which he calls “long-run” or “rightly understood” interests, corresponds to this idea that specific interests can always, in the long-run, be realized more efficiently and without conflict in a market economy. Thus, Mises writes that the “rightly understood” interests are “harmonious” (16–7).As Leroux (2011, 136) noted, Mises’s formulation is very similar to that of Frédéric Bastiat. Not in the sense that all specific interests become exactly the same of course, but in the sense that their heterogeneity does not systematically lead to conflict and predation within society. In other words, the only way to achieve one’s most desired goals in a free market is to be able to first produce what the other members of society desire. It is in this sense that, although different, all interests are harmonious; everybody profits from the fact that everybody else achieves his goals. Systematic clashes cannot occur without state privileges: “Under free trade,” Mises tells us, “the manufacturers of shoes are simply competitors. They can be welded together into a group with solidarity of interests only when privileges supervenes, e.g., a tariff on shoes (privilegium favorabile) or a law discriminating against them for the benefit of some other people (privilegium odiosum).” (7).
Thus, in this perspective, we may understand social evolution or devolution by defining two broad classes: those who participate in and extend the process of division of labor (those who make a living by attempting to produce what is desired by consumers) and those who benefit from its destruction in the short-run (those who receive privileges from the state). The first class (the productive class or, using the French classical liberal terminology, the spoliés or the industrieux) is struggling in a fight against the second class (the spoliateurs).It becomes immediately clear what Marx’s mistake was; it was a misidentification of the “exploiters” and the “exploited” (Hoppe 1990, 83–5, 92 n.13). The whole history of mankind under statist conditions can indeed be understood by describing class conflicts between the productive class and the parasitic class. This is not the case with the arbitrary class distinctions of the Marxists. For a more detailed analysis of the similarities and differences between the Marxist and the Austrian theory of class conflicts, see Hoppe (1990). It is the task of history and sociology to identify the specific composition of these classes and to describe their interactions at any given time and place.
In order to assess the extent to which capitalism prevails (and, consequently, the extent to which division of labor and social evolution occur), a sociologist must then look at the specific group conflicts occurring in a society and their singularities. He must identify the composition of the productive class and of the parasitic class in order to understand the particular elements of socialism that prevent social evolution.
2.4. Ideology and the Role of Ideas
All of this leads to a final question: given that increasing the division of labor reduces class conflicts and leads to social evolution whereas the reduction of it leads to more class conflicts and social devolution, what factors determine the shift of societies towards one or the other? The most important factor, according to Mises, is the role of ideas and of ideology.
Vilfredo Pareto thought that what can convince a population to adopt certain ideas or ideologies are emotions or sentiments rather than reason (Valade 1990, 147). This is why, in his opinion, socialist ideas triumphed over classical liberal ideas. The former were defended by appealing to emotionally pleasing utopian promises whereas the latter were generally defended by mere arguments (Pareto 1902, 66–7). Some actions and ideas are therefore irrational. And this was the foundation of his sociology, i.e., the study of “non-logical” actions (Pareto 1917, 76; Valade 1990, 265).
In contrast, for Mises, there is no such thing as “non-logical actions.” Indeed, we have already seen that, according to him, every action must be conceived as rational to be understandable. There is no point in arguing against Pareto that emotions and sentiments play a role in shaping ideas. However, as Boudon for instance maintained, the manner in which passions are oriented is not intrinsic to them (Fillieule 2014, 102). Anger, for instance, can be used to appeal for either socialistic or capitalistic ideas. One must provide the public with justifications for why they should be angry at capitalism in order to convince them to support socialism. One must provide a plausible justification for attributing to capitalism an event or condition that makes people angry. Actions will be guided by accepted ideas.
Indeed, Mises ([1949] 1998, 177) argued that ideas and the process of thinking are presupposed by any action. The origin of these ideas is social, i.e., thought is always influenced by the social context of an individual. But this does not imply that society has any thoughts of its own that it imposes on the individuals (Mises 1990, 290–91). Only individuals can think. The individual must thus reconstruct, in his own mind, the ideas that he encounters in society into an ideology. For Mises ([1949] 1998, 178), an ideology includes elements of scientific ideas and elements of moral ideas. Praxeology has nothing to say about moral ideas, according to him. But from the moment we know or assume to know the ultimate ends of individuals, praxeology can judge the quality of the means that are thought to bring about the desired ends. Thus, any ideology aiming at human prosperity that is in any way antithetical to the division of labor will lead to failure (Mises [1949] 1998, 180–84). But describing how or why such ideology is accepted and how it is connected to a particular social change is a matter of history or thymology. And contextual rationality can be used as an additional tool to understand an ideology and the manner by which it spreads.This was noted by Fillieule (2014, 100–02).
For instance, Mises ([1922] 1951, 358) writes that the workers’ typical adherence to socialism can be understood by looking at what, given their social context, can lead them to accept the tenets of the socialist doctrine. Mises indicates:
The workman in the large or medium scale capitalist enterprise sees and knows nothing of the connections uniting the individual parts of the work to the economic system as a whole. His horizon as worker and producer does not extend beyond the process which is his task. He holds that he alone is a productive member of society, and thinks that everyone, engineer and overseer equally well as entrepreneur, who does not, like himself, stand at the machine or carry loads, is a parasite. Even the bank clerk believes that he alone is actively productive in banking, that he earns the profit of the undertaking, and that the manager who concludes transactions is a superfluity, easily replaceable without loss. Now from where he stands, the worker cannot see how things hang together. He might find out by means of hard thinking and the aid of books, never from the facts of his own working environment. Just as the average man can only conclude from the facts of daily experience that the earth stands still and the sun moves from east to west, so the worker, judging by his own experience can never arrive at a true knowledge of the nature and functioning of economic life. (Mises [1922] 1951, 358)
Given this fact, it becomes easier for the socialist ideologue to argue that it is the economic system of capitalism which makes the workers’ tasks underappreciated, and that substituting socialism for capitalism would bring them greater wealth and recognition. This helps shaping their own beliefs: “The masses incline towards Socialism, not because it really tends to their interests but because they believe that it does so.” (Mises [1922] 1951, 358) An ideology is propagated through the use of reasons provided to the public with the aid of which they can make sense of their own local situation and orient their passions (see Boudon 1986).
It is precisely because some actors are more prone to commit such errors that they support socialism; these actors truly believe that the market economy leads to an outcome which is ethically or economically undesirable, and this is the exact reason why they oppose it. It is without any doubt his belief that ideas are the driving force of action that led Mises to carefully address the mistakes of the socialist doctrine. For once the public is aware of them, it becomes difficult to implement it. True enough, resentment of those who succeed under capitalism can still be felt (see Mises [1956] 2008). But resentment does not constitute an argument. And once all arguments in favor of socialism are shown to be invalid, it becomes increasingly difficult to orient the public’s passions against capitalism: “Only ideas can overcome ideas and it is only the ideas of Capitalism and of Liberalism that can overcome Socialism. Only by a battle of ideas can a decision be reached.” (Mises [1922] 1951, 507)
To those like Pareto who believe that reason can never triumph over passions, Mises responds: “This pessimistic point of view is completely mistaken in its estimate of the influence which rational and quiet reflection can exercise on the masses. It also exaggerates enormously the importance of the part played by the masses, and consequently mass-psychological elements, in creating and forming the predominant ideas of an epoch.” (Mises [1922] 1951, 507–08) Since the masses are much less prone to think about ideas, they tend to accept the ideas of those who have the time and ability to do so (Ibid.). Educating the thinkers can then influence the ideas of the masses, which can then allow capitalism to triumph over socialism (510). But, it is true, the opposite can also occur.
It is ideas, then, as was also pointed out by Salerno (1990, 53), that are the driving forces of social change for Mises. And it is the task of history and sociology to study the variations in the spread of ideas and ideologies in order to understand social evolution or devolution (Mises 1990, 295, 297–98). Their task is to inquire about the reasons that made an idea consistent with the extension of the division of labor spread to the population sufficiently to bring social evolution (or that made an idea that is inconsistent with it spread to slow down or reverse this evolution).
Now let us sum up everything that has been said in the second section of this paper. Mises provided us with a general framework of understanding for sociological inquiries. In light of this, a sociologist must identify the reasons that made specific ideas prevail in society or in some of its parts. This can explain the specific composition of the productive class and the unproductive class of a society. This class composition then informs us on how, specifically, and to what extent, socialism or capitalism prevailed in a society. In turn, this explains how a society evolved or devolved, since capitalism leads to an increase in the division of labor whereas socialism leads to a decrease in it. We can thus, following Mises’s methodological singularism, reconstruct step by step the evolution or devolution of society while answering many singular sociological questions along the way. With all these insights, sociologists can usefully contribute to our understanding of social phenomena and social changes that occurred throughout history.
- CONCLUSION It has been shown in this paper that Ludwig von Mises, although primarily an economist, has addressed both the epistemological questions and many of the controversial topics of the discipline of sociology. In brief, sociology is a historical discipline. Its main task is to provide us with an understanding of actions and the results of actions that occurred in the past or are likely to occur in the future. It must in particular attempt to find the values and ideas that influenced the shift towards social evolution or devolution. It must also attempt to identify the reasons why these values and ideas prevailed.
To do so, praxeology is necessary but insufficient; sociology must use additional tools to analyze the social world. It must have specific criteria on which to base its judgements about social evolution or devolution, i.e., the extension or destruction of the process of division of labor. It must assume contextual rationality and use methodological individualism in order to identify whether and why different groups of individuals shared the values and ideas they had at the time and place they had them. It must find out if these values and ideas were consistent or antithetical to social evolution and connect them to historical trends. It requires the identification of classes of individuals based on whether their ideas, values, and actions were consistent or antithetical to social evolution. In brief, sociology must be a praxeologically oriented study of general history. In strike contrast to holistic sociology, a Misesian sociology (not unlike a properly understood Weberian or Boudonian sociology) is first interested in the individual and his rationality in order to understand larger complex social phenomena.
As such, and by considering “macrosocial” phenomena such as society or culture as the result of individual actions and interactions based on ideas (“microsocial” phenomena), Misesian sociology allows for a better understanding and explanation of social change than by considering macro phenomena as the ultimate bases of social explanations or by considering both macro phenomena and micro phenomena as analytically independent entities of equal importance in providing explanations. Contrary to contemporary metatheories such as that of George Ritzer (see Ritzer and Stepnisky 2018, 596–600), which often correctly assert that there exist interactions between the micro and the macro levels of explanation but fail to recognize the more fundamental character of action and thought in our understanding of social phenomena, Mises’s allows us to reconstruct macrosocial phenomena of interest from their ultimate origins in actions and ideas. Even when, from a strictly analytical perspective, an explanation seems to be only involving macrosocial phenomena, one can upon further investigation recognize that, ultimately, the proper explanation is rooted in actions and ideas. For instance, an increase in population can indeed explain why we divide labor more, as Durkheim argued, but this is only because individual actors recognize that dividing labor more is a means to avoid the decrease in standards of living it would otherwise bring. And the ultimate explanation for population increases must also be found in actions and ideas. Failing to recognize such microsocial origins to macrosocial phenomena can lead to the erroneous belief that individuals play only a very minor role (if any) in the formation of their own thoughts and actions, as Durkheim thought; the individual’s ideas and actions are then merely seen as the unavoidable result of deterministic social forces that are imposed on him. Although it is often heuristically useful to consider an aggregate social phenomenon as given in order to explain some other phenomena, one must always keep in mind while doing so that these social phenomena are ultimately rooted in actions and ideas.
These many insights of Mises can help sociologists (or economists interested in complementing their work with sociology) reconstruct the discipline of sociology on firmer grounds.
Quarterly Journal of Austrian Economics 22, no. 2 (Summer 2019) full issue. ABSTRACT: This Lou Church Memorial Lecture given at the AERC in March 2019 focuses on the outcomes of the Enlightenment: reason, the individual, equality, property rights, the separation of church and state, science and politics freed from religious dogma; but also the effort to remove important mediating institutions such as the Church. What is required to be reintroduced that the Enlightenment destroyed?
religion libertarianism enlightenment
The Lou Church Memorial Lecture
It is broadly accepted that out of Enlightenment thinking came many of the “goods” of our society; goods economic, political, and social. Goods ranging from the material wealth and the technology we enjoy to classical liberalism and libertarianism. It is on the latter that I will focus.
An exhaustive discussion of the connection of Enlightenment thought to Classical liberalism and libertarianism is not necessary for this audience, so I will summarize: reason, the individual, equality, property rights, the separation of church and state, and science and politics freed from religious dogma. These pillars underlie the classical liberalism that many point to and exclaim: here, we finally found freedom! Instead, what if these have cost us our freedom?
What is Enlightenment? Immanuel Kant gave his answer:
Enlightenment is man’s release from his self-incurred immaturity. Immaturity is man’s inability to make use of his understanding without direction from another….” Have courage to use your own reason!” That is the motto of enlightenment. (Kant 1784)
There is Diderot’s Encyclopedia, considered “one of the greatest cultural and intellectual achievements of the Enlightenment;” (Champion 2012) a 20 million word man-made blueprint for the creation of a rational, improving and cultivated society.
Theology is kneeling, subordinate to reason. Diderot explained: “in countries enlightened by the light of reason and philosophy… the priest never forgets that he is man, subject and citizen.” (Champion 2012) Or as Steven Pinker proclaims: Enlightenment Now: The Case for Reason, Science, Humanism, and Progress. In other words, the case against tradition and religion—and by “religion,” read “Christianity.”
Yet who can deny the progress? It is easy to identify the many “goods” we attribute to Enlightenment thinking—the acceleration of trade and the drastic improvements in the economic standard of living. Political concepts such as classical liberalism are developed, and therefore—we believe—our freedoms.
Well, maybe. As Hans Hoppe (2018) offers, “According to the proponents of this theory,” of which he mentions Francis Fukuyama and Steven Pinker, “what makes the present age so great and qualifies it as the best of all times is the combination of two factors.” Hoppe offers first, the highest levels of technology and natural science in human history—to which he raises no objection; and second, the highest level of human freedom—which Hoppe considers “a historical myth.”
N. T. Wright offers: “Any movement that gave us… the guillotine as one of its first fruits and the Gulag as one of its finest cannot simply be affirmed as it stands.” (Wright 2008)
The “bads” of the Enlightenment are not so readily admitted by its proponents: communism, eugenics, racial purity, selective breeding, National Socialism, Fabianism, Progressivism, fascism, egalitarianism, modern democracy, freedom from all intermediating governance institutions, the ineffective separation of church and state, the American Revolution, the French Revolution.
Regarding the two revolutions: The America that came out of the Revolution is described by Ralph Raico as “…the model liberal nation, and, after England, the exemplar of liberalism to the world.” This “exemplar of liberalism” didn’t survive four-score-and-seven years, ending in 1861—and if you prefer to make a case for 1846 or even 1812, you will get no argument from me. Whatever one believes regarding liberalism, staying power certainly cannot be considered a meaningful characteristic.
But this example is much more successful than what came shortly thereafter: from his magnum opus, From Dawn to Decadence, Jacques Barzun offers (2000): “…the French Revolution of 1789 must be called the Liberal Revolution.” What does Barzun mean by “liberal”? He offers as an example a law passed two years after the outbreak: there are to be no interests other than the interests of the individual and the general interest of all; no intermediate interests are permitted.
An attack not only on tyrannical authority, but also on guilds, associations, universities, and especially Christianity—every intermediating institution that provided decentralization in governance and stood against the monopoly authority of a centralizing state; every intermediating institution that Robert Nisbet suggests offered the individual room and cover for his freedom.
Simon Schama (1989) offers that such an attack on intermediating institutions was welcomed by the elite; the people—powerless without these intermediating institutions or the king to turn to—saw it another way.
Not all Enlightenment thinkers wished for the guillotine or the gulag, as we certainly know; many sincerely held man’s liberty in their sights. John Gray (2018) offers that the asserted universal truth of the link between the Enlightenment and liberal values is tenuous; it was strongest in Enlightenment monotheists and weakest in those thinkers hostile to monotheism.
Yet a generic “monotheism” offered no sustainable foundation. Our liberties were born well before the Enlightenment in a specific cultural and religious tradition; those who lived in and developed this tradition would not refer to themselves blandly as “monotheists.”
Let’s look at this history. Barzun offers:
The truth is that during the 1,000 years before 1500 a new civilization grew from beginnings that were uncommonly difficult…. showing the world two renaissances before the one that has monopolized the name. …the Germanic invaders brought a type of custom law that some later thinkers have credited with the idea of individual freedom.…no rule was held valid if not approved by those it affected. …Anglo-Saxon law… defined crime literally as breaking the peace.
This era was born after the fall of Rome; Germanic tribes mixed with Christianity to create a culture that valued Christian ethics and German honor, resulting in what Fritz Kern describes as the old and good law; law of custom and good tradition. A man’s oath made his law. Any noble could veto the king if he could demonstrate his right in the old and good law. A law regime about as libertarian as has ever existed for an extended period in the west—and even the world.
Neither the Church nor the king held sovereignty. If anything held “sovereignty,” it was the law. Each of the Church and king competed with the other, in different yet overlapping circles; with one or the other taking a stronger or lessor role over the years. In the space between Church and king, freedom blossomed; in the space between Church and king, numerous meaningful intermediating governance institutions took root, giving the individual both the room and the means to exercise his freedom.
It was a time when the Church could reprimand the king despite having no army and no physically coercive means other than what the king provided. Libertarians speak approvingly about the use of shunning when dealing with non-aggressive trespasses. Well, try the eternal shunning of excommunication.
In Ecclesiastes we read of the meaninglessness of life when weighed against the eternity that God has placed in the hearts of men. In the Europe of the Middle Ages, the noble was concerned with his eternal life and God’s eternal kingdom and this concern shaped his behavior; no longer the case since the Enlightenment. The common motto for today’s enlightened “nobility” is “he who dies with the most toys wins.” This is reflected in our time: corruption, lust, and greed define the new nobility.
During much of the Middle Ages, there was a meaningful and functional separation of Church and king, each superior in its realm, neither with sovereign power or authority. Each offering an avenue for appeal if one felt his liberties were unfairly compromised by the other.
Today we have the subordination of church to state. One recalls the exchange between the Jewish priests and Pilate regarding Jesus’ fate. Pilate asked: “Shall I crucify your king?” and in reply, the priests shouted “We have no king but Caesar.” Sounds like a typical Sunday morning in America.
With the Enlightenment, the idea of leaning on tradition and custom was thrown out. The most important tradition to remove was Christianity. Not necessarily its ethics, just the supernatural history, the theology, and the church—as if the ethics could exist for long without God and an institution behind these. Barzun offers, “The Bible must be shown to be a set of fables invented by ignorant or designing people.”
What was a generally accepted belief in Christianity throughout the population began to dissolve in the eighteenth century. N.T. Wright (2018) points to the earthquake in Lisbon on All Saints Day in 1755 as a key event in this regard. A massive earthquake and calamity that completely shook Christianity; man’s reason could not accept that a good and wise God would allow such terrible tragedies.
Drop the ritual and prayers, ignore the priests and monks. “Wipe out the disgrace!” Voltaire said of the Roman Catholic Church. Voltaire—“the Enlightenment illuminated” according to Schama—did his part to make this so, through a series of four and five page pamphlets, consolidated into A Portable Philosophic Dictionary. Who needs 1700 years of scholarship and tradition to shape your philosophy when you can have a portable dictionary?
No more of this God of the Bible; Deism became the religion of “reasonable” men. God did create the universe, but the story of Genesis is a fable. God did set the rules — the laws of science; He has no reason to interfere thereafter. Jesus? Sure, He was a wise and good man; but out with the Virgin Birth and the Resurrection.
The road from Deism went through a revived Epicureanism and ended in Nietzsche’s infamous “God is dead,” to be found in “The Parable of the Madman,” published toward the end of the nineteenth century. After all, how big a leap is it from Deism’s “watchmaker” to Epicureanism’s gods that don’t care to “God is dead”?
“Where has God gone?” [Nietzsche’s madman] cried. “I shall tell you. We have killed him—you and I. We are his murderers. …Whither are we moving now? …Are we not perpetually falling? Backward, sideward, forward, in all directions? Is there any up or down left? Are we not straying as through an infinite nothing?” (Nietzsche [1974] 1882, 1887; 181–82)
The madman found that no one would listen; he lamented that he came too early. The Great War, the suicide of the west, was still a few years away.
What did Nietzsche see as replacing God and His moral law? Man-made ethics would be at the top of the pyramid; the enlightened elite were happy to comply. They would be the “superman,” establishing a “new ethos”: new standards of right and wrong, replacing Christian virtues.
Each of us using our own reason, making our own compass, creating our own definition of true north. One cannot even claim the “non-aggression principle” in such an environment. On what basis?
Well, we do have Hoppe and his argumentation ethics. But not so fast! From his radio broadcasts during World War Two, C.S. Lewis (1941) offers that two people properly argue on the basis of some standard. Frank van Dun (2018) offered a similar comment at last year’s Property and Freedom Society conference. To summarize: argumentation ethics is constantly appealing to the other person’s conscience—the things we already share; literally, common knowledge.
But the ideas of the Enlightenment—Liberty, Equality, the individual, patriotism, and Progress—are all abstract ideas, large buckets that can be filled with a wide variety of contents. We complain that these terms don’t have the meaning that we intend, or the meaning as originally intended—just as socialists complain the same thing.
Who is to say how and with what these buckets should be filled? Based on what foundation? Based on whose reason? Without a common conscience, who—or what—will arbitrate? Voltaire has said “commonsense is not so common.” Well, without sense that is common, on what basis do we live peacefully—in a state of conviviality, as van Dun puts it?
We can’t, and we have proved it. Barzun describes the Great War as “the blow that hurled the modern world on its course of self-destruction.” Yet this blow was struck in the west at the time we consider to be the most enlightened, peaceful and free. The decades before the outbreak of the war are known as La Belle Époque: “the beautiful era.”
It was an optimistic time, born after the end of the Franco-Prussian War in 1871. Regional peace, political stability, passport-free travel, material prosperity, technological and scientific innovations, literature and music. The height of what we might consider classical liberalism and freedom.
Certainly there was regional peace in Europe. But there was much violence between and among these same actors (and against the native populations) in the battle for colonies around the world. The art of violence was practiced and perfected; arms were developed in order to ensure victory. This art would soon be turned inward.
The Great War—perhaps alone among all substantial human conflicts—remains almost unexplainable. Why and how could such a thing have happened when and where it did—in this “beautiful era,” among the enlightened people? Aleksandr Solzhenitsyn (1983) offered an answer: “Men have forgotten God.” Nietzsche’s madman would agree.
In the Great War’s wake, western culture and society were transformed in speed and magnitude perhaps unknown in history: family life broken, careers ended, government allowance in the place of productive work, and a tide of egalitarianism; in other words, the perfect cultural soil for the expansion of monopoly state power.
War became total war, in large part driven by another gift of the Enlightenment, modern democracy. While Lincoln established the precedent fifty years earlier, it was finally in the Great War when war of all against all became generally accepted throughout and within Europe, an event for the nation and not merely the combatants—an “Advance to Barbarism,” as offered by F.J.P. Veale (1953). Poison gas, air raids over civilian populations, submarines destroying ships regardless of flag or purpose, the blockade of civilian food and supplies, even peace not leading to relief.
And church towers used as observation posts, leading to their destruction; painting a picture of the cost of the Enlightenment far better than my few-thousand words.
The war shattered the utopian visions of these students of Enlightenment, leading to the change from what we now call Classical Liberalism to its modern incarnation. Barzun describes this transition as the Great Switch; a switch from the idea that the best government is one that governs least to the best government is one that will give us liberty, good and hard. The “deplorables” are not capable of liberty; it must be forced upon them. At the time, the transition was barely noted, except by authors such as Chesterton and Belloc.
This new liberal now had nothing standing between him and the individual—all intermediating institutions, especially Christianity and the Church, had been stripped of any meaningful role. Each individual was standing naked, to be molded like clay by these progressive, enlightened, “reasonable” intellectuals. Legislation would solve every problem in life. Every need and want would be met, all bestowed via government largesse.
Barzun describes these naked individuals as impotent: the receivers of benefits, victims, lacking room to breathe, oppressed by his fellows and the state alike. This naked individual now had but one objective: the Unconditioned Life—emancipation from the realities of this world; nothing to stand in the way of every wish; expecting no rebuffs. Life with no conditions; anything goes, and you can’t stop me. My pleasure is my highest priority; the highest goal in life is to be happy.
Enlightened man, like his forefathers after the flood who attempted to build a tower to heaven in order to be like God, found—as Paul VanderKlay says—that when you try to bring heaven down to earth, you bring hell up with it. We need not even look to the “isms” of interwar Russia, Italy, or Germany for examples of this; it is sufficient to look to the social justice liberalism and grievance studies curriculum of America today.
Barzun concludes his magnum opus with a listing of the decadence found in the west over the last century; man’s liberation from all norms, traditions, and customs; nothing left to provide governance except the state—and a state happy to oblige.
What happened to the promise of the Enlightenment? We consider the individual and reason as born in the Enlightenment to be key foundations of liberty. As the meaning of these concepts has been divorced from God, these have actually brought on liberty’s downfall. Without God, the Enlightenment’s liberty is a house built on sand.
The individual was discovered not in the Enlightenment or even in the Renaissance. Anselm of Canterbury offered us the individual in the eleventh century, with roots to be found even centuries before. Anselm’s individual had a sense of self-awareness and personal identity; an individual with a moral responsibility; an individual requiring spirituality.
This was an individual who found his freedom within the cultural and religious context of the time, free to live according to and within this tradition. This individual found and was able to maintain his freedom via the many intermediating institutions of the time—most importantly the Church, which could stand against the king.
The Enlightenment’s guillotine killed all intermediating institutions, thus killing the freedom of this individual. We now have an individual freed from such troublesome burdens as truth, justice, and mercy; an individual freed from any moral responsibility; an individual standing naked and impotent in front of the state; an individual living free… in a gulag.
Meanwhile the state pushes further division—ever-more individualized individuals. The state encourages and subsidizes culture-destroying behavior, as absent governance provided by custom and tradition, governance will be provided by the state.
As the Enlightenment freed our reason from revelation and tradition, the result should be no surprise. Just because your reason has been freed doesn’t mean that the strongman’s reason will leave you alone or that your reason will convince him. As his reason is no longer bound by anything other than his reason, it will not be your reason that governs but his. To what higher authority can you appeal? There is no authority higher than man’s reason, and the strongman’s reason has bigger guns than does your reason.
Recognizing this “strongman’s reason,” John Gray (2018) offers:
What if the Enlightenment’s future is not in the liberal West, now almost ungovernable as a result of the culture wars in which it is mired, but Xi Jinping’s China, where an altogether tougher breed of rationalist is in charge? It is a prospect that Voltaire, Jeremy Bentham and other exponents of enlightened despotism would have heartily welcomed.
Maybe God knew what He was doing when he warned Adam off of the tree of the knowledge of good and evil, with death the consequence of man’s reason without God.
The Hoover Institution’s Peter Berkowitz offered a five-part challenge to Patrick Deneen’s recent book “Why Liberalism Failed.” While suggesting that Deneen has gone too far and attributed too much fault to the concepts of the Enlightenment, in part four he does recognize the detrimental features of contemporary society:
…the scorn for inherited wisdom, the demotion of duty in favor of personal preference, and the obsession with material goods and superficial amusements at the expense of citizenship, friendship, and love—promoted by the individualism and statism that arise from taking the principles of freedom and equality to an extreme. (Berkowitz 2018a)
Jordan Peterson asked regarding the postmodernists: What from the Enlightenment do you toss out the window before things get ugly? Jonathan Goodwin (2018) suggests that this is the wrong question if one’s objective is liberty. The question should be: what is required to be reintroduced that the Enlightenment destroyed?
In part five of his critique of Deneen’s book, Berkowitz aims at answering this question. To this end, he cites Edmund Burke. From Burke’s “Reflections on the Revolution in France,” written in 1790:
History consists, for the greater part, of the miseries brought upon the world by pride, ambition, avarice, revenge, lust, sedition, hypocrisy, ungoverned zeal, and all the train of disorderly appetites…. These vices are the causes of those storms. Religion, morals, laws, prerogatives, privileges, rights of men, are the pretexts. (Berkowitz 2018b)
It is worth noting: none of the vices identified by Burke violate the non-aggression principle—except maybe revenge, depending on how cold the dish is when served. Yet, perhaps, recognizing these vices as dangers to liberty—and incorporating this recognition into their work—is an appropriate task for libertarian thinkers of tomorrow. Continuing with Berkowitz:
[Burke] rebuked the French revolutionaries for supposing that “the rights of men” authorized the blanket repudiation of inherited faith, the established regime, and the country’s settled laws and their replacement with new modes of moral judgment and political order derived from pure reason.
Given the cost to liberty of this repudiation, perhaps libertarian thinkers might incorporate something of the inherited faith and tradition when considering liberty as the objective.
Further, Alexandr Solzhenitsyn, from his Harvard University commencement address in 1978. Having lived under a communist regime his whole life, he understood that a society without an objective legal scale is a terrible one, but a society with only an objective legal scale is as well. In such a society, man has been given freedom for good and evil—and such a society has no defense against the decadent abyss.
He suggests that for a thousand years man had freedom within a framework of his religious responsibility, but no such responsibility attaches today. Solzhenitsyn offers:
This means that the mistake must be at the root, at the very basis of human thinking in the past centuries. I refer to the prevailing Western view of the world which was first born during the Renaissance and found its political expression from the period of the Enlightenment. …the proclaimed and enforced autonomy of man from any higher force above him.
Nietzsche ([1998] 1889) offered the consequences of killing God in Twilight of the Idols: despite the wishes of many Enlightenment thinkers—the “English Flatheads” as he describes them—when one gives up the Christian faith one also loses the right to Christian morality.
What is this moral Christian “right” if not, at minimum, the non-aggression principle? This is what man has given up in the Enlightenment. We have traded Christian morality—and therefore our liberty—for the enlightened super-man’s reasonable right to decide what is moral.
Libertarians point to many Enlightenment thinkers and their theories and concepts that freed the individual and empowered reason; concepts that we believe offer the foundations for liberty. But we knew all of this before the so-called age of reason; we did not need the Enlightenment to become enlightened.
Hans Hoppe has made it acceptable, at least in these circles, for me to cite as foundational for liberty the Decalogue—certainly the portion of it that related to man’s relationship to man: honor your father and mother; do not murder, do not commit adultery, steal, or bear false witness; do not covet your neighbor’s wife or his possessions.
As Hoppe offers, “Some libertarians may argue that not all of these commandments have the same rank or status.” Quite true. In some cases, we see non-violent trespasses. The question for the libertarian as libertarian: does the violation rise to the point of requiring formal, physical punishment?
Jesus answered this question. We read in John chapter 8 of the Pharisees bringing to Jesus a woman caught in adultery—certainly not an offense that libertarians would view as rising to the level deserving of physical punishment. The law commanded stoning for such an offense. The Pharisees asked Jesus what should be done with this woman.
His reply: He that is without sin among you, let him cast the first stone. Yes, it was a sin; but it was not a violation worthy of physical punishment. One by one, the accusers left. Jesus then admonished the woman, “go, and sin no more.” Advice and counsel, not punishment, is the example Jesus gave us regarding what we would describe as non-violent trespasses.
Libertarians lament our inability to convert the masses. “Who can disagree with the logic and purity of the non-aggression principle?” we cry, while pouring ashes on our head. Maybe we should consider this lack of a common conscience; maybe we should consider that for us to move toward liberty, this cultural and religious tradition must be the foundation.
Goodwin recently asked: is libertarianism sufficient for liberty? Is our objective to purify libertarian theory, or is it to find liberty?
Maybe we should consider what it means to have lost the right to Christian morality when it comes to moving toward liberty. If our objective is liberty, maybe we should consider the necessity of regaining this lost right.
Paul offered the consequences of discarding the knowledge of God by the enlightened of his generation in Romans 1, beginning with verse 18 through to the end of the chapter. We read of God’s wrath against those who suppress the truth by their wickedness. From Paul:
…just as they did not think it worthwhile to retain the knowledge of God, so God gave them over to a depraved mind, so that they do what ought not to be done. …Although they know God’s righteous decree that those who do such things deserve death, they not only continue to do these very things but also approve of those who practice them.
Paul could be writing to our generation. From the seventh of his eight-part Gifford Lectures, Wright (2018) offers: “To be an image-bearer is more than just behavior; otherwise we put the knowledge of good and evil before the knowledge of God.”
By not keeping the knowledge of God before individual reason, good stands no chance against evil. As good loses to evil, we most certainly lose our liberty. This, ultimately, is the cost of the Enlightenment.
When a parent leaves the work force to focus on parenting, this shows up in government stats as lower employment and less consumer spending — suggesting a less productive economy. But that's not what's going on at all.
Original Article: Why the Government Can't Measure Income, Happiness, or Well-Being.
Here is Hans Hoppe's first treatise in English — actually his first book in English — and the one that put him on the map as a social thinker and economist to watch. He argued that there are only two possible archetypes in economic affairs: socialism and capitalism. All systems are combinations of those two types. The capitalist model he defines as pure protection of private property, free association, and exchange — no exceptions. All deviations from that ideal are species of socialism, with public ownership and interference with trade.
Narrated by Jim Vann.
Download the complete audiobook (10 MP3 files) here. This audiobook is also available on Soundcloud, Apple Podcasts, Google Podcasts, and via RSS.
[Originally published in Volume 5, No. 1 (Spring 2002) of the Quarterly Journal of Austrian Economics.]
A central theme of all schools of economics is the notion that goods are scarce. The extent of human wants and needs is sufficiently great that the means man would apply to those ends are limited, requiring that he choose among alternative actions. The purpose of this article is to call attention to a facet of scarcity that stems from this fundamental notion and that is of relevance to economic decision making, the determination of what goals to pursue, and how to attain them. This facet is the ownership of these scarce goods. The fact of ownership means that there is an additional problem faced by those who would use such goods, beyond the fact that such goods are physically unable to satisfy all conceivable uses to which they could be put. This problem is how to convince the owner, who by the very meaning of ownership is entitled to complete control over those goods, to part with those goods (so that they may be applied to other uses).
Since some owners may be more willing to part with those goods than others, the notion of how scarce some good is for a particular use cannot be answered outside the context of ownership and the valuations of property owners, making scarcity in this sense subjective as well. The existence of and need for property is a consequence of scarcity, which is further affected by the very institution to which it gives rise. However, this “problem” in a sense supplies its own solution, as ownership implies the ability to exchange, and consequently, the emergence of exchange ratios in a common unit (that is, money prices) that permit economic calculation and thus the ability to coherently compare prospective courses of action.
This article will attempt to elaborate on this idea, and applications of this notion will be made to the problems of socialism, monopoly capitalism, and business cycle theory.
Scarcity in the General Sense We live in a world characterized by scarcity. That is, the physical amount of the things man would use to satisfy his wants and needs are limited in relation to those wants and needs.Air, for example, is physically of finite supply, but no wants are currently left unmet on account of this. Thus, air cannot qualify as an economic good and in this sense is of “unlimited” supply. It is for this reason that conflicts can arise over things: if goods were so plentiful that another’s use of them would not preclude my use of them, then no disagreements could arise over their use. It is because of the possibility of such conflicts that some means of conflict resolution is needed, and this is precisely why any theory of conflict resolution—ethics—is ultimately a theory of property rights (Rothbard 1998; Hoppe 1989, 1993). When scarce goods become owned, then conflict over their use is resolved (at least in principle). These goods then become property, and as the owner of property, I am entitled to exclude others from the use of the goods manifesting themselves as property. Of course, questions as to how property may be justifiably acquired must be resolved,See the preceding references. Kinsella (1996) provides an overview of other such recent work. but once such questions are addressed, economic interactions between men become exchanges of property under a system delineating how such exchanges may legitimately take place.
Thus the concept of property stems from that of scarcity. This connection has long been recognized. Menger (1976, quoted in Salerno 1999) argues that
[A person’s] property is not ... an arbitrarily combined quantity of goods, but a direct reflection of his needs, an integrated whole, no essential part of which can be diminished or increased without affecting realization of the end it serves. (p. 84)
Salerno further notes that property is “a praxeological category that refers to a purposively created structure of goods that is adjusted through the operations of economizing to serve the structure of ends aimed at by an individual actor” (p. 84), the need for which (economizing) is entirely due to the fact of scarcity. Scarcity is a fundamental concept of economics and, more generally, of human action, as we confront scarcity with every action.
Unowned goods become property precisely because their use by one person means that others will be unable to use them. When a good is unowned (for example, in a state of nature), the question of acquiring it and making it one’s property is a question, as with all actions, of choosing one course of action over another. However, given a system of property rights that determines how goods may be justly acquired, interactions with others do not necessarily arise. That is, as an unowned good, no one else has any justifiable claim over it. Others may desire it or hope the prospective owner puts it to a certain use, but in attempting to obtain it, one needs, in principle, no more than one’s own labor. Cooperation with others is not necessary (though of course it may be preferable to acting alone).
Scarcity as Derived from Ownership The case is different regarding goods that are owned. Here, interactions with others necessarily arise when nonowners seek to put the good to an alternative uses. The owner, presumably, has a just claim over the use of that good, and he alone may decide how that good is put to use. Different property rights regimes may place greater or lesser constraints over the extent of his use, but ultimately the owner determines what will happen to this good. Of course, with a system of property rights there must not only be constraints on how property is acquired, but also on how it is exchanged. Still, what determines the terms on which exchanges of property take place are the desires of property owners on both sides of an exchange.
Because of the fundamental fact of scarcity, a good can be applied to multiple ends, any one of which precludes the others from being realized. In deciding whether to homestead an unowned good (that is, apply one’s labor to acquiring the good and so become the just owner), a person must judge whether that choice will best meet his ends. He must then make a further choice as to how the good should be obtained and used. Of course, he must understand the property rules for his society, so that his actions are justifiable, but in this case the only barriers due to scarcity that he faces are the facts that by homesteading the good, he cannot do something else, and that by using the good in one way he cannot use it in some other way.
He of course faces these same difficulties when deciding whether to acquire an owned good. However, now he faces an additional problem: namely, how to obtain access to property from which he is forbidden, absent the owner’s consent. The scarcity he now faces is distinct from the fundamental or general scarcity that characterizes our world. For under a private property regime, the owner alone decides how available an owned good will be for various purposes. This scarcity stemming from ownership holds across all property. For to obtain someone else’s property, I must engage in some kind of exchange with that owner, and this presumably will involve an exchange of property. If, say, owners of beer are demanding $20 a bottle for their product, then if I so desire beer that I will pay this price in money property, my money property likewise becomes scarce to me and I must be quite careful in how I apply it elsewhere. On the other hand, with money prices, I am at least able to coherently apprehend scarcity in this sense, as there exists numerical ratios that allow me to compare prospective actions to anticipated outcomes.
Thus we can see that goods can be considered scarce not only on the basis of the limits of their physical supply relative to wants, but also on the basis of the desires of the owners of those goods. The need for and existence of property stems from a fundamental fact of reality regarding objects as goods—namely, scarcity. However, once a good becomes property, there is a further aspect of scarcity that must be considered, and this aspect stems from ownership. Because of scarcity in the fundamental sense, one is forced to make choices. An action made in one endeavor is an action that cannot be made in another. A ton of steel used to make cars cannot be used to make railroad tracks.
Because of scarcity due to ownership, one is forced to take something else into consideration: how to persuade the owner of the good in question to part with it, and this is distinct from the notion of scarcity as reflecting a limited physical supply relative to wants (although, of course, it is ultimately dependent on this fact). Now, the question is not only whether to use steel to make cars versus railroad tracks, but how to obtain the necessary steel from the person who owns it. Depending on the relative ease with which this can be done (that is, how much other property must be given in exchange for this steel), one application might be chosen over the other, and it is possible that neither will be feasible. The owner may be so insistent on keeping his property that the only price (in terms of money property) that will change his mind is sufficiently high for an entrepreneur to judge that these goods cannot be profitably applied anywhere. Or, the owner might be sufficiently generous that an entrepreneur will judge a wide range of projects to be feasible. In either case, the good in question is scarce to the extent that the owner wants it scarce.
Property is a means for solving one problem: the fact that prospective means in the physical world are of insufficient supply to meet all our ends, so conflicts with others may arise as a result. Property rights in these means establish boundaries which exclude others from using these means, and so serve as a way of resolving conflicts over them. (Of course, any property rights system, including systems based on the violation of such rights, for example, the State, is only effective to the extent that people are willing to abide by it.) In solving one problem—namely, disagreement over (scarce) goods in a state of nature—property creates another problem: the fact that an owner must now be persuaded to part with his property if one desires to apply that good to some end. However, as a property rights system must provide some way of exchanging validly owned goods, the system permits a solution to this problem: specifically, economic calculation. The amount of property one must surrender to acquire some other property, deemed more important to satisfying one’s needs, can be determined in terms of money prices. One can calculate whether the anticipated proceeds from some course of action will exceed the costs required to presumably bring that action about.
So under a system of property rights, economic decision making must take scarcity into account, not only in the usual sense of choosing which wants are to be satisfied with a finite physical supply, but also in the sense that how available a good is depends also on the circumstances arising from that particular good being owned. When a good is owned (and on the free market, ownership implies not just control but the ability to exchange), the notion of a quantifiable amount of property needed to acquire that good comes into existence. This in turn leads to numerical exchange ratios (prices), which are the basis of economic calculation for comparing prospective gains and costs. Whether a particular good will be scarce or plentiful relative to a potential use then depends on how much property that good’s owner demands for it; the question of how to “best” produce something cannot be answered outside the framework of a property rights system for determining what factors are available (attainable) for its production. Indeed, the availability of factors in an economic sense plays a role in determining what should be produced in the first place.
Implications for Economic Decision Making Under a private property regime, there is a duality: On the one hand, consumers, as property owners, determine what is produced to the extent that producers whose products are unwanted by consumers will soon find themselves out of business. On the other hand, producers, as property owners, determine what is consumed to the extent that they decide to allocate their property to certain production processes. If the owner of some factor of production will not commit that factor to some line of production, those products will not be produced and, hence, not consumed. He may come to regret his decision, but that can only be revealed in the future, not now. The wishes of consumers and the “knowledge” of other entrepreneurs are irrelevant. As Rothbard (1993, p. 561–66) argues, the concept of “consumer sovereignty,” if used in any but the above sense, is false.
Attention here must be drawn to the aspect of scarcity that derives from the specific fact of ownership, as opposed to the more general condition that the physical supply of a good is insufficient to meet all wants regarding that good. To be sure, we live in a world where goods exist only in finite physical amounts, so that not all wants can be satisfied. However, a subset of this more general form of scarcity is the scarcity that depends on the subjective valuations and desires of property owners. Whether a good is scarce or plentiful from this standpoint depends on the wishes of the owner(s) of that good.Of course, if nobody else wants the good in question, then from the point of view of these others, the good is quite plentiful. However, to acquire an owned good requires the consent of the owner, and his desires will determine how scarce the good is for use by others. A few pounds of wheat, for example, may be more plentiful than a ton of wheat, if the owners in the former case are extremely generous with their property while the owners in the latter case are extremely covetous of theirs. It is this component of scarcity, and not only the general fact of physical scarcity relative to wants, which is relevant for economic decision making. Even to acquire an unowned good from a state of nature requires the concept of self-ownership, such that one can compare the amount of property one would receive by acquiring the good oneself or working in a different line of production. (This leaves aside issues of alienability in ones body compared with physical objects; see Kinsella 1999.)
Under a capitalist system, it is largely irrelevant who owns what.Provided, of course, that unowned goods may be homesteaded (that is, unowned goods can become property), and that one can expect such rights to be respected over time. More precisely, the functioning of a market does not depend on particular ownership, only on the fact of ownership. As a consumer of beer, it may matter quite a bit to me that the owners of factors that could produce beer are unwilling to devote their resources to such production, thus yielding less beer than (technically) possible. However, with unfettered private property rights (such that valid exchanges are unhindered), there will be no situations of surplus or shortage, where actors cannot adjust prices and where there are willing sellers and buyers, but no willing buyers and sellers, respectively. (Markets “clear,” in other words.A “common-sense” equilibrium, as opposed to the general disequilibrium case of unmet desires at any given time, see Gordon (1995).) It is only important that someone owns a factor of production. In that case, one may compare the anticipated revenues (in terms of money property) from an action with the costs (also in terms of money property) of bringing that action about. Once one has formed a judgment as to how much property consumers will give for some product, one can calculate how much property (in the same units) one can afford to give to acquire the means judged appropriate to produce that good. Regardless of whether a particular factor is owned by a miser or a freewheeling sort, exchange ratios result that permit the meaningful comparison of various actions on the market.
Factors of production are valuable because the output they produce is valuable. But because the outputs of production are subjectively valued, it is not possible to compare outputs with potential inputs on the basis of value. However, under a system of private property in the means of production, numerical exchange ratios (prices) exist which permit precisely this comparison (that is, economic calculation). Whether a factor owner is stingy or generous (so that the price of his factor is “high” or “low”) is irrelevant to the fact that economic calculation is the tool of entrepreneurs who must always first form a judgment about the future. Whatever “knowledge” may be “embedded” in the prices in those two different cases in no way changes the fact that, in either case, the factor in question can only be applied to production if an entrepreneur judges that it will be profitable, and if he can obtain property sufficient enough to acquire it (Hülsmann 1997). Indeed, the question of whether he can afford this factor determines the profitability of that factor in any given venture. The scarcity induced by ownership is always addressable by economic calculation.
The question of what goods to produce cannot be answered separately from the question of how scarce the factors needed to produce that good are. However, this scarcity is dependent on the ownership of those goods, and not simply on the fact that such resources exist in physically finite amounts. Thus one can never speak of value scales as such for the purposes of economic planning. One must always speak in terms of how much (anticipated) property consumers are willing to give in exchange for those goods, which, when combined with the amount of property (referred to a common unit) needed to obtain the means for producing those goods, enables one to decide what is to be produced for consumption.In fact, the price of any good depends both on the demand and supply of it, so one can never speak of prices for consumer goods without reference to prices for producer goods. For a discussion of price formation on the market, see Rothbard (1993, chaps. 2 and 3). Value scales of consumers are only part of the problem. If a particular factor owner will not surrender his property for less than what other entrepreneurs think it can yield in some line of production, then that factor will not be used in such a way, regardless of consumer wishes (or competing entrepreneurs’ knowledge thereof).Likewise, if factor owners are unable to ask for as much property as they would like to for their products (as is the case under, say, price controls), then they will not do so, and furthermore, prospective buyers of those factors will deem them more plentiful than they actually are. This is another example of the illusions fostered by the property rights violations of the State; see Hülsmann (1998).
Predecessors The notion that the scarcity of a good depends on the ownership of that good is not entirely new. Indeed, an early economist of Austrian bent, Bastiat (1966b, chap. 1), spoke of the subjectivity of scarcity (and its flip side, abundance) when he noted that people have different attitudes toward scarcity depending on what side of a transaction they are on. In fact, property played a key role in his thought. Consider the following passage from Bastiat (1966a, p. 228):
What I now say, what I declare with conviction as an absolute certainty in my own mind, is this: Yes, there is constant interaction between private property and the communal domain. ... But the second assertion, amplified and exploited by the socialists, is even more dangerously erroneous; for this interaction does not cause any part of the communal domain to be appropriated into the domain of private property, but, on the contrary, constantly extends the former at the expense of the latter. Private property, inherently just and legitimate, because it always is proportional to services, tends to convert onerous utility into gratuitous utility. It is the spur that impels the human intellect to realize the latent potential of the forces of Nature. It attacks, to its own profit admittedly, the obstacles that stand in the way of gratuitous utility. And when the obstacle is surmounted to any degree, we find that it results in corresponding benefit to all. Then, tirelessly, property attacks new obstacles, and this process continues with never an interruption, steadily raising the standard of living, bringing the great family of man nearer and nearer the goals of community and equality.
There are probably a number of ways to interpret this passage, but its emphasis on the centrality of property in human society is clear. Bastiat clearly recognizes the role property plays as a means toward our ends. However, one can discern (at least, with a broad reading) elements of the role of economic calculation here. For by permitting exchange ratios (Bastiat elsewhere speaks of the necessity of exchange for determining value), individual ownership of property allows all others in society to appraise such property as means for meeting their ends, whereas such an appraisal would be impossible without property. The means available to man without economic calculation are of extremely limited scope; private property enabling such calculation broadens this scope enormously.
Among modern Austrians, it is Rothbard who comes closest to calling explicit attention to this concept in his discussion of monopoly prices (Rothbard 1993, chap. 10). Here, Rothbard notes that the notion of “restrictionist” production (a charge frequently leveled against entrepreneurs in support of antitrust policies) makes no sense on a free market, as the fact of scarcity means that one always restricts some production by the simple fact of pursuing one course of action over another. According to Rothbard,
In the real world of scarce resources in relation to possible ends, all production involves choice and the allocation of factors to serve the most highly valued ends. In short, the production of any product is necessarily always “restricted.” Such “restriction” follows simply from the universal scarcity of factors and the diminishing marginal utility of any one product. But then it is absurd to speak of “restriction” at all.
And in his discussion of the concept of “consumer sovereignty” (pp. 561–66), Rothbard notes the dual role all men play as both consumers and producers, and that the proper conception is one of self-sovereignty. The notion that producers serve consumers is true in the sense that producers must make things that consumers want, otherwise they will go out of business. However, it is false in a literal sense, and certainly unjustifiable in an ethical sense.
In the context of a different controversy of relevance, namely the socialist calculation debate, Rothbard (1991) quotes Professor Georg Halm:
It is true that the central authority would know quite well how many capital goods of a given kind it possessed or could procure....; it would know the capacity of the existing plant in the various branches of production; but it would not know how scarce capital was. For the scarcity of the means of production must always be related to the demand for them, whose fluctuations give rise to variations in the value of the good in question.
It can only be added to this insightful statement that “demand” must be understood to include reservation demand, the amount that sellers will withhold from the market (see Rothbard 1993, p. 118). But of course, something can only be withheld on an unhampered market if it is validly owned, so we see again the key role ownership plays in the decision making of all market participants, both of existing owners and prospective owners (that is, nonowners). The scarcity of a factor of production will depend not only on the demand for the products it can produce, but also on the judgments and valuations of the factor owner regarding its use.
The key point, the explication of which has been the objective of this here, is that restriction and sovereignty on the market stems from ownership, both in the sense of producers as owners of themselves, and as owners of the factors of production which they alone may decide how to best dispense with. In this case, scarcity of both consumer and producer goods is derived from the judgment of property owners. While scarcity is a fundamental fact of our existence, scarcity on that subset of existence, the market, is entirely dependent on ownership. If one wishes to attack a producer on the grounds that he makes his goods scarce, then one must do so on ethical grounds, for by granting him control over these goods, one grants the notion of their availability for production to be a question for him to decide. One cannot speak of consumer goods being scarce without reference to the scarcity of the goods needed to produce them, and this scarcity on the market must ultimately be considered in terms of the ownership of those factors.
We will use the term catallactic scarcity to refer to this notion of scarcity that derives from a good being owned, in distinction from the more general fact of scarcity, which we will term physical scarcity. Of course, physical scarcity is understood to have an economic component of its own, specifically the limitation of means relative to ends. However, we make the distinction to call attention to the ownership-dependent aspects of scarcity. By understanding catallactic scarcity as inseparable from ownership, we can turn attention to applying this concept to several current debates in Austrian economics.
Application I: Economic Calculation and Socialism The comparison of prospective gains with potential costs as a criterion of economic decision making has been referred to as economic calculation (Mises 1998, chap. 12). It was Mises who put forward the argument over seventy years ago that economic calculation is impossible under socialism, and that such an economic system is therefore not rational (Mises 1990; 1998, chap. 26). There has recently been a debate within the Austrian School over what, precisely, this argument means, with some researchers taking the position that the argument refers to the absence of private property, such that exchange ratios permitting computation of profit and loss are impossible (for example, Herbener 1991; Salerno 1993; Hoppe 1996); others interpret it as meaning that information conveyed by prices does not exist under socialism, such that opportunities for profit go unrevealed (for example, Kirzner 1996 and Horwitz 1998). These two camps may be called, respectively, “Misesian” and “Hayekian.”The neoclassicist position seems to be sympathetic to the Hayekian interpretation, see Yeager (1994). See also, among others, Hülsmann (1997) for a detailed analysis of these issues.
It is not the purpose here to enter into this debate. However, some support will be given for the Misesian framing of the argument by highlighting the centrality of privately owned property to economic decision making, and we will now turn to this topic.
Under socialism, of course, there is no private ownership of the means of production. Thus, the notion of scarcity in an economic sense has no meaning in such a system. A socialist planner may have complete knowledge of the physical amounts available to him, and all the ways to use them, but this is irrelevant for the purposes of economic planning. For this, he must have some knowledge of a factor’s catallactic scarcity, but this is entirely dependent on that factor being owned (so that exchange ratios may be formed). This “knowledge,” however, does not refer to some physico-chemical property of the good that could be “conveyed” to him through a price system. Rather, this knowledge refers to no more than being able to determine how much property he must give to acquire the good, which will then constrain what kind of consumer goods he can create with it. Under different patterns of ownership, this kind of catallactic scarcity will change, so there is in fact nothing objective the planner can know about. But when the factor is owned, prices for economic calculation can always be formed. Without any notion of catallactic scarcity of the means of production (which depends on ownership, not knowledgeProperty and knowledge are not the same thing, and unlike property, knowledge itself can never be scarce in any sense. That I have an idea in no way precludes someone else from having that idea, while ownership arising from scarcity does imply such exclusion (Kinsella 2001).), there can be no notion of what consumer goods are economically feasible.
What does not exist without private property (however incompletely attenuated) is a means for objectively comparing different courses of action, given a judgment about the future. At most, prices inform about how much property must be given now to acquire a particular factor of production. They tell nothing about how to use that factor or whether the future will prove some such use fruitful or not. Entrepreneurial judgment is required for this, and if some factor owner will not surrender his property for less than an entrepreneur thinks its products can be sold for, that factor will not be so used. It is ownership, not knowledge, that determines the status of the factor (Hülsmann 1997).
Thus, in a socialist economy, it is not enough to know (however completely) available physical amounts of resources and technologies for combining them along with consumer value scales. To speak of an action being economically “efficient” or rational requires being able to meaningfully compare inputs and outputs. One must be able to quantify what consumers will be willing to give in return for the outputs of production, and similarly relate the inputs of production to the same “standard.” However, it is clear that no such thing can be done in a socialist state, where there can be no ownership in the means of production, and so notions like catallactic scarcity (and resulting exchange ratios in terms of other property) are meaningless. It makes no sense to speak of how much property can be given in exchange for socialized factors of production, so it likewise makes no sense to speak of what products should be produced for consumption, as the ability to consume depends on the ability to produce. Knowing consumer preferences is of no use in solving this problem.
Socialism thus severs the duality between consumption and production, and this is its fatal flaw, not an absence of knowledge that could be conveyed by prices. (The equations of neoclassical economics explicitly make this dichotomy and consider only the physical scarcity of resources for production, and so are of no use for economic planning, even apart from knowledge problems and their static nature.All of these equations in their various guises essentially try to “maximize” utility subject to physical and technological constraints on available resources. Even granting that, with complete knowledge and perfect foresight, a planner could allocate resources for a given period based on these equations, the question of how much of his available resources he should hold in reserve for future consumption cannot be so addressed. At some point a planner must stop cannibalizing an existing capital structure and at the very least maintain that structure, so capital goods must be included in his value scale. However, it is nonsense to include indirectly valued means among his directly valued ends. Even means must be economized, but unlike ends, recourse to their utility is futile for doing so. They only have utility because of the (direct) utility of the ends they produce, but it is only the utility of ends that one may appraise, in terms of the wants they remove. Only monetary prices permit the appraisal of both means and ends. The choice of how to “model” available means in these equations is arbitrary at best, if not absurd (for example, modeling capital “growth” like some sort of natural phenomenon). Thus, as Salerno (1990, p. 56) noted, “[s]ocialism will have particularly devastating effects on the economy’s capital structure.”) To be sure, it has never been demonstrated how this transmission of knowledge through prices supposedly occurs, or exactly what information, “tacit” or otherwise, is contained in prices, but the point is that under a private property system, it is irrelevant whether someone “knows” of great, unmet demand toward which some factor of production can be applied. On the free market, such a factor is presumably owned, and unless that owner is willing to part with his property (which requires an exchange of other property), that factor cannot be applied to that production process, regardless of how much knowledge one possesses of alternative uses for it.
Also, one wonders where the importance of “decentralized” knowledge lies (see Hoppe 1996). For ownership is both centralized and decentralized: centralized in the fact that one and only one person controls access to some good (even when the good is jointly owned, different people own different shares), and decentralized in the fact that under a private property regime (either free or partly free), anyone can attempt to acquire the good by offering sufficient property in exchange. Indeed, at what stage does “economic knowledge” become decentralized? When, say, ownership of some physical supply is more or less evenly distributed? Why not when a single person owns 99 percent of a good? In either case, prospective actions can be coherently evaluated (“appraised”) via economic calculation. It is the existence of markets that permits economic calculation, not the decentralization of knowledge, economic or otherwise.
One may concede, however unlikely, that a socialist planning board may have complete knowledge of resources, technologies, and tastes, and may be able to assemble factors to produce some list of desired goods. However, this output has no economic meaning because there is no notion of exchanging one state of affairs for another, of sacrificing consumption to production and vice versa. One may contend that the central planning board could not “know” whether a particular allocation of resources is economically efficient, or whether they are meeting some needs at the expense of other, more urgent needs. However, these objections only make sense within the context of ownership of the goods and resources in question. However, it is pointless to exchange property for production purposes based on subjective valuations, and economic calculation with market prices (exchange ratios) permits the subjective valuations of consumer goods to be indirectly imputed to producer goods. But again, it is ownership and not knowledge that is central to this process, for only ownership enables the exchange ratios necessary for this comparison process to come into being.
What are economically wasteful inputs under one realization of private property rights may be profitable under another realization, depending on the desires of property owners, both from the point of view of producers as well as consumers. Correspondingly, a different set of outputs (consumer goods) will be economically rational or irrational, depending on these circumstances. Under such a system, it only makes sense to speak of less urgent needs being met if an entrepreneur obtains a loss on his venture. With different patterns of ownership, that venture may well prove profitable, in which case one would say he has met urgent needs. One cannot say, for example, that it is always economically wasteful to build a car with gold. It is only under current conditions (of ownership, valuations, etc.) that such an activity is wasteful. Under different conditions, it may well be profitable.
So, the problem with socialism is not that the central planning board will not know how to best meet given ends. It is that without the notion of privately owned means of production (and hence catallactic scarcity of those means), the notion of what ends are appropriate at all makes no sense. One may postulate a “market” for consumer goods in a socialist state, with “prices” for these goods. However, these prices have no relation whatsoever to their counterparts in a capitalist state, even if numerically they should happen to be the same. For the prices in a capitalist system imply an amount of property that can be given in exchange for that good. In a capitalist system, this (money) property encompasses consumer as well as producer goods. Obviously, whatever property can be obtained in a socialist economy must exclude producer goods, so the notion of “prices” as exchange ratios, even among consumer goods, is severely restricted if not meaningless.
Application II: Monopoly Capitalism Of course, it may be objected that, even under socialism, catallactic scarcity also exists, as the central planning board does in fact own the means of production in the society under its control. However, this is better characterized as controlling these factors, as ownership suggests that one can divest oneself of property, and of course this cannot happen under socialism (if the system is to remain socialistic). A contrast may be made with the situation of monopolies under capitalism. Under capitalism, a person may be the sole owner of some particular factor or class of factors. In principle, however, one can always offer such a person property in exchange for these factors, so there is a notion of scarcity in the sense of what uses these factors can be profitably put to, relative to what must be used to first acquire them. Such a situation cannot, even in principle, occur under socialism. Indeed, we again see the duality of exchange that exists under a private property system. To own something means that someone else must surrender a certain amount of property in order to become the owner. How much property depends on the valuations of the prospective exchangers. Even a “monopolist” can in principle be persuaded to part with his goods, and an entrepreneur can at least attempt to calculate how much this will take. Such an endeavor may prove fruitless, but it is at least possible. (Likewise, if no one has any interest in or anticipates any profitable use of the monopolist’s goods, then the fact that he is sole possessor poses no problem for entrepreneurs.)
So even an extremely restrictive monopolist faces a categorically different situation than the director of the central planning board. The monopolist can in principle transfer ownership (for a price), while the director cannot. The extent to which the monopolist is willing to do so determines the scarcity (economic) of his factors, and thus what is feasible to produce for consumption. Whether the director would be generous or covetous is irrelevant; neither characteristic changes the fact that he cannot dispose of these goods, so attaching economic significance to them is impossible (or, better, meaningless), unlike under a private property system. Furthermore, from an economic perspective, the monopolist, as an owner, behaves no differently if he restricts use of his factors or applies them. In either case, his subjective valuations and judgment of how best to satisfy himself drives his actions. This aspect of economic behavior, either committing or withholding resources, is the dual part of every economic action under private property. For the director, it makes absolutely no sense to speak of him withholding resources. For what end? For the director, he must apply these resources, so the notion of catallactic scarcity which implies the need to conserve resources is absent. Again, the duality between production and consumption is severed under socialism.
Even if an entrepreneur should happen to come into ownership of all the means of production in some society, his position is quite different from that of the director of the central planning board under socialism. The monopolist can always assign economic significance to his property by entertaining bids from others, and of course he can accept those offers. In a capitalist society, money prices encompass both consumer and producer goods. For the central planner, it is absurd to think he can receive bids for the property under his control. He cannot exchange his property, so any attempts by him to “play” market are just that: meaningless games.More generally, as states may be considered territorial monopolists of judicial and protective services, one can make a distinction between privately owned governments, such as monarchies, which can engage in economic calculation, and publicly owned (“caretaker”) governments, such as democracies, which cannot. For more on this distinction, see Hoppe (1999).
Should the monopolist actually refuse all offers, he can still in principle accept them at any time. And in fact it is his stance that determines the notion of catallactic scarcity in his society. For assuming he came about his goods justly (that is, mixed his labor with unowned land or acquired, through voluntary exchange with others, property likewise created (Hoppe 1989, 1993; Rothbard 1998), then there can be nothing wrong in an ethical sense with him hoarding all of his goods. (Of course, socialism violates the “natural” property rights of others, and this alone would disqualify socialism as a justifiable system, but this is a separate issue.) Whether his hoarding, which would presumably lead to great suffering for others, is wrong in a moral sense is an entirely different matter. In this case, the scarcity in society is quite extreme—one might say far “greater” than the mere fact of limited physical amounts.
The director of the central planning board is in no such position. The notion of him accepting or refusing an offer for his property (so that numerical exchange ratios for economic calculation could be formed) is absent under socialism. Any bid he could receive would be meaningless, for he cannot surrender any factor of production. Under capitalism, the bids made to factor owners, be they monopolists or not, permit the evaluation of prospective actions. That is, prospective gains can be meaningfully compared with costs because a common unit of comparison exists. No such common unit exists under socialism. Even a monopolist can coherently compare the gains from applying a factor to production himself or selling it to someone else. The socialist director cannot sell a factor. Single ownership of a good does not abolish markets for that good, so prices can still be formed. Coercive socialism, however, does abolish markets.
Application III: Business Cycle Theory As a further, albeit brief, application of the concept of catallactic scarcity as determined by ownership, consider Austrian business cycle theory. The details of this theory need not be expanded upon here, and some familiarity will be assumed (for example, Rothbard 1983; Mises 1998, chap. 20). The main thrust of the theory is that economic downturns (“recessions”) are attributable to the fact that credit inflation distorts the structure of production, which depends on the time preferences of consumers (their willingness to forego current consumption in favor of future consumption). Thus, “artificially” low interest rates give rise to a (lengthened) structure of production inconsistent with the (unchanged) time preferences of consumers, necessitating at some point a restoration of the original structure (a boom-to-bust process).
Certain aspects of this theory have been criticized by Hülsmann (1998), in particular the notion that downturns are the consequence of credit inflation. (Hülsmann accepts the descriptive details of the nature, but not the cause, of the cycle as laid out by Austrian business cycle theory.) Among other points, he argues that inflation, like any other unanticipated change, can be correctly forecast by entrepreneurs, so there is no reason to presume that they will be so misled. (This is actually, in one form or another, a common critique of the theory.) Austrian business cycle theory in its usual form is at best, then, a contingent theory of economic downturns. Instead, he argues for an essentialist rendition of Austrian business cycle theory, wherein error is not a consequence of past conditions (no such consistent theory is possible), but rather is inherent in the system of banking that exists today throughout the Western world (that is, fractional reserve banking, the lending out of demand deposits in excess of reserves).
Some support will be given here for Hülsmann’s argument. First, it should be noted that, on a free market, it is consumer time preferences that determine the length of the structure of production. The more consumers are willing to save (that is, forego current consumption in favor of future consumption), the more far-removed or “roundabout” production processes can be relative to the finished product.See Rothbard (1993, chap. 8) for a more detailed discussion of this process. That is, the scarcity of capital goods in an economic sense is determined by ownership, namely the willingness of consumers to exchange their current property for future claims to property. This property can then become owned by entrepreneurs, who can assemble a structure of production as described above (that is, via judgments and economic calculation). Whether the consumers directly give their property to entrepreneurs or (more likely) use banks as an intermediary is irrelevant. The key point is that the availability of capital goods again depends on private property (ownership).
The situation is quite different under a system of fractional reserve banking. Here it is not property and the subjective valuations of its owners that determine scarcity (in the economic sense) and drive production processes. Rather, it is the ability of banks to create titles to property not backed up by actual property.See Hoppe et al. (1998) for more on this point, as well as the purely juridical nature of fractional reserve banking. That is, catallactic scarcity, which depends on the ownership of property, is not the determinant of production (and thus, ultimately, consumption). Instead, the catallactic scarcity of capital goods is inherently misrepresented under this system, as the bankers do not surrender their own property in exchange but rather create “false” property, claims to property divorced from existing property. It thus appears that more property is available for production than actually exists, and here is the nature of the crisis as laid out by Austrian business cycle theory—the mismatch between consumer time preferences and entrepreneurial judgments thereof.To use Hülsmann’s (1998) term, the illusion of more property is created by fractional reserve banking. More generally, as an inherently aggressive institution, the State relies on many other illusions to continue its existence, for example, the illusion that people can remain owners of themselves and their property while granting the State the ability to unilaterally tax, jail, etc.
Indeed, one may refer to this situation as a “political discovery process,” as distinct from a fallacious “price” discovery (Hülsmann 2000), since the availability of capital is not determined by the value judgments with property of individual owners, but by the ability of bankers to discover how much they can jointly issue titles to property in excess of actual, existing property. That is, the scarcity of capital is not determined by the subjective valuations of the owners of capital, whether they are generous or greedy with their property. Rather, the amount of capital is determined by the actions of others—in this case, other bankers. The more other bankers expand their lending beyond reserves, the greater latitude any other banker has for doing the same. This situation does not result when considering individual property owners, where the decision to make property available is entirely up to the individual owner. In fact, the entire concept of property at all is distorted under fractional reserve banking, for in this case what constitutes “property” is dependent on the will of the bankers to create something out of nothing. Under a true property regime, one cannot create something out of nothing, regardless of the intensity of one’s desires. This is not true under fractional reserve banking, where the only constraint on any individual bankers desires is the extent to which other banker’s are likewise willing to inflate.
Thus the notion of scarcity of capital goods (and the resultant production structure based thereon) is completely blurred under fractional reserve banking, and it is the nature of the system that is the ultimate source of the error (malinvestments) and that Austrian business cycle theory attempts to explain. To be sure, the concept of catallactic scarcity is not completely obliterated, as it is under full-blown socialism. It remains the case, though, that the scarcity of capital is falsely represented under fractional reserve banking.
Conclusion To conclude and summarize, the notion of scarcity of a particular good for economic purposes must include reference to the ownership of that good, and not just the limited physical amount of that good relative to wants. It is scarcity in this economic sense (that is, the willingness of the owner of some good to exchange it for something else) that is of central importance to economic decision making (calculation, comparing anticipated revenues with prospective costs in a common denominator), both in deciding how to produce something, as well as what to produce. One cannot hope to reproduce the results of an unhampered market with systems that destroy the central characteristic of that market. Various forms of violent intervention in the market abolish this crucial notion of scarcity, either completely, as under socialism, or partially, as under fractional reserve banking, with results that are, at best, arbitrary from the point of view of consumers. In actuality, of course, the realized results have been utterly disastrous.
It is not a question of “knowing” how valuable ones actions can be, and learning of this through the price system. The point is that action within society is always action within a system of property rights, restricted or unrestricted to some degree. Given constraints on our actions as imposed by such a system, the question becomes, what must one do to attain one’s goals? In a system of property rights, one must exchange property for property, based on judgments of the future. Only under a system of property rights can one quantify and compare in a common unit gains relative to losses (comparison of procedures for producing subjectively valued goods being otherwise impossible), and only under a system of unfettered property rights is the duality between consumption and production preserved. That is, only then are there objective constraints on both what is produced and consumed. Social democracy and state capitalism as currently exist in the Western world blur this duality, while complete socialism demolishes it.
Joe Salerno is Academic Vice President of the Mises Institute and one of the world’s leading economists in the Rothbardian tradition. He discusses his intellectual roots, as well as his scholarly work on money and banking. But Bob also asks Joe to recount some of his funny adventures with Murray Rothbard.
For more information, see BobMurphyShow.com. The Bob Murphy Show is also available on iTunes, Stitcher, Spotify, and via RSS.
The Economic Theory of Costs: Foundations and New DirectionsMatthew McCaffrey, Ed.London and New York: Routledge, 2018, xiv + 270 pp.
Karl-Friedrich Israel (KF_Israel@gmx.de) is lecturer at the Department of Law and Economics at the University of Angers, France.
Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.
This collection of essays edited by Dr. Matthew McCaffrey deals with one of the most fundamental fields of economic research: The Economic Theory of Costs. Indeed, it is so fundamental because of its close connection to all other central areas of research in theoretical economics, such as the theory of choice, value, price, capital, production, risk, uncertainty, and entrepreneurship. All of these are covered in some way in the book.
It spans over 263 pages and is separated into five parts, each containing two essays. Only the last part includes a third essay by the editor himself. Almost all of the eleven chapters are published for the first time in this collection and constitute pieces of original research. The one exception is chapter 4. It contains the first but ultimately discarded draft of Rothbard’s fifth chapter for Man, Economy, and State that was uncovered in the Rothbard archives at the Mises Institute a couple of years ago by Dr. Patrick Newman. He has re-edited and published it previously in this journal (Rothbard and Newman, 2015).In the volume it is also indicated that chapter 5 by Dr. Guido Hülsmann is a reprint of an earlier publication in the Quarterly Journal of Austrian Economics. This is incorrect. Hülsmann’s essay has only been published very recently as a GRANEM working paper (Hülsmann, 2017). The provided reference actually corresponds to the earlier publication of Rothbard’s draft chapter (fn. , p. 144). The page numbers in the earlier reference to the first publication of the draft chapter given in the book are wrong (fn. , p. 126). The reviewer earnestly promises that the rest of the review will be less pedantic. In fact, these are the only errors of this sort that have been spotted.
McCaffrey sets the stage with an introductory chapter, explaining that the contributions contained in the volume stand in the “causal-realist” tradition (McCaffrey 2018, p. 2), which is closely related to the distinctly Mengerian variant of the Marginalist Revolution and the research program that emerged out of it: Austrian economics. The purpose of the book is “to showcase a variety of research strands within the modern Mengerian tradition that relate in some way to the theory of cost” (p. 3). Menger and his intellectual heirs reconstructed economic theory on thoroughly subjectivist grounds, showing that costs in their various forms are derivatives of the subjective values of ends pursued or foregone. The subjective nature of costs is highlighted directly in the first part of the book entitled “Cost and Choice.” From there on the contributions proceed to different areas, applying the basic insights of the theory of costs to some relevant theoretical problems. We will go over them in the order maintained in the book, expanding on a number of selected issues that are of particular importance according to the undoubtedly subjective assessment of the reviewer.
PART 1 – COST AND CHOICE In the first chapter of the book, Dr. Jonathan Newman clarifies some of the foundations of the notion of costs, which he ultimately always considers to be opportunity costs. In particular, he highlights their subjectivity and forward-looking nature: “The ordinality and subjectivity of preferences applies to both value and cost. Just as value is appraised in action ex ante, so are costs” (p. 12). An opportunity cost, in this >ex ante sense, is the subjective value of the next best perceived alternative course of action, all expected consequences taken into account.
Newman identifies two common but contradictory notions of opportunity costs in the standard literature. The first simply defines them as the subjective value attached to the next best choice alternative. According to the second they are objective physical production trade-offs. Both notions are typically presented side by side in modern standard textbooks. This might account, as Newman persuasively argues, for some of the confusion on the topic identified in the literature and by experimental research (Ferraro and Taylor, 2005).
Probably more interesting for readers of this journal, however, is Newman’s discussion of George Reisman’s stance on opportunity costs as well as the recent back-and-forth between Dr. Eduard Braun and Dr. David Howden on the topic (Howden, 2015, 2016b, 2016a; Braun, 2016a, 2016b). Howden criticized Braun in a review of his book Finance Behind the Veil of Money (Braun, 2014), for among other things abandoning the opportunity cost concept. This critique triggered the debate. Newman sides with Howden and reiterates and expands on his convincing arguments for why the notion of opportunity costs, understood as forward-looking subjective expectations of the value of alternative courses of action, is important and useful to analyze human choice. Howden also showed why the ex post evaluation of opportunities is indispensable to find out whether one could have done better than one actually did. Yet these points are not even disputed by Braun. Both Howden and Newman fail to appreciate the actual problem hinted at in Braun’s analysis, namely, the identification of profit in human action and, more specifically, the ex post identification of monetary profits.
Taking ex post opportunity costs as the relevant benchmark for identifying monetary profit leads to a very strange result: A profit could only be made if one had actually invested in the best (or shall we say most profitable) project out there. Imagine tech investor Pete who happens to have picked the project FB for his investment. FB turns out to be the best among all the projects. Pete strikes it rich and actually makes a monetary profit. The latter is determined by the difference between the generated monetary income from FB and the unrealized monetary income Pete could have earned by investing an equal amount of money in the next best alternative.
Now assume that instead it turned out that there was an even better project. Let us call it Twttr. It has generated, for some other investors, an even higher monetary return than FB. This means that Pete would have made a loss instead, as Reisman and Braun lament by providing a number of other examples of this kind. Under this notion of opportunity costs, only investments in Twttr would have generated a monetary profit. This led Braun to focus instead on costs understood as historically incurred monetary outlays for his analysis of financial markets and interest rates. In fact, Newman implicitly acknowledges that Braun has a point when he considerably narrows down the applicability of the opportunity cost concept by stating “that opportunity costs cannot be identified in hindsight and that opportunity costs may only be identified for one choice at a time” (p. 20). If that is so, then good for Braun that he got rid of it for his purposes.
Moreover, it is not quite correct to accuse Braun of denying the importance of alternative uses of resources and foregone opportunities altogether. They are precisely what determines the monetary outlays necessary to acquire the means of production for any given investment project. The higher the expected subjective value of the alternative ends, to the attainment of which those factors could have been dedicated instead, from the perspective of the relevant market participants, the higher will be their money prices, and hence the monetary outlays necessary for the realization of the project.This argument is made, for example, in chapter 10 of the book by Dr. Per Bylund. The investor thus has to compensate for the alternative ends forgone. Costs understood as monetary outlays are indeed, in this very important sense, opportunity costs.
In the second chapter of McCaffrey’s book, Dr. Joseph Salerno presents a very dense theoretical discussion of the “unitary valuation process” (p. 32) that gives rise to money prices paid for goods on the market. He tries to show why there is no such thing as an income effect as a result of price changes along the demand curve for a specific good in causal-realist price theory, and thus responds to a long-standing debate in neoclassical economics.
He argues first of all, following the causal-realist approach to price theory, that an individual’s demand curve for a certain good is a higher-order abstraction. It can be derived on the basis of an ordinal value scale, on which all relevant goods including money are ranked, as well as the existing stocks of these goods in possession of the individual at the given moment. Second, the ranking of money relative to other goods presupposes a given purchasing power—“or rather, a definitely anticipated purchasing power of money” (p. 36). In other words, the purchasing power of money has to be held constant in order to derive the demand curve at the given moment in the first place.
All that happens in response to changes in prices along the demand curve are then substitutions with other goods according to the value scale of the agent. There is no income effect, or as Salerno terms it, purchasing power effect>, because a given purchasing power is a prerequisite for the derivation of the demand curve. The income effect is then merely an “illusion” (p. 35) stemming from the misapplication of demand curves.
However, the reviewer is puzzled by the question of how a price change could be possible without also changing the purchasing power of money. If the purchasing power of money is to be understood as the array of goods that can be bought with a given amount of money, then surely a price change for some good necessarily changes the purchasing power of money. But if a constant purchasing power is presupposed for the derivation of a demand curve, must the very idea of a price change along a given demand curve then not be considered bogus? Rather, under these assumptions, an exogenous change in the supply curve of a good that causes “price changes along the demand curve” must also trigger an alteration of the demand curve itself, to the extent that the subjective value of money changes in light of changes of its purchasing power.
To the reviewer it seems wrong to assume that the purchasing of money as such needs to be held constant in order to construct the demand curve for a specific good. Rather, one has to hold constant the purchasing power of money with respect to other goods and of course the actor’s subjective value scale. In other words, the opportunity costs of spending money on the specific good for which the demand curve is derived need to be held constant. If that is done, there seems to be a way to reconcile a kind of “income effect” with causal-realist price theory. In the reviewer’s eyes, a better term would be “wealth effect.”This idea is further developed in Israel (2018).
Salerno goes on to show why his result does not contradict the possibility of a backward-bending labor supply curve. The latter is possible without an income effect, solely on the basis of the law of marginal utility and a given value scale on which leisure is ranked against money balances. Salerno thus counters a critique raised by Caplan (1999) against Rothbard’s denial of the income effect, while still assuming that the backward-bending supply of labor is possible.
PART 2 – THE EVOLUTION OF CAUSAL-REALIST PRODUCTION THEORY The next two chapters are dedicated to production theory in the causal-realist tradition. Dr. Patrick Newman provides a review of Rothbard’s evolving thought on the topic in chapter 3, which is geared to Rothbard’s original draft chapter on production theory for Man, Economy, and State (Rothbard 2009), republished as chapter 4 in this volume. Rothbard ended up thoroughly revising his production theory and rejected this early version of the chapter. It therefore illustrates the evolution of Rothbard’s thought on the topic. Newman’s accompanying chapter is of great value for the student as well as the historian of economic thought as a brief comparative outline of different approaches to production theory.
Rothbard’s original draft chapter is much closer to the Marshallian partial equilibrium approach to production theory, although it already emphasized a number of weaknesses, such as the fact that one cannot develop a robust theory of investment from the perspective of an isolated firm. Rothbard’s final theory of production, however, adopts an Austrian general equilibrium approach as described by Newman. The latter is distinct from the Walrasian general equilibrium approach and essentially characterized by four features.
First, Rothbard rejects the conceptual distinction between competitive and monopoly prices for the analysis of a market economy as being arbitrary. The formal conditions that define a competitive situation are never met in the real world. As Rothbard pointed out even in his earlier draft chapter: “In this interpretation, every seller of an individualized commodity is a ‘monopolist’” (p. 85). Second, no firm can be a mere price taker. Every firm has some impact on the prices of its products and in that sense always acts under imperfect competition in neoclassical standard terminology.
Third, the standard isocost-isoquant derivation of factor demand curves is rejected as it obfuscates the causal link of price determination that runs from the money prices of the final product to the prices of the factors of production by backward imputation. In the causal-realist analysis, actual and expected output prices explicitly determine the capitalist-entrepreneur’s willingness to pay for factors of production according to their discounted marginal revenue product.
Lastly, the perspective taken in causal-realist production theory is not the one of a manager of some selected firm who in isolation—that is, at specified and constant factor costs—expands production until marginal revenue equals marginal costs. Instead, the vantage point of the capitalist-entrepreneur is taken, who can invest in a variety of different lines of production, which in a dynamic setting will have unequal rates of return. For any individual project it might therefore not be optimal to actually expand production to the point of optimality derived in the Marshallian partial equilibrium approach.
PART 3 – RISK, UNCERTAINTY AND COST In chapter 5 of the book, entitled “The Myth of the Risk Premium,” Dr. Guido Hülsmann sets out to defend a rather bold theoretical claim. He argues that
the prevailing conception of risk as related to the gross rate of interest is ill-founded. It is wrong to conceive of the gross interest rate as the sum of separate components. A closer analysis reveals that the whole idea of a risk premium within the gross rate of interest is a myth and should be discarded from economic science. (p. 134)
His analysis of risk is based on the Misesian distinction between class and case probability as well as the principle of subjective value. The most fundamental claim in Hülsmann’s essay is that probability is not an ontic category, but an epistemic one—that is, probability and more specifically risk is nothing out there in the real world, but it instead refers to our imperfect state of knowledge about the latter. The real world and its transformation is simply what it is: “It is subject to the inexorable laws of cause and effect” (p. 136). These laws are not risky or probable as such, but there is risk involved as far as our knowledge and value judgments about them are concerned.
Case probability refers to the type of imperfect knowledge relevant in the sciences of human action. It refers to cases where actors know some causal relationships, but they know neither all of the related causal chains nor everything there is to know about the relationships that they are aware of, such as their relative importance as compared to other casual factors. Hülsmann explains that subjective value judgments function as a filter through which our partial knowledge becomes relevant for human action. To the extent that one subjectively conceives of a case-probable risk associated with some investment project—that is, a factor that would negatively change its outcome—one attempts to eliminate or diminish that risk as far as possible. At the same time, one tries to amplify the factors that positively influence the outcome. This is the task of entrepreneurship or, as Hülsmann calls it, “the production of success” (p. 138). To the extent that subjectively conceived case-probable risks cannot be eliminated, they have an impact on one’s ex ante subjective assessment of the future value of that investment, and on the assessment of the marginal value product of related factors, but it has no impact on the discounting of these values as such.
Hülsmann argues that the differences in observable gross interest rates can thus not be explained by a risk premium as part of the gross interest rate. Instead, they simply “result from different subjective appreciations of available investment opportunities” (p. 142). He concludes that
the risk component in the gross interest rate is a sort of optical illusion. Different prices for different assets result from the fact that buyers and sellers appreciate them subjectively. From a microeconomic perspective, the implied differences in yield might be called risk premia. And one might use such premia in computations with an internal interest rate, to distinguish more interesting ventures from less interesting ones. But this does not alter the fact that the idea of a risk premium is an intellectual short-cut. It does not correspond to any real object. (p. 144)
The following essay by Dr. Jeffrey Herbener presents the theory of cost as an “example of the mistreatment of time in economic analysis” (p. 147). He incorporates cost curves, which Rothbard thought would not add anything, into the causal-realist framework of the analysis of production decisions and factor pricing. Herbener uses them very effectively to illustrate two implications of the passage of time.
In a pedagogically useful reconstruction of the theory of factor pricing, he first contrasts the timeless neoclassical general equilibrium theory, in which prices of factors of production correspond to the factor’s marginal revenue product and are determined simultaneously with final output prices, with the Austrian analysis of price determination in the evenly rotating economy (ERE). The latter takes production time, or the time structure of production, into account. Hence, factor prices correspond to the discounted marginal revenue product (DMRP). Future output prices determine the capitalist-entrepreneur’s demand for factors of production and thus determine factor prices in the present. Since there is no uncertainty in the ERE, the capitalist-entrepreneur’s factor demand is always such that the money prices paid for the factors used in production correspond to the DMRP and are thus consistent with future output prices. Any change in consumer preferences alters the equilibrium state as output prices change and hence factor demand and factor prices adjust accordingly.
As Herbener points out: “In actual markets, this adjustment process is rarely, if ever, completed, because the underlying causal factors are continuously changing” (p. 160), and because there exists uncertainty of the future. Uncertainty is the second implication of the passage of time for the theory of costs. The passage of time implies change, and change implies uncertainty. According to Herbener, this had not yet been satisfactorily incorporated into the theory of cost in the causal-realist tradition (pp. 160, 165). Capitalist-entrepreneurs discount the MRP, but in the real world they can only anticipate the latter. Hence, factor prices in the present are determined by the factor’s anticipated discounted marginal value product (ADMRP).
It is in Herbener’s words the “spectrum of foresight possessed by the various entrepreneurs” (p. 166) that determine the “speed and accuracy” of the adjustment process toward the equilibrium state as well as the distribution of profits during that process. As he summarizes:
Those with superior foresight move earlier into what prove to be profitable lines of production and earn profits which will then be capitalized into the prices of assets more specific to that line of production as the less-astute entrepreneurs follow suit. Even when the adjustment process reaches its climax and no additional profit can be earned from a further expansion of production because cost structures have been pushed up by rising prices for the more-specific assets used, the entrepreneurs with superior foresight will have earned capital gains by buying the more-specific assets earlier in the process than less-astute entrepreneurs. (p. 166)
PART 4 – CAUSAL-REALIST PRICE THEORY: DEBATE AND SYNTHESIS Chapter 7 of the collection contains a revision of the theory of monopsony, a concept that has been dismissed almost completely by both Mises and Rothbard. Dr. Xavier Méra argues that they and their followers “may have gone too far” (p. 170). Méra offers a brief overview of theories of monopsony, arguing that the new standard theory is essentially at a dead end in that it defines a monopsony in very much the same way as a monopoly is commonly defined, namely, in terms of a deviation from the pure and perfect competition model—that is, a situation in which supply and demand schedules from the perspective of the individual buyers and sellers, respectively, are less than perfectly elastic. Méra argues that this criterion “implies a nirvana fallacy,” since “such perfection is beyond anybody’s reach” (p. 174). Instead, in Rothbardian spirit, monopolies and monopsonies are to be regarded as the result of government intervention, whereby sellers or buyers are granted privileges over potential competitors. The consequences are to be analyzed in terms of more or less elastic supply and demand curves and how the interventions affect these elasticities.
Elaborating on one of his earlier publications on the topic (Méra, 2010), he argues that, when dealing with a producer, monopoly and monopsony are separable from each other only in so far as there could exist perfect competition on the other markets—that is, either the factor markets in case of a monopolist or the output markets in case of a monopsonist. Since perfect competition never exists, a producer is always both a monopolist and a monopsonist, or indeed neither of the two. A monopsony privilege on the factor markets always amounts to some form of monopoly privilege on the output market, albeit not in the absolute sense, and vice versa. Méra explains:
If it is often noticed that a monopoly is a monopsony or a monopsony is a monopoly, this is rarely considered a necessity. And it is true that, with an exclusive grant of monopoly privilege on the sale of a good, one may be its sole seller while still one among many buyers of its non-specific factors of production. However, even in this case competition is hampered on the factors’ markets since no competitor is allowed to hire them for the production of the monopolized good. With an exclusive grant of monopsony privilege, one may be the sole buyer of a factor of production while still one among many sellers of a good it helps to produce, provided this factor is not indispensable to its production. Yet even in this case competition is hampered in the product market, because competitors are not allowed to produce the product using this factor. (p. 178)
The important question is to what extent the granted privileges increase the price differential between factors of production and output in response to a restriction of output and factor demand, and thus to what extent they allow for monopoly-monopsony gains. Thus, Méra develops a “theory of monopoly price-gap” (p. 176).
In his discussion of non-specific factors (e.g., labor), Méra makes a very valuable theoretical contribution within the causal-realist framework. He shows that a monopolist-monopsonist could conceivably push money prices even for non-specific factors (e.g., wages) under certain conditions below the market-clearing rate. If the demand for the output that the monopolist-monopsonist sells is inelastic, then the buyers’ overall sum of money spent on that output will increase in response to a restriction of supply. This implies a reduction of money spent on other goods. The selling prices of those goods will fall along with the other producers’ demand for the non-specific factors of production. Hence, prices of the non-specific factors will, as a result, be pushed downward.
This, however, in and of itself, does not seem to be a sufficient condition for what Méra attempts to show. He neglects a potential offsetting effect. While nominal expenses of the buyers of the monopolist-monopsonist’s product on other goods will go down, nominal expenses of the monopolist-monopsonist on various other goods, in his or her capacity as consumer or investor, will go up as a result of the realized monopoly-monopsony gains. This will have exactly the reverse effect, increasing monetary revenues of other producers and hence their demand for the non-specific factors of production. It is not clear where the net effect lies.
Of course, this does not change the fact that Méra has nicely illuminated the mechanism by which prices for non-specific factors, such as wages, might be pushed below the market clearing level as a result of monopoly-monopsony power.
In the next essay, Dr. Mateusz Machaj deals with some Post-Keynesian criticisms of the neoclassical marginalist theory of product pricing and shows that the Austrian theory is mostly immune to those criticisms. Yet, he holds that “in some cases the Post-Keynesian contribution to price theory strengthens Austrian arguments about the market process, especially in those aspects where Post-Keynesians are anti-neoclassical” (p. 195).
Post-Keynesians tend to highlight the relative importance of quantity and inventory adjustments instead of price adjustments in response to changing conditions of demand. Prices tend to be more or less “sticky.” Moreover, they argue that output prices are rarely set in such a way that marginal revenue equals marginal cost. Machaj shows that Austrians have at least implicitly already addressed these considerations, which he argues could be interpreted as being “the result of a plain state of rest perspective” (p. 196). In contrast, neoclassical economists “seem to talk about the final state of rest,” which is another way of saying that they abstract from uncertainty, change and time as shown and discussed in Herbener’s essay in chapter 6 of the volume. The Post-Keynesian qualms stem from these unrealistic assumptions in the standard neoclassical theory, but “economic reasoning can rely on the realistic momentary equilibrium of the plain state of rest for analyzing the pricing process,” (p. 196) as Machaj argues.
In his discussion of the imputation process (pp. 198–200), Machaj gives the hypothetical example of shirt production. He supposes that blue and green shirts are produced and sold at the same price even though demand for blue shirts is much higher. Sellers have adjusted quantities instead of prices. He argues correctly that such a case would not prove the limitations of the marginalist approach, but his explanation strikes the reviewer as somewhat unsatisfactory. He writes:
According to Böhm-Bawerk, the law of costs is actually an idea about marginal utility in disguise. In the shirts example, for instance, it does not matter that demand (and marginal utility) for blue shirts is higher relative to green shirts. What matters are the marginal utilities of other goods and services that would have to be given up in order to reproduce blue shirts. And since green and blue shirts require basically the same sacrifice, virtually the same marginal utility would have to be lost. If we lose the last-produced blue shirt, we only have to give up the production of the last green shirt and switch green dye for blue (just as when we lose the most important blue shirt we only have to use the marginal shirt as the first). Therefore we have a perfect explanation of why the costs of both shirts are the same—in the end, their marginal utilities of reproduction are the same. (p. 199)
This does not really explain why their selling prices remain the same. In the plain state of rest analysis, they remain the same because of the price-elasticity of demand anticipated by the producers. If they anticipate that price-elasticity is high for whatever reason, they might not raise the price for blue shirts, and instead start to expand blue shirt production as far as this appears to be profitable—that is, simply to the point where marginal revenue equals marginal costs or demand is anticipated to be satisfied at the prevailing price. This in turn increases demand for blue dye and exerts upward pressure on its price. Whether or not “in the end, […] [the] marginal utilities of reproduction” of green and blue shirts are the same, depends on whether or not blue dye production can be expanded without significant increases in marginal costs.
In the end, the pricing of the factors of production depends on the prices of the final output. Indeed, Machaj puts this fundamental Böhm-Bawerkian insight very vividly:
From the perspective of an individual producer, it may seem that sellers practice cost-based pricing. Yet at the same time, this fact in no way validates the broad marginalist point that costs themselves result from other potential investment avenues that could be undertaken. Once we look at the economy as a whole, we see price-based costing despite the fact that firms attempt to engage in cost-based pricing. (p. 200)
PART 5 – ECONOMIC ORGANIZATION, ENTREPRENEURSHIP AND THE FIRM The first chapter of the last part of the book is by Dr. Mihai-Vladimir Topan. It contains a discussion of the compatibility of Austrian economics and “transaction cost economics” as developed most notably by Ronald Coase and Oliver Williamson. Topan comes to the conclusion that transaction cost is a “chameleonic instrument which raises more questions than it solves” (p. 220). Consequently, incorporating transaction costs as a general abstract notion into Austrian economics would in his eyes not improve the theoretical analysis, neither in the areas of economics of property rights nor the theory of the firm, which he specifically investigates.
The most obvious problem with the notion of transaction costs is that it is not well-defined. Topan argues that it is based on a misleading dichotomy between production and exchange, or the firm and the market. Transaction costs are somehow related to the latter but not the former. Topan explains the problem:
Praxeologically, as Mises would say, any human action has the structure of an exchange—autistic exchange or interpersonal (direct or indirect) exchange—involving the giving up of a certain state of affairs in favor of another that is expected to be more satisfactory. […] Thus, the general category of costs, understood as opportunity costs of the actions undertaken by human agents, cannot theoretically be split into two categories—production costs and exchange (or transactions) costs. They are simply part of the same general category of cost with no substantive difference to set them apart. (pp. 209–210)
The vague notion of transaction costs has thus been applied to all kinds of questions in economics. There is what Topan calls a “transaction cost imperialism” (p. 217), in which attempts are made to explain not only firms, but markets themselves as well as all kinds of market phenomena, such as money, in terms of transaction costs. The notion ends up proving too much: “Coase suggests that the effects of transaction costs are ‘pervasive in the economy.’ The problem is that if transaction costs explain everything, they end up explaining nothing” (p. 218).
The next essay in McCaffrey’s volume does not deal with the elusive concept of transaction costs, but rather applies the more common notion of opportunity costs in order to show, in a first step, that value logically precedes costs> even if understood as outlays for production. Indeed, Dr. Per Bylund explains that it is the anticipated value of investment projects that leverages the costs in existing lines of production in an entrepreneurial economy. This is because the demand for factors of production increases when new lines and methods of production are explored. This is again an application of Böhm-Bawerk’s theory of factor pricing via imputation that was discussed and applied previously in the book.
The new element in Bylund’s chapter, with respect to the rest of the book, is his discussion of entrepreneurship and management as distinct economic functions. He draws certain implications from this distinction for the socialist calculation debate. His analysis seems to be targeted towards rebutting a recent contribution to the debate by Denis (2015). The latter has argued that one could have public ownership of, but decentralized decision making and control over, the means of production. This arrangement, which he terms “several control,” would provide market prices and thus allow for economic calculation.
Without having studied Denis’s contribution and judging solely from Bylund’s brief description, the reviewer suspects that such an arrangement of “several control” could strongly resemble what we observe in the real world today, for example, in Sweden or the US. After all, there is no full-blown private property, but rather a “fiat property” arrangement. There is decentralized “ownership” or control over the means of production and their revenue product only to the extent that a centralized state, or, if you like, a democratic collective, grants it.
Bylund argues that in Denis’s world there could be no entrepreneurship. There would merely be management. The validity of this claim depends, of course, on the definition of the terms. However, from Bylund’s outline, one gets only an intuition, and by no means a clear-cut answer as to where exactly the line is drawn. At one point, he states: “The entrepreneurial function is here one that provides value creation relative to other types of production that already exist in the market” (p. 230). The entrepreneur develops “new supply functions that disrupt the market and discover previously unknown demands […] [T]hey require new uncertainty-bearing and are consequently entrepreneurial” (p. 232). In contrast,
within the firm’s production process, the manager can improve its technical efficiency […] or the effectiveness of the already-established production process by reducing waste and lead times, and consequently increasing overall resource utilization. […] The product can also be refined in its functionality, features, and quality, particularly as the firm learns about its customers’ specific wants and can therefore better target those most highly valued. (p. 235)
What precisely distinguishes refinement of an existing good and the creation of new ones is not perfectly clear, but surely both, if successful, create value and thus economic growth. So does the reduction of waste.
At one point, the distinction is made more specific, when Bylund claims that entrepreneurship, that is, the “creation of a new supply function entails the withdrawal of capital from its existing use and the subsequent investment in the new endeavor, which requires ownership” (p. 232). If ownership is a necessary condition, then indeed in Denis’s world there can be no entrepreneurs by definition.
However, a lot seems to depend on how such an arrangement of “several control” is exactly exercised. As mentioned above, it could look more or less exactly like the US or Sweden today, where presumably there are at least some entrepreneurs. To what extent there will be interference with the free exchange of rights to control, exchange, and combine resources and factors of production in different endeavors is simply an extra layer of uncertainty. Successfully bearing this uncertainty requires entrepreneurial skill.
Now, one might not want to call that entrepreneurship, but this is a semantic issue and actually not the most important point of the essay. More importantly, Bylund argues that a pure management economy would be regressing or shrinking even if there are market prices. It is important to note that he does not directly criticize and reject Denis’s claim that one could have market prices under “several control.” Thus, Bylund seems to accept the idea that a pure management economy could have market prices.
It seems to the reviewer that a well-managed economy without entrepreneurial innovation, where market prices exist, would not necessarily be shrinking. It could expand and grow in at least three respects, namely, as mentioned above, by the reduction of waste, the refinement of existing goods, and through the accumulation of capital and the expansion of the physical output of known goods in existing lines of production. If the relative demand in terms of known goods changes, a well-managed economy would also be capable of redirecting factors of production from one existing line to another. The managers who are confronted with increases in demand could bid away factors of production from others.
There are, of course, undeniable problems if there truly is no innovation in the economy. Exhaustion of non-renewable resources might serve as an example. But this does not change the fact that Bylund’s conclusion that in a management-driven economy “value will not only not be created but will be actively destroyed” (p. 239) is exaggerated. The theoretical discussion does not suffice to support this claim.
The last essay is entitled “Economic Calculation and the Limits of Social Entrepreneurship.” It is written by the editor of the volume. McCaffrey links the Misesian theory of economic calculation to aspects of “social entrepreneurship.” In the introduction, social enterprises are defined as follows:
Social enterprises are business organizations that are not motivated by the desire to generate monetary profits for traditional shareholders. Instead, the profits of social enterprise are used to solve “social” problems, often by addressing the same kinds of needs as charitable organizations. Social enterprises are special, however, because they support their missions through successful commercial ventures rather than through donations. (p. 244)
Indeed, the weasel word “social” requires further explanation here. McCaffrey explains that “action is ‘social’ to the extent it fosters cooperation and thereby encourages specialization and the division of labor” (p. 245). It is thus ultimately “inaccurate to contrast social with non-social enterprises” (p. 246) in this broad sense of the word. Enterprises are always social, but may be so in different ways.
Moreover, using Fetter’s notion of psychic income, and the Misesian derivative of psychic profit, McCaffrey shows that it is likewise untenable to call any enterprise strictly “not-for-profit.” Social enterprises are bound up with a kind of profit motive too. If the “social cause” pursued by the enterprise involves giving money in some form or another to certain groups, it must generate monetary income if it attempts to be more than a mere charity organization, as McCaffrey points out (p. 249).
These considerations show that it is much more difficult to clearly distinguish the social and mundane types of entrepreneurship. There is no clear-cut theoretical distinction between them that makes their analysis in terms of economic calculation fundamentally different. This is the underlying point of McCaffrey’s essay. He nonetheless maintains that “[e]conomics provides wide-ranging theories of social interaction, value, calculation, profit, and pricing that can be used to rigorously define the domain of social entrepreneurship” (p. 259). However, the “social element” is ultimately simply one form of consumption, which has to be financed in some way.
McCaffrey discusses complementary social enterprises, which operate exactly like mundane enterprises, except that they donate their profits to some “social” cause and let their costumers know it. Yet, when it comes to integrated social enterprises, the pursuit of the “social” cause is tied up into the production process itself. In practice, this means that the entrepreneurs are willing to pay morefor some factors of production. They might hire homeless workers and pay them a salary above their discounted marginal revenue product (p. 257).
In so far as the pursuit of the “social” cause is valued by the customers, the entrepreneurs will attract additional revenue. It might turn out after all that the homeless workers are really not paid above their marginal revenue product as McCaffrey shows. If the pursuit of the “social” cause does not attract additional revenue from costumer spending, it must be financed out of other sources. These could be the “entrepreneur’s profits, the capital of the enterprise, the land of the enterprise, or the wages of other employees if they are willing to forego part of their potential earnings, as in the case of volunteers for a charitable cause” (p. 257).
McCaffrey thus shows in his article that enterprises in pursuit of a “social” cause are limited by profit and loss and hence by economic calculation, just like mundane enterprises. If they generate monetary profits, they can better promote the cause. If they incur losses, the continued existence of the enterprise and promotion of the cause becomes a matter of charity on the part of the entrepreneurs or other stakeholders. One way or the other, the subjective value creation, that is, the psychic income or want satisfaction, created by the enterprise has to be strong enough to attract finance of its expenses.
ABSTRACT: In exalting the subjectivity of value, the marginalist revolution posed a fundamental problem for economic theory. Each person chooses how to allocate his means and thereby, economize his actions by rank ordering the value of alternatives. Being interpersonally incomparable, ordinal ranks cannot serve directly to economize means within a division of labor. Neoclassical economists solved this problem by foregoing an explanation of the division of labor grounded in the reality of human persons and instead, constructed formal, mathematical models. F.A. Hayek’s subjectivist response to the neoclassical project was to augment formal, mathematical models with select characteristics of human persons. In contrast, Ludwig von Mises grounded economic theory in the reality of human persons. He demonstrated how voluntary exchange of goods for and against money generate cardinal numbers from ordinal ranks. Actual money prices emerging from actual human choices constitute the necessary condition for economizing resources across the division of labor. Unlike subjective valuations, which cannot be compared interpersonally, and barter exchange ratios which are incommensurate, money prices can be compared. Economic calculations of net income and net worth, furthermore, are a phenomenon of the market economy alone. Mises’s approach not only solved the problem of economizing resources in a division of labor, but provides a robust framework for economic research.
KEYWORDS: economic calculation, subjectivism, economizing, general equilibrium, socialism JEL CLASSIFICATION: B13, B14, B24, B25, P11, P21, P51 Jeffrey Herbener (jmherbener@gcc.edu) is chair of the Department of Economics and Sociology at Grove City College.
Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.
It is probably no exaggeration to say that every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism (Hayek, 1955, p. 52).
INTRODUCTION F.A. Hayek (1955, pp. 52–53) appended the following footnote to his famous maxim concerning subjectivism quoted above:
This is a development which has probably been carried out most consistently by Ludwig von Mises, and I believe that most peculiarities of his view which at first strike many readers as strange and unacceptable trace to the fact that in the consistent development of the subjectivist approach he has for a long time moved ahead of his contemporaries. Probably all the characteristic features of his theories—from his theory of money (so much ahead of the time in 1912) to what he calls his a priorism—his views about mathematical economics in general and the measurement of economic phenomena in particular, and his criticism of planning all follow directly (although, perhaps, not all with the same necessity) from this central position. See particularly his Grundprobleme der Nationalökonomie (1933) and Human Action (1949).
One achievement of the Salerno camp in the second calculation debate was to demonstrate that Hayek, at least, leaves the wrong impression of the relationship between Mises’s work and his own. By referring to “the subjectivist approach,” Hayek seems to imply that his approach and that of Mises are fundamentally the same. Although Hayek admits to some differences in particulars, since Mises’s views, as he puts it, “all follow directly (although, perhaps, not all with the same necessity) from this central position.”
Mises, however, did not accept the subjectivist approach of Friedrich von Wieser, on which Hayek patterned his own framework, but instead worked within the causal-realist approach of Carl Menger and Eugen von Böhm-Bawerk.On Wieser’s approach, see Bostaph (2003). In discussing the two traditions in Austrian economics, Joseph Salerno (1999, p. 37) wrote:
It is important to note that even at this early stage, the Austrian school was deeply divided on a crucial issue of basic theory. On the one hand, Böhm-Bawerk fully absorbed Menger’s causal-realist approach to price theory and endeavored to develop it further and apply it to new areas. Wieser, on the other hand, seized narrowly on Menger’s “subjectivism” as embodied in the principle of marginal utility and, while usefully elaborating some of the implications of this principle, completely ignored the structure of reality-based price theory that Menger had labored to build upon it. Wieser’s purpose was to construct his own peculiar ideal of social welfare based on a state of general equilibrium that he called “natural value,” and to link it through the concept of marginal utility to foundations in human psychology.
With his acceptance of general equilibrium and emphasis on human psychology, Hayek belongs to the Wieserian wing of the Austrian school. Hayek attempted to graft onto the neoclassical general equilibrium conception his own insights into human learning, knowledge, and other “subjectivist” elements. In discussing the main contributions to modern price theory for an entry in The New Palgrave: A Dictionary of Economics in the early 1980s, which remained unpublished at the time, he wrote (Hayek, 1992, pp. 53–54):
Equally important is what may well be regarded as the final formulation of the marginal utility analysis by J.R. Hicks of the marginal utility analysis of value in the concept of the marginal rate of substitution, based on the indifference curve technique introduced by Irving Fisher and F. Y. Edgeworth. This conception of varying rates of substitution or equivalence, wholly independent of any conception of measurable utility, may well be regarded as the ultimate statement of more than half a century’s discussion in the tradition of the Austrian school….
Arguably, Hayek’s claim about Mises leading the advance of subjectivism may not be mistaken per se, however, Mises’s approach to grounding economic theory on a proper subjectivist foundation differed dramatically from that of Wieser and his followers.
ECONOMIC CALCULATION AND SUBJECTIVISM IN HUMAN ACTION In his magnum opus, Human Action, Mises subsumes subjectivist aspects of catallactics within the concept of economic calculation. The book is organized into seven parts containing 39 chapters. He devotes one entire part of the book, part 3, to economic calculation. It contains three chapters. In one of those chapters, Valuation without Calculation, we find Mises’s discussion of the subjectivity of value. He did not offer insights about how the advance of the concept of subjectivity can make the general equilibrium framework more suitable to economic theorizing. Instead Mises focused on two fundamental principles concerning the subjectivity of value.
First, he juxtaposed the ordinal ranking inherent in valuation with cardinal numbers in which the goods being ranked are measured. He did this to demonstrate a principle of economic calculation. He wrote (Mises, 1998, p. 201):
The immediate goal of acting is frequently the acquisition of countable and measurable supplies of tangible things. Then acting man has to choose between countable quantities; he prefers, for example, 15 r to 7 p; but if he had to choose between 15 r and 8 p, he might prefer 8 p…. This is tantamount to the statement that he prefers a to b and b to c…. It certainly does not render reckoning with cardinal numbers possible. It does not open a field for economic calculation and the mental operations based upon such calculation.
Second, he referenced the principle he (Mises, 1998, p. 699) would call in his critique of socialist schemes to provide a method of economic calculation, “the fundamental theorem of modern economics,” namely diminishing marginal utility. His purpose was, again, to make a fundamental point about economic calculation. Mises (1998, p. 206) wrote:
There is no method available to construct a unit of value. Let us remember that two units of a homogeneous supply are necessarily valued differently. The value attached to the nth unit is lower than that attached to the (n–1)th unit.
Mises (1998, p. 206) concluded this line of argument with the following words:
It is a fictitious assumption that an isolated self-sufficient individuals or the general manager of a socialist system, i.e., a system in which there is no market for the means of production, could calculate. There is no way which could lead one from the monetary computation of a market economy to any kind of computation in a nonmarket system.
In the subsection that closes out this section of the book, which Mises titled, “The Theory of Value and Socialism,” Mises (1998, p. 207) wrote the following about subjectivism:
The illusion that a rational order of economic management is possible in a society based on public ownership of the means of production owed its origin to the value theory of the classical economists and its tenacity to the failure of many modern economists to think through consistently to its ultimate conclusion the fundamental theorem of the subjectivist theory.
ECONOMIC CALCULATION AND THE PROBLEM OF ECONOMIZING As noted above, Mises considered the “fundamental theorem of modern economics” diminishing marginal utility, which can be deduced from a person economizing with homogeneous units of a good. Although diminishing marginal utility is accepted by all modern economists, Mises was the first to perceive the implication of its reasoning for making economizing decisions about the use of resources in society and its application to this problem in socialism. Concerning the proposal of mathematical economists to solve the problem of economizing in socialism, Mises (1978, p. 112) wrote:
They failed to see the very first challenge: How can economic action that always consists of preferring and setting aside; that is, of making unequal valuations, be transformed into equal valuations, and the use of equations? Thus the socialist came up with the absurd recommendation of substituting equations of mathematical catallactics, depicting an image from which human action is eliminated for the monetary calculation in the market economy.Quoted in Salerno (1999, p. 58).
The deficiency in economic theory that needed correcting, according to Mises, was a fallacy economists held concerning economic calculation. Mises (1998, p. 202) wrote:
The elaboration of economic theory is heuristically dependent on the logical processes of reckoning to such an extent that the economists failed to realize the fundamental problem involved in the methods of economic calculation…. They misconstrued economic calculation. They took it for a category of all human action and ignored the fact that it is only a category inherent in acting under special conditions…. But they did not comprehend that money prices are the only vehicle of economic calculation. Thus most of their studies are of little use. Even the writings of the most eminent economists are vitiated to some extent by the fallacies implied in their ideas about economic calculation.
Contrary to Hayek, who thought that general equilibrium theory could be corrected by grafting subjectivist insights onto it, Mises perceived that the deficiency of the general equilibrium construct stemmed from its fallacious treatment of money. He identified two mistakes. First, the general equilibrium construct conceived of a market economy with only direct exchange and concomitantly asserted the neutrality of money. He wrote (Mises, 1998, pp. 203–204):
A serious blunder that owes its origin and its tenacity to a misinterpretation of this imaginary construction [a market with direct exchange] was the assumption that the medium of exchange is a neutral factor only…. This is, of course, what the fable of money’s neutrality implies. The whole theory of catallactics, it was held, can be elaborated under the assumption that there is direct trade only. If this is once achieved, the only thing to be added is the “simple” insertion of money terms into the complex of theorems concerning direct exchange. However, this final completion of the catallactic system was considered of minor importance only. It was not believe that it could alter anything essential in the structure of economic teachings. The main task of economics was the study of indirect exchange.
Only later economists realized that some of the most important and most intricate problems of catallactics are to be found in the field of indirect exchange and that an economic theory which does not pay full regard to them is lamentably defective.
Second, Mises noted a more momentous error drawn from the imaginary construct of a fictitious barter world, namely, that value is objective and can be measured by money.Mises (1998, pp. 697–699) repeats his indictment of the general-equilibrium framework in chapter 26 in which he criticizes mathematical economists for perpetuating the fallacy that economic calculation was possible in socialism. He wrote (Mises, 1998, p. 205):
Even Friedrich von Wieser and Irving Fisher took it for granted that there must be something like measurement of value and that economics must be able to indicate and to explain the method by which such measurement is effected. Most of the lesser economists simply maintained that money serves as “a measure of values.”
Mises’s corrective of the deficiencies of general equilibrium theory was based on his integration of money into subjective-value theory. He demonstrated (Mises, 1953) in 1912 how ordinal ranks are transformed into cardinal numbers suitable for economic calculation in a market economy. Buyers and sellers have preferences for a good they intend to exchange relative to money. They exchange to acquire the mutual benefit latent in the reverse ordering of their preferences. Competitive bidding by the buyers and competitive offering by the sellers results in a market-clearing price. As Rothbard (1991, p. 65) recounts it:
In the course of that notable integration of monetary theory and “micro” marginal utility theory, Mises was one of the very first to realize that subjective valuations of the consumer (and of laborers) on the market are purely ordinal, and are in no way measurable. But market prices are cardinal and measurable in terms of money, and market prices bring goods into cardinal comparability and calculation (e.g., a $10 hat is “worth” five times as much as a $2 loaf of bread).
Mises did not fully work out this integration and its implications until the German-language predecessor of his magnum opus, Human Action.See Rothbard (1991, p. 65) and Salerno (1999, p. 56). In that work, he demonstrated that the market economy is the only solution to transforming rank orders of value into cardinal numbers suitable for making economizing decisions in a division of labor. Only three alternatives to the market solution of monetary prices exist, according to Mises.
One is inter-personal value comparisons among the participants in the division of labor. Yet, modern economists all agree that inter-personal comparisons of value are impossible and therefore, this alternative is not entertained by modern economists as a solution to the economizing problem. A second alternative is imputation of value across the division of labor by a single person. Valuation, Mises argued, can be applied only to a self-sufficient economy, i.e., an economy in which a person is the producer of everything he consumes.As Mises (1998, p. 210) concedes, valuation is adequate to economizing resources within a family economy or that of a small tribe as well as a single person. In this case, a single mind can integrate the use of its resources across the entire array of producer goods with which it acts. It does this by imputing the value of lower-order goods to those of higher order. According to Mises, however, a single mind cannot decompose the value of the end achieved into the value of each factor’s contribution. He wrote (Mises, 1998, p. 332):
Valuation as it can be practiced by an isolated actor (Robinson Crusoe or a socialist board of production management) can never result in a determination of such a thing as quotas of value…. It is permissible to declare that, due allowance being made for time preference, the value attached to a product is equal to the value of the total complex of complementary factors of production. But it would be nonsensical to assert that the value attached to a product is equal to the “sum” of the values attached to the various complementary factors of production. One cannot add up values or valuations. One can add up prices expressed in terms of money, but not scales of preference…. The process of value imputation does not result in derivation of the value of the single productive agents from the value of their joint product. It does not bring about results which could serve as elements of economic calculation.
Mises insisted that in making economizing decisions about the use of resources in an extended division of labor, it is necessary to disentangle the contribution of each complementary factor of production used in producing each good. The necessity arises because factors of production are neither perfectly specific to each good nor perfectly non-specific among all goods. Absent either of those extreme conditions, economic calculation cannot be done by knowing only the value of goods of first order and the technical conditions of production of these goods. Which raises the third alternative: using the cardinal numbers of production possibilities as the basis for economic calculation. Although technical consideration allow the decomposition of the physical contribution to output made by each factor, these numbers have no connection to value of the ends attained. Mises wrote (1998, p. 208):
[The fact that] the various means allow for various uses, set man the tasks of allocating them to those employments in which they can render the best service. Here the computation in kind as applied by technology is of no avail. Technology operates with countable and measurable quantities of external things and effects; it knows causal relations between them, but it is foreign to their relevance for human wants and desires…. [Technology] ignores the economic problem: to employ the available means in such a way that no want more urgently felt should remain unsatisfied because the means suitable for its attainment were employed—wasted—for the attainment of a want less urgently felt.
In an extended division of labor, individual factors of production can be shifted from one line of production to another and configured in various combinations with other complementary factors of production in each production process. Therefore, to know whether or not a particular configuration of complementary factors of production will be more economizing for society than another configuration, prices of individual factors of production must exist. Mises (1998, pp. 209–210) wrote:
[The practical man] must know whether what he wants to achieve will be an improvement when compared with the present state of affairs and with the realizable projects which cannot be put into execution if the project he has in mind absorbs the available means. Such comparisons can only be made by the use of money prices…. Where there are no money prices, there are no such things as economic quantities. There are only various quantitative relations between various causes and effects in the external world. There is no means for man to find out what kind of action would best serve his endeavors to remove uneasiness as far as possible.
Mises concluded this line of inquiry by returning to the starting point in Robinson Crusoe, i.e., production in self-sufficiency instead of a division of labor. Crusoe could compare the value of output with the value of the complementary factors used because the possible combinations he can exploit are simple enough for him to impute value adequately for economizing.All of the combinations of factors of production can be valued by Crusoe through his own experience. Such cannot be done by a single person in a division of labor, especially the extended division of labor in a modern, capitalist economy. He wrote (Mises, 1998, p. 210):
There is no need to dwell upon the primitive conditions of the household economy of self-sufficient farmers. These people performed only very simple processes of production. For them no calculation was needed, as they could directly compare input and output. If they wanted shirts, they grew hemp, they spun, wove, and sewed. They could, without any calculation, easily make up their minds whether or not the toil and trouble expended were compensated by the product. But for civilized mankind a return to such a life is out of the question.
ECONOMIC CALCULATION AND THE SCHEMES OF SOCIALISM With his theory of economic calculation in hand, Mises critiqued the schemes of socialists to rationally allocate resources in chapter 26 in Human Action. Both the title of the chapter, “The Impossibility of Economics Calculation under Socialism,” and the summary list of schemes indicate Mises’s emphasis on economic calculation. He wrote (Mises, 1998, pp. 699–700):
The various schemes proposed can be classified in the following way:
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Calculation in kind is to be substituted for calculation in terms of money....
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Starting from the ideas of the labor theory of value the labor-hour is recommended as the unit of calculation….
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The unit is to be a “quantity” of utility….
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Calculation is to be made possible by the establishment of an artificial quasi-market….
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Calculation is to be made with the aid of the differential equations of mathematical catallactics….
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Calculation is to be made superfluous by resorting to the method of trial and error….
All of these socialist schemes, except number 6, are attempts to have economic calculation under socialism. And Mises’s critique of the socialist director using the method of trial and error to make economizing production and investment decisions relies on his views of economic calculation. He argued (Mises, 1998, p. 700) that economizing decisions fall into a category of trial and error in which “the only mark of the correct solution is that it has been reached by the application of a method considered appropriate for the solution of the problem.” His example is solving a multiplication problem. He wrote (Mises, 1998, p. 700):
One may try to guess the correct result by trial and error. But here the method of trial and error is no substitute for the arithmetical process. It would be quite futile if the arithmetical process did not provide a yardstick for discriminating what is incorrect from what is correct.
In the case of economizing decisions, the only way to discover if trial and error has succeeded is by a computation of profit and loss. Mises wrote (1998, p. 701):
The problem of socialist economic calculation is precisely this: that in the absence of market prices for the factors of production, a computation of profit and loss is not feasible.
We may assume that in the socialist commonwealth there is a market for consumers’ goods and that money prices for consumers’ goods are determined on this market…. But the characteristic mark of the socialist system is that the producers’ goods are controlled by one agency only in whose name the director acts, that they are neither bought nor sold, and that there are no prices for them. Thus there cannot be any question of comparing input and output by the methods of arithmetic.
Concerning the socialist scheme for a quasi-market, Mises noted that it represents the triumph of his approach to economics. He wrote (Mises, 1998, p. 702):
It is therefore nothing short of a full acknowledgement of the correctness and irrefutability of the economists’ analysis and devastating critique of the socialists’ plans that the intellectual leaders of socialism are now busy designing schemes for a socialist system in which the market, market prices for the factors of production, and catallactic competition are to be preserved. The overwhelmingly rapid triumph of the demonstration that no economic calculation is possible under a socialist system is without precedent in the history of human thought. The socialist cannot help but admitting their crushing final defeat.
Finally, Mises made it perfectly clear that the defeat of socialism owed nothing to the mathematical economics of general equilibrium. The problem of directing the use of resources in an economizing manner must start with existing conditions, which are not those of equilibrium but have been brought about by both successes and failures of the past. Even if the final equilibrium configuration of resource allocation is known, the economizing problem remains: how to move step-by-step from existing conditions to those of final equilibrium. For the solution to this problem, the mathematical expression of the state of final equilibrium is of no use. Mises wrote (1998, p. 709):
Even if, for the sake of argument, we assume that a miraculous inspiration has enabled the director without economic calculation to solve all problems concerning the most advantageous arrangement of all production activities and that the precise image of the final goal he must aim at is present to his mind, there remain essential problems which cannot be dealt with without economic calculation. For the director’s task is not to begin from the very bottom of civilization and to start economic history from scratch. The elements with the aid of which he must operate are not only natural resources untouched by previous utilization. There are also the capital goods produced in the past and not convertible or not perfectly convertible for new projects. It is precisely in these artifacts... that our wealth is embodied. Their structure, quality, quantity, and location is of primary importance in the choice of all further economic operations…. [The director] must try to take advantage of every piece of the already available capital goods in the best possible way.
CONCLUSION Mises’s integration of money into the subjective theory of value did more than put monetary theory on solid ground. It set the entire body of economic theory on the causal-realist foundation laid by Carl Menger. Doing so required a reconstruction of price and production theory. Not merely grafting subjectivist elements onto general equilibrium theory, but rebuilding this theory from the bottom up. No better evidence of the soundness of this approach exists than Mises’s demonstration that central planners cannot allocate resources in an economizing manner in socialism for lack of economic calculation.
Since the second calculation debate made apparent Mises’s achievement in providing a truly general theory of economics, the causal-realist approach has been advancing on several fronts. To mention just a few: business cycle theory has been refined (Salerno, 2012); the theory of entrepreneurship and organizational theory has been developed (Klein, 2010); the theory of cost has been reconsidered (McCaffrey, 2018); the theory of interest has been further considered (Herbener, 2011); and Mises’s concept of entrepreneurial appraisement has been extended (Herbener and Rapp, 2016).
ABSTRACT: This article discusses the influence of the initiation of the Second Socialist Calculation Debate on my own subsequent research and contributions to that debate, and briefly summarizes that research presented in articles on arguments made by Plato, Karl Marx, Friedrich von Wieser, Friedrich Hayek, Lionel Robbins, Joseph Schumpeter, and Israel Kirzner. It also mentions some of the changes in Austrian economics understanding stimulated by the Second Socialist Calculation Debate, and suggests a direction for future research.
KEYWORDS: Friedrich Hayek, Karl Marx, Lionel Robbins, Friedrich von Wieser, calculation, socialism, sociology JEL CLASSIFICATION: B1, B2, P2, P5 Sam Bostaph (bostaph@udallas.edu) is Emeritus Professor of Economics at the University of Dallas.
Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.
It is a pleasure to be here at this prestigious conference, and to be on this panel concerned with the most important economic issue of the past two centuries—that of economic calculation. After all, to economize is to calculate; it is to seek the lowest expected opportunity cost of the means to achieve the end for which one is economizing. That is why Mises argued that the socialist planned economy is in reality no economy. It cannot by definition calculate the expected opportunity costs of higher order goods in order to assess their relative scarcity, and thus enable a decision of how they are to be efficiently used in the production of lower order goods. It cannot do so because without private property in higher order goods, there cannot be market-determined prices for those goods to reveal their current relative scarcities and thus allow economic calculation.
Joe Salerno asked each of us to discuss our respective contributions to the second socialist calculation debate, how this most recent debate influenced our later research, and how we think Austrian economics has changed as a result of that debate.
My own interest in this topic stems from my interest in imagined, as well as attempted, historical utopias. As a scholar in the Austrian school tradition, I cannot help being in part a sociologist. Albion Small recognized this aspect of the Austrian school in his book Origins of Sociology (1924) where he devoted considerable space to a discussion of Carl Menger’s contribution to the discipline. Of course, I use the term “sociology” in the sense that Ludwig von Mises used it in his early scholarship. Later, Mises would substitute the term “praxeology” for “sociology” as the latter term came to mean a sort of philosophy of history, rather than a science of human action.
At one time, I intended to write a history of various theories of communism. In researching the topic, I came across a comment by Karl Marx in his inaugural article as editor of the Rheinische Zeitung. Marx identified Plato as an early communist theorist. “That can’t be true,” I thought. The research that falsified any such claim led to my 1994 contribution to David Reisman’s edited collection Economic Thought and Political Theory. Of course I argued against such a simple-minded assessment of Plato’s Republic and Laws. I also became aware of Friedrich von Wieser’s attempt at rationalizing a socialist utopia in his Natural Value during the preliminary research I did on communist theories.
At one time, I intended to write a history of various theories of communism. In researching the topic, I came across a comment by Karl Marx in his inaugural article as editor of the Rheinische Zeitung. Marx identified Plato as an early communist theorist. “That can’t be true,” I thought. The research that falsified any such claim led to my 1994 contribution to David Reisman’s edited collection Economic Thought and Political Theory. Of course I argued against such a simple-minded assessment of Plato’s Republic and Laws. I also became aware of Friedrich von Wieser’s attempt at rationalizing a socialist utopia in his Natural Value during the preliminary research I did on communist theories.
Meanwhile, Joe Salerno had attracted my interest back to Austrian school theory with his 1990 article “Ludwig von Mises as Social Rationalist.” There Joe began the process of dehomogenizing Mises and Hayek and initiated the second socialist calculation debate, which has occupied some of us Austrians for the past thirty years. When I read Joe’s 1993 contribution to that debate, it struck me that his reference to Hayek as strongly influenced by his teacher and mentor, Wieser, deserved a firm grounding. That caused me to go back and intensively read Wieser. The result was my summer 2003 QJAE article “Wieser on Economic Calculation under Socialism.” After having exhaustively studied Wieser’s published writings on the socialist planned society, I not only placed him in the general equilibrium tradition of Walras, but also explained the total emptiness of his theory of planning. I found his concept of a unit of “natural value” as the basic unit of economic calculation to be nothing but a faux “util” and thus a fantasy, and his explanation of “imputation” as the method of deriving the values of higher order goods from the “natural values” of first order goods to be spurious. The terms in his equations are ambiguous, and his conception of imputation appears to be an attempt at a mere static theory of distribution.
I concluded that Hayek’s attempt to use Wieser’s “simple economy” of socialism as an analytical device as late as 1941 in his Pure Theory of Capital, as well as a number of his other laudatory references to Wieser over the years, to be telling. Also, Hayek’s use of a general equilibrium context for most of his own theoretical work places him pretty firmly in the Walras/Wieser tradition. This may explain Hayek’s emphasis on knowledge problems in his critique of the planned socialist society, rather than on its inability to use economic calculation.
To my surprise and delight, my article won the 2005 Lawrence A. Fertig prize. For that I remain greatly thankful to the prize committee. I was stimulated to continue my research on Wieser and that had two results. While a visiting professor at the University of Economics in Prague, Czech Republic, in 2005 I had the honor of delivering the inaugural Wieser lecture. This later appeared as an article titled “Friedrich von Wieser’s Theory of Socialism: A Magnificent Failure” in the university’s journal Politicka Ekonomie. There I argued that the views that became the backbone of Wieser’s last book, The Law of Power (1926), actually lay behind many of his expressed criticisms of the market economy and his desire to rescue the theory of the planned economy.
Perhaps those previous two articles explain why I was later invited to contribute the Wieser chapter in a book collection on Austrian school economists. Unfortunately, after I had completed my 55-page contribution, publication apparently fell through and the book was never published. I hope to be able to harvest something from that manuscript at some point in the future.
At any rate, articles in the second calculation debate continued to stimulate my research and one result was a QJAE article arguing that Mises’s methodology was not an extension of that of Lionel Robbins. Rather, the influence actually ran the other way, although significant differences between the two approaches remain.
Another project that stemmed from arguments presented during the recent calculation debate was a result of references to Joseph Schumpeter as another of Wieser’s students. Schumpeter is known particularly for his theory of economic development and his concept of the entrepreneur as a force for “creative destruction.” I was intrigued to look for signs of Wieser’s influence on Schumpeter and I found them while reading through Schumpeter’s various publications. More importantly, I was astonished at the generally ad hoc nature, classical school roots, and Walrasian general equilibrium context of Schumpeter’s work. Schumpeter’s entrepreneurial theory stands in stark contrast to that of Mises, as well as to Israel Kirzner’s extension of Mises’s concept of functional entrepreneurship.
The result was my 2013 QJAE article unfavorably contrasting Schumpeter’s theory of entrepreneurship with that of Kirzner. The research on Kirzner’s theory had a further result. I decided to use it in a historical study of the steel magnate and entrepreneur, Andrew Carnegie. After obtaining a publisher, I read through the major biographies of Carnegie and discovered that none of them really explained why Carnegie was successful. They detailed his success, but only historically. Historical explanation needs more than bare facts, however obtained. It needs the application of theory to identify historical cause and effect relations. What was missing from what I read was the grasp of economic understanding that is only provided by Austrian school theory. So, I used an Austrian school context and Kirzner’s entrepreneurial theory as key elements of my economic biography of Carnegie.
Now that I am done with that project, I plan to return to writing my book on the early Austrian school trio of Menger, Böhm-Bawerk, and, of course, Wieser. So far, I only have about a couple of hundred pages and I am stuck on Böhm-Bawerk’s capital theory, but hope to dislodge myself. I particularly want to understand why Menger viewed Böhm-Bawerk’s capital theory as a big mistake.
How has Austrian economics changed as a result of the second economic calculation debate? Well, it certainly opened my eyes concerning the development of the Misesian paradigm, as compared to that of Hayek. And, it greatly increased our understanding of the theoretical failures of the various planned socialist society models. In addition, it has produced a refinement of our understanding of what Misesian economic calculation assumes as necessary for the market process to take place. Most particularly, it has highlighted the radical importance of private property rights, subjective aspects of ownership that affect relative scarcity, and accurate cost accounting.
Added to that is the additional understanding of the underwhelming arguments for what is now called “market socialism.” I find it ironical that when pressed to explain how market socialism could solve each of the successive problems identified with their successive models, advocates of market socialism step-by-step adopted features of the private property, free market model. And they have done this while still trying to keep an iron grip on their wish for an economy with no private property rights in higher order goods.
This started with the Lange/Taylor early attempts to adopt a surrogate perfect competition, general equilibrium model, with no private property in higher order goods. After this was exposed as a fantasy, then came Lange’s use of a Walrasian auction model of price determination. After that was knocked down, market socialism’s defenders proposed to turn firm managers into pretend entrepreneurs, without giving them the discretion over all of the firm’s physical and financial resources that exists in a private property regime. This infects the market socialist financial sector with a fatal weakness. The administrators have no financial skin in the game—kind of like the Board of Governors of our Federal Reserve System. And we all know the recent consequences of that morbid fact.Of course, there is a sense of “skin in the game” for administrators in a Stalinist system. See Simon Sebag Montefiori (2004), for detailed descriptions of the arrest, imprisonment, sentencing to forced labor, or execution of soviet administrators, as well as their families, who failed to achieve the goals set for their production units during the Stalin era of the USSR. This even extended down to the local level of agricultural production. In his Memoirs (1996, pp. 24–27), former General Secretary, then President of the USSR, Mikhail Gorbachev relates how his grandfathers were arrested, tortured, and accused of being Trotskyite counterrevolutionaries for their loss of grain, destruction of livestock, and repression of local Stakhanovites during the 1930s. One was exonerated and the other sent to a forced labor camp.
One is left with the question of why some perfectly intelligent people still lust for a society without private property rights in potentially productive resources. Is it simply the result of a personal lust for power? Or does it stem from the envy of those who are more materially successful in a free market context? I leave the question for future research. Particularly, I hope that young Austrian school economists will turn their interest to China. Under Xi Jinping, it looks like we have an emerging Stalinist regime. If so, it will function no better than its original, as the socialist calculation debate has taught us.
ABSTRACT: Murray Rothbard developed the concept of decision-making rent as a return to a kind of unhirable labor performed by the entrepreneur in his role as owner and ultimate decision-maker of the firm. Rothbard conceived owner’s rent as separate from profit and loss and the decision-making function as concerned with productive organization and technique, which is distinct from the function of forecasting uncertain future market conditions. Vlad Topan (2012) disputes Rothbard’s position and contends that ownership rent does not exist because decision-making ability is meaningless in the absence of uncertainty. In this paper, I argue that Topan’s critique rests on fundamental misconceptions about the nature of entrepreneurship in Austrian economics.
KEYWORDS: decision-making ability, decision-making rents, ownership function, entrepreneurship, firm JEL CLASSIFICATION: D20, D21, L20, L21, L26 Joseph T. Salerno (jsalerno@mises.org) is Academic Vice President of the Mises Institute.
I am indebted to David Gordon, Carmen Dorobăț, Matthew McCaffrey, and Mark Thornton for their very helpful comments and suggestions, which clarified and improved the argument of the paper. Responsibility for remaining errors or obscurities is mine alone.
Quarterly Journal of Austrian Economics 21, no. 3 (Fall 2018) full issue, click here.
Vlad Topan’s “Note on Rothbardian Decision-Making Rents” (2012) is a welcome and thoughtful addition to a neglected topic in the Austrian theory of entrepreneurship: what Murray Rothbard (2009) has dubbed the “decision-making” or “ownership” function of the capitalist-entrepreneur. This productive function had been recognized and discussed by Carl Menger, Eugen von Böhm-Bawerk, and Ludwig von Mises before Rothbard. Unfortunately, after the publication of Man, Economy, and State in 1962, the concept dropped out of the Austrian literature until the present author traced out the development of this concept in Austrian writings in his article, “The Entrepreneur: Real and Imagined” (Salerno, 2008).
The main thrust of Topan’s note is to deny Rothbard’s claim that there exists a specific form of income that is a return to the ultimate decision-making function of capitalist-entrepreneurs as property owners and is separate and distinct from their interest return as capital-investors and pure profit (or loss) return as entrepreneurial uncertainty bearers. In particular, Topan disputes Rothbard’s claim that the ownership function and its correlative income of decision-making rent has any place in the equilibrium conditions of the evenly rotating economy (ERE).
Despite the great degree of care and ingenuity that Topan puts into constructing his case, I believe that it rests on two fundamental errors.
First, Topan conflates Mises’s imaginary construct of the pure entrepreneur with what Mises (1998, p. 256) called the “entrepreneur-promoter” or simply “promoter.” The former, according to Mises (1998, pp. 253–254) is not a human actor but a single “definite function” that is embodied in “an imaginary figure” who is “propertyless” and whose only function is to bear risk. As such, for Mises the pure entrepreneur is a “methodological makeshift” designed to enable the economist to analytically isolate profit (and loss) from the interest earned on capital, both of which are inextricably bound together in the net income received by business owners and investors in the real world. In sharp contrast, Mises’s entrepreneur-promoter is a real actor who owns capital and puts it at risk by purchasing factors of production that he judges are undervalued relative to the prospective value of the future product they will yield. He is then obliged to efficiently combine these factors according to a technical plan in a time-consuming productive venture that he must oversee to completion. Indeed, Mises (pp. 254, 302) pointed out that it is not possible to think through the concept of a pure entrepreneur who owns no capital to a logical conclusion and he explicitly warned against the “error” of confusing the pure entrepreneur with the entrepreneur “in a living and operating market economy.”Rothbard (1997, p. 249) recognized and adamantly rejected Mises’s concept of the pure entrepreneur, “which treat[s] the entrepreneur as an entirely separate entity, and not just as the forecasting aspect of the activities of the capitalist or laborer.” In his own treatise, Rothbard (2009, p. 510) avoided the construct when analyzing the nature and causes of profit as a return to the function of uncertainty-bearing and spoke of “the active entrepreneurial element in the real world [that] is due to the presence of uncertainty.” Rothbard (2011, p. 285) also noted that Israel Kirzner’s conception of the pure entrepreneur, who owns no capital and earns profits essentially by arbitraging price differences, finds “a certain amount of textual justification in Mises.”
Topan (2012, pp. 76–77), however, ignores the distinction drawn by Mises between the two types of entrepreneur and, at the outset of his note, selects six quotations from Mises’s and Rothbard’s works which, because they are presented out of context, emphasize uncertainty-bearing while either completely ignoring or downplaying the role of ownership in the definition of the entrepreneur. In addition, at least four of these quotations refer specifically to the pure entrepreneur as Mises defined the term. Thus, for example, Mises (1998, p. 254) is quoted by Topan (p. 76) as follows: “The term entrepreneur as used by catallactic theory means: acting man exclusively seen from the aspect of the uncertainty inherent in every action.” But in the sentence immediately before the sentence quoted by Topan, Mises referred to this one-dimensional delineation of the function of the entrepreneur as being embodied in “an imaginary figure” that is a “methodological makeshift.” Moreover, in the very next paragraph following the one containing the quoted sentence, Mises (1998, p. 254) carefully demonstrated that this “imaginary construction of a pure entrepreneur” involves a logical contradiction, because he owns no property and, therefore, bears no risk!As Mises (1998, p. 254) described him,This [pure] entrepreneur does not own any capital. The capital required for his entrepreneurial activities is lent to him by the capitalists in the form of money loans.... Nevertheless, he remains propertyless for the amount of his assets is balanced by the amount of his liabilities. If he succeeds, the net profit is his, if he fails the loss must fall upon the capitalists, who have lent him the funds. Such an entrepreneur would, in fact be an employee of the capitalists who speculates on their account and takes a 100 per cent share in the net profits without being concerned about the losses.
The second quotation that Topan (76–77) draws from Mises (1998, p. 288) likewise refers to the pure entrepreneur and not the entrepreneur-promoter:
Like every acting man, the entrepreneur is always a speculator. He deals with uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur’s profits stem is his ability to anticipate better than other people the future demand of consumers.
In the paragraph immediately preceding the one in which this passage appears, Mises (1998, p. 288) made it clear that he was here focusing exclusively on entrepreneurial profit and loss and how changes in the data bring about differences between the selling prices of products on the one hand and the sum of the prices of their factor inputs on the other. At the same time, he explicitly abstracted from how such changes “affect the sellers of labor and those of original nature-given factors of production and of the capitalists as money-lenders.” In other words, Mises was once again describing the pure function of entrepreneurship and not the integral, flesh-and-blood entrepreneur. Likewise, in two of the three passages that Topan (p. 77) quotes from Rothbard, Rothbard is clearly referring to the function of “entrepeneurship” or what he calls the “active entrepreneurial element” and not to the real property-owning capitalist-entrepreneur.
Topan’s first error leads to and is compounded by a second error. Jumbling up two different concepts of the entrepreneur at the start of his note and overemphasizing the single function of uncertainty-bearing predisposes Topan to ignore the distinct decision-making function that is inextricably bound up with the choice of the organization and technical combination of heterogeneous capital goods and labor factors, particularly management. Thus Topan (p. 79) argues:
Specifically, by introducing this additional distinct function of ownership and its subsequent (supplementary) form of remuneration/income, [Rothbard] ends up separating—something considered as a shortcoming in Kirzner—ownership from entrepreneurship. If this is not so, and if it is still the ownership function that also receives the profit/loss residuum, then we have a function with two incomes, a situation which violates the “one function—one income” principle implied in the theory of distribution. Not to mention the emptying of the catallactic function of the entrepreneur, that would remain without an income share.
This assertion betrays Topan’s single-minded focus on the function of the disembodied pure entrepreneur to the exclusion of the real person of the capitalist-entrepreneur who embodies a number of conceptually distinct “catallactic functions.” For Rothbard and Mises the “one function—one income principle implied in the theory of distribution” is not violated by recognition of a decision-making rent that accrues to the entrepreneur qua property owner. Nor does Rothbard, a la Kirzner, “separate ownership from entrepreneurship” by identifying a separate property-owning function, as Topan (p. 79) claims. For all three functions of the capitalist-entrepreneur involve property. The capitalist function is advancing property in the form of wages and rents to the factors of production; the specifically entrepreneurial function is choosing the factors and allocating them to the production of property in definite forms that are anticipated to facilitate the achievement of ends chosen in light of forecasts of uncertain future market conditions; and the decision-making or ownership function involves supervising and organizing the various elements of productive property into a coherent structure of means, i.e. the firm, according to known techniques in order to achieve the chosen ends in the most efficient way possible.
Let us clarify the argument by analyzing the concrete data that must inform the analysis of the functions and corresponding incomes of the capitalist-entrepreneur. Indeed, by noting that some entrepreneurs earn profits while others suffer losses, Topan implicitly recognizes that it is a datum of everyday experience and of human history that people differ greatly in their capacities to anticipate and adjust their actions to changes in the world that affect their ends and means. Without inserting this subsidiary empirical postulate into the chain of praxeological reasoning, it would be impossible to account for the fact that some individuals are better entrepreneurs than others.As Mises (1998, p. 256) put it, economics must take into account “the promoter concept” because “it refers to a datum that is a general characteristic of human nature.... This is the fact that various individuals do not react to a change in conditions with the same quickness and in the same way.... There are in the market pacemakers and others who only imitate the procedures of their more agile fellow citizens.” Topan presumably would agree too that praxeology must recognize the obvious fact that people have different time preferences and therefore that they save and invest different proportions of their incomes, accumulate greater or less capital and receive unequal amounts of interest payments in the real world and in the ERE. Topan would also surely grant that economic theory must proceed on the empirical observation that individuals vary in their skills, aptitudes, energy, motivation, and productivity with respect to different types of labor and therefore receive unequal wage rates in the real world and that such wage inequalities would persist in the ERE.
Topan inexplicably seems to balk, however, at incorporating into economic theory the mundane observation that business owners differ markedly in their levels of technical knowledge, mental and physical energy, clarity of memory, strength of purpose, supervisory abilities, communications skills, aptitude for calculating and interpreting financial data, etc. But surely these differences affect the quality of the decisions capitalist-entrepreneurs make in choosing and combining the concrete elements of their property into an integrated structure of means in order to achieve their ends, even if they all correctly forecast the value of these ends. It is these qualities that cause people to differ in what Rothbard (2009, p. 602) calls “for want of a better term... the decision-making function or ownership function.” As this function is described in the long passage Topan (2012, pp. 78–79) quotes from Rothbard, it is clear that it has nothing to do with uncertainty per se. Rather it deals with the ultimate technical, supervisory, and organizational decisions that a capitalist-entrepreneur alone must make with respect to the disposition of his productive property. It may help to clarify this concept by describing it in the familiar context of everyday life before addressing it in a business environment.
Suppose that someone is throwing a large party with a certain theme and ambience that she anticipates would greatly please her guests. She has formed a creative overall vision of the prospective party—the future “product” or end—and is aware of the concrete means necessary to realize her vision. But to prepare for the party rationally and efficiently, the hostess must use her existing knowledge, skills, and abilities in many diverse areas: menu selection; food preparation, including both the knowledge of recipes and the skills to execute them; selection of wines and other beverages that complement the meal; location, layout, and decoration of the “space” for the party; the timing of the food and beverage service; the music that best comports with the guests’ diverse tastes and with the theme of the party; the optimum number, selection, and seating arrangement of guests; the suggested dress; the crafting of attractive and informative party invitations and so on. The hostess also must attend to mundane matters like the sufficiency of bathroom facilities and toilet items, the adequacy of parking, and the proper sequestering of her children and pets.
In addition the hostess must actively supervise and make continual decisions relating to the coordination of the overall “flow” of the party as it proceeds, whether or not she decides to “outsource” one or more tasks to a party planner, caterers, a professional DJ, or bartender. These hired “managers” do not spontaneously coordinate their actions with one another and with the hostess’s overarching plan for the party. Moreover, she requires the interviewing skills and psychological insight necessary to accurately assess the technical competencies and work ethic of the personnel she is considering, as well as the leadership skills to motivate those she hires to engage with her in realizing her vision for the party.
To take a simple example, the party would turn out very differently depending on whether the hostess: suffered from a chronic illness and needed to take a nap midway through the party; were prone to overindulging in alcoholic beverages; were easily flustered by mishaps; or were healthy, vital, resilient and remained alert to every aspect of the party.
The point is that given the same resources and using the same standard of success, parties hosted by different people with varying knowledge, skills, aptitudes, capacities for mental focus and physical stamina would vary in success, even if they all could foresee exactly how the party would turn out as a result of their decisions. In other words, the variations in success of different hostesses need not be due exclusively to uncertainty-bearing, that is, anticipating and visualizing guests’ reactions to the theme and ambience of party; they may just as well be caused by disparities in their “ultimate decision-making ability” as owners of property.
We may even extend our fanciful party example to the ERE. Individuals of given but different decision-making abilities would host parties at regular intervals, purely as social events and not for monetary gain. Each would throw the same parties over and over again and the regularity of their purchases of party supplies would not upset market supply and demand conditions.There is nothing preventing economists from extending the ERE to an analysis of household activities because it is a mental construct of their own making. As Mises (1998, p. 248) pointed out, the ERE is consistent with many different assumptions so long as they do not disturb supply and demand conditions. Thus, he wrote, “Only such change as do not affect the configuration of price-determining factors may be considered in its [the ERE’s] frame…. We are free to assume that infants are born, grow old, and finally die, provided that total population figures and the number of people in every age group remain constant.” Elsewhere Mises (2003, p. 16) remarked:A theory of action could conceivably be constructed on the assumption that men lacked the possibility of understanding one another by means of symbols, or on the assumption that men—immortal and eternally young—were indifferent in every respect to the passage of time and therefore did not consider it in their action. The axioms of the theory could conceivably be framed in such universal terms as to embrace these and all other possibilities…. We forgo these possibilities because conditions that do not correspond to those we encounter in our action interest us only in so far as thinking through their implications in imaginary constructions [e.g., the ERE] enables us to further our knowledge of action under given conditions. [Emphasis added.] They would all know the future perfectly but some would be renowned as great hosts or hostesses, others as relatively inferior ones. However, all those who host dinner parties would of course enjoy a surplus of satisfaction gained over satisfaction sacrificed in the foreclosure of other consumption opportunities to use the resources devoted to the party. As with spending on all consumption activities, the marginal utility of the end chosen would exceed that of the end foregone. Furthermore, these psychic “rents” to party hosts would persist in the ERE, although there would be no monetary or other objective expression of them and no method of comparing their magnitudes between different people.
What is true of owners of property in the service of extra-catallactic ends is also true of business owners. Now, given that the differences in decision-making abilities among individuals in household and business activities are a datum of human action—although these abilities admittedly may develop over time in the real world of change as a result of practice, experience, or formal instruction—we are free to assume that they exist and are frozen in the ERE. In business, the differential monetary rents to decision-making ability derive especially from owners’ organizational skills, technical knowledge and psychological insight although more mundane qualities such as health, physical energy, and aptitude for financial calculation may also affect such rents. Surely these personal qualities influence how successful the owner of the firm is in organizing and adapting the diverse yet complementary elements of his property to his entrepreneurial forecasts of future market conditions. Furthermore, the owner is unable to divest himself of the ultimate decision-making function even if he delegates most or all decisions about technology, organization and personnel to hired managers and technicians. This is not to deny, of course, that to the extent that the owner performs routine technical or straightforward managerial tasks that can be performed by hired labor, he is functioning as a pure laborer rather than as an owner making ultimate decisions about his property and is earning normal wages rather than special ownership rents.
In a neglected article published in 1935, M. M. Bober (1935) presented an enlightening discussion of the entrepreneur-owner’s crucial and undivestible function, while recognizing that it would continue under static conditions and earn a rent. Bober’s aim in the article was to connect the short-run and long-run analysis of the size of the firm and explain the U-shape of the long-run average cost curve by identifying the factor that remained fixed even in the long-run. This factor was the ultimate decision-maker or the “entrepreneur,” whom Bober (1935, pp. 81, 83) characterized as the “fixed factor at the apex of the whole structure” of the firm whose “personality and... power [becomes] diffused over a wide area” as the firm grows in size. Bober continued:
That some managerial operations can be delegated admits of no doubt; but there remains a solid substratum of activities that must emanate from one final source of authority and responsibility, and not only under dynamic conditions but under static conditions as well.... Officers and foremen die or resign, and new ones are to be selected; security issues mature, and the problem of financing reappears; short-term loans are recurrently made, and dealings with bankers are involved.... There is also the important problem of supervision, and the greater the differentiation and delegation of powers the more vital is the problem. Furthermore, it is difficult to assume that the bearer of final responsibility can afford to play hide and seek with static conditions, disappearing from the scene or relaxing in the tasks while static conditions prevail, and assuming the helm only when the industry is undergoing alterations.
Bober (1935, p. 83) also saw that entrepreneurs of “infra-marginal” firms earn differential rents depending on their abilities and these rents exceed the rent that “will suffice to attract into the industry the marginal entrepreneur.”Unfortunately, Bober (1935, pp. 83–84) was under the influence of the perfect competition doctrine. And, although he did recognize the distinction between static and dynamic conditions, he mixed up profit and decision rent. He also treated the latter as a cost to the firm just like differential rents to hirable factors, despite the fact that he seemed to discern that the ultimate decision-making function was unhirable.
Let me now turn to an analysis of Topan’s specific critique of Rothbard’s concept of decision-making rents. Citing several passages from Rothbard’s work, Topan (2012, p. 80) comments, “Rothbard seems to assimilate... the income of decision-making to a type of wage, and to view decision-making ability as some sort of labor.” But Topan (2012, pp. 80–81) notices a “tension” in Rothbard’s use of the concept. The tension arises, according to Topan, because on the one hand, decision-making is “logically antecedent” to labor but on the other it is a “special type of labor” requiring “some unique ability or talent.” But I suggest that this tension is merely semantic and not substantive. In suggesting a name for the function, Rothbard (2009, p. 610), as we saw, was not completely comfortable with the term “decision-making,” prefacing his suggestion with “for want of a better term,” and then offering “property-owning” as a possible alternative designation. Furthermore, in the passages that Topan (2012, pp. 82–83) cites as evidence to support his point, Rothbard repeatedly and clearly characterizes the decision-making function as “a certain kind of labor,” “an attribute of a labor factor” and the return to this factor as “wages of decision-making.” Viewed in context, there is no tension in Rothbard’s concept of the decision-making function. It is a unique kind of labor factor that is not separable from property ownership and therefore can never be hired.Topan (2012, p. 85) is therefore simply wrong in his claim that Rothbard rejects the idea that the decision-making function is “a special subcategory [of labor], special enough so that it deserves a separate and dedicated catallactic function, together with a form of income.” The passage in Rothbard (2009, p. 565) that Topan cites to support his claim clearly refers to the illicit distinction between the workers and the managers of the firm, both of whom are “hired by its owners.” (Emphasis added). In contrast to hirable labor, technically it has no market and, hence, no implicit wage, which is why Rothbard (2010, pp. 602–603) formally dubs its return a “rent” rather than a “wage.”Rothbard (2009, p. 559) draws the distinction between wage and rent as follows: “A wage is the term describing the payment for the unit service of a labor factor. A wage, therefore, is a special case of rent; it is labor’s ‘hire’.” (Emphases in the original.)
Topan raises an important point when he notes that, according to Rothbard’s analysis, the rent of any factor employed in production must be positive to induce its owner to participate in production. But what, asks Topan (2012, p. 84), is being rewarded by these positive rents when a firm’s owner qua entrepreneur suffers losses as a result of erroneous judgment of future market conditions? Does the decision per se generate a positive rent, even though it is an “uninspired decision” penalized by entrepreneurial losses? Topan answers in the negative and concludes that the Rothbardian concept of decision-making must imply “successful decision-making.”
As we saw above, however, for Rothbard, the owner’s “decision-making function” does not involve entrepreneurial decisions made under uncertainty. In fact, it is the application of a special type of labor, the oversight and stewardship of one’s productive property used by the owner or hired labor for a specific purpose. These decisions are not to be deemed successful or unsuccessful, but, like all “decisions” to expend labor of any kind, better or worse in terms of the physical quantity and quality of the product. In this sense, employing the same ingredients, recipe, cooking utensils, and kitchen appliances, my wife makes better “decisions” than I do in baking cookies. This outcome has nothing to do with uncertainty of the future but to existing differences between our baking skills. To extend the example to the market realm, a bakery owner deciding between employing me or my wife as a baker would need the technical expertise and insight to judge the present differential between our baking skills. If he hires my wife, his decision will generate higher owner’s rent than if he hires me.
Topan’s attempt to subsume the decision-making function and owner’s rent under entrepreneurship and profit may be criticized from another angle. Suppose that due to gross technical ineptitude the owner of specific means of production is unable to bring his product to the market. For example, the bakery owner above hires a baker whose cakes fail to rise and cookies turn out too hard to chew and the output is disposed of as waste. Surely in this case the failure is purely technical and there would be no question of earning a profit or loss because there is no product supplied on the market and entrepreneurial forecasting does not enter into the matter.I am indebted to David Gordon for this point.
Topan (2012, pp. 84–85) further argues that supposing that rents, like profits, can be positive or negative—as they would be if they were judged by the binary criterion of successful/unsuccessful—then the relationship between rents and profits would be unclear because both pertain to ownership. If decision-making alone pertains to ownership, Topan contends, then entrepreneurship as uncertainty bearing would be an empty concept. Alternatively, if the decision-making function is bound up with uncertainty-bearing, then, contrary to Rothbard’s view, nothing remains of the function in the ERE, from which uncertainty has been banished.
Topan’s arguments on these points betray a failure to fully grasp Rothbard’s rent theory. Rothbard (2009, pp. 559, 571–572, 694) maintains that only rents of factors actually used in production, whether marginal or supramarginal, must be positive. Submarginal factors like desert land, mines with the least accessible ore deposits, or potential laborers who suffer from severe mental or physical disabilities would earn zero rents in the ERE. Likewise, business owners who are inadequate as decision-making stewards of their productive property would incur such high production costs that their firm’s return in the ERE would fall short of the natural rate of interest. Such firms, of course, would not be in business in equilibrium. There would thus be submarginal decision-makers who are earning zero—never negative—rents in the ERE precisely because they are not operating firms.As Rothbard (2010, p. 603) points, out, even marginal firms operating in the ERE earn positive decision rents:[T]he marginal land earns some rent, even if ‘close to’ zero. Similarly, the marginal firm earns some rent of decision-making ability. We can never say quantitatively how much it will be, only that it will be less than the corresponding ‘decision rents’ of the supramarginal firms.
For Rothbard, then, decision-making rents in the ERE, like the rents of land and hirable labor factors, are completely independent of entrepreneurial profits under dynamic conditions. While Rothbard does not explicitly discuss the variation of pure profit and owner’s rent in the real world of uncertainty, Mises did so in some detail. Like Rothbard, Mises (1998, p. 288) maintained that the uncertainty-bearing and ownership functions are conceptually separate and distinct, warning, “One must not confuse entrepreneurial profit and loss with other factors affecting the entrepreneur’s proceeds.” He thus distinguished the “specific entrepreneurial function” which involves “determining the employment of the factors of production” from the entrepreneur’s personal “technological ability” including his “ability to hire adequate helpers.”
For Mises, therefore, “specific entrepreneurial profit or loss” is not influenced by the quality of the owner’s technological ability, which differs between owners and earns higher or lower “wage rates or quasi-wage rates.”Note that Mises, too, is reluctant to apply the unqualified term “wage-rates” to the entrepreneur’s undivestible technical function. For example, entrepreneurs of inferior technical ability in the bottling industry will experience more bottles bursting per given quantity filled in their plants than in more efficiently run plants. However, as Mises (1998, p. 189) pointed out, this reduces physical output and raises production costs, but “does not affect entrepreneurial profit and loss.” According to Mises, the owner’s knowledge of productive techniques is better or worse, but not uncertain. Thus Mises (1998, pp. 189–190) argued that if the risks of accidents are insurable, they
...do not introduce uncertainty into the conduct of the technological processes. If an entrepreneur neglects to deal with them duly, he gives proof of his technological insufficiency. The losses thus incurred are to be debited to bad techniques applied, not to his entrepreneurial function.... [T]he specific entrepreneurial profits and losses are not produced by the quantity of physical output.... What produces them is the extent to which the entrepreneur has succeeded or failed in anticipating the future—necessarily uncertain—state of the market.
In the real world, then, owners of going concerns always earn decision rents, which are part of the composite return to capitalist-entrepreneurs intermingled with profit and interest. Contrary to Topan, to recognize that pure profit and ownership rent together determine the success or failure of the firm under dynamic conditions is not to deny that they are functionally independent of one another. Mises (1998, pp. 289–290) is especially emphatic on this point:
The elimination of those entrepreneurs who fail to give their enterprises the adequate degree of technological efficiency or whose technological ignorance vitiates their cost calculation is effected on the market in the same way in which those deficient in the performance of the specific entrepreneurial functions are eliminated. It may happen that an entrepreneur is so successful in his specific entrepreneurial function that he can compensate losses caused by technological failure. It may also happen that an entrepreneur can counterbalance losses due to failure in his entrepreneurial function by the advantages derived from his technological superiority or from the differential rent yielded by the higher productivity of the factors of production he employs.... The technologically more efficient entrepreneur earns higher wage rates or quasi-wage rates than the less efficient in the same way that the more efficient worker earns more than the less efficient.
In sum, although owner’s rent of an operating firm is always positive, a firm may fail because either: the rents may be insufficient to offset entrepreneurial losses; or the inferiority of decision-making ability compared to that of other owner-entrepreneurs in the industry may result in a relatively high cost structure that wipes out any pure profit and drives the firm’s net return below the natural interest rate. We thus must reject Topan’s claim that Rothbard’s concept of decision making refers “to uncertainty bearing and overcoming.” His contention is based on confounding specifically entrepreneurial “decision making,” which refers to adjusting production to uncertain future market conditions, with “decision making” aimed at efficiently supervising and coordinating his existing property in light of his present production plan.
Topan (2012, p. 86) makes one final attempt to eradicate the owner’s decision-making as an independent category of economic theory by subsuming it under “entrepreneurial judgments,” which he asserts “must be as specific as possible.” By this he means that such judgments should be understood as “referring to particular circumstances of time, place and persons from the future.” But here Topan all but concedes the point. Owner’s decision making, in Rothbard’s and Mises’s view, refers to judgments of present labor skills, productive techniques, and organizational structures, as noted above.
Topan (2012, p. 87) recognizes that if the ownership function is completely eliminated from economic theory, as he advocates, then he must provide an alternative explanation for the ubiquitous phenomena of high-cost versus low-cost firms. He suggests but downplays the possibility of entrepreneurial errors because these would generate cost differences “of a rather ephemeral nature.” The “more lasting” inter-firm cost differences, he attributes to different preferences for non-pecuniary income among “skillful entrepreneurs” who may, for example, choose an inferior location for their enterprise because of its proximity to their home. But, here again, Topan is admitting owner’s rent into his analysis by the back door. For, unless the entrepreneur is purchasing the land for speculative purchases, his choice of the site is based on his technical knowledge of what constitutes a superior or inferior location for the production of a specific good to be sold on an uncertain future market. He would thus be trading off part of his decision rents rather than entrepreneurial profits for the psychic benefits of a short and pleasant commute to work.
In conclusion, I do not believe that Topan has succeeded in establishing his case that Rothbard’s concepts of the ownership function and its corresponding income of decision-making rent have no place in economic theory. On the contrary, these concepts are essential to comprehending the role of the capitalist-entrepreneur in real-world markets.
Murray N. Rothbard (1926–1995) was one of the most important participants in Ludwig von Mises’s seminar, and undoubtedly the premiere Austrian economist of the twentieth century. Here, David Gordon discusses Rothbard’s contributions to economic theory and their broader historical context.
In his 1962 Man Economy and State, Rothbard built on Mises’s work and further developed the complete deductive science of economics called Praxeology. Gordon highlights several of Rothbard’s contributions including the impossibility of a monopoly price occurring on the free market, the implications of the calculation problem on the size of the firm, and the impracticalities of fractional reserve banking. Rothbard’s exposition of the Great Depression and his work in History of Economic Thought are also discussed.
The Who Is? podcast is available on iTunes, Google Play, Stitcher, Soundcloud, and via RSS.
[Chapter 11 from Human Action.]
- The Gradation of the Means2. The Barter-Fiction of the Elementary Theory of Value and Prices3. The Problem of Economic Calculation4. Economic Calculation and the Market
- The Gradation of the Means Acting man transfers the valuation of ends he aims at to the means. Other things being equal, he assigns to the total amount of the various means the same value he attaches to the end which they are fit to bring about. For the moment we may disregard the time needed for production of the end and its influence upon the relation between the value of the ends and that of the means.
The gradation of the means is, like that of the ends, a process of preferring a to b. It is preferring and setting aside. It is manifestation of a judgment that a is more intensely desired than is b. It opens a field for application of ordinal numbers, but it is not open to application of cardinal numbers and arithmetical operations based on them. If somebody gives me the choice among three tickets entitling one to attend the operas Aïda, Falstaff, and Traviata and I take, if I can only take one of them, Aïda, and if I can take one more, Falstaff also, I have made a choice. That means: under given conditions I prefer Aïda and Falstaff to Traviata; if I could only choose one of them, I would prefer Aïda and renounce Falstaff. If I call the admission to Aïda a, that to Falstaff b and that to Traviata c, I can say: I prefer a to b and b to c.
The immediate goal of acting is frequently the acquisition of countable and measurable supplies of tangible things. Then acting man has to choose between countable quantities; he prefers, for example, 15 r to 7 p; but if he had to choose between 15 r and 8 p, he might prefer 8 p. We can express this state of affairs by declaring that he values 15 r less than 8 p, but higher than 7 p. This is tantamount to the statement that he prefers a to b and b to c. The substitution of 8 p for a, of 15 r for b and of 7 p for c changes neither the meaning of the statement nor the fact that it describes. It certainly does not render reckoning with cardinal numbers possible. It does not open a field for economic calculation and the mental operations based upon such calculation.
- The Barter-Fiction of the Elementary Theory of Value and Prices The elaboration of economic theory is heuristically dependent on the logical processes of reckoning to such an extent that the economists failed to realize the fundamental problem involved in the methods of economic calculation. They were prone to take economic calculation as a matter of course; they did not see that it is not an ultimate given, but a derivative requiring reduction to more elementary phenomena. They misconstrued economic calculation. They took it for a category of all human action and ignored the fact that it is only a category inherent in acting under special conditions. They were fully aware of the fact that interpersonal exchange, and consequently market exchange effected by the intermediary of a common medium of exchange — money, and therefore prices, are special features of a certain state of society's economic organization which did not exist in primitive civilizations and could possibly disappear in the further course of historical change.The German Historical School expressed this by asserting that private ownership of the means of production, market exchange, and money are "historical categories." But they did not comprehend that money prices are the only vehicle of economic calculation. Thus most of their studies are of little use. Even the writings of the most eminent economists are vitiated to some extent by the fallacies implied in their ideas about economic calculation.
The modern theory of value and prices shows how the choices of individuals, their preferring of some things and setting aside of other things, result, in the sphere of interpersonal exchange, in the emergence of market prices.Cf. especially Eugen von Böhm-Bawerk, Kapital and Kapitalzins, Pt. II, Bk. III These masterful expositions are unsatisfactory in some minor points and disfigured by unsuitable expressions. But they are essentially irrefutable. As far as they need to be amended, it must be done by a consistent elaboration of the fundamental thoughts of their authors rather than by a refutation of their reasoning.
In order to trace back the phenomena of the market to the universal category of preferring a to b, the elementary theory of value and prices is bound to use some imaginary constructions. The use of imaginary constructions to which nothing corresponds in reality is an indispensable tool of thinking. No other method would have contributed anything to the interpretation of reality. But one of the most important problems of science is to avoid the fallacies which ill-considered employment of such constructions can entail.
The elementary theory of value and prices employs, apart from other imaginary constructions to be dealt with later,See below, pp. 237-257. the construction of a market in which all transactions are performed in direct exchange. There is no money; goods and services are directly bartered against other goods and services. This imaginary construction is necessary. One must disregard the intermediary role played by money in order to realize that what is ultimately exchanged is always economic goods of the first order against other such goods. Money is nothing but a medium of interpersonal exchange. But one must carefully guard oneself against the delusions which this construction of a market with direct exchange can easily engender.
A serious blunder that owes its origin and its tenacity to a misinterpretation of this imaginary construction was the assumption that the medium of exchange is a neutral factor only. According to this opinion the only difference between direct and indirect exchange was that only in the latter was a medium of exchange used. The interpolation of money into the transaction, it was asserted, did not affect the main features of the business. One did not ignore the fact that, in the course of history, tremendous alterations in the purchasing power of money have occurred and that these fluctuations often convulsed the whole system of exchange. But it was believed that such events were exceptional facts caused by inappropriate policies. Only "bad" money can bring about such disarrangements. In addition people misunderstood the causes and effects of these disturbances. They tacitly assumed that changes in purchasing power occur with regard to all goods and services at the same time and to the same extent. This is, of course, what the fable of money's neutrality implies. The whole theory of catallactics, it was held, can be elaborated under the assumption that there is direct exchange only. If this is once achieved, the only thing to be added is the "simple" insertion of money terms into the complex of theorems concerning direct exchange. However, this final completion of the catallactic system was considered of minor importance only. It was not believed that it could alter anything essential in the structure of economic teachings. The main task of economics was study of direct exchange. What remained to be done besides this was at best only a scrutiny of the problems of "bad" money.
Complying with this opinion economists neglected to lay due stress upon the problems of indirect exchange. Their treatment of monetary problems was superficial; it was only loosely connected with the main body of their scrutiny of the market process. About the turn of the nineteenth and twentieth centuries, the problems of indirect exchange were by and large relegated to a subordinate place. There were treatises on catallactics which dealt only incidentally and cursorily with monetary matters, and there were books on currency and banking which did not even attempt to integrate their subject into the structure of a catallactic system. At the universities of the Anglo-Saxon countries there were separate chairs for economics and for currency and banking, and at most of the German universities monetary problems were almost entirely disregarded.Neglect of the problems of indirect exchange was certainly influenced by political prepossessions. People did not want to give up the thesis according to which economic depressions are an evil inherent in the capitalist mode of production and are in no way caused by attempts to lower the rate of interest by credit expansion. Fashionable teachers of economics deemed it "unscientific" to explain depressions as a phenomenon originating "only" out of events in the sphere of money and credit. There were even surveys of the history of business cycle theory which omitted any discussion of the monetary thesis. Cf., e.g., Eugen von Bergmann, Geschichte der nationalökonomischen Krisentheorien (Stuttgart, 1895). Only later economists realized that some of the most important and most intricate problems of catallactics are to be found in the field of indirect exchange and that an economic theory which does not pay full regard to them is lamentably defective. The coming into vogue of investigations concerning the relation between the "natural rate of interest" and the "money rate of interest," the ascendancy of the monetary theory of the trade cycle, and the entire demolition of the doctrine of the simultaneousness and evenness of the changes in the purchasing power of money were marks of the new tenor of economic thought. Of course, these new ideas were essentially a continuation of the work gloriously begun by David Hume, the British Currency School, John Stuart Mill and Cairnes.
Still more detrimental was a second error which emerged from the careless use of the imaginary construction of a market with direct exchange.
An inveterate fallacy asserted that things and services exchanged are of equal value. Value was considered as objective, as an intrinsic quality inherent in things and not merely as the expression of various people's eagerness to acquire them. People, it was assumed, first established the magnitude of value proper to goods and services by an act of measurement and then proceeded to barter them against quantities of goods and services of the same amount of value. This fallacy frustrated Aristotle's approach to economic problems and, for almost two thousand years, the reasoning of all those for whom Aristotle's opinions were authoritative. It seriously vitiated the marvelous achievements of the classical economists and rendered the writings of their epigones, especially those of Marx and the Marxian school, entirely futile. The basis of modern economics is the cognition that it is precisely the disparity in the value attached to the objects exchanged that results in their being exchanged. People buy and sell only because they appraise the things given up less than those received. Thus the notion of a measurement of value is vain. An act of exchange is neither preceded nor accompanied by any process which could be called a measuring of value. An individual may attach the same value to two things; but then no exchange can result. But if there is a diversity in valuation, all that can be asserted with regard to it is that one a is valued higher, that it is preferred to one b. Values and valuations are intensive quantities and not extensive quantities. They are not susceptible to mental grasp by the application of cardinal numbers.
However, the spurious idea that values are measurable and are really measured in the conduct of economic transactions was so deeply rooted that even eminent economists fell victim to the fallacy implied. Even Friedrich von Wieser and Irving Fisher took it for granted that there must be something like measurement of value and that economics must be able to indicate and to explain the method by which such measurement is effected.For a critical analysis and refutation of Fisher's argument, cf. Mises, The Theory of Money and Credit, trans. by H. E. Batson (London, 1934), pp. 42-44; for the same with regard to Wieser's argument, Mises, Nationalökonomie (Geneva, 1940), pp. 192-194. Most of the lesser economists simply maintained that money serves "as a measure of values."
Now, we must realize that valuing means to prefer a to b. There is — logically, epistemologically, psychologically, and praxeologically — only one pattern of preferring. It does not matter whether a lover prefers one girl to other girls, a man one friend to other people, an amateur one painting to other paintings, or a consumer a loaf of bread to a piece of candy. Preferring always means to love or to desire a more than b. Just as there is no standard and no measurement of sexual love, of friendship and sympathy, and of aesthetic enjoyment, so there is no measurement of the value of commodities. If a man exchanges two pounds of butter for a shirt, all that we can assert with regard to this transaction is that he — at the instant of the transaction and under the conditions which this instant offers to him — prefers one shirt to two pounds of butter. It is certain that every act of preferring is characterized by a definite psychic intensity of the feelings it implies. There are grades in the intensity of the desire to attain a definite goal and this intensity determines the psychic profit which the successful action brings to the acting individual. But psychic quantities can only be felt. They are entirely personal, and there is no semantic means to express their intensity and to convey information about them to other people.
There is no method available to construct a unit of value. Let us remember that two units of a homogeneous supply are necessarily valued differently. The value attached to the nth unit is lower than that attached to the (n-1)th unit.
In the market society there are money prices. Economic calculation is calculation in terms of money prices. The various quantities of goods and services enter into this calculation with the amount of money for which they are bought and sold on the market or for which they could prospectively be bought and sold. It is a fictitious assumption that an isolated self-sufficient individual or the general manager of a socialist system, i.e., a system in which there is no market for means of production, could calculate. There is no way which could lead one from the money computation of a market economy to any kind of computation in a nonmarket system.
The Theory of Value and Socialism
Socialists, Institutionalists and the Historical School have blamed economists for having employed the imaginary construction of an isolated individual's thinking and acting. This Robinson Crusoe pattern, it is asserted, is of no use for the study of the conditions of a market economy. The rebuke is somewhat justified. Imaginary constructions of an isolated individual and of a planned economy without market exchange become utilizable only through the implication of the fictitious assumption, self-contradictory in thought and contrary to reality, that economic calculation is possible also within a system without a market for the means of production.
It was certainly a serious blunder that economists did not become aware of this difference between the conditions of a market economy and a non-market economy. Yet the socialists had little reason for criticizing this fault. For it consisted precisely in the fact that the economists tacitly implied the assumption that a socialist order of society could also resort to economic calculation and that they thus asserted the possibility of the realization of the socialist plans.
The classical economists and their epigones could not, of course, recognize the problems involved. If it were true that the value of things is determined by the quantity of labor required for their production or reproduction, then there is no further problem of economic calculation. The supporters of the labor theory of value cannot be blamed for having misconstrued the problems of a socialist system. Their fateful failure was their untenable doctrine of value. That some of them were ready to consider the imaginary construction of a socialist economy as a useful and realizable pattern for a thorough reform of social organization did not contradict the essential content of their theoretical analysis. But it was different with subjective catallactics. It was unpardonable for the modern economists to have failed to recognize the problems involved.
Wieser was right when he once declared that many economists have unwittingly dealt with the value theory of communism and have on that account neglected to elaborate that of the present state of society.Cf. Friedrich von Wieser, Der natürliche Wert (Vienna, 1889),p. 60, n. 3. It is tragic that he himself did not avoid this failure.
The illusion that a rational order of economic management is possible in a society based on public ownership of the means of production owed its origin to the value theory of the classical economists and its tenacity to the failure of many modern economists to think through consistently to its ultimate conclusions the fundamental theorem of the subjectivist theory. Thus the socialist utopias were generated and preserved by the shortcomings of those schools of thought which the Marxians reject as "an ideological disguise of the selfish class interest of the exploiting bourgeoisie." In truth it was the errors of these schools that made the socialist ideas thrive. This fact clearly demonstrates the emptiness of the Marxian teachings concerning "ideologies" and its modern offshoot, the sociology of knowledge.
- The Problem of Economic Calculation Acting man uses knowledge provided by the natural sciences for the elaboration of technology, the applied science of action possible in the field of external events. Technology shows what could be achieved if one wanted to achieve it, and how it could be achieved provided people were prepared to employ the means indicated. With the progress of the natural sciences, technology progressed too; many would prefer to say that the desire to improve technological methods prompted the progress of the natural sciences. The quantification of the natural sciences made technology quantitative. Modern technology is essentially the applied art of quantitative prediction of the outcome of possible action. One calculates with a reasonable degree of precision the outcome of planned actions, and one calculates in order to arrange an action in such a way that a definite result emerges.
However, the mere information conveyed by technology would suffice for the performance of calculation only if all means of production — both material and human — could be perfectly substituted for one another according to definite ratios, or if they all were absolutely specific. In the former case, all means of production would be fit, although according to different ratios, for the attainment of all ends whatever; things would be as if only one kind of means — one kind of economic good of a higher order existed. In the latter case each means could be employed for the attainment of one end only; one would attach to each group of complementary factors of production the value attached to the respective good of the first order. (Here again we disregard provisionally the modifications brought about by the time factor.) Neither of these two conditions is present in the universe in which man acts. The means can only be substituted for one another within narrow limits; they are more or less specific means for the attainment of various ends. But, on the other hand, most means are not absolutely specific; most of them are fit for various purposes.
The facts that there are different classes of means, that most of the means are better suited for the realization of some ends, less suited for the attainment of some other ends and absolutely useless for the production of a third group of ends, and that therefore the various means allow for various uses, set man the tasks of allocating them to those employments in which they can render the best service. Here computation in kind as applied by technology is of no avail. Technology operates with countable and measurable quantities of external things and effects; it knows causal relations between them, but it is foreign to their relevance to human wants and desires. Its field is that of objective use-value only. It judges all problems from the disinterested point of view of a neutral observer of physical, chemical, and biological events. For the notion of subjective use-value, for the specifically human angle, and for the dilemmas of acting man, there is no room in the teachings of technology. It ignores the economic problem: to employ the available means in such a way that no want more urgently felt should remain unsatisfied because the means suitable for its attainment were employed — wasted — for the attainment of a want less urgently felt.
For the solution of such problems technology and its methods of counting and measuring are unfit. Technology tells how a given end could be attained by the employment of various means which can be used together in various combinations, or how various available means could be employed for certain purposes. But it is at a loss to tell man which procedures he should choose out of the infinite variety of imaginable and possible modes of production. What acting man wants to know is how he must employ the available means for the best possible — the most economic — removal of felt uneasiness. But technology provides him with nothing more than statements about causal relations between external things. It tells, for example, 7 a + 3 b + 5 c + … xn are liable to bring about 8 P. But although it knows the value attached by acting man to the various goods of the first order, it cannot decide whether this precept or any other out of the infinite multitude of similarly constructed precepts best serves the attainment of the ends sought by acting man.
The art of engineering can establish how a bridge must be built in order to span a river at a given point and to carry definite loads. But it cannot answer the question whether or not the construction of such a bridge would withdraw material factors of production and labor from an employment in which they could satisfy needs more urgently felt. It cannot tell whether or not the bridge should be built at all, where it should be built, what capacity for bearing burdens it should have, and which of the many possibilities for its construction should be chosen. Technological computation can establish relations between various classes of means only to the extent that they can be substituted for one another in the attempts to attain a definite goal. But action is bound to discover relations among all means, however dissimilar they may be, without any regard to the question whether or not they can replace one another in performing the same services.
Technology and the considerations derived from it would be of little use for acting man if it were impossible to introduce into their schemes the money prices of goods and services. The projects and designs of engineers would be purely academic if they could not compare input and output on a common basis. The lofty theorist in the seclusion of his laboratory does not bother about such trifling things; what he is searching for is causal relations between various elements of the universe. But the practical man, eager to improve human conditions by removing uneasiness as far as possible, must know whether, under given conditions, what he is planning is the best method, or even a method, to make people less uneasy. He must know whether what he wants to achieve will be an improvement when compared with the present state of affairs and with the advantages to be expected from the execution of other technically realizable projects which cannot be put into execution if the project he has in mind absorbs the available means. Such comparisons can only be made by the use of money prices.
Thus money becomes the vehicle of economic calculation. This is not a separate function of money. Money is the universally used medium of exchange, nothing else. Only because money is the common medium of exchange, because most goods and services can be sold and bought on the market against money, and only as far as this is the case, can men use money prices in reckoning. The exchange ratios between money and the various goods and services as established on the market of the past and as expected to be established on the market of the future are the mental tools of economic planning. Where there are no money prices, there are no such things as economic quantities. There are only various quantitative relations between various causes and effects in the external world. There is no means for man to find out what kind of action would best serve his endeavors to remove uneasiness as far as possible.
There is no need to dwell upon the primitive conditions of the household economy of self-sufficient farmers. These people performed only very simple processes of production. For them no calculation was needed, as they could directly compare input and output. If they wanted shirts, they grew hemp, they spun, wove, and sewed. They could, without any calculation, easily make up their minds whether or not the toil and trouble expended were compensated by the product. But for civilized mankind a return to such a life is out of the question.
- Economic Calculation and the Market The quantitative treatment of economic problems must not be confused with the quantitative methods applied in dealing with the problems of the external universe of physical and chemical events. The distinctive mark of economic calculation is that it is neither based upon nor related to anything which could be characterized as measurement.
A process of measurement consists in the establishment of the numerical relation of an object with regard to another object, viz., the unit of the measurement. The ultimate source of measurement is that of spatial dimensions. With the aid of the unit defined in reference to extension one measures energy and potentiality, the power of a thing to bring about changes in other things and relations, and the passing of time. A pointer-reading is directly indicative of a spatial relation and only indirectly of other quantities. The assumption underlying measurement is the immutability of the unit. The unit of length is the rock upon which all measurement is based. It is assumed that man cannot help considering it immutable.
The last decades have witnessed a revolution in the traditional epistemological setting of physics, chemistry, and mathematics. We are on the eve of innovations whose scope cannot be foreseen. It may be that the coming generations of physicists will have to face problems in some way similar to those with which praxeology must deal. Perhaps they will be forced to drop the idea that there is something unaffected by cosmic changes which the observer can use as a standard of measurement. But however that may come, the logical structure of the measurement of earthly entities in the macroscopic or molar field of physics will not alter. Measurement in the orbit of microscopic physics too is made with meter scales, micrometers, spectrographs-ultimately with the gross sense organs of man, the observer and experimenter, who himself is molar.Cf. A. Eddington, The Philosophy of Physical Science, pp. 7-79, 168-169. It cannot free itself from Euclidian geometry and from the notion of an unchangeable standard.
There are monetary units and there are measurable physical units of various economic goods and of many — but not of all — services bought and sold. But the exchange ratios which we have to deal with are permanently fluctuating. There is nothing constant and invariable in them. They defy any attempt to measure them. They are not facts in the sense in which a physicist calls the establishment of the weight of a quantity of copper a fact. They are historical events, expressive of what happened once at a definite instant and under definite circumstances. The same numerical exchange ratio may appear again, but it is by no means certain whether this will really happen and, if it happens, the question is open whether this identical result was the outcome of preservation of the same circumstances or of a return to them rather than the outcome of the interplay of a very different constellation of price-determining factors. Numbers applied by acting man in economic calculation do not refer to quantities measured but to exchange ratios as they are expected — on the basis of understanding — to be realized on the markets of the future to which alone all acting is directed and which alone counts for acting man.
We are not dealing at this point of our investigation with the problem of a "quantitative science of economics," but with the analysis of the mental processes performed by acting man in applying quantitative distinctions when planning conduct. As action is always directed toward influencing a future state of affairs, economic calculation always deals with the future. As far as it takes past events and exchange ratios of the past into consideration, it does so only for the sake of an arrangement of future action.
The task which acting man wants to achieve by economic calculation is to establish the outcome of acting by contrasting input and output. Economic calculation is either an estimate of the expected outcome of future action or the establishment of the outcome of past action. But the latter does not serve merely historical and didactic aims. Its practical meaning is to show how much one is free to consume without impairing the future capacity to produce. It is with regard to this problem that the fundamental notions of economic calculation — capital and income, profit and loss, spending and saving, cost and yield — are developed. The practical employment of these notions and of all notions derived from them is inseparably linked with the operation of a market in which goods and services of all orders are exchanged against a universally used medium of exchange, viz., money. They would be merely academic, without any relevance for acting within a world with a different structure of action.
Quarterly Journal of Austrian Economics 20, no. 3 (Fall 2017)Public Debt: An Illusion of Democractic Political Economy, by Giuseppe Eusepi and Richard E. Wagner, Edward Elgar, 2017
Professors Giuseppe Eusepi of Sapienza University of Rome in Italy and Richard E. Wagner of George Mason University have added another book to the already extensive list of literature on the political economy of public debt. The purpose of their book is to correct two major flaws in the existing literature. First, they argue that it is “pure illusion to treat a democratic regime as being indebted.” Second, they try to show that it is “pure mythology to treat so-called fiscal policy as the means by which governments manipulate public debt to promote systemic stability” (Eusepi and Wagner 2017, p. vii). Surely, both claims will strike the average reader as bold and by no means self-evident. They require analytical substantiation and clarification of terms. What exactly is illusory and mythical about the indebtedness of democratic regimes and their fiscal policy? Eusepi and Wagner’s analysis spans 164 pages separated into 6 chapters.
In the first chapter of the book, the authors provide a very brief overview and some fundamental criticisms of the conventional macroeconomic approach to fiscal policy and public debt. The legacy of Keynes’s General Theory in putting deficit spending at the forefront of fiscal policy measures to promote macroeconomic stability and full employment is well known and has been widely discussed among modern economists. Eusepi and Wagner argue that treating “political activity as a balance wheel to offset changes in private activity is overwhelmingly at work in contemporary political economy” (p. 7) and critically add “that the image of the balance wheel reflects the hold of myth and not the power of logic and observation.” According to the authors, underlying the balance wheel view is a “mythical” as opposed to a “realistic” type of theory, because it is merely “postulating” instead of actually “generating” the outcomes under consideration. In their view, the conventional “theory contains no explanation grounded in individual action that is able to generate the observed result.” In other words, it lacks microfoundations.
The authors themselves draw the connection to the famous microfoundations debate in modern macroeconomics. However, following Kirman (1992), they argue that representative agent analysis has not actually solved the problem, but only added another layer of “mythical” thinking. In this respect, one might say that Eusepi and Wagner are close to the “ultimate in microfoundationalists,” a label Hartley (1997, p. 107) used to describe Austrian economists in the Misesian tradition. Yet, the book is not a contribution to the latter, but rather to public choice theory.
The authors’ main point of contention seems to be that fiscal policy and public debt do not actually serve as a balance wheel, regardless of whether policy makers should try to use it as such. They do not engage in prescriptive policy analysis. Rather, they try to explain fiscal policy as an emergent phenomenon. They argue that a theoretical framework for the explanation of policy measures that we observe around us must take due account of the actual institutional environment within which the relevant actors make decisions, and needs to abstain from idealizing assumptions about their underlying motives. Eusepi and Wagner put themselves in the tradition of The Machiavellians (Burnham, 1943), including Niccolò Machiavelli himself, Gaetano Mosca, Roberto Michels and Vilfredo Pareto, who did not idealize politics, but treated it, arguably more realistically, as a struggle for power. In particular, they build upon the work of Antonio de Viti de Marco.
The authors do not intend to contribute to modern macroeconomics, but explicitly to the political economy of public debt. They hold that a “realistic line of analysis […] cannot rest content with positing relationships among aggregate variables, for to proceed in this fashion is to make it impossible to generate insight into the causal forces that are in play within a society” (Eusepi and Wagner, 2017, p. 32). Moreover, they explain that what they call “realistic” analysis is akin to Peter Boettke’s (2007) “mainline” in economic thought. The latter provides a broader and more encompassing perspective on social phenomena than conventional macroeconomics. It includes, for example, analyses of the relevant political regimes. In chapter 2, Eusepi and Wagner thus develop some preliminary thoughts on the differences between monarchical and democratic regimes as well as some implications for the analysis of public debt.
According to the authors, debt in monarchical regimes, where state activities are financed out of income from royal property, can analytically be treated just like debt in any individual case. Monarchs would certainly be more powerful than regular persons, but they remain individuals that manage their private property and take credit using their own property as collateral. The authors mention that the “macro literature contains many references to sovereign debt and the possibility of sovereign default” and claim that this “literature is reasonable for monarchical and dictatorial regimes, but it is not reasonable for democratic regimes” (p. 39). They argue that the “theory of choice is a useful framework for personal debt as well as for a monarch’s debts. It is not, however, generally useful for democratic debt because democratic debt emerges through some institutionally governed process of interaction” (p. 38).
While democratic debt may indeed emerge out of a somewhat more complex process, in which many individuals, negotiations and political bargains are involved, it strikes the reviewer as a rather odd claim to deny that the theory of choice is a useful framework for its analysis. After all, taking out a loan to finance public expenses, or increasing taxes as an alternative, is always a matter of choice on the part of government officials, regardless of the political system. It might be true that the theory of choice as such does not tell us very much about the subject matter, but that would also be the case when analyzing the indebtedness of monarchical regimes. A detailed analysis of the structural differences, that is, the institutional circumstances and incentives, under which representatives of democratic governments on the one hand and monarchs on the other make decisions, is required. Different arrangements of property rights are in fact a key issue. Put differently, monarchical debt also “emerges through some institutionally governed process of interaction,” although it is a very different one.
Eusepi and Wagner recognize the role of property rights and briefly discuss their relationship with taxes, the latter being the most important source of finance for democratic regimes. According to the authors, taxes represent an infringement upon private property rights or a transfer of property rights from private citizens to public officials, depending on what view of democracy is underlying the analysis. They move on, focusing mainly on the differences between the idealized version of democracy as self-governance, in which property rights are voluntarily transferred by consent, and its actual features in the real world, which include varying degrees of coercion. In reference to Schmitt (1996), they argue that power and subordination are relevant features of all political systems, but “democratic regimes generate mythologies that disguise that power by invoking an ideology of self-governance.” However, “power operates all the same.” (p. 40)
While this is a very important point, the authors overlook that the masquerade of power and despotism in democratic regimes is just an instance of a more general phenomenon that is not unique to democracies. Whoever is in power under whatever political system has an incentive to create and spread an ideological justification for their position in order to protect it. This is as true for democratically elected officials as it is for monarchs or dictators. Take North Korea and the personality cult around the Kim family as a timely example of a hereditary dictatorship.
In the third chapter of the book, the authors provide some further discussion of what characterizes the democratic process of political decision making. In particular, they suggest that an economy is better thought of as an “ecology” instead of an “engine.” The former view stipulates a system that comprises multiple economizing agents and allows for a realistic analysis of the subject matter, while the latter view pictures an economy as a machine constructed for a specific purpose. It is congenial to the mythical mode of analysis in modern macroeconomics. Chapter 3 picks up some of the thoughts from the beginning of the book and provides a transition towards the analysis of public debt under two types of democracy that follows. The subsequent chapter focuses on what de Viti de Marco (1936) called “cooperative” democracy, an idealized system that reflects the consent of the governed and represents an analytical benchmark. Chapter 5 covers public debt under “monopolistic” democracy, a more realistic form of democracy, which generates “gains for some people by imposing losses on other people” (Eusepi and Wagner, 2017, p. 85).
At the core of their argument lies the idea that public debt in democratic regimes does not follow the same principles as private debt under private law, namely, the principles of private property and freedom of contract, precisely because public debt generally emerges at the expense of some people, that is, against their will. The authors claim that “public debt falls within the rubric of public law and public ordering,” (p. 84) which operates differently, since it allows for coercive property transfers.
Chapter 4 starts with the benchmark case of public debt under the ideal of cooperative democracy. The conclusion should be straightforward, but is not drawn explicitly in the book. If state activities always reflect the consent of the people, there is no difference whatsoever between private law and private ordering on the one hand and public law and public ordering on the other. State activities would fall under the nexus of voluntary and mutually beneficial exchange relationships. In reality, however, the benchmark condition of consent is virtually never met. The authors still regard it as a useful point of analytical departure against which to compare real-world monopolistic democracies.
Eusepi and Wagner try to provide what they call a “canonical model of democratic debt” and explain that a
truly explanatory theory of democratic debt within the framework of a cooperative state must be able to explain the emergence of public debt from an initial situation where such debt did not exist. The model of the cooperative state requires that we explain how a set of people might choose to create public debt, just as it must explain how a set of people will agree to tax themselves. Otherwise, all one can do is start with the existence of debt or taxation and assert that this prior existence reflects the consent of the governed because the analyst presumes that consensus is an inviolable property of democracy. (pp. 85–86)
Now, interestingly, the authors are of the opinion that a meaningful notion of public debt is very difficult to conceive even within a cooperative state, or at least, that it is not plainly obvious how public debt could emerge under such a state. This is surprising. Indeed, the assumption of perfect consent is entirely heroic when it comes to actual nation states as they exist, but if we decide to start with that assumption for analytical purposes, it is not very challenging at all to explain the emergence of public debt, that is, a debt contract for which all citizens of the state collectively pledge to pay back a loan plus interest over some period of time.
All citizens might agree, given their time preferences, that it is preferable to finance some desirable government project not out of savings and their current incomes, but via a loan that they promise to repay out of future income. In order for the people truly to be indebted collectively, the creditor must come from outside. Otherwise, only a subgroup of the people would be indebted while the rest would not. Analytically, there would be no difference between this case and, for instance, a married couple taking out a loan together to purchase a house. Of course, it is not the husband who gives a loan to his wife, or vice versa, but there has to be an external creditor for the couple to be collectively indebted.
The word tax might not be very helpful when describing the sum of money voluntarily given to pay back the loan, but this is a semantic issue, not a substantive one. In fact, all taxes paid under a cooperative state would be voluntary payments made because the expected benefit of the government projects so financed exceeds the opportunity costs from the individual perspective of every person in the community. We would be entirely in the realm of private ordering based on the principles of private property and freedom of contract. This is the implication of the assumption of consent, but it goes without saying that it is not “an inviolable property of democracy” in the real world.
Eusepi and Wagner do not provide such a general and simple analysis. Instead, they give the example of a town that by consent of the inhabitants decides to build a dam. They invoke all kinds of complications in the form of disagreements among the citizens about how to finance the dam. Some might prefer to pay the tax directly out of current income or savings. Others might prefer to take out a loan. In such a scenario, the town would of course not collectively go into debt. Only some citizens would, collectively in subgroups or individually. Other citizens of the same state might even become their creditors. This would not be an instance of public debt as described above.
Eusepi and Wagner argue that when the town’s council decides to issue bonds to finance the dam, it would inevitably replace private ordering by public ordering (p. 88). However, the authors forget that under a cooperative system, it can do so only if every citizen gives consent. In such a case, we would remain within private ordering. What the authors convincingly convey, however, is that when we relax the assumption of cooperative democracy, which they implicitly do already in their discussion of the benchmark case, various problems with respect to public debt arise. These include that some inhabitants may be forced against their will to pay back a sum of money that government officials have borrowed to finance projects they themselves disapprove of. This precisely is the problem of political power.
The relevant question then is how can we approach the limiting case of cooperative democracy without coercion? Eusepi and Wagner make the important observation that as “a practical matter of democratic operation, the ideal of a cooperative democracy is surely limited to relatively small-scale democracies,” which is why they work with the example of a town “that contains a few thousand people at most, and where people can easily and nearly costlessly move somewhere else if they choose to do so” (p. 86).
The obvious conclusion seems to be that the right of opting out of public programs, including full-blown secession for sub-communities, must be granted in order to approach cooperative forms of governance. However, the authors do not dwell on this point. It is ironic that these rights exist, for example, in the monarchy of Liechtenstein.
Approaching the cooperative state is not primarily a question of public debt. Yet, it is reasonable to assume that genuine public debt would be extremely low, if it existed at all, under a cooperative state. Again, the tiny monarchy of Liechtenstein has practically no public debt outstanding. The authors conclude the fourth chapter by claiming that “de Viti’s ideal of a genuinely cooperative state is a limiting case that is difficult even to approach with respect to public debt, though it might be more easily approached without public debt” (p. 110). This might be true, but public debt ultimately does not seem to be a cause of non-cooperative or monopolistic governments. Quite to the contrary, it is, at least in its excessive form, one important effect of monopolistic governments. There are numerous problems involved in public debt, and it exists in such large quantities, because virtually all governments are monopolistic in de Viti de Marco’s terms.
Chapter 5 explicitly turns to the analysis of public debt under monopolistic democracies. In reference to Mosca (1939) and Pareto (1935), the authors hold that for “the most part, actual democratic systems operate in monopolistic fashion, meaning that they entail the dominance of a relatively small number of people over larger numbers” (Eusepi and Wagner 2017, p. 111). The authors explain that “people differ in their interests in and talents for acquiring political power. Possessing and wielding power will be more attractive to some people than to others. In this setting, political activity will become the province of subsets of people within any geographical territory.” Following Mosca, one might call this relatively small number of people the ruling class. For these people, public opinion and sentiment are the most important sources of power as explained, for example, in Wieser (1926) and de Jouvenel (1948). The characteristic feature of power, not only in monopolistic democracies, but in any political system, is that those who “hold positions of power can […] distribute costs and gains among the population over which they rule” (Eusepi and Wagner, 2017, p. 112).
According to the authors, debt contracts of monopolistic governments never reflect the will of all the people, but merely the will of some. Given that most actual states are monopolistic rather than cooperative it becomes clear what the authors could mean by calling public debt an “illusion.” It is illusory to take public debt for what the generated ideological tale of democracy as self-governance would have us believe. Public debt does not emerge out of consent, but is imposed upon the people by the ruling class that has successfully provided “ideological formulations that resonate with voter sentiments, such that people can support measures they would have opposed had they engaged truly in logical reasoning” (p. 130). This could include increased deficit spending.
More precisely, the burden of debt is imposed on a subgroup of the people. After all, there are also supporters of deficit spending among the electorate, and it is strictly speaking impossible to say, whether their support for public debt truly stems from a lack of logical reasoning as Eusepi and Wagner suggest. As a matter of fact, it might stem from perfectly logical reasoning. It is of course possible to personally benefit, directly or indirectly, from public debt. The authors do not consider this possibility. They realize that public debt virtually always “creates both voluntary and involuntary debtors” (p. 153), but even more importantly it creates voluntary creditors, who bring themselves in a position to benefit from the government’s power to tax. Others may benefit from public debt indirectly, when they become recipients of the additional government spending made possible by debt finance.
Under monopolistic democratic rule, public debt becomes a tool of power. Eusepi and Wagner correctly emphasize that it covers up a redistribution of wealth behind “illusory” slogans and “ideological images” such as “we owe it to ourselves” (p. 163). The authors point out that the bulk of public debt is in fact not even made explicit through the sale of bonds, but remains implicit in the form of other liabilities that the governments hold, for example, social security programs. They call this implicit public debt a “systemic form of collective lying” (pp. 138–141). They argue that it “is systemic and not personal lying because it is an emergent quality of a system of public ordering more than a quality of any politician, though it is also easy enough to find lying politicians, just as it is possible to point to lying business people for that matter.”
However, it seems rather odd to call lying a quality of a system. Here, the authors have forgotten, for a very brief moment, their ultra microfoundationalist inclinations. It is always individuals that lie, and if the system of public ordering encourages lies for personal benefit and the benefit of selected parties, it will attract opportunistic characters ready to tell them.
In the final chapter of their book, Eusepi and Wagner conclude that “there can be no such thing as public debt in a democracy because a democracy is not a sentient creature.” And furthermore, they claim that there “is no public that can pledge its wealth in exchange for credits from other people” (p. 163). Taken as such, these claims are exaggerated and slightly confusing. It is true that a democracy is not a sentient creature, of course, but neither is a monarchy. Democracies are composed of sentient creatures, if you like, and it is conceivable that they unanimously engage in a debt contract and pledge their wealth as collateral. It might be very unlikely to observe in any given community of a certain size, since such an arrangement would imply a socialization of personal default risk, but it is not impossible.
However, it is clear that much of the image of public debt, generated in ideological discourse is completely illusory. Professors Eusepi and Wagner have provided a fair number of arguments to substantiate this somewhat adjusted claim. The reviewer would hold that public debt is not an illusion of democratic political economy, but simply a very different creature from what it is made to be.
(Excerpt from chapter 17 of Mises: The Last Knight of Liberalism, pp. 765–67.)
Mises’s exposition of economic science differed decisively from all modern authors in that it drew a sharp line between praxeology and psychology. This has remained a defining feature of the works of his disciples.
Mises did not contest that the psychological background of a person, his worldview, knowledge, conscious motivations, subconscious urges, and so on have an immediate impact on his behavior. Neither did he ignore the important psychological problems that his friend F.A. Hayek began to stress in those years, in particular, that of knowledge acquisition. Mises’s point was that there were also laws of human behavior that exist in complete independence of these psychological dispositions.
For example, in chapter 4, Mises discusses ends and means, scales of values, and scales of needs. He does not deal with the question of how or why people select ends and means, or how or why they have certain values and certain needs. He argues that in every human action we do use means to attain ends, and that needs and values can be rankedMurray Rothbard later argued that as a consequence of the mere fact that people rank their choice alternatives, it follows that demand curves must slope downward to the right. See Murray N. Rothbard, Man, Economy, and State, 3rd ed. (Auburn, Ala.: Ludwig von Mises Institute, 1993), chap. 2. Mises made no such inference. He was skeptical about the use of graphical methods in exact analysis (he did accept them as pedagogical devices). In chapter 15 (“The Market”) he points out that consumers are sovereign because their buying decisions steer the market.Mises, Human Action, p. 270. This is obviously true, irrespective of what consumers buy or the reason why they make these purchases. Therefore he does not deal with these questions. In chapter 16 (“Prices”) Mises states that the number of market participants determines how narrow the margins are within which prices are determined. Yet this implies that the number of market participants has no influence on how prices are formed. Irrespective of the number of market participants, market prices are always determined by the decisions of marginal buyers and sellers.Ibid., p. 324. Thus, all prices can be explained as a result of the mere fact that market participants prefer one good A to another good B.Ibid., pp. 328f.
Praxeology is the science of these laws. It examines the ramifications of the mere fact that a man makes this or that choice. Considering the relationship between a choice and its consequences, praxeology examines the suitability of different means to attain particular ends. In praxeological analysis, the ends are “given,” not in the sense that human beings cannot choose them or that the choice of the right end is not problematic, but in the sense that the choice of ends is outside the scope of this particular science.Mises would later discuss the irrelevance of homooeconomicus for modern economics in Human Action, pp. 62ff. He concluded that "theorems concerning commodity prices, wage rates, and interest rates refer to all these phenomena without any regard to the motives causing people to buy or to sell or to abstain from buying or selling" (p. 64).
With respect to the knowledge of market participants, Mises emphasized the fact that the individual market participants are not equally well informed. Yet even if they all had the same information they would appraise this information differently.Ibid., p. 325.
As to equilibrium, he stated again and again that the market never reaches such a state, that it is a mere mental construct the only function of which is to analyze profits and losses. That is, the equilibrium construct is needed to explain a particular component of price spreads. It is not required to explain prices (wages, interest, commodity prices) as such.Ibid., pp. 245ff.
Consequently, in Mises’s view, equilibrium is not the right benchmark for the evaluation of the market. To critics of economic science who complain that the market never produces a perfect balance between different goods and services, Mises replies in two steps.Ibid., p. 647, for example. First, he points out that this fact of imbalance does not refute economic doctrine because economic science explains any state of affairs as it results from the fact that consumers make certain valuations. Second, he observes that the relevant benchmark for the market is government intervention. And because government officials are not supermen, one cannot make the a priori assumption that entrusting them with the maintenance of the market will bring improvement. As the analysis of government interventionism shows, the very opposite is the case.
The Ludwig von Mises Memorial Lecture, sponsored by Dr. John Brätland. Includes introductory remarks by Joseph Salerno. Presented at the Austrian Economics Research Conference at the Mises Institute in Auburn, Alabama, on 10 March 2017.
Quarterly Journal of Austrian Economics 19, no. 4 (Winter 2016)
ABSTRACT: As the first application of the praxeological discipline of “Cratics” (Taghizadegan and Otto, 2015), a theory of the supply and demand of bads is developed. On this foundation, a violence cycle theory will be introduced in analogy to the praxeological business cycle theory (according to Ludwig von Mises). Central to this approach are the subjective perceptions of threats and possible bluffs regarding the backing of those threats. Such a violence cycle theory can explain the stability of structures of violence and reveal new interpretations of the “long peace” hypothesis.
KEYWORDS: Austrian school, praxeology, catallactics, coercionJEL CLASSIFICATION: B53Those actions and things which render a marginal utility to men can be described as goods. In analogy, those actions and things which cause to expect a “marginal disutility” can be described as bads. Catallactics, i.e., the economics of direct and indirect exchange, can describe the process of the interaction of men who mutually promise and transfer goods to each other. In this case, concrete exchange relations are documented in the form of prices, reflecting subjective preferences and promises. The supplier of a good communicates the following promise:
I promise to give the good A to a person who offers me, at least, X in return.
A potential counterparty, however, communicates:
I promise to give, at most, X to a person who offers me the good A.
The exchange, i.e. the contracting, follows as the implementation of the given promises.
Similarly, coercive interactions as described by the discipline of cratics (cf. Taghizadegan and Otto, 2015), contain promises as an essential element. In analogy to catallactics, we can distinguish suppliers and counterparties regarding bads. The supplier of a bad pursues a marginal utility on his part by making the counterparty act in a certain way through promising a bad in case of that counterparty’s refusal. Critical herein is the specific and subjective expectation of the ensuing damage, the marginal disutility, rather than some objectively quantifiable harm. In particular, the expected disutility depends on the counterparty’s situation. The promise, i.e. the threat, to kick a paraplegic’s leg might lead to a smaller expectation of disutility than is the case with a non-paraplegic person.
A threat can be considered as an “offer” of a bad. It is an offer only in an extended sense, since it can be rejected by the counterparty—but not without incurring costs. The actual interaction, however, runs contrary to a catallactic process: In catallactics, the offering party endeavors to contract in order to obtain a certain good in exchange for another good. In cratics, contracting implies the unilateral transfer of the good in order to avoid the bad. Non-contracting on the part of the counterparty implies to keep the good and to “test” the validity of the threat to execute the bad. The “supplier” of the bad makes the following promise:
I promise to not execute the bad B on those who, at least, provide me with good G in return.
The “consumer” of a bad is a party that acknowledges the validity of the threat and therefore gives in to it. Thus, the term “bad” might be somewhat counterintuitive, however, it helps to establish the mirror-inverted analogy to catallactics. The consumer of a good ascribes a higher marginal utility to this good than to the asked exchange good and therefore wishes to transact. The “consumer” of a bad expects a higher marginal disutility from the bad than from giving up the demanded good. Herein, the “consumer” confirms the (validity of the) bad and encourages the “supplier” of the bad to provide more thereof, much like a catallactic consumer encourages a supplier to offer more of the same good. In effect, the “consumer” of the bad communicates the following promise:
I promise to give G if the bad B is not done to me.
Goods are offered in the hope of meeting demand—meaning, a willingness to pay more than the costs, i.e. the marginal disutility from employing the factors of production. Bads are offered based on the expectation that, for the “consumer,” the willingness to evade the bad is inferior to the marginal utility of the good. The willingness to evade therein denotes the amount of utility or value that the counterparty is willing to risk in order to evade the respective bad. Namely, the “consumer” risks that his costs to evade the bad exceed the costs of the bad itself. In effect, a high willingness to pay implies a large demand for goods, or a large willingness to contract, whereas high willingness to evade implies low demand for bads, or a low willingness to contract. In catallactics, the willingness to evade is irrelevant, since evasion costs are typically zero. In cratics, the willingness to pay—i.e., the readiness to contract—amounts to a willingness to obey, to give in to threats.
In analogy to the turnover of goods, the turnover of bads can be illustrated with analytical functions. Such supply and demand functions, to be sure, do not reflect reality in an exact manner, but rather serve to illustrate certain mechanisms: the higher the willingness to pay for a certain good, the more suppliers can expect turnover and will therefore join the market. In the case of bads, the tendency is the same: The higher the willingness to pay (willingness to obey), the more bads will be offered, whereas the higher the willingness to evade, the less bads remain as effective threats on the “market.”
Needless to say that this analogy must not be misunderstood. The “market” for bads is no market at all. At this point another analogous term would be necessary. The term “market” is derived from the Latin word mercatus, which in turn stems from merx: a product or good. Bads in Latin would be malae merces, so that one could form the concept of a malmarket, but that would probably be too much of a play of words. Let us stay with the Greek language: catallactic for a market order, cratic for a coercive order, whereby the study of the first is called catallactics while the study of the second is denoted as cratics. This contrast resembles Franz Oppenheimer’s (1924) juxtaposition of the political and the economic means—the former would be cratic, the latter would be catallactic.
Back to the dynamics of the willingness to evade, where we can observe two extreme cases: A zero willingness to evade would mean to give up all values without resistance. There would be a maximum of bads, but a minimum of actual violence. As soon as “buyers” with a zero willingness to evade are discovered by “producers” of bads, the former—reluctantly—nurture the production of bads, which may entirely drive out the production of goods.
Let us clarify that example conceptually: “Production” of bads means the intention, preparation and propagation of harm to other people to the benefit of the “producer” at the lowest cost possible. In this case, a threatening appearance could constitute a “factor of production.” When a bully runs into a classmate who has no willingness to evade, an angry look alone could be enough to be recognized as the offer of a bad, whereupon the transfer of snacks may follow without resistance, amounting to the immediate contracting in this coercive exchange. This would typically lead to a marginal rise of the production of bads, both because the producer of bads will be encouraged to further employ his “production factor,” and because successors may appear who recognize how easy it is to obtain other people’s goods. If, in a given “market,” all the “buyers of the bads,” i.e., those who give away the demanded goods, exhibited zero willingness to evade, the production of goods would not be profitable anymore, because even the smallest bads would lead to their uncompensated transfer. Such a society would break apart very quickly, because all those “buyers” would run out of resources. A short period of absolute non-violence—during which violence was not necessary to break the will of the “buyers”—would yield to a period of violence among the producers of bads.
In contrast, a maximum willingness to evade would require the highest degree of violence for coercive exchange. Every threat would immediately be checked for its “backing.” The “demand” for bads would be reduced to a minimum because the potential “buyers” preferred to risk the bad. A maximum willingness to evade may have two reasons: A maximum distrust in threats, and/or an absolute firmness with regard to one’s principles, whereby one would risk everything in order to avoid giving up one’s principles and values. In catallactics, analogous reasons would explain a minimum willingness to pay for offered goods: A maximum distrust in promises on the market, and/or an absolute firmness with regard to one’s principles, which do not allow for a gain in utility through exchange (hostility against trade, defeatism etc.).
A cratic “buyer” expects that the cost of the evasion is higher than the demanded payment (buying into the threat). A catallactic buyer expects that the gain in utility through the offered goods is higher than the loss in utility through the demanded payment. The cratic “price” amounts to the demanded payment (loss of utility) to evade the threatened bads. The higher the demanded price and the higher the willingness to evade, the less the “demand.”
In the field of catallactics, interventions in prices and quantities are known that have a cratic character by themselves. Namely, they are efforts to replace particular exchange relations of goods by means of the threat of bads. Every imperative or prohibition represents a cratic exchange: An “offer” (the threat) of bads is linked to an action or non-action preferred by the coercive party. At first sight, again, the analogy between omissions (caused by prohibitions) and services (preferred actions as goods) might seem overstretched. However, the objective character of the action to be performed or refrained from is a technical, not an economic question. An economic judgment of actions according to their technical content would violate the value neutrality principle, and amount to an arrogation of knowledge, respectively. In contrast, in the disciplines of medicine and religion, to name only two striking examples, action cannot easily be distinguished from non-action. In addition, catallactic offers can aim at a non-action, such as an offer of money to a street musician in exchange to stopping the performance.
Following these introductory remarks, let us now proceed to the core of this work, the analogy to business cycle theory. Namely, broadly speaking, the cratic character of offers or threats is not always obvious. Bluffs (or deceptions) might have the same effect as price and quantity interventions. A particularly important field of such deceptive interventions is described by the business cycle theory according to the Austrian school of economics (see Mises, 1912). It describes the periodical emergence of an economic boom, followed by a bust. The reason for this typical pattern is a credit expansion beyond the level of real savings, which is revealed in suppressed interest rates. Such interest rates would be untenable and, in particular, would cause illiquidity, were they not enabled by cratic interventions (compulsory wealth transfers, privileges such as those arising from central banking, contract breaches without consequences, etc.).
This distortion of interest rates is, on the one hand, a price intervention, and, on the other hand, a deception. The lowered interest rate has a similar effect as a maximum price coercively set at a level below the market price. In this case, demand is higher than supply. The interest rate is the price for savings; the demand for savings—thus indebtedness—rises; the supply of real savings—the propensity to save—decreases. This would cause a supply gap, if the created circulatory credit had not filled that gap. But since the circulatory credit is based on the assumption that bank deposits will not be withdrawn, it is a deception regarding the true extent of available savings. During phases of credit expansion arising from artificially low interest rates (a “maximum rate of interest fixed below the market rate”), consumption and investment are booming at the same time. The overestimated savings and thus resources considered as disposable are unbacked promises. The insufficient backing within the financial system will be uncovered through a bank run, a run on illiquid banks, which without bailouts would have to default on their depositors. In the economy, an insufficient backing of promises with resources will be visible through unexpected price increases, which cause the illiquidity of entrepreneurs who are now unable to finish their projects.
An analogous, systematic discrepancy between promise and backing—namely, between threat and capability to execute—exists in the field of cratics. An actor can, very easily, issue threats that exceed what he himself is capable and willing to execute. In the same way, entrepreneurs can make incorrect estimations about their own liquidity. Whenever such miscalculations accumulate, cycle patterns appear. In his “General Theory of Error Cycles,” Jörg-Guido Hülsmann describes such accumulations of errors as illusions of legitimacy (Hülsmann, 1998). When, in the above schoolyard example, at some point in time it becomes common practice to hand over one’s snacks to the bully, the need to “back” his threat disappears. One day he could lose his physical ability to supply the bads—punching disobedient schoolmates. As long as this ability is not checked, the bully can still collect the goods—until the day when a person again takes a risk and the illusion of the powerful bully bursts.
This pattern of deceptions and bursting illusions resembles the business cycle. The illusion starts a phase of apparent stability that actually appears to be particularly peaceful and free from violence: the threat boom. The issuer of threats is peaceful at this stage—he might even thank the classmates for handing over their snacks and return half of them. At this stage, the contracting of bads is high. Let us remember: The contracting of bads does not imply a preference for such bads (they are, after all, bad). However, it does imply the willingness to engage in cratic exchange, which consists of the delivery of goods or the execution or omission of actions in exchange for the non-execution of the threat. After the revelation of the incapacity to execute the threats, the stage of apparent voluntariness is followed by an explosive correction: The willingness to contract falls extremely rapidly. Even if the bully seeks rapid execution, he now detects that his power is “illiquid”: it does not suffice to meet the suddenly accumulating challenges. While, during the boom, the physical overpowering of an individual was sufficient, now the physical overpowering of larger groups becomes necessary. The threat boom ends with a correction of the level of coercion, in which the power of the aggressor competes directly with the resistance of the victims. Now the schoolyard exhibits a high level of violence. Actually, it is a period of the reduction of (implicit) violence in which unsustainable cratic relations finally yield to catallactic relations. Clueless teachers might intervene to stop the violence, by sanctioning the challenging pupils. Thereby, the correction might be postponed, creating the impression that the bully stood up against the challenges to the backing of his threats. In the worst case, the teachers intervene for the purpose of a superficial reduction of violence by artificially legitimizing the bully’s claim: “The wiser head gives in!” Through this, another threat boom could follow, where the bully could increase his demands even more—after all, the wiser head has to give in! Apparent peacefulness would increase again, up to the point where someone decides to challenge the bully again.
Coercive rule as a systematic implementation of cratic exchange is possible either through a physical superiority of the rulers or through the illusion of superiority, as De la Boëtie observed a long time ago:
He who thus domineers over you has only two eyes, only two hands, only one body, no more than is possessed by the least man among the infinite numbers dwelling in your cities; he has indeed nothing more than the power that you confer upon him to destroy you. (La Boëtie, 1550)
The paradox of prolonged apparent peacefulness of coercive rule can thus be explained through the violence cycle theory presented here. That puts the observation in its true light—that open violence may have decreased throughout the last centuries. One of the most detailed expositions of this development is Steven Pinker’s (2011). He reasoned that in the course of history the “better angels” within human nature have prevailed against the “inner demons”—leading to modern man being more civilized. The presented empirical evidence seems conclusive: The violence among individuals as well as between states (wars) seems to have decreased.
Two of the many reasons that Pinker proposes for this development are of direct concern to the field of cratics: On the one hand, he argues, the growth of Leviathan—the centralized state monopoly on the use of force—has displaced the violence between smaller units, while on the other hand, commercialization has made people more peaceful. The latter argument finds confirmation in the fact that catallactic transactions are able to replace cratic transactions: After all, for each bilateral action he envisions, man can choose whether to employ the cratic or the catallactic mode. The former argument finds, at best, partial confirmation. Phases of cratic legitimacy may indeed have a pacifying effect. This idea goes back to Thomas Hobbes and can be confirmed by praxeological analysis—but with serious reservations that lead to conclusions which differ completely from those drawn by Hobbes and Pinker.
Indeed, the violence cycle has a paradoxical effect which complicates its quantitative assessment—just like the business cycle. The possible “evaluation of the backing” of promises of violence can lead to violent corrections after peaceful periods, a cratic recession, during which the violence is bid up dramatically. This explains the conclusion of Hobbes that such “evaluations of the backing” should be completely avoided, which can only succeed through the subjects’ complete renunciation to challenge the government. Otherwise a civil war would be imminent:
For those men that are so remissly governed that they dare take up arms to defend or introduce an opinion are still at war; and their condition, not peace, but only a cessation of arms for fear of one another; and they live, as it were, in the procincts of battle continually. It belonged therefore to him that hath the sovereign power to be judge, or constitute all judges of opinions and doctrines, as a thing necessary to peace; thereby to prevent discord and civil war.” (Hobbes, 1651, chapter XVIII)
The fallacy lies in considering the high potential of violence during the cratic recession as the natural state—just like the fear of the high “clean-up costs” of economic recessions, which usually show a steep rise in unemployment and insolvencies. In fact, however, the recession is a corrective process, revealing the discrepancies between economic actions and economic realities which had accumulated during the artificial boom. Hobbes sees fear of violence as the only chance for pacification and dismisses catallactic alternatives, the possibility for people to reach complementary or inverse goals by peaceful means without harming each other. This leads to an interventionist perspective on politics, seeking a monopoly of fear, analogous to economic policy claiming the monopoly of trust for the state, as the supposed guardian of money and contracts. Hobbes’ concept of man is, accordingly, biased:
Of all passions, that which inclineth men least to break the laws is fear. Nay, excepting some generous natures, it is the only thing (when there is appearance of profit or pleasure by breaking the laws) that makes men keep them. (Hobbes, 1651, chapter XXVII)
If fear were really the main reason for rule-consistent behavior, the costs of violence would be uneconomically high for Leviathan: The sanctions for breaches of law would have to be backed to a degree where the related costs would reach the level of income from cratic action. In the short term, it may be possible to compensate for a lower likelihood of revelation of violence with more draconian penalties. But in this way the legitimacy further decreases and thereby also the subjects’ “willingness to contract” (willingness to obey). These dynamics are missed by Hobbes, as well as the observation that in times of long and far-reaching peace obtained through a highly stable coercive setup (i.e, a high level of implicit fear and obedience), the probability of a “black swan” of massive violent corrections—or, more generally, reactions—is growing: in particular, our violence cycle theory suggests a correlation between the intensity of violent reactions and the lengths and intensities of the respective preceding coercive periods, that is of those periods within a certain culture or society that are characterized by a stable coercive setup. Following Nassim Taleb, the distribution of the intensity of violent outbursts indicates a fat tail (Taleb, 2012); accordingly, we assume a fat-tail distribution regarding the length (and intensity) of preceding coercive periods. Hence, we also agree with Taleb’s criticism of Pinker, particularly regarding the evaluation of our present-day situation. On a side note, to be sure, Taleb’s analysis does not distinguish between the internal and external type of a violent outburst (civil war versus interstate war). Indeed, we argue that a violent reaction does not necessarily have to affect the coercing party or institution, as would typically be the case in a civil war. Rather, we hold that interstate wars have consistently been employed by coercing institutions as a means to divert internal backlashes.
With threat boom and threat bust as the two elements of a cycle, the total enacted violence across such a cycle—or in economically more precise terms: the total volume of contracted and enacted bads—may be considerably higher than it would be without the cycle, or with a less pronounced one. Analogously, the growth in prosperity over the entire economic cycle is lower than it would be without boom-and-bust sequences. This is so both because the boom constitutes a distortion in which goods are misallocated—meaning, allocated not in accordance with the preferences and plans of the people—and because the bust, while it might correct this distortion, typically produces highly damaging side effects in the process, which would not have been “required” with a less pronounced or non-existing cycle.
However, this perspective does not only apply for archaic or low-level regimes of fear but also for modern regimes of legitimacy. Indeed, Hobbes praised fear, which he correctly recognized as a stabilizing element of cratic structures, as a corollary of freedom:
Fear and liberty are consistent: as when a man throweth his goods into the sea for fear the ship should sink, he doth it nevertheless very willingly, and may refuse to do it if he will; it is therefore the action of one that was free: so a man sometimes pays his debt, only for fear of imprisonment, which, because nobody hindered him from. (Hobbes, 1651, chapter XXI)
Similaly, legitimacy is used as a synonym for freedom in modern cratic systems, for example under the terms “rule of law” and “democracy.” However, whereas in catallactics unbacked promises can be corrected sooner and on a smaller scale, because the self-interest of the people serves as a corrective, cratic promises can expand to a higher degree. The potential “black swan” consists in a sudden implosion of legitimacy. In effect, the legitimization of cratic exchange reduces its costs below the otherwise necessary level and leads to the preponderance of the political (cratic) means over the economic (catallactic) means. The resulting preponderance of supply and contracting of bads leads to an allocation of means which, on average, corresponds less to the preferences and plans of the people than would be the case without such legitimization and the resulting violence cycle.
There is a similar problem in case of interstate violence. Peaceful coexistence is not only stabilized by mutual threat potential, but also by perceived legitimacy of predominance, respectively transfer of sovereignty. Praxeological analysis, however, shows that these seemingly stable arrangements are more fragile than is generally perceived, because these arrangements themselves sow the seeds of “corrective catastrophes.”
The problem of “black swans” in case of the threat potential through weapons of mass destruction is a matter of common knowledge. Nassim Taleb probably had precisely this in mind when criticizing Pinker:
Ancestral man had no nuclear weapons, so it is downright foolish to assume the statistics of conflicts in the 14th century can apply to the 21st. A mean person with a stick is categorically different from a mean person with a nuclear weapon, so the emphasis should be on the weapon and not exclusively on the psychological make-up of the person. (Taleb, 2012)
Let us translate this into the language of cratics: Frequent evaluations of the backings of geopolitical arrangements through small scale skirmishes may at first exhibit a higher rate of violence, while in the long term they could harbor a lower potential of violence than a peace order (or the order of a cold war), the backing of which can only be evaluated through the use of nuclear weapons. We have survived the 20th century without mutual destruction, but to deduce therefrom the superiority of a peace order based on massive threat potential would be a statistical fallacy, as Taleb observed. The fallacy of the “survivor bias” fits in every sense of the word: The world has frequently been on the brink of catastrophe. We have survived; that is why we can praise modernity as the best of all worlds, which, as Pinker empirically claims, may show less violence and war than earlier epochs. If that lottery had turned out differently, there would be hardly anyone left to sing such praises. A mere 100 years ago, a similar analysis would also have praised an apparent age of peace:
Panelists in 1912 could have produced compelling evidence documenting the decline of great power war. The previous century had been the most peaceful on record, continuing the decline in great power war over the previous three centuries. There had been zero great power wars for nearly four decades, a 50% decline over the last two centuries, and zero general wars involving all of the great powers for 97 years. This was the longest period of great power peace in the last four centuries of the modern European system.” (Levy and Thompson, 2013, p. 412)
As well, in the case of interpersonal violence, a low level of violence can have causes other than the development of so-called angelic behavior—unless one praises obedience as an angelic virtue and condemns human freedom as a satanic temptation. Cratic structures which enforce obedience through physical superiority, rather than through habit and legitimization, correspond to the phenomenon of stationary bandits, which Mancur Olsen (1993) analyzed economically. Olson concludes that the monopolization of the use of violence should minimize such violence. The stationary bandit replaces non-stationary bandits and contents himself with less, though continuous, prey. Our analysis, however, indicates that this compensation is not certain: The same rationality leads to a lower and thus cheaper backing of threats for a stationary bandit. On the one hand, this enables, ceteris paribus, a higher level of exploitation. On the other hand, since criminals (who also operate cratically) are the first ones who evaluate the backing of threats, a lower degree of backing by the “primary, stationary bandit” may imply that the quality of his “service” (security) relates very poorly to his cost level (appropriation of goods). In extreme cases, the population may be harassed to an insupportable degree through unbacked threats, while at the same time left completely and utterly at the mercy of criminals who operate with backed threats. In such a setup, peacefulness may purely result from defenselessness. The officials seem to get along with forms and stamps; weapons are hardly used. But behind this facade of peacefulness grows a black swan of cognitive dissonance that is expressed at first through declining trust and increasing resentment. It is difficult to predict the behavior of people who have been peaceful only due to apathy and blindness, when they suddenly fear for their survival. Explosions of violence at the end of such a cycle cannot be excluded. In effect, this is the risk of pacification through fear or legitimization of cratic threats. Ultimately, a level of violence at which threats are challenged and thus evaluated more often might be higher in the short term, but should be lower in the long term—even in the case where, during a long threat boom, people get accustomed to “angelic peacefulness.”
The threat boom is not only characterized by the fact that one day a correction is due, which can lead to an explosion of violence (revolutions, civil wars, uprisings), but also by the fact that it leads to a systematic overestimation regarding how well the existing order corresponds to the preferences of the people. It is similar to an economic boom: The order books and supermarkets are full, the companies are flourishing, but the markets are distorted—less and less of what the people intrinsically demand is produced while, rather, value destruction takes place. Scarce and therefore valuable resources are transformed into less valuable things. Similarly, during a threat boom, behind a facade of legitimacy, hidden exploitation takes place. Of course, “value” and “exploitation” are normative concepts. Expressed in a value neutral way, it boils down to a situation in which actions are legitimized as valuable and just, and are thus encouraged, which, after revelation of the consequences, are regarded as destructive and exploitive in hindsight. The problem lies precisely in this encouragement, thus in the dynamics: A hidden tension between aspirations and reality is growing.
The violence cycle theory facilitates a critical analysis of the succession of periods of war and peace. Furthermore, it allows a new interpretation of the prevailing civilization and reduction of inter-personal violence in large parts of the world throughout modernity. Cratic analysis also nourishes the debate about an ethical justification of state violence with new insights, e.g., through a critical examination of the possibilities and conditions for a minimization of violence.
The violence cycle theory is more than a mere analogy to the business cycle theory. The business cycle is not a necessary result of monetary expansion, as Hülsmann has shown. Monetary expansion is usually linked to a cycle of erroneous trust by entrepreneurs in the institutional framework and distorted market signals. Hülsmann argues:
The mere fact that the quantity of money changes does not prevent the entrepreneurs from judging correctly what influence it will exercise on market prices. (Hülsmann, 1998, p. 4)
He concludes that the business cycle theory is “not generally and apodictically valid.” Thus, a more general theory is needed, even to explain the business cycle in the first place—the business cycle is not an explicans, but an explicandum, on which the cratic cycle theory may shed additional light. Trust in unbacked promises, misled by coercion, may play a larger role than previously thought. Of course, trust is a subjective category and does not allow for deterministic or quantitative predictions. Misguided booms, based on unbacked promises or threats, are not necessarily corrected; if gullibility increases at the same pace, they may go on forever. If they are corrected, they tend to collapse; disillusionment is self-reinforcing.
Hopefully, these introductory considerations help to show the potential of further application of “cratics,” i.e., the praxeology of coercion and violence, in the fields of ethics, political science and history.
The Ludwig von Mises Memorial Lecture sponsored by James Walker. Recorded at the 2016 Austrian Economics Research Conference. Includes an introduction by Joe Salerno.
The Lou Church Memorial Lecture sponsored by the Lou Church Foundation. Recorded at the 2016 Austrian Economics Research Conference. Includes an introduction by Joe Salerno.
Quarterly Journal of Austrian Economics 18, no. 4 (Winter 2015): 378–408
ABSTRACT: Although commonly misconstrued as a statement concerning the “correctness” of prices, the Efficient Market Hypothesis (EMH) is a statement about their informational content. The aftermath of the recent recession has brought renewed skepticism to EMH, even leading some to redefine it as the “inefficient” market hypothesis. We demonstrate that such a course of action is misguided, as it changes the nature of the input (i.e., the market) but not the truth value of the statement (i.e., whether markets are efficient). We outline further several logical fallacies of the Hypothesis which negate its usefulness. We conclude by showing that the EMH was never a hypothesis and as such is best considered a conjecture. As a conjecture, it is increasingly difficult to reconcile with market behavior in both theory and practice.
KEYWORDS: efficient markets, informational efficiency, EMH, equity returnsJEL CLASSIFICATION: B53, G14
The literature on market imperfection and market failure is voluminous, ever-growing, and filled with Nobel laureates. Identify a new source or instance of market “failure,” and you’re likely to win a Nobel Prize, or so it seems.
Phishing for Phools: The Economics of Manipulation and Deception, by Nobel Laureates George A. Akerlof and Robert J. Shiller, presents the thesis that we are overly confident in unregulated markets and that entrepreneurs accrue profit by preying on hapless consumers, exploiting “our weakness in knowing what we really want” through the market’s tendency “to spawn manipulation and deception.” Mavens of manipulation themselves, Akerlof and Shiller claim many, if not most people — especially the poor — are irrationally exuberant and are induced into buying things they really do not want. How do they know what the consumer really wants, one might ask? The answer is that anything the authors would not do themselves is ipso facto not in the best interest of the consumer. In fact, it is something that “no one could possibly want.”
We’ll Decide What’s Best For YouTheir opening chapter is an exercise in convoluted methodology. In it, Akerlof and Shiller obliterate any distinction between adroit entrepreneurship/marketing and deception/fraud. The most fundamental problem, however, is that Akerlof and Shiller think that what people really want is what is (objectively) good for them. They refuse to recognize that even if consumers were aware of the costs of eating Cinnabon — their bête noire in the opening chapter — and consuming a high calorie meal devoid of nutrients, they still might choose to eat Cinnabon. In their paternalist fervor, they cannot fathom that some people, in some places, at some times, might be willing to make such a trade off.
Rejecting Mises’s economic tautology that business owners stay afloat by satisfying consumer preferences through voluntary exchange, they believe that, instead, business owners compete for who can best deceive their customers. They call Cinnabon’s efforts to attract customers by making their product more desirable and available in convenient locations “phishing.”
Is the alternative, then, to mandate that businesses instead locate their stores in inconvenient locations, where they are less likely to sell their products to increase market efficiency? No answer is forthcoming. Also never answered by the duo is, if advertising is so effective at deceiving consumers, why do firms not spend nearly all of their budgets on advertising? Wildly exaggerating the problem they present, Akerlof and Shiller even think that the cumulative effect of “phishing” that companies like Cinnabon do through luring people in with the aroma of their cinnamon rolls may be as significant as the financial crash of 2008.
“Information Asymmetry” or Just Division of Labor?They also maintain that the incompetence of the average person prevents them from wisely investing their funds. What they do not show is that a disinterested bureaucrat spending someone else’s money has an incentive to invest carefully, which they simply assume. No matter that an individual has knowledge of his time, place, and preferences that a bureaucrat cannot have, regardless of whether or not consumers make systematic cognitive errors. What they call informational asymmetries, i.e., the different levels of knowledge among consumers and producers, should properly be called the division of labor and knowledge in society, which underpins all markets and gives us a basis to make exchanges in the first place. It is for the very reason, namely that producers of goods know more about the goods they produce, that we purchase from them. Hence, in criticizing information asymmetry in markets, they are criticizing all exchange. Akerlof and Shiller habitually succumb to this Nirvana fallacy, holding up the utopian ideal of perfect information as their (unreachable) model, and then when markets fail to reach this ideal, assume that this justifies government intervention, never giving us a reason why these systemic cognitive biases and information asymmetries can be avoided by bureaucrats more than they can by the average consumer.
Variety and Convenience Are Bad Things?Fundamentally, they mistake the beauty of the market and its convenience with manipulation. When they see a wide variety of products to choose from within arm’s reach, such as in a supermarket, they view it as a scheme to induce consumerist depravity and indulgence, rather than as a wonder to behold. They critique overpaying for health plans at the same time they critique obesity. We also see them succumbing to extraordinarily misleading explanations of history. For instance, in chapter six, they repeated the canard that Upton Sinclair’s The Jungle exposed the meatpacking industry’s unsanitary practices, when in fact his book was a complete fabrication, making no mention of this.
In general, Akerlof and Shiller appear oblivious to the roles consumer reporting institutions, competition, reputation, repeated dealings, and quality assurance play in doing just what they claim markets fail to do. If they desired to write a complete, and balanced look at the phenomenon they studied, rather than forward their agenda — what is in reality a jobs program for economists — they had ample material with which to work. The “heroes” of the story, instead, are primarily government regulators, and others who “step back from the profit incentive.” The profit incentive, for them, is essentially a one-way trip down Deceit Drive toward Manipulation Station. This single chapter focuses on the ways these problems are overcome, but they present nothing but impotency regarding the ability of businesses to do anything other than manipulate and deceive. The market, apparently, cannot provide solutions to or protect against this predatory behavior they attribute to these businesses, evidence to the contrary notwithstanding. We are left with the impression that these phishing problems are real, devastating, pervasive, and unresolved, as well as the impression that the solution is government regulation and bureaucratic administration. Nothing could be further from the truth.
In every instance, Akerlof and Shiller showcase their own “irrational exuberance” and monomania for decrying consumer choices, rather than market failures arising from information asymmetries. What else can we conclude from the foregoing but that there are informational asymmetries abounding about the true value of the information in Phishing for Phools — and that it is, objectively, something that “No One Could Possibly Want” to buy? If there is anything that could shake one’s faith in unregulated markets, it’s that anyone could be duped by Phishing for Phools.
Walter Block has assembled thirty chapters defending behavior that is probably offensive to most Americans, such as dwarf tossing and stereotyping, and many that are downright illegal, such as dueling and smuggling. Plus, he's provided us with humorous cartoons at the end of many chapters. The bottom line message in Freedom in All Realms: Defending the Undefendable is that the true test of our commitment to personal liberty doesn't come when we permit others to engage in those peaceable, voluntary acts with which we agree. It comes when we permit others to engage in peaceable, voluntary acts we find offensive. (Walter E. Williams)
The modern age of economic intervention began under the pretense of helping workers. Professor Sennholz demolishes the entire edifice that gave rise to this movement.
We were told that workers must be organized into unions. They must have job protection. Their safety must be guaranteed by legislation. There must be a minimum wage. People under the age of 15 must never engage in remunerative work, for that would be exploitation. And workers need retirement income. If unemployment rises, nothing short of full scale central planning is required!
So on it goes, except for one inconvenient fact: the age of intervention accomplished precisely the opposite of its stated goals for workers. The unemployment of the 20th century was government created. And today, workers are taxed, regulated, and regimented to their own detriment.
Here is the uncompromising case against the entire interventionist regime erected on behalf of workers. No one does a better job in showing how the state has harmed the very group that it claimed to be backing.
Sennholz refutes dozens of theoretical fallacies and exposes the bad policies that flow from them. His focus on current trends like "mandated benefits" explains how they have so drastically increased labor costs. He also deals with the feminist arguments against the free market, and makes a strong case for the benefits of the underground economy. A principled and readable work that unfies theoretical rigor and a passion for liberty.
The life and work of Ludwig von Mises is marked by the appearances of large treatises, on topics from money to methodology. But along the way, he also wrote many shorter articles and essays. The essays collected in this volume are from the interwar period, when Mises was working for the Vienna Chamber of Commerce. They concern monetary policy, fiscal policy, the boom and bust cycle, trade, economic calculation, socialism, and the history of ideas.
Some of the essays have never before appeared in print, and only surfaced with the discovery of Mises's personal papers, which had landed in Moscow after World War II. This volume is beautifully produced and printed, with outstanding editorial work by Richard Ebeling. A special bonus is a Soviet-sponsored attack on Mises, appearing in a Soviet journal, and published here for the first time.
Free Prices Now! begins by asking why the human race is still so poor. How can it be that billions still lack even enough to eat? It then provides the answer. A prosperous society is a cooperative society. Cooperation in turn depends on trust. And trust requires honesty.
The most reliable barometer of economic honesty is to be found in prices. Honest prices, neither manipulated nor controlled, provide both investors and consumers with reliable economic signals. They are the foundation for a successful economy.
A corrupt economic system does not want honest prices, honest information, or honest results. The truth may be unprofitable for powerful government leaders, private interests allied with them, or economic “experts” whose careers have been devoted to price manipulations and controls.
The US Federal Reserve and other central banks have created a system of “liar loans” and false prices. Other parts of government have contributed as well. In effect, the regulators on whom we depend have become dis-regulators.
Can it really be this simple, that economic prosperity and job growth depend on allowing economic prices to tell the truth, free from the self-dealing and self-interested theories of powerful special interests?
Yes.
Although Lewis takes us inside the complexities of the national economy and the Federal Reserve, his lively and transparently clear writing style makes it easy for anyone to follow him.
In its most basic application, the TANSTAAFL principle is a simple statement of reality: everything of value has a cost. The TANSTAAFL principle can also be interpreted as a mandate for a policy of full-cost pricing. In a world where resources are scarce, everything has a cost. Scarce resources are used most efficiently when the price paid by the final user reflects all costs, including waste disposal, harm from pollution, and depletion of non-renewable resources.
Author Edwin G. Dolan is a leading environmental economist and academic. This 40th anniversary edition includes the full original text along with a new introduction and extensive commentaries on each chapter by the author. The commentaries explore aspects of environmental issues that have changed over time, for example, the arrival on centre stage of climate change, something that merited only a few words in the 1971 edition. They also discuss things that have not changed: for example, the tendency of government to play the role of villain at least as often as that of hero when it comes to protecting environmental values. As the author repeatedly emphasizes, it is as important today as in the past to apply the TANSTAAFL principle: the polluter must pay.
Austrian economists are known for supporting free markets and criticizing government intervention. In fact, many people mistakenly think of Austrian economics as nothing more than a radical defense of free markets, though it’s really a framework for studying human action and its social implications.A similar error is to describe critics of free markets as “Keynesians.”
Still, you can usually spot free market conclusions lurking in the background of Austrian work, and this raises important questions about how policy implications influence the development of theory. For example, is it possible that the need to justify free market policies distorts Austrian research? This is the argument made in a new collection of essays edited by Guinevere Nell, titled Austrian Theory & Economic Organization: Reaching Beyond Free Market Boundaries.
Nell claims that contemporary Austrian economists focus on doing research that they know will arrive at “mandatory free market conclusions.” Thus, according to Nell, their work is more about ideology than methodology, and any research questioning free market orthodoxy is shunned and dismissed.
According to Nell, the Austrian status quo must give way to a more unbiased “post-Austrian” approach to economics, especially in organization theory (the focus of this collection). Of course, not all of this book’s contributors share her views. However, most of the chapters are consistent with her goal of developing Austrian ideas without concern for making them fit free market conclusions.
In practice, this boils down to making several claims Austrians are likely to find controversial. There are variations on the core themes, but the basic ideas are as follows:
free markets produce extensive social and economic problems,government (e.g., market socialism) can be a valuable form of spontaneous order, andgovernment can improve on market outcomes, especially with regard to social justice.I’m not convinced the book succeeds in defending any of these propositions. Before explaining this assessment, however, I’d like to emphasize that this is only a short summary of some issues I noticed while reading the book. For a fuller discussion of its merits and failings, my full-length review (with additional references) is here.
To begin, the book’s core premise strikes me as flawed, because it’s not obvious to me that the eponymous free market boundaries exist, and if they do, how Austrian research has suffered from them. Now, I don’t object to posing questions about this kind of bias, because complacency and prejudice are real and constant threats to academic research. However, I do think it’s reasonable to expect that any claims of bias be supported with specific evidence, and furthermore, that critics be able to clearly explain, in detail, how bias hinders the development of current research.
Unfortunately, contributors to this volume offer precious few examples of free market bias undermining research, and when examples do appear, they’re usually mistaken. For instance, one author claims Mises and Rothbard were unable to discuss utility and welfare economics, while another suggests that cooperatives and other horizontal forms of organization can’t be explained by an Austrian approach. A basic literature review shows these claims are unfounded.
This brings me to another major theme of the collection: alternative forms of economic organization. Several chapters criticize traditional corporations, and propose replacing them with cooperatives and other “democratic” organizations. I actually agree these are topics worth exploring, as it’s clear that in a free society the role of the corporate form would be, at the very least, greatly reduced. If the authors limited themselves to discussing such problems, I would have few objections. Unfortunately, some of them try to push further by arguing that alternative forms of organization represent solutions to free market problems that Austrian economists can’t or won’t acknowledge.
In particular, several chapters seem to suggest that Austrian economics consists of little else but singing the praises of traditional, hierarchical, profit-maximizing business. I find this claim simply baffling, and unsurprisingly, the authors don’t support it with serious evidence. Even worse, most chapters ignore the most valuable Austrian contribution to organization theory: Mises’s writing on economic calculation. Mises not only provided the definitive critique of central planning; his work is also vital for showing whether any form of production — from market anarchy to totalitarian socialism — will work in practice. These forms include cooperatives, social enterprises, and many others.
Sadly, errors of omission and commission are scattered throughout the book. Unsupported assertions and missing evidence are common, as is blaming the market for public policy failures. There are even tired allusions to Hayek and the Grand Neoliberal Conspiracy™. Such comments make it clear that the chapters most critical of Austrian economics are actually the ones least familiar with it.
Happily, several chapters — in my view, the most successful ones — actually support the views Nell criticizes. These essays are presented as a kind of benchmark against which to measure the more controversial chapters, but they do a good job of showing why there isn’t much reason to fear that Austrian economics is hopelessly biased by free market ideology.
For instance, Randall Holcombe’s chapter offers a nice overview of the concept of spontaneous order, and explains why top-down methods to improve these orders are doomed to failure. Likewise, Per Bylund provides a searching essay on the necessity of hierarchy in market firms. Last, Ed Stringham and Caleb Miles review historical and anthropological evidence on the origin of states. They show convincingly that, contrary to popular belief, states did not emerge as the result of a social contract, but through a combination of force and persuasion.
Yet, each of these papers cuts against the general motivation of the book as well as its most ambitious contributions; if anything, they highlight the value and necessity of the Austrian tradition, and the persistent relevance of economists like Mises.
The world waits to see if next week is finally the week that the groundhogs at the Fed announce their long-anticipated interest rate hike. Can the economy survive whatever small bump the Fed deals out? Perhaps, but any temporary stability doesn’t change the inherent instability of our current monetary regime. Even with today’s technology, central planners can’t predict the future or know the “optimal quantity of money.” Only by returning to true sound money, and a proper appreciation for the market, will true, sustainable prosperity emerge.
In honor of the twenty-fourth anniversary of the collapse of the Soviet Union, we have a special guest on the latest episode of Mises Weekends, Dr. Yuri Maltsev. A Mises Senior Fellow and a Soviet economist during the Gorbachev era, Maltsev shares his thoughts on the West’s enduring love affair with socialism. He and Jeff also discuss its political consequences in regard to Obama, Trump, and the Bernie Sanders phenomenon. This is an interview you won’t want to miss.
And in case you missed any of them, here are this week’s featured Mises Daily articles and some of our most popular articles at Mises Wire:
Piketty Is Wrong: Markets Don’t Concentrate Wealth by Louis RouanetWhy Gold-Backed Money Doesn’t Bring Booms and Busts by Frank ShostakEnd the Sugar Tax Now by Gary GallesGovernment Debt Is Not Like Private Debt by Simon WilsonNo, "Big Data" Can’t Predict the Future by Per Bylund"Capitalism" Destroyed Itself? by Matt McCaffreyBlowing Up the Death Star Didn’t Destroy Economy, Building It Did by Tho BishopMan, Economy, and Beer: Rothbard-Themed Gastropub Opens in ConnecticutArticle Submission Guidelines for Mises DailyIndia’s Failing Gold Monetization Scheme: Seizure Imminent? by Paul-Martin FossViva Venezuela ... But Not Yet by Carmen Elena DorobățGun Control Fails: What Happened in England, Ireland, and Canada by Ryan McMakenTranscript: Ask David Gordon AnythingTop Ten Most-Read mises.org Articles in NovemberGerman translation of "PC is Control, Not Etiquette"Thanks, Janet Yellen: Homeownership in US Falls to 25-Year Low by Ryan McMakenWhy the No-Fly-List Gun Ban Is a Terrible Idea by Tho BishopBubble Watch: No-Down-Payment Jumbo Mortgage Makes a Comeback by Paul-Martin Foss
With Google’s dominance in the online search engine market we entered the Age of Free. Indeed, services offered online are nowadays expected to be offered at no cost. Which, of course, does not mean that there is no cost to it, only that the consumer doesn’t pay it. Early attempts financed the services with ads, but we soon saw a move toward making the consumer the product. Today, free and unfree services alike compete for “users” and then make money off the data they collect.
Data has always been used, but what’s new for our time is the very low (or even zero) marginal cost for collecting and analyzing huge amounts of data. The concept of “Big Data” is taking over and is predicted to be “the future” of business.
There’s a problem here, and it is the over-reliance on the Law of Large Numbers in social forecasting. Statistical probabilities for events may mathematically converge to the mean, but is it applicable in the real world? The answer is most definitely yes in the natural sciences. Repeated controlled experiments will weed out erroneous explanations or causes to phenomena, at least assuming we’re good enough at separating and controlling those causes.
What about the social sciences? In this age of scientism, as Hayek called it, we’re told “Big Data” will completely transform production, logistics, and sales. The reason for this is that vendors can better target customers and even foresee what they might want next. Amazon.com does this on their web site in crude form, where they make suggestions based on your purchase history and what others with similar purchase histories have searched for. Sometimes it works, and sometimes it doesn’t.
There is some regularity to our interests and behavior. All of us are, after all, human beings — and we’re formed in certain cultures. So one American with interests x, y, and z may have other interests similar to another American who also has an interest in x, y, and z.
Human Behavior Is UnpredictableBut similarity is not the same thing as prediction. Amazon.com’s suggestions or the highly annoying ads following you around web sites are useful methods for sellers because they can somewhat accurately identify what not to offer. Exclusion of very low-probability interests increases the probability for suggesting something that the person behind the eyeballs focusing on the computer screen may be interested in.
To use as prediction, however, exclusion of almost-zero probability events is far from sufficient. Indeed, prediction requires that we are able to accurately exclude all but one or a couple highly probable outcomes. And we have to be able to rely on that these predictions turn out to be true. Otherwise we’re just playing games, and so we’re making guesses. Sure, they’re educated guesses (because we’ve excluded the impossible and almost-impossible), but they’re still games and guesses.
Where Big Data FailsSpeaking of guesses, Microsoft’s Bing search engine, which powers the Windows digital assistant Cortana among other things, has produced a prediction engine with the purpose of predicting sports and other results. They rely on very advanced algorithms and huge amounts of collected data.
Amazingly, they did very well initially and predicted the outcomes of the World Cup perfectly. So maybe we can use Big Data to get a glimpse of the future?
No, not so. The Bing teams are learning a lesson only Austrians and, more specifically, Misesian praxeologists, seem to be alone in grasping: that there are no constants in human action, and therefore that predictions of social phenomena are impossible. Pattern predictions, as Hayek called them, may not be impossible, but predictions of exact magnitudes are. For instance, we can rely on economic law (such as “demand curves slope downward”) to estimate an outcome such as “the price will be lower than it otherwise would have been,” but we can’t say exactly what that price will be.
When it comes to sports, reality shows and other competitions between individuals or teams, the story is exactly the same. The team with a better track record doesn’t always win. Why? They have objectively performed better than the other team, perhaps exclusively so, but this doesn’t say anything about the future. We’re not here referring to the philosophical doubt as in “will the sun shine tomorrow?” (maybe something changes completely the sun’s ability to shine during the night).
The Social Sciences Are DifferentIn the social sciences we’re dealing with complex phenomena. Action and, especially, its outcome is the result of a complex system of social interaction, psychology, and much more. Are the players in both teams as motivated and focused as they were before? Did anything in their personal lives affect their mindsets or psyches? How do the players within their teams and players in other teams react on each other before and during the game? A team with a poor track record can upset a team with an objectively better track record; this happens all the time. Sometimes for the sole reason that the better team underestimates the worse team, or because the underdog feels no pressure to perform and therefore plays less defensively.
Bing’s prediction engine struggles with this, just as we would predict. As Windows Central reported recently, the prediction engine had its “worst week yet” picking only four of fourteen winners in the NFL. Overall, its track record was approximately two-thirds right and one-third wrong (95–53). It’s definitely better than tossing a coin, but pretty far from actually predicting the results.
In other words, if you’re placing bets you may want to use the Bing prediction engine. That is, unless you have the type of tacit, implicit understanding of what’s going on that the engine is missing. Maybe you can beat it, or maybe not. In either case, you cannot count on coming out a victor each and every time.
The reason for this is that the outcome simply cannot be predicted perfectly — or even close to it. Even the players themselves cannot predict who’ll win a game, but they may have inside information about whether their own team seems motivated and focused. It is not a perfect method, however, and it certainly cannot be scientific.
Even with Big Data there’s no predicting of social events — there’s only guessing. Yes, guessing with access to huge amounts of data is easier, at least if the data is reliable and relevant. But a good guess is not the same thing as a prediction; it is still a guess, and it can be wrong. Winning every time requires luck.
Being a government means never having to say you’re sorry. And it also means you get to blame everyone else for all the problems you’ve caused.
This week at mises.org, we explored how deeply indebted governments blame the ones who lend them money, while government prosecutors blame entrepreneurs, businesses, and “white collar crime” for other problems in the economy. And surges in drug prices, we’re told, have nothing to do with government control of the drug market.
Lackluster new jobs data and continued surges in home price inflation confirm that the distortions of the Fed-induced boom continue to add up.
But even with all the bad news, the miracles of the market place point toward a brighter future. This week on Mises Weekends, Rod Martin, a co-founder of PayPal and world renown philosopher-capitalist, joins Jeff for a wide-ranging interview covering such topics as the refugee situation in Europe, unrest in the Middle East, and why some cultures are more prosperous than others. Martin contrasts the difficulties world governments have in confronting global macro-crises with the hope and resilience of technological innovation and entrepreneurship.
Indeed, Ludwig von Mises would have easily understood how market innovations outpace government innovations, since Mises, whose birthday we celebrated this week, pioneered our understanding of how government intervention cannot achieve the goals it tries to achieve. Be sure to see this never-before-published essay by Bettina Bien Greaves, and this newly-discovered recording of a Mises lecture from 1962.
In case you missed any of this week’s Mises Daily and Mises Wire articles, take a second look:
The Reality Behind the Numbers in China's Boom-Bust Economy by Yonathan AmselemDrug Shortages, Price Gouging, and Our Broken Health Care System by Michel AccadThe Coming Corporate "Crime Wave" by William L. AndersonLuwig von Mises, Genius? by Bettina Bien GreavesGovernments Turn to the UN to Avoid Paying Their Debts by Nicolás CachanoskyThe Military Gravy Train: Full Speed Ahead by Andrew SyriosThe Silent, Slow, Stubborn Revolution Carmen Elena DorobățCollege Athletics: Public Institutions Are the Real Sham By Jonathan NewmanThe Real Estate Crisis in North Dakota's Man Camps by Mark Thornton
For decades, Ludwig von Mises (1881–1973) was the leading spokesman for the Austrian school of economics. An advocate of free markets and a critic of government interference, he stood for peaceful and voluntary cooperation. Whenever possible, he spoke out for individual freedom. Yet he grew up in Europe when socialism was on the rise and people wanted government to regulate “profiteering” capitalists who “exploited” workers. How did Mises, schooled in such an environment, acquire free market ideas?
Mises was born in pre-World War I Austria-Hungary and raised in Vienna. As a young man Ludwig surely had a healthy interest in fun and games, but he was also a conscientious student. At seven, he was already reading newspapers and collecting extra newspaper editions. His early interest was in history. But when he read Carl Menger’s Principles of Economics (1871) and encountered the subjective, marginal utility theory of value, he realized that economics was not history but a science of reason and logic. As Mises wrote later, reading Menger made him an economist.
While still at the Gymnasium, the equivalent of high school, young Ludwig adopted a motto from Virgil, “Do not yield to the bad, but always oppose it with courage.” Menger’s explanation that subjective values guide the actions of individuals enabled Mises to recognize that the “good,” for which he would strive “with courage,” was whatever promoted freedom from individuals to seek their subjective values. And anything that prevented individuals from pursing their personal subjectively-chosen goals was the “bad” to which he would refuse to yield. Thus an understanding of subjective value theory made Mises an advocate of individual freedom.
With the realization that everyone’s actions were always guided by his or her subjective values, permitted Mises to explain all economic phenomena as the results of what people do in the attempt, as Mises put, to “relieve some felt uneasiness.” Prices, wages, the division of labor, barter, media of exchange, trade, interest rates, even markets themselves, evolve as countless individuals, act, adapt, and readapt as he or she thinks best given the circumstances, each hoping to attain his or her various personal goals. Thus the economic phenomena we assume as “given and on which we base our actions are the unintended consequences of countless purposive actions of individuals.
I once asked Mises what original idea he had contributed. His reply: “Everything I have written and said I learned from someone else.” True, no doubt. But the genius of Mises, like that of an inventor or entrepreneur, rests on creating something new and original by further developing something already known. By adding something to earlier theories, he made at least three major contributions. First, he developed economics as a logical science and integrated it with all other knowledge. Second, he pointed out that a socialist society, without private property owners competing with one another, would not be able to discover where, when, and how best to use property in production. And third, by reasoning from Knut Wicksell’s theory that a “natural interest rate” prevails on the market among would-be borrowers and lenders, Mises explained the trade cycle as due to interest rates forced down artificially, distorting the “natural interest rate,” disturbing the loan market and causing widespread business ups and downs.
By recognizing that all individuals, everywhere and always, act on the basis of their subjective values Mises explained not only economic phenomena but also how individuals adapt and adjust when non-market forces disturb and distort market phenomena. Thus, Mises built on subjective value theory and added to knowledge. This was Mises’s genius!
Quarterly Journal of Austrian Economics 18, no. 2 (Summer 2015)The present volume, prepared as a Ph.D. dissertation, is the only known work of Chi-Yuen Wu, a Chinese scholar contemporary with Ludwig von Mises. In 1939 Wu completed his doctorate at LSE under Lionel Robbins, and then returned to China at Southwest Associated Universities. Since nothing is known of his career after this time, we are left wondering if he kept writing, or how he coped with the rise of the communist regime in his native country. Nevertheless, the achievements of the present work are even greater for this reason. An Outline of International Price Theories was singlehandedly able to keep Wu on the radar of economic research for almost a century, a testimony to his acumen and mastery of his topic.
The book is an overview of the historical development of international price theories.
Quarterly Journal of Austrian Economics 18, no. 2 (Summer 2015)Symposium: Is There A Missing Element in Economics?
ABSTRACT: John Mueller believes economics is fatally flawed because it cannot account for charitable love between persons. It therefore lacks an explanation of gifts, and thus, of “final distribution.” Mueller’s argument is especially important for Austrians because it draws on a shared heritage in the history of economic thought, namely, ideas from Scholastic political economy. In this article, I survey some of the major points that emerged from the symposium on Mueller’s work, and suggest additional criticisms of his thesis. First, love and gifts can be explained with reference to the exchange element in human action. Second, Mueller’s four-part economic system is based on a somewhat arbitrary classification of basic concepts, including a faulty conceptualization of distribution. Third, love, which Mueller claims economics must explain, can be accounted for through Mises’s notion of thymology. I close by posing some questions for future research, especially regarding the contributions of pre-classical schools to the history of economic thought.
KEYWORDS: action, exchange, gifts, crime, love, distribution, praxeology, thymology, history of economic thoughtJEL CLASSIFICATION: B11, D19, D30
Quarterly Journal of Austrian Economics 18, no. 2 (Summer 2015)Symposium: Is There A Missing Element in Economics?
ABSTRACT: I am pleased to comment on Michael Watson’s paper, “Mueller and Mises: Integrating the Gift and ‘Final Distribution’ within Praxeology” (2015), which continues a conversation we have had on a gap I believe the Austrian school has in the matter of gifts and crimes. Despite Peter Boettke’s and my agreement in some criticisms of the Chicago School, I believe that the Austrian school’s theory suffers from essentially the same gap in its own version of neoclassical economics. While I welcome Watson’s effort to fill this theoretical gap with Mises’s concept of “autistic exchange,” I think it too falls short through “underdetermination,” because it attempts to make a single element—the theory of utility—explain both consumption and “final distribution.” I suggest that further research is needed before we can establish the conditions under which the value of personal gifts can adequately be calculated.
KEYWORDS: normative economics, positive economics, Austrian economics, history of thought, Ludwig von Mises, John D. Mueller, heterodox economics, autistic exchange, catallacticsJEL CLASSIFICATION: A13, B25, B53, D64
Quarterly Journal of Austrian Economics 18, no. 2 (Summer 2015)Symposium: Is There A Missing Element in Economics?
ABSTRACT: John Mueller claims that Austrian economics does not have the tools to explain the economy. His major criticism against Neoclassical economics and its Austrian variant is that Austrian economics does not have an economic theory of the gift and does not treat persons as ends. Institutions like nonprofits, charities, churches, and especially families cannot be explained with the concepts that Austrians and Neoclassicals use: utility, production, and exchange. There is a missing element, which he calls the “final distribution.” I concede that Austrian literature neglects the gift and distributive economy, but argue that Ludwig von Mises gave us a concept—autistic exchange—from which a theory of the gift can be developed. I also discuss how that relates to the Austrian discussion of the catallactic and non-catallactic economy.
KEYWORDS: normative economics, positive economics, Austrian economics, history of thought, Ludwig von Mises, John D. Mueller, heterodox economics, autistic exchange, catallacticsJEL CLASSIFICATION: A13, B25, B53, D64
Hillary Clinton’s latest campaign salvo attacked “quarterly capitalism,” the supposedly irresponsible corporate focus on short-term results at the expense of long-term growth. She promised government fixes.
Short-Termism, Share Prices, and IncentivesIs there too much short-termism in business firms? To answer this, let’s look at participants’ incentives.
Shareholders own the present value of their pro-rata share of net earnings, not just present earnings. They do not want to hurt themselves by sacrificing good investments today which raise that expected present value. Owners often tarred as too selfish do not ignore those consequences. Critics also confuse short-term corporate results as the goal, when they are actually valuable indicators of the likely future course of net earnings. Just because good short-term results raise stock prices does not imply excessive short-termism.
Since share prices are both a primary metric for managerial success and basis for their rewards, and they reflect the present value of expected future net earnings, managers’ time horizons reflect shareholders’ time horizons, stretching far beyond immediate measures.
Bondholders, who want to be paid back, incorporate the future, where repayment risks lie, in their choices. Workers and suppliers are also sensitive to firms’ future prospects, and the prospect of those relationships being terminated if things start turning south forces consideration of the future in present choices.
Beyond misinterpreting share price responses to good short-term results as short-term bias, Clinton’s main proof of short-termism was that firms have increased stock buybacks, supposedly sacrificing worthwhile investments by returning funds to shareholders. She ignores that those funds will largely be invested elsewhere with better prospects. But she also ignores that the buyback binge reflects the Fed’s long-term artificial cheapening of borrowed money. When debt financing gets cheaper relative to equity financing, firms substitute toward debt. But a firm substituting debt financing for an equal amount of equity controls no fewer funds for future-oriented investments.
The Role of the Fed and Government InterventionConfusing business responses to artificial Fed interventions as business-caused only begins the list of government created biases toward short-termism. Constant proposals to raise corporate tax rates and worsen capital gains treatment in the future reduce the after-tax profitability of good investments. Regulatory mandates and impositions pile up, with far more put in the pipeline for the future, doing the same. Energy policy threatens huge increases in costs, reducing likely investment returns. And the list goes on.
That government regulators will put more emphasis on the future than the private sector is also contradicted by political incentives. Owners bear predictable future consequences in current share prices, but politicians’ incentives are far more short-sighted.
Government Is More Short-Term Oriented Than the Private SectorAn election loser will be out of office, and capture no appreciable benefit from efforts invested. So when an upcoming election is in doubt, everything goes on the auction block to buy short-term political advantage. And politicians’ incentives drive those facing the DC patronage machine. That is why so much “reform” meets Ambrose Bierce’s definition of “A thing that mostly satisfies reformers opposed to reformation.” The mere passage of bills in the political nick of time, even largely unread ones, can be declared victorious legacies, with harmful consequences never effectively brought to bear on decision-makers.
Not only is politics inherently more short-sighted than private ownership and voluntary contractual arrangements, there is a cornucopia of examples of government short-termism at the expense of the future, whose magnitude dwarfs anything they promise to reform.
Unwinding Social Security and Medicare’s 14-digit unfunded liabilities will punish future generations, caused by massive government overpromising to buy earlier elections. Other underfunded trust and pension funds threaten similar future atonement for earlier short-term “sins.” Expanding government debt similarly represents future punishment for short-term political payoffs. Foreign and military policy have similarly turned away from dealing with long-term issues. But serious long-run issues like immigration escape serious attention because “public servants” are afraid of short-run interest group punishment.
Political attacks on short-termism, and reforms to fix it, are beyond confused. They ignore financial market participants’ clear incentives to take future effects into account. They are clueless about what provides evidence of short-termism. They treat private sector responses to government impositions as private sector failures. They ignore far worse political incentives facing “reformers.” And they act as if the most egregious examples of short-termism in America, all government progeny, don’t exist.
There is little to Clinton’s criticism and alleged solutions beyond misunderstanding and misrepresentation. We should recognize, with Henry Hazlitt, that “today is already the tomorrow which the bad economist yesterday urged us to ignore,” and that expanding government’s power to do more of the same is not in Americans’ interests.
University of Sussex Professor Mariana Mazzucato is making headlines with her 2013 book The Entrepreneurial State, which argues that government, not the private sector, ultimately drives technological innovation. In a series of detailed case studies from information technology, pharmaceuticals, biotech, and other industries she argues that government labs and public agencies are mainly responsible for the fundamental, high-risk discovery and development that makes these technologies possible, with profit-seeking entrepreneurs jumping in only later, after the difficult work has been done.
This is a very old argument, skillfully brought to life in Mazzucato’s writings (and a popular TED talk). Remember President Obama’s “you didn’t build that” remark to entrepreneurs, during his 2012 presidential campaign? “Somebody invested in roads and bridges. If you’ve got a business — you didn’t build that. Somebody else made that happen. The Internet didn’t get invented on its own. Government research created the Internet so that all the companies could make money off the Internet.”
The view that private actors are short-sighted, and that only government can afford (or is willing) to make the long-term, high-risk, patient investments in research and development needed for technological progress is in every basic economics textbook. Even economists who are generally favorable toward free markets and limited government will say sure, the market is good at producing shoes or trucks or laptop computers, but the market cannot provide basic research — it is a “public good” that only government can provide. The New York Times recently opined:
Fundamental innovations such as nuclear power, the computer and the modern aircraft were all pushed along by an American government eager to defeat the Axis powers or, later, to win the Cold War. The Internet was initially designed to help this country withstand a nuclear exchange, and Silicon Valley had its origins with military contracting, not today’s entrepreneurial social media start-ups. The Soviet launch of the Sputnik satellite spurred American interest in science and technology, to the benefit of later economic growth.
There are several problems with this kind of argument. First, it confuses technological innovation (impressive to engineers) and economic innovation (valuable to consumers). Second, it confuses gross and net benefit — of course, when government does X, we get more X, but is that more valuable than the Y we could otherwise have had? (Frédéric Bastiat, call your office.) Third, it confuses treatment and selection effects of government spending — government typically funds scientific projects that would have been undertaken anyway, such that a main benefit of government spending on science and technology is to increase the wages of science and technology workers. Fourth, as writers like Terence Kealey have pointed out, if you look carefully at the details of the sorts of programs lauded by the Times, you find they were grossly inefficient, ineffective, and potentially harmful. (Kealey offers a powerful critique of Mazzucato’s specific views here.)
Does War Drive Innovation?It’s useful to illustrate these points by considering the specific argument that war is an important, and even necessary, source of scientific progress, because technologies developed by the state to fight wars often have important civilian uses. Innovation is a side benefit of war, say war’s defenders.
Social science textbooks also assume that war spurs innovation and note that the large-scale manufacturing of penicillin, for example, and the development of nylon and aerosol sprays occurred during the First World War. But that’s nothing compared to the many benefits of the Second World War, we’re told, which brought us benefits ranging from atomic energy to jet engines and the world’s first electronic computing devices, which were developed to break the Nazi “Enigma” codes. Moreover, key innovations in management practice came out of the Second World War, we’re reminded, including management techniques used to improve logistics, procurement, and operations research.
The Second World War changed the nature of scientific research as well. After the war, large-scale federally-funded laboratories devoted to practical applications for new research replaced the small academic laboratories that had existed before the war. Naturally, these new laboratories were geared toward producing new technologies that the federal government wanted, and scientists flocked toward these jobs and new well-funded facilities.
It’s true that many (though not all) of these technologies were developed — typically not invented, but refined — by government scientists working on military projects. The question nevertheless remains as to whether or not this model of innovation benefits society at large. Is this a “good side” of war?
“Crowding Out” and Interest-Group PoliticsThe answer is no, for multiple reasons. First, if we look at each of these cases carefully, we find that the government was usually inefficient, chose bad technologies that crowded out other, privately-funded technologies, and led to inertia in research in directions that the private sector would likely never have supported.
But there is a more basic theoretical problem with the claim that military research gives us great new technologies we otherwise wouldn’t have.
It is certainly true that governments spend money on building things or doing things that otherwise would not have been built or done. But this is not necessarily a good thing.
Take the Egyptian pyramids, for example. Had there been no pharaoh, commanding a huge budget, with the ability to mobilize vast quantities of resources (including labor), there would be no pyramids. But were the pyramids unambiguously good for the people of Egypt? They were not, of course, and the pyramids were simply monuments to the power of the pharaoh and the state religion. To this day, governments build monuments to themselves all the time, whether they’re huge statues or atomic bombs. Sure, without the federal government, we might not have the Lincoln Memorial. Is that an argument for government?
Pyramids and statues are cases of the state producing a good that likely would not have been produced in any form by the private sector, but even in cases in which the government shapes the development of private goods and technologies, the distorting effects on the final outcome of research and development can be significant.
We can see these distortions in the effects of the work of Vannevar Bush, the initiator of the Manhattan Project. Bush was chairman of the National Defense Research Committee (NDRC), and later director of the Office of Scientific Research and Development (OSRD), in the Second World War.
Bush wanted a peacetime successor to the OSRD and pushed for creation of the National Science Foundation, which was established in 1950. The NSF was controversial (one proposal was vetoed by Truman in 1947) because of the lack of accountability. A key figure was Senator Harley Kilgore of West Virginia, who initially opposed Bush’s plan to distribute the money through universities (he preferred the government to own the labs) but later agreed to Bush’s model. As Kealey describes it, Kilgore’s goal was not to generate new knowledge. Rather,
Kilgore wanted to create a reserve of scientifically trained personnel who could be mobilized for strategic purposes. ... The National Science Foundation, therefore, was created in 1950, in the same year (and for the same reasons) as the National Security Council.Economic Laws of Scientific Research, p. 154.
A few scholars have recognized the potentially harmful effects of this approach. Best known is the “distortion thesis” of historian Paul Forman, which holds that WWII and Cold War national security concerns distorted the path of the physical sciences.
Applied to technology, there is the “crowding out” thesis, most closely associated with Seymour Melman, which maintains that, during the Cold War, commercial R&D was crowded out by government-funded R&D. As summarized by the distinguished historian of technology David Hounshell,
“Research, development and manufacture for a single customer (the national security state or the military) led firms and whole industries into a kind of fatal attraction, which ultimately undermined their ability to compete in the global economy in which consumers had very different wants than those of the military; “spin offs” from military projects into the civilian economy simply did not compensate for the drawbacks of being dependent on military contracting.
Again, the Broken Window FallacyWe see once again the relevance of Frédéric Bastiat’s Broken Window Fallacy. That is, the research and development institutions created and sustained by government are like the pane of glass in the broken window. We see it being repaired but cannot see what might have been produced with those same resources had the glass not been broken.
Similarly, we see what is produced by government scientists producing R&D for the state, but we don’t see things we would have had the market been able to function in the absence of a giant militaristic government.
There is no doubt that military spending had a substantial effect on technological innovation. But was it a good one? Military spending distorts the efforts of scientists and engineers, and redirects them to particular projects, ones that do not necessarily generate benefits for consumers.
Military-funded R&D, like any government-funded projects, does not have to pass any kind of market test, so there is no way to know if it is actually beneficial to consumers. We cannot rely on the judgments of government scientists and scholars to say what are the “best” technologies. Remember Betamax? The experts told us that Betamax technology was superior to VHS tapes, from an engineering point of view. Yet, in the end, VHS proved to be economically superior in that consumers ultimately chose VHS over Beta. Betamax failed the market test in spite of its arguably superior technology.
Today, when we look at private companies like Google, Apple, and Facebook and marvel at their innovations, we should remember that these companies are constantly subject to market tests, and that the goods and services they innovate must be accepted by consumers to be profitable. When they succeed, we know that they are creating value for society because consumers have chosen their products and services over others.
Success, for government-funded researchers and engineers, on the other hand, means winning grants and contracts, and getting more money from the taxpayer, who has little say in what gets done.
The reality is far more complicated than the myths repeated by those who claim that many of the technologies and innovations we now value were produced single-handedly by government. Yet, the historical reality does not diminish the ease with which Obama and other fans of government spending can point to innovations like the internet and the interstate highways and say “you didn’t build that.” We can only speculate on what might have been produced had the market been allowed to function. Likewise, we can still see the pyramids today and marvel at the innovation that went into their construction, but unfortunately, the wealth and labor stolen from ordinary Egyptians to build them has now been long forgotten.
GDP purports to measure economic activity while largely divorcing itself from the quality, profitability, depth, breadth, improvement, advancement, and rationalization of goods and services provided.
For example, even if a ship — built at great expense — cruised without passengers, fished without success, or ferried without cargo; it nevertheless contributed to GDP. Profitable for investors or stranded in the sand; it added to GDP. Plying the seas or rusting into an orange honeycomb shell; the nation’s GDP grew.Starting in December of 1991, the Bureau of Economic Analysis (BEA) of the U.S. Department of Commerce emphasized gross domestic product (GDP) over that of gross national product (GNP) as a measurement of production within the U.S. The difference between GNP and GDP lies in the treatment of income from foreign sources: GNP measures the value of goods and services produced by U.S. nationals, while GDP measures the value of goods and services produced within the boundaries of the U.S., regardless as to the nationality of ownership. For purposes of this article, the differences between each measurement are unimportant and therefore “GDP” is utilized synonymously with GNP.
Stated alternatively, GDP fails to accurately assess the value of goods and services provided or estimate a society’s standard of living. It is a ruler with irregular hash marks and a clock with erratic ticks.
As proof, observe this absurdity: in 1990, Soviet GDP equaled half of US GDP, according to the 1991 CIA Factbook. No one visiting the Soviet Union in 1990 would believe their economy came close to 50 percent of the quality and quantity of the goods and services produced in America. GDP-defined production may have been strong, but laying roads to nowhere, smelting unusable steel, and baking barely edible breads stretches the definition of “production.” And this describes the goods which were actually produced. There is no accounting for the opportunity cost of forfeited essential goods and services.
How can this be? Why does GDP poorly reflect economic size and vitality? The blame largely resides with three fallacious concepts embedded within GDP “measurements”:
(1) intermediate goods (e.g., steel) must be eliminated to avoid “double counting”;(2) government expenditures consist of viable economic activities; and(3) imports should be netted against exports.
The Overstatement of ConsumptionWhich transactions should be included within GDP? Since most products consist of other products, GDP architects attempt to avoid “double counting” transactions by largely including only final goods and services produced. By their methods, the production of a car is counted (as an increase in inventory), but the metal, rubber, and plastic purchased in its creation is not. But the rules behind what makes a transaction “final” are arbitrary. The logic could just as easily justify including the sale of an automobile to a consumer and disregarding its previous production. In addition, any “final” transaction during a given time period does not necessarily include intermediate goods produced in that same time period: metal, rubber, and plastic purchased today will likely be for a different car produced or sold in a different (future) time period.
Regardless as to the arbitrary nature of determining final sales and notwithstanding the problem of temporally matching intermediate goods with their associated final sales, the exclusion of certain “intermediate” transactions simply excludes massive volumes of economic activity. Thus, GDP understates the economy as a whole while grossly overstating its consumption component relative to business investment. A better measure of overall production was employed in 2014, after years of urging from Mark Skousen, when the US Commerce Department began publishing Gross Output which incorporates intermediate transactions. Using Gross Output, the commonly cited statistic of consumption accounting for 70 percent of all economic activity quickly falls to a mere 40 percent.
The Treatment of Government Expenditures as ProductiveIf GDP purports to measure economic activity which benefits society, the inclusion of government expenditures is dubious. GDP “produced” in the Soviet Union is no different than GDP “produced” by any government — the difference is but one of scale. All government spending is to some degree malinvestment, for as Murray Rothbard noted:
Spending only measures value of output in the private economy because that spending is voluntary for services rendered. In government, the situation is entirely different ... its spending has no necessary relation to the services that it might be providing to the private sector. There is no way, in fact, to gauge these services.
The absence of voluntary action renders prices impotent, and without true price discovery, benefits cannot be ascertained. This does not mean all goods and services provided by government would cease to exist; rather, some production (e.g., hospitals, schools, roads, etc.) would revert to the private sector. To the extent government expenditures for goods and services would be produced by the free market, the true government contribution to GDP may be positive but overstated (it currently approximates 20 percent of US GDP). A more accurate depiction of economic activity would reduce if not eliminate the contribution of government expenditures. Or perhaps, as Rothbard argued, the higher of government receipts or expenditures should actually be deducted from GDP since “all government spending is a clear depredation upon, rather than an addition” to the economy.
The Problems of Subtracting Imports from ExportsAs Robert Murphy has noted several times, the netting of imports against exports in determining GDP seriously understates the contribution of trade to overall economic activity. To wit, an economy which exports $1 and imports $1 will have the same GDP contribution (zero) as one which exports $100 billion and imports $100 billion. Obviously, the latter economy would be far worse off with the sudden cessation of trade.
A fixture of GDP is the mercantilist mentality of treating exports positively and imports negatively. Why are exports additive to GDP while imports are deductive? If the goal of GDP is to measure the goods and services provided to people within a geographic region, imports — not exports — are the benefit. Exports are but payment for imports. The problem and confusion arises because the GDP calculation unrealistically excludes other forms of payment: it should make a difference if imports are funded with increasing debt levels or if funds are accumulated from previous years of compensated exports. If China converted over $1 trillion in US debt instruments into imports of American goods and services, its people benefit today, but under GDP accounting, the negative impact of imports would offset greater consumption and/or government spending (the increase in GDP was previously realized in the years during which exports created a trade surplus).
GDP is Designed to Advance the Keynesian AgendaSimon Kuznets (1901–1985) revolutionized econometrics and standardized measurements of GDP, with his research culminating in his 1941 book, National Income and Its Composition, 1919–1938. While not a Keynesian per se, the nature and timing of his research fueled the Keynesian revolution since central planning requires economic statistics. As Murray Rothbard noted:
Statistics are the eyes and ears of the bureaucrat, the politician, the socialistic reformer. Only by statistics can they know, or at least have any idea about, what is going on in the economy. Only by statistics can they find out ... who “needs” what throughout the economy, and how much federal money should be channeled in what directions.
GDP’s faulty theoretical underpinnings and politically motivated acceptance distort the performance and nature of an economy while failing to satisfactorily estimate a society’s standard of living. In fact, Kuznets partially understood this. In his very first report to the US Congress in 1934, Kuznets said “the welfare of a nation [can] scarcely be inferred from a measure of national income.” Yet the blind usage of GDP persists. That its permanence and persistence only serves the Keynesian policies of greater consumer spending, increased government expenditures, and larger exports through currency debasement should not be considered coincidental. Unfortunately, the resulting economic stagnation, debt accumulation, and price inflation are as inevitable as they are predictable.
Volume 18, Number 1 (Spring 2015)ABSTRACT: This paper examines Roger W. Garrison’s interpretation of John Maynard Keynes. Garrison has given economists a useful way to illustrate Keynes’s theory, but there are two fundamental problems with Garrison’s interpretation. First, the shape of the Hayekian triangle cannot be fixed in Keynes’s theory. Second, Garrison’s interpretation contradicts the IS-LM model. The demand constraint is derived from the IS-LM model and the IS-LM demand constraint is used to illustrate Keynes’s theory.
KEYWORDS: John Maynard Keynes, Roger W. Garrison, IS-LM model, Hayekian triangle, capital-based macroeconomics, Keynesian demand constraint, socialization of investmentJEL CLASSIFICATION: E12, E22, E32, E43, E52, P20, B22
WeMateusz Machaj is assistant professor at the Institute of Economic Sciences at the University of Wroclaw, Wroclaw, Poland. I would like to thank to Professor Joseph Salerno for many years of his invaluable help. This article is an outcome achieved due to indispensable long-term academic guidance of Professor Salerno. My intellectual development would have not been possible without his personal support, and without the study of his masterful works on monetary theory and general economic theory. understand knowledge as an acquaintance with various facts and natures of objects in the real world. By studying and investigating aspects of our lives we get to “know” certain things and we classify these inquiries into disciplines. We can widen knowledge in total by different methods. In order to achieve progress in gained knowledge we use dissimilar frameworks to learn mathematics, physics, economics, social relations, characters of our friends, or languages. It is also important that we can learn some of these things through different methods, especially different methods for different people, or different methods for the same people over time. One term “knowledge” is being used to deliberate in general about all those disciplines, yet this should not cloud first and foremost feature of knowledge: its heterogeneity.
The Austrian school has been mostly successful in economic theorizing because it realistically emphasizes heterogeneous nature of the world. Whereas various neoclassical schools, or their siblings, tend to homogenize economic phenomena, the Austrians tend to do the opposite. The prime example of the case is theory of capital, which in the Austrian version is built on the notion that capital goods do not have a common physical denominator (which could theoretically express its aggregated “amount”). Starting from such basic observation the Austrians were able to build their own theory of socialism and theory of the business cycle. As Roger Garrison notes (1992, p. 171, emphasis added),
If capital goods were wholly non-specific, if the collection of them were fully homogeneous such that any one capital good is a perfect substitute for any other, then production processes could proceed as if time ran both ways. A half-finished performance hall could be completed — with no effects on cost or construction time—as a bowling alley; the production process that yields musical instruments could — with an eleventh-hour change of mind — yield bowling pins and bowling balls instead.
Under homogeneous circumstances the issue of proper allocations would never have to arise, since every process would already be fully integrated and properly coordinated. The problem of the trade cycle would be nonexistent, since any inconsistency in the various diverse stages of production would be absent. Similarly any socialist economy would not fail at the basic problem of equilibrating the capital goods market, because optimal allocations of them would have already been chosen.Mises notes (1966, pp. 206–07) that under perfect substitutability of capital goods would imply that “all means of production ... would be as if only one kind of means — one kind of economic goods of a higher order existed.” Therefore in a socialist economy one could calculate according to the usage of the one universal higher order good (e.g., kilograms of such good), and avoid the problem of valuation of heterogeneous factors of production (non-perfect substitutability of capital goods).
Other important Austrian contributions are also more or less related to the issue of heterogeneity. For this reason it could even be seen as a typical feature of the modern Austrian economist’s toolbox. Austrians are different, because Austrians heterogenize.
The same approach to heterogeneity applies for different types of “knowledge.” A typical model breakthrough comes from Hayek’s example of a breakaway from the neoclassical approach. Hayek’s famous contribution comes from the analysis on how knowledge is “used in society” (Hayek 1945). Yet even though this analysis of complexity of economic phenomena is fruitful and worth of deeper studying, it (along with others) created a lot of side debates about the “knowledge” problem under hypothetical socialist order. We will attempt to refrain from settling those debates here. Our goal is to follow Hayek’s footsteps and to try to distinguish several types of knowledge. The goal can allow us to settle the definitional importance of knowledge for Mises’s argument about the impossibility of the rational allocation of resources under socialism.
Here we offer our (arbitrary) classification of knowledge, which, though not very rigorous, helps to navigate through the usages of the term in the calculation debate. It is important to keep in mind that we don’t want to completely classify various types of knowledge, but to envision how it relates to the socialist puzzle.
Objective “Technological” KnowledgeAlthough other types below could also be seen as objectively existing.The word “objective” seems suitable, because the main feature lies in the interpersonal aspect of this knowledge, which can be simply transmitted from one person to another. It is knowledge which is coded in textbooks and countless publications.During the socialist calculation debate the term “technological” knowledge was used (see Mises 1966, p. 699). Due to its specific “objectivity” it can be communicated between the people with the use of alphabet, algebra and other symbols. Without those symbols there would be no abstract thinking, and consequently man would still live in caves (Cassirer 1944, pp. 46–47). Objectivity is here to be understood as the possibility to be (potentially) universally recognized by any intelligent being, no matter what place and time one lives in. Due to language and objectivity of those statements knowledge can be transmitted (sometimes through the painful process of learning) between all intelligent (and sufficiently capable) individuals.
Such knowledge can include statements from all developed sciences be they empirical or non-empirical; mathematics and logic, physics and chemistry, climatology and biology, economics and sociology, politics and history, etc. Even though all those disciplines differ and use radically dissimilar methods, they can be grouped into one big family of objective Science. There are multiple examples of that knowledge such as (geology) “earth is not flat,” (biology) “spiders eat flies,” (physics) “the speed of light is constant,” (mathematics) “In Euclidean geometry parallel lines do not intersect,” (climatology) “Earth is warmer than it was 40 years ago,” (economics) “minimum wage leads to higher unemployment,” (history) “Julius Cesar did not invent the caesar salad,” and so forth.
The important fact is that none of those statements has to do with distinct characteristics of the particular being who is proposing them. They are as general as possible and can be presented by a male teenager in Africa, a female doctor in Germany, or retired astronaut in the Moon. Also they are conditioned by the concept of Wertfreiheit. They are value-free. Their most important feature is correctness or incorrectness, no matter the values, opinions and views of the person proposing them. During the socialist calculation debate such knowledge was seen as easily obtainable and possessed by socialist bureaucrats.
Hayekian KnowledgeHuman knowledge does not end with such universal and communicative observations. Not all the data can be effortlessly gathered in objectified and interpersonal form. Some information is hard or costly to transfer, so perhaps it seems sensible to use the name “transfer problem.” There exist two main reasons causing the transfer problem to arise. The first one is a subjective nature of individually “witnessed” data, which become a part of “tacit knowing.” Hayekian knowledge is perceived by an individual. At the same time it is being used by the individual even though she or he cannot formulate it explicitly and communicate it to another person. Tacit information is beyond textbooks and often beyond personal recognition of it (Polanyi 1966, p. xviii). Since personal boundaries are difficult to overcome such knowledge remains hidden behind individual barriers of the mind (Huerta de Soto 2010, pp. 27–28).
The second reason for the transfer problem is decentralized nature of Hayekian knowledge. At first it may seem that the reason is no different from the first one. Nevertheless the difference is important, because in the first case barriers have more to do with individual’s limits. In the second case scantiness of the data is an objective fact important for practical reasons. Because countless individuals are working with complex data, it is practically impossible for any isolated individual to gather their knowledge and unify it into one objective formula (even without admitting the “tacit” element of it). Hayek wrote extensively about its economic importance (see his illustrations in Hayek 1945, p. 522). He also made it an important part of the argument against market socialism model (Hayek 1940, pp. 192–93).
The examples of that knowledge could be “John knows unspoken local customs,” “Jack is the only one who knows how to talk to Mary,” “Martin knows how to start that machine,” etc.
Misesian KnowledgeAn important question that arises with the title of the section is: why make a difference between “Hayekian” and “Misesian” knowledge? We are inclined to do so, because Mises emphasized the role of prices in the economy, whereas Hayek attempted to go further and focus on something underneath prices: production functions. For the former, prices per se were of interest. For the latter something more substantial had to be hidden behind those prices. Hence local conditions and knowledge about them was named by us as “Hayekian.” In the case of Mises, all aspects associated with calculation and prices will be seen by us as “Misesian” knowledge.
Therefore Misesian knowledge is strictly associated with monetary prices, and has three interrelated features in different time dimensions:
- past prices and praxeological recapitalizations undertaken in the past,2. current price offers,3. “current allocation activities” (Salernian “social appraisement process”On the appraisement process see Salerno (1990, p. 42; 1994a, p. 120). It is of course debatable to call activities as “knowledge.” But, as we explain below, we will stretch a little bit and name them “knowledge,” because from a certain perspective this is what the central planners would need to “know” — the actions of private owners — in order to act efficiently.).
Strictly speaking prices are ratios of exchange between sovereign owners in a realized transaction. In that sense they are phenomena of the past. Currently existing, though not yet realized, price offers are also often seen as “prices” of the present circumstances. Competing and cooperating owners of the factors of production establish a nexus of contracts that allows them to create the price structure. The phenomena of price activities arise in all instances of economic calculation — realized past prices , past actions undertaken to correct them, current price offers, and current actions based on calculation outcomes and expectations about future prices. Clearly, at every point in time part of the existing Misesian knowledge is objective and known, but part of it is always beyond human recognition, because it will be determined in the future: allocation activities undertaken after the acquaintance with price offers. That is why entrepreneurship consists of a combination of knowledge and ignorance.
Past prices can be observed and expressed in the form of statistics, therefore they belong also to our first category of knowledge (as we emphasized in the beginning we are not searching for fully non-overlapping definitions). Nevertheless past prices are only the beginnings of calculation, since they only reflect past choices conditioned by outdated anticipations (see Mises 1966, p. 330). The next constituents are price offers, which in the Misesian sense are not yet “prices.” They are offers formed today under current market conditions, which are different from the conditions under which past prices had been formed. Therefore in contrast to realized prices they convey some form of current information and views about the future. If someone theorizes about prices as information signals, currently available price offers perform this function (they are not strictly speaking prices as exchange ratios).They also include current understandings of past trends in prices. The information on past prices visioned as valuable is being reflected in the current appraisal.
Price offers and past prices close the category only of existing Misesian knowledge. Economic calculation involves economic activity under uncertainty, what results in changes of economic conditions and unexpected outcomes (with price changes). It is one thing to know past prices and current price offers, but it is another to act upon those prices. Past prices inform entrepreneurs about past events. Current price offers inform entrepreneurs about today’s conditions and expectations about the future. Potential, not realized, prices “transmit” correct and incorrect entrepreneurial anticipations about possible marginal valuations of resources they own. That is why they do not transmit strictly Hayekian “knowledge,” but can include entrepreneurial perspectives on Hayekian knowledge.
All knowledge associated with various past and present instances of monetary calculation is not sufficient for the market process to happen. The driving forces for it are allocation activities (part of yet non-realized Misesian knowledge of what would private entrepreneurs do). These are actions undertaken by entrepreneurs after recognition of current price offers (with considerations on past prices and recapitalizations). The central owner under socialism has precisely the following problem: he cannot know allocation activities based on current price offers.At some point Hayek suggested this is not the main problem, because “price expectations and even the knowledge of current prices are only a very small section of the problem of knowledge” (Hayek 1937, p. 51). In the other paper he suggested otherwise. See Hayek (1984, pp. 57–58). He is not in a position to recognize what private owners would do, and how they would exclude each other from the market process. He is able to gather data on past prices, or even price offers right before the complete nationalization of resources, but he cannot know which allocation activities would have been performed under private property. Even if he or she knew all the relevant Hayekian knowledge, it would not suffice to solve allocation problems under socialism, since all of the Misesian knowledge would have to be known. The activity of entrepreneurs is something which cannot be implicit in the informational parameters of any system of equations, or any prices based on past or current data (see Salerno 1994, p. 120).
Three distinctive examples of Misesian knowledge could be: (1) “Lemons sold for 3 dollars per kilogram yesterday,” (2) “This flat is for sale for a million dollars,” (3) “Martin decided to produce 30 uniquely designed cars and price them at $3 million per car.”
“Full” Economic KnowledgeComplete economic knowledge is not anything “real,” but it is one of the assumptions in the possible “mathematical” solution to the calculation problem (which was never consequently defended by anyone). It boils down to knowledge of all possible “production functions” available to human beings. Hayek had this type of knowledge in mind when he theorized about allocation problems after postulating many ifs; if we possess all relevant information, all preferences, all knowledge of available means, then the problem of allocation is “purely one of logic” (Hayek 1945, p. 519).
In the neoclassical analysis, production functions are very simple (they have to be) and easily subjected to mathematical formulation. They use only a few variables as factors of production. Their coefficients are given and their influence on production is established and well known. At the same time, since the equations are simple and use few variables, “marginal rates of substitutions” can be inferred from those equations. They can become sorts of shadow prices, which could in theory substitute real world monetary prices and entrepreneurial assessments.Stigler and Becker (1977, p. 77) use the term “shadow price” to label a valuation for a good, which is not sold or purchased in the market. They use it for a different type of a discussion, but the idea to use the concept of “shadow price” is similar as in here. A “shadow price” is something which is to be inferred from subjective valuations and can substitute market pricing. Yeager uses “shadow price” in the analogous sense (Yeager 1994, p. 101). Those substitution levels can demonstrate, for example, “how much more is being produced when x amount of factor A is substituted for y amount of factor B?” Such contingent tradeoffs could be used for rational allocation.From the equations we can know how much of an additional amount of one factor of production is needed to replace decreased amount of the other factor if one wishes to maintain the level of output. These types of rate can be known only if production function is simple and known.
In reality such full economic “knowledge” cannot be achieved for two main reasons. Firstly, as Austrian economists have emphasized, production functionsActually the word “function” is a doubtful name, but it is a topic for another discussion. There is not much typically “functional” about production processes. are complex and each one of them is extremely specific. Production functions consist of many factors of production, which cannot be constricted and grouped into such macroeconomic (or microeconomic) variables as “K” (capital goods) and “L” (labor), or additionally “H” (human capital) and “A” (technology, or “total factor productivity”). Real world production functions have many more variables and their coefficients are not stable numbers. Due to complexity of those functions, simultaneous equations of production functions cannot in fact be “solved” even in “theory.” Walrasian equations can surely be solved, because they are simple and have as many equations as unknowns with known coefficients (Walras 1954, p. 238).Walras later on (when he deals with progress) allows for adjustable coefficients, but still the system contains “as many equations as there are unknowns to be determined” (p. 384). They appear to be mathematical tasks. By assuming such a trivial world of flat production functions, one is assuming away essential problems of complex economic reality.
The second reason for the lack of such “full” knowledge of the real world is uncertainty and human creativity. However precise the production functions are, they are never accurate, because people are never in a position to fully determine the future. They cannot “close” production functions and make them “complete,” because they would have to include all possibilities about the future.This is why a neglected Barone stated that “it is frankly inconceivable that the economic determination of the technical coefficients can be made a priori” (Barone 1908, p. 287). Ironically he later became to be quoted for having “solved” the problem of economic calculation under socialism, even though he did not believe so and actually argued the opposite. Assumptions about the knowledge of those functions implicitly embrace the notion that future is largely foreseen, and that man can anticipate what he or she will learn in the future. Human beings are not omniscient and the future is purely uncertain (in the Knightian sense). It cannot even be subjected to calculus of class probabilities, because in the course of economic events case probability prevails. By assuming away the uncertainty of the future, the fundamental problems of entrepreneurship are also assumed away. Change implies necessity for economic decision making (Mises 1966, p. 212).As Hayek (1945, p. 94) notes “economic problems arise always and only in consequence of change.” With full knowledge of the future, human beings do not face the problem of proper judgments, since all of them are optimal and efficient. Henceforth “full” economic knowledge (which would allow “shadow prices” instead of monetary prices) is impossible to be achieved, because production functions are too complex and because people can never have a complete list of “correct” functions (which would include information about future events).
The last few sentences seem too trivial and obvious to be mentioned, but there is an interesting consequence of them for the Hayekian concept of knowledge. The complete full economic knowledge is not split up and partitioned between the individuals, therefore it does not become “Hayekian knowledge” when decentralized. If we somehow summed up all the Hayekian knowledge we would still not achieve “full knowledge.” In referring to the hypothetical concept of full economic knowledge Mises writes “no single man can ever master all the possibilities of production, innumerable as they are,” and so the entrepreneurs are divided between their tasks in the environment of monetary calculation (Mises 1990, p. 17). Hayek has a footnote to that Mises’s passage when he refers to the “division of knowledge” (Hayek 1937, p. 50). Yet this is not what Mises had in mind, since clearly full economic knowledge, “all the possibilities of production, innumerable as they are,” cannot be either known or divided between individuals just as infinity cannot be divided into finite numbers. Mises’s point was that “full knowledge” can never be achieved, not that it is in some way divided between the people (compare with Horwitz 1998, p. 430).
As we see, full economic knowledge is unachievable because of the “complexity” and “indeterminacy” of what we sometimes call “production functions.” Indeterminacy problems were to be avoided only if man could turn into a sort of “Laplace’s demon” — entity capable of gaining knowledge about “everything,” meta-knowledge, which would allow the possessor of it to project reality in any way he or she wanted. Fortunately we deal in this article with humans, not gods; henceforth we can set such issues aside for philosophers and theologians. The theoretical economic system can never be “complete” in such sense.
Knowing, Guessing and the Market ProcessPerfect Laplacian knowledge leads to perfect forecast. All-knowing man possessing features of the Laplacian “demon” could notice and understand the position of any molecule (even a social “molecule”) in the (social) universe. Such recognition would allow for the planning of every future step ahead and effectively adjust actions to any desirable and possible state of affairs. No mistakes would be committed and the equilibrated Utopian dream could be realized. Any step away from such perfect knowledge results in uncertainty. In order to cope with uncertainty people try to forecast future events.
Beyond the point of perfect knowledge the strict connection between knowledge and forecast breaks. At the extreme, perfect knowledge allows for perfect forecast.“It may be added that knowledge, in the sense in which the term is here used, is identical with foresight only in the sense in which all knowledge is capacity to predict” (Hayek 1937, p. 51). It might be stated that we need calculation, because we can never possess enough knowledge. Once we move away from perfect knowledge we also move away from perfect foresight. Moreover, under the circumstances of uncertainty more knowledge does not always mean better forecasts. It may be truer for cases of natural sciences. The more we know about physics, or chemistry, the better we can forecast “behavior” of the matter. It is slightly different with knowledge of social sciences, where knowledge to some extent improves our understanding of the social world (not necessarily forecasting abilities). More Hayekian, or more current Misesian knowledge, does not necessarily lead to a better economic forecast.
Portions of social knowledge do not guarantee that foreseeing will be in a better shape. Entrepreneurs might be equipped with Hayekian knowledge, but this does not guarantee their success. They can gain a lot of Hayekian knowledge in the market, but still these gains will not automatically transform themselves into entrepreneurial successes. Even the elements of Misesian knowledge do not assure that. Entrepreneurs can acquaint themselves with past prices (realized exchanges) and price offers (currently existing ratios). Knowledge of those is not a formula for commercial accomplishments. When the entrepreneur starts to gather all the price data and gets to know current and previous price offers, it is still not enough to bring him good foresight. Moreover, it is almost nothing. The entrepreneur can gather all that knowledge, and still lose money.
Additionally, gains in knowledge per se do not reap entrepreneurial gains. The effective entrepreneur is not someone who knows “more” than others. There are many entrepreneurs who accomplish a lot even though they were less knowledgeable than their rivals. Especially in the light of the fact that many huge entrepreneurial successes work like in the romantic Schumpeterian story of the entrepreneurs, who break the existing social structures. Sources of triumphs for any entrepreneur do not lie in the typical knowledge build-up, but often in envisioning what is unseen and most likely cannot be seen. All those actions are subjected to revisions and to praxeological recapitalizations in the form of losses and profits, as well as changing asset ownership. Good choices are indicated by correct monetary imputation, and do not have to be correlated with gains in information, or any type of “knowledge” acquisition (Salerno 1990a, pp. 59–60; 1990, pp. 42–43).
Naturally, it does not follow that “knowledge” has nothing to do with forecasts and entrepreneurship. Nevertheless, the entrepreneurs are not spreading Hayekian “knowledge” in their calculations. First of all, in the case of the unfortunate word “transmission,” they are transmitting some things, but these are not Hayekian knowledge and not in the form of prices. Entrepreneurs are transmitting their judgments, and they do it mostly in the form of price offers conveying this information. Whether correct or incorrect, price offers given by sellers of goods and services inform us about how market conditions are currently perceived. The yet to be successful entrepreneur is the one who is capable of “spotting” false prices, a discrepancy between current price offers for factors of production and prices for consumer goods which will be created in the future. “Spotting” is a metaphor, since technically we can only “spot” what already exists. “False prices” do not exist yet. They shall only materialize once the future becomes present. Hence the reason why Kirznerian “profit opportunities” are blurred by clouds of uncertainty and they do not exist yet. Current price offers inform us how entrepreneurs envision today future market conditions. Precisely that kind of “information” is hidden behind prices, not information about proper ways of adjusting “production functions.”
In the neoclassical framework entrepreneurial choice is given by the intersection of the marginal revenue curve and marginal cost curve. The main oversimplification in such an apparatus comes from the coincidence of the two and presupposed incidental existence. In reality one can get to know marginal cost curves by searching for price offers (more or less). Nevertheless the marginal revenue curve does not exist; it cannot be spotted and properly acted upon. We cannot be alert to the marginal revenue curve because it is not there yet. Instead of one marginal revenue curve there is virtually unlimited number of potential non-realized marginal revenue curves. Each of them has case probability assigned to it, thus strictly speaking it has no numerical probability at all. Whoever is more successful in picking the “proper” curve, wins. The “proper” solution is offered with the future being realized. In order to foresee the demand, one does not need to “know more” than others. One needs to make a proper judgment (Hülsmann 1997, p. 35). The “selection” mechanism cannot be reduced to gains in any mentioned type of knowledge.
In other words, the market process is not driven by entrepreneurs who know more, but by entrepreneurs who deliberately select arbitrary types of information and act upon them. A real world forecast is based on those selections of information. Information is interpreted, understood and used.As Kirzner points “possessing all this information is not the same as having assimilated it” (Kirzner 1996, p. 150). In this sense “assimilation” process is always subjective (both for the entrepreneur and hypothetical central owner under socialism). What types of information are available to various entrepreneurs? As we saw in the process of economic calculation there is lots of it: realized transactions, which inform us about habits; and recapitalizations, which inform us about the extent of past mistakes. On top of that there are current price offers, which inform us about competitive potential in the market e.g., in which field we can be outcompeted by others and in which fields can we rely on the division of labor. Finally, there are undertaken actions and reallocations by other owners. All this Misesian type of knowledge is generated by the market, based on praxis, and can be referred to as the social appraisement process.
Not only is the world and its information heterogeneous, but so too are individuals. Each entrepreneur is different and has his unique entrepreneurial vision, which can be expressed through the use of property. Entrepreneurs differ in their judgments and disagree on what is economical, and what is not (Lavoie 1985, p. 123). Whoever performs well enough in this task outcompetes his rivals in the market process.
Let us take the case of an entrepreneur producing machines with the use of steel. He can notice past prices for finished products (machines) and past prices of steel. They can inform him about past exchanges and demonstrate past market conditions. He can evaluate them and engage in Verstehen. Any information he gets by contemplation can be useful for current price considerations. Equally useful are “present prices,” price offers for steel. (The entrepreneur also tries to anticipate future prices of the machines). Steel prices inform the entrepreneur how steel is being valued by sellers and by his competitors, other entrepreneurs who alternatively employ steel (to produce something else or similar). Henceforth current prices (offers and transactions from the immediate past) at least inform the entrepreneur of how valuable alternative employments for various factors are, or how other market participants envision the markets of goods produced with steel (compare with Yeager 1994, pp. 95–96). This notification of how much factors are expected to be worth, is a relevant part of the market process and entrepreneurial division of labor.
Accurate anticipation of future prices based on individual understanding of selected information leads to profits. In everyday life we notice how new information changes the prices and actions of market participants. The person acquiring new knowledge cannot be sure that its spread should change prices in a particular way. In some cases we can be almost close to certainty what the effect should be. But it can never be “fully” known in advance. If new fields of oil are discovered, the anticipation is that the price of oil should go down. Nevertheless it need not to, and we can envision scenarios in which the opposite happens. Successful entrepreneur is the one who can “interpret the information” correctly, but only in the ex post sense. He acts very often against the tide and the rest of the market.
The crucial side of the competitive process is its legal aspect. The mechanism of entrepreneurial selection is based on property shifts, which result from monetary calculation. This works despite psychological motivations of the participants, or their “knowledge,” or their “ignorance.” It does not matter what entrepreneurs’ incentives are, or what kind of information they possess. They can know a lot, or little, they can be motivated in their actions by their personal skills, or act upon an ideological bias. Whatever they know, and whatever their incentives are, as economists we do know that those who satisfy consumers most survive in the market. We do not even have to assume that entrepreneurs are interested in “maximizing” profits (Alchian 1950, pp. 212–13).Actually “maximization” is also an improper word, since it would imply we have a particular “function” to be maximized. In reality, entrepreneurs choose between various rates of profits and case probabilities associated with them. Their personal interests and motivations are not important. Profits are the link between consumer satisfaction and entrepreneurial decisions acknowledging them. That is why the market process “works” — because calculation has consequences for allocations.
In the economic analysis of socialism we can assume many things. If we assume that planners have “full knowledge,” then we “solve” the problem with an unrealistic assumption. In the real world planners can only gain other types of knowledge. They can possess all the necessary technological knowledge, and even the more specific Hayekian knowledge of time and place. We can even add that planners could possess scatters of Misesian knowledge: they could accurately know past prices and price offers right before the imposition of the socialist order. Yet even this knowledge does not solve the main socialist deficiency: the central owner does not know what are, or would be, the allocations of private owners. He cannot substitute them, or even hire them as bureaucrats, because tangible entrepreneurial skills are manifested in the realms of praxeological boundaries conditioned by asset ownership. When the central owner nationalizes the resources, all entrepreneurial skills are outlawed and simply lost.Mises (1990, p. 38) brilliantly emphasized this in his initial article: “Unfortunately ‘commercial-mindedness’ is not something external, which can be arbitrarily transferred. … The entrepreneur’s commercial attitude and activity arises from his position in the economic process and is lost with its disappearance.” They cannot be recovered by any bureaucratic structure, because there is no real world competition set in the property regime.
ConclusionsAs we have seen, in economics “knowledge” can have many different meanings. In assessing economic systems one has to be careful in making particular assumptions about “knowledge,” because any discussion may turn out to be blurred by definitional barriers. Depending on what we exactly mean by the term “knowledge” various conclusions about its possession or non-possession can be reached. It all comes down to what exactly we understand by this term.
ReferencesAlchian, Armen A. 1950. “Uncertainty, Evolution, and Economic Theory.” Journal of Political Economy 58(3).
Barone, Enrico. 1935 [1908]. “The Ministry of Production in the Collectivist State.” In F.A. Hayek, ed., Collectivist Economy Planning. London: Routledge and Kegan Paul.
Cassirer, Ernst. 1944. An Essay on Man: An Introduction to a Philosophy of Human Culture. New Haven, Conn.: Yale University Press.
Garrison, Roger. W. 1992. “The Limits of Macroeconomics.” Cato Journal 12(1) (Spring/Summer).
Hayek, Friedrich August. 1937. “Economics and Knowledge.” In Individualism and Economic Order. Chicago: University of Chicago Press.
——. 1948 [1940]. “Socialist Calculation III: The Competitive Solution.” In Individualism and Economic Order. Chicago: University of Chicago Press.
——. 1945. “The Use of Knowledge in Society.” American Economic Review 35(4).
——. 1984. “Two Pages of Fiction.” In C. Nishiyama, K. R. Leube, ed. The Essence of Hayek. Stanford, Calif.: Hoover Institution Press.
Horwitz, Steven. 1998. “Monetary Calculation and Mises’s Critique of Planning.” History of Political Economy 30(3).
Huerta de Soto, Jesús. 2010. Socialism, Economic Calculation, and Entrepreneurship. Cheltenham, UK: Edward Elgar.
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Mises, Ludwig von. 1966. Human Action: A Treatise on Economics. Chicago: Contemporary Books.
——. 1990. Economic Calculation in the Socialist Commonwealth. Auburn, Ala.: Mises Institute.
Polanyi, Michael. 1966. The Tacit Dimension. Garden City, N.Y.: Doubleday.
Salerno, Joseph. 1990. “Ludwig von Mises as a Social Rationalist.” Review of Austrian Economics 4.
——. 1990a. “Postscript: Why a Socialism Economy is ‘Impossible’.” In Ludwig von Mises, Economic Calculation in the Socialist Commonwealth. 1990. Auburn, Ala.: Mises Institute.
——. 1994. “Reply to Leland B. Yeager on “Mises and Hayek on Calculation and Knowledge.” Review of Austrian Economics 7(2).
Stigler, George, and Gary S. Becker. 1977. “De Gustibus Non Est Disputandum.” The American Economic Review 67(2).
Walras, Léon. 1954. Elements of Pure Economics, or The Theory of Social Wealth. London: American Economic Association and the Royal Economic Society by Allen and Unwin.
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Ten years ago Joe Salerno inherited the Mises Institute’s summer fellowship program from his predecessor, Jörg Guido Hülsmann. Generously funded by Peg Rowley, summer fellows are given time to study Austrian economics firsthand with some of the current masters. Not only is a sense of camaraderie inculcated amongst the participants, but they are also given access to the world’s best Austrian economics library and other resources. Frequent visits by friends of the Institute give these young scholars the ability to ask questions about the theory and history of the movement, and give them an ability to become a part of its ongoing evolution.
Central to this fellowship is the mentorship of Professor Salerno himself. Under his stewardship the program has brought 138 students to the Institute’s facility in Auburn, Alabama, from 2005 to 2013. These students have produced magnificent works central to Austrian economics during their summers in Auburn, and have gone on to take active roles in both the academic community and with private industry.
Perhaps more important than the careers that these young scholars have gone on to live is the enlightenment that they have shared with others through their daily lives. Using their argumentation skills fomented during their stays at the Mises Institute, these scholars have had their reach extended to others in subsequent encounters. We are all the better off for it.
The contributors to the present volume come from the ranks of PhD students, post-doctoral researchers and university professors. They have reached out to others in a bid to have the truth of their studies heard by the widest audience possible. Professor Salerno’s work in fostering debate and encouraging students during their summer in Auburn has no doubt been influential in spurring on this activism.
The present book is divided into three sections: money, policy and what we can refer to as mundane economics, the study of the basic, yet vital topics of the science. Each section represents an important area of Professor Salerno’s own research and his imprint on each chapter should be apparent to the reader. Suffice to say, a brief overview of his contributions will assist the reader in seeing his impact on the development of these young Austrian scholars in particular, and on Austrian economics in general.
Influence on Mundane EconomicsProfessor Salerno is one of the leading contemporary theorists in the Austrian tradition. A former colleague of Murray Rothbard’s, Professor Salerno has made his unfading mark on the theoretical Austrian literature through several influential as well as highly provocative articles. He has also changed the landscape for Austrian theorizing and the self-perception of Austrians.
His perhaps most debated contribution is “Mises and Hayek Dehomogenized” (1993), an article that essentially rewrote the history and sociology of the Austrian school. Professor Salerno here argues that “the Mengerian tradition was developed in very different directions by his brilliant followers, Eugen von Böhm-Bawerk and Friedrich von Wieser, and by their own students and followers” (1993, p. 114). In fact, Professor Salerno argues, these directions constitute “very different paradigms.” The former focuses on monetary calculation and resource allocation using actual market prices and comprises the social rationalism of Mises (Salerno 1990) and the judgmental entrepreneur (Salerno 2008b); one may also add the distinctly Austrian method of praxeology (see e.g., Rothbard 1951a; 1951b). The latter, in contrast, is a “general equilibrium tradition” (Salerno 2002) focused on the problem of coordination due to dispersed and tacit knowledge (see Hayek 1937; 1945) and much more inclined to quantitative analyses.
While only one of many influential contributions, the “dehomogenized” article represents Professor Salerno’s contributions to Austrian theory well. His contributions to “mundane” theory are primarily in the form of integrating existing theories and prospective theoretical perspectives by offering reinterpreting and contextualizing commentary, comparisons, and theoretical extensions. While perhaps not as glamorous as producing thousand-page treatises, this important integrative work is what produces a consistent body of theory that defines and furthers a tradition or school of thought.
Salerno’s work has strengthened the Austrian theoretical tradition and helped identify precursors and “proto-Austrians.” His work stretches beyond publishing in specifically Austrian journals and discussing exclusively Austrian theorists. Much thanks to Professor Salerno’s work, we are able to trace the philosophical origins of Austrian thought centuries if not millennia back in time and can identify kinship with other traditions. To exemplify, Professor Salerno has pursued illuminating commentary on the legacies of Carl Menger (Salerno 2004; 2010a), Eugen von Böhm-Bawerk (Salerno 2008), Ludwig von Mises (Salerno 1995a; 1999; 2012), Murray N. Rothbard (Salerno 2006), as well as of the French Liberal school’s Jean-Baptiste Say and Frédéric Bastiat (Salerno 1978; 1985; 1988; 1998; 2001), and has addressed the theoretical origins and shortcomings of opponents and competing traditions (Salerno 1992). Professor Salerno has also addressed traditions in monetary theory (Salerno 1991), but this work has come to be overshadowed by his important theoretical advances related to macroeconomics and money, especially monetary policy, business cycle theory (Salerno 1989; 2012b), and the calculation problem (Salerno 1990b; 1994b; 1996a).
Money and PolicyBesides his work on the more mundane aspects of economics, Professor Salerno has pushed forward the development of the one topic, besides method, that most separates neoclassical from Austrian economists: business cycle theory. This focus stems from the fact that the
Austrian theory [of the business cycle] embodies all the distinctive Austrian traits: the theory of heterogeneous capital, the structure of production, the passage of time, sequential analysis of monetary interventionism, the market origins and function of the interest rate, and more. (Salerno 1996b)
While this focus on business cycle theory has most recently been summarized in Salerno (2012), the bulk of his work on the topic has fallen into monetary theory and history. (Understandably so, as manipulations to the money supply as the root of economic disturbances remain the bulwark of the Austrian theory.) As the title of his most comprehensive book alludes to (Salerno 2010b), the undercurrent of his life’s work can be summed up in two words: “sound money.” In this agenda, Professor Salerno can be included in a long line of great economists championing a solid currency for the economy to be built upon, starting with the Spanish scholastics in the sixteenth century, expanded upon by David Ricardo and his fellow “bullionists” in the early nineteenth century, and most forcefully and completely argued by Ludwig von Mises in the early twentieth century. According to Mises (1971, pp. 414–16),
the sound money principle has two aspects. It is affirmative in approving the market’s choice of a commonly used medium of exchange. It is negative in obstructing the government’s propensity to meddle with the currency system. … Sound money meant a metallic standard. … The excellence of the gold standard is to be seen in the fact that it renders the determination of the monetary unit’s purchasing power independent of governments and political parties.
Professor Salerno has made available to his professional colleagues, students and laymen alike the true historical role and functioning of the “gold standard” (in its myriad forms). His work (Salerno 1983) on defining what a true gold standard entails has been instrumental in recognizing red-herring gold standards, imperfectly designed as they were, and which are commonly used to denigrate the usefulness of the “barbarous” monetary relic. His most comprehensive work on the topic (Salerno 1984), shows that the international gold standard is an oft-misunderstood beast because of the aggregative tactic the profession chooses to look at economic phenomena. Taking a more disaggregated approach to monetary and balance-of-payments theory allows one to see the true equilibrating mechanisms promoted by a healthily functioning gold standard.
Nor have these historical insights been merely apparent, allowing one to gain an understanding of a past disconnected from the future. In “War and the Money Machine: Concealing the Costs of War beneath the Veil of Inflation,” Professor Salerno lays out a theory of war finance, showing that monetary inflation obscures the cost of war and contributes to the capital decumulation and wealth destruction that ultimately ensues. That war-time inflation paves the way to “economic fascism” should be more than apparent to the reader who considers the socialization of large swaths of the American economy that have taken place over the past fifteen years in the wake of the ongoing “War on Terror,” an insidious undertaking with an enormous price tag. With some estimates of the total cost of this war as high as $5.5 trillion (nearly $20,000 per American citizen) the role of inflation in financing this broad-reaching undertaking cannot be overstated (Eisenhower Study Group 2011).
Professor Salerno has been instrumental in demonstrating that Ludwig von Mises’s contributions to the theory of money in the early twentieth century not only predated and were ignored by many mainstream economist, but is also far superior (Salerno 1994a). In light of this, it is to his credit that he has not ignored mainstream monetary theory completely. In Salerno (2006) he gives a “Rothbardian” analysis of the familiar equation of exchange. His insights allow the reader to see clearly and in a way that is not possible via the vacuous quantity theory that
the Quantity Theory of Money as expounded in terms of the Quantity Equation gets matters exactly wrong: it is not the flow of spending that determines the price level, given a level of output that is exogenously determined in some separate and mysterious real process. Rather the money prices and quantities of goods exchanged, which are codetermined in the overall market process, are the causal determinants of the spending flow. (Salerno 2006, p. 51)
Never content to rest on the laurels of his forebears, he has striven to improve upon the great works they have achieved. Salerno (1987) provides a better measure of the “true” money supply. Unsatisfied with the existing “M”s expounded with near unanimity by the rest of the profession, Professor Salerno builds off Rothbard (1963, pp. 83–86; 1978; 1983, pp. 254–62) to provide a better answer to a seemingly simple question: how much money is floating around out there? Not only is the exercise admirable for its clarity, it also shows a dedication to truth seeking and an undogmatic approach to economic analysis. Though clearly following in the footsteps of Rothbard, Professor Salerno does not hesitate to correct the dean of the Austrian school in his previous attempts to define the money supply.
To the Next GenerationThe contributions to economic science discussed above, although formidable, will not be Professor Salerno’s greatest professional achievement. The thirteen contributors to the present volume have all learned from him, and there can be no doubt as to the influence he has had on their intellectual development. Just as Professor Salerno very clearly is influenced by the Menger-Mises-Rothbard tradition of the Austrian school, each of these thirteen authors (as well as the other summer fellows under his tutelage, and the thousands of people who have listened to his lectures and read his works) can be considered an intellectual descendant of his. To introduce the adjective, we are all “Salernians” in some way.
Professor Salerno was not only present for the rebirth and revival of Austrian economics in the mid-1960s, he has been an important focal point of its continual growth over the ensuing decades. With this book, we present to him the evidence that the discipline is in good hands, and that his reach and influence has not only been wide, but also strong, ensuring its promulgation for another generation. It is with this contribution that his most lasting influence has been made, and continues to grow with each passing year. Thanks, Joe.
ReferencesEisenhower Study Group. 2011. “Cost of Iraq, Afghanistan, and Anti-Terrorism Operations.” Watson Institute for International Studies, Brown University. Accessed 27 August 2014.
Hayek, F. A. v. 1937. “Economics and Knowledge.” Economica 4(13): 33–54.
——. 1945. “The Use of Knowledge in Society.” American Economic Review 35(4): 519–30.
Mises, Ludwig von. 1971. The Theory of Money and Credit, 2nd ed. Irvington-on-Hudson, N.Y.: Foundation for Economic Education
Rothbard, Murray N. 1951a. “Mises ‘Human Action’: Comment.” The American Economic Review 41(1): 181–85.
——. 1951b. “Praxeology: Reply to Mr. Schuller.” The American Economic Review 41(5): 943–46.
——. 1963. America´s Great Depression. Princeton, N.J.: Van Nostrand.
——. 1978. “Austrian Definitions of the Supply of Money. In Louis M. Spadaro, ed., New Directions in Austrian Economics, pp. 143–56. Kansas City: Sheed, Andrews and McMeel.
——. 1983. The Mystery of Banking (New York: Richardson and Snyder.
Salerno, J. T. 1978. “Comment on the French Liberal School.” Journal of Libertarian Studies 2(1): 65–68.
——. 1983. “Gold Standards: True and False.” Cato Journal 3 (Spring): 239–67.
——. 1984. “The International Gold Standard: A New Perspective.” Eastern Economic Journal 10 (October/December): 488–98.
——. 1985. “The influence of Cantillon’s Essai on the Methodology of J. B. Say: A Comment on Liggio.” Journal of Libertarian Studies 7(2): 305–16.
——. 1987. “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the U.S. Economy.” Austrian Economics Newsletter 6 (Spring): 1–6.
——. 1988. “The neglect of the French liberal school in Anglo-American economics: A critique of received explanations.” Review of Austrian Economics 2(1): 113–56.
——. 1989. “Comment on Tullock’s ‘Why Austrians are wrong about depressions.’” Review of Austrian Economics 3(1): 141–45.
——. 1990. “Ludwig von Mises as social rationalist.” Review of Austrian Economics 4(1): 26–54.
——. 1990b. “Postscript: Why a socialist economy is ‘Impossible’.” Economic Calculation in the Socialist Commonwealth. Auburn, Ala.: Mises Institute.
——. 1991. “Two Traditions in Modern Monetary Theory: John Law and A. R. J. Turgot.” Journal de Economistes et des Etudes Humaines 2(2–3): 337–80.
——. 1992. “The Development of Keynes’s Economics: From Marshall to Millennialism.” Review of Austrian Economics 6(1): 3–64.
——. 1993. “Mises and Hayek Dehomogenized.” Review of Austrian Economics 6(2): 113–46.
——. 1994a. “Ludwig von Mises’s Monetary Theory in Light of Modern Monetary Thought.” Review of Austrian Economics 8(1): 71–115.
——. 1994b. “Reply to Leland B. Yeager on ‘Mises and Hayek on Calculation and Knowledge.’” Review of Austrian Economics 7(2): 111–25.
——. 1995a. “Ludwig Von Mises on inflation and expectations.” Advances in Austrian Economics 2: 297–325.
——. 1995b. “War and the Money Machine: Concealing the Costs of War beneath the Veil of Inflation.” Journal des Economistes et des Etudes Humaines 6 (March): 153–73.
——. 1996a. “A final word: Calculation, knowledge, and appraisement.” Review of Austrian Economics 9(1): 141–42.
——. 1996b. “Why we’re winning.” Austrian Economics Newsletter 16(3).
——. 1998. Review of “J.-B. Say, An Economist in Troubled Times.” Journal of the History of Economic Thought 20(4): 524–27.
——. 1999. “The Place of Mises’s Human Action in the Development of Modern Economic Thought.” Quarterly Journal of Austrian Economics 2(1): 35–65.
——. 2001. “The Neglect of Bastiat’s School by English-Speaking Economists: A Puzzle Resolved.” Journal des Economistes et des Etudes Humaines 11(2).
——. 2002. “Friedrich von Wieser and Friedrich A. Hayek: The General Equilibrium Tradition in Austrian Economics.” Journal des Economistes et des Etudes Humaines 12(2).
——. 2004. “Menger’s theory of monopoly price in the years of high theory: the contribution of Vernon A. Mund.” Managerial Finance 30(2): 72–92.
——. 2006. “A Simple Model of the Theory of Money Prices.” Quarterly Journal of Austrian Economics 9(4): 39–55.
——. 2008. “Böhm-Bawerk’s Vision of the Capitalist Economic Process: Intellectual Influences and Conceptual Foundations.” New Perspectives on Political Economy 4(2): 87–112.
——. 2008b. “The Entrepreneur: Real and Imagined.” Quarterly Journal of Austrian Economics 11: 188–207.
——. 2010a. “Menger’s Causal-Realist Analysis in Modern Economics.” Review of Austrian Economics 23: 1–16.
——. 2010b. Money, Sound and Unsound. Auburn, Ala.: Mises Institute.
——. 2012. “Ludwig von Mises as Currency School Free Banker.” Procesos de Mercado: Revista Europea de Economía Política 9(2): 13–49.
——. 2012. “A reformulation of Austrian business cycle theory in light of the financial crisis.” Quarterly Journal of Austrian Economics 15(1): 3–44.
AustrianSimon Bilo is assistant professor of economics at Allegheny College, Meadville, Pennsylvania. This paper is a revised version of selected sections of my 2006 M.A. thesis. I would like to thank Peter Boettke, Per Bylund, Gene Callahan, Jan Havel, Marek Hudík, Juraj Karpiš, Shruti Rajagopalan, Walter Stover, Lawrence White, and participants of the Graduate Student Paper Workshop at GMU for their valuable comments and suggestions during earlier drafts of this paper. A draft of the paper was also presented at the Austrian Scholars Conference in 2009. I gratefully acknowledge the financial help that I received from the Mercatus Center at George Mason University while working on this project. All the usual caveats apply. I have known Joseph Salerno for about ten years. These were ten formative years for me — I was an undergraduate student in Prague back then; now I am teaching economics myself. Salerno played an important role in this journey of mine: he was my adviser in the summer of 2005 at the Mises Institute, he kindly agreed to write letters of recommendation for me when I was applying for graduate school, and we would see each other when the two of us were attending the Colloquium on Market Institutions and Economic Processes at New York University. economists have not ventured into the field of international economics very often and most of the exceptions wrote their work a long time ago. This is the case with the work on money and credit by Mises (1953 [1924], esp. pp. 170–86), Hayek’s discussion of monetary nationalism (1999 [1937], esp. pp. 61–73), Machlup’s (1939, 1940) and Haberler’s (1950) contributions, and Rothbard’s brief discussion in Man, Economy, and State (2004 [1962], esp. pp. 828ff.).
Of the few recent contributions made to this field, two authored by Salerno (1994a; 1994b) highlight the subjectivist perspective that Mises (1953 [1924]) holds about the determinants of the purchasing power of money in geographically separate locations. Physically identical goods in different locations are different economic goods even if we assume away all transportation costs. Because people often value separate economic goods differently, prices of physically identical goods in different locations might vary even in general equilibrium.
The insight that there can be an equilibrium with different prices between physically identical goods in different locations is important from the perspective of the absolute purchasing power parity theory, which is one of the models that tries to explain foreign exchange rates. This theory assumes the law of one price and implies that equilibrium exchange rate must equalize prices of physically identical goods across different currency areas when the prices of the goods are converted into same currency. Currently available data, however, bring this idea of absolute purchasing power parity into question: the general consensus is that in spite of high variability of foreign exchange rates, it takes a number of years at best before the exchange rate adjusts to a deviation from parity (Rogoff 1996; Taylor and Taylor 2004). It is this “purchasing power parity puzzle” (Rogoff 1996) that Mises’s subjectivist view on purchasing power of money can explain: if physically identical goods in different locations are different economic goods, it is not surprising that they have different price tags when the prices are expressed in the same currency and that absolute purchasing power parity does not hold. Yet, at the same time, there can still be a tendency toward equilibrium in the exchange rate between two currencies. The equilibrium exchange rate, however, does not reflect the purchasing power parity condition but rather the subjective valuations of goods in each currency area, given the prices of those goods in their respective domestic currencies.
In what follows, I develop the argument from the previous paragraph. I first review the insights of Mises and Salerno on the subjectivist theory of the purchasing power of money and then look at how these insights apply in the setting of two currency areas with a floating foreign exchange rate. In conclusion, I formulate the underlying subjectivist theory of foreign exchange rates.
Subjective Valuation Differentiates Purchasing Power of Money Across SpaceIn the section on “Alleged Local Differences in the Cost of Living,” Mises (1953, pp. 175–78) stresses the importance of the position of goods in space when considering the valuation of those goods and their relative prices. He illustrates how important the location of goods is by comparing the prices in Karlsbad, a desired spa destination, and prices in other cities. While the same type of good costs more in Karlsbad than in other cities, the price difference is justified because goods in Karlsbad are perceived as different types of goods. In other words, “[i]f [person] has to pay more in Karlsbad for the same quantity of satisfactions, this is due to the fact that by paying for them he is also paying the price of being able to enjoy them in the immediate neighborhood of the medicinal springs” (Mises 1953, pp. 176–77).
To generalize the previous example, one can say that the position of a good in space matters — geographic location is an important characteristic of an economic good that can change one’s perception of this good, and consequently its value and price. Physically identical goods in different locations can then be priced differently even in equilibrium (Mises 1953, pp. 177–78; Salerno 1994b, pp. 251–52).
Arbitrage Does Not Equalize Purchasing Power of Money Across SpaceOne can object that while the demand for goods might differ by location, the difference at least does not apply in the case of tradable goods, which can be easily transported from one place to another. The demand for apples in the city of Meadville in Northwestern Pennsylvania, for example, might be lower than the demand for apples in Manhattan, incentivizing suppliers to distribute apples accordingly and eventually equalize the prices of apples in both places. If the existing relative supply of apples in these two places results in lower relative price of apples in Meadville, this incentivizes entrepreneurs to ship apples from Meadville to Manhattan to equalize the profits from selling apples in the two different places. Assuming perfect competition and zero transportation costs, one might say that profits equalize when the price of apples in Meadville is the same as the price of apples in Manhattan.
However, since tradable goods are usually bundled with non-tradable complements as Rogoff (1996, pp. 649–50) and Taylor and Taylor (2004, pp. 136–37) briefly note, location also affects the prices of tradable goods. Shelf-space, for example, is one such non-tradable complement: returning to the apple parable, a sufficient lack of shelf-space in Manhattan may fail to incentivize shop-keepers to supply enough apples to equalize prices between Meadville and Manhattan. In this case, the opportunity cost of supplying so many apples is too high; Manhattan shop-keepers would rather use the scarce shelf-space to offer other products while keeping the price of apples relatively high.
To generalize the example, one can say that tradable goods often need to be bundled with non-tradable complements when sold in specific geographic locations. Since these complements might be subjectively valued and priced differently across locations, opportunities to arbitrage price differentials across space are limited. This limitation might then lead to price differentials between physically identical goods sold in different geographic locations.
Subjective Valuation Differentiates Purchasing Power of Money also Across Currency AreasThe conclusion that physically identical goods can vary in equilibrium prices between different locations also applies to the case of two separate currency areas. This application suggests that foreign exchange rates do not necessarily correspond to the absolute purchasing power parity of the respective currencies. To illustrate this point, I will use a modified version of the previous section’s apple parable.
Assume that there are only two places in the world: Manhattan and London. Each city has its own independent fiat currency so that people in Manhattan use the dollar ($) and people in London use the pound (₤). Let’s assume an equilibrium where an apple in Manhattan costs $6 and where a physically identical apple located in London sells for ₤2. Assuming away transportation costs, the absolute purchasing power parity theory says that the equilibrium exchange rate between dollars and pounds is $6 per ₤2, i.e., $3/₤1. If the foreign exchange rate was different, the purchasing power parity theory suggests that this would create a state of disequilibrium with associated arbitrage opportunities that buyers and sellers will exploit until the exchange rate $/₤ is equal to the ratio of the price of apple expressed in dollars over the price of apple expressed in pounds.
However, the subjectivist insight proposed by Mises (1953) and emphasized by Salerno (1994a; 1994b) suggests a very different conclusion about the equilibrium exchange rate. Following the example, even if $6 and ₤2 are the equilibrium prices of apple in Manhattan and London respectively, the two prices tell us little about the equilibrium foreign exchange rate between dollars and pounds. The difference in geographic location means that apple in Manhattan and apple in London represent two different economic goods. The difference means that while $6 is the price of an apple in Manhattan, we cannot necessarily infer from this that in equilibrium people are willing to pay the pound equivalent of $6 for an apple in London. People might be paying more or less for an apple in London than its dollar equivalent, depending both on the demand for apples in London and on the prices and subjective values of complementary non-tradable goods necessary to sell apples in London. Assuming that the equilibrium price of an apple in London is ₤2, this implies the exchange rate $/₤ can be below or above the absolute purchasing power parity of $3/₤1.
Purchasing power of money is therefore unequal across currency areas in the same way it is unequal across different geographic locations within the same currency area. Goods with identical physical characteristics but different locations are different economic goods (Salerno 1994a, p. 107). In equilibrium, such goods can have different prices when their respective prices are converted into the same currency unit. As a result, equilibrium foreign exchange rate does not have to equalize the prices of goods across currency areas and therefore does not have to adhere to the absolute purchasing power parity condition.
Foreign Currency is Valued Subjectively as a Means Toward Goods in Its Currency Area/p>If absolute purchasing power parity is not the equilibrium condition for the foreign exchange rate between two currencies, what are the equilibrium conditions? It is important to realize in this regard that people demand money because it is medium of exchange (Mises 1953, pp. 30ff.) — a medium of directly purchasing goods in its corresponding currency area. Assuming that money does not have non-monetary uses, people value different currencies against each other depending on the economic goods they can procure with those respective currencies (Mises 1953, pp. 180–81).
The foreign exchange rate of a currency thus depends on the prices that people expect to pay for goods using the currency. If expected prices increase in one currency, demand for that currency drops at the foreign exchange market and its exchange rate becomes less favorable; if the expected prices decrease, the demand for the currency increases and its exchange rate becomes more favorable. In contrast to the absolute purchasing power parity theory, however, the relationship between the foreign exchange rate between two currencies and the prices of goods that people using each currency can buy is qualitative and does not follow a pre-determined mechanical formula. The numerical imprecision of the law explaining determinants of foreign exchange rates is a necessary consequence of the fact that most of the goods that people buy with each currency are different economic goods that people value subjectively. People’s subjective valuations therefore act as a filter for every price change of a good expressed in that currency: people ultimately decide to what extent the price change has an effect on their demand for the currency in question.
Conclusion: Subjectivism and International EconomicsIn his 1994a and 1994b articles, Salerno restored attention regarding Mises’s subjectivist approach to monetary theory and international economics. This approach helps us to understand why economists have been struggling to empirically confirm the absolute version of the purchasing power parity theory. They have been unsuccessful because the theory assumes the law of one price for goods that have identical physical characteristics but which differ in location. Because the difference in location means that these goods are in reality different economic goods, the law of one price does not have to hold and the absolute purchasing power parity can be violated even in equilibrium. The subjectivist approach to international economics thereby gives us yet another illustration of the importance of subjectivism in economics that was emphasized by Hayek (1952, p. 31).
ReferencesHaberler, Gottfried. 1950. The Theory of International Trade. William Hodge & Company.
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TextbookGuillaume Vuillemey is a PhD student in economics at Sciences Po, Department of Economics, Paris, France. I was a summer research fellow at the Mises Institute in 2009, under the guidance of Professor Joseph Salerno. descriptions of financial markets draw a clear and seemingly unambiguous distinction between spot and future transactions. Whereas future transactions are often confined to derivatives markets, everyday trades on stocks, bonds or other assets are said to be spot. Furthermore, common descriptions of spot transactions usually do not distinguish between (i) the time a trade is agreed upon and (ii) the time it is paid for and delivered, as both are assumed, by definition, to take place virtually at the same point in time.
This chapter provides a theoretical investigation of high-frequency trading (HFT), which arises from the lag existing — even for seemingly spot transactions — between steps (i) and (ii). To this end, I shall redefine the dichotomy between spot and future transactions when the settlement of trades does not occur in real time but with a lag, and when this lag can be exploited by algorithms, computerized techniques or human decisions.
High-frequency trading consists of trade exposures opened and closed between settlement dates by market participants ensuring that their net open exposure at the settlement time is zero (implying that none of the trades performed intraday are either paid for or delivered). HFT transactions are not akin, for conceptual understanding, to usual trades that would merely be executed “faster” or to positions being liquidated after a shorter period of time. One distinguishing characteristic of HFT activities is that they can be performed with virtually zero cash or securities’ holdings in the first place, as the trader ensures a zero net position at the settlement date.
This chapter investigates two questions. First, does HFT imply that intraday buy and sell trades are performed using temporarily ex nihilo created fiat money? Second, can the case where securities are agreed-upon but never delivered create multiple (therefore conflicting) but valid property rights on particular assets? The issue at hand resembles those raised by fractional reserve banking. Importantly, this chapter does not comment on the status of high-frequency trading under various legal systems or jurisdictions — this is left for future research — and instead focuses only on the theoretical conditions under which the above-mentioned consequences may occur.
If the above questions are to be given a positive answer, then serious consequences follow as regards intraday liquidity management in payment and settlement systems. An example is that of “failures to deliver” arising from high-frequency trading from naked short selling, whereby a trading institution is not able to deliver at settlement date securities it has been selling during the day.On the extent of failures to deliver in the United States, see SEC Fails-to-Deliver Data. Other consequences may relate to intraday collateral management, for instance in the case where securities are bought and delivered as collateral before the settlement of the initial purchase. Besides economics, ethical and legal issues raised by the potential over-issuance of property rights through high-frequency trading activities are akin to those raised by Mises (1996) or Huerta de Soto (2011) in the case of fractional reserve banking. An overview of Mises’s views on fractional reserve banking and monetary theory can be found in Salerno (1994).
Answering the above questions requires a careful analysis of the consequences of the lag between the time trades are agreed and the time they are paid for and delivered. I will show that, when clearing and settlement do not occur in real time, trades that are usually — theoretically and/or legally — described as spot must be treated as futures if a careful economic analysis is to be conducted. I also provide a criterion to distinguish between spot and future trades. Finally, I show that the over-issuance of property rights arising from HFT exists when transactions which should be treated as futures are legally or factually treated as spot.
The remainder of the chapter is structured as follows. First, high-frequency trading is described and is shown to be merely the exploitation of the lag between the time trades are agreed upon and the time they are settled. Its fundamental difference with other (“usual”) trading activities is also highlighted. Then, the distinction between spot and future transactions is refined. Trades on financial markets where settlement is delayed are shown to be meaningfully understood as futures. Finally, I define the conditions under which certain legal treatments of high-frequency trades as spot or as future transactions may lead to the over-issuance of property rights, thus give rise to liquidity risk in payment and settlement systems.
High-Frequency Trading as the Exploitation of Delayed SettlementI shall start by examining the nature of high-frequency trading and the conditions under which it arises. High-frequency trading on an exchange platform consists of trades usually performed by computer algorithms so as to benefit from private information regarding the order flow or from small price variations over short horizons (ranging from a few milliseconds to a few hours). The major characteristic of high-frequency trading algorithms is that they ensure a virtually zero net open exposure at the end of each trading day, so that no cash or securities have to be physically delivered. High-frequency trading has recently become a sizeable phenomenon on financial markets, as it represents up to 70 percent of all trades on some organized stock exchanges (see Swinburne 2010).
I do not propose an extensive review of the literature (which can be found in Gomber et al., 2011). Most of the academic work revolves around the consequences of high-frequency trading on particular aspects of the price system, typically on the price formation mechanisms (bid-ask spreads, “price discovery” mechanisms, etc.).Another issue regarding high-frequency, which has been less dealt with in the literature, is the extent to which it is akin to insider trading, as some high-frequency traders benefit from their technological superiority to get market information (on incoming buy and sell orders especially) ahead of other market participants. This issue is not addressed in the present chapter. For instance, one oft-mentioned concern relates to the fact that high-frequency trading may amplify price volatility to the extent of triggering “flash crashes.”The most prominent example of so-called “flash crash” occurred on May 6, 2010, when the Dow Jones Industrial Average plunged by about 9 percent before recovering in a few minutes. High-frequency trading algorithms have been shown to play a role in the amplification of the drop (see SEC, 2010). Among the main findings documented in the empirical literature are a reduction in trading costs and bid-ask spreads (see Brogaard 2010; Hasbrouck and Saar 2010) and a decline in short-term volatility (see Jarnecic and Snape 2014 or Brogaard 2011). Contrasting with the existing literature, this chapter focuses on an issue of a completely different order, largely neglected up to now. I do not focus on the empirical or theoretical consequences of high-frequency trading on particular aspects of the price system, but instead provide a theoretical analysis of high-frequency trading as regards property rights on cash and on traded securities. More precisely, do HFT activities lead to the over-issuance of property rights or to the ex nihilo creation of money?
An essential preliminary to be mentioned is a key institutional feature of present-day financial systems, namely the lag that exists on financial markets between the time trades are agreed (prices and quantities are decided upon) and the time payment and delivery actually take place. Whereas trade orders can be executed at any point in time during the trading day, clearing and settlement occur at one point only during the day, usually at the end of the trading session or up to T+72 hours. It is of utmost importance to highlight that such a time lag for so-called spot transactions is essentially institutional, i.e., that it does not primarily exist as a consequence of any physical or operational constraint. With the advent of computerized technologies at all stages of post-trade processing, real-time settlement (or quasi real-time settlement, as several actors have to be coordinated) could be a perfectly valid and implementable contractual or legal framework. For instance, real-time gross settlement systems (abbreviated RTGSA comprehensive overview of RTGS payment systems is provided by the Bank of International Settlements (1997).) exist for interbank payments — such as Fedwire in the United States and TARGET2 in Europe.
As a preliminary, I shall examine the extent to which high-frequency trades differ from other (“usual”) trades and show that high-frequency trading primarily exists as a consequence of delayed settlement. One key theoretical question for my purposes is actually whether high-frequency trades are akin to “usual” trades that are performed faster (an asset being bought at some date and sold a short moment — from microseconds to several hours — later), i.e., trades that could be fully described in theoretical terms by the canonical description of exchange phenomena (see Mises, 1996, for example). I aim to show that high-frequency buy-and-sell trades cannot be understood theoretically as a combination of spot buy and sell transactions.
I shall begin with a mere description of the steps involved in any combination of spot buy and sell transactions. For trader A, a usual buy-and-sell transaction amounts to (i) agreeing with B on prices and quantities, (ii) paying the agreed-upon monetary units to B in exchange for the agreed-upon good, and at a later date (iii) agreeing with C on prices and quantities and finally (iv) delivering the agreed-upon good to C in exchange for the agreed-upon monetary units.
On the contrary, high-frequency buy-and-sell operations do not imply, at any time, either any disbursement of cash or any physical delivery of a security or good. This is due to the fact that steps (i) and (iii) occur between two settlement dates, so that the buy and sell transactions never have to be paid for or delivered. If a buy-and-sell operation is performed within a few seconds, or even within a few hours, it will never have to be physically settled. One characteristic of high-frequency trading is indeed that investment positions are held for short periods of time so that net exposures are virtually zero at the end of each trading day, when clearing and settlement occur. As a result, high-frequency trading activities can virtually be performed with zero initial cash and zero initial securities (neglecting trading fees or initial cash balances to be maintained at the exchange platform). One may thus move in and out of investment positions thousands of times a day without having either to pay for the securities it buys or to physically deliver the securities it sells. A trader who consistently ensures a zero net open exposure at the end of the trading day can perform his activities without any holding of either cash or securities in the first place.
It must be clear at this stage that the latter feature — the absence of any physical payment or delivery — exists only because of the delayed settlement of all trades. If trades were to be cleared and settled in real time, or in approximately real time, then high-frequency trading would essentially disappear as it would become impossible to trade without virtually any cash or securities initial endowment. What would remain would eventually be buy-and-sell trades that are executed “quickly,” but not high-frequency trades. In order to further understand high-frequency trading, the legal consequences of delayed settlement have to be clearly grasped.
Spot vs. Futures and the Status of Financial TradesGiven delayed settlement, can trades on financial markets be regarded as spot transactions? A clear understanding of the distinction between spot and future transactions is of utmost importance for my purposes, as each of these transactions implies different consequences regarding the property rights at stake. What is usually referred to as a spot transaction is a transaction where both (i) the agreement between two parties on prices and quantities and (ii) the payment on one side, the delivery of the agreed-upon goods on the other side (or clearing and settlement) occur virtually at the same time, meaning that the time span between steps (i) and (ii) is insignificant for human action and for economic theory. One can see that what is crucial to the definition of a spot transaction is whether settlement is delayed or not.
The dichotomy, however, is not as clear-cut as it seems. Strictly speaking, agreement on prices and quantities on one side, and payment and delivery on the other side, are very unlikely to occur at the exact same time in everyday exchanges. Think of a baker who gives a piece of bread to a customer and receives cash only a few seconds after both parties agreed on prices and quantities. Clearly, considering physical time, there is a lag between the agreement between the parties and the process of payment and delivery. Does this imply that this transaction should not be considered as spot but as future? Considering physical constraints, what lag is low enough so that a transaction can be considered spot and not future? One hour? Ten seconds? One microsecond? Phrased this way, the question is misleading and the distinction between spot and future transactions has to be rephrased. The relevant time to be considered is not the physical time but the time of human action. More precisely, one is faced with the problem of continuums in human action and economic behavior. Rothbard (2001, pp. 264–65) argues:
The human being cannot see the infinitely small step; it therefore has no meaning to him and no relevance to his action. Thus, if one ounce of a good is the smallest unit that human beings will bother distinguishing, then the ounce is the basic unit. … If it is a matter of indifference for a man whether he uses 5.1 or 5.2 oz. of butter, for example, because the unit is too small for him to take into consideration, then there will be no occasion for him to act on this alternative.
Similarly, if the lag between the time a trade is agreed and the time it is paid for and delivered has no relevance for human action, then it does not make sense to label as future a transaction where such lag is, say, of 10 seconds. Asserting that it is irrelevant for human action means that the buyer of the agreed-upon good does not and cannot engage in any other transaction or operation involving property rights on the good between the time prices and quantities are decided upon and the time payment and delivery take place. For example, the good bought cannot be pledged as collateral once its purchase is agreed but before it has actually been received. What fundamentally distinguishes a spot from a future transaction is not the physical time lag that virtually always exists (even if very short) between the time a trade is agreed and the time it is paid for and delivered, but whether this time lag is relevant and meaningful for human action. A similar argument has recently been made by Bagus and Howden (2012), who distinguish between demand and term deposits in the debate on fractional reserve banking.
Consider a trading platform with a low level of computerized automation, a relatively low speed of order execution (as compared to present-day speeds) and an end-of-day clearing and settlement. This is roughly akin to what used to exist about fifteen years ago before the tremendous technological improvements underwent by trading platforms. On such an exchange, a lag between clearing and settlement exists but it is essentially irrelevant for human action, as it cannot be exploited — or possibly very marginally. Thus, everyday transactions on such a platform can, without any major theoretical difficulty,In a world where the automation of stock exchanges through computer systems is low or inexistent, i.e., where high-frequency trading or multiple intraday transactions on the same security are virtually not possible, treating as spot a transaction that is technically future (with a maturity of a few hours up to 24 hours) may only matter in case of bankruptcy — for example, if bankruptcy is declared between the time a trade was agreed and the time it was supposed to be paid for and delivered. be treated legally and conceptually as spot.
The whole picture changes with technological improvements when high-frequency trading arises, i.e., when the lag between the time trades are agreed upon and the time they are paid for and settled can be meaningfully exploited. More precisely, a security that has been bought at some point during the day can then be re-sold before being first physically received. Faced with the above-outlined continuum problem, I explained that the distinction between spot and future transactions is to be expressed not in terms of the physical time between agreement and settlement but in terms of time meaningful for human action. Therefore, if high-frequency trades are to be understood as trades that are agreed upon but never paid for and delivered, they can no longer be understood as spot transactions and can conceptually be defined more meaningfully as future transactions. Future transactions differ from spot transactions in that they are agreed in the present but paid for and delivered at a future date, so that the time lag between the agreement on prices and quantities on one side, and the clearing and settlement on the other, is no longer irrelevant for economic and legal theory. In terms of property rights, spot and future transactions are different in esse. Spot transactions are the exchange of property rights over present goods, whereas future transactions are the exchange of claims on property rights on future goods.
If it is clear that high-frequency trades are to be considered as futures, what about trading positions that are kept open until the settlement date, i.e., transactions that will indeed be paid for and delivered? An important issue to highlight is that nothing makes it possible to distinguish ex ante a high-frequency trade from any other trade. When a buy or sell order is executed on the market (“execution” here referring not to the fact that a trade is paid for and delivered, but merely to the fact that a buyer is matched with a seller, i.e., that an agreement on prices and quantities is reached), nothing makes it possible to identify trades of two different types as there cannot exist prescience, at least for an external observer, about whether the position will be liquidated or not before the settlement date. All trades are potentially high-frequency trades ex ante. When there is no real-time settlement, all trades must therefore be regarded as futures in the first place, so as to account for the institutional lag between the time of order execution and the time of clearing and settlement. Indeed, the possibility that a particular trade be high-frequency always exists before the settlement time. In this context, trading positions that are left open over at least one settlement date can be considered similar to future contracts that are kept until maturity, whereas trading positions that are liquidated before settlement date are akin to future contracts that are never delivered.
Legal Treatment and Consequences for Property RightsAll transactions that are usually regarded as spot in economic analysis have been shown to be better understood as futures. Moreover, I explained how different are the implications of spot and future transactions in terms of property rights. Following the above analysis, one needs now to investigate how various legal or contractual arrangements may result or not in the over-issuance of property rights or in the ex nihilo creation of fiat money. Can one think of cases where such over-issuances from high-frequency trades exist because of the lag between the time trades are agreed and the time they are cleared and settled?
First, if all trades on financial markets are to be seen as futures, it must be emphasized that future transactions do not entail any over-issuance of property rights. When one sells at some date a security to be delivered in the future, it does not matter at all whether he actually owns the security in the first place. To understand this, the distinction between a present good and a future good must be restated. What is exchanged in a future transaction is a claim on a future good against a claim on future money. One must emphasize that only claims are exchanged, so that no property rights on present money or securities are exchanged (or involved in any way). Therefore a future transaction, if properly dealt with contractually and legally, is not and cannot imply any over-issuance of property rights. The only point in time where property rights on actual physical securities and on money matter is at the maturity date, i.e., when the future transaction has to be settled. The same reasoning applies for any trade (including high-frequency trades) correctly understood as a future trade. When a security “is bought” during a trading session, what is actually bought is a claim on a future security to be delivered at the settlement time (say, the end of the trading day). Similarly, what is sold in such a transaction is not present money but a claim on future money. If all trades on financial markets are to be treated legally and contractually as future transactions in this precise sense, then high frequency trading does not imply any over-issuance of property rights. A high-frequency trader would then be perfectly akinOne slight difference is that one party usually has to pay a present premium in order to enter a future transaction. This, however, is not a necessary element of a future contract. The only payment that a high-frequency trader has to make — like any other trader — is the trading fee to the exchange platform. to a trader on futures markets who buys and sells contracts on oil, currencies or whatever securities but consistently unwinds his positions before the maturity date (i.e., never gets delivered with the underlying assets nor pays for any of these assets). Such traders consistently trade claims on future goods but never wait for the maturity of the future contract. This cannot lead to the over-issuance of property rights. In such a case, it is likely beneficial to market liquidity, similar to dealers in futures markets providing liquidity to end-user investors.
Alternative theoretical cases shall nevertheless be considered. Up to now, I have explained without further explanation that high frequency trading does not imply the over-issuance of property rights if trades are “treated legally and contractually as future transactions.” Such a proviso is of the utmost importance. Confusion may indeed come from the fact that what has been here described as future transactions is usually, in textbook explanations of the phenomenon, described as spot transactions. What if trades that are factually futures (as they are paid for and delivered only at an end-of-day settlement date) were to be treated legally and contractually as spot? Or, in other terms, what if an inconsistency in the legal framework exists, so that delayed settlement is the norm for transactions legally treated as spot? Once again, I shall make clear that the issue whether trades are treated as future or as spot under various legal systems or jurisdictions is complex and is not discussed in the present chapter, as my focus is on economic theory only.
In this case, a high-frequency trader buying a security during the day (to be delivered at the end of the trading day) could possibly engage in other operations involving property rights on a present security — not only claims on property rights on future securities — for example by pledging this security as collateral. Until either the settlement date or the date the position is liquidated, there would be two seemingly legitimate owners of the exact same security. This case would clearly result in an over-issuance of property rights that are not backed by actual physical securities. This is reminiscent of “circulation credit” or “inflation” in Mises’s sense (Mises 1981; Salerno 2000). Similarly, assume that a seller is able to use intraday the cash he is supposed to be delivered only at the settlement date — for example to repay a maturing debt — then such cash must be considered as ex nihilo created fiat money, as no one renounced yet to this quantity of money in the present. Once again, this would merely be an over-issuance of fiat money, which may have serious implications for liquidity risk in payment and settlement systems in a stressed environment.
ConclusionThis chapter provided a theoretical examination of high-frequency trading, focusing on whether it creates either additional property rights that are not backed by physical securities or ex nihilo created money. This is likely to occur as high-frequency traders can buy and sell large amounts of securities without virtually any cash or securities endowment in the first place. One key feature for a theoretical understanding of high-frequency trading is that it exploits the lag between the time trades are agreed and the time they are paid for and settled. In turn, high-frequency trading as it is currently practiced would essentially disappear if clearing and settlement were to be implemented in real time.
Whereas the time lag between the execution of a trade (i.e., the matching of a buyer and a seller) and its settlement has long been virtually irrelevant for human action as it could not be exploited — or only to a very limited extent — the advent of electronic trading platforms and of computerized trading algorithms enabled exploiting this lag to a greater extent. What used to be considered as spot transactions without any major conceptual difficulty can no longer fit the stylized description of a spot transaction, i.e., a transaction where payment and delivery occur virtually at the same time as the agreement on prices and quantities. Given that powerful computer techniques enable exploiting smaller and smaller lags (nowadays a few microseconds), the dichotomy between spot and future transactions has to be re-thought. Faced with the continuum problem, I argue that the distinctive criterion which ultimately matters is not the physical time lag that almost necessarily exists between trade agreement and delivery, but whether this lag is meaningful for human action — or, eventually, for algorithms executing models designed by humans. In that regard, all transactions usually regarded as spot have to be treated conceptually as futures with the advent of high-frequency trading techniques (of course, as long as the institutional lag between trade execution and delivery is maintained).
Turning to a legal analysis of high-frequency trading, I show that — in a system where settlement is delayed — the issue whether an over-issuance of property rights exists ultimately depends on whether it is treated legally as spot or future. If high-frequency trades are properly dealt with as futures — i.e., not as an exchange of property rights on goods, but as claims on property rights on goods — then no such consequences follow. This implies, for example, that traded securities cannot be pledged as collateral before they are physically delivered. On the contrary, if high-frequency trades are treated legally, contractually or factually as spot, then there exists over-issuance of property rights, even though it is for short time periods. This gives rise to liquidity risk in payment and settlement systems.
Following the above analysis, two research directions are to be outlined for future work. First, I set a theoretical framework indicating under which legal arrangements high-frequency trading may or not lead to the over-issuance of property rights. A survey of the existing legal frameworks in the United States or in Europe would be highly valuable as a complement. Second, from a theoretical perspective, the framework set out above could be extended to the study of another controversial market practice, namely naked short-selling. Naked short-selling occurs when a security is shorted before being first borrowed or located. A legal issue therefore is whether it is fraudulent in that one is selling something he does not own in the first place. This practice could be fruitfully analyzed not as the shorting of a security but as the shorting of a claim on a security, therefore as a future.
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ModernPer Bylund is John F. Baugh Center Research Professor in the Department of Entrepreneurship at Baylor University in Waco, Texas. I had the great pleasure and privilege of being a summer research fellow in 2009 and 2010, and a postdoctoral research fellow in 2012. This chapter is an extension of the theoretical perspective developed in my dissertation at the University of Missouri, which was originally developed while a summer fellow at the Mises Institute and with the help and encouragement of Professor Salerno. economic theory tends to treat production, the process of generating valued consumption in a market, as a function carried out within firms and so out of reach for the general market (Coase 1937). Firms are seen as “black box” generators of output from inputs in accordance with a calculable and formalized “production function,” and both inputs and outputs are exchanged at competitive money prices in market transactions. The market, consequently, is seen as simply a means for efficiently allocating resources through the price mechanism. The development and production of the specific goods and services that are directly valued by consumers is considered of much lesser import.
In contrast, Austrians emphasize the causal processes in the economy and therefore pay much attention to production — the way value is created through consumer wants satisfaction — and capital theory — how factors are utilized to support production. Austrians recognize that the specialized market process consists of and is dependent on an intricate structure of productive resources. This structure supports roundabout production processes that exploit productivity-enhancing uses of non-permanent intermediate (produced) goods. Such an advanced production apparatus is dependent on the specific uses of capital goods that facilitate taking factors of production through stages aimed at eventually satisfying consumer wants.
This distinctly Austrian perspective on the market as a process of production is the subject for this chapter, with specific emphasis on how changes to the economy’s production apparatus or capital structure are brought about. The aim is to elaborate on the implications of the market’s capital and production structure and thereby illustrate a specific theoretical problem that is conspicuously missing in the Austrian analysis. I draft a solution to this problem by addressing potential remedies made available by market actors exercising productive entrepreneurship. In this sense, the essay elucidates a realm for entrepreneurship within production and capital theory.
Production and Capital StructureCapital goods can be defined as “the produced goods that must be combined still further with other factors in order to provide the consumers’ good” (Rothbard 2004 [1962], p. 299). These intermediate or “produced” goods that can only indirectly satisfy consumer wants are “a necessary way station to increased consumption” (Rothbard 2004 [1962], p. 966; emphasis in original). Seen as a whole, they compose “an intricate, delicate, interweaving structure of capital goods” (Rothbard 2004 [1962], p. 967; Lachmann 1978 [1956]), a production structure that in its current length and form is configured to satisfy wants already anticipated by entrepreneurs.
A production structure is composed of specific capital goods, themselves a combination of other capital goods and original factors. It is assembled and configured in a specific way for a specific purpose (Lachmann 1978 [1956]) and operated by specialized labor. Production is temporally dependent since it must be carried out in time. Carrying out a production process with already existing, supporting capital goods takes time, as does the production of the capital goods used in the process. The existent production structure was brought together and configured in the past, and is used and operated in the present to produce consumers’ goods available in the future.
Time, therefore, is both a limitation and a factor of production: due to its irreversibility, it “puts the future services of certain resources beyond our reach in the present and so makes it impossible to anticipate their use” (Hayek 1941, p. 52). In other words, we cannot conceive of specialized production without capital. Even acknowledging that there is a capital structure supporting production in multiple stages ultimately appears insufficient for us to fully understand the production process. For this reason, a theory of production is of limited use without a capital theory that also includes action and so explains the structure’s dynamic: how and why the production structure has taken a certain shape and how and why the structure changes over time. As we will see, the Austrian conception of production subject to the heterogeneous structure of productive capital indicates a problem related to the structure of tasks in an economy’s production apparatus. This problem does not exist for Robinson Crusoe but is potentially crippling in a specialized market, and it requires entrepreneurship and integration to be solved.
Roundabout Production Without Existing CapitalImagine that a person P, in a world without existent capital, decides to manufacture a product A with the intention of making it available for consumers in the open market. To the extent the production process requires (or is more productive with) capital, these capital goods must first be produced. Regardless of the complexity of the specific production process, the only possible way of realizing production of A is to first produce the necessary intermediate goods such as tools and machinery, and then, at a later time and using the intermediate goods, produce A. To make this happen, P therefore accumulates the resources necessary, gets busy creating the means to carry out the production process, and then produces the end product.
Due to P’s productive endeavor to establish the necessary structure for their envisioned production process, the world now has capital. This capital gives P a competitive advantage in the market by creating a unique production capability (Barney 1995; 1991), which increases in the overall valuable output in the economy. The direct effect of the “advancing capital structure increases the marginal productivity of labor” without requiring an increase in “the labor energy expended” (Rothbard 2004 [1962], p. 578). The capital created is essentially an extension of and therefore facilitates more productive uses of labor. In this sense, the investment creating “non-permanent resources enables us [the market] to maintain production permanently at a higher level than would be possible without them” (Hayek 1941, p. 54, emphasis in original). Overall, P’s endeavor has brought about a situation where the original factors — land and labor — are used more efficiently toward satisfying consumer wants than was the case before. Production has become more roundabout.
The value of this better use of original factors is measured by the subjective valuations of consumers who benefit from this production. As Austrians have known since Menger (2007 [1871]), the market value of the capital produced is derived from consumer benefits. This means the value cannot be established until consumer valuation of the end product has been revealed through market action (purchases of the product). The market value of the produced capital — the indirect means to satisfy consumer wants — is equal to their contribution to the value consumers ultimately place in the consumption good produced (Mises 1951 [1936]; Rothbard 1987).
The temporal sequence of actions within the production process is then exactly the opposite of how its value is derived. Production begins with the extraction of the highest-order goods from their natural state and the production of intermediate or capital goods, and continues through the stages to eventually produce the lowest-order good offered to consumers. Upon consumers’ decision to purchase the lowest-order good at a certain price, the market value of capital goods is established by imputation “upstream” through the higher orders to the highest order and original factors (Menger 2007 [1871]). There can be no capital that is not preceded by production, and there can be no specialized, roundabout production without the existence of capital.
Roundabout Production In the Specialized MarketLet us now turn to analyzing a specialized market economy with existing advanced production structures, as does e.g. Rothbard (2004 [1962]) and Coase (1937). We assume a market with highly specialized production with a capital structure that is well configured to satisfy consumer wants. As capital is heterogeneous, by which is meant that it “is not an amorphous mass but possesses a definite structure [and] is organised in a definite way” (Hayek 1941, p. 6), the capital structure entails both productivity gains and high costs of adjustment. As the market data change, the existing capital structure will be misaligned to real consumer wants. In this sense, the specialized market place is very fragile to (unanticipated) changes.
This problem is partly recognized in the Austrian business cycle theory, but it is scarcely elaborated. Rather, it is acknowledged that the realignment process of the market’s capital structure, from the anticipated and prepared-for market situation to the new and revealed situation, takes time. This is undoubtedly true, and this process is carried out by entrepreneurs (broadly defined), who are “eager to earn profits, appear as bidders at an auction, as it were, in which the owners of the factors of production put up for sale land, capital goods, and labor” (Mises 1998 [1949], p. 335). Time-consuming and costly realignment follows (cf. Williamson 1985, pp. 21–22).
Yet this problem does not arise only when the market process is affected by abrupt and/or unanticipated exogenous change such as the expansion of credit by banks and the subsequent distortion of market prices. In fact, any reconfiguration, elaboration, or expansion of the capital structure, whether as a reaction to changing consumer preferences or as a means toward increased productivity and economic growth, is subject to what we can describe as a “specialization deadlock”: production structure based inertia to which both market actions and actors are subject.
A specialized market consists of production processes that encompass many stages and where the stages are carried out separately by specialized labor operating specialized capital structures configured to facilitate this particular (and perhaps similar) stage. While there may be several uses for specialized capital, each of the uses tends to be highly specific and the capital goods are therefore very limitedly substitutable in the market. To the degree capital traded in the market has undergone a particular transformation by being irreversibly combined into a non-decomposable unique (or uniquely aligned) capital good, there is no existent market for the produced means of production. New capital goods exist in a non-salable state to the degree their uses have no or very limited substitutability and lack obvious substitute uses. Whether or not a market for specialized capital goods emerges depends on the competitive discovery process (Hayek 1978) as entrepreneurs imitate and attempt to surpass the original entrepreneur’s successful production achievement (Bylund forthcoming; 2011).
While the uniqueness of particular capital goods in specialized production may severely limit their markets (both in terms of demand and supply), this may not constitute more than a temporary problem. The problem emerges as specialized capital is utilized in roundabout production processes under intensive division of labor. Assuming a market with entrepreneurs alert to and ready to adjust errors and misalignment through arbitrage (Kirzner 1973), and therefore an equilibrating market process, the market should soon approach stasis.
Entrepreneurs, eager for profit, will bid for capital and labor factors that they perceive to be undervalued or in otherwise suboptimal use. Provided entrepreneurs do not commit more errors than successful adjustments, and provided consumer preferences do not frequently, radically, and unexpectedly change, a market without innovation has limited opportunity for growth and productivity increase. In fact, even allowing for innovation of capital goods, which can be usefully thought of as finding new productive combinations of land factors and existing capital (Schumpeter 1934 [1911]), will not facilitate economic growth through productivity increases unless there is also a corresponding intensification in the division of labor. As Mises (1998[1949], p. 164) notes,
The division of labor splits the various processes of production into minute tasks, many of which can be performed by mechanical devices. It is this fact that made the use of machinery possible and brought about the amazing improvements in technical methods of production. Mechanization is the fruit of the division of labor, its most beneficial achievement, not its motive and fountain spring.
The truthfulness of the temporally dependent order in Mises’s claim can easily be shown, as we shall see in the next section.
The Specialization DeadlockConsider the specialized market in the previous section. Assuming the market is minimally regulated and therefore without artificial barriers of entry, we can assume with Rothbard (2004 [1962], p. 369, fig. 41) that the rate of interest income for capitalist investments in each production stage will be approximately the same. Entrepreneurial arbitrage will see to it that this holds true within one production process as well as across parallel, competing processes. Alert entrepreneurs will discover and correct through arbitrage any “errors” revealed by above-normal returns in any process or stage. Profitable (successful) undertakings tend to be imitated and loss-generating (unsuccessful) are abandoned by entrepreneurs eager to earn profits, which suggests an equilibrating process consisting of continuous adjustment through correction (Shane 2003). This, in turn, suggests that markets are effectively created for specific capital goods utilized in production processes as entrepreneurs set out to imitate and emulate processes that earn profits (Stigler 1951; Bylund 2015). The economy in this sense functions as a continuous “discovery process” where competition for profit is the driving force toward better alignment between the totality of the production structure and consumer wants (Hayek 1978).
Along the lines of this reasoning one can develop a theory of strategic management based on the resources used within the firm, as has been done by Barney (1986; 1991) and others. The incentive of any firm (or rather, its owners and management) is here to strive for including and utilizing as rare and unsubstitutable resources as possible that are still valuable in production. The rarer and less substitutable (and imitable) the resources, the longer a firm can stay ahead of its competition and earn above-normal profits — competitors are simply unable to emulate the capital recipe of success. But it should be noted that while this competitive advantage may last for some time due to the unavailability of necessary resources for competitors, it will eventually be undermined by the discovery of better processes or alternative implementations of the same process.
The reason for this is that capital goods are produced and non-permanent. Even in situations where a certain capital good cannot be imitated or emulated (however unlikely this scenario is), it must be reproduced when it is used up or expired. The serviceability of capital can be extended through investments in maintenance, upkeep, and repairs. Still, capital is ultimately consumed during the production process, which means the owner of a unique capital good used in profitable production must at some point invest to extend its productive life. In a specialized market economy, any such reproduction must to some degree depend on the availability of market for materials, parts, etc., — the higher-order goods used in production of the capital good. It is therefore an impossibility that a certain resource combination — a particular capital good — is non-reproducible over time.
But even so, as Mises shows in the quote above, capital is ultimately dependent on division of labor preceding its development and use. Only through the splitting of tasks can capital goods be (1) innovated and (2) utilized in new processes. The former holds true simply because new specializations (that is, a more intensive division of labor) are necessary in order to produce a new type of capital good, at the very least in the tasks of combining factors or configuring an existing capital good. The latter is illustrated by Mises’s example of mechanization of the minute tasks that are made into separate tasks only through the splitting of existing, more broadly defined, tasks.
Consider a production process in our previously assumed specialized market that is dedicated to the production of bread. It consists of the following division of labor: a farmer produces wheat, a miller produces flour, and a baker produces and sells the bread. Each stage uses capital: the farmer uses a plow in the spring and sickle in the late summer, the miller uses milling stones, and the baker uses an oven. One can imagine making this process more roundabout through the innovation of new capital goods to support either of the stages, e.g. a tractor for the farmer or a blender for the baker (Böhm-Bawerk 1959 [1889]). But no such capital can be made available for the farmer or baker without an innovative entrepreneur figuring out the full production process for that specific capital good. This amounts to a much greater undertaking than the error-correction type of arbitrage provided by Kirznerian entrepreneurs (Kirzner 1973; 2009).
An alternative is to make the bread-producing process itself more roundabout through the insertion of more narrowly specialized labor: splitting a task into several (Smith 1976 [1776]; Bylund forthcoming). The splitting of a task is different from simply “adding” labor power. The farmer can “hire” labor workers to carry out the same tasks as he is already carrying out, which increases output through increasing the volume of labor being used in the process. As these workers need to be paid — and likely monitored (Alchian and Demsetz 1972; Williamson 1993) — it is not obvious that this is a profitable investment for the farmer. Where an increase in the number of workers leads to diminishing returns, the farmer is likely to make a loss on invested funds.
The alternative is to engage in intensifying the division of labor, which, as suggested in the Mises quote above, entails taking an existing task and dividing it into a number of more narrowly defined tasks. In the case of the bread production process, this amounts to replacing one of the existing stages with several new and separate tasks in the same way a hypothetical original production process was split from self-sufficiency toward specializations in farming, milling, and baking.
Where a market stage already consists of easily separable tasks, such as the plowing, sowing, watering, and harvesting of farming, specialization may not be more than a minor change. For instance, a farmer having hired labor workers may assign specific tasks to different workers and thereby simplify specialization. This must be preceded by increased density of labor factors (Durkheim 1933 [1892]) and can be facilitated by coordination through centralized ownership (Stigler 1951). As this type of “marginal” or incremental specialization can be rather easily brought about, it may not constitute an economic problem of production. In fact, such productivity-increasing measures should be easily discernible for the actors themselves: we know that “work performed under the division of labor is more productive than isolated work and that man’s reason is capable of recognizing this truth” (Mises 1998 [1949], p. 144; emphasis added). This is not a division of labor as much as it is a rational (re)allocation of labor input across already existing chores. But this means it also cannot constitute a problem for competing farmers, who as (or even more) easily can institute this type of division of labor by imitation or emulation. So we may, for the sake of simplicity, assume that such comparatively simple opportunities have already been exploited. Indeed, we can think of the inefficient use of laborers on the farm as an “error” to be corrected by the alert farmer.
This leaves the type of disruptive specializing that suggests a new production sub-process to replace a commonplace and standardized task carried out by market actors. We can now begin to discern the problem, since all the “low-hanging fruits” in terms of productivity-increasing allocative measures are easily exploitable and so should tend to already be exploited. What remains is the unintuitive or highly coordinative task-splitting that requires foresight, investment, and perhaps development of new types of capital goods to be realized. Add to this situation how within-stage (horizontal) competition should tend to standardize the procedures used and therefore effectively produce market standards around best practices. This is the process through which markets are created, which was explained by Stigler (1951). While the market may not reach a general equilibrium, it can easily be seen how its competitive process brings about standardizing at the production possibilities frontier. At this point, further specializing should seem unattainable if at all advantageous — much like splitting the task of “driving a taxi” into the more specialized tasks of driving straight, driving around corners, and going in reverse.
Further advances in productivity requires the adoption of a more intensive division of labor — the further splitting of existent tasks — and the use of (new) capital to replace labor with automatic execution of newly identified and separated “minute tasks.” The market, in other words, finds a state of rest in the sense of a highly restricting inertia — if not impossibility — of adopting further productivity-increasing measures. Specialization cannot go further through incremental adoption of better utilizations of labor. Whether or not market actors have exhausted all opportunities for further incremental improvements to production processes, the market is in a specialization deadlock.
Breaking Free From the Specialization DeadlockSo far we have considered production in the market: while not all actions necessarily take place independently and under the price mechanism, we noted how markets are generated as new production structures are imitated by competitors (Stigler 1951; Bylund 2011; forthcoming). For all tasks carried out in an economy’s production apparatus, therefore, there is semi-standardization within the limits of substitutability where the price mechanism is applicable. In other words, there is a tendency toward standardization of best practices through competition as improvements are all but universally implemented through profit-induced imitation in the open market.
So far we have not made any assumptions about who brings about or profits from the adjustments made in the market. The reason for this is that opportunities for incremental changes to the production structure are neither difficult to discover nor to implement or observe /imitate. This suggests the function of adjustment can be carried out by most or all market actors and without much foresight, coordination or investment. Indeed, the farmer who hires labor workers and assigns different responsibilities to them is engaging in (a weak form of) specialization and division of labor, but in such a mundane fashion that it is of little analytical importance. These tasks were already carried out — they may even have been identified as separate such — and the increased density due to increased volume of available labor facilitated an “obvious” opportunity for “specializing.” Rather than each labor worker switching between the same or similar tasks, each worker could save time and energy by streamlining their work and so focusing on a single or only a few tasks serially divided among them (Smith 1976 [1776]). This type of improvement in productivity is, indeed, within the limits of man’s capability of reason. In fact, we might expect the common worker, knowledgeable of the production process as well as the “particular circumstances of time and place” (Hayek 1945, p. 521), to identify and act to implement such productivity-increasing measures.
But this only augments our perception that the specialization deadlock is an economic problem. It should furthermore be an increasing problem as a market becomes more intensely specialized, since specializing increases heterogeneity and therefore lowers the overall density of workers carrying out similar tasks in the market place. As opportunities for specializing are exploited, taking specialization even further may necessitate much less obvious changes — and coordination. So far in our discussion, we have not included more than minimal coordination in the market place, primarily through the price mechanism and simple agreements.
Consider the case of the tractor noted above. In order to provide a tractor in this market, actors need to break free from the specialization deadlock. This is a problem of innovation, coordination, and capital investment, since it includes the insertion of a new productive sub-process to produce a higher-order good (the tractor) to be used in farming. This sub-process requires its own division of labor to carry out tasks specific to tractor production. In this case, this is a novel process the tasks of which may not have been more than limitedly known. But this need not be the case: we can easily imagine splitting the existing tasks into several independent subtasks. The solution is however found to be the same: innovation, coordination, and capital investment are necessary for the implementation and thus realization of the new tasks and thereby the more roundabout production structure.
It is not within the scope of this chapter’s discussion to specify the exact nature of implementing such improvements to the production structure. This has been done elsewhere (Bylund 2011; 2015; forthcoming), so it should therefore be sufficient to point out that this is the role of the innovative and imaginative entrepreneur. But it should also be noted that there can be no blueprint for the implementation (realization) of such novel production processes that introduce a radically intensified division of labor since their functioning is strictly unknowable — detailed information about the intricate workings of a previously unseen sub-process is revealed only through its implementation process. For this reason, the entrepreneur can only guide the project and must rely on the decentralized problem-solving or proxy-entrepreneurship of employed workers (Foss, Foss and Klein 2007). This appears to require an integrated production structure, which is commonly referred to as a firm.
Implications for Economic TheoryWhat has been drafted above suggests that production theory is incomplete without both capital theory and entrepreneurship. This may appear obvious to Austrians, but the entrepreneurship aspect appears often missing or lacking in discussions on capital theory. Rothbard’s discussion on production theory in Man, Economy and State can serve as an illustrative example.
Rothbard here provides a groundbreaking discussion on production theory, but his discussion on the effect of saving on the economy’s production stages is severely lacking. Increased saving, states Rothbard, shifts “investment further up the ladder to the higher-order production stages.” And further: “Simple investigation will reveal that the only way that so much investment can be shifted from the lower to the higher stages … is to increase the number of productive stages in the economy, i.e. to lengthen the structure of production” (Rothbard 2004 [1962], p. 519, emphasis in original). Perhaps this is a necessary conclusion, but as we have seen in this chapter, increasing the number of production stages implies the splitting of tasks and, essentially, breaking free from the specialization deadlock of the existent capital structure. We can hardly assume that this process is automatic or immediate (and it is of course unlikely that Rothbard would rely on such an assumption).
But even if we allow this process to be time-consuming, any production process must already encompass a full-length process with stages covering the production distance from virgin land to consumer. A more roundabout production process does not add stages to the “top,” but must split a stage into several or insert a new sub-process in-between or to assist existing stages. This has implications for the income accruing to factors and capitalists involved in each stage, since a “local” intensification of the division of labor by splitting one stage into many necessarily disrupts production.
Rothbard seems to assume a preexisting market for each production stage, which suggests standardization and substitutability throughout the market and thus somewhat accurately determined market prices. From the perspective of Rothbard’s discussion, it may not be limiting but useful to rely on analytical aggregates and talk of “readjustment.” But “readjusting” the production structure to new levels of saving is a much messier process than the type of arbitrage-like allocative adjustment we discuss above — and much messier than is shown in Rothbard’s analysis. Changes to the length of the production structure means the structure is disrupted by an imaginative entrepreneur, which has implications throughout the “intricate, delicate, interweaving structure of capital goods” (Rothbard 2004 [1962], p. 967). It is insufficient and potentially misleading to assume changes in the savings rate reallocates “capital” within the production process (and therefore across the production apparatus’ existing stages). More realistically, productive investments can fundamentally change production processes by splitting or inserting stages, and this can bring about important changes to the economy’s capital structure.
It is furthermore insufficient to treat the entrepreneur as simply the discoverer of price discrepancies who then acts to shift factors from one production process to another to better account for their “real” value (Rothbard 2004 [1962], p. 511; cf. Kirzner 1973; Sautet 2000). As Rothbard (2004 [1962], pp. 858–59) puts it:
to view entrepreneurship as simply the founding of new firms is completely invalid. Entrepreneurship is not just the founding of new firms, it is not merely innovation; it is adjustment: adjustment to the uncertain, changing conditions of the future. This adjustment takes place, perforce, all the time and is not exhausted in any single act of investment.
But as we saw above, while adjustment takes place “all the time” it can and does take place within the limits of the existing division of labor intensity; “adjustment” is unable to deal with the specialization deadlock and therefore excludes disruptive innovation. In other words, it does not include “breaking free” from the deadlock through revolutionizing the production structure, which necessitates realizing an innovative splitting of tasks — which in turn requires integration (a firm) (Bylund 2015). Entrepreneurial adjustment ensues upon and as a consequence of disruption, but it is limited to corrections given the existing production or capital structure and incremental improvements to it.
In this sense, we have drafted a scope for entrepreneurship with the help of capital and production theory that both confirms and challenges Rothbard’s analysis. It confirms Rothbard’s focus on adjustments, which are carried out “all the time” through the market’s competitive discovery process and “is not exhausted in any single act of investment.” This can potentially be seen as a “Kirznerian” type of entrepreneurship (Kirzner 1973; 1979; 1999; 2009). Yet Rothbard, by not including the type of disruptive entrepreneurship that can be found in e.g. Schumpeter (1934 [1911]), sees no significance in organization or its function in the market. He therefore does not recognize the causal relationship between the division of labor and the creation of capital that Mises notes and that we here found to suggest a solution to the interlocking compatibilities of the production structure that we refer to as the “specialization deadlock.”
In fact, it appears Rothbard in Man, Economy and State fails to recognize the great importance of the division of labor for production and capital theory as well as for the evolution of society. This chapter attempts to show, in line with Mises’s view (Mises 1998 [1949]; Salerno 1990) as well as Rothbard’s later and more astute understanding (Rothbard 1991), how the importance of the division of labor hardly can be exaggerated, but that it in fact can be used to explain the process of capital creation.
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InXavier Méra holds a PhD in economics from the University of Angers and teaches at IÉSEG School of Management in Paris, France. I was a Mises Institute research fellow in 2009, 2010 and 2011, and would like to thank Professor Salerno, my fellow research fellows and the Institute staff and faculty for making these experiences enjoyable and intellectually rich. I am especially indebted to the Institute’s and research program’s donors, without whom none of this would have been possible. This chapter is an extension of a paper originally developed with the help and encouragement of Professor Salerno while a summer fellow. Thanks to Simon Bilo and Per Bylund for their thoughtful comments on a previous version. 2009, I had for the first time the opportunity of participating in the Mises Institute summer fellowship program under the guidance of Professor Salerno. On this occasion, I worked on an article touching upon the theme of monopoly price theory, a shared research interest of ours (Salerno 2003, 2004). My goal was to focus on how the pricing of factors of production is affected when their products are sold at monopoly prices (Méra 2010).
Now, the very nature of the issue at hand required to take a “long run” perspective since it concerns the production decision point, a decision which must be made by some capitalist-entrepreneur in anticipation of its future returns. Because of this focus, I noticed in the course of my research that Ludwig von Mises and Murray Rothbard tend to emphasize the same requirement for a monopoly price to emerge, as far as the demand schedule for the monopolized good is concerned, in the long run and in the “immediate run” (when the good is already available).
This is problematic because, as I intend to explain below, their criterion of a seller or a cartel of sellers facing an “inelastic demand” above the “competitive price” (Mises) or the “free-market price” (Rothbard) is only required in the immediate run. This has consequences in regard to the question of the limits to monopoly pricing, a question that Rothbard (1962, pp. 680–81) briefly but explicitly deals with in his “A World of Monopoly Prices?” section when he asks “Can all selling prices be monopoly prices?” He also provides insights outside of this section which also have direct implications for that question. Most notably, he explains that the very concept of a monopoly price makes sense only as a byproduct of interventionism, arguably an improvement over Mises’s theory. Nonetheless, Rothbard’s take, as well as Mises’s, suffers from this issue of the inelastic demand criterion and related weaknesses that I intend to highlight and repair below. Since these shortcomings happened not to be decisive for the article I worked on under Professor Salerno’s supervision, I had left them at that.In Méra (2010), my remarks in relation to the issue of the inelastic demand criterion are confined to footnotes. The present article essentially elaborates on these remarks. It seems appropriate then to deal with them here.
I begin with a brief summary of Rothbard’s view of monopoly prices as a hampered market phenomenon only. I interpret this modification of Mises’s monopoly price theory in the following way: the limits to monopoly pricing are shown to be narrower than what Mises thought. In other words, there is less room for monopoly prices to emerge in a market economy than Rothbard’s mentor considered.
Then I explain how, on the other hand, the ambiguous treatment of the inelasticity of demand criterion in Mises and Rothbard’s analysis leaves less room for monopoly prices than there really is. Although in contrast the modern neoclassical theory’s treatment of monopoly avoids the same ambiguity and its consequences, I show that the reason is accidental and that this should not be mistaken as a sign that it provides a superior alternative.
Finally, the main theory and policy implications of our findings are stressed: if there can be monopoly prices without inelastic demand schedules above free market prices, the price distortion potential of monopolistic privileges is more important than what Rothbard envisages. It becomes then all the more urgent to refrain from granting them if one wants to spare the bulk of consumers from the effects of factor misallocation.
Re-Thinking the Limits to Monopoly Pricing: Rothbard’s ContributionIn relation to Mises’s exposition of monopoly price theory, Rothbard’s central contribution is to show that the dichotomy between a competitive and a monopoly price is illusory in a free market framework. The movement from a competitive price to a monopoly price and the movement from a sub-competitive price to a competitive price are indistinguishable, for instance. The most fundamental reason is that the seller is in the same position vis-à-vis the demand schedule, whatever case one considers. All that we know based on Mises’s praxeology is that, nonmonetary factors aside, the seller will try to obtain a price above which the demand schedule is elastic. This is true when he can obtain a monopoly price. But this is true as well as when he can only charge a competitive price. Otherwise, he would charge a higher price. In other words, both prices appear to be distinguishable only if one arbitrarily postulates that a certain price is competitive so that a higher price can be considered as a monopoly price if the seller can increase his monetary income or net revenue by selling the good at this higher price. Absent an independent criterion to conceive of this competitive price, the whole dichotomy fades away (Rothbard 1962, pp. 687–98). If one cannot distinguish between two things, they are essentially the same.O’Driscoll (1982, pp. 190–91) argues that “a distinctively Austrian theory of monopoly remains to be written” and more specifically that “Murray Rothbard and Dominic Armentano, present a distinctive theory with roots deep in the history of economics and with strong affinity to the common-law treatment of monopoly. Their theory is not, however, the outcome or development of any particular Austrian insight.” However one might argue that Rothbard’s take is distinctly Austrian in its realization that the usual dichotomy of a competitive and a monopoly price in a free market is an anomaly in the context of Mengerian price theory (as developed by Mises). After all, Rothbard’s point is that the competitive price benchmark in a free market cannot be derived from the fundamentals of action. As a consequence, it appears as a foreign element forced into the theoretical edifice.
On the contrary, there is an identifiable criterion providing the basis for such a distinction once one contrasts actions occurring in a free market framework with actions occurring while some potential sellers are excluded from the market under threats of or outright aggression. As Rothbard (1962, p. 904) puts it:
We have seen above that on the free market, every demand curve to a firm is elastic above the free-market price; otherwise the firm would have an incentive to raise its price and increase its revenue. But the grant of monopoly privilege renders the consumer demand curve less elastic, for the consumer is deprived of substitute products from other potential competitors. Whether this lowering of elasticity will be sufficient to make the demand curve to the firm inelastic (so that gross revenue will be greater at a price higher than the free market price) depends on the concrete historical data of the case and is not for economic analysis to determine.
In other words, one can conceive of a monopoly price, as compared to a free market price, because the demand schedules that remaining sellers face are altered. These sellers are then not in the same position vis-à-vis these demand schedules than they would be when anyone has the right to compete with them. They will then be able to charge a monopoly price if the demand schedules they now face, independently or together as a cartel, are inelastic above the free market price, which is only possible if the market demand schedule is inelastic above the free market price (Rothbard 1962, p. 674).If the grant of privilege is given to one seller only, then the demand schedule he now faces is the market demand schedule.
Now, these simple yet profound insights mean the following, in relation to the question of the limits to monopoly pricing. If Mises and all the writers who have claimed that monopoly prices could arise in a free market framework have been mistaken here about their nature, they have underestimated the limits to monopoly pricing in society. Rothbard’s contribution — recasting the theory of monopoly price as part of a theory of interventionism — implies the claim that the scope for monopoly prices is narrower than what Mises thought.It was quite narrow already as compared to the views of some of Mises’ predecessors (Salerno 2003, pp. 60–62). Indeed there was no doubt for Mises that government is by far the main source of monopoly prices (Mises 1949, p. 363).
The Overlooked Case of Monopoly Prices with Elastic Demand SchedulesEven if one endorses Rothbard’s contribution, one might nevertheless argue that there is more room for monopoly prices than he thought. To understand this, one must focus on some condition required for a monopoly price to emerge that both Rothbard and Mises have repeatedly stressed in their writings on the topic. The above quote displays this condition. The demand schedule that the holder of a monopolistic privilege faces must be such that above the free market price (or the competitive price, for Mises), one or several prices bring in more revenue. This is the “inelasticity of demand” criterion. The implication is that monopoly pricing in society is limited to the extent that demand schedules are elastic in the relevant ranges. For Rothbard then, the less goods there are for which people are eager to increase their expenses on above their free market prices, the less room there is for monopoly pricing, no matter how effective the grants of privilege are at hampering competition.
There can be no quarrel with this as long as one takes an immediate run perspective in which the goods to be sold or withheld from the market are readily available. Matters are different however once one focuses on the production decision points, when people try to maximize net income and not necessarily gross income. Increasing one’s net income by restricting one’s production of a good is possible even if one faces an elastic demand schedule above the free market price, provided that one’s average production expenses fall at a high enough pace (or rise slowly enough). All that is really required is that total expenses fall more than total income. The decisive consideration is not inelasticity of demand. If it remains of course a factor of emergence of monopoly prices, it is not a necessary criterion anymore. The limits to monopoly pricing are not as narrow as what Rothbard suggests.
Mises and Rothbard’s Conflation of the Immediate Run and the Long RunNow the reader familiar with Mises and Rothbard’s writings might ponder. These authors did not forget to take production expenses into account in their discussions of monopoly prices, did they? To be sure, they did not. The point is however that Mises (1944), Mises (1949) and Rothbard (1962) never explicitly recognize that the inelasticity of demand criterion needs to be qualified once production is taken into account. In these expositions, they tend to jump from an immediate run to a long run perspective and vice versa without saying so. As a consequence, inelasticity of demand for the product appears to be a required criterion even when the analysis focuses on the production decision point.
For instance, in the paragraph following the above quote, Rothbard (1962, p. 904) mentions the restriction on production and the inelasticity criterion in the same breath, as if maximizing gross income still was the relevant consideration for the monopolist at the production decision point:
When the demand curve to the firm remains elastic (so that gross revenue will be lower at a higher-than-free-market price), the monopolist will not reap any monopoly gain from his grant. Consumers and competitors will still be injured because their trade is prevented, but the monopolist will not gain, because his price and income will be no higher than before. On the other hand, if his demand curve is inelastic, then he institutes a monopoly price so as to maximize his revenue. His production has to be restricted in order to command the higher price. The restriction of production and higher price for the product both injure the consumers.
Here the restriction of production comes as an afterthought, once one has considered which price would maximize gross income. Or, earlier, Rothbard (1962, p. 672) introduces the theory of monopoly price by quoting a passage of Human Action in which Mises focuses on the production decision point:
If conditions are such that the monopolist can secure higher net proceeds by selling a smaller quantity of his product at a higher price than by selling a greater quantity of his supply at a lower price, there emerges a monopoly price higher than the potential market price would have been in the absence of monopoly.
This is compatible with an elastic demand. And yet, Rothbard immediately adds, as if it was no different:
The monopoly price doctrine may be summed up as follows: A certain quantity of a good, when produced and sold, yields a competitive price on the market. A monopolist or a cartel of firms can, if the demand curve is inelastic at the competitive-price point, restrict sales and raise the price, to arrive at the point of maximum returns. If, on the other hand, the demand curve as it presents itself to the monopolist or cartel is elastic at the competitive-price point, the monopolist will not restrict sales to attain a higher price. [Emphasis in the original]It is not without justification then, that Armentano’s summary of Rothbard’s position conflates the immediate run and the long run: “It has been common, of course, to speak of monopoly price as that price accomplished when output is restricted under conditions of inelastic demand, thus increasing the net income of the supplier.” (Armentano 1978, p. 103). See also Armentano (1999, p. 48) and Armentano (1988, p. 8). See also Costea (2003, pp. 47–48) and Costea (2006, p. 45) describing Mises’s position in the same way.
Similarly, in Human Action, the required condition of the inelastic demand for a monopoly price to emerge is defended, and then production considerations are added with no qualification of the criterion. The initial requirement reads as follows:
The reaction of the buying public to the rise in prices beyond the potential competitive price, the fall in demand, is not such-as to render the proceeds resulting from total sales at any price exceeding the competitive price smaller than total proceeds resulting from total sales at the competitive price. (Mises 1949, p. 355)
Then he starts discussing the problem of resource allocation and production expenses. As a consequence, “net proceeds” (Mises 1949, pp. 357, 358, 359, 374) now become the relevant consideration, as they should. And yet, no mention is made of the fact that the previously stated requirement is not strictly valid anymore when he later refers to a “propitious configuration of demand” (Mises 1949, p. 370).
In Mises (1944), the same ambiguity is to be found in an even more pronounced way because Mises shifts back and forth from the immediate run to the long run perspective. First, Mises (1944, p. 2) posits the inelasticity of demand criterion with a numerical example. Given an existing stock of a good, the monopolist does not restrict his sales because demand is such that the total proceeds diminish at any higher price than the competitive one: “If a rise of the price above the competitive price results in a more-than-proportional restriction of the quantity bought by the public, the total proceeds of the seller would drop.” In the next paragraph, he switches to the long run perspective by considering the problem of the allocation of factors and then explains that,
… if some special barriers prevent other people from competing with the monopolistic sellers, a restriction of the production of copper or shoes that does not comply with the demands of the consumers becomes possible. Although the consumers are ready to pay for additional quantities of copper or shoes at prices which would render an expansion of production profitable on a competitive market, the sellers, sheltered by monopoly, do not expand production if they are better off under a state of affairs which results in a higher income for them with curtailment of production. (Mises 1944, p. 2)
Notice how Mises speaks here of mere “income” and not “net proceeds,” despite the fact that he is considering the production decision point. And on the next page, he comes back to the immediate run inelasticity of demand requirement. Both the immediate and long run perspectives are in effect conflated.Klein (2008, p. 177) has noticed that in his general discussion of price determination, “Rothbard (1962) is somewhat imprecise in distinguishing among equilibrium constructs.” We might add that this is true of Mises too, at least in the context of monopoly price theory, as illustrated above. On the distinctions between a “plain state of rest” (PSR), a “final state of rest” (FSR), the intermediate “Wicksteedian state of rest” (WSR) coined by Salerno (1994), and an “evenly rotating economy,” as a complete set of precise equilibrium constructs, see Klein (2008, pp. 172–83). Rothbard’s “immediate run” (PSR) and “long run” equilibriums (FSR) that we have been using here are sufficient for our present purpose however. It does not fundamentally alter Rothbard’s discussion and our analysis here if one interprets them in terms of WSR and FSR instead, since the PSR and the WSR are both about decisions to be made regarding some already produced goods. As one consequently fails to consider the case of a monopoly price with an elastic demand schedule, one narrows the limits to monopoly pricing too much (beyond Rothbard’s reduction to cases of interventions).
Surprisingly enough, given the evidence of conflation that we have shown, it turns out that in one instance Mises has implicitly considered the case of a monopoly price with an elastic demand. Mises (1944, p. 7) draws a table with hypothetical figures showing slightly decreasing average expenses as production expands. There are four prices considered, 5, 6, 7 and 8 monetary units per unit of product and a higher price always implies lower proceeds: the demand is elastic on whatever range we consider above 5, which Mises declares to be the competitive price. According to the inelasticity criterion, there is therefore no room for a monopoly price. But Mises writes that “the monopoly price most favorable to the monopolist is 7” (6, 7 and 8 are monopoly prices)! The reason of course is that, given the figures he chooses, the expenses required diminish more than the proceeds when one reduces the scale of production. Nevertheless, he does not mention explicitly that this is a case of a monopoly price with an elastic demand while, as shown above, he conflates the relevant required criteria for the immediate and the long run perspectives in the same article.
Rothbard too implicitly recognizes the case of a monopoly price with an elastic demand somewhere. In Power & Market, he reproduces an extract from Man, Economy, and State which claimed that an inelastic demand schedule is required for a monopoly price to arise. It is repeated word for word except for one added qualification: “The monopolist, as a receiver of a monopoly privilege, will be able to achieve a monopoly price for the product if his demand curve is inelastic, or sufficiently less elastic, above the free-market price” (Rothbard 1970, p. 44, emphasis added). Inelasticity is not a necessary requirement anymore. He does not explain the addition of the “sufficiently less elastic” criterion but one can certainly see that it makes perfect sense, in light of Mises’ example above and our comments.
To avoid conflation, one can explicitly refer to the two decisions points and thereby disentangle the two required criteria. Kirzner’s exposition comes closer to this than Mises’ and Rothbard’s (Kirzner 1963, pp. 265–96) and is arguably superior in this regard. Another is to call the immediate run and the long run monopoly prices differently. This is, as Salerno (2003, p. 31) notices, what Fetter (1915, pp. 80–81) does, writing of a “crude monopoly price” when the sale of an already produced stock of a good is considered, and of a mere “monopoly price” for a good when its production is considered. Then it can be easily grasped that a crude monopoly price requires an inelastic demand schedule above the free market price, whereas a mere monopoly price does not.
The Trouble with Rothbard’s Falling Costs ProvisoThe lack of a clear-cut explicit distinction in Mises and Rothbard’s analysis between the immediate run and the long run can lead to some further confusion. If one ignores the case of a monopoly price with an elastic demand, it is difficult to make sense of Rothbard’s proviso, according to which a monopoly price will arise when one is striving for maximum net proceeds, “whatever the actual configuration of money costs, unless, indeed, average money costs are falling rapidly enough in this region to make the “competitive point” the most remunerative after all” (Rothbard 1962, p. 674).
The reason is the following. For the “competitive point”Rothbard speaks of a competitive point instead of a “free market point” because the context is his discussion of Mises’ theory. The reader must not get confused by this. This discussion is relevant in Rothbard’s framework once the theory is fixed and depicts how a monopoly price actually contrasts with a free market price instead of a “competitive” price. As Rothbard (1962, p. 903) puts it in his chapter on interventionism and socialism: “In chapter 10 we buried the theory of monopoly price; we must now resurrect it. The theory of monopoly price, as developed there, is illusory when applied to the free market, but it applies fully in the case of monopoly and quasi-monopoly grants.” to yield a higher net return than the restrictive alternative with an inelastic demand, it would be necessary that expenses fall in absolute terms when one increases production, not merely on average, since gross income falls when one expands until the free market point (by definition of the inelasticity of the relevant range of the demand schedule). But this is impossible. Average expenses might fall when production is increased, because of the indivisibility of some factors of production. Total expenses cannot. If the producer-seller will face an inelastic demand for his product in the future, restriction must pay whatever the configuration of expenses is. And believing that a proviso is required here amounts once again to an unjustifiably narrow view of the limits to monopoly pricing.
The proviso makes sense only once one recognizes the possibility of a monopoly price with an elastic demand. In general, the higher the average expenses become as production expands, the more likely it is that cutting production below the free market level pays. Hence the case of a monopoly price with an elastic demand, provided that average expenses become low enough when one reduces production below the free market level (“low enough” meaning that total expenses fall at a faster pace than total receipts in order for net proceeds to rise). In other words, the more they rise instead, or fall at a slow pace, the less likely it is that net proceeds will be higher at a lower level of production, the more chances there are that the free market level of production is the most remunerative. But this possibility arises only when the demand is elastic above the free market price. When doing less brings in more gross revenue, restriction in the monopolized industry always pays. Any other conclusion unduly narrows down the limits to monopoly pricing.
The Current Textbook Treatment as a Superior Alternative?It could be argued that the orthodox take on monopoly as found in Arnold (pp. 223–58) or any microeconomics textbook is superior to Mises and Rothbard’s in at least one respect: there is no risk of the sort of conflation we have pointed out here because there is no immediate run analysis to conflate with a long run perspective in its treatment of the issue. In that neoclassical approach, the sellers are producers too, even in the short run. There is no question of what to do with an available stock of a good. There is no reason then for inelasticity of demand to be a distinguishing criterion since monetary profit maximization — and therefore money costs — are relevant considerations in all cases.
Apart from the fact that getting rid of the immediate run is per se problematic since the useful and realistic concept of a crude monopoly price disappears from the picture, the most fundamental reason why inelasticity has no decisive role in that approach is that it is based on different categories with different criteria than the older monopoly price theory. As Caplan (1997) puts it, in modern neoclassical theory,
there is always some degree of monopolistic distortion unless firms face a horizontal demand curve. For unless firms face a horizontal demand curve, a profit-maximizing firm sets its price above its marginal cost. In the absence of perfect price discrimination, this means that there is a “deadweight loss” — or unrealized gains to trade.
In other words, the fundamental distinction here is between “pure and perfect competition” with perfectly elastic demand schedules and “imperfect” or “monopolistic competition” with downward sloping demand curves (“monopoly” being the extreme case in which only one seller would face the market demand schedule).
Turning toward this approach as an apparently more rigorous alternative brings in its whole theoretical apparatus with its weaknesses that Mises and Rothbard have identified. For although Caplan (1997) claims that he affords “all too little attention to the modern neoclassical theory,” Rothbard (1962, pp. 720–22) actually demonstrates that perfect elasticity is impossible since it is not compatible with the always holding law of marginal utility. As a consequence downward sloping demand curves for individual sellers and the corresponding “failure” to equate price and marginal cost are no signs of monopolistic distortion and the marginal cost pricing criterion cannot serve as a realistic criterion to conceive of a competitive price.
It should be kept in mind that the older monopoly price theory does not depend on the benchmark of “pure and perfect competition,” which explains why Mises and Rothbard found something of value in it whereas they entirely dismissed the newer view (Mises 1949, pp. 356–57; Rothbard 1962, pp. 720–38).
Conclusion: Theory and PolicyIs there more to say about the maximum limits to monopoly pricing than the fact that in the immediate run, elastic demand schedules deprive monopolistic privilege holders of opportunities to charge “crude” monopoly prices? Or that demand schedules which are too elastic in relation to average production expenses deprive monopolistic privilege holders of opportunities to charge monopoly prices for their products? According to Rothbard (1962, p. 681), in the aforementioned “A World of Monopoly Prices?” section of Man, Economy, and State, “monopoly prices could not be established in more than approximately half of the economy’s industries,” among other reasons because it is impossible for every industry to face an inelastic demand schedule since buyers cannot spend more in every industry.
Now, as explained above, the inelasticity of demand criterion is only required in the immediate run perspective of deciding what to do with an available stock of a good. As a consequence, if at most half of the economy’s industries could face inelastic demands above their free market prices, there could still be other monopolized industries able to charge monopoly prices provided that their total expenses fall at a rapid enough pace when they reduce production. More than half of an economy’s industries might then charge monopoly prices. The limits to monopoly pricing are then larger when one focuses on the production decision points. In light of our explanations, Rothbard’s neglect of this insight is attributable to his and Mises’s tendency to conflate the immediate and long run perspectives in their expositions.
The implications are straightforward. As far as pure theory is concerned, Rothbard underestimated the impact of granting monopoly privileges on price formation. If monopoly prices can arise without inelastic demand schedules, factor allocation is correspondingly altered to the detriment of the bulk of consumers, beyond the already recognized alteration occurring under the condition of inelastic demand schedules. As far as policy is concerned, it becomes all the more urgent to abolish monopoly privileges, or to refrain from enacting them in the first place, if one wants to minimize factor misallocation.
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ScholarsAmadeus Gabriel is assistant professor in the Department of Finance and Economics at the La Rochelle Business School, France. I was a summer fellow at the Ludwig von Mises Institute as an undergraduate student in 2006, and later as a graduate student in 2011. of the Austrian tradition are particularly known for their important work in the field of monetary economics. They analyze the dynamics of fiat money and its impact on the real economy. However, empirical attempts to support the theoretical claims are relatively rare. In this chapter, I sketch an empirical strategy to test whether a change in the monetary regime has significantly impacted the accumulation of public debt and government deficits in the United States. Government deficits appear to be significantly lower under the gold standard regime and significantly higher under a regime of fiat money after controlling for other explaining factors such as, for instance military expenses or interest charges.
This chapter is structured as follows. Section 2 gives an overview about the nature of money to understand the dynamics of fiat money. Section 3 outlines why the introduction of a fiat money regime potentially increases the accumulation of public debt. Section 4 outlines the econometric model to account for the effects of different monetary regimes on public debt. Furthermore, potential lines of research are provided to improve the explanatory power and robustness of the model. Section 5 concludes.
Monetary Mechanisms and Monetary PolicyAs Mises repeatedly stresses, money is the fruit of indirect exchange (Mises 1980, p. 45). Thus, the emergence of money is spontaneous and becomes necessary as the division of labor increases and wants become more refined (Mises 1980, p. 5). Individuals only choose to have recourse to indirect exchange when the goods they can acquire are more marketable than those which they surrender.
As a result, the most marketable commodities will become common media of exchange and their position is strengthened as their relative marketability increases in comparison to other commodities (Mises 1980, p. 6). The main function of money according to Mises is its universal employment as a general medium of exchange (Mises 1980, p. 7).
Hülsmann (2008) introduces a further distinction between natural and forced monies. Natural money corresponds to money that arose through voluntary actions of individuals which circulates until it is displaced by an external pressure. Alterations to the former type of natural money are defined as forced money. In this case, money no longer complies with individual preferences, but is the result of a welfare reducing imposition. As a consequence, forced monies are per definitionem less socially beneficial than natural monies, as they only exist due to the violations of individual rights. Based on this distinction, it is possible to introduce a further division between credit money and paper money. As Hülsmann (2008) points out, the value of credit money (a claim to money in the future) is based on the trust that the respective sum of money is eventually refunded in the future.
Paper money or fiat money owes its existence to legal privileges. Hülsmann (2008) emphasizes that paper money has never spontaneously emerged as a result of the voluntary actions of individuals. Legal tender laws impose the use of a lower quality paper money at the expense of the natural money. The bad money, i.e., the overvalued paper money, drives the good money, i.e., the undervalued natural money out of the market as their legal equivalence is only due to imposed laws and do not reflect the economic reality. This process is known as Gresham’s law, named after Thomas Gresham (Hülsmann 2008, p. 127). Naturally, this leads to inflation of the overvalued money, “because this money is produced and held in greater quantities than would be the case in the absence of the price control” (Hülsmann 2008, p. 127). The natural limit in money production is distorted as the full consequences are not borne by the money producer. Legally established values are not altered and constraining competitive processes are suspended under legal tender laws. Moreover, Cantillon effects, named after the French economist Richard CantillonSee Richard Cantillon, La nature du commerce en général (Paris: Institute national d’études démographiques, 1997). enforce the enrichment of money producers under the regime of legal tender. As Hülsmann (2008, p. 44) points out, there can be no simultaneous increase of all prices as newly created money enters the market. The first users of the new money have the privilege to use it on goods priced according to the quantity of money that existed before the increase in the money supply. However, the newly acquired purchasing power does not remain unnoticed and spreads out through the economy. Prices eventually adjust upward due to the increased demand of the initial users. The last receivers have not benefited from the new money. To the contrary, they suffer a deteriorated quality of the money and higher price levels.
As Hülsmann (2008, p. 89) argues, debasement was traditionally the way to inflate the money supply. The nominal value of a coin was modified not reflecting the metal content any longer or the content of metal was reduced without an according change in the nominal value. However, debasement reached a whole new level with the emergence of fractional-reserve banking, i.e., the issuance of coins or bank notes which are not fully covered by the available reserves. This significantly reduced the cost of money production. According to Hülsmann (2008, p. 93), there are three main reasons that led to this phenomenon.
In the first place, the warehousing institutions, the original function of banks to the late 1700s, have been perverted. Second, credit banking has been perverted as banks use deposits for loans. Lastly, it was a natural response to the threat of government expropriation. As banks feared that their holdings would be eventually confiscated, they preferred to lend out the funds. However, as individuals eventually find out about the debased monies, it is necessary to guarantee a continual demand through legal tender laws. This privilege is the ultimate explanatory link for all other monetary advantages.
In addition to the outlined factors, the twentieth century witnessed the development of maturity mismatching in the banking sector (Bagus and Howden, 2009), i.e., borrow short and lend long. Nowadays, this is considered as one of the main functions of banks. For instance, Freixas and Rochet (2008) point out that “modern banks can be seen as transforming securities with short maturities, offered to depositors, into securities with long maturities, which borrowers desire.” Necessarily, this implies a certain “risk” for banks if the credits are not covered by corresponding savings of depositors. If depositors require their funds, banks can have recourse to derivatives (such as swaps or futures) or engage into interbank lending to limit this “liquidity risk.” However, this type of risk management is very costly. In a competitive environment where the success of a bank’s business is based on its ability to gain confidence of depositors, the constant mismatching of maturities must be relatively limited. Depositors are not likely to give their money to banks that accumulate negative working capital and struggle to refinance their debt.
To recapitulate, money evolved spontaneously in the market. Historically, gold and silver were chosen as the common medium of exchange for their practical purposes. For reasons of convenience, warehouses arose to store these metals and certificates were issued. As a consequence, certificates were traded in everyday business and rarely redeemed into gold. Unfortunately, this created a temptation to engage into fractional-reserve banking and to issue certificates in excess of the actual gold reserves. At some point, governments entered into the game and monopolized the minting of coins and established legal tenders laws. Under the classical gold standard from 1815–1914, a fractional gold standard was institutionalized and guaranteed by the respective states. As already outlined above, fractional-reserve banking diminishes the cost of money production and increases the profitability of banks. As a consequence, there is a tendency to threaten the financial stability of banks as the continual issuance of credits in excess of savings is eventually discovered by depositors and creditors. Bank runs and the liquidation of assets are naturally the cause as people lose confidence.
The drawbacks of this business model must be resolved by some external institution that guarantees the liquidity of banks. This is the role of central banks (Bagus 2012). Central banks are lenders of last resort for commercial banks. Banks can now refinance their debt through short-term credits and liquidity problems can be limited as the production of money is coordinated by the central bank. However, under the gold standard, even coordinated money expansion was limited by the fear of redemption in a crisis. By the 1970s the burden of the gold standard was removed and the doors were further opened for the lucrative business of money creation.
Monetary Policy Since the 1970s in the United StatesThe abolition of the gold standard on August 15, 1971, led to the establishment of a regime of paper monies for most of the national currencies. Before this date all national currencies were linked to the gold standard via the US dollar. As the US decided to go off gold altogether, the fractional-reserve gold certificates basically became paper money (Hülsmann 2008, p. 223). The new fiat money standard magnified moral hazard at a large scale. Fiat money allows producers of money to “create ex nihilo virtually any amount of money” (Hülsmann 2006, p. 10). The growth of the money supply increased significantly after the decision to go off the gold window. The M3 monetary aggregate grew by 12.42 percent in 1972 in the US, although the average growth rate was about 6.76 percent in the decade before.
Under the regime of William McChesney Martin from 1951 to 1970, monetary policy was relatively conservative. Growth rates of the CPI were below three percent during the early 1960s (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 23). As Martin points out in testimony to the Joint Economic Committee: “the Fed has a responsibility to use the powers it possesses over economic events to dampen excesses in economic activity by keeping the use of credit in line with resources available for production of goods and services.Martin’s testimony to the Joint Economic Committee, February 5, 1957. Cited by (Bremner 2004, p. 123). In 1964, Martin expressed his concerns about increasing inflation as federal spending increased a lot during the second half of the 1960s. Bremner (2004, p. 191) cites a quote by Martin which summarizes his worries: “I think we’re heading toward an inflationary mess that we won’t be able to pull ourselves out of.” Martin expressed in his last press conference that he had “feelings of failure for not having controlled inflation” (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). By 1970, Martin was replaced by Arthur F. Burns. He commenced a period of high inflation and very low real interest rates, a byproduct of loose money now simplified by the full fiat money standard. However, even before the suspension of payment by the Fed in 1971, the federal funds rate was already lowered from 8.02 percent during the first quarter in 1970 to 4.12 percent by the fourth quarter of the same year (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). What are the implications of low or even negative real interest rates? They reduce the incentives for people to save money and at the same time the cost of debt is significantly reduced. Even though federal funds rates were eventually raised during the following years, they never kept up with the running inflation rates and real interest would only be over 2 percent in the second quarter of 1976 (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 26). Thus, during his tenure until 1978, real interest rates were only above 2 percent for three quarters. The Per Jacobsson Lecture on “The Anguish of Central Banking” (Burns 1979) summarizes his views on monetary policy and central banking relatively well. Basically, the upward pressures on prices by interest groups are the real reason for the inflationary policy by the Fed. According to him, the Fed does not have enough power to effectively fight against inflation “as it is illusory to expect central banks to put an end to the inflation that now afflicts the industrial democracies” (Burns 1979, p. 21). After a short intermezzo by Miller whose tenure ended into an emergency sale of US gold and borrowings from the International Monetary Fund (IMF) (Dowd and Hutchinson 2010, p. 251), President Carter moved Miller to the Treasury department and appointed Paul Volcker as the chairman of the Fed.
As a consequence, the federal funds rates increased significantly from 2 percent to 12 percent (Dowd and Hutchinson 2010, p. 251) and real interest rates remained high during the 1980s. Just as Burns, he was also invited to give the Per Jacobsson Lecture, but concluded that inflation had been defeated under his regime. However, as the problem of inflation was apparently controlled, another chairman, Alan Greenspan was appointed. He supported the deregulation of the banking sector under Reagan (Dowd and Hutchinson 2010, p. 252). Greenspan emphasized that inflation must be kept low during his confirmation hearings (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 32), however it took only a few months until this plan was scrapped. Greenspan responded to the stock market crash of October 1987 by cutting interest rates and by declaring that the Fed is disposed to provide “liquidity” in such a case (Fernandez-Villaverde, Guerran-Quintana, and Rubio-Ramirez 2010, p. 32). Later, interest rates were kept low, even as inflation reached 6 percent during 1989–1990. The policy of low interest rates continued until 1994, where the Federal funds yield reached the lowest levels since the 1960s. As a reaction to this inflation scare, interest rates doubled, although Greenspan was reluctant to take this action initially.Board of Governors FOMC Transcripts, February 3–4, 1994, p. 55. However, this led to big losses for many entities that were betting on low interest rates. Most notoriously California’s Orange County defaulted on its debt by speculating with derivatives on low interest rates (Dowd and Hutchinson 2010, p. 53).
By February 1995, Greenspan announced that his policy of increasing rates is over.Testimony to the House Banking Committee, February 22, 1995). Effectively, the money supply growth was 2.6 percent higher than nominal GDP during this tenure. The failure of Long-Term Capital Management in 1998 (Lowenstein 2001) illustrated perfectly the approach which was taken by the Fed by now. Not only was a bailout organized, but under Greenspan interest rates were subsequently cut three times to calm down financial markets. This low-interest policy basically allowed the financial sector to maintain more activity of unsustainable trading activities. Ultimately, this policy fueled the dotcom bubble during which stocks were even more overevaluated than during 1929 (Garrison and Callahan 2003). As a consequence, interest rate raises followed in the year 1999 and 2000 which eventually triggered the bust of the stock market. However, already by 2001, the federal funds rate was lowered again to fight the ongoing recession. Together with the occurrence of the 9/11 terrorist attacks and fiscal policy under the newly elected President Bush, interest rates attained the lowest level since 1961 by the year 2002. From 2002 to his retirement in January 2006, Greenspan kept interest low below 3 percent. This period also witnessed the housing bubble and the closely tied structured finance crisis. The burst of this bubble finally led to the current financial crisis. The following “non-moderate” recession is accompanied by nominal interest rates which are currently approaching zero, while real interest rates are simply negative. The development of the federal funds rate can be depicted as follows in figure 1.
To summarize, ever since the fight on inflation of the early 1980s under Volcker, interest rates have been declining. The most substantial reductions happened in the post-era of the dotcom bubble and as a response to the terrorist attacks of 2001. Likewise, federal funds rate have been lowered to an all-time low to fight the current recession. Monetary policy of the last thirty years substantially reduced the cost of debt and consequently eased the issuance of debt securities in the financial market.
Fiat Money and Public DebtFiat money and legal privileges reduce the natural barriers to the creation of credits. Debts are an easy way to increase the expenses of governments. Furthermore, debts are by far more popular than the alternative, i.e., taxes. However, governments are special debtors as they can have recourse to means of financial repression: “Financial repression occurs when governments implement policies to channel to themselves funds that in a deregulated market environment would go elsewhere” Reinhart, Kirkegaard, and Sbrancia (2011).
There are several measures that increase artificially the demand of sovereign bonds, however the main measure of financial repression is to keep nominal interest rates low through loose monetary policy. It reduces the interest expenses for governments and high inflation reduces the cost of debt at the expense of the creditors. Similarly, traditional investors are more likely to put their money into government bonds as savings accounts are not profitable enough. In the case of negative real interest rates, as witnessed 1945–1980 and since 2007 (Reinhart, Kirkegaard, and Sbrancia 2011), it even becomes a supplementary tax in addition to the redistributive consequences of inflation. Figure 2 shows the evolution of government debt during the phase of positive real interest rates and a sharp increase since 2007 when real interest rates were negative again.
Empirical ImplicationsBuilding upon the theoretical arguments of this paper, it is manifest to test whether public debt and government deficits have, ceteris paribus, significantly increased under a full fiat money standard.
Yoon (2012) shows, using a new recursive method for unit root testing, that the U.S. public debt–GDP ratio was explosive in nature during the sample period. This is an interesting result as a standard unit root test such as an augmented Dickey-Fuller test shows that this series contains an unit root and is therefore stationary (Bohn 2008). As a result, there is no concluding evidence about the properties of public debt in the United States during this period.
Figure 4 suggest that wars played a major role for the accumulation of debt. As Figure 3, Yoon (2012) points out “The War of Independence, Spanish–American War, the Civil War, World War I, and World War II — explain the high debt–GDP ratio in 1791 and the sharp increases in 1812–16, 1861–66, 1916–19, and 1941–46.” By way of contrast, the debt–GDP ratio has generally declined during peacetime periods, with the exception of the Great Depression/New Deal era (1929–39), the 1980s, and the post-1921 period.” Furthermore, the author interprets the exceptional period from the 1980s onwards as a result of the Cold War and the “post-2001 war on terror.”
There might be a potential endogeneity bias for the decision to adopt (or leave) the gold standard or a fiat money standard, which could likely lead to spurious results for our analysis. Basically, this would mean that some underlying factor accounted for both the choice of the monetary regime and the differences in the level of public debt. For example, war times and a suspended gold standard have been highly correlated in history for obvious reasons. However, as Bernanke (2004, p. 16) outlines, those decisions are highly influenced by internal and external political factors so that it is very unlikely to be an issue for our analysis.
Empirical StrategyOne potential empirical strategy has been outlined in Gabriel (2014). As outlined above, there is conflicting evidence about the stationarity of public debt. To overcome this problem, I analyze GDP deficits as the dependent variable for the sample period from 1800 to 2012 (Bohn 2008). In this paper, I use a VAR(2) model which controls for several factors such as military spending to capture the war periods or interest charges to capture the cost of debt.Refer to Gabriel (2014) for the details of the model, where several tests, such as e.g., autocorrelation in error terms, to account for a potential downward bias are provided. The model allows us to make interesting forecasts of how the dependent variable should have evolved during the period of the full fiat money standard (1971 to the present) after controlling for the outlined variables. Figure 4 summarizes the findings of Gabriel (2014).
The red line describes actual data on GDP deficits for the specified period. As described before, the VAR(2) model is applied to the dataset from 1800–1970 to generate a forecast of the how the values should have evolved based on the specified framework. This is the blue line. Finally, the green area corresponds to the confidence interval for the forecast of the VAR(2) model. This graph shows that actual deficits are in general higher (except for the year 2000) than they should be. Thus, the interpretation of this period by Yoon (2012) as a result of the Cold war is not supported by this analysis. The noteworthy GDP deficit figures must be explained otherwise. The theoretical arguments in this chapter make a case that the dynamics of fiat money are a plausible explanation for this observation.
ConclusionAustrian scholars in monetary economics are not tired of pointing out the dynamics of fiat money and their impact on the economy. This chapter attempted to complement their theoretical arguments by providing a short historical overview of monetary policy in the United States. A preliminary empirical assessment provides evidence that the switch to the current monetary regime possibly explains higher GDP deficits after controlling for other factors such as military expenses or interest charges. A more detailed analysis on this issue is left for future research.
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AMatthew McCaffrey is an assistant professor of enterprise at the University of Manchester, Manchester, United Kingdom. I was a summer research fellow from 2008–2013. Professor Salerno served on my master’s thesis committee in 2010, and we have since collaborated on several research projects. This essay was inspired by our work on the history and theory of entrepreneurship, for which Professor Salerno was an invaluable mentor. serious interest in the entrepreneur is often considered a defining characteristic of the Austrian school. This attention is evident in its prehistory, in the writings of Richard Cantillon, Jean-Baptiste Say, and others (Hébert 1985; Hébert and Link 1988), and also in Carl Menger’s foundational Principles of Economics (1871). Entrepreneurship plays a central role in the work of Ludwig von Mises as well, who often referred to it as the “driving force of the market.” However, despite the universal importance assigned to the entrepreneur among Austrian economists, there is still much discussion about what exactly entrepreneurs do, and their precise function in the market economy. The questions involved are often complex and cover a wide range of problems, such as the determination of profit and loss, the role of uncertainty and speculation in the market, and the equilibrating properties of arbitrage, to name only a few. As a result, the various theories of entrepreneurship that have appeared in the Austrian tradition, each of which has its own fundamental assumptions and goals, have been the source of disagreements about economic theory and policy.
One controversial problem that remains to be thoroughly examined is the relationship between entrepreneurial theory and public policy. The relevant questions are: does economic policy have a direct effect on entrepreneurial behavior, and if so, can the study of entrepreneurship inform economists regarding the welfare outcomes of intervention into the market process? Thus far, the conventional wisdom on this subject (and on entrepreneurship in general) has been largely informed by the writings of Israel Kirzner, which have proved quite influential among recent generations of Austrian economists. Kirzner argues that policy interventions remove the incentive provided by pure profits, thereby hampering entrepreneurs’ ability to discover beneficial opportunities in the market. This in turn implies that opportunities for mutually beneficial market exchange are passed over, and interference with entrepreneurial alertness therefore undermines the welfare-increasing properties of the market process, which normally encourages entrepreneurial alertness and discovery.
Given that Austrian economists are often critical of the various economic arguments in support of regulation, it should not come as a surprise that an entrepreneurial theory linking intervention to welfare losses would be readily accepted. However, I argue that the view of entrepreneurship advanced by Professor Kirzner faces serious difficulties when it tries to explain the effects of public policy on entrepreneurship. I suggest that more satisfactory answers to questions of policy can be found by considering intervention through the framework of entrepreneurial calculation and judgment. This approach was pioneered mainly by Ludwig von Mises, especially in his famous dispute over the feasibility of socialism. Mises’s work has in turn been expanded and elaborated by later economists, especially Joseph Salerno, whose contributions to our knowledge of the entrepreneur’s distinct role cannot be overstated (1990a, 1990b, 1993, 2008). The work of economists like Mises and Salerno clearly demonstrates that the calculation-judgment theory is applicable to a wide range of policy problems, and firmly establishes the dangers of economic intervention for the market process.
Entrepreneurial Incentives and Economic PolicyThis section explores the relation between alertness theory and economic policy. The framework for Kirzner’s policy analysis is found in his theory of “entrepreneurial incentives,” developed primarily in his book Discovery and the Capitalist Process (1985).A thorough review of the theory of entrepreneurial incentives is beyond the scope of this paper, which deals only with its application to economic policy. For a more complete exposition, cf. McCaffrey (2014). Entrepreneurial incentives are a way to explain the roots of alertness and their role in promoting opportunity discovery. This is necessary because for Kirzner discovery falls outside the conventional economic presentation of incentives, as I will now explain. A consistent theme in Kirzner’s writings is the contrast between what he calls “Robbinsian maximizing” and entrepreneurial alertness. Robbinsian maximizing is a textbook description of how individuals engage in the weighing of alternatives, perform cost-benefit analysis, and maximize utility.It has been argued that Kirzner interprets Lionel Robbins too narrowly, mistakenly concluding that he is simply an early proponent of the conventional economic approach to utility maximization (Salerno 2009). In other words, Robbinsian maximizing involves individuals perceiving and reacting to incentives in the usual economic sense. However, “ordinary” incentives cannot be used to explain entrepreneurs’ discovery of opportunities, Kirzner argues, because incentives must be known to an actor in order to be incorporated into standard utility calculus. But pure profit opportunities are unknown; they are waiting to be discovered, and therefore cannot consciously play into the cost-benefit analysis of individuals. Alertness to opportunities must therefore be explained by factors other than conventional economic incentives.
Kirzner calls these factors “entrepreneurial incentives.” Entrepreneurial incentives are contained in previously-unforeseen profit opportunities. Unlike ordinary incentives, pure profit opportunities attract the attention of entrepreneurs because it is in the entrepreneur’s interest to notice them (1985, pp. 28–29). Previously-unseen profit opportunities represent potential gains for entrepreneurs, who will be alert to them provided the opportunity is valuable enough. Entrepreneurial incentives are therefore another way of saying that opportunities cause their own discovery. Kirzner calls this conclusion a “paradox,” because it is unclear how such causation could occur:
How, one must surely ask, can an enhancement of the desirability of a particular course of action which by the very definition of this kind of incentive has not yet been noticed inspire its discovery? How can an unnoticed potential outcome, no matter how attractive, affect behavior? How can the attractiveness of an unknown opportunity that awaits one around the corner possibly inspire one to peer around that corner? (1985, pp. 108–09; emphasis in original)
Unfortunately, Kirzner does not resolve the paradox. Instead, he suggests that, although the foundations of alertness require serious investigation, the tendency of opportunities to cause their own discovery is a part of our basic factual knowledge of the economy (1985, p. 109).
Kirzner’s views on the foundations of alertness have already received critical attention (Hülsmann 1997; Foss and Klein 2010; Friedman and Evans 2011), and it has been argued that the opportunity paradox places the alertness theory on insufficient foundations (McCaffrey 2014). Because potential entrepreneurs are prevented by definition from knowing of the existence of an opportunity, and even of searching for it, the causal explanation of alertness must come from some other source, specifically the opportunity itself, and the “open-ended” environment it resides in. The problem pointed out by the critics is that it is logically unsatisfactory to think of unknown opportunities as causing alertness, or helping to “[switch] on the entrepreneurial antennae” (1985, p. 109). Opportunities are not acting agents, and without this key connection between opportunities and discovery, alertness theory runs into difficulty, almost anthropomorphizing opportunities in order to explain how they inspire discovery.
Consequently, this problem carries over to Kirzner’s analysis of economic policy as well, in that the alertness approach does not provide a framework for real-world analysis of the welfare effects of government intervention. Kirzner’s research in entrepreneurship is generally intended to demonstrate the equilibrating and welfare-enhancing properties of the market process, with policy considerations playing a secondary role. Nevertheless, thinking in terms of entrepreneurial incentives is supposed to shed new light on economic policy prescriptions too, explaining how hampering the market process produces inferior welfare outcomes, thus adding vital support to more conventional analysis.
Although economists have developed numerous ways to analyze public policy, many of these are framed in terms of the effects of regulation on ordinary incentives. Kirzner, however, argues that there is danger in thinking only in these terms, to the neglect of the welfare implications of entrepreneurial incentives (Kirzner 1984; 1985, pp. 132–33). This is because changes to entrepreneurial incentives affect the market process in a special way. Specifically, economic regulations hamper entrepreneurial alertness, and prevent the discovery of new opportunities, resulting in welfare losses. This assessment depends on the paradox of alertness discussed above.
Kirzner’s view of economic policy is a straightforward application of his incentive theory, and he describes the connection between regulation and entrepreneurial incentives as “intuitively obvious” (Kirzner 2009). Specifically, economic policy poses a threat to human welfare when it reduces or eliminates entrepreneurial incentives. When economic policy eliminates a profit opportunity or renders it less remunerative, it becomes less attractive to entrepreneurs. Because it is no longer in an entrepreneur’s interest to notice the opportunity, it tends not to be noticed. By reducing the rewards (in terms of pure profit) attached to alertness, regulation therefore decreases the likelihood that entrepreneurs will be successful discoverers:
[D]irect controls by government on prices, quantities, or qualities of output production or input employment may unintentionally block activities which have, as yet, not been specifically envisaged by anyone. Where these blocked activities turn out to be entrepreneurially profitable activities (perhaps as a result of unforeseen changes in data), the likelihood of their being discovered is then sharply diminished. Without necessarily intending it, the spontaneous discovery process of the free market has thus been, to some extent, stifled or distorted. (Kirzner 1982)
Intervention eliminates new and unknown opportunities, preventing entrepreneurs from being drawn to them, and ultimately preventing welfare-enhancing market coordination. How precisely does regulation affect alertness? The answer seems to be that,
To announce in advance to potential entrepreneurs that [for example] “lucky” profits will be taxed away is to convert open-ended situations into situations more and more approximating those of a given, closed character. The complete taxing away of pure entrepreneurial profit can, it is clear, succeed only in removing from potential entrepreneurs all incentive for paying attention to anything but the already known. (Kirzner 1985, p. 111, emphasis in original)The last sentence seems to imply that entrepreneurs can pay attention to the unknown. Unfortunately, Kirzner does not explain exactly what this might entail.
Kirzner seems to be arguing that entrepreneurs possess a general knowledge of “where to look,” such that if this general field becomes less profitable, they will be less likely to notice specific opportunities in it. Yet if opportunities are discovered without ordinary incentives (such as those involved in search efforts), it is not clear how giving entrepreneurs general information would aid or hamper discovery. Would not information about where to look simply affect ordinary, known incentives? If expressed in these terms, the thrust of Kirzner’s argument would be unobjectionable. It would imply that when government announces a certain kind of production is no longer profitable, entrepreneurs acknowledge this change, alter their calculations accordingly, and shift their resources to more remunerative forms of production. Yet this view of entrepreneurship and regulation relies on the conventional approach to incentives: the open-ended-vs.-closed distinction is most plausible if entrepreneurs can act and search for opportunities, or, even better, exercise judgment about how to use resources. But if we try to apply the specific notion of entrepreneurial incentives to policy analysis, the causal problem of alertness appears again.
Consider an example. Suppose there are two industries, auto manufacturing and software engineering. In each of these industries entrepreneurs are earning the same returns, and as far as all potential entrepreneurs are concerned, both industries are equally attractive. Let us then suppose the government announces that a new tax will be levied on the profits of the auto industry, while the software industry will be left unhampered. According to Kirzner, opportunities in auto production have been eliminated, and potential entrepreneurs will now perceive the industry as closed, which in turn means relatively few profit opportunities will be discovered there. There are two ways to explain this result. First, entrepreneurs might acknowledge the new policy, ignore the auto industry, and focus their attention elsewhere. This would involve action and search, however, and is not consistent with Kirzner’s theory of alertness. The second possibility is that entrepreneurs do not act differently in response to the new tax policy, but instead the lack of profitability in auto manufacturing unconsciously steers them away from that industry and toward others. This seems more in keeping with Kirzner’s theory, but it returns us once again to the question of causation.
A potential entrepreneur’s knowledge of the tax could certainly influence his deliberate search efforts and decisions about production. But how could it influence the passive state Kirzner uses as a starting point? If a profitable opportunity cannot, by itself, cause its own discovery, how can we be sure that an unprofitable opportunity will have the opposite effect, and tend to remain unnoticed? If an entrepreneur does not know that an opportunity exists, how can a policy that decreases the profitability of that opportunity change the likelihood of his noticing it? In order to answer these questions, it seems we must incorporate other kinds of behavior, such as search or judgment.
I will not add to this criticism other than to point out that if entrepreneurial incentives cannot be integrated into a theory of unhampered markets, then the implications for restricted markets are ambiguous. If one believes there is no necessary tendency for entrepreneurs to notice opportunities (or even that opportunity discovery is not the best basis for a theory of entrepreneurship), then the above policy analysis loses its force; regulation might just as well hamper erroneous incentives or errors as prevent entrepreneurial success.Also, regulation need not simply inhibit the discovery of profitable opportunities: it might also produce new opportunities for rent-seeking or other forms of destructive entrepreneurship (Foss and Klein 2010). Based on the above discussion, it should be clear that policy analysis poses a problem for alertness theory.
In addition to typical policy questions, the opportunity-causation problem also has implications for the debate over the feasibility of central planning, a system of organization Kirzner argues is subject to a lack of proper entrepreneurial incentives (1982). Using the entrepreneurial-incentives approach, however, the case against central planning might actually be weakened:
It is true in a trivial sense that entrepreneurs can be defined as those who are “alert to profit opportunities,” but we wonder why agents of the central planning board could not be equally alert. The real issue is not alertness, but the magical property that Kirzner attributes to those who are alert: the property of thereby finding what they are looking for (a profit opportunity) and knowing what to do about it. If mere alertness — activated by “the profit motive” … — were all it took to produce the requisite knowledge, one could incentivize central planners with the same motive or an even stronger one, such as the death penalty … (Evans and Friedman 2011)
There is then a difficulty in explaining how entrepreneurial alertness differs in market versus non-market (e.g., socialist) settings. If alertness is a universal phenomenon, as Kirzner believes, then it is unclear how or why government agencies do not also possess some degree of alertness — or why they could not be motivated to alertness. Once again, the necessary links between opportunity and alertness — and between decreased opportunity and non-alertness — are missing. Without them it does not seem possible to apply Kirzner’s alertness theory to economic policy, at least in the manner he suggests. The solution, I argue that we can solve this problem by relying on the concept of entrepreneurial calculation using money prices.
As mentioned above, Kirzner recognizes the problem involved in not explaining opportunity causation, yet still draws theoretical and policy conclusions as if the paradox had been resolved. It is difficult to escape the feeling that Kirzner accepts it as a matter of course that the market process produces beneficial welfare outcomes, and further, that this is the direct result of entrepreneurs tending to discover profitable opportunities. As he himself puts it, “there can be no doubt that such inspiration [i.e., entrepreneurial alertness] has been of enormous importance throughout recorded human history” (1985, p. 109). But this is a conclusion to be reached by careful reasoning, not a fundamental assumption. And until we clarify these assumptions and more clearly explain the foundations of entrepreneurial theory, economic policy is bound to remain a controversial subject. While this is far from an exhaustive discussion, I hope it is sufficient to demonstrate the need for careful scrutiny of the alertness hypothesis in economic policy, and moreover, to spark economists’ interest in alternative theories of entrepreneurship that more easily explain the effects of regulation on entrepreneurial behavior.
Entrepreneurial Calculation and JudgmentThe problems of the alertness approach do not mean that entrepreneurial theory must give up any hope of policy relevance. However, they do require us to more carefully consider the basic elements of theory, and how they relate to real-world human behavior. To this end, I suggest that instead of a theory of entrepreneurial alertness, what is needed is a theory of entrepreneurial judgment. The judgment approach to entrepreneurship has a long history within the Austrian school, and can be traced back at least as far as Menger’s writings. Menger did not write extensively on the entrepreneur, but he did describe a number of different ways entrepreneurship can occur (1994, pp. 159–61). Two forms of entrepreneurship that are relevant for judgment are “the act of will by which goods of higher order … are assigned to a particular production process” and the “supervision of the particular production process” (Menger 1994, p. 160; emphases in original). Both of these aspects of entrepreneurship point to the idea of a capital-owning, decision-making entrepreneur (Salerno 2008).
The judgment approach flourished in the works of Menger’s disciples, especially in the writings of Böhm-Bawerk (McCaffrey and Salerno 2014), Frank Fetter (McCaffrey unpublished), and Ludwig von Mises. Of these economists, Mises’s writings have received the most attention, and are the subject of controversy. Yet a careful study of his writings shows that his work falls within the judgment tradition. This thread of Mises’s thought begins with early writings such as The Theory of Money and Credit (McCaffrey 2013), and continues on through his more systematic exposition of entrepreneurship in Human Action (Salerno 2008; Foss and Klein 2010). The judgment view was further elaborated by Murray Rothbard, who placed his own discussion in the midst of an extended treatment of production theory (2004, pp. 509–55).Rothbard also drew attention to the Austrian heritage in entrepreneurship and pointed out several confusions about this legacy (1985; 1987). Among more recent generations of economists, the judgment theory has been developed by Joseph Salerno (2008) and has crystallized in such works as Foss and Klein (2012). This approach to entrepreneurship is therefore well-established within the Austrian school, and in fact represents a dominant trend in historical Austrian thinking on the subject.
The judgment approach views entrepreneurship as the function of residual decision making about the use of heterogeneous capital goods in production. In other words, the entrepreneur is the individual or group ultimately responsible for the direction of an enterprise, and this entails the ownership of capital and the direction of the factors of production. Because production takes time, arranging the structure of production implies that entrepreneurs make speculative judgments about the future state of the market. Eventually, consumer demand will reveal whether particular uses of capital were justified. If his initial judgments were correct, the entrepreneur earns profits, and if not, he incurs losses. The entrepreneur therefore bears the uncertainty of the future in exchange for the chance to reap profits. The key point, however, is that in order to do this entrepreneurs must exercise judgment about the allocation of resources.
However, when making decisions entrepreneurs first require some method of comparing the costs and benefits of each alternative use of scarce resources in order to determine which combinations of the factors will serve the most urgent needs of consumers. Entrepreneurs find this means of evaluation in monetary calculation. Calculation consists in entrepreneurs appraising the future prices of the factors of production through their “‘experience’ of past prices and … their ‘understanding’ of what transformations will take place in the present configuration of the qualitative economic data” (Salerno 1990a, p. 60). Once these mental estimates have been formed, entrepreneurs are in a position to gauge the relative merits of alternative arrangements of the factors. But their experience and understanding must be expressed in terms of a common denominator, namely money prices:
[A]s Mises points out, economic calculation involves arithmetic computation and … it is for this reason that economic calculation can only be calculation in terms of money prices. … As the only possible tool of calculable action, money prices do not merely permit people to utilize their individual “knowledge of particular circumstances of time and place” to enhance the efficiency with which goods are produced in society, prices render possible the very existence of social production processes. (Salerno 1990b)
Calculation therefore provides the “indispensable mental tool for choosing the optimum among the vast array of intricately-related production plans that are available for employing the factors of production within the framework of the social division of labor” (Salerno 1990a, p. 52). In other words, calculation provides, among other things, a basis for entrepreneurs’ judgment regarding the direction of the factors. More profoundly, calculation is actually the fundamental characteristic of a rational economic system, which is simply impossible in its absence, as in the case of socialist societies (Mises 1998 [1949]; Salerno 1990a; 1990b; 1993).
The distinct traits of calculation and judgment are all absent in the alertness view. This is a necessary result of Kirzner’s distinction between Robbinsian maximizing and entrepreneurial discovery, which excludes capital ownership, uncertainty bearing, and monetary losses from the start. Yet this exclusion is precisely why alertness theory stumbles when it confronts policy analysis. Because Kirzner cannot incorporate ordinary economic decision making into entrepreneurship, he instead explains it by appealing to variables outside the sphere of action, i.e., the existence of pure profit opportunities, which in turn leads to the problems discussed above. However, a capital-owning, uncertainty-bearing entrepreneur who earns monetary profits or losses can play an integral role in policy analysis.
The Policy Implications of EntrepreneurshipWith the ideas of entrepreneurial calculation and judgment in mind, we can now make sense of the link between public policy and entrepreneurial theory. One distinct advantage of the calculation-judgment theory is that it is easily integrated into policy analysis; the causal connections between policy and entrepreneurship are not metaphorical or paradoxical, but can be analyzed using fairly straightforward economic tools. What is more, by showing how policy interventions interfere with the process of economic calculation and judgment, we can more clearly determine the welfare implications of such interference.
Ownership and Political EntrepreneurshipThe application of judgment theory begins with the idea of ultimate or residual control over an enterprise. By determining where the locus of control and decision making lies, we can determine the scope and extent of entrepreneurial calculation, and also see how it might be hampered. More importantly, by discovering which individuals ultimately own and allocate resources, we can see how entrepreneurial behavior is different across institutional and policy contexts. The most obvious examples to contrast are entrepreneurial behavior in the market and in the political realm.
We have already said something about entrepreneurial calculation in the market. In sharp contrast is the element of “entrepreneurship” that occurs within government. Although decision making within government is often complex, it is clear that within any given state there is some form of ultimate authority over resource allocation. The exercise of this control may be termed “political entrepreneurship” (McCaffrey and Salerno 2011). Political entrepreneurship is distinct from market entrepreneurship in at least two important ways: first, it occurs outside the sphere of economic calculation, and second, it is financed through coercive redistribution as opposed to voluntary exchange.Note that Kirzner’s entrepreneur does not possess resources in either a political or a market setting. Therefore, market entrepreneurship cannot easily be distinguished from political entrepreneurship based on this difference or on considerations of the entrepreneur’s methods of finance. The non-voluntary nature of public finance means that no matter how decisions are made, they will conflict with the current preferences of the public at large, while the absence of calculation means decisions lack rational direction. Political entrepreneurship — i.e., government decisions about the allocation of resources—therefore diverts the stream of spending away from the path it would have taken in an unregulated market, and also distorts the structure of production (Rothbard 2004, pp. 1151–55, 1167–68; McCaffrey 2011). Political entrepreneurship cannot therefore produce the same welfare-enhancing effects as market entrepreneurship, and the absence of entrepreneurial calculation within government means that it never could.
Entrepreneurship and the Institutional FrameworkThe judgment approach also allows us to see how policy shifts the entrepreneurial function from one individual or group to another, and how this shift affects welfare outcomes. Changes in the entrepreneurial function are most relevant in a system of economic intervention. Under interventionism, ownership is systematically shared between government and private individuals, or in other words, there is a forcible separation of the ownership and control of the means of production. One way to describe this situation is “institutionalised uninvited co-ownership” (Hülsmann 2006; emphasis in original). For instance, when a government nationalizes an auto manufacturer or even the auto industry, entrepreneurs in these firms surrender their decision making ability, and the entrepreneurial function is shifted from the market to the political sphere. Even if entrepreneurs nominally retain ownership of the firm, they are little more than the managers of the enterprise — they can ultimately be replaced by the political entrepreneurs, who retain residual control. A system of government intervention, because it alters the pattern of ownership of the factors, also involves a systematic transfer of decision-making authority over them. Intervention therefore changes the pattern of entrepreneurship in society, by shifting the entrepreneurial function from some individuals to other more favored groups, be they rent-seeking firms or political entrepreneurs themselves.
“Institutionalized uninvited co-ownership,” is also closely tied to the incentive problem known as “moral hazard,” defined as, “the incentive of a person A to use more resources than he otherwise would have used, because he knows, or believes he knows, that someone else B will provide some or all of these resources” (Hülsmann 2006). When ownership and control are forcibly separated, a wide range of “perverse” incentives — such as moral hazard, adverse selection, and the tragedy of the commons — are brought into play. Under a system of free contracting, entrepreneurs (principals) must use judgment to arrange incentives within the firm, thereby mitigating moral hazard. However, when ownership is forcibly shared, the scope for calculation and judgment are reduced, prolonging or even institutionalizing incentive problems.
Moral hazard is not the only aspect of government intervention that can be viewed in an entrepreneurial light though. A closely related subject is the problem of “regime uncertainty.” This term was coined by Higgs (1997) as a way to explain the conditions which led to the long-term decline in private investment during the Great Depression. Higgs argues that entrepreneurs were reluctant to invest in a political environment hostile to their profit-seeking interests. In particular, widespread fear existed among businessmen that under the New Deal regime, industries would be nationalized, while taxes and other regulations would severely curtail profitability. What is more, the ideological stance of the Roosevelt administration was decidedly anti-business, creating an environment in which the viability of the fundamental institutions of the market economy was thrown into question. The uncertainty produced by the regime thus resulted in depressed investment and significantly delayed recovery.
Yet if the task of the entrepreneur is to allocate resources in the face of uncertainty, why would regime uncertainty pose a special problem? Regime uncertainty is relevant for judgment because it represents uncertainty about the institutional environment in which entrepreneurs make decisions; in a way, it tears the canvas on which entrepreneurs are trying to paint. One way to express this idea is to say that regime uncertainty occurs at a different institutional “level” than entrepreneurs are used to dealing with (Bylund and McCaffrey unpublished). That is, when regimes create fear about the security of the very system of private enterprise — in practice, the security of property rights and profits — they throw the “rules of the game” into question. Entrepreneurial judgment, on the other hand, usually takes place at the level of the “play of the game,” with certain institutional constraints taken for granted.
One result is that regime uncertainty undermines judgment by threatening its raison d’être. In a regime that is considered friendly to private enterprise, entrepreneurs constantly strive to earn profits and avoid losses. When regime uncertainty appears, however, entrepreneurs cannot be sure of the link between successful judgment and monetary rewards, and they therefore restrict their profit-seeking behavior (Bylund and McCaffrey unpublished). Reduced activity by entrepreneurs implies reduced effort to calculate in the economy, and ultimately, decreases in consumer satisfaction. There is then a reasonable chain of causation running from policy (actual or threatened), to entrepreneurs’ perceptions of monetary incentives, to a decline in entrepreneurial activity, and finally, to resulting welfare losses.Note that these links would be absent if entrepreneurs were unaware of the existence of monetary incentives. Judgment therefore provides a substantive connection between regime uncertainty and welfare.
This is one way the conventional effects of regime uncertainty can be expressed in entrepreneurial terms. We can also imagine the reverse of regime uncertainty, when entrepreneurs believe returns will be guaranteed no matter the quality of their judgment. Of course, guarantees of profitability and security are not found in the market; they are, however, often made by government in its negotiations with rent-seeking firms. When guarantees are made, profit-seeking activities increase because entrepreneurs believe they will be protected (e.g., through grants of monopoly privilege or bailouts), whether their investments are wise or not. Entrepreneurs are more likely to engage in risky and unprofitable production when convinced they will not ultimately bear the uncertainty of their decisions. This again hints at moral hazard.
ConclusionThe theory of the entrepreneur is one of the most important components of economic science. But although it is vital for economists to understand the driving force of the market, it is equally important know how public policy hampers this force. The most obvious obstacle to economic progress is government intervention in the market economy, which inevitably involves interference with the decisions of the entrepreneur. Yet how we think of the entrepreneurial function matters greatly for our conclusions about exactly how economic policy changes the entrepreneurial process and the welfare outcomes of the market economy. If, following Kirzner, we view the entrepreneur as a resource-less and inactive agent awaiting the serendipitous discovery of profit opportunities, policy analysis becomes effectively impossible. Because the existence of profit opportunities does not explain a tendency toward entrepreneurial success, it likewise does not show how changes to the policy environment tend negatively to impact discovery and the welfare of market participants. The alertness theory does not then provide a substantial foundation on which to build a distinctly entrepreneurial approach to policy analysis.
However, once we take into account the vital roles of calculation and judgment, it is easy to see that economic policy distorts and changes entrepreneurs’ behavior. Judgment theory relies on the concrete notions of capital ownership, calculation in terms of money prices, and decision making about the use of the factors, all of which can be seen at work in the real world. Intervention shifts the pattern of ownership and therefore also falsifies the money prices entrepreneurs use to appraise the factors of production. Intervention also directly abrogates the judgment of entrepreneurs by diverting the structure of production from the course it would have taken in an unregulated market. The direction and scope of entrepreneurial decision making are thus altered, and consumer welfare is reduced. Moreover, public policy can drastically affect the business environment in which entrepreneurs act, threatening the fundamental institutions of the market economy on which entrepreneurs rely. This depresses entrepreneurial activity, resulting in a general loss of welfare.
Judgment, through its connections to economic calculation, provides a concrete reference point from which to analyze the effects of policy. Calculation is mass to judgment’s velocity, and together they form the driving force of the market. This view of the entrepreneur not only has a long history within the Austrian school, but has already been applied to numerous problems in theory and policy, and will no doubt serve as a useful tool for analyzing many more. It therefore represents a positive way forward for scholars in economics and public policy.
As a final thought, let me add that while the future is bright, so too is the past; in other words, it is vital to recognize that many of the most important advances in Austrian economics have emerged from careful reflection on the foundations laid by the giants of the tradition, whose insights must never be taken for granted. As our thinking on entrepreneurship moves forward, it too should be mindful of its roots in the Austrian school, and always take care to appreciate the contributions of previous generations. With that in mind, it is safe to say that as this tradition grows and thrives in the coming years, it will owe no small debt to Joseph Salerno.
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ThroughoutJ. Patrick Rhamey is assistant professor in the Department of International Studies and Political Science at Virginia Military Institute in Lexington, Virginia. I was a summer fellow in 2007 and 2008. During these experiences, under the advice and support of Dr. Salerno, I developed a passion for the field of international conflict. Furthermore, Dr. Salerno instilled in me the importance of thinking strategically regarding interdisciplinary theorizing and the importance of interdisciplinary work to the future of the social sciences. his career, Dr. Salerno has sought to expand the influence of Misesian scholarship, not only through his own research, but also classroom engagement, graduate student mentorship, and the education of the general public. His impressive body of work represents a true educator whose interest is fundamentally the advancement of human knowledge. It is in this spirit that this chapter seeks to provide an initial blueprint for the interdisciplinary expansion of Austrian principles to the political science realm, specifically the subfield of international relations theory. While international relations theory has strong shared origins in classical liberal approaches (Van de Haar 2009), recent theoretical evolution across the dominant paradigms has increased the potential for an expansion of Austrian ideas. Many theories within the subfield of international relations have begun to experience something of an “individualist shift” both methodologically and theoretically.This trend originates in the renewed emphasis on domestic politics as a source of foreign policy behavior and extends to recent research examining the underlying causes of individual decision-making (Putnam 1988) and the relationship between the preferences of individual decision-makers and foreign policy selection (Bueno de Mesquita 1999). For these reasons, if approached correctly, international relations research is a field ripe for future interdisciplinary engagement.
Notably, there does not exist an absence of political science research by Austrians, though these contributions remain beyond mainstream political science discourse. Perhaps the best examples are Murray Rothbard’s Power and Market and the concluding chapter of Man, Economy, and State which explicitly engage the effects of coercion, or politics, on human behavior.Indeed, the clarity of analysis from one volume to the other highlights the artificial and unnecessary division of the two works by the initial publisher. The foundation of the argument focuses primarily on the voluntary interactions of individuals in the absence of violence (economics), and yet concludes by engaging the reality that coercion (politics) is nearly always and everywhere present and “economic analysis must be extended to the nature and consequences of violent actions and interrelations in society” (Rothbard [1962] 2004, p. 875). In essence, the fields of economics and political science are highly complementary if not inherently intertwined. Unfortunately this early clear intersection of the two fields of inquiry did not occur more broadly, as political science, the younger of the two, developed from a combination of European legal and historical approaches (Carr 1939; Morgenthau 1948) and early American behavioralist research (Merriam 1924; Key 1934; Key 1966).While some influence from economics is present in contemporary political science research, it is primarily of the positivist variant, to which there has been a significant backlash in the form of “post-positivist” theoreticians (e.g., Peterson 2004; Tickner 2005). However, unlike economics where certain biases may exist, Austrian ideas surrounding political organization, coercion, and the state are somewhat accepted. For example, James C. Scott’s The Art of Not Being Governed: An Anarchist History of Upland Southeast Asia and Charles Tilly’s “War Making and State Making as Organized Crime” share many commonalities with Rothbardian analysis of the state and are standard reading in undergraduate comparative politics courses.
This chapter proceeds by outlining the evolution of international relations theory over the past two decades with specific attention to the progression of theoretical development toward a greater focus on human action. While most research is heavily positivist in its construction, theoretical development over the course of the past two decades has led, steadily, away from the abstractions of traditional neorealist (Waltz 1979) and liberal institutionalist (Keohane and Martin 1995) paradigms that have dominated international relations research. New theoretical approaches that offer greater recognition to human agency, as well as new methodological challenges in qualitative research, provide an opportunity for Austrian engagement. Following a discussion of these theoretical approaches, I conclude with suggested strategies for continued expansion of Austrian ideas to the social sciences outside economics.
The Current State of the International Relations LiteratureI first introduce through a simple illustration the relative position of the dominant international relations theoretical perspectives in the context of two fundamental criteria in Figure 1. The theories are organized according to their assumptions concerning the effect of anarchy on preferences, and thereby behaviors (y-axis), and the assumed level of analysis determining the type of actor under study (x-axis). Organizing each perspective by their nuanced conceptualizations on these two particular subjects provides an effective means of discussing their unique attributes within the context of their overarching similarities. (See Figure 1 on the following page.Immediately the reader will notice the placement of constructivism. While I do not discuss constructivism at length in this chapter, constructivism is unique given its assumption of an endogenous relationship between levels of analysis. As examples, the key systemic features which frame state’s conceptions of world politics such as state sovereignty (Treaty of Westphalia) and anarchy are not universal truths, but social constructions by the states themselves (Wendt 1992, 1995). It is this endogenous relationship between society, state, and system the graphical portrayal is intended to illustrate.)
Notably, either abstraction presents potential problems for future Austrian interdisciplinary analysis. In particular, the level and corresponding relevant unit of analysis being anything beyond the individual is an inherently hostile assumption, as praxeological analysis recognizes accurately that only individuals are capable of action. For example, neorealists may assume for theoretical purposes that all states are rational unitary actors, but such an assumption is ineffective in generating common sense explanations of real world phenomena, given “there are no such things as ends of or actions by “groups,” “collectives,” or “states,” which do not take place as actions by various specific individuals (Rothbard [1962] 2004, p. 2). However, in the theoretical space that minimizes such abstractions, specifically the liberal and neoclassical realist conceptual spaces, the possibility for the development of an interdisciplinary Austrian discourse is quite plausible. Driving this evolution toward the individual over the past two decades of international relations research is in part the desire of applied research to understand real world outcomes, leading to what J. David Singer (1961) termed “vertical drift” wherein theories built on such abstractions as “state behavior” become applied to explaining foreign policy choices by individuals.
For much of international relations, anarchy defines contextual constraints, where expected behavior follows from the strength of the anarchy assumption (Powell 1994). Implied for many authors, particularly in the realist tradition, is that given anarchy and human depravity, conflict will ensue. Even neoliberal institutionalists acknowledge the anarchy assumption of neorealism, resigning themselves to searching for those conditions in which “cooperation under anarchy” is a possibility (Axelrod and Keohane 1985). If anarchy is as salient a political problem as neorealists suggest, then actors seek nothing more than power, as apart from coercive government their security is impossible to guarantee (hence Waltz’s characterization of the system as “self-help”). However, if anarchy is merely an environmental condition suggesting the absence of a single coercive entity, rather than being a constraint that determines behavior, then gains are not inherently zero-sum and cooperation is not only possible, but likely the dominant strategy within the anarchic context.This distinction between anarchy as a defining characteristic that causes states to behave a certain way, as is the assumption by neorealists, versus anarchy as merely a systemic condition that describes the absence of a single coercive entity, as is the assumption by liberal researchers in international relations, has dramatic consequences for expectations of state behavior. Flowing from the neorealist assumption that anarchy causes behaviors are the assumptions that all states pursue self-help strategies, all gains are relative and mutually exclusive, and thereby this systemic condition leads inevitably to conflict. However, if anarchy is merely a descriptive characterization of the international system as the absence of government, which through liberal logic may be a systemic condition that expands possible behaviors rather than constrains as realists would claim, it cannot be assumed anarchy inherently leads to competition over relative gains and conflict. The “strength” of the anarchy assumption in international relations theory is thereby the degree to which the condition of anarchy forces states to behave in a specific manner.
On the right side of the horizontal axis are the predominantly system-focused explanations of international politics, depicting states as unitary actors. In this context, simplistically, the relationship of anarchy is perceived as either an aspect of the environment (English school) or the prime determinant of state preferences (Neorealism). On the left hand side of the graph reside those theories of international politics which focus on a sub-state unit of analysis, each providing an explanation of state behavior as a determinant of either group or individual action. The “Effect of Anarchy” in this context is parallel to the underlying discussion of the “state of nature” in much of political philosophy.It is worth noting that the conceptions of “anarchy” in international relations theory are not entirely identical in classical realism and neorealism (or lower horizontal pairings) as the graph may suggest, as Morgenthau did not share Waltz’s view that the international system is inherently conflictual due to the effect of anarchy (see Morgenthau 1948, pp. 39–40). However, Morgenthau does share the Hobbesian view of human nature which is an abstraction based upon the Hobbesian view of the state of nature, or anarchy. Morgenthau’s conception of human nature, the basis for his description of statesmen and justification for the primacy of the state, exists as an extension of the idea of man’s nature under conditions of anarchy, even if he does not agree anarchy exists in the reality of international politics. Perhaps a more appropriate title for the y-axis would be “conception of human nature” ranging from good to bad. However, I expect in that case a footnote would be necessary explaining the nuances of the systemic level. The point here, however, is simple: philosophically the effects of anarchy on behaviors and human nature are directly related. Toward the top of the y-axis, anarchy has a powerful effect on human behavior, wherein man cares only for his self-preservation resulting in a Hobbesian existence that can only be described as “nasty, brutish, and short.” Alternatively, toward the bottom of the vertical axis, the state of nature, or anarchy, does not imply chaos. Intrinsic to anarchy in this Lockean conception is the principle of natural law endowed to the individual, wherein everyone is entitled to “life, liberty, and property.” In this context, human nature is not so negatively viewed, as individuals are capable of organizing themselves. Government, thereby, is either only necessary to protect person and property against those occasional individuals who seek to violate the principles of natural law, or alternatively is entirely unnecessary if individuals are capable of interaction absent a monopolizing coercive force (Rothbard 2002a). The vertical axis across both levels of analysis can also be described as the degree to which cooperation is possible in the absence of a centralized government in international politics.
Given the existing landscape of international relations theory, Moravcsik’s (1997) conception of liberalism, designated simply as “liberalism” in the illustration, provides the clearest potential avenue for the application of Austrian ideas. Recognizing the failures of systemic, state focused neorealism to account for domestic sources of state behavior (notably the collapse of the Soviet Union), Moravcsik (1997) presents a reframed variant of liberalism in international relations to fully account for the dynamics of policy formation. As both economists and political scientists are well aware, the term liberalism has been construed to mean a myriad of things, both within and beyond international relations research. Moravcsik’s articulation of a liberal theory of international relations is an attempt at salvaging liberalism’s “self-inflicted” condition. However, as the author makes clear, he is providing a “restatement” of liberal theory built squarely on classical liberal foundations.Notably this restatement is not neoliberal institutionalism, which unfortunately dominated the term liberalism until very recently. In terms of assumptions, neoliberal institutionalism shares the entirety of the neorealist core (including the states as rational actors abstraction) while moderately relaxing the implications of anarchy on state preferences. Given this relation, Keohane’s (1993) statement that neoliberal institutionalism “borrows as much from realism as from liberalism” is disingenuous. Institutionalism borrows entirely from realism, while only moderately co-opting liberalism’s focus on the human progressivity (Zacher and Matthews 1995). To use the example of cooperation, it occurs despite systemic conditions of anarchy because actors determine that by doing so they can improve their condition (e.g., Axelrod and Keohane 1985). The core assumptions regarding states as rational unitary actors and the system organization as anarchic are identical. Neoliberal institutionalism appears to remain ambivalent to the historical emphasis of classical liberalism on the individual and the promotion of human freedom, leaving preferences as exogenously determined. I’ll refrain from delving further into the nuances of neoliberal institutionalism and neorealism, as the neo-neo debate has been thoroughly explored elsewhere (Jervis 2003; Baldwin 1993; Powell 1994). Liberalism as defined by Moravcsik thereby is explicitly a theory of preference formation, and it is in this particular conceptualization of liberalism that the most fruitful possibilities of interdisciplinary theorizing with Austrian researchers lies.
Moravcsik makes a series of core assumptions emphasizing preference formation and the evolution of interests within domestic society. First, the fundamental actor in international relations is the individual. Decisions are made by individuals acting in response to an environment to satisfy subjective goals determined by subjective sets of values. Already, we have dramatically complicated the study of international relations away from systemic theories. Second, and by extension, the state is a subset of individuals in society reacting to the preferences of individuals in the society at large. Actors in government, like actors in domestic society, have their own sets of values and preferences and exist in a particular institutional context, be it democratic or authoritarian. This environmental constraint shapes the availability and perceived values of the policy options available to state actors, but individuals remain the only entity capable of action. Finally, preferences across potential behaviors, and the resulting causal processes in policy choice, are constrained further by the international environment of interacting individual preferences and material capabilities (or opportunity to achieve some end).
Moravcsik (1997) essentially constructs a “bottom-up” view of international politics, tracing the source of state behaviors to the initial development of preferences by individuals within societies. What individuals within states want “is the primary determinant of what they do,” not the nature of the system as anarchic (Moravcsik 1997, p. 521), opening the door to understanding political phenomenon as they actually happen rather than under a predefined set of unrealistic abstractions. However, to employ liberalism to better understand outcomes we must have some means of logically deducing the source of preferences, of which Moravcsik lists three: ideational, commercial, and republican. The ideational components capture particular political, national, and socioeconomic cleavages and are manifest in normative explanations of the democratic peace (Dixon 1994), ethnicity based explanations of foreign policy behaviors (Davis and Moore 1997), and liberal economic preferences (Mousseau 2003). Commercial incentives are driven by motivations for some subjectively defined economic gain. These may take the form of trade and investment behaviors, but also may manifest themselves through preferences for resource access and even coercive seizure (e.g., Snyder 1991). Finally, republican sources of preferences are rooted in the political institution’s method of filtering the preferences articulated by the domestic populace. Likely the best examples are provided by the institutional democratic peace literature, but more specifically selectorate theory (Bueno de Mesquita et al. 1999). Indeed, selectorate theory, may provide the best illustration of the bottom-up preference formation process presented by liberalism while retaining a focus on individual action.
The implication of this articulation of liberal theory is a complete reformulation of how we conduct international relations research to refocus not on states, but upon the individual within society. Neorealism, restricted to the system level and states as actors, fails to independently account for state preferences, and so a focus on human action is the logical transition. However, a focus on individuals does not eliminate the systemic realm, in so far as the system is defined through the behaviors of other individuals engaging in their own series of actions within and between political systems.See the conceptual discussion of interactions in Bueno de Mesquita et al. (1999). Furthermore, given the necessity of such a transition toward the individual and human action, there has been something of a convergence in international relations theory. For example, Jack Snyder’s (1991) work on empires, if one was ignorant of his self-identification as a “realist,” is indistinguishable from the theoretical processes outlined by Moravcsik. Specifically, Snyder discusses the logrolling interests of domestic actors, ideational preferences, and political institutional configurations all contributing to the propensity and rate at which empires historically over-expand — an outcome that is impossible to explain under any framework where states are rational unitary actors.
This international relations shift toward liberalism seems intuitively obvious, occurring quite broadly in mid-range topical analysis (see Oneal 2012): individuals have values for ends and employ means to achieve those ends. However, understanding, operationalizing, and incorporating the preferences of actors, determining their relative importance, and then interacting those aggregate preferences with state structures and the preferences of others individuals outside the state is a daunting task, and attempts to do so do not debunk clearly deduced theory as the burden of properly specifying such empirical analysis is exponentially greater than traditional state-level studies. However, with advancements in technology, the ability to conduct econometric tests of liberal ideas are more accessible and plausible, providing a means to mathematically sort out myriad coinciding human behaviors. In particular, the recent availability of multilevel modeling to political scientists is intuitively appropriate for testing liberal hypotheses, which employ indicators from across arenas of political interaction (e.g., actors both within and between states). Indeed, progress for the field entails “an increasing ability to explain and connect complex phenomenon” both theoretically and methodologically (Dryzek 1986, p. 301).
Liberalism in international relations theory is not the only path that has evolved to grant greater attentiveness toward the inherent basis of social science research in human action. Neoclassical realism possesses many of liberalism’s strengths while attempting to maintain many of classical realism’s fundamental Machiavellian assumptions. Like liberalism, neoclassical realism “explicitly incorporates both external and internal variables.” However, “the scope and ambition of a country’s foreign policy are driven first and foremost by its place in the system and specifically by its relative material power capabilities … the impact of such power capabilities on foreign policy is indirect and complex … translated through intervening variables at the unit level” (Rose 1998, p. 146). Though political preferences are influenced by the actor’s position in the power hierarchy relative to all other actors in the system, human action still is the fundamental phenomenon of interest. Indeed, there are close parallels evident in not only the analysis, but also the conclusions, of neoclassical realists and Austrians on the topic of war and empire. For example, both Snyder (1991) and Salerno (1995) engage in similar discussions of the relationship between inflation and imperial expansion, as well as highlighting it as a catalyst of further international conflict and long run unsustainability.Snyder’s Myths of Empire is both an excellent example of neoclassical realism and source of many parallels with existing Austrian perspectives, including coalition behavior in democracies leading to warlike behaviors, the pervasiveness of certain “myths” of external threat exploited by politicians to justify conflicts, and the inevitable destructive consequences of imperial overexpansion. Another possible example is that of Robert Higgs (1987) “ratchet effect” and the “phoenix factor” discussed by Organski and Kugler (1977). Distinctly, while liberalism is a theory of preferences from the bottom up, neoclassical realism is a theory of preferences from the bottom down. Though liberalism as discussed is perhaps more amenable to Austrian engagement, both approaches, however, attempt to integrate individual behaviors into a general theory of international relations, albeit with different emphases on the relative importance societal influences.
Perhaps neoclassical realism and liberalism constitute different roads leading to the same destination. Both take seriously the need to incorporate greater complexity into our theories to better account for political phenomenon. Encouraging for practitioners of international relations, and the potential for interdisciplinary engagement with the Austrian school, is the drifting of paradigms not further apart, but closer together. These two latest iterations of realism and liberalism are perhaps more theoretically compatible than ever before in the past, constituting, in Lakatosian terms, progress in the field. In conjunction with rising methodological interest in deductive theory development and qualitative analysis (see Goertz 2005), a fruitful cross discipline dialogue incorporating the Austrian school as a next necessary step to this theoretical evolution in international relations is now possible.
Strategies for Future Interdisciplinary EngagementIn order for such a debate to both occur and be fruitful, not only must the theoretical components be compatible and international relations researchers amenable to an Austrian turn, as I argue they now are, but the presentation of the ideas must be done in a thoughtful and effective manner. Just as in the presentation of any argument or position, the negative aspects of the method by which it is presented, or the individual doing the presenting, affect audience receptivity. For this reason, it is necessary for those engaging mainstream IR theory in advocacy of an Austrian perspective to be somewhat strategic, or at least minimally thoughtful, in the method and context of that interaction. While international relations as a field may be ready for interdisciplinary engagement, there are, in my opinion, three broad strategic impediments currently limiting the persuasiveness of the Austrian school to the social sciences (and the general public) that must first be addressed.
Strategy 1: Comprehension Before EngagementOne great pitfall to any interdisciplinary engagement is a failing to fully understand the core theories, methods, and even discipline specific jargon of the field you seek to engage.Perhaps the best example is the term “institution” which possesses numerous definitions dependent upon the field and context within which it is used. Comprehension is a necessary condition to effective engagement, and in its absence, attempts at an intellectual exchange may be dismissed or misunderstood, harming future discourse. As one example, there is a frequent and unfortunately persistent mischaracterization in Austrian circles of democratic peace theory, often inappropriately conflated with neoconservative foreign policy prescriptions. As but one example, a recent discussion by Hans Hoppe (2013) on the democratic peace grossly mischaracterizes the theory as including the claims “In order to create lasting peace, the entire world must be made democratic” and “war must be waged on those states to convert them to democracy and thus create lasting peace.” Such a claim about democratic peace is a complete invention, as there is not a single piece of democratic peace research in international relations that states either. Indeed, the original conceptualization of the democratic peace in modern political science empirical research was labelled the “libertarian peace” and focused on libertarian normative values (Rummel 1983). Such claims are completely absent in both the normative (Dixon 1994) and institutionalist (Bueno de Mesquita et al. 1999) explanations of the empirical finding, which has been described as “the closest thing we have to an empirical law in the study of international relations” (Levy 1989, p. 88). Indeed, the empirical record even suggests that newly created, unstable democracies are the most violent states in the system (see Mansfield and Snyder 2002). Dr. Hoppe appears to confuse the democratic peace, which originates as a deductive theory about domestic influence on the polity by Immanuel Kant ([1795] 1991, p. 113) and/or the rise of capitalist preferences by Joseph Schumpeter (1950; 1955), with neoconservative foreign policy recommendations (e.g., Kagan 2012) and the idealist policy prescriptions of Woodrow Wilson.Notably, Kagan and many neocons operate out of the field of history. There are no significant neoconservative international relations scholars, due both to the absence of any clear logic behind such an approach as well as a dearth of empirical evidence for such policies’ effectiveness. Wilsonian idealism, likewise, is generally absent in contemporary research, and the term exists in the present typically as a pejorative used by neorealists in describing liberal theorists (e.g., Mearsheimer 1995).
While the criticism of such neoconservative policies that follows in Hoppe’s analysis is well crafted and would be predominantly shared by most democratic peace theorists, the failure to properly engage the enormous extant literature and demonstrate a basic knowledge of the theory as it currently exists in international relations fosters and supports divisions between the two social science fields rather than providing interesting political science insights from an Austrian perspective. Research in coercive hierarchical power relationships and the dissemination of democracy (Organski 1968; Rasler and Thompson 1994), the causal development of clear individual preferences within democratic (and non-democratic) institutional frameworks (Mousseau 2003; Peceny and Butler 2004; Gartzke 2007), and the relationship of foreign policy behaviors to institutional coercive strength (Rhamey 2012) all go ignored through this failing to engage international relations scholarship. Such a dialogue between these systemic and liberal approaches with Austrian scholarship has enormous potential for better understanding human action in the political context.For an introduction to the democratic peace in international relations, see Russett et al. (1995).
Strategy 2: Engage and Incorporate MathematicsIf a priori science is a valuable approach, and we cannot knowingly observe the underlying motivations of actors, then generalizable and observable patterns of behavior should no doubt be present throughout a cadre of relevant historical events. While exploration of a single event may require a potentially dangerous divination of motivation in order to sensibly explain an historical episode, as well as any relevance to praxeological theories, econometric large-N analysis possesses the virtue of mathematically organizing possible relationships between events to uncover generally present correlations. A relationship between observable phenomena that are generalizably present in coincidence with an outcome of interest should correspond with any reasonably developed praxeologically deduced theorem, and certain types of statistical analysis may heavily complement Austrian research.Importantly, there is an intuitively plausible potential relationship between the praxeological approach and Bayesian empirical analysis that requires additional future attention by social scientists. Bayesian analysis recognizes the inherent uncertainty underlying observable events, obvious when observing real world phenomenon, as we cannot understand the complexity of motivations inherent in individual decision-making. However, rather than the explicitly inductive process of Bayesian updating, conceivably our priors may be updated instead by the deductive expression of a praxeologically based theory, permitting a more effective and appropriate large-N test. In other words, the logical posterior for an Austrian Bayesian model is the deductively generated theoretical information where probabilistic analysis is conditional on common sense claims. While the idiosyncrasies of a single case may make for difficult historical illustration, laws of human behavior capable of explaining real world occurrences, in a Mengerian sense, should be observably evident in a statistically significant fashion across a relevant population in a properly specified model.“Properly specified model” is simply one that accurately manages the nature of the data (e.g clustering, time series, hierarchical data structure) while also organizing the data to logically fit deduced theoretical priors. Generally, the problem in social sciences is not the models, but poor application and interpretation. While the failure to demonstrate expected empirical relationships that can be deduced from a praxeological approach does not, by definition, disprove the theory, it can serve the quite important purpose of highlighting deficiencies or logical fallacies within a deduced theorem. Theories are not apodictically true simply by labeling themselves a priorist, and a failing to observe generally present historical relationships that should coincide with the theory in a properly constructed econometric model is potentially an indication of a failing in the theory’s initial deductive logic. Furthermore, formal modeling, such as that often employed in applications of selectorate theory (see Bueno de Mesquita et al. 2008), can be a helpful means of organizing information regarding causal processes arrived at through clearly deduced theories.
Austrians often criticize econometric analysis as promulgating poorly developed or even illogical theories through the manipulation of algorithms to provide corroborating mathematical relationships. However, such a cautionary note surrounding statistical analysis is made by any serious approach to the social sciences, even in the most positivist corners, and an emphasis on theory prior to econometric testing is taught in every mainstream graduate research design course.Such criticisms are present in the most frequently used texts for such courses in political science and sociology doctoral programs, such as those by Shively (1974), King et al. (1994), Goertz (2005), and Ragin (2008). This attack on econometrics, then, is something of a straw man caricature of econometric research as such inductive, hyper-positivist work is not the standard in mainstream social science. Instead, the hostility toward mathematics is more likely an indication of mathematical ignorance of underlying statistical algorithms, a confusion regarding statistical claims surrounding causality, or simply an attempt to promulgate a bad, illogical theory when confronted with a lack of, or even contradictory, empirical evidence. While properly developed social science theory is not dependent on empirical “proof,” an absence of such is typically a sound indication that something in the theory’s logic has gone awry. This is not to suggest that historical method of careful logical argumentation on a case by case basis is without merit (e.g., Rothbard 2002b). However, such qualitative approaches, while interesting, may not provide the most effective social science illustrations regarding generalizable theories. Econometric knowledge is neither the foundation nor the end goal of social science research, but if done well, it is an important tool in the arsenal of the social scientist and should be embraced.
Strategy 3: Focus on Academic EngagementThe ideas of the Austrian school have the potential to contribute greatly to the social sciences, but perceptions of those ideas, and thereby their dissemination, may be marred, however unfairly, by an unclear union between the intellectual development of theory building and libertarian political activism. As such, scholars should promote a clear distinction between Austrian research and political activism, not allowing scholarly work to be shrouded by irrelevant, and sometimes counterproductive or contradictory, agendas. This strategic concern is particularly applicable to interdisciplinary expansion to political science and international relations, fields already highly sensitive to the politicizing of social science research. In these fields, new research programs viewed as pandering to particular ideological perspectives or political groups, regardless of whether they are left, right, or libertarian, are likely to be quickly dismissed. For this reason, the community of Austrian scholars should promote a clear distinction between Austrian research and political activism.
In part due to the efforts of scholars such as Dr. Salerno, the Austrian school has grown in prominence and exposure by leaps and bounds in the academic community, both within economics and beyond. However, the growth of the Austrian school as a heterodox approach may also tend to attract elements that seek to exploit rising interest for personal profit, or those attracted to the community not necessarily by its ideas, but its distinctiveness from the existing status quo. Such groups may include racists, fear-mongers, or simply those advocating apophenic views contradictory to empirical reality. Clearly, as an intellectual enterprise that not only values the development of thoughtful theoretical and empirical research, but also one with a deep dedication to principles of human liberty, the scholarly community must act to quickly condemn any such groups that may attempt to associate themselves with the Austrian school for no other reason than its rising popularity. Organizations or individuals whose mission is contrary to that of advancing sound social scientific thought and human liberty central to the Austrian school should be immediately and quickly dismissed. Obviously most Austrian scholars are quick to condemn these types of groups or individuals, but a more active, vocal, and immediate stance is necessary within the scholarly community in opposition to such detrimental associations to prevent negative perceptions by broader academe and to preserve the school’s intellectual integrity. In addition to being clearly opposed to principles of human liberty and Austrian thought, such negative associations would also be highly detrimental to the advancement of interdisciplinary opportunities across the social sciences.
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In this article IPhilipp Bagus is professor of economics in the Department of Applied Economics I at Universidad Rey Juan Carlos, Madrid, Spain. Professor Bagus was a summer research fellow in 2006 and 2009. This chapter is an extension of the theoretical perspective developed in the article “The Quality of Money,” for which the he received very valuable comments by Professor Salerno. The author wishes to thank David Howden for excellent comments on the present article. Joseph T. Salerno has not only been a very important mentor and friend for me. With his humor, positive attitude, and generous support he is a precious asset for Mises Institute summer fellows such as I was for two years. Thank you, Joe. With his articulate, intransigent and courageous support of sound money, he is an invaluable asset for the Austrian school. He not only always stands up to defend the theoretical advances of Mises and Rothbard, he also has added to the corpus of Austrian theory. would like to continue in the tradition of Mises, Rothbard, and Salerno to analyze how sound monetary regimes affect the quality of money. The value of money, as of any other good, depends on its usefulness or quality in the eye of its user. Money’s quality can be defined as “the capacity of money, as perceived by actors, to fulfill its main functions, namely to serve as a medium of exchange, as a store of wealth, and as an accounting unit” (Bagus 2009, pp. 22–23). Changes in money’s quality affect the demand for money and, consequently, its purchasing power. The quality of a monetary regime, in turn, may be defined as the capacity of a monetary system to provide an institutional framework for a good medium of exchange, store of wealth, and accounting unit.
While the quality of a monetary system or regime is perceived subjectively by actors, there are several objective characteristics that tend to influence this perception. In a trial and error process actors normally do not base their perceptions of their institutional framework on poor whims, as they suffer the consequences of poor judgment. Guided by the objective qualities of monetary systems, actors tend to benefit as they can hedge against depreciation or gain from appreciation of the currency. They can protect their monetary wealth more efficiently. In this article we will analyze these objective qualities of “good” monetary systems.
Connection Between the Quality of Monetary Regimes and Money’s Purchasing PowerThe quality of monetary systems has been neglected in the literature.Bagus (2009) discusses the quality of money in general. Bagus and Schiml (2009, 2010) and Bagus and Howden (2009a, 2009b) analyze the quality of the currency unit through the central bank’s balance sheet. Bagus and Howden (2011) point out that Iceland’s central bank adopted an explicit lender of last resort function that deteriorated the quality of Iceland’s monetary regime. Comparative analyses of monetary systems from an institutional perspective are rare.The mainstream focuses narrowly on the aspect of central bank independence and mostly neglects all other aspects. Neither do textbooks delve into the qualities of monetary systems, an exception being White (1999). Rather, monetary policies within the setting of our current fiat money systems are analyzed, sometimes enriched by a narrative of the evolution of some historical monetary regimes, yet without providing a comparison of them. The neglect of a comparison might be caused by the belief that we have found the best monetary system. Fiat monetary systems are controlled by a central bank and can be manipulated to provide a supposedly perfect money fulfilling its functions as a medium of exchange, store of value, and unit of account. Moreover, qualities of monetary regimes are hardly measurable or usable in econometric analysis which makes the question unattractive for modern econometric research. Recently, the financial crisis has led to doubts about the set up of the financial system and the monetary system in particular, which makes a comparative analysis of the monetary system timely.
The quality of monetary systems influences the demand for money and, thereby, money’s purchasing power. While much emphasis has been put on the quantity of money and its influences on money’s purchasing power, money’s quality, and the quality of monetary systems are equally important for money’s price, if not more so. In fact, money’s quantity may be interpreted as one of several characteristics that determine money’s quality and the likelihood and capacity of monetary regimes to increase or decrease money’s quantity is one of the important characteristics of the quality of a monetary regime.
Changes in monetary systems may lead to sudden changes in money’s quality and purchasing power. More specifically, a change in the monetary regime may lead to a pronounced change in the valuation of money in relation to other goods. Imagine that actors regard the new monetary system as a worse provider of a medium of exchange, store of wealth, and accounting unit than the preceding system. Actors value money less intensely with respect to other goods. This may be illustrated by an example of an individual’s value scale before and after the regime changes.
Value scale before regime change...20th 5th $10 bill21st Hamburger meal22nd 6th $10 bill23rd cheeseburger24th 7th $10 bill25th Bottle red wine26th Bottle white wine
In our example our person having seven $10 bills in his pocket would not buy wine priced at $10. However, she would give up one $10 bill for a cheeseburger that she values higher than the 7th bill she owns. She would also spend the 6th bill for the hamburger meal valued higher. Let us look at the value scale of the regime change by which the perception of money’s quality falls. The new monetary regime is in the eyes of actors providing a worse medium of exchange, store of value, and unit of account than the preceding regime.
Value scale after regime change...20th Hamburger meal21st Cheeseburger22nd Bottle red win23rd 5th $1024th Bottle white wine 25th6th $1026th 7th $10
We see that goods tend now to be ranked higher on the value scale relative to money units than before.Salerno (2006, p. 52) refers in this context to “the relative rankings of goods and of money among market participants.” This relative ranking is immediately and potentially strongly affected by changes in monetary regimes. After the change, the person would give $10 for a bottle of white wine. She would also buy red wine, cheeseburger, or a hamburger meal with $10. The prices of these good would tend to increase. Without any increase in the quantity of money, money is valued less in comparison to goods due to the qualitative deterioration of the monetary regime. Money’s purchasing power decreases. Brisk changes in purchasing power may be caused by a change in monetary regime. This gives us reason to analyze the quality of different monetary regimes and how changes to them influence their quality.
Qualities of Monetary RegimesMonetary regimes provide a framework within which money fulfills its functions. As the unit of account function is fulfilled by nearly all monetary systems equally well and it is impaired only in extreme situations, we will concentrate of the characteristics of good medium of exchange and store of value.As Röpke states, referring to the German 1922–1923 hyperinflation (1954, p. 121), money’s functions often disappear in a certain order. First, money ceases to be used as storage of wealth, when actors start to think that it continuously will lose value. Second, when the fluctuations of the value of money increase and money loses its value faster, money loses its function as a unit of account. People started to calculate in other units. In 1923, they started to calculate in gold and even the German government calculated its taxes in gold mark. The last function that is lost in a hyperinflation is the function as medium of exchange. People progressively started to use foreign exchange to transact (Bresciani-Turroni 1968, p. 89). In November 1923, the mark was completely abandoned as a medium of exchange.
We will begin with the characteristics of a good medium of exchange and the influence on it by a monetary regime. A good medium of exchange has low storage and transportation costs. Other properties are easy handling, durability, divisibility, resistance to tarnish, homogeneity, and ease in recognition. These properties hardly change today as paper-based fiat standards have eased the physical usability of the monetary unit, as well as the costs to provide it. In commodity standards these qualities may change when society switches from one commodity to the other. For instance, a change from a silver to a gold standard may imply an increase in the quality of money as gold is more durable than silver, which suffers from oxidization. A more relevant property of a medium of exchange is the number of users. More users imply more demand for the medium of exchange. As more people accept it in trade, the medium of exchange is more useful. Changes in monetary systems may increase the number of users and thereby the quality of the money. For instance, at the end of the nineteenth century ever more countries left their silver standards to adopt the gold standard. The increased use of gold as a currency increased its quality as money. Similarly a switch from Germany’s Deutsche mark to the more widely used Euro or from national fiat currencies to a world fiat money increases the quality of money as a medium of exchange. The tendency of an increase in the quality of money as a medium of exchange is, however, counteracted by possible decreases in its functionality as a store of value.
Ironically, maybe the most important characteristic for a medium of exchange is the existence of ample non-monetary demand for the money as either a consumer good or a factor of production. The demand for other, non-monetary purposes assures that there exist unsatisfied wants which are intense and permanent (Menger 1892, p. 5). The non-monetary demand serves as “insurance” for the money holder as it stabilizes its value due the constant demand.The main disadvantage of Bitcoin is that it virtually lacks such an “insurance.” If the money is demonetized, in the worst case scenario, by the government or because people turn to another medium of exchange, it will still retain its use value. A money with a very low or no non-monetary demand loses almost all its value in a demonetization. Its value is totally dependent on the monetary demand for the good and the confidence in it. Its value tends to be more volatile than the value of a money that has a stabilizing non-monetary demand. If the insurance breaks away even without any change or expected change in money’s quantity, its quality is reduced, leading to a tendency for its purchasing power to decrease. This is so, because the risk of demonetization and a complete loss of value for money holders without a non-monetary demand insurance is greater than for a monetary unit with a use value. Without this insurance, the demand for money tends to fall, leading to a fall in purchasing power. Therefore, if there is a switch from a monetary regime with ample non-monetary demand such as a gold standard to a monetary regime without a relevant non-monetary demand such as a fiat money standard, the quality of the money regime is reduced, independent of (expected) quantity changes.
The store of value function is another important function of money. There are several characteristics of a good store of wealth.
One of its most important characteristics is the possibility of increases in its quantity. Different monetary regimes allow for different mechanisms to increase the quantity of money, thereby influencing money’s quality. Thus, monetary systems may set strict and less strict limits for increases in the money supply. A switch from a monetary system that strictly limits the quantity of money and its possible increases to a monetary system that makes increases in the money supply more likely and less predictable implies a deterioration of the quality of money.
For the quality of the monetary regime the stability of the financial system it fosters is also important. There are monetary regimes that are more prone to generate business cycles, over-indebtedness and illiquidity than other regimes. Business cycles, over-indebtedness and illiquidity may provoke interventions and bailouts on part of the government or monetary authorities. In the wake of the bailouts the quantity of money is often increased, or even the quality of the monetary system is diluted. For instance, redemption into specie might be suspended or a new monetary order may emerge (e.g., the introduction of a world fiat money). Consequently, money’s quality is affected negatively by a change toward a more instable monetary system.
The probability of demonetization is a related factor influencing money’s quality. Some monetary systems are more prone to demonetization than others. Systems that come along with an instable financial sector may lead to collapse or public bailouts that endanger the confidence in the monetary unit. Another factor that affects money as a store of value is the potential for general manipulation by the government. Interventions by the government often decrease the quality of money in its own favor by increases in money’s quantity or through a deterioration in the reserves backing it. A government could, for instance, confiscate the gold reserves of its fiat currency to pay for expenditures thereby decreasing the quality of money. Some systems are less prone to government intervention than others where the government has a stronger foothold in the system.Herbener (2002, p. 11) points out that the government is likely to use those footholds to switch to ever more interventionary monetary regimes: Given any foothold in monetary affairs, the state would always move step by step to an inflationary monetary regime, the exercise of which would eventually cripple, if not destroy, the market itself. Given the power to coin gold, the state would come to suppress the coinage of private mints by waiving its mintage fee. Once securely dominant as a money producer, it would make its coins legal tender, leading to the possibility of seigniorage from debasement. Likewise, if the state had the power to issue money substitutes, it would suppress the issue by private banks by waiving the printing or accounting fees. Once securely dominant as a money substitute producer, the state would rescind redemption to capture the revenue from inflating the stock of its, now, fiat paper money. The more independent a monetary regime is from the government, the higher is the quality of the currency. A switch to a monetary system more dependent or open to interventions by a government means a deterioration of money’s quality.
A 100 Percent and Free Gold StandardI will now analyze the quality of money in different monetary regimes.For an analysis of the devolution of monetary systems see also Hoppe’s (1994) analysis. Hoppe shows how money and credit deteriorates as a result of government intervention. Rittershausen (1962, p. 334) and Veit (1969, p. 88) offer classifications of monetary regimes. Rittershausen focuses on the legal tender and emphasizes that systems were beside specie also bank liabilities are legal tender diminish the quality of the currency. His classification is similar to mine. I will start with the highest quality monetary regime and work my way downward to systems of lower quality. In a 100 percent gold standard, only gold (or 100 percent backed gold certificates) is money and banks hold 100 percent reserves for their demand deposits. The following analysis applies mutatis mutandis to other 100 percent commodity standards such as a 100 percent silver standard.Similary, gold and silver may be in use simultaneously. I picked the example of gold out for two reasons: the historic importance of the gold standard and its unique qualities.
A 100 percent and free gold standard offers all the qualities of good money. Gold has a relatively high value in a small size, thus reducing storage and transportation costs. It is easy to handle in exchange and easily divisible. It is homogenous. Its grade is easy recognizable and it is resistant to tarnish. There exists a tremendous non-monetary demand for gold all over the world. Gold is also relatively hoardable as it can be bought and sold in large amounts without losses. Moreover, the production costs of gold are very high, as is the existing gold stock. Anyone can mint coins; the government has no foothold in the monetary system. Gold is, thus, difficult to manipulate by governments. Only by outright coin clipping or by changing the monetary regime itself can the government manipulate gold. Furthermore, these two kinds of gold manipulations can face strong resistance, as they are highly visible when gold is in the hands of the citizenry.
In addition, in a 100 percent gold standard there is unlimited and unconditional redemption. The banking system is per definitionem liquid; it cannot be brought down by a bank run, as there are 100 percent reserves. The economy and the government are less likely to have negative effects on the quality of money than in other regimes. This is so, because a 100 percent gold standard strengthens the economy and puts limits on the spending of government. As there is by definition no credit expansion and no artificial reduction of interest rates, there is no credit created business cycle. And as taxation is unpopular and government debt cannot be monetized but has to be paid out of taxes, government has to be fiscally more responsible. The tendency toward slowly falling prices in such a system when economic growth exceeds increases in gold production makes debts less attractive.For an analysis of growth deflation see Salerno (2003). Overindebtedness is therefore quite unlikely.
In a free 100 percent gold standard there exists also monetary competition. No one imposes gold as money and other monies can compete freely with it. The competition in the production of money ensures the quality of money. Bad money is pushed out of the market by good money (Hayek 1978, pp. 1–3).For the advantages of currency competition see Klein (1974) and Vaubel (1977, 1988). Only the money that best fulfills and keeps fulfilling the function as unit of account, storage of wealth and a medium of exchange prevails under free competition. There is no central bank, no monetary monopoly or legal tender laws. Hence, there will be a discovery process for the best currency. Different issuers in a trial and error process compete in offering currencies to their customers. Inefficient producers of money disappear. Only the efficient producers of money that produce money in a quantity and quality fitting consumers’ wishes best will survive. As money users usually prefer a stable currency, there will be a competitive process toward stable currencies.
Lastly, the monetary system tends to be stable. 100 percent reserves on demand deposits ensure that no bank runs on demand deposits will lead to a banking crisis. Moreover, there are harsh limits to other types of maturity mismatching, i.e., borrowing short and lending long (Bagus 2010; Bagus and Howden 2010). Borrowing short and lending long is a very risky business. Competitors, by assuming short-term debts and not rolling over the debt, might drive banks into bankruptcy. Speculators may also short bank stocks and try to instigate a run on the short-term liabilities of banks. Customers will attend those banks that limit this risky behavior. In short, in a free market maturity mismatching is strictly limited and there is no reason why banks would systematically err about the amount of short-term renewable savings. More importantly, the promoters of excessive maturity mismatching such as government guarantees for banks are limited, or absent, as there is no central bank that could roll over short-term debts nor credit expansion increasing constantly the money supply making a roll-over of short-term debts easier. The financial system in a 100 percent gold standard is, therefore, very stable. The chance that governments will be tempted to bailout the financial system diluting the value of money or the monetary regime is reduced.
Fractional Gold StandardsI will now analyze fractional reserve gold standards with different properties. I will not explore every theoretical possibility but will concentrate on the historical monetary regimes. The first fractional reserve standard is a gold coin standard.Again, the analysis applies mutatis mutandis to other fractional reserve commodity standards. In a gold coin standard banks hold fractional reserves and gold coins are in circulation. A gold coin standard contains the same properties in regard to its functions as a medium of exchange as a 100 percent gold standard. Gold is not perishable, homogeneous, has a great value in a small bulk, etc.
The main difference concerning the quality of the money, though, comes with money’s function as a store of wealth. In a gold coin standard, money is easier to manipulate for governments than in a 100 percent gold standard, as the government typically holds the monopoly of the mint. In addition, banks are allowed to produce fiduciary media, i.e., money substitutes not backed by gold. The banking system does not necessarily have to hold 100 percent reserves, as credit expansion is possible. Credit expansion, by causing business cycles, weakens the economy and helps to monetize government debts. In a recession, there is the danger of government bailouts diluting money’s value. Recessions may also be used as a pretext to increase government’s foothold in the economy, for instance by installing a central bank. If a central bank is installed, the quality of money falls even more, as this agency is a foothold of the government into the monetary system that is likely to reduce the quality of money further.
Moreover, credit expansion serves as a promoter of maturity mismatching, i.e., borrowing short and lending long. In the case of roll over problems of short-term debts, banks may use their own deposits as a substitute for financing. In addition, credit expansion tends to increase the money supply which reduces the risk of maturity mismatching. The financial system becomes more unstable by the tendency for excessive maturity mismatching. This makes a government bailout implying a deterioration of the money standard more likely.
Furthermore, an important difference of a fractional gold standard and a 100 percent gold standard is the effect of increases in the quantity of money on its quality. When in a 100 percent gold standard new gold is mined, this gold naturally is of the same quality as the old money. The quality does not deteriorate. Yet, when in a fractional gold standard, the amount of fiduciary media, i.e., paper money, increases, the quality of the currency decreases, as there are less gold reserves per monetary unit. The reserve ratio shrinks and the average backing of the currency deteriorates.
Gold Bullion StandardThe gold bullion standard tends to emerge from a gold coin standard. When in a gold coin standard, credit expansion creates recurrent banking crisis, and banks tend to press for the installation of a lender of last resort, the central bank. At the same time, banks are interested in a reduction of coins in circulation which is realized in a gold bullion standard, where the government does not mint coins. Typically, the gold reserves are centralized in a central bank. The currency is backed by gold bullion and the reserves centralized in a central bank. The currency can be exchanged against bullion at a fixed rate. Gold coins likely disappear from circulation.
In such a system the quality of money is reduced vis-à-vis a gold coin standard. It is more difficult to hoard gold as only bullion can be exchanged against currency. Due to the difficulties of redeeming and transporting bullion, less currency will be redeemed into gold and gold will practically disappear from day-to-day transactions. Consequently, banks can reduce their gold reserves. This allows for greater credit expansion, which, via business cycles, weakens the economy and helps to monetize government debt. As banks tend to reduce their reserves, they become more illiquid. Greater credit expansion and the introduction of a central bank reduce also the risk of maturity mismatching. Excessive maturity mismatching adds to the instability of the financial system. The higher probability of bailouts and further denigration of the regime deteriorates the quality of the currency.
As there is a lower amount of gold in the hands of the public it is easier for the government to suspend redemption altogether without leading to a double standard and facing the resistance of people to hand over their gold. Thus, the government can manipulate the money and deteriorate the money standard easier.
Gold Exchange StandardThe next step down in the quality of monetary standards is a gold exchange standard. A gold exchange standard is a fixed exchange rate system like the Bretton Woods system. Currencies are pegged at a fixed rate with a main currency that can be redeemed into gold bullion. Only central banks can redeem one currency into gold bullion through the main central bank which was the case during the Bretton Woods era with the Federal Reserve System.
A gold exchange standard leads to a further centralization of gold reserves and allows the banking system outside the main country to expand credit on top of the main currency. The main banking system also is likely to use its privileged position in order to expand credit. The system sows the seeds of its own collapse if the main country expands credit, thus imposing a cost on the rest. The exploitation of this position will then meet the resistance of the other countries who start to demand redemption as happened in the case of Bretton Woods, when the French government demanded payment in gold.
As a consequence of a higher capacity for credit expansion, business cycles will become more volatile, harming the economy. In addition, monetization of debt on a larger scale becomes possible. Maturity mismatching increases and the financial system grows more unstable increasing the chance of diluting bailouts. The tendency toward price inflation also increases, which in turn incentivizes people to take on debts. The population’s day-to-day connection with gold becomes looser and less resistance will be felt when the connection is cut by the government altogether.
It should be pointed out that becoming the main currency in a gold exchange standard may in some sense increase the quality of this main currency. It is very profitable to be an international reserve central bank (Rittershausen 1962, p. 408). Other central banks hold reserves of the main currency at very low interest rates. Other central banks must fear devaluations that would imply losses in their assets. When a currency becomes the main currency it implies therefore an increase in its quality. Other economic agents are more likely to accept and hold this currency.
Within these fractional reserve standards we may distinguish between systems where the unit of account and medium of exchange are separated and those where they coincide. In systems where unit of account and medium of exchange are separated, people calculate in a currency such as gold but pay also with another medium of exchange such as bank notes or deposits. These notes and deposits may have a discount in relation to payments in specie. Therefore, a credit expansion may lead to a higher discount leaving unharmed the integrity of the gold currency. Prices denominated in bank notes increase but not denominated in specie. If, on the other hand, bank notes and deposits have to be accepted at par due to legal tender laws, the quality of the system decreases. Credit expansion in this case cannot lead to a discount anymore but deteriorates the quality of specie as prices denominated in gold increase.
Fiat Paper Money StandardA brisk change in the quality of the monetary regime occurs when redemption is finally suspended altogether leading to a fiat paper currency. In a fiat paper money standard as the world has been on since 1971, not even central banks are able to redeem the currency against bullion. There is no guarantee anymore to receive any specific amount of gold for the currency. Hence, the quality of the money has declined.The fall in the quality of money helps to explain historical price inflations. When the U.S. went off the gold standard in March 1933, wholesale price soared 14 percent over 1933 and 31 percent by 1937. When the U.S. went off the gold reserve standard (the Bretton Woods system) in August 1971, wholesale price increased 4.35 percent during the rest of the year, more than 13 percent between 1972 and 1973, and over 34 percent between 1972 and 1974 (Hazlitt 1978, p. 76).
There is a wide divide between redeemable claims to gold as in the gold standards discussed above and unredeemable paper money. Unredeemable paper money presents a claim on something that is not specified. Fiat paper money fluctuates in value according to the holder’s belief of what the fiat money will be able to purchase. This estimation may fall very low and easily to zero. It is completely dependent on trust. If trust evaporates its value may well fall to zero, without dramatic changes in the money’s quantity.
The capacity of irredeemable paper money to serve as a store of wealth is dominated by this uncertainty. Nothing of this sort happens with a (convertible) money certificate that, for instance, can be exchanged at any moment against gold. As Rist (1966, p. 200) summarizes: “In short, convertibility is not a mere device for limiting quantity; convertibility gives notes legal and economic qualities which paper money does not possess, and which are independent of quantity.” Therefore, when the redemption of bank notes and deposits in a gold standard is suspended, the quality of money, from one second to the next, is reduced (independently from what might happen to money’s quantity).
Once redemption is suspended, there is no safety net for the value of the currency to fall back to. Money is not connected any longer with the industrial demand for gold. The “insurance” of a strong industrial demand for the money holder is gone.One might argue that “de facto” redemption, i.e., interventions of the central bank selling its assets are an insurance. However, there is no legal insurance or security whatsoever that central banks will intervene at the point of time the money holder wants.
Production costs of new paper money are very low, increasing the likelihood of increases in the money supply. Moreover, as redemption is suspended, the last control against government manipulation is gone. The floodgates for governmental manipulation of the money supply are open. Now the only restriction for government is its own will to put a limit on the production of additional money. These limits are typically formalized through the statutes and mandates of the central bank.
As a central bank can print an unlimited amount of money and bail out banks, moral hazard ensues. Maturity mismatching increases and reserve ratios are reduced. Credit expansion leads to more volatile business cycles harming the economy. The monetization of government debts by using the printing press has become easier. The financial system becomes even more fragile than before. Government bailouts become more likely and deteriorate the quality of money. As a consequence, money practically loses its function as a good store of wealth. Price inflation becomes a feature of everyday life. As people become accustomed to increasing prices, they start to incur more debt. Both the indebtedness and fragility of the economy increase. Thus, at the instant the monetary system is deteriorated to fiat paper money system, the quality of money declines sharply.
Switching Monetary Regimes and Money’s Purchasing PowerChanges in the quality of money can be made within a certain monetary regime and by changing the monetary regime. Any move up the qualitative ladder explained above from the bottom to the top, i.e., from a fiat paper money, to a gold exchange standard, to a gold bullion standard, to a gold coin standard to a 100 percent free gold standard implies a substantial improvement in quality. Any move down the qualitative ladder implies a deterioration of the quality of money and a tendency for price inflation. Downward movements have been more common in history. Especially in preparation of or during war efforts, monetary regimes were often changed for the worse (Rittershausen 1962, p. 366).
Improvements in monetary regimes have occurred in history. For instance, resumptions of specie payments, i.e., a change from a fiat paper money to some variant of a gold standard have occurred in history at various times; especially when specie payment was suspended during war and later resumed. Examples are the resumption of specie payment in Great Britain after the Napoleonic Wars and after World War I, as well as the resumption of specie payment after the U.S. Civil War in 1879. When it is expected that specie payment will be resumed, people expect the quality of money to increase and money’s price can rise immediately. This is probably one cause of the price deflation in the U.S. before the resumption of specie payment in 1879 (Bagus 2015). Another example is Peel’s Bank Act of 1844 which prohibited the issue of unbacked bank notes. The failure of Peel’s Bank Act was to not include bank deposits in the provision. The introduction of a 100 percent reserve ratio for demand deposits as well, would have increased the quality of the monetary regime strongly.
In general, however, the evolution has been downward from gold standards of a higher quality to gold standards of a lower quality and finally to fiat money standards. In fact, once we step down from a 100 percent gold standard, the seeds are sown for a progressive deterioration of the money regime. Government gets a foothold in the monetary system. Credit expansion by the central bank lead to excessive maturity mismatching, overindebtedness, and financial instability. In the crisis caused by these monetary regimes, bailouts tend to occur leading to higher government debts which are later monetized. In theses crises the regime is also often denigrated. For instance, redemption of specie payments may be suspended in a banking crisis.
ConclusionBeside money’s quantity also its quality influences its purchasing power. In this paper we have analyzed the quality of monetary regimes which consists in providing an institutional framework for a good medium of exchange, store of value and medium of account. Changes in monetary regimes may lead to substantial changes in money’s quality and thereby affect money’s demand and purchasing power. The highest quality regime contains a 100 percent gold standard. Fractional-reserve gold standards contain the seeds of their own deterioration, leading via credit expansion to economic and banking crisis. Via progressive government intervention and centralization of reserves a gold coin standard deteriorates into a gold bullion standard and a gold exchange standard.
The switch from a gold exchange standard to a fiat paper standard is a watershed. There is no non-monetary demand for the money unit anymore. Its value is solely maintained by trust and confidence while the insurance of an ample non-monetary demand has vanished. Government and central banking control monetary affairs totally. Recurrent recessions and bailouts of the financial system become likely, deteriorating the quality of money. Future research may focus more on the qualities of different monetary regimes and how their switch affects the quality of money and also economic growth. A switch to a higher quality regime of money in a recession may positively affect confidence and economic growth.
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EconomistsDavid Howden is professor of economics and chair of the Department of Business and Economics at St. Louis University, at their Madrid campus, Madrid Spain. beyond a certain age will recall a simple mnemonic when listing money’s main functions: “Money is a matter of functions four, a medium, a measure, a standard, a store.” The four functions of the categorization of money are known today as the, (1) medium of account, (2) measure (or unit) of value, (3) standard of deferred payments, and (4) store of value. The rhyme alludes to the fact that economists thought that money served a somewhat broader role once upon a time than it does today.
The mnemonic also makes clear that money has several well-defined uses, unlike other economic concepts, like “goods” which have innumerable uses subjectively determined by their users, or a “price” which is the unique objective embodiment of these uses. In this way, money is special.
Due to good luck endued in him by his parents, Joe Salerno is of the age necessary to be included in the group of economists who cut their teeth in monetary economics by learning this rhyme. Unfortunately, he may well be old enough to have forgotten it, as well as where he left his glasses, his wife’s birthday, their anniversary, and all sorts of other things important to his life!Amongst other things important to his life, I will take the liberty to include the first time Joe met me. By my “young” mind’s recollection, this was at a dinner at a taco house in Auburn, Alabama, some balmy early June evening in 2008. This was the first of two summers I would spend at the Ludwig von Mises Institute as a summer fellow under the guidance of Joe. Thank you, Joe, for your intellectual encouragement, mentoring and, of course, friendship, over these past six years.
In this chapter I will revisit the use of this simple mnemonic to underscore what money is. I will then use these insights to augment Salerno’s (1987) work on the “true money supply.”
Money is as Money DoesIn an unsettling way, the old adage that “money is as money does” has a ring of truth to it. When defined, as it commonly is in introductory economics textbooks, as “the generally accepted medium of exchange,” money can be a variety of goods, provided they meet three criteria: (1) that the good is used to settle exchanges, (2) that the good is the final means of settlement, i.e., not credit, and (3) that the economic community generally accepts such a good to settle exchanges. Economists then move on to a discussion of whether a “good” is a candidate for inclusion in the definition of the money supply when it satisfies all three of these conditions. The result is any of the common “M” measures of money.
While it is trivially true that money is as money does, there must be a better way to approach the problem. The old trusty mnemonic hints at how we can proceed.
In the common story of the origin and evolution of money, one central aspect is the reduction of transaction costs (i.e., Menger 1871, chap. 8, 1892). In a moneyless world there is a double-coincidence of wants problem, as elaborated by Jevons (1875, p. 3). As the scope of trades is limited and the costs associated with setting an agreeable price once trading partners do meet is high, there is an incentive for traders to use specific goods that are widely demanded to settle their transactions. As more individuals use these few specific goods to settle their exchanges, they gain a value for exchange purposes in addition to the value they possess for direct use. The process ends when one (or very few) goods begin to be traded solely for exchange purposes, and their acceptance is due to the knowledge that they can be easily traded with, and accepted by, another individual. Money is the outcome of this process, and it is also clear that whatever good is functioning as money will also be the generally accepted medium of exchange as a result.
Money’s use during its evolutionary process is clearly for exchange purposes but there is also an additional role of great importance. Mises (1949, pp. 244–51) sheds light on this by way of his equilibrium construct of the “evenly rotating economy” to demonstrate when money is not necessary. Only in a world of full certainty — one where all expenditures are known in advance, both in magnitude and timing — would money not be necessary. The reason comes from a simple opportunity cost analysis.Confusions suffered while interpreting the results of Mises’ evenly rotating economy commonly center on misunderstandings of what role money is embodying within it. Specifically, it is not necessary for money to circulate as a medium of exchange but it is of importance that it exists to denominate prices (Howden 2009, 8 n.8).
Since money functions as the final means of settlement, it is also always and everywhere a present good. Indeed, money functions as the present good par excellence and as such yields no interest payment. Holding money will always force an individual to incur a cost in terms of the yield on whatever other best but foregone option is available to him. Rather than forego an opportunity by holding money, if the individual knew in advance what his monetary demands would be he would either lend his money at interest until it was needed, or would turn to the futures market to settle his future transactions at some discounted value in the present.
Depart from the perfectly certain world, however, and one runs into the intractable problem of how to best meet his future needs. As Mises (1949, pp. 14, 249) shows, money serves as a security hedge to guard against these uncertain situations. The key problem is that “[u]ncertain of what, when, where or the amount of future expenditures, individuals demand to hold an amount of money to safeguard against this uncertain future” (Bagus and Howden 2013, p. 236).
Of course, other highly liquid money substitutes can also serve this role to some degree. Rothbard (1962, p. 713) refers to these as goods as a type of “quasi money,” but to the extent that they are not perfectly liquid assets or the final means of settlement, they cannot function as “money.”
Thus, while a highly liquid very short-term bond may substitute for money in some ways, the fact that it is never the final means of settlement and is itself open to some degree (however small) of default risk forever trap it in the category of quasi moneys and stop it from claiming a monetary status. Chief among these quasi moneys in today’s economy are money market mutual funds (currently amounting to about $2.7 trillion) and liquid assets used as collateral by the shadow banking industry.Notoriously difficult to define or measure, some estimates place the size of the shadow banking system in the United States at $19 trillion as at year-end 2011 (Singh 2012). By way of comparison, the True Money Supply figure, defined in Salerno (1987) and elaborated on below, was substantially smaller at the end of 2011 — $7.3 trillion.
In this brief discussion of the evolution and use of money there are several roles taking place concurrently. The most obvious one is the medium of exchange — a unit to transfer in settlement of pecuniary obligations. There is also the role of money in mitigating our felt uncertainty, however. In order to function accordingly, we must identify what the relevant uncertainties are that the individual will face.
Having already commented on the unknowledge of what, how much or when we will need purchasing power in the future, we can now comment on why money is held as a hedge against these expectations. After all, most individuals can and do hold a variety of liquid non-money financial assets to assist them with their future expenses, e.g., equities, short-term bonds or certificates of deposit. All of these non-money financial assets have a risk inherent in them which the money holder must overcome.
It is useful to think about financial assets in terms of two characteristics — when are they available, and what value they will have at that moment when they are used. The first criterion can be divided into two categories. A good is either a present good, i.e., it can be used at any time, or it is a future good, i.e., its value cannot be realized until some point in the future. The values in question also come in two distinct forms. A financial asset either trades at par or market value, with the latter fluctuating as per supply-demand conditions in the market. All financial assets can be classified according to these characteristics, as in Figure 1.
In the scope of financial assets, money is unique. It is the only good that is available at a moment’s notice and at par value. The par value nature of a financial asset comes from the fact that its payout is defined in terms of itself. One dollar held as currency or on deposit equals one dollar of purchasing power. Likewise, bonds are denominated in terms of money units (e.g., dollars), such that the purchaser receives a set nominal amount of said currency units upon maturity. In contrast, financial assets that trade at market value are purchased in terms of “shares” (or a claim to shares in the case of a future), with each share deriving its value from an underlying asset, whether it exists in the present or the future. When an individual buys a share in a company, the value is defined as a percentage of the company’s future earnings stream, discounted to the present at an appropriate discount rate.
Equities and money are both present goods in the sense that their respective values, or purchasing powers, are unleashed at a moment’s notice. The owner of equity is forever unsure of the value he will receive for the sale of his shares, however, as it is dependent on market conditions at the time of sale. The owner of a bond is assured the value of his asset, but only if he waits until maturity to sell it. (He can, of course, sell at any moment though the value he receives will be dependent on supply-demand conditions at the time, i.e., he will receive the market value at that moment in time, effectively making the bond an equity investment ex post.)
In a superficial sense, money is demanded because it is highly liquid. Yet this cannot be the sole reason money is demanded, as other financial assets such as equities and heavily traded debt securities are also highly liquid. Money is also demanded because its nominal purchasing power is guaranteed, as it is with bonds if we abstract from default risk. Thus, in some ways money exhibits features of equity securities (e.g., high liquidity) and other features more common in debt (e.g., par value redemption).
More to the point, money is demanded because of its uniqueness. Money is the only asset that is able to combine both features — par value and on demand availability — into one package. It is this combination that makes money such an exceptional, and also essential, part of a portfolio of financial assets.
Money as Medium of Exchange and Unit of Account, Present and FutureThus far I have been able to establish some characteristics of money without making reference to its specific functions. Actually, the causality runs the other way ‘round. There are some specific roles needed to be filled in the economy, and money (broadly defined for the moment) is the good that emerges to serve these roles. To understand why, consider two of the common functions of money in our introductory mnemonic. To jog the younger reader’s mind (as well as Joe’s): “Money is a matter of functions four: a medium, a unit, a standard, a store.”
The obvious two functions that correspond to what any introductory economics course teaches us are those of the unit of account and medium of exchange. In one very important way, these two roles share a common link. They both perform their role in the present. Money serving as a numéraire to express prices allows for value comparisons in the here and now, and when we exchange money we settle our transactional obligations instantly. Thus, the unit of account and medium of exchange are both present functions of money.
Although we commonly think of money in terms of these present functions, is it also possible for money to have future functions? Again, returning to our mnemonic we see that the other two roles — the store of value and standard of deferred payments — are important roles that money is expected to perform at some future date. Whether money will prove itself to be a useful store of value will not be known until the future is revealed. Long-dated contracts can be defined in terms different than the common unit of account by the standard of deferred payments.A weight of gold served this purpose for most of history, even when a different currency unit was used in exchange for more short-term oriented pricing. This changed in the United States starting with the Legal Tender Act of 1862 (which, despite a tumultuous start was finally ruled constitutional in the 1884 case of Juilliard v. Greenman, 110 U.S. 421). Despite contracting for settlement in a different good than was commonly used as the medium of exchange, legal tender laws effectively make the standard of deferred payments (as well as the other monetary functions) the same as the preferred money of the state. Since payment must be accepted if rendered in the legal tender, even a pre-agreed alternative cannot be upheld in a court of law.
Each of money’s four roles has a temporal dimension, but they also have a common connection by the general category of use that they are satisfying. Generally speaking money is either used to price a good for sale (if one is the seller) or exchange for the good to complete the transaction (if one is the buyer). Figure 2 shows how money’s four roles dovetail with the two criteria defining their demand. Money, by serving in any of these four functions, is demanded to set prices or exchange for goods, either now or in the future.
As previously alluded to, one monetary good need not serve all of these roles simultaneously. Historically, many goods have served as pricing units without also being exchanged to settle transactions. Although gold and other precious metals have commonly served as pricing units in recent history, accounts abound of other, less common goods, performing the same role. Cigarettes in POW camps (Radford 1945), large circular Rai stones on the South Pacific islands of Palau and Yap (Bryan 2004) and even slave women (cumal) in Early Medieval Ireland (Nolan 1926) are well-known (and well-used) examples provided by economists.
Likewise media of exchange are varied over history, though much less so than with the units of account. The reason for this is straightforward. As per Menger’s theory of the evolution of money, for money to achieve the status of the “generally accepted medium of exchange,” it must be broadly demanded throughout the economy. Together with some of the objective properties of precious metals (e.g., divisibility, durability, difficulty to counterfeit, etc.), metallic goods were used because of the assuredness that the recipient would accept them.
Pricing units need not be chosen mindful of this constraint. Instead they have been selected for criteria that include general knowledge of their value, constancy of value of time (or, at least, a non-volatility of value compared to the values of other goods), and ease of recognition. Divisibility has never been an issue for pricing units, as fractions of any unit can express value as well as any whole number. Fractions of women were used to define fines in ancient Ireland, though these prices were not paid with the aid of a steady-handed surgeon. Instead they were settled with another good functioning as a medium of exchange, at the going exchange rate of that good for women.Although using fractions of women to pay fines could lead to more accurate convictions and judicious verdicts, as with King Solomon’s ruling to “split the baby,” as recounted in 1 Kings 3: 16–28.
Money’s four roles are a direct outgrowth of the fact that what we call “money” is actually the combination of several functions commonly embodied in one good. Denominating the prices of all goods in terms of one good brings great computational ease when comparing the opportunity costs of alternatives. Not only is the calculation provided by money prices “a device for lowering transaction costs relevant to deliberate search,” it is also the embodiment of a social arrangement allowing for spontaneous learners to easily recognize overlooked opportunities (Kirzner 1979, p. 150).
As an example, a simple economy consisting of ten goods to exchange against each other would have 45 “prices” if there was not a single good used to express their value with a common denominator.An economy with n goods will result in (1/2)(n-1)(n) direct exchange ratios. Using one of these ten goods to express all other prices results in only nine prices (with the price of the good in terms of itself, one, making an additional tenth “price”). In the modern economy, the number of goods is many orders of magnitude greater than this example. The average car, to take one small component of the vast number of goods produced in the American economy, has upwards of 15,000 separate parts. If these individual parts were transacted without a common pricing unit, there would be over 112 million separate exchange ratios! Since the automotive industry is less than 2.5 percent of the whole American economy, I leave it to the reader to consider the number of “prices” that could exist across the United States lacking a common denominator through the unit of account. Needless to say it is doubtful that such computational complexity resulting from direct exchange ratios would allow for anything more than a simplistic, nearly autarkic, economy.Confusions around the origin and emergence of money commonly treat the unit and account and medium of exchange interchangeably. David Graeber (2011) is unconvinced by Menger’s evolutionary theory, relying on anthropological data that seems to suggest there was never a time when direct exchange existed, an important first step in the path to a money emerging as a form of indirect exchange. As proof, Graeber points to the lack of pricing boards showing prices expressed in terms of multiple goods. In this criticism, Graeber asks too much and too little. Too much because he extends what is really an example of a lack of multiple units of account as means to express prices to conclude that there was never a time with multiple goods functioning as media of exchange. On the other hand he asks too little by expecting there to be evidence of a primitive society expressing prices in terms of all, or many, other goods. Given the computational problems discussed above for a small economy not using a common unit of account, I would expect that this monetary function was eclipsed by one, or a very small number of, goods in anything more advanced than a very primitive society, thus explaining the lack of anthropological evidence from very early human developments.
Money may be a present good, but the people who use it are always future oriented. Thus there will be a necessary forward-looking perspective on each of money’s two roles, in addition to their demands in the present.
The store of value, being the future extension of the medium of exchange role, is probably the simplest future-oriented function to understand. Money is demanded in the present to settle current debt and transactional obligations. However, due to the uncertainty inherent in the future, there will need to be a medium of exchange demanded today to fulfill requirements in the future. The exact dates and magnitudes of these expenses are as yet unknown, but the money saved today must retain its value, or purchasing power, until that unknown future date.
Thus, the store of value function is the other side of the medium of exchange coin. Economists often couch their discussion of the store of value function as if it was a way to transmit wealth to the future. Such an understanding of the role obfuscates the issue. Money is not demanded to transmit wealth into the future, although it can certainly perform this role. Almost no one holds a sum of money today because he is preserving his “wealth” for the future. After all, there is an opportunity cost to using money for this role given its lack of interest return. In its place, investment vehicles commonly perform this task.
Money serving as a store of value is more correctly thought of as the property whereby money will only be demanded today based on its expected purchasing power in the future. This future purchasing power will be determined by how well the medium of exchange preserves its value, i.e., functions as a store of value. Note that this is quite different from more typical discussions of storing wealth for the future in the general sense, something which is not unique to the monetary asset. We are here concerned with money’s ability to preserve its value to be used in the future for monetary needs, which are, incidentally, the same category of needs that money is demanded for in the present as a medium of exchange.
The standard of deferred payments functions as the reverse side of the unit of account coin. It is the ability of a good to express the value of other goods, but over a longer time horizon than the standard unit of account. As an example of this distinction today, despite having lost 98 percent of its purchasing power over the last 100 years, the U.S. dollar has managed to do so with constancy. Each year prices increase by around 3 percent on average, notwithstanding some outlying periods. On a year-to-year basis the U.S. dollar performs well as a unit of account, and, e.g., a clothing shop, can take comfort in knowing the price tag made in one year will suffice for the following year as well; menu costs are minimal. Over longer periods the dollar has performed terribly and lacking an alternative good to use as the standard of deferred payments, Americans have had to suffer the costs of hedging their bets on long-term contracts denominated in dollars.
When using the term “money,” what economists have in mind is actually any of the four specific roles performed by money. In this way, one reason that monetary economics has become so confused is that the very adjective in its title is ill-defined. Furthermore, with the exception of select works in the now well-aged “New Monetary Economics” literature (Black 1970; Hall 1982a, b; Greenfield and Yeager 1983), very few serious attempts have been made to look at money’s individual roles in isolation of their shared embodiment in a single good. General equilibrium models are at a loss to incorporate money since they have no scope for a medium of exchange. It has been difficult to integrate money into basic utility analysis since money confers no direct utility, unlike other goods. (And since utility analysis forms the bedrock of microeconomics, the economics profession has long grappled unsuccessfully at providing “microfoundations” for monetary economics.) In short, much has been lost by using one word — money — to describe four different functions.
Multiple or a Unique “Monetary” Good?The source of the muddled state of present monetary economics stems, at least in part, from the simple fact that for the better part of a century, one good has served all four monetary roles. This is understandable given that the enforcement of legal tender laws effectively forces one good (i.e., the legal tender) to serve all roles simultaneously. Before the passage of such laws in the mid-nineteenth century, an American could purchase a home with a mortgage denominated in ounces of gold and furnish it with goods priced in U.S. dollars. Neither dollars nor gold would be needed to pay for either transaction, as silver could be exchanged at the market rate. With the advent of legal tender laws, prices could still be struck in any good, but the payer would always be able to use U.S. dollars in settlement. As a result, U.S. dollars became the dominant pricing unit, both for current and long-dated contracts.
Yet there is still another reason why one good would assume all roles concurrently. Consider the origin of the demand for money. Mise’s use of the evenly rotating economy illustrates that it is only the existence of uncertainty that makes money a necessity. Money need not exist as a medium of exchange, not in any abstract sense anyhow, since any contract can be settled with a future if its magnitude and timing are known in advance (or an option if not even the timing is known).
Money is held to mitigate the holder from the uncertainty concerning his future transactions needs. In this way, one may get the impression that money’s key role is the store of value —the ability for it to unleash purchasing power in the future. Such thinking is also erroneous, as there are several assets that can provide more-or-less good stores of value over time. (It is often recollected that one ounce of gold has purchased a good men’s suit for hundreds, if not thousands, of years.)
The way that money insures the holder from uncertainty stems from its unique properties as a financial asset, as in Figure 1. It is the unique good that is redeemable at par value at a moment’s notice. From this simple fact we can derive three important insights about what money is.
The first is that a good only functions as “money” when its two general functions coincide. Specifically, if a good is used as the pricing unit and is also exchanged to settle transactions, it will by necessity trade at par value. At the same time, since money is the generally accepted medium of exchange it will also be available on demand since the timing of future transactions cannot be estimated, evenly probabilistically, in the present. This is important to the extent that we can see why money takes on its specific role in the schema of financial assets, a position attributable to the specific monetary demands by individuals.
The second insight is that we can better explain what is not money. In short, any asset not trading at par value and available on demand cannot be so categorized. The reason is that it would negate the original reason why money is held — to mitigate uncertainty. Holding an asset as “money” even though it is not available on demand (e.g., a future or a bond) entails a degree of risk since there is no guarantee that the purchasing power will be available at that moment when the holder demands it. What good is a 30-year bond to the holder as money if he requires funds in ten years’ time?
On the other hand, holding a good that trades at market value (e.g., equities) will give the holder no assurance that its value will be retained, either in whole or in part, at that moment when the holder needs it. Holding Enron shares may have seemed to satisfy an individual’s demand for money superficially, but when it turned out that his shares were worthless, he moved on to satisfy this monetary role by means of another good.
Thus only goods available on demand and at par value can survive as money, and these two criteria are only fulfilled when a good is used as a pricing unit and as a medium of exchange simultaneously.
Finally, we gain some insight into better defining what the money supply is. Currency obviously fits the bill, but what of bank accounts? To the extent that they are guaranteed to be paid on demand and at par value, demand deposits also comprise an important component of the money supply. Herein lays two important caveats. Fractional-reserve banks do not necessarily come with either of these assurances. As recent events in Cyprus have made clear, fractional-reserve deposits are effectively equity holdings masquerading as money. When bank assets lost sufficient value to render them illiquid, depositors were paid out a corresponding fraction of their account’s value, an event akin to receiving the market value of a number of shares. Alternatively, some fractional-reserve banks honor the par value redemption of their deposits, but only after the depositor incurs a waiting period to receive his funds. Such a condition is imposed in nearly all banking systems on redemption requests above a certain amount.
Historically, a similar condition was used liberally on fractional-reserve deposit accounts under the guise of the “option clause.”Checkland (1975, p. 85) describes the Scottish free-banking period as one of “continuous partial suspension of payments.” This has since been heralded as a stabilizing force of free-banking systems lacking a guarantor such as a central bank to function as a lender of last resort (White 1984, pp. 28–29; Selgin 1988, pp. 161–62; Selgin and White 1994, pp. 17–26). Such advocacy gets the problem of stabilizing the monetary system exactly backwards. Solving the problem of banking instability by removing the on demand criterion, even if for only a short while, removes one-half of the key features making money so unique. It also removes one-half of the reasons why money is demanded.
Thus, deposits held in fractional-reserve bank deposits are a tenuous component of the money supply. Provided that the issuing bank can maintain on demand and par value redemption, there is no significant problem. Changing either of these aspects effectively removes the asset from the upper-left quadrant in Figure 1, and relegates the former “money” to some other financial role.
(Re)defining the Money SupplyDefining the money supply is tricky business. This is so not least because of what criteria define monetary assets, but also because some of those assets are not capable of performing their jobs without serious caveats. I will close with some brief and sundry comments on Salerno’s (1987) definition of the “true money supply.”
In writing this pithy article, Salerno builds from the theoretical framework of Rothbard (1963, pp. 83–86; 1978; 1983, pp. 265–62) used to accurately define the money supply. In doing so Salerno diverges from Rothbard by excluding life insurance net policy reserves, owing to the fact that very few, if anyone, considers them to be part of the money supply. Since the supply in question is concerned with the “generally accepted” medium of exchange, Salerno excludes this component due the lack of perception that it is money on the part of money holders.
While this exclusion is warranted if one is concerned with money as the “generally accepted medium of exchange,” it is unwarranted if one defines “money” under a different set of criteria. As money is demonstrated herein to be defined as “the unique financial asset that is available at par value, on demand,” the inclusion of life insurance policy reserves is not only warranted, but necessary. Indeed, some works, e.g., Nash (2009), Lara and Murphy (2010), point to the use of life insurance policies as a bank account, and thus implicitly include these reserves in the money supply.
Salerno also excludes money market mutual funds (MMMF) because they are not instantly redeemable, nor are they par value claims to cash. While they may look like this at first glance, a MMMF is an equity claim to a managed investment portfolio of short-term, high-grade financial assets. Cases where these funds have “broke the buck,” i.e., the net asset value of the underlying portfolio drops below the value of MMMF claims to the assets, have historically resulted in either the owners receiving less than the par value of their holdings, or a capital infusion from the fund’s sponsors. Likewise, Salerno excludes short-term time deposits on the grounds that they are not available on demand.
More common attempts to define the money supply have suffered from an ad hoc approach, as is the case with the common “M” measures.Alternative measures of the quantity of money run into similar difficulties. The “Divisia” monetary aggregates developed by Barnett (1980) use what are essentially the same types of money and money substitutes as in the more common M measures, though weighted by their expenditure share instead of evenly. Austrian economists have made great strides by realizing that the money supply can be defined by the two main reasons that money is demanded, whether to facilitate payments or to provide an uncertainty hedge. Most notably this approach follows Rothbard (1962, pp. 756–62) in defining the reservation demand to hold money separately from its exchange demand (Howden 2013, p. 21).
Ultimately, definitions of the money supply are tricky because they grapple with four problems at once. These four problems allude to money’s four roles, as listed in the opening mnemonic. I will end this chapter with one approach to measure money, and draw one implication.
In one way, money defines prices that will need to be paid for with the medium of exchange. The stock of exchange media available to settle these prices is one “money supply.” For simplicity I suggest we call this “exchange supply of money,” Mx.
Money as used to price goods comes with one complication. At any given time there is a set of obligations priced in terms of the money unit that require the medium of exchange to settle (e.g., debts coming due). To this set we can include those goods desired (but not obliged) to be purchased, which are priced in the money unit and which the medium of exchange will be required to settle (e.g., consumers and producers goods). The sum of these prices, or units of exchange, comprises what we can call the “pricing supply of money,” Mp. There is also a known amount of units of account that will arise at a future date, due to existing debt contracts yet to be fulfilled. The standard of deferred payments, thus, can also be defined with some degree of certainty in the present and we can call this the “future pricing supply of money,” Mp´.
This approach to defining the money supply gives rise to several distinct quantities, only one of which has any bearing to the more commonly given measures. While the Mx supply is easily understood, both Mp and Mp´ are determined not by any monetary factor, but instead by the demand of individuals to purchase goods and services (whether on the current spot market or on some futures market in the past). Readers will see an affinity between this approach and Salerno (2006), whereby prices are not the result of the demand for money per se (as is commonly extrapolated from the quantity theory of money), but are rather the result of the demands for goods and services which in turn create the pricing money supplies, Mp and Mp´.
One implication of, and benefit from, using several “money” supplies is that it allows for an alternative method to look at how the purchasing power of the medium of exchange fluctuates over time. If, e.g., Mx < Mp, the value of the medium of exchange must rise to clear the market. Since some of the prices that comprise the supply of pricing units of money, Mp, are fixed at a pre-defined value (e.g., those resulting from a previous debt contract), either the prices of goods contained in Mp will fall, or the real value of the supply of the medium of exchange, Mx, will rise. Of course, these implications are just two sides of the same coin.
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TheEduard Braun holds a postdoctoral position to the chair of economics at Clausthal University of Technology, Clausthal-Zellerfeld, Germany. I attended the Mises University in 2007 and was a summer research fellow in 2008. The present chapter is an outflow of my introduction to and study of German economic thought between 1800 and 1950, which I became interested in while a summer fellow at the Mises Institute under the direction of Professor Salerno. Historical school of economics does not enjoy the best reputation among present-day economists, but especially the Austrian school appears to be out of sorts with its former adversary in the Methodenstreit. It seems fair to say that David Gordon’s (1996, p. 7ff.) account, according to which the members of the Historical school bluntly rejected economic laws like the principle of supply and demand, is generally accepted among Austrian scholars today. In the English-speaking world, Friedrich von Hayek, Joseph Schumpeter, and Ludwig von Mises are mainly responsible for this state of affairs (Hodgson 2010, p. 296; Grimmer-Solem and Romani 1998, p. 268).
I do not try, in this chapter, to overturn this negative judgment. However, I would like to point out that there are some elements in the body of Austrian Economics that definitely stem from the Historical school. Surprisingly, the Historical school acts as the model for Mises’s capital concept and, by implication, for his economic calculation argument against socialism. Mises’s discussion of the fundamental difference between capitalism and socialism does not, or not only, rest upon praxeological reasoning. In fact, the same praxeological laws apply in both capitalism and socialism. In order to make his case, Mises has to presuppose several historical institutions that only exist in developed and monetized market economies. In this context, he draws on concepts developed by the Historical school. It was not necessary for him to acknowledge his debt to this school — and possibly he was not even aware of it — because he could act on the authority of Carl Menger, at least regarding the capital concept they both employed. Carl Menger himself, however, derived the capital concept on which Mises would later rely directly from Richard Hildebrand, a member of the Historical school. Like in monetary theory (see Gabriel 2012, p. 41), the influence of the Historical school on Mises concerning capital theory was an indirect one — via Menger.
The present chapter starts, in section 2, with a short presentation of how Menger, in 1888, changed his point of view on capital, and continues, in section 3, with the demonstration that Menger, in adopting the new and different view, made a step toward the Historical school. Section 4 traces this historical point of view on capital in Ludwig von Mises’s writings. It cannot be said that section 5 demonstrates, once and for all, that Mises implicitly admitted that economics is, in some sense, a historical science. But it tries to indicate the difference he made between praxeology and economics. The former he calls the general theory of human action, but the latter he does not consider to be entirely free from historical preconditions. Finally, section 6 contains a short discussion of Albert Schäffle’s analysis of economic calculation as a central institution of capitalism. Apparently, Mises argument against the feasibility of socialism was at least foreshadowed by a member of the often ridiculed Historical school.
Carl Menger on CapitalCarl Menger changed his point of view on capital theory considerably between 1871 and 1888 (Schumpeter 1997, p. 187; Braun 2014). He did not discuss capital very deeply in his Principles (Stigler 1937, p. 248), but to the extent he did, he advocated a capital theory that is concerned with production. His capital theory was connected to his vision of the production process as divided into several successive stages, where consumer goods result from the successive processing of combinations of higher-order goods to lower-order goods. Menger (1871, p. 155) says that one possesses capital if one “already has command of quantities of economic goods of higher order … in the present for future periods of time.” By adding this aspect to production theory and associating it with capital theory, he laid the groundwork for Austrian capital theory as developed by Böhm-Bawerk (1930), Friedrich von Hayek (1941), and Ludwig Lachmann (1978).
It is seldom recognized that by 1888 Menger had changed his view. In a long article on the subject — Zur Theorie des Kapitals (A Contribution to the theory of capital) — Menger proposed a radically different vision of the scope of capital theory. Streissler (2008, p. 371) is of the opinion that, by writing his article, Menger only made a prepublication attempt to refute the theory of Böhm-Bawerk. However, it seems more probable that Menger turned against all capital theories — including his own one — which have been developed by economists in disregard of everyday language use and established business practices. At the very outset, he declares that it is
a mistake that cannot be disapproved of enough when a science … denotes completely new concepts by words that, in common parlance, already describe a fundamentally different category of phenomena — a category that is also important for the respective discipline — correctly and properly (Menger 1888, 2).
It could be suggested that he was referring mainly to Böhm-Bawerk’s theory in this quote. However, there is every indication that Menger also implicitly revoked his earlier point of view. For the common parlance concept of capital is not identical with his own one from the Principles at all. In Menger’s (1888, p. 37; emphasis added) words, the common parlance view has nothing to do with the production process or the different orders of goods:
When businessmen and lawyers speak about capital, they do mean neither raw materials, nor auxiliary materials, nor articles of commerce, machines, buildings and other goods like this. Wherever the terminology of the Smithian school has not already penetrated common parlance, only sums of money are denoted by the above word.
He hastens to add that capital only embraces sums of money that are dedicated to the acquisition of income, and that “sums of money” not only refers to plain money, but to the monetary value of all kinds of business assets in economic calculation.
Menger thus switched sides in a debate that seems to be as old as economics itself. Does the term “capital” refer to a production factor or does it refer to the organization of the market economy by calculating entrepreneurs who maximize the monetary yield on their financial capital? At a first glance, the distinction between these two viewpoints does not seem to create a great problem. To give an example, even Mises (1949, p. 260 ff.) contains traces of both concepts of capital. He reserved the plain term “capital” for the economic calculation of entrepreneurs but, for lack of a better term, he referred to the produced goods of higher orders as “capital goods.” The next section will demonstrate, however, that the two sides of the term capital do not fit together harmoniously; rather they roughly correspond to the two sides of the Methodenstreit between the Austrian and the Historical school of economics. Menger’s earlier concept was elaborated to Austrian capital theory, whereas his concept of 1888 turns out to be the one endorsed by the Historical school.
The Historical School as the Source of Menger’s Later Viewpoint on CapitalThe first thing that must be mentioned is that Gustav Schmoller, Menger’s principal opponent in the Methodenstreit, was quite happy with Menger’s later standpoint on capital theory. In his Grundriß der allgemeinen Volks-wirtschaftslehre, Schmoller (1904, p. 180; emphasis added) appreciated Menger’s step toward the common parlance concept of capital:
Where one has provisions of goods in mind that technically serve further production, one may also use the term capital; often it will be better to say acquisitional wealth. All in all it seems to me to be the right thing to return, with C. Menger, to the capital notion as established in business life.
In fact, it can hardly surprise that Schmoller welcomed Menger’s shift of opinion. In his 1888 article, Menger clearly adopted the viewpoint of the Historical school of economics.
It is easy to demonstrate this point. When Karl Rodbertus (1843, p. 23ff.) made, probably for the first time in the history of economic thought (Jacoby 1908, p. 27), the distinction between social and private capital — between capital as a production factor and capital as a means of acquisition and calculation denominated in money — he ascribed each term to a distinctive problem area. For him, social (or real) capital is a universal, absolute, and pure concept that can be defined independently of time and place. It is the capital concept that he thought is apt for economic science. Private capital, on the other hand, only has relative importance. It results “from the arbitrary ingredients of a historical state of affairs. It would disappear if profit-yielding property disappeared” (Rodbertus 1843, p. 24, n.; emphasis added).
In other words, the capital concept which Menger used in his Principles and which later Austrians like Böhm-Bawerk, Hayek, and Lachmann adopted (and which relates to Mises’s “capital goods”) can be found in any economic system and in any time period. Individuals in isolation, like Robinson Crusoe, employ higher order goods in the same way as a socialistic and a capitalistic society does. It is a general theoretical concept and independent of historical factors. Monetary calculation, on the other hand, which is the background of Menger’s later (1888) capital concept, is only a historical phenomenon. It is neither part of Robinson’s island nor of a socialist society. It only appears in a developed and monetized market economy where property rights to the means of production are enforced. Later on, German economists like Adolph Wagner generally referred to this concept of capital as the historical-legal one (Jacoby 1908, p. 28).
That Carl Menger adopted the viewpoint of the Historical school becomes even more obvious when one compares his 1888 article with what Richard Hildebrand had written five years earlier. Hildebrand, a member of the Historical school teaching in Graz, Austria (Schulak and Unterköfler 2011, p. 25), had written a book on monetary theory that contained one chapter on capital. There, he clearly foreshadowed Menger’s later position. First of all, like Menger (1888), he rejected the efforts of economists to create capital concepts that deviate from common parlance. Hildebrand (1883, p. 72, n. 35) counters the
idea that the capital concept is open to arbitrary terminology at all, or that science, in a way, has to create or invent the concept in the first place. To the contrary, the concept of capital … is a fact that is already given by economic life.
Second, Hildebrand’s positive view of the common parlance concept unsurprisingly coincides with Menger’s. He (1883, p. 74, n. 35) states that “capital indeed can only be thought of or imagined as a certain sum of money,” and, like Menger, he immediately adds that capital also comprises real assets in so far as they have or represent monetary value.
Ludwig von Mises on CapitalAs opposed to nearly all other Austrian economists to the present day, Ludwig von Mises did not follow Menger’s discussion of capital as contained in the latter’s Principles, but was oriented toward the 1888 article on capital theory. This shines through, for the first time, in his treatise on Socialism where he explicitly refers to Menger (1888) and states:
[W]e must first ask what significance is attached to the term [capital] in business practice. … The concept of capital is derived from economic calculation. Its true home is accountancy — the chief instrument of commercial rationality. Calculation in terms of money is an essential element of the concept of capital. (Mises 1951, p. 123)
In his Human Action, Mises went a step further and not only stuck to the monetary notion of capital, but explicitly rejected the social (or real) capital concept. He (1949, p. 262) called it a confusion to argue, as some economists do,
that “capital” is a category of all human production, that it is present in every thinkable system of the conduct of production processes — i.e., no less in Robinson Crusoe’s involuntary hermitage than in a socialist society — and that it does not depend upon the practice of monetary calculation.
So in fact, without admitting it though, Mises adhered to the capital concept developed and called for by the Historical school of economics. He did not follow the early Menger or Böhm-Bawerk, who had assigned capital theory to the analysis of the production process; he rather built upon Menger’s later article which was, as shown above, a concession to the Historical school.
The Historical Character of Economics — According to Ludwig von MisesWhy did Mises rely on the historical-legal capital concept? After all, Mises argued that economics is a part of the more universal science praxeology, and that praxeology is the science of every kind of human action (Mises 1949, p. 3). According to this classification, no historical relativity is involved in economics, and therefore the real capital concept, which can easily be reconciled with every individual human action like it is done in Crusoe economics, seems to suggest itself. However, it is often overlooked that economics is not identical with praxeology, even in Mises’s own thinking.
Whereas praxeology, the general theory of human action, “can be precisely defined and circumscribed” (Mises 1949, p. 235), the scope of economics can not so easily be demarcated. Its relationship to praxeology is not a simple one, and especially its area of application is not easy to determine.
The specifically economic problems, the problems of economic action in the narrower sense, can only by and large be disengaged from the comprehensive body of praxeological theory. (Mises 1949, p. 235; emphasis added)
And here comes the main point. Other than praxeology, which is general and absolute, economics is bound to special preconditions and, consequently, is not a general theory in the same way as praxeology. This claim is emphasized by Mises himself when he adds that “in this disengagement [of economics from praxeology], historical and conventional aspects cannot be ignored” (1940, p. 226; emphasis added).I quote from Mises’s Nationalökonomie because the same passage in Human Action does not seem to make sense: “Accidental facts of the history of science and conventions play a role in all attempts to provide a definition of the scope of ‘genuine’ economics” (Mises 1949, p. 235). The same is true for the third edition. The historical relativity of economics, which Mises admits in these few words, manifests itself a few lines further where he says that economics and catallactics are “the analysis of those actions which are conducted on the basis of monetary calculation,” and that the analysis of socialism, where monetary calculation does not exist, “is possible only through the study of catallactics, the elucidation of a system in which there are money prices and economic calculation” (Mises 1949, p. 235).
In short, economics itself does not deal with all human actions in all kind of societies, but only with human actions that are directly or indirectly connected to money prices and economic calculation. It is true: in order to do this adequately, economics presupposes a general theory of human action — praxeology — but it is not identical with it.Joseph Salerno comes to a similar conclusion concerning another important economic concept: The entrepreneur-promoter does not exist under all circumstances, either. The entrepreneur-promoter “cannot be defined with praxeological rigor; it can only be identified by a historical judgment” (Salerno 2008, p. 195).
It should be remembered that Mises’s (1951) famous argument according to which a collectively planned society is not feasible is also based on historical institutions. Without exchange between money and producers’ goods, he argued, prices of these goods cannot be determined and consequently economic calculation becomes impossible in socialism. This argument is not based on praxeology alone, but it presupposes, for the market economy which serves as benchmark, the existence of money, monetary calculation, and property rights to the means of production. It was this aspect of capitalism that Mises focused on, and from this perspective it becomes clear why he adhered to the historical-legal capital concept. This kind of capital does not exist in socialism, and therefore it could help to distinguish capitalism from any other economic system.
The Economic Calculation Argument as Found in Albert Schäffle’s WorkThat Mises’s use of the capital concept endorsed by the Historical school is no coincidence is apparent when reading the approach of earlier members of this school to the question of economic calculation. In this regard, especially Menger’s predecessor on the chair of economics in Vienna, Albert Schäffle (1823 — 1903), must be mentioned. It has been noted before that Schäffle at least hinted at the difficulties a socialist society would face when allocating the available resources to the myriads of different uses. Schäffle is cited for having argued, in Hodgson’s (2010, p. 300) words,
that a system based on calculations concerning labour time faced intractable problems, including the heterogeneity of labour and the inaccessibility of relevant data, and would undermine individual incentives.
Apparently, Schäffle had at least a sense of the calculation problem of socialism, although, according to Hodgson at least, he primarily seems to have aimed at the well-known incentive problem. Huerta de Soto (2010, p. 100) goes a step further and imputes to Schäffle the demonstration
that, without imitating the system of price determination found in market processes, it would be inconceivable that a central planning agency could efficiently, in terms of both quantity and quality, allocate society’s resources.
However, neither Hodgson nor Huerta de Soto argues that Schäffle has anticipated Mises’s argument in the proper sense. They merely concede him to have sensed the difficulties of organizing production without the help of economic calculation.
It does not become clear, in their short remarks, how close Schäffle actually came to deal with questions that later became central for the Austrian school. In his Kapitalismus and Socialismus, a book which Hodgson and Huerta de Soto do not analyze and which has not been translated into English, Schäffle demonstrates that he was well aware of the problem that has to be solved by any economic order. In this, he partly anticipated Leonard Read’s famous story I, pencil where it is shown that even in the production of such a simple thing as a pencil more or less the whole world participates.
The social character of the human economy shows that everyone, from morning to night, depends on the work of the whole humanity. I wake up in the morning and put on a dressing gown: the wool it consists of has been grown, years ago, in Australia; it has been shipped to Trieste by Dalmatians, freighted to Moravia by Italian workers and the staff of the Austrian railways, spun and woven there with the help of English machines, and dyed with African colors. (Schäffle 1870, p. 103)
Confronting the complicated relationships of the modern production process, Schäffle (1870, p. 105; emphasis added) uttered the question: “The economic miracle of the much discussed division of labor — by which means is it accomplished?”
So he clearly posed the question that Mises would answer in his discussion of the possibility of economic calculation under socialism. Furthermore, he was well aware of the fact that the socialist authors had either not realized that socialism has to solve this problem or had provided merely superficial solutions. This becomes clear in the second edition of Kapitalismus und Socialismus which was part of a larger work on the social sciences. First, Schäffle pointed out that socialism must think of something that could substitute private entrepreneuship:
With the abolition of private capital as the profit-oriented director of the economy, the difficulty occurs to achieve productivity, which was aspired by private capital in its own interest, in the same or even a larger and progressing measure, so that the fairer distribution of the created wealth does not end up with less to distribute than the present-day market. (Schäffle 1881, p. 317; emphasis removed)
Therefore, he continued, socialism must find a means of minimizing costs. But “[h]ow are the [socialist] managers of the production process supposed to determine the ‘socially required’ amount of costs?” (Schäffle 1881, p. 317). This would be a very difficult task, he noted, as the ‘socially required’ amount of costs depends on numerous and variable factors. Socialist theorists deceive themselves as long as they ignore this problem:
In my opinion, socialism exposes itself to a fateful and economically cardinal calculation error as long as it does not try to contrive ways and means which guarantee, in a better way than the current competition among capitalists does, that no arbitrary measure of “socially required” amount of labor is found and asserted for the determination of exchange value, but the one that is as low as possible from a social and evolutionary point of view. (Schäffle 1881, p. 318)
How deep Schäffle actually analyzed the whole question of economic calculation in socialism is difficult to tell. He wrote several books, like The Quintessence of Socialism and The Impossibility of Social Democracy, touching on this topic. Hodgson (2010), who analyzed them, has not found a systematic treatment of the issue. Kapitalismus und Socialismus, from which I have quoted above, is a treatise of more than 700 pages and consists of public lectures Schäffle had given in Vienna. Therefore, it does not contain a systematic line of argument. Schäffle neither comes up with a proposal for the organization of the production process under socialism nor does he outrightly deny its possibility. He rather seems to advocate a mixed economy as he does in his other books (Hodgson 2010, p. 311). However, a profound judgment can only be made after a thorough study of all of his works which include, next to his lengthy monographs on socialism, several multi-volume textbooks on economics and sociology.
At this place it suffices to register that Albert Schäffle, a member of the Historical school, came close to seeing the problem of economic calculation under socialism. Whether he analyzed it satisfactorily is not top priority. One must not forget that, unlike Mises and Hayek, Schäffle wrote decades before the Bolshevik Revolution and had no real-world example of socialism to consider. Furthermore, he mainly wrote before the neoclassical revolution, thus lacking the apparatus necessary for the dismantling of Marxist theory (Hodgson 2010, p. 306). At any rate, Schäffle and the Historical school can be shown to have points of contact with Austrian Economics, whatever the methodological differences may be. Whether these links are worth a closer inspection and whether modern Austrians can profit from it cannot be foretold. For my part, I believe that the comprehensive rejection of a whole school of thought will rarely be justified.
ConclusionStreissler (1990, p. 31) has called it a myth that the early members of the Austrian school elaborated their novel insights independently of and in contrast to German economics of their day. I would not go so far as to maintain that the fundamental opposition between the Austrian and the Historical school is also a myth. At any rate, I tried to show in this chapter that at least some caveats must be made. Although he did not stress this point, even Ludwig von Mises, the father of the general theory of human action, in some of his theoretical arguments presupposes the existence of historical conditions and institutions. The connection to the Historical school can best be seen in the fact that both Menger and Mises employed its capital concept. Mises’s argument on the impossibility of economic calculation under socialism is based on it, and it even seems that the argument naturally flows from it. At least one member of the Historical school, Albert Schäffle, was led to similar, though less elaborated and precise views concerning the role of economic calculation in capitalism and socialism.
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InMarek Hudík is postdoctoral fellow at the Center for Theoretical Study at Charles University in Prague, Prague, Czech Republic. I was a summer research fellow at the Mises Institute in 2009. Throughout the fellowship, I greatly benefited from Professor Salerno’s kind help and constant encouragement. his introduction to the second edition of Rothbard’s Man, Economy, and State, Professor Salerno (2004) argues that Rothbard’s purpose in writing his treatise was not to develop a heterodox school of economics and break with the prevailing body of thought. On the contrary, Rothbard examined contemporary literature and attempted to integrate this literature with his own views. As Salerno shows, Rothbard believed that his treatise could draw other economists to the ideas that used to be part of the mainstream in the not-so-distant-past. We now know that Rothbard did not succeed in this and that as of today, there still is a communication gap between the Austrians and the rest of economic profession. This paper argues that the gap could be narrowed if the Austrian economics becomes more mathematized.By “mathematization of economics” I mean the “use of mathematical techniques … in economic arguments” (Backhouse 1998, p. 1848). An alternative definition of the term can be found in Beed and Kane (1991, p. 581), who understand it as the “increasing emphasis given to mathematical economics.” For a discussion of the concepts of mathematization, formalization, axiomatization, and abstraction, see e.g., Weintraub (1998) and Backhouse (1998).
At a first glance, mathematization of Austrian economics may seem to be contradiction in terms. Yet, at a closer inspection, the idea turns out to be not paradoxical at all: note for instance, that the “literary” character of Austrian economics is typically not included among its defining characteristics (Machlup 1982; Leeson and Boettke 2006; O’Driscoll, Jr., and Rizzo 2002); in a similar vein, Vaughn (1998, p. 2) sees the Austrian aversion to mathematics as a “superficial identifying characteristic,” and Backhouse (2000, p. 40) points out that, to the best of his knowledge, no Austrian has “ever explained why mathematics cannot be used alongside natural-language explanations”; on top of that, Moorhouse (1993, p. 71) reviewing Mises’s views on mathematical economics concludes that there is “no major methodological gulf between praxeology and neoclassical mathematical economics.”
Admittedly, Rothbard, as well as some other Austrians, raised objections against mathematization; but his demonstrated preferences speak otherwise: he sometimes expresses his ideas formally or semi-formally (e.g., Rothbard 2004, pp. 120–121, 152–153, 234). In addition, there is a long line of authors whom we may count as Austrian or Austrian-inspired who occasionally use mathematics in their economic writings. These include Wicksteed (1910), Fetter (1915), Hayek (1941), Haberler (1950), Machlup (1939), Morgenstern (von Neumann and Morgenstern 1953), McCulloch (1977), Garrison (1978), Murphy (2005), Leeson (2010), etc.
Some of these authors even explicitly claim that mathematization of economics is, at least to a certain extent, methodologically acceptable or even desirable. For example, Hayek (1952, p. 214) sees mathematization as “absolutely indispensable to describe certain types of structural relationships”; Machlup (1991) roots for “polylinguistic scholarship” characterized by coexistence of mathematical and non-mathematical language; in Boettke’s (1996) view, formal models are “fine” when constrained by an understandability criterion; and according to Morgenstern (1963, p. 19), an outright supporter of mathematization of economics, the laws of society will be written in the language of mathematics, just like the laws of nature.
This paper acknowledges that mathematization has costs and benefits. At the same time, it admits that it is probably impossible to determine the range of levels of mathematization for which benefits outweigh costs. Given this limitation, the aim of this paper is thus rather modest: it merely attempts to show that the optimal level of mathematization is not zero. More specifically, this paper points out the benefits of mathematization that seem to have been overlooked by some Austrian authors and it shows that most of Austrian criticisms which supposedly challenge mathematization, in fact point to different issues.
Benefits of MathematizationMises (1996; 2003; 1977) and Rothbard (2004; 1997a; 1997b) claim that formalization adds nothing to our knowledge as it only involves translation of verbal statements into symbols.This claim seems uncontroversial: it is put forward by both critics of mathematization (e.g., Novick 1954) and its advocates (e.g., Samuelson 1952). However, see Dennis (1982a; 1982b) for criticism of this view; see also Weintraub (1998, p. 1844) who posits the view of mathematics as an engine of discovery as an alternative to mathematics as a language. According to Rothbard (1997a, p. 61; 2004, p. 325), benefits of formalization are none, and therefore formalization should be cut through the principle of Occam’s razor.This Rothbard’s claim is problematic: if true, how would we explain that mathematics itself (or any other discipline) became formalized? Indeed, until the Renaissance, there was basically only “literary mathematics”: for instance the symbols “+” and “—” first appeared in the late fifteenth century and “=” was introduced only in the early sixteenth century (Cooke 2005, p. 432). Mises (1996, p. 333) suggests that if there is any benefit to formalization at all, it is pedagogical: diagrammatic exposition can be helpful to students of economics. Mises thus indirectly admits that mathematics (in a diagrammatic form) contributes to clarity of exposition. But why restrict this benefit only to students? Should not economists always communicate with their colleagues in the clearest possible way, especially when presenting new ideas?
Clarity of exposition achieved through diagrammatic representation is but one (and perhaps even not the most important) benefit of the use of mathematics in economics. I propose that mathematics offers also the following three benefits: First, mathematics is nowadays a common language of most economists and other researchers across disciplines — it is thus necessary to communicate ideas; Second, mathematics is less ambiguous than verbal language as it forces one to define precisely the meanings of concepts; and Third, mathematics is generally more efficient than verbal language, both for “producers” and “consumers” of economic ideas. These three benefits of mathematization are now discussed in turn.
Mathematics as a Common LanguageIf the great majority of economists use mathematics, it pays for each individual economist to use mathematics too; this is simply a coordination problem. The use of verbal language may lead to misunderstanding by the rest of the profession. When an Austrian and another economist speak of marginal utility or time preference, for example, do they in fact mean the same things?For a discussion of different definitions of marginal utility, see Hudík (2014a). On the ambiguity of time preference definition, see Potužák (2014).
There are numerous examples in the history of economic thought when translation into the language of mathematics helped to clarify the differences between competing approaches.Admittedly, there are also instances when mathematization contributed to ambiguity of economic concepts (Stigler 1950). In this context, it should also be noted that there usually is more than one way of formalizing a theory and this further complicates the issue (Beed and Kane 1991). For instance, Marshall’s (1982) translation of Ricardo’s theory of price formation into mathematics allowed for distinguishing between the classical and marginalist theories and facilitated the latter’s acceptance. Similarly, mathematics in the hands of Hicks (1937) and some others helped to detect the differences between “Keynes and the classics” on macroeconomic issues and contributed to the creation of the “neoclassical synthesis.” According to one observer:
Keynes was impressed by the help given by mathematics when numerous economists (Harrod, Hicks, Samuelson, Bryce) cleared up confusions in his General Theory and also presented his system neatly with the help of mathematics. (Harris 1954, p. 384)
Several decades later, formalized language of mathematics revealed that the dispute between “monetarists” and “Keynesians” was not about a general theoretical framework but about different empirical assessment of the value of parameters of the same model (e.g., Modigliani 1977; Mayer 1995). To plunge into more heterodox waters, Roemer (1982; 1988) is one of several economists who formalized Marxian economics and thus helped readers to compare the similarities and differences between Marxism and other mathematized approaches.
With respect to Austrian economics it is interesting to note that according to Chipman (1954, p. 364), “it is hard to find in mathematical economics any discussions more abstruse and difficult to follow than the great verbal debates between the Austrian and American schools on capital theory.” Fortunately for Chipman and others, several attempts to formalize Böhm-Bawerk’s theory have emerged (e.g., Dorfman 1959; 1995; 2001; Potužák 2014) and helped to clarify the debate. Very helpful in this respect is also Garrison’s (1978; 2000) partly formalized treatment of Austrian macroeconomics.
Mathematization is of course not the only way of dealing with the “language-coordination problem.” For instance, one may ignore the majority of economists and choose to “play the game” only with those who use his (i.e., verbal) language. However, this would in effect amount to creating a closed school of thought whose members are able to communicate only with each other but would not be able to interact with the rest of the discipline.Interestingly, until the first half of the twentieth century, i.e., before mathematical methods spread through the discipline, mathematical economics was considered to constitute such closed group. See e.g., Clark (1947). Closed schools of thought are analogous to closed economies: they protect their cherished ideas from competition. As in the case of trade, such a state of affairs benefits “producers” of ideas but hurts the “consumers” who receive products of inferior quality. Rothbard (1987) seems to have been aware of these adverse effects of isolated groups and perhaps that is also why he chose to communicate with the mainstream.Similar attitude was adopted by many Austrians before and after Rothbard, including Böhm-Bawerk, Mises, and Hayek.
Another possibility of approaching the “language-coordination problem” is to stick to verbal language with the proselytizing aim of persuading the rest of the profession to use it, too. In other words, one may be trying to change the language convention, and achieve a switch from a “mathematized equilibrium” to a “verbal equilibrium” of the “language coordination game.” Nevertheless, success of such an attempt seems unlikely, all the more for the fact that the “mathematized equilibrium” is — as I argue below — superior.
Mathematics as a More Precise LanguageOne of the benefits of mathematization is that it forces us to formulate our ideas precisely (e.g., Klein 1954; Tinbergen 1954; Chiang 1984; Clower 1995). It is sometimes correctly argued that verbal language can be made as precise as the language of mathematics (e.g., Menger 1973; Beed and Kane 1991). In reality, however, this opportunity very often goes unexploited: unless one is forced to express ideas formally, one is perhaps not even aware that the language is ambiguous. Perhaps the best example of increased clarity due to formalization is the creation of the supply and demand model. As Schumpeter (1994, p. 602) points out:
the sponsors of supply and demand [of the 19th century], again with the unnoticed exception of Cournot (and very few others, such as C. Ellet and D. Lardner), even experienced difficulty in setting on its feet the very supply-and-demand apparatus, the claims of which to a place in economic theory they tried to assert. They talked of desires or desires backed by purchasing power, of “extent” of demand and “intensity” of demand, of quantities and prices, and did not quite know how to relate these things to one another. The concepts, so familiar to every beginner of our own days, of demand schedules or curves of willingness to buy (under certain general conditions) specified quantities of a commodity at specified prices, and of supply schedules or curves of willingness to sell (under certain general conditions) specified quantities of a commodity at specified prices, proved unbelievably hard to discover and to distinguish from the concepts—quantity demanded and quantity supplied.
Precision of mathematics also helps to derive implications of one’s assumptions and to demonstrate possible inconsistencies (e.g., Dorfman 1954; Clower 1995). For instance, Samuelson (1957), by formulating Marxian model of wages and interest discovered an error in Marx’s theory that went unnoticed for 90 years (Brems 1975). Mathematics may also help to discover inconsistencies in the Austrian economics: Austrian economists work with preference scales; at the same time, they sometimes criticize the transitivity assumption used by other economists (Block and Barnett 2012). Yet, it is straightforward to show formally that an ability to rank alternatives on a single scale corresponds to the assumptions of completeness and transitivity of the preference relation. In other words, whenever a preference scale is introduced, completeness and transitivity of preferences are implicitly assumed (Hudík 2012). To use a different example, with the help of some simple mathematics it can be demonstrated that, contrary to Rothbard’s (2004, p. 240) claim, the principle of diminishing marginal utility does not necessarily imply a downward-sloping demand curve (Hudík 2011a).
Interestingly, Rothbard sees the ambiguity of the verbal language as an advantage. He quotes Bruno Leoni and Eugenio Frola:
the lack of mathematical precision in ordinary language reflects precisely the behavior of individual human beings in the real world. ... We might suspect that translation into mathematical language by itself implies a suggested transformation of human economic operators into virtual robots. (Rothbard 1997a, p. 62)
This argument is unpersuasive on several grounds: First, it is not at all clear why researchers should use imprecise language just because their researched subjects are imprecise; one can (and, indeed, should) talk precisely even about imprecision. Second, Leoni and Frola’s argument seems to imply that economists should not describe human behavior by concepts which are not used by the acting individuals themselves. However, this requirement imposes unnecessary constraint on economic theories. For instance, economists would be barred from referring to the law of marginal utility merely because people are generally unaware of this law. Finally, Leoni and Frola neglect the fact that economics mostly deals with an order which emerges as an unintended consequence of human actions (Hudík 2011b) where their argument is inapplicable. Consider, for example, activities of speculators which inadvertently contribute to efficient allocation of resources. I assume that we want to be able to describe these consequences even though speculators themselves are unaware of them.
Mathematics as a More Efficient LanguageMathematics is often more efficient than verbal language for both “producers” and “consumers” of economic ideas. From the perspective of the “producers”, mathematics economizes on effort: laborious thought processes are “embodied” in simple rules for manipulation of mathematical symbols (Whitehead 1911, p. 41). In this context Duesenberry (1954) understands mathematics as a “capital good” increasing productivity of economist’s “labor.” On the one hand, Duesenberry admits that it may be true that one cannot do anything with mathematics which cannot be done with verbal language; on the other hand, however, he claims that verbal language is much less efficient; according to his analogy, “[o]ne probably cannot do anything with power shovels that cannot be done with picks and hand shovels” (Duesenberry 1954, p. 361). Analogously, Chiang (1984, p. 5) thinks of mathematics as a “mode of transportation.”This metaphor seems to have been used for the first time by Fisher (2007); for similar metaphors, see e.g., Pareto (1897), Champernowne (1954), Tinbergen (1954), Menger (1973) and McCloskey (1994).
Chiang (1984, p. 4) mentions another aspect of the efficiency of mathematization of economics: there exists a large number of mathematical theorems at economists’ disposal. Consequently, we do not have to rediscover these theorems whenever they arise in a new context (Dorfman 1954, p. 376). Thus, for instance, in order to prove his theorem of the existence of (“Nash”) equilibrium in strategic games, Nash applied first Brouwer’s and later Kakutani’s fixed point theorems (Kuhn and Nasar 2002). Half a century before Nash, Euler’s theorem was applied to address the “adding-up problem” in the theory of distribution (Stigler 1994).For more examples of mathematical theorems that were directly applied in economics, see Debreu (1984).
As for “consumers” of economic ideas, mathematics often allows them to economize on their time and attention: as Klein (1954, p. 360) puts it, “[t]here is a real merit in condensing wordy volumes or manuscripts into a few understandable pages.” Nash may again be used as an example here: his famous dissertation thesis that earned him the Nobel Prize has only twenty seven pages; his paper on the existence of Nash equilibrium takes up only one page (Nash 1950a), while his ground-breaking paper on the bargaining problem is eight pages long (Nash 1950b). It is safe to assume that without formalization Nash’s papers would have to be considerably longer.As usual, there is a dissenting view, this time it is Marshall’s: The chief use of pure mathematics in economic questions seems to be in helping a person to write down quickly, shortly and exactly, some of his thoughts for his own use … It seems doubtful whether anyone spends his time well in reading lengthy translations of economic doctrines into mathematics, that have not been made by himself. (Marshall 1982, p. ix)
Costs of MathematizationMathematization does, naturally, have its costs. As pointed out by Morgenstern (1963, p. 2), when evaluating costs of mathematization, one has to distinguish among (i) criticism of inappropriate use of mathematics, (ii) criticism of the underlying economic model which happens to be analyzed mathematically, and (iii) criticism of mathematization.
In the first category we find criticisms of Bourbakism in economics (McCloskey 1994), of the use of calculus (Boulding 1948; Rothbard 1977), or of applying the mathematics of nineteenth-century mechanics to economics in general (Mirowski 1989). Likewise, criticisms of failed attempts to mathematize phenomena which seem to be impossible to address with known mathematics belong to this category (Beed and Kane 1991; Wutscher et al. 2010), as do also criticisms of misinterpreting quantitative economics (Mises 1996, pp. 55–56)It should be added that Mises criticized the use of quantitative methods to test theories; there is no argument in Mises’s writings against using quantitative methods in applied research. See also Leeson and Boettke (2006). and measurement (Rothbard 1977). None of these or similar criticisms, justifiable or not, represent arguments against the use of mathematics in economics as such.
Type (ii) criticisms are also not arguments against mathematization. They include criticism of unrealistic assumptions (e.g., Keynes 1964; Leontief 1971; Beed and Kane 1991; Wutscher et al. 2010) or criticism of particular concepts that happen to be used by mathematical economics, such as equilibrium (Wutscher et al. 2010). It is important to repeat that most mathematization is simply a translation of verbal statements into symbols; hence, the problem must be with theories themselves, not mathematics (Backhouse 1998; 2000). One may interject that the use of certain branches of mathematics (e.g., calculus) requires some additional assumptions such as continuity and differentiability (Menger 1973); but again, this criticism concerns only the application of a particular branch of mathematics to particular economic problem and is consequently not a general argument against mathematization. Furthermore, technical assumptions used by mathematical economics are often harmless: for instance, it is well-known that all important conclusions of standard demand theory can be obtained without the assumption of continuous and differentiable utility functions. Yet, continuous and differentiable functions are often used for the sake of convenience.
Actual costs of mathematization are identified by type (iii) criticisms. What are these costs? I identify three: first, tendency to downplay factors which are difficult to formalize; second, tendency to lose touch with reality; third, decrease of intelligibility for lay people. Note, that the first two costs are not inherent to mathematization per se; they are rather incidental to it and can perhaps be avoided. More importantly, though, none of these costs constitutes by its nature an argument for avoiding the use of mathematics altogether.
Downplaying Factors Not Amenable To FormalizationA tendency to neglect everything that cannot be easily formalized is a drawback of mathematization acknowledged by mathematical economists themselves (e.g., Debreu 1986). For instance, Krugman (1996; quoted in Backhouse 1998) argues that economists ignored important models for spatial economics just because these models could not be formalized.
Sometimes economists go so far as to demand that theories must refer only to quantifiable magnitudes. In his Nobel lecture Hayek (1975, p. 434) points out that
while in the physical sciences the investigator will be able to measure what, on the basis of a prima facie theory, he thinks important, in the social sciences often that is treated important which happens to be accessible to measurement.
He gives an example of quantifiable relationship between aggregate demand and total unemployment on one hand, and relationship between unemployment and the structure of relative prices and wages on the other. The former is accepted as “scientific,” while the latter is neglected as not testable because we never know what the equilibrium prices and wages are.
Other phenomena that are difficult to treat mathematically and are often mentioned by the Austrians are subjectivism and Knightian uncertainty. Again, these can be argued to receive insufficient attention by economists.For the debate on formalization of Knightian uncertainty, see Caplan (1999) and Wutscher et al. (2010); for an attempt to formalize subjectivism in games, see Hudík (2014b). Still, one may wonder if perhaps the limits of mathematization, whether in this particular case or in general, do not often coincide with the limits of scientific investigation: are currently non-mathematizable phenomena amenable to science at all?
I suggest that the way to deal with the phenomena which are currently difficult to mathematize is not only a careful use of known mathematic tools but also development of new tools. For example, before von Neumann and Morgenstern (1953) mathematical economics (and, as a matter of fact, any branch of economics) was unable to deal with strategic decision problems. Hence, von Neumann and Morgenstern constructed a completely new branch of mathematics to deal with strategic issues. As this example illustrates, the limits of mathematization are not given but constantly evolve.
Losing Touch with RealityIt is often argued that mathematization leads to a loss of contact with reality (e.g., Boulding 1948; Champernowne 1954; Novick 1954; Šímová and Šíma 2012).On the other hand, Brems (1975) provides the following counter-example of verbal treatment leading to focus on imaginary problems: investment in the Keynesian theory was considered a function of the rate of interest instead of the change of the rate of interest, only because verbal economics was unable to handle difference or differential equations. This can have several reasons: In Debreu’s (1986, p. 1268) view, the power of mathematics is such that the “seductiveness of [mathematical] form becomes almost irresistible” and researchers thus tend to forget economic content. Still, Debreu argues that separation of models and reality can sometimes be an advantage. For instance, it is said to bring economics closer to the ideology-free ideal (see Düppe 2010).Morgenstern praised mathematical economics for exactly the same reason. See Leonard (2010).
According to Duesenberry (1954, p. 362), loss of touch with the real world is simply given by the job description of an economic theorist: the aim of the theorist is not to explain a particular set of observations but to show general consequences of a set of premises. To this argument we may add that a theorist also aims at universalization: she also attempts to show that two or several seemingly separate theories are merely different manifestations of the same principle. Hence, theoretical research is necessarily often disconnected from reality as it focuses on logical consistency of theories. From this perspective, criticism of the separation of mathematical models from reality could be interpreted as a criticism of theoretical research as such and as a plea for focusing on applied research. I hasten to add that the debate on optimal allocation of resources between theoretical and applied research is extremely important (see e.g., Šťastný 2010); yet, it is a different debate than the one on costs and benefits of mathematization.
IntelligibilityIt is probably true that the more formalized a model is, the less intelligible it is to lay people. Should economists worry about this trade-off? On the affirmative side stands the consideration that economic literacy is low which in turn has substantial negative externalities as citizens and voters are called upon to form opinions on many economic issues (e.g., Becker 2000; Šťastný 2010). On the other side stands the argument that, as in any other science, researchers should write primarily for other researchers and educating lay people should be left to popularizers: as individual economists differ in their skills and talents, there are benefits from specialization.Steven Levitt is an exception that may in fact prove the rule: his pop-economics books are co-authored with the journalist Stephen Dubner. Trading off benefits of formalization for intelligibility of academic writing to the general public thus seems inefficient. A different question is whether economists have sufficient incentives to be popularizers; but that is again for another debate.
ConclusionExamination of benefits and costs of mathematization suggests that the issue is not whether to use mathematics in economics or not; instead, the issue is what kind of mathematics is appropriate and how it should be used (cf. Backhouse 2000; Rosser 2003). It should be stressed that mathematization by no means is in conflict with the Austrian methodology, although some aspects of Austrian economics may be difficult to formalize at the present state of knowledge. This limitation, however, does not imply that we should give up on pushing the limits of mathematization further. Given that spreading ideas among the bulk of modern economists requires the use of mathematical language, one may only hope to see more and more mathematized Austrian economics in the future. For as they say: b(m) - c(m) > 0, for some m > 0.
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InMateusz Benedyk is a PhD Candidate at the Faculty of Social Sciences, University of Wrocław and the President of Ludwig von Mises Institute Poland. The author would like to thank Mateusz Machaj and David Howden for their helpful comments. I was a summer research fellow in 2012. This chapter was inspired by Professor Salerno’s many contributions in the field of history of the Austrian school of economics and his investigations regarding the monetary theory. recent decades we have witnessed several debates on the legacy of Friedrich von Hayek in the realm of monetary policy. His writings have been both endorsed and attacked by economists from opposing branches of Austrian economics.For example Hayek was attacked for not seeing the merits of fractional reserve banking by Lawrence H. White, “Why Didn’t Hayek Favor Laissez Faire in Banking?” History of Political Economy 31, no. 4 (1999): 753–69; and for not blaming fractional reserve bankers for business cycles by Walter Block, Kenneth M.Garschina, “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process,” Review of Austrian Economics 9, no. 1 (1996): 77–94. Part of the problem is that Hayek partially changed his mind throughout his life and gave different policy prescriptions in the 1970s than he did in 1930s.For the discussion of Hayek’s writings in 1970s and 1980s see G. R. Steele, “Hayek’s Theory of Money and Cycles: Retrospective and Reappraisal,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 3–14. Here we will deal primarily with the earlier works of Hayek. But even the interpretation of his major works on money, banking and business cycle from 1920s and 1930s poses some problems.
We would like to shed some light on the Hayekian analysis of different monetary institutions. Specifically, we want to clarify what the economic consequences of such institutions: fractional and one-hundred percent reserve banking; and various monetary policy norms of central banks.This list does not pretend to exhaust all of the Hayek’s insights in the field of money. It includes only the problems that created numerous controversies and rivalrous interpretations in the literature. More comprehensive study should include e.g., effects of various international monetary systems and the differences between central and free banking or between token and commodity money. Special attention will be given to the differences between constructs of pure money and business cycle theories as opposed to policy prescriptions. The first section discusses the relation between fractional-reserve banking and the business cycle. It also deals with Hayek’s opinions on one hundred percent reserve banking. In the second section we debate the claim of Hayek endorsing the monetary policy of stabilizing the level of nominal spending. Several concluding remarks are offered in the last section.
Fractional and One-Hundred Percent Reserve BankingIn Hayek’s view the contemporary organization of the banking sector was responsible for the cyclical fluctuations of the economy. He devoted the whole chapter of the Monetary Theory and the Trade Cycle to show that the expansion of credit by fractional-reserve banks must necessarily lead to unsustainable boom even if there is no central bank.Friedrich A. Hayek, “Monetary Theory and the Trade Cycle,” In: idem, Prices and Production and Other Works, ed. Joseph Salerno, Auburn 2008, pp. 73–103.
According to Hayek the magnitude of the bank’s credit expansion depends on its cash reserves. The crucial point is “that the ratio of reserves to deposits does not represent a constant magnitude, but, as experience shows, is itself variable.”Ibid., p. 91. If, for whatever reason, economic conditions improve and banks consider their cash reserve to be excessive, they will grant additional credit to their customers. “[F]or reasons of competition ... the bank that first feels the effect of an increased demand for credit cannot afford to reply by putting up its interest charges; for it would risk losing its best customers to other banks that had not yet experienced a similarly increased demand for credit.”Ibid., p. 93.
This expansion of credit occurres without corresponding growth of savings. Other banks cannot distinguish between deposits created out of new savings and the ones created without it. They will join the credit expansion, as money from other banks will be deposited in their company, and lower their growing reserve ratio. The effect of the process is that the money rate of interest is for the time being lower than the natural rate.
Only so long as the volume of circulating media is increasing can the money rate of interest be kept below the equilibrium rate; once it has ceased to increase, the money rate must … rise again to its natural level and thus render unprofitable … those investments which were created with the aid of additional credit.Ibid., p. 94.
Since fractional reserve banking is in Hayek’s view responsible for the business cycle, it’s hardly a surprise that he mentioned on several occasions the idea of one-hundred percent reserve banking. As early as 1925 he discussed the idea shortly in a review of Federal Reserve monetary policy after the crisis of 1920. Hayek wrote the following:
The older English theorists of the Currency School, who, as we already pointed out, understood the nature of cyclic fluctuations better than most of the economists who came after them, also hoped that cyclic swings could be prevented by their proposals for the regulation of note issues. … If the basic idea underlying the Peel’s Act were consistently implemented and a 100 per cent gold coverage were required for bank deposits as well as for bank notes, the problem of preventing depressions would be resolved in a drastic manner.Friedrich A. Hayek, “Monetary Policy in the United States after the Recovery from the Crisis of 1920,” In: Idem, Good Money. Part I, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 5, Indianapolis 2008, p. 111, n. 37.
A monetary system without business cycle seems like a desirable goal, but Hayek was not eager to advocate the idea of abolishment of fractional reserves. In Monetary Theory and the Trade Cycle Hayek stated clearly that in case of one hundred percent reserve banking:
[t]he stability of the economic system would be oFriedrich A. Hayek, Monetary Theory…, p. 103.btained at the price of curbing economic progress. The rate of interest would be constantly above the level maintained under the existing system. … The utilization of new inventions and the “realization of new combinations” would be made more difficult, and thus there would disappear a psychological incentive toward progress.
Hayek didn’t elaborate further on this point. It therefore seems unconvincing: why would capitalists earning a higher rate of interest on their capital be discouraged to innovate and invest? Shouldn’t a system where entrepreneurs make mistakes on a regular basis (malinvest during the business cycle) be more disruptive for innovators?On this point see: Joseph Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (2012): 22–23, 37–38. Jesús Huerta de Soto thinks that “maybe it would be wiser to interpret the assertions Hayek made in 1929 (in Monetary Theory and the Trade Cycle) in the context of the lecture given before the Verein für Sozialpolitik. ... Hayek’s speech was subject to a rigorous examination by professors who were little inclined to accept conclusions they viewed as too original or revolutionary.”Jesús Huerta de Soto, Money, Bank Credit and Economic Cycles, translated by Melinda A. Stroup, Auburn 2006, pp. 470–71, n. 74.
Hayek returned to the idea of one hundred percent reserve banking in 1937 in the series of lectures published as Monetary Nationalism and International Stability. In the fifth lecture he reviewed briefly “The Chicago Plan of Banking Reform.”Friedrich A. Hayek, "Monetary Nationalism and International Stability," In: Idem, Prices and Production and Other Works, pp. 410–13. This time Hayek’s objections to the abolishment of fractional reserve banking were completely different:
The most serious question which it raises, however, is whether by abolishing deposit banking as we know it we would effectively prevent the principle on which it rests from manifesting itself in other forms. … [T]he question is whether, when we prevent it from appearing in its traditional form, we will not just drive it into other and less easily controllable forms. … The [Peel’s Banking] Act of 1844 was designed to control what then seemed to be the only important substitute for gold as a widely used medium of exchange and yet failed completely in its intention because of the rapid growth of bank deposits. Is it not possible that if similar restrictions to those placed on bank notes were now placed on the expansion of bank deposits, new forms of money substitutes would rapidly spring up or existing ones would assume increasing importance?Ibid., pp. 411–12.
This analysis does not mention any economic deficiencies connected with the system of one hundred percent reserve banking. The obstacle is of a practical nature — whether we will be able to stop the creation of new money substitutes that will take the place of bank notes and deposits.A description of these obstacles is a major part of Hayek’s discussion of the Chicago Plan. It’s therefore an overstatement to say that “in Monetary Nationalism and International Stability, [Hayek] changed his mind, proposed a constant money supply and advocated the demand for a 100-percent reserve requirement in banking” — Jesús Huerta de Soto, Money…, p. 470, n. 74. We may conclude here that Hayek saw the merits of advocating for an end of fractional-reserve banking — a seed of the business cycle in the contemporary economy — but never fully endorsed the program of one hundred percent reserve banking, pointing to problems of both a theoretical and practical nature.
Central Bank’s Policy PrescriptionsThe greatest controversies regarding Hayek’s stance on monetary theory arise from the central bank’s policy norms that Hayek allegedly proposed. Since we live (as Hayek did as well) in a world of central banks managing the fractional-reserve banking system, we may ask if there is something the monetary authorities can do to mitigate the business cycle.We have already discussed the possibility of central banks requiring banks to hold one hundred percent reserves on deposits, so we won’t mention the subject in this section. Recently Lawrence White stated:
Hayek’s business cycle theory led him to the conclusion that intertemporal price equilibrium is best maintained in a monetary economy by constancy of “the total money stream,” or in Fisherian terms, the money stock times its velocity of circulation, MV. Hayek was clear about his policy recommendations: the money stock M should vary to offset changes in the velocity of money V, but should be constant in the absence of changes in V.Lawrence H. White, “Did Hayek and Robbins Deepen the Great Depression?” Journal of Money, Credit and Banking 40, no. 4 (2008): 754–55, emphasis added.
White’s bold statements led Marius Gustavson to propose a ‘Hayek Rule’ — understood as keeping MV constant — as a norm for Federal Reserve’s policy in the 21st century.Marius Gustavson, The Hayek Rule: A New Monetary Policy Framework for the 21st Century, Reason Foundation Policy Study 389 (2010). Gustavson’s study includes references to White’s 2008 paper. Two questions arise:
(1) Did Hayek endorse such a policy?
(2) Does Hayek’s business cycle theory provide a justification for “Hayek Rule”?
To properly answer these questions it’s useful to consider the theoretical context of Hayek’s business cycle investigations. For Hayek the main puzzle was how to integrate the theory of business cycle into the general equilibrium theory.In Hayek’s words: “By ‘equilibrium theory’ we here primarily understand the modern theory of the general interdependence of all economic quantities, which has been most perfectly expressed by the Lausanne School of theoretical economics.” — Friedrich A. Hayek, Monetary Theory…, p. 19, n. 15. In other words: how it is possible that forces leading markets to clear fail to coordinate consumers’ preferences and producers’ decisions during the business cycle? Hayek’s view was that we should focus on the active role money plays in the economy. The introduction of money breaks the clear process of price formation in barter and makes it possible that “real” factors responsible for price formation will be for some time hindered by monetary factors.
Beginning in mid-1920s Hayek struggled to describe the active role money plays in price formation in a more detailed fashion.Between 1925–1929 Hayek was preparing a book on the subject titled Geldtheoretische Untersuchungen, which he never completed. Two articles Hayek published at the time were excerpts from the book: Intertemporal Price Equilibrium and Movements in the Value of Money (originally appeared in German in 1928) published in Good Money. Part I; The Paradox of Saving (published in German in 1929) published inter alia in Prices and Production and Other Works. The English translation of the unfinished manuscript of the Geldtheoretische Untersuchungen has been recently published as Investigations into Monetary Theory, first chapter of: Friedrich A. Hayek, Business Cycles. Part II, ed. Hansjoerg Klausinger, The Collected Works of F.A. Hayek, vol. 8, Chicago 2012. He came up with the idea of “neutral money” — a set of conditions needed for the money to be neutral toward prices. His first idea was that the supply of money must be constant in order to be neutral. In the 1930s he changed his mind and advocated the idea that money may be neutral when the effective money stream (MV) is constant.This evolution of Hayek’s thought is well documented in another paper of Lawrence H. White, “Hayek’s Monetary Theory and Policy: A Critical Reconstruction,” Journal of Money, Credit and Banking 31, no. 1 (1999): 109–20. Does it follow that Hayek advocated the monetary policy of stabilizing MV? Not necessarily.
In the second edition of Hayek’s Prices and ProductionFriedrich A. Hayek, Prices and Production, [In:] Idem, Prices and Production and Other Works, pp. 301–04. and in a paper from 1933 titled On ‘Neutral’ MoneyFriedrich A. Hayek, On ‘Neutral’ Money, [In:] Idem, Good Money. Part I, pp. 228–31. we find some clarifications as to the proper relation between the theoretical concept of neutral money and the prescribed monetary policy. In the latter Hayek wrote: “The concept of neutral money was designed to serve as an instrument for theoretical analysis, and should not in any way be set up as a norm for monetary policy, at least in the first instance.”Ibid., p. 228. Hayek stressed the monetary policy can have different goals than getting close to the state of neutral money. He also mentioned the stable MV is not the sufficient condition for money to be neutral.
It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, first, the total money stream remained constant, and second, all prices were completely flexible, and, third, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.Friedrich A. Hayek, Prices and Production, p. 304. Almost identical statement in: Friedrich A. Hayek, On ‘Neutral’ Money, p. 230.
Lack of perfect foresight regarding the future value of money and any degree of price stickiness make neutral money an impossibility. One could argue that even though we cannot reach perfection, it is still a good idea to pursue the ideal. But Hayek saw other problems with stabilizing the level of nominal expenditures. In Prices and Production he briefly discussed the problems with changing money velocity due to hoarding, dishoarding, changes in business organization etc.
For, in order to eliminate all monetary influences on the formation of prices and the structure of production, it would not be sufficient merely quantitatively to adapt the supply of money to these changes in demand, it would be necessary also to see that it came into the hands of those who actually require it, i.e., to that part of the system where that change in business organization or the habits of payment had taken place. It is conceivable that this could be managed in the case of an increase of demand. It is clear that it would be still more difficult in the case of a reduction. But quite apart from this particular difficulty which, from the point of view of pure theory, may not prove insuperable, it should be clear that only to satisfy the legitimate demand for money in this sense, and otherwise to leave the amount of the circulation unchanged, can never be a practical maxim of currency policy.Friedrich A. Hayek, Prices and Production, p. 297.
For Hayek it was clear that pumping money in any place in the economy as a reaction for increased demand for money in another place would not suffice to get closer to money neutrality. The money would have to be given to exactly those persons whose demand has increased. Hayek understood well that giving more money to a single person will result in a series of small adjustments of incomes and spending habits of many individuals cooperating with the agent, who got the money in the first place.Example of such an analysis can be found in: Friedrich A. Hayek, Monetary Nationalism…, pp. 353–59. Increasing the quantity of money in places where the demand for money remained unchangedFor example when central bank buys large quantities of securities in a Quantitative Easing program. would entail another round of necessary adjustments of incomes and spending patterns without accommodating the original change in money velocity.
Apart from abstract arguments about problems with implementation of stable MV policy Hayek specifically argued against monetary policy measures to combat deflation during the Great Depression as late as 1932. In a preface to English translation of Monetary Theory and the Trade Cycle Hayek wrote:
[The existence of deflationary process] does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. … To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about; because we are suffering from a misdirection of production, we want to create further misdirection — a procedure that can only lead to a much more severe crisis as soon as the credit expansion comes to an end.Friedrich A. Hayek, Monetary Theory…, pp. 5, 6–7.
Not only did Hayek differentiate between theoretical concepts and policy norms, find practical problems in stabilizing MV and explicitly rejected fighting the recession with money creation, but he actually proposed another policy norm in the writings on money neutrality and constant flow of spending. In Prices and Production he mentions only that “Hence the only practical maxim for monetary policy to be derived from our considerations is probably the negative one that the simple fact of an increase of production and trade forms no justification for an expansion of credit, and that—save in an acute crisis—bankers need not be afraid to harm production by over-caution.”Friedrich A. Hayek, Prices and Production, p. 298. In On ‘Neutral’ Money Hayek dared to propose a more specific solution:
[I]t seems to me that the stabilization of some average of the prices of the original factors of production would probably provide the most practicable norm for a conscious regulation of the quantity of money.Friedrich A. Hayek, On ‘Neutral’ Money, p. 231.
In light of these passagesInterestingly White quoted the same passage from “On ‘Neutral Money’” in Lawrence H. White, Hayek’s Monetary Theory…, p. 117. it seems that White’s statement about Hayek’s clear policy recommendation of stabilizing the level of nominal spending is unfounded — Hayek explicitly endorsed another rule and found problems with implementing targeted nominal spending rule.
There are big differences between stabilizing MV and stabilizing the prices of factors of production. Proponents of stabilizing MV claim that a shrinking nominal GDP is an indication that the central bank should increase the money supply (we need to remember that NGDP is only an approximation of the level of spending, since GDP excludes transactions of goods that are not final. If we want to measure the level of spending properly we should include all money transactions). A proponent of stabilizing MV could argue that even if money expenditures rose during the boom phase, it would be unwise to let it shrink to the pre-boom level. Therefore Quantitative Easing I in the USA would be justified since NGDP was falling between Q3 2008 and Q2 2009.According to “The Economist”: “Hayek believed the central bank should aim to stabilise nominal incomes. On that basis Mr [Lawrence] White thinks the Fed was right to pursue the first round of quantitative easing, since nominal GDP was falling, but wrong to pursue a second round with activity recovering.”
A proponent of stabilizing the prices of the factors of production could argue that it’s unwise to maintain prices at the inflated boom level. Lower input prices would actually stimulate the demand by entrepreneurs to start investing again. Hence, if we look at the level of factors of production prices we see a different story. Let’s take for example Producer Price Index. At the end of the previous recession — in 2002 the index (1982=100) stood at around 100 points. At the bottom of recession in February 2009 it stood at around 160 points, so it would indicate that monetary policy was extremely accommodative.All the data is taken from Federal Reserve Bank of St. Louis.
There is also another “Hayekian” problem connected with advocating QE: can the central bank actually gather and process all the information needed to fight the shrinking money expenditures in the same manner as private banks would do.For the discussion see: William N. Butos, “Monetary Orders and Institutions: A Hayekian Perspective,” Quarterly Journal of Austrian Economics 15, no. 3 (2012): 259–76.
ConclusionsFriedrich von Hayek rarely stated clearly his monetary policy proposals. He was mostly interested in the field of pure monetary theory (at least in the 1930s). It seems to us that his theories of money and business cycle can give good arguments for people advocating one hundred percent reserve banking. When it comes to monetary policy of the central bank Hayek briefly proposed the idea of stabilizing the prices of factors of production, but did not elaborate on why this should be the best policy.
Perhaps it is unfortunate Hayek used the framework of general equilibrium theory to investigate the problem of the business cycle.For other problems associated with Hayek’s methodological choices see: Joseph Salerno, "Mises and Hayek Dehomogenized," Review of Austrian Economics 6, No. 2 (1993), pp. 113–46. This might lead many to confuse the highly abstract and unrealistic conditions of general equilibrium with the desired state of monetary affairs, whereas occurrence of these conditions would actually mean that money is not needed in the economy at all.Ludwig von Mises, Human Action. A Treatise on Economics, Auburn 1998, pp. 250–51. Only late in his life Hayek managed to incorporate his more dynamic view on economy regarding competition and entrepreneurial discoveries into the money and the area of business cycles. In Denationalization of MoneyFriedrich A. Hayek, The Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies, [In:] Idem, Good Money. Part II, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 6, Indianapolis 2008, pp. 128–229. he finally proposed the idea of opening the sphere of money and banking to the competition instead of leaving it to the plans of bureaucrats.
In a lecture from October 1977 Hayek stated:
The interesting fact is that what I have called the monopoly of government of issuing money has not only deprived us of good money but has also deprived us of the only process by which we can find out what would be good money. We do not even quite know what exact qualities we want because in the two thousand years in which we have used coins and other money, we have never been allowed to experiment with it, we have never been given a chance to find out what the best kind of money would be.Friedrich A. Hayek, Toward a Free Market Monetary System, [In:] Idem, Good Money. Part II, p. 234.
This call for a competition in the field of money seems to me the best example of a truly Hayekian monetary policy.
ReferencesBlock Walter, Kenneth M. Garschina. 1996. “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process.” Review of Austrian Economics 9(1): 77–94.
Butos William N. 2012. “Monetary Orders and Institutions: A Hayekian Perspective.” Quarterly Journal of Austrian Economics 15(3): 259–76.
Gustavson Marius. 2010. “The Hayek Rule: A New Monetary Policy Framework for the 21st Century.” Reason Foundation Policy Study 389.
Hayek F. A. 2012. Business Cycles. Part II. In The Collected Works of F.A. Hayek, vol. 8, Hansjoerg Klausinger, ed. Chicago: University of Chicago.
——. Good Money. Part I: The New World, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 5, Indianapolis 2008.
——. Good Money. Part II: The Standard, ed. Stephen Kresge, The Collected Works of F.A. Hayek, vol. 6, Indianapolis 2008.
——. Intertemporal Price Equilibrium and Movements in the Value of Money. In idem, Good Money. Part I, pp. 186–27.
——. Monetary Policy in the United States after the Recovery from the Crisis of 1920. In idem, Good Money. Part I, pp. 71–152.
——. Monetary Nationalism and International Stability. In idem, Prices and Production and Other Works, pp. 331–422.
——. Monetary Theory and the Trade Cycle. In idem, Prices and Production and Other Works, pp. 1–130.
——. On ‘Neutral’ Money. In idem, Good Money. Part I, pp. 228–31.
——. Prices and Production. In idem, Prices and Production and Other Works, pp. 189–329.
——. 2008. Prices and Production and Other Works: F.A. Hayek on Money, the Business Cycle, and the Gold Standard, Joseph Salerno, ed. Auburn, Ala.: Mises Institute.
——. "The Paradox of Saving." In idem, Prices and Production and Other Works, pp. 131–87.
——. The Denationalization of Money: An Analysis of the Theory and Practice of Concurrent Currencies. In idem, Good Money. Part II, pp. 128–229.
——. “Toward a Free Market Monetary System.” In Good Money. Part II, pp. 230–37.
Huerta de Soto, Jesús. 2006. Money, Bank Credit and Economic Cycles, translated by Melinda A. Stroup. Auburn, Ala.: Mises Institute.
Salerno Joseph T. “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (2012): 3–44.
——. "Mises and Hayek Dehomogenized," Review of Austrian Economics 6, no. 2 (1993), pp. 113–46.
Steele G. R., “Hayek’s Theory of Money and Cycles: Retrospective and Reappraisal,” Quarterly Journal of Austrian Economics 8, no. 1 (2005): 3–14.
White Lawrence H. 2008. “Did Hayek and Robbins Deepen the Great Depression?” Journal of Money, Credit and Banking 40(4): 751–68.
White Lawrence H. 1999. “Hayek’s Monetary Theory and Policy: A Critical Reconstruction.” Journal of Money, Credit and Banking 31(1): 109–20.
White Lawrence H. 1999. “Why Didn’t Hayek Favor Laissez Faire in Banking?” History of Political Economy 31(4): 753–69.
After Joey Rothbard’s death, I flew to New York to organize the disposal of Murray and Joey’s goods according to their wills. Books and papers went to the Mises Institute, of course, where they are the center of our library and archives. But my strongest memory, aside from ineffable sadness, was the printed document on the small table next to Murray’s reading chair in the living room. It was Joe Salerno’s doctoral dissertation.
To me, that has always symbolized Murray’s relationship with Joe, whom he praised as a wonderful economist, and — perhaps almost as important in our times — as a brave fighter against error and sellout.
Joe has been a strong intellectual influence on the Mises Institute since our founding. How appropriate that he is also Murray’s successor as our academic vice president.
Joe influences so much. The Mises University, the Austrian Economics Research Conference, and the Summer Fellows Program are all under his aegis, and much the better for it. Not only is Joe an important scholar, he is a teacher of the sort we would all have loved to have had. No one could be more patient, rigorous, detailed, and loving. Forget Mr. Chips. We’ve got Joe Salerno.
Austrian economists are justifiably proud of the rich heritage handed down by Carl Menger, Eugen von Böhm-Bawerk, Ludwig von Mises, Murray Rothbard, and their contemporaries, and Austrians are keenly interested in the origin and development of their ideas. An appreciation for history has led some modern economists, mistakenly, to see the Austrian tradition as static, rigid, and backward-looking, focused on the achievements of the past rather than discoveries and new developments.
As the contributions to this volume attest, nothing could be further from the truth. Austrian economics is a vibrant, healthy, growing tradition, confident in its core propositions while filled with lively debates and exciting new advances. These authors of the essays collected here build upon, refine, extend, and challenge the contributions of their teachers, just as previous generations have done, all the way back to Menger.
Joseph Salerno’s own work is a vibrant illustration of this pattern. Salerno has made seminal contributions to the development and application of Austrian economics, while remaining within the broad, causal-realist tradition pioneered by Menger and refined by Böhm-Bawerk, Mises, and Rothbard. Salerno’s early work was in monetary economics and the history of economic thought. His doctoral dissertation (Salerno 1980) offered a novel interpretation of the “bullionist controversy” and subsequent developments in British monetary theory and policy. He also published a number of important papers on the largely-neglected French liberal school of Say, Destutt de Tracy, Dunoyer, Bastiat, and Molinari, among others, and their important predecessor (and proto-Austrian) Cantillon (Salerno 1978; 1983; 1988). Along with Rothbard he developed a distinctly Austrian approach to measuring the money supply (Rothbard 1978; Salerno 1987), one consistent with Austrian concepts of the nature and role of money.
It was his work on money that led Salerno to a significant breakthrough in the interpretation of Mises’s economics. It had long been recognized, inside and outside the Austrian school, that Mises’s great accomplishment in his Theory of Money and Credit (1912) was an integration of monetary theory into the general, subjectivist, marginalist understanding of value, prices, and markets shared by the Austrian, Walrasian, and Marshallian schools. Prior to Mises, prices were typically analyzed as exchange ratios between goods, not ratios between goods and a monetary unit. Money was a “veil,” overlaying (or obscuring) underlying economic relationships. Mises showed that economic actors evaluate units of money the same way they evaluate discrete units of other goods and services, namely in terms of marginal utility, and that the general theory of economic value also explains the value of money. In a perceptive Postscript to a reprint of Mises’s 1920 essay on socialist calculation, Salerno (1990a) highlighted the degree to which Mises’s analysis of socialism flowed from his analysis of money. As Salerno (1990a, p. 35) put it:
Mises’s pathbreaking and central insight is that monetary calculation is the indispensable mental tool for choosing the optimum among the vast array of intricately-related production plans that are available for employing the factors of production within the framework of the social division of labor. Without recourse to calculating and comparing the benefits and costs of production using the structure of monetary prices determined at each moment on the market, the human mind is only capable of surveying, evaluating, and directing production processes whose scope is drastically restricted to the compass of the primitive household economy.
In other words, what Mises means by “economic calculation” is monetary calculation. The core problem facing the government planner is not that he lacks the “knowledge of particular circumstances of time and place,” as Hayek (1945) famously put it, but that he lacks the real-world monetary prices needed to weigh alternative benefits and costs, to estimate rates of return on investment, and hence to allocate resources rationally in a complex world.
This insight led to a profound revaluation of Mises’s contributions and the role of Mises’s work in the history of economic thought. By the 1980s Hayek’s profound and influential social theory, which emphasized the challenges of economic organization under dispersed knowledge and limited understanding, and was deeply wary of attempts to reconstruct society according to some “rational” plan, was embraced by most Austrian economists. Even today, Hayek’s pithy line from The Fatal Conceit (1988, p. 76) — “The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design” — adorns many an email signature line and blog masthead. But, as Salerno carefully demonstrated, this anti-rationalist, incrementalist, evolutionary, “English” approach to economics, law, and social theory was particular to Hayek, and not at all shared by Mises.
In “Ludwig von Mises as Social Rationalist” (1990b) and “Mises and Hayek De-Homogenized,” (1993), Salerno offered a different interpretation of Mises and Mises’s place within the Austrian tradition. Salerno argued that Menger’s younger colleagues Böhm-Bawerk and Weiser extended Menger’s approach along distinct, sometimes contradictory, paths. What we might call a Wieser-Hayek-Kirzner strand of Austrian economics emphasizes disequilibrium, the informational role of prices, and profit-seeking behavior as an equilibrating force. In contrast, the Böhm-Bawerk-Mises–Rothbard strand emphasizes monetary calculation and the entrepreneur as a purposeful, forward-looking agent. In my own work on the entrepreneur (Klein 2008a; Foss and Klein 2012; Klein and Bylund 2014) I have highlighted two distinct Austrian interpretations of the entrepreneurial role. In Kirzner’s (1973) influential formulation, the entrepreneur is a largely passive “discoverer” of profit opportunities created by disequilibrium “gaps” in the current structure of market prices. As I read Mises — largely influenced by Salerno’s interpretation — the entrepreneur plays a different role in Mises’s system, namely deliberate, active, purposeful action in the face of uncertainty in pursuit of economic gain. In the former approach, the market does the work, and the entrepreneur need not be “rational,” only alert to preexisting opportunities. In the latter, the entrepreneur makes use of monetary calculation to plan and act to bring about an improvement in market conditions. I view my own work here as largely an extension of Salerno’s interpretation of Mises.
While some of Salerno’s contemporaries such as Israel Kirzner and Leland Yeager challenged Salerno’s “two Austrian traditions” thesis (Yeager 1994; Kirzner 1999), Salerno’s intellectual mentor, Murray Rothbard, embraced it. Indeed, Rothbard hailed Salerno’s work on calculation and knowledge as a major advance in the Austrian tradition, and an improvement on his own understanding. Rothbard (1989) described Salerno’s “Social Rationalist” paper as “a wonderful, superb advance and breakthrough, not only in the history of economic thought, but also in economic theory itself. ... In a sense, this sort of breakthrough experience is something like the joy of an intellectual conversion.” Rothbard went on to note that while he had harbored reservations about Hayek’s emphasis on the division of knowledge and coordination of plans, he had never quite been able to articulate why he felt uncomfortable about Hayek’s approach to the calculation problem. “Even though steeped in Mises, I had never really paid enough attention to his society-as-division-of-labor theme, and the crucial rationalism there.” Rothbard also described Salerno’s “Mises and Hayek De-Homogenized” as “a magnificent achievement.”
Most important, Rothbard (1989) saw Salerno’s contributions as exemplifying the general pattern of advance and development within the Austrian school:
Your article also points up an important point for the history of thought generally and for Austrian economics in particular. People have bitterly accused me of resisting all change in Austrian economics and of denouncing any differing opinions. Not true: I welcome change and advances in Austrian theory provided that they are true, i.e., that they work from within the basic Misesian paradigm. So just as I think I have advanced beyond Mises in developing the Misesian paradigm, people like Hans Hoppe and yourself have advanced the paradigm still further, and great!
Like the contributors to the present volume, I hope to make my own incremental advances to the Austrian tradition by building on Salerno’s work, just as Salerno built on Rothbard, Rothbard built on Mises, and so on.
Another of Salerno’s important contributions is his reinterpretation of the rise, decline, and rebirth of the Austrian tradition itself. Most accounts of the Austrian school trace its demise to the 1930s and 1940s, as Austrian capital theory was attacked by Knight and Sraffa and Austrian monetary and business-cycle theory was attacked by Keynes and his followers. The rise of positivism and mathematical formalism rendered the Austrians’ causal, verbal style obsolete anyway. Then — according to the typical account (e.g., Vaughn 1994) — the Austrian school experienced a dramatic revival following the South Royalton conference and Hayek’s Nobel Prize, both of which occurred in 1974.
Salerno offers two important corrections to this story. First, he argues that the core of the Austrian system as it developed in the late nineteenth and early twentieth centuries was not its distinct approach to money and the business cycle, but Menger’s causal, realistic account of price formation (Salerno, 1999). Austrian economics was not — as even some contemporary Austrian economists seem to believe — verbal Walrasian or Marshallian microeconomics plus capital-based macroeconomics (and spontaneous order and plan coordination and the knowledge problem as additional glosses). Instead, Austrian economics was a different kind of microeconomics. As Salerno demonstrated, Mengerian price theory peaked before 1920 following the contributions of Böhm-Bawerk and a few European Mengerians, and the particularly important work of the English economist Philip Wicksteed and the Americans John Bates Clark, Frank Fetter, and Herbert Davenport. Unfortunately, during this time most younger European, British, and American economists were adopting Marshall’s eclectic, mechanistic approach, and interest in Menger faded. More important, the “fourth” generation of the Austrian school, led by Hayek and including Morgenstern, Haberler, and Machlup, were heavily influenced by Schumpeter, who had introduced Walrasian price theory to the German-speaking world. In other words, by 1920 most economists, including the younger Austrian economists, had abandoned the causal, realistic approach to value, prices, and markets offered by Menger and Böhm-Bawerk.
The importance of Mises’s Human Action (1949) is not, in this interpretation, simply that it provided an overview of Mises’s mature thinking on a variety of economic topics — a sort of advanced Austrian textbook. As Salerno (1994; 1999) argues, Mises’s treatise offered no less than a rehabilitation and restatement of Mengerian price theory, one further developed by Rothbard in his Man, Economy, and State (also widely mistaken for a textbook). Salerno is himself a major contributor to this revival of Austrian price theory, in particular by highlighting and developing the various equilibrium constructs used by Mises and Rothbard (e.g., the “plain state of rest,” the “final state of rest,” and the “evenly rotating economy,” and what Salerno (1994, p. 99) calls the “Wicksteedian state of rest,” a concept implicitly, but not explicitly, analyzed by Mises and Rothbard).
Second, Salerno (2002) argues that the Austrian revival should be dated not from 1974, starting with the South Royalton Conference, but from 1962–63, when Rothbard published Man, Economy, and State (1962), America’s Great Depression (1963), and What Has Government Done to Our Money? (1963), the works that sparked the younger South Royalton participants’ interest in Austrian economics. Interestingly, these works all deal with what I have called “mundane Austrian economics” (Klein 2008b) — the analysis of value, prices, markets, money, capital, and government intervention — and not the more esoteric philosophical, methodological, and political topics that interest so many Austrians today. Salerno’s introduction to the 2009 edition of Man, Economy, and State is a major contribution to doctrinal history in its own right, pointing out Rothbard’s many advances beyond Mises, particularly in the areas of capital theory and monopoly theory.
In all these revisionist essays, Salerno demonstrates a keen grasp of the underlying theoretical and doctrinal issues, bringing out nuances and subtleties overlooked by other writers. Indeed, many Austrian writings on the Austrian school paint a somewhat tedious and even maudlin picture in which the major thinkers and writers agree on fundamental issues and are united in a desperate battle against socialists, Keynesians, and interventionists. As Salerno points out, the truth is far more interesting. While the early and later Austrians shared many core constructs, theories, and doctrines, there was a tremendous variety of ideas and approaches within the Austrian school, as there continues to be today. The Austrian tradition from its inception was a living, breathing, and lively intellectual movement, filled with internal as well as external controversy. This variety continues to the present, and it is important to review, analyze, sometimes synthesize, and other times disentangle the different theories and methods. Far from indicating weaknesses within Austrian economics, these controversies demonstrate its strength. Vive les différences!
To summarize, Salerno’s contributions range across a variety of subjects (money, price theory, comparative economic systems, doctrinal history, and more) and employ a variety of methods, while remaining squarely in the causal-realist tradition established by Menger, Böhm-Bawerk, the Anglo-American Austrians, Mises, and Rothbard. He is an exceptionally clear thinker and an excellent writer, witty and erudite as well as thoughtful and informative.
I met Joe Salerno in 1989 at an early edition of the Mises Institute summer instructional conference (later expanded into today’s “Mises University”). He was already a rising star in the Austrian movement, but came across then — as he does now — as a regular guy, a wisecracking, sharp-tongued, unpretentious, rough-hewn fellow from New Jersey. He remains one of the funniest people I’ve ever met, and I can’t recall how many hours I’ve spent laughing with him (and his charming wife Helen). I’ve lectured, along with Joe, at the Mises University for the last twenty years, and he is enormously popular with students, for his humor as well as his knowledge.
Joe took over for Guido Hülsmann as director of the Mises Summer Fellows Program in 2004, and it has been a joy to watch him embrace the role of mentor for dozens of younger scholars, many of whom have contributed to the present volume. Besides having a huge influence on his contemporaries, Joe has become the leader of the Austrian movement to its younger practitioners. Speaking for my fellow Austrians, I can say, with pleasure, that we are all Salernians now.
ReferencesFoss, Nicolai J., and Peter G. Klein. 2012. Organizing Entrepreneurial Judgment: A New Approach to the Firm. Cambridge: Cambridge University Press.
Hayek, F. A. 1945. “The Use of Knowledge in Society.” American Economic Review 35: 519–30.
——. 1988. The Fatal Conceit: The Errors of Socialism. In W. W. Bartley III, ed., The Collected Works of F. A. Hayek. Chicago: University of Chicago Press.
Kirzner, Israel M. 1973. Competition and Entrepreneurship. Chicago: University of Chicago Press.
——. 1999. “Mises and His Understanding of the Capitalist System.” Cato Journal 19: 215–32.
Klein, Peter G. 2008a. “Opportunity Discovery, Entrepreneurial Action, and Economic Organization.” Strategic Entrepreneurship Journal 2: 175–90.
——. 2008b. “The Mundane Economics of the Austrian School.” Quarterly Journal of Austrian Economics 11: 165–87.
Klein, Peter G., and Per L. Bylund. 2014. “The Place of Austrian Economics in Contemporary Entrepreneurship Research.” Review of Austrian Economics 27: 259–79.
Rothbard, Murray N. 1978. “Austrian Definitions of the Supply of Money.” In Louis M. Spadaro, ed., New Directions in Austrian Economics, pp. 143–56. Kansas City: Sheed Andrews & McMeel.
——. 1989. Letter to Joseph T. Salerno, March 28.
Salerno, Joseph T. 1978. “Comment on the French Liberal School.” Journal of Libertarian Studies 2: 65–68.
——. 1980. “The Doctrinal Antecedents of the Monetary Approach to the Balance of Payments.” PhD Dissertation, Department of Economics, Rutgers University.
——. 1983. “The Influence of Cantillon’s Essai on the Methodology of J.B. Say: A Comment on Liggio.” Journal of Libertarian Studies 7: 305–16.
——. 1987. “The ‘True’ Money Supply: A Measure of the Supply of the Medium of Exchange in the US Economy.” Austrian Economics Newsletter 6: 1–6.
——. 1988. “The Neglect of the French Liberal School in Anglo-Saxon Economics: A Critique of Received Explanations.” Review of Austrian Economics 2: 113–56.
——. 1990a. “Postscript: Why a Socialist Economy is ‘Impossible.’” In Ludwig von Mises, Economic Calculation in the Socialist Commonwealth. Auburn, Ala.: Mises Institute, 1990, pp. 34–46.
——. 1990b. “Ludwig von Mises as Social Rationalist.” Review of Austrian Economics 4: 26–54.
——. 1993. “Mises and Hayek Dehomogenized.” Review of Austrian Economics 6: 113–46.
——. 1994. “Ludwig von Mises’s Monetary Theory in the Light of Modern Monetary Thought.” Review of Austrian Economics 8: 71–115.
——. 1999. “The Place of Mises’s Human Action in the Development of Modern Economic Thought.” Quarterly Journal of Austrian Economics 2: 35–65.
——. 2002. “The Rebirth of Austrian Economics — in Light of Austrian Economics.” Quarterly Journal of Austrian Economics 5: 111–28.
——. 2009. “The Ambition of Rothbard’s Treatise.” In Murray N. Rothbard, Man, Economy, and State with Power and Market, Scholar’s Edition. pp. xix–l. Auburn, Ala.: Mises Institute.
Vaughn, Karen I. 1994. Austrian Economics in America: The Migration of a Tradition. Cambridge: Cambridge University Press.
Yeager, Leland B. 1994. “Mises and Hayek on Calculation and Knowledge.” Review of Austrian Economics 7: 93–109.
The Next Generation of Austrian Economics: Essays in Honor Joseph T. Salerno is a celebratory volume honoring the work of a respected and beloved teacher. It signifies a flourishing career of significant achievement, and also the gratitude and well-wishes of his students.
Dr. Salerno, longtime Professor of Economics at Pace University and Academic Vice President of the Mises Institute, is honored in these pages by the very students whose lives and careers he influenced. His important work in monetary theory and policy, not to mention his great exposition of Austrian school sociology, are addressed here by contributors such as Dr. Philip Bagus, Dr. David Howden, Dr. Per Bylund, Dr. Mateusz Machaj, Dr. Matthew McCaffrey, Dr. Peter Klein, and others.
Salerno stands at the head of what may be termed the “5th generation” of Austrian economists, having been both a friend and close associate of the late Murray Rothbard (not to mention a young attendee at the famed 1974 South Royalton conference). But as this volume illustrates, Joe is also a great friend, mentor, and godfather to an emergent new generation of formidable Austrian economists.
This is the essay that overthrew the socialist paradigm in economics, and provided the foundation for modern Austrian price theory.
When it first appeared in 1920, Mises was alone in challenging the socialists to explain how their pricing system would actually work in practice. Mises proved that socialism could not work because it could not distinguish more or less valuable uses of social resources, and predicted the system would end in chaos. The result of his proof was the "socialist calculation" debate.
Narrated by Gennady Stolyarov II. The full text is available online here.
Download the complete audiobook (7 MP3 files) here. This audiobook is also available on Apple Podcasts, Google Podcasts, and via RSS.
A recent article in the left-leaning Independent argued that student volunteers are useless. In one project putting UK college students to work building a local school, the work was so awful that local Ugandan masons "dismantled the structurally unsound work [the students] had done — relaying bricks and resetting timbers whilst the students slept."
"Giving back" is big these days, but how can we know if we’re really making a contribution, or if we, like those students, are just tourists who need cleaning up after.
Economics, fortunately, gives us a very elegant answer: The best way to "give back" is to earn honest money and lots of it.
I teach in a business school. As horrifying as this might seem, one of the biggest debates among business academics is social responsibility. The terms of the debate are familiar: the lefties, who dominate even business-schools, want business to do charity as penance for their wicked money-making. Meanwhile, the "pro-business" view comes from Adam Smith: greed, for lack of a better word, is good. Because the Invisible Hand turns self-interest into social good.
Of course, we can go further: the money you earn isn’t just morally neutralized by the Invisible Hand. Rather, the money you earn actually indicates that you’ve contributed to the world. More money means more contribution. In Man, Economy and State, Rothbard points out that a voluntary price puts a floor on the value created. Higher price received means more value created for others.
If somebody is willing to pay Kobe Bryant $300,000 per game, that means Bryant creates at least $300k of value per game. Kobe may well be an excellent computer programmer or veterinarian, but $100k per hour is probably his highest contribution. He can sleep easy knowing that he "gives back" plenty simply by playing basketball on TV.
The logic is the same for us mortals: so long as your salary is honestly earned, chasing the highest pay is precisely how you make your highest contribution to society. By "honestly" here I mean obtained without coercion. So no force, no fraud. This means the mafia and government are, of course, out -— salaries paid for hijacking trucks, witness intimidation, or public schooling may simply reflect the ability of your employer to extort money from others.
Among “honest” livings, then, the data is clear on the best way to “give back” to society: learn math. Starting with petroleum engineering, paying $103,000 per year for a bachelor's degree, fourteen of the highest twenty starting salaries are engineering. After petroleum, top are chemical, nuclear, computer, and electrical. The rest are still math-heavy: actuarial mathematics, computer science, information systems, statistics, and everybody's favorite dismal science, economics.
Of course, not all of us are good at math. Perhaps your education was heavy on recycling milk cartons or learning union songs. So many cartons, so many songs just doesn’t leave time to develop the skills that actually help others.
Well, there's still hope: Khan Academy, Udacity, and Udemy have cheap or free math courses, nicely done and easy on the brain. Some parents have their kids on calculus at age 8 at Khan Academy, which is forbidden in public schools. And, of course, Mises Academy has economics; the Austrian flavor, which is much recommended over the store-brand.
Still, not everybody wants to learn math. And we all deserve the opportunity to give back. So the highest-paid non-math jobs are: nursing ($55k starting), construction management ($52k), finance (less math than it seems), and business (almost no math). Then, of course, there’s the biggie: entrepreneurship. Here you write the rules, so you earn as much as you’re willing to put in.
So that's the heroes. Let's take a moment for the selfish reactionaries. Those who are unwilling to give back. Who just want to sponge off the petroleum engineers and actuarial mathematicians of the world, contributing little to the world's problems.
No surprise here. The least-valued courses of study include: journalism, drama, music, anthropology, psychology, English. All pay so little that you're really not contributing much of anything. Now, it's not a crime to be selfish: a free society means you're free to read French deconstructionists or to make pretty collages. Instead of giving back to society by learning calculus or making pretty Gantt diagrams for R&D.
Still, it's sad that so many just don't have the social awareness to go out and learn to differentiate a function. Instead they sit around writing thesaurus-busting jeremiads about the world's unsolvable problems that they, themselves, won’t get off the couch to solve.
Of course, then there's the coercive professions: bureaucrats, prison guards, public teachers. Since their salaries are seized at gunpoint and distributed by government unions, we can’t actually know if they contribute anything at all. Perhaps they do, perhaps they don’t, putting us back at the Ugandan stonemason problem.
Bottom line for the student of any age: if you want to make a difference to society, first learn to differentiate a function. If you can't do that, at least look for something honest that earns a lot of money. Only then can you be sure you're really helping others.
Image source: iStockphoto.
Volume 17, No. 3 (Fall 2014)ABSTRACT: Keynes’s theory of Aggregate Expenditures from the General Theory is examined and criticized. Keynes suggested numerous reasons why his marginal propensity to consume (MPC) might vary across individuals, over different time periods, and might be fundamentally heterogeneous in other respects, but assumed a constant MPC for tractability. He also argued that saving was a leakage (1920, pp. 19–20; 1936, pp. 81–85), but ignored the role of financial intermediation, which makes savings available to finance additional expenditure. More importantly, he ignored the injection of newly-created money which boosts both consumption and investment expenditure but does not depend on saving (Mises, 1949, pp. 567–573). When the amount of saving available to finance consumption and investment expenditure is correctly acknowledged, the effective multiplier is greatly increased, computed now as m = ∆Y/∆AE = 1/(MPS)RRR = 1/((1-MPC)RRR). However, it should be kept in mind that, like the money multiplier, the Keynesian multiplier is merely an upper limit which can only be approached asymptotically and over time. In light of this caveat, the multiplier becomes a relatively unimportant concept. Because the required reserve ratio appears in the corrected multiplier, the significance and potential impact of 100 percent reserve banking reforms are also addressed.
KEYWORDS: Keynesianism, aggregate expenditure, stabilization policy, fiscal stimulus, multiplier effectJEL CLASSIFICATION: B31, E21, E22, E61, 0431. INTRODUCTIONIs Keynesian stimulus policy in any sense justifiable or warranted? And has it ever been? Substantial literature argues that it is and has been effective, and will continue to be needed in the future, though it has repeatedly been proven ineffective both empirically and as policy. Nevertheless, it remains the cornerstone of economic policy followed by the U.S. and virtually all advanced economies, and recommended by intergovernmental development lenders, if not actually forced by them on developing nations. This paper will demonstrate that the Keynesian expenditure multiplier is not a positive policy guide, and that Keynesian stabilization policy should be abandoned.
Though not the only economist to advocate counter-cyclical macroeconomic stabilization, Keynes remains strongly identified with all variants of such policy approaches, and they are appropriately characterized as Keynesian (Hansen, 1953; Lerner, 1944; Patinkin, 1963, pp. 343–348; Clarke, 1988; Dimand, 1988; Salant, 1989; and Backhouse, 1995; among many others). Although a distinction can be drawn between theories and policies explicitly proposed by Keynes during his life and in his writings, and those proposed by his many followers (Leijonhufvud, 1968, pp. 6-35), among them Hansen (1932, pp. 305–313 [ch. 20]; 1941, pp. 261–289 [chs. 12 and 13]; 1949, pp. 115–142; 1953, pp. 86–114; 1960, pp. 140–150; 1951, pp. 629–674 [chs. 33–35]; 1964, pp. 11–39, 43–55), Lerner (1936, 1944, pp. 296–312; 1951, pp. 245–258), Meade (1951), Robinson (1953; 1956, pp. 208–221; 1962, pp. 63–69; 1969, pp. 15–39, 91–97), Samuelson (1954), and Salant (1989), the strong common thread of counter-cyclical fiscal activism which Keynesian economics shares with Keynesianism more broadly considered, cannot be denied. Lucas and Sargent (1978) concluded that Keynesian economics had to be abandoned, yet the U.S., like most advanced economies, never really superseded deficit finance except for a brief period in the late 1990s, and returned to it in response to the 2007–2009 recession and its aftermath. Keynesian models never seem to die, notwithstanding clear analytical limitations (Backhouse and Laidler, 2004; De Vroey and Hoover, 2004). The thesis of this paper is that Keynesian stabilization policy is not justified by its purported theoretic foundations in the aggregate expenditures multiplier and the marginal propensity to consume.
The Keynesian Resurgence which started in 2008 is currently scheduled to last until the Second Coming. Perhaps longer. In the eventuality, all but inconceivable to Keynesian-inspired policy-makers and their cheerleaders, that the continued and persistent failure of Keynesian policy leads to it becoming once again widely discredited, new resurgences can be anticipated whenever capitalism fails once and for all, as it had utterly and inexorably during the financial crisis of 2007. This rendered private property obsolete and necessitated a progressive socialism directed by an “elite” of pretentious intellectuals and dirigiste technocrats. Never mind that the elite inspired and presided over the unsustainable expansion which led to the collapse. Predictably, the proposed remedy for failed financial regulation is always expanded, more encompassing, and ideologically triumphalist regulation.
Keynesian policy today is inspired less by serious contemporary economics, whether fallacious or not, than the aspirations of policy makers whose economic impact is aptly described by analogy to navigators who persistently run their ship aground whenever the rising tide threatens to float it free. Some Keynesian proponents acknowledge the recovery attained under the Resurgence has thus far been lackluster, but attribute this to the inadequacy of the stimulus and bailout spending. This in a financial environment where the U.S. has nearly quadrupled the monetary base over a four-year period. Among others, former chair of the Council of Economic Advisors Christine Romer (2011) calls for continued monetary and fiscal stimulus to facilitate continued recovery. She deplores the “theorists” ruled by an arbitrary religious faith that monetary expansion leads to inflation. In her view, policy should be formulated by hard-headed “empiricists” like herself, who can correctly observe that after an unprecedented expansion of base money and increasing money in circulation by over 20 percent since the start of the recession, consumer price index (CPI) inflation has not risen too much above pre-recession levels. In addition to ignoring actual prices actual consumers have actually been paying for actual groceries and gasoline, she also ignores the statistical impact on the CPI of weighting housing costs, which have fallen markedly since the start of the recession, at their higher, pre-recession levels. This makes the CPI understate inflation by overstating the impact of falling rental and real estate markets. Housing prices have fallen the most in the urban markets where they were most overvalued before the speculative bubble burst, which are the only markets captured in the CPI.
Interestingly, Romer’s own empirical research finds that tax cuts are more effective in stimulating the economy than fiscal spending or monetary expansion (Romer and Romer, 2010). The unhelpful and uninformative division of the profession into virtuous and pragmatic “empiricists,” who can formulate effective policy responses, and bad, dogmatic “theorists,” who are mired in non-Keynesian rhetoric, is about as helpful as reviving the division of the profession into “salt-water” and “fresh-water” economists (Krugman, 2009). Salt-water economists were orthodox Keynesians at Eastern Establishment schools and Berkeley. Fresh-water economists were monetarists and New Classicals near the Great Lakes. Where, for example, does the Austrian school fit in these spurious intellectual taxonomies? Keep in mind these are no more than ad hoc rhetorical devices, intended to be abandoned or superseded as convenient. It may be an admirable distinction for the Austrian school to pass under the radar of the economic ideologues, who remain as uniformed about economic reality as they are insistent on asserting their mistaken views in the realm of public policy.
The great moderation, the protracted though clearly unsustainable policy-induced economic expansion of 1982–2007, was a period during which the business cycle was considered as obsolete as Keynesian stabilization policy had previously rendered it during the 1960s. This multiparadigm period was marked by an informal division of labor, with Keynesian and post-Keynesian theorists dominating long-run economic analysis, and new classical economists dominating analysis of short-run phenomena. The Keynesian perspective is that an increase in saving reduces aggregate income in the short run, but somewhat schizophrenically, according to uncontroversial views of long run economic growth typified by the Solow growth model, also contributes to sustainable growth (Welfens, 2011, p. 109).
The remainder of this paper is organized as follows. First, the historical evolution of the theory of the consumption function is developed in section 2, focusing on its implications for the marginal propensities to consume and save. The familiar Keynesian multiplier is derived in section 3. Then, Keynes’s treatment of saving as a leakage is criticized and corrected to account for financial intermediation in section 4. The possibility of accelerated intermediation is discussed in section 5. Implications of 100 percent reserve banking are discussed in section 6, and the impact of hyperbolic time discounting is developed in section 7. Concluding comments are presented as section 8.
- THEORYKeynes framed what is now called the absolute income hypothesis defining the traditional or naïve Keynesian consumption function: C = C0 + MPC(Y), whereC0 is autonomous consumption and MPC is the marginal propensity to consume (Keynes 1936, pp. 113–119). Thus consumption expenditure C becomes a function of current income Y. A more sophisticated variant may substitute disposable income Yd which takes into account taxes, transfers, and other sources of income. D’Orlando and Sanfilippo (2010) argued that many results deriving from this naïve model of consumption were both well-grounded on behavioral economics and enjoyed sound empirical support.
Duesenberry (1949) next proposed the relative income hypothesis, arguing that consumption was determined less by current absolute income, but by individuals’ income relative to others in society. He proposed a consumption function in terms of the average propensity to consume C/Y,
Ct/Yt = a – b(Yt/Y0),
where the greater an individual’s consumption Yt exceeded the average Y0, the lower would be their average propensity to consume. Thus, even in very poor and rich societies, the richest will consume less of current income than the poorest, who will consume all or nearly all of their income.
Modigliani and Brumberg (1954) later framed the life-cycle hypothesis, arguing that consumers seek to maximize the intertemporal utility from a stream of consumption expenditure. They demonstrated it was optimal for consumers to smooth consumption even if their income was erratic or varied over the course of their career. This accorded with the observation that typical income patterns tend to rise as a worker gains experience and seniority, peaking just prior to retirement, and then being zero or significantly lower during retirement. Rather than severely restrict consumption early in their careers and during retirement, workers would generally benefit both from borrowing against future expected income to finance higher consumption early in their career, especially if they have high time preference, and later on by saving for retirement.
Modigliani and Brumberg’s life cycle consumption function depended on both accumulated wealth W and current income Y, expressed as
C = aW + bY,
where a is the marginal propensity to consume as a fraction of wealth, and b is the conventional Keynesian MPC. This function can be subsumed into the Keynesian absolute income hypothesis if aW is conflated with Keynes’ C0, autonomous consumption, merely implying the plausible interpretation that C0 rises with higher W. Dividing both sides by current income gives
C/Y = b + a(W/Y),
which gives the relationship between the average propensity to consume (APC, = C/Y) and the ratio of accumulated wealth to current income.
One implication of the life-cycle hypothesis was that worker saving would be determined by the average growth rate of GDP. High growth would reward savers more, and furthermore would encourage additional saving which would be required to enjoy an average standard of living in retirement. Increases in life expectancy or lowering of the retirement age would also encourage greater saving, as workers would have to save for a longer retirement period. Modigliani and Brumberg were able to show that in a steady-state economy, working savers would transfer wealth to retired dissavers as these retired workers used up the wealth they had accumulated earlier. If the population grew over time, there would be relatively more workers and fewer retirees, lowering the burden on the working savers while increasing the benefit to the average retiree, but for a shrinking or aging population, this outcome would be reversed, perhaps unsustainably. Increasing productivity would increase income over time, which would tend to encourage additional saving and increase the stock of wealth, both acting to increase the balance of net saving by workers over dissaving by retirees.
Two problems were raised with the life-cycle hypothesis: 1) empirically, younger workers apparently refrain from borrowing against future expected income in the amount that would maximize their utility given the model’s assumptions; and 2) similarly, it was also observed that retirees generally consume less than is strictly consistent with their actual life expectancy. The failure of younger workers to borrow enough may result from ignoring debt aversion in relatively naïve intertemporal utility functions, and when student debt is considered, today’s young workers do borrow against future expected income, more so than ever before. Today the level of student loan debt for many consumers is comparable to mortgage borrowing. Three explanations were proposed to explain retirees’ failure to consume in accordance with their life expectancy: 1) retirees may overoptimistically estimate their life expectancy; 2) retirees are highly risk averse and cannot easily reenter the workforce except at significantly diminished wages, so they have a precautionary motive to retain substantial savings to cover unforeseen financial contingencies, such as market reversals or medical expenses; and 3) retirees may retain some unconsumed wealth to bequeath to their descendants.
To address perceived shortcomings of earlier consumption theories, Friedman (1957) proposed the permanent income hypothesis. Although his refinement of Modigliani and Brumberg is equivalent to merely extending individual life expectancy to infinity, in terms of interpretation, Friedman distinguished between permanent and temporary income. Extending life expectancy to infinity incorporates a bequest motive. Permanent income includes interest income on accumulated assets, regularly-occurring asset appreciation, and the non-variable component of current income, e.g., that part of attributable to accumulated human capital, as long as worker skills do not become obsolete rapidly. For many salaried workers, the permanent component of their wages is basically the whole amount, as long as workers perceive strong job security. For workers in less secure positions, it would be only the opportunity cost of the next best wage they could receive if they lost their current job. It would not include variable overtime demands or sales commissions, but recurring seasonal variations would average out. Temporary income, the variable component, or income perceived by workers as temporary, does not support much consumption spending—Friedman suggested this component should be saved and only the interest spent on additional current consumption, because then any interest on permanent additions to capital would be an addition to permanent income. It could be argued that low time preference individuals save temporary income to boost their asset stock and therefore increase their permanent income, but that individuals with higher time preference are more prone to spend temporary income immediately.
Both the life-cycle and permanent income hypotheses predict individuals act to smooth consumption over their lifetimes, as that is a utility maximizing strategy in these models. Younger workers with relatively low current incomes should borrow against higher expected future incomes and retirees should dissave (Thaler, 1990, p. 195), though empirically workers either do not typically do this at all, or do so less than the two hypotheses predict (Hall, 1978; Flavin, 1981, 1983; Hall and Mishkin, 1982; Wilcox, 1989; Zeldes, 1989; Singleton, 1990; Campbell and Mankiw, 1990; Carroll, 1994; Shea, 1995; Souleles, 2002; Stephens, 2003). In particular, young workers seem either to pessimistically under-appraise either their own future income stream or overall economy-wide growth, or both (Courant, Granmlich, and Laitner, 1984). Retirees also avoid consuming all remaining wealth as their life expectancy diminishes, perhaps due to bequest motives, or because consuming the whole stock of accumulated assets prior to death would be financially catastrophic, or both. Tests of the permanent income and life cycle hypotheses are highly sensitive to the method for segmenting income and consumption into permanent and transitory components. For example, Shirvani and Wilbratte (2009), using multivariate stochastic detrending, found that permanent consumption is determined by permanent income, but that the transitory component of consumption was not related to either permanent income or transitory income. Zeldes (1989) found that poor household consumption was constrained by current income, but rich household consumption was not.
The persistent failure of any compact single-parameter consumption function to adequately explain real-world consumption behavior led to new efforts to capture additional determinants of consumption behavior. Real-world consumers enjoy consumption, but also desire the security—and perhaps the status—offered by accumulated saving. For example, in his celebrated Diary, Samuel Pepys repeatedly expresses delight in the size of his increasing savings, though perhaps equally so in specific acts of consumption.Pepys (1893, vol. 1, pp. 34, 56, 155, 158–159, 194–195, 219, 234, 253, 274, 283, 292, 322; vol. 2, pp. 39, 93, 152, 231, 235, 254, 276, 303, 327, 351, 380, 400, 405; vol. 3, pp. 74, 94, 142, 173, 175, 216, 272, 303, 338, 370; vol. 4, pp. 88, 116, 137, 161, 191, 217, 261, 278, 398, 323, 328, 341, 361, 378, 398; vol. 5, pp. 2, 33, 42, 57, 173, 225, 246, 265, 285, 331, 362; vol. 6, pp. 42, 112, 190). He also expresses significant discomfort the one time his net worth declined (vol. 1, p. 253), but to be quite accurate, his delight in consuming food, wine, entertainment, etc. is just as well documented and equally noteworthy. The need for a more realistic and encompassing theory of consumption, combined with the empirical failure of earlier naïve theories, led to a more sophisticated multidimensional approach.
The behavioral life-cycle hypothesis (D’Orlando and Sanfillipo 2010) proposes segregating income and wealth into different categories with different MPCs: current income, savings (current assets), and future income. They note that empirically, consumers demonstrate different responses to changes in different categories of wealth and income, a behavior called mental budgeting. D’Orlando and Sanfillipo credit Keynes with the seminal identification of most of the basic underlying factors explaining consumption behavior: utility maximization based on foresight and calculation, preference for procrastination (high time preference), cognitive scarcity, imitation, status quo bias, short time horizon, prodigality (which may also come from high time preference), mental budgeting (where different accounts are kept for different classes of income, including permanent and transitory, as well as different classes of wealth-bearing assets), risk aversion, ambiguity aversion, and debt aversion.
Consumers characteristically have different MPCs for wealth derived from different sources, from assets which are earning different returns—whether from interest/dividend income or asset appreciation—and for physical assets in different locations, as well as for financial assets with varying degrees of liquidity, or different exposure to various kinds of risk, e.g., foreign-denominated assets exposed to exchange-rate risk, etc. (Thaler, 1994, p. 188). It has also been found that MPCs are magnitude-inconsistent—MPCs for small changes in income and/or wealth are significantly higher than for larger changes (Thaler, 1990; Heath and Soll, 1996; Souleles, 2002).
MPCs also vary with time horizon, that is, they are time-inconsistent in that long-term preferences deviate from the short-term preference for immediate gratification (Rabin, 1998, p. 38), which incidentally explains Pepys’s behavior. Consumers make very patient, low-time-preference tradeoffs between costs and benefits far in the future, but still desire immediate gratification (Ho et al., 2006, p. 21). Behaviorally, consumers also employ imitative or habitual heuristics to avoid the deliberation costs of processing available information or of collecting that information in the first place (Stigler and Becker, 1977, p. 82; Pingle, 2006, pp. 340–342). It has also been suggested that retirees spend less because they can spend more time in leisure activities like food preparation or bargain hunting, and thus their consumption is closer to what the life cycle and permanent income hypotheses predict, though their expenditure is lower (Becker, 1965; Aguiar and Hurst, 2005). Small changes in income are more likely to be perceived and treated as temporary, while sufficiently large changes are likely to be perceived as permanent, resulting in correspondingly large adjustments in consumption spending and living standard. However, this would not explain the behavior of younger workers.
Time preference ensures consumers prefer current to future satisfaction, but their actual behavior suggests an even higher preference for current consumption, such as might be explained by the more distant future appearing less certain, and consumers are increasingly risk averse for decisions which extend over longer time periods (Feldstein, 1985), and are thus exposed to more risk, for a longer period, and of a less definable character. One reason consumers may care less about the future is the uncertainty regarding future consumption opportunities, as well as how their preferences may change between now and then (Thaler et al., 1997, p. 648; Pesteau and Possen, 2006, p. 4). Debt aversion offers an additional reason young workers do not consume more (Thaler, 1992, p. 10), but that may be offset in the data by the massive student loan debt many young workers now accumulate.
One feature of behavioral life cycle models is that consumers do not know if a change in income will be permanent, but to some extent act as if they were, more that the level of uncertainty suggests (Shirvani and Wilbraitte, 2009, p. 59). Consumers behave as if they keep separate mental accounts (Prelec and Lowenstein, 1998), which are subjective rather than precise, and distinguish among current disposable income, with a very high MPC, and current assets, with a much lower or even near-zero MPC (Heath and Soll, 1996, p. 41). Unsurprisingly, future income and assets both have very low MPCs. Welfens (2011, p. 126) suggests high time preference by either consumers or policy makers, perhaps driven by poor institutional arrangements, should influence policy makers to adopt short-run Keynesian policies, because economic growth is not possible unless institutions are changed to favor it.
Seventy years of investigations into Keynesian-inspired consumption theory and a variety of appealingly parsimonious hypotheses have led to the general conclusion that consumer behavior is not so simple after all. And if the MPC cannot be averaged over a whole economy and is not time invariant, there can be no multiplier effect, as the next several sections will demonstrate.
- DERIVATION OF THE MULTIPLIERThe Keynesian multiplier is derived as follows (Keynes, 1936, ch. 10, pp. 113–131). Y represents income and output, and AE is aggregate expenditures, all measured in dollar terms. Any increase in income and output is decomposed into an infinite stream of increases in expenditure:
∆Y = ∆AE0 + ∆AE1 + ∆AE2 + ∆AE3 + … + ∆AEn + …
Each element in this infinite sum is related to the immediately preceding element by the marginal propensity to consume (MPC). Keynes also defines the marginal propensity to save (MPS). Any change in disposable income is divided between consumption and saving, so the marginal propensities to save and consume add to one: 1 = MPC + MPS. Although the MPC may vary across individuals, in Keynes’s construction there is one overall average MPC for the economy at any point in time, so the MPC is assumed to have a constant value less than 1.00 and usually greater than 0.50:
∆Y = ∆AE0 + (MPC)∆AE0 + (MPC)∆AE1 + (MPC)∆AE2 + … + ∆AEn + …
Because the MPC relates each element in the series to the one preceding, the series can be expressed exclusively in terms of the initial increase in expenditure and progressively higher orders of the MPC:
∆Y = ∆AE0 + (MPC)∆AE0 + (MPC)2∆AE0 + (MPC)3∆AE0 + … + (MPC)n∆AE0 + …
Note, however, that MPC heterogeneity derived from time and magnitude inconsistency breaks down the logic of this derivation in a way that mere aggregation over heterogeneous agents does not. Given the implicit assumption that the aggregate or economy-wide MPC is time invariant over the period it takes to arrive at the final change in income ∆Y, this is equivalent to the infinite convergent series:
∆Y = (MPC)0∆AE0 + (MPC)1∆AE0 + (MPC)2∆AE0 + (MPC)3∆AE0 + … + (MPC)n∆AE0 + …
which can be expressed as:
∆Y = ∑i=0,∞(MPC)n∆AE0 = ∆AE0∑i=0,∞(MPC)n
Finally, for infinite convergent sums, and dividing ∆Y by the initial ∆AE to define the multiplier, we have:
m = ∆Y/∆AE = 1/(1 – MPC) = 1/MPS
It is important that the MPC be strictly less than one for the infinite sum to converge. Although some individuals could conceivably spend more than their whole income through borrowing, transfers, confidence fraud, etc., the economy-wide average cannot exceed one. Even when institutionalized under government sponsorship, confidence fraud does not increase aggregate wealth or income.
For agents with high time preference, the MPC is very high in the short run, but diminishes as additional rounds of consumption occur. For agents with low time preference, the MPC is initially low and remains low for later rounds of expenditure.This points to the efficacy of hyperbolic, rather than standard exponential, discounting, which has been explored in the behavioral economics literature (Strotz, 1956; Phelps and Pollak, 1967; Laibson, 1997; Angeltos, 2001, p. 50, n. 13; Frederick et al., 2002, p. 360; Ho et al., 2006, p. 21; D’Orlando and Sanfilippo, 2010). The great sin in Keynes’s view is having too low an MPC, and therefore too high an MPS (Keynes, 1920, p. 20; 1936, pp. 81–85, 116–119). This view ignores the possibility of financial intermediation, not to mention monetary injection.
- THE MULTIPLIER WITH FINANCIAL INTERMEDIATIONWe start as before, with a hypothesized increase in total income and output being arrived at as the infinite sum of a series of increases in expenditure:
∆Y = ∆AE0 + ∆AE1 + ∆AE2 + ∆AE3 + … + ∆AEn + …
Some part of each increment of income received as expenditure, measured by the MPC, is immediately spent on consumption goods. At the outset however, we differ from Keynes by observing that the part not spent on consumption, measured by the MPS, does not simply disappear, as Keynes assumed, but is placed in the hands of financial intermediariesBanks and other financial intermediaries act solely as middlemen when they lend person A’s deposits to person B. In principle, A could lend to B directly, so the bank is nothing more than a middleman in this case. However, most bank intermediation today relies on credit creation by banks—when the bank lends A’s deposits to B, A can still spend their demand deposits or withdraw their time deposits, and now so can B. Here, banks are not purely middlemen, but increase the amount of money in circulation by creating additional credit. Credit created by private banks is sometimes called intermediated credit. Monetary expansion by the central bank encourages credit creation by increasing private bank lending, while making additional funds available for that purpose, increasing the multiplier as described in this section. To distinguish credit created through fractional reserve banking (intermediated credit) from credit which results from an expansionary money supply, the latter is sometimes called injected credit (Cochrane, Call, and Glahe, 1999). The distinction is significant but has no bearing on the present discussion. I am greatly indebted to an anonymous reviewer for pointing out this distinction as a potential source of confusion. who lend a good part of this portion to finance investment expenditures. The amount of each increment of expenditure loaned out by the financial intermediaries to finance investment is given by MPS(1 – (RRR), where RRR is the required reserve ratio.The RRR is formally a regulatory constraint set by the central bank or other authority, but banks typically hold non-zero excess reserves in addition. The actual amount of unloaned deposits banks hold is determined by their effective reserve ratio. Although in reality, this varies with banks’ risk tolerance, awareness of actual risk exposure, and differences in the kinds of lending particular institutions specialize in, etc. these real-world variations can be ignored for the present discussion. The effective reserve ratio for demand deposits is directly analogous to the loan loss reserve ratio held on saving or time deposits. Thus the presentation applies equally well to all deposits. RRR is conventionally thought of as being arbitrarily set by regulatory authorities, currently approximately 10 percent for the U.S. In practice, this quantity can be thought of as the actual bank intermediation rate, which captures not only banks’ required reserves, but excess reserves they hold voluntarily hold over and above the amount dictated by the reserve requirement, as well as loan loss reserves on time deposits not subject to the reserve requirement. For expository convenience and simplicity, all deposits are treated the same.
In Keynes’s formulation, each element in the expenditure series was related to the preceding by the MPC, but in adapting Keynes’s multiplier scheme to account for financial intermediation, we can see that each element is related to the preceding by MPC + MPS(1 – RRR). Since MPC + MPS = 1, we can rewrite this constant as 1 – MPS + MPS – MPS(RRR) or 1 – MPS(RRR). Thus, each increment of expenditure is reduced from the preceding one by a far smaller amount:
∆Y = ∆AE0 + (1-MPS(RRR))∆AE0 + (1-MPS(RRR))∆AE1 + (1-MPS(RRR))∆AE2 + … + ∆AEn + …
Following the standard derivation, each increment of expenditure can be expressed in terms of the initial one:
∆Y = ∆AE0 + (1-MPS(RRR))∆AE0 + (1-MPS(RRR))2∆AE0 + (1-MPS(RRR))3∆AE0 + … + (1-MPS(RRR))n∆AE0 + …
And the whole series can be expressed as higher orders of (1-MPS(RRR)):
∆Y = (1-MPS(RRR))0∆AE0 + (1-MPS(RRR))1∆AE0 + (1-MPS(RRR))2∆AE0 + (1-MPS(RRR))3∆AE0 + … + (1-MPS(RRR))n∆AE0 + …
This can be expressed as:
∆Y = ∑i=0,∞(1-MPS(RRR))n∆AE0 = ∆AE0∑i=0,∞(1-MPS(RRR))n
And for infinite convergent sums, we can now write the multiplier as:
m = ∆Y/∆AE = 1/(MPS(RRR)) = 1/((1-MPC)(RRR))
Table 1. Modified Keynesian Multipliers as a Function of the Effective Reserve Ratio
Note particularly that even with very high reserve requirements, the multipliers adjusted for intermediation are much higher than Keynes suggested. One consequence of this finding is that, far from being a drag on the economy or a leakage out of current expenditure, the amount of income saved boosts the multiplier substantially. If the reserve requirement is ten percent, each dollar saved results in ten times as many dollars of additional income as Keynes suggested, irrespective of how the MPC may vary throughout the economy.
Keynes introduced the now-familiar, though quite obviously wrong, idea that saving represents a drag on output in The Economic Consequences of the Peace (Keynes, 1920, pp. 19–20). In the Treatise on Money (Keynes, 1930 I, p. 279) he attributes recessions to a mistaken tendency for agents to save in excess of investment, rather than for investment to exceed saving. Apparently here he was referring to the economy after a collapse of aggregate expenditure, rather than during the unsustainable expansion which would have to precede a recession. According to the Treatise on Money, too much saving causes recessions (Keynes 1930 I, pp. 172–179), but by the time of the General Theory, saving and investment are always equal by definition (Keynes, 1936, pp. 74–85), though saving remains a necessary evil.Robinson (1969, pp. 95–97) makes the more sophisticated observation that saving is necessarily neither good nor bad. Its contribution to economic growth depends on whether it is invested and how productive those investment goods turn out to be. This comes close to approaching the Austrian school’s doctrine of capital multispecificity (Lachmann, 1956, pp. 2–3).
- THE AGGREGATE EXPENDITURE MULTIPLIER AND THE MONEY MULTIPLIERThe derivation presented in section 3 above makes the relatively reasonable assumption that each round of additional investment expenditure simultaneously accompanies each additional round of lending by the financial intermediaries. But what if financial intermediation happens significantly faster? Clearly, under appropriate circumstances, banks can lend money more rapidly than borrowers can spend it on consumption, and indeed, until the funds are spent on consumption, they are saved. Except for the small fraction held as bank reserves, these unspent funds are available to be loaned out.
This section presents a derivation of the multiplier with instantaneous, or at least, very rapid, financial intermediation. Now each element in the summation is related to the one preceding not by MPC + MPS(1 – RRR), but by the much greater quantity MPC + MPS(1 – RRR)/RRR. Here the amount of additional income which is spent on consumption is the same as in Keynes’s original multiplier, but now, instead of the remainder being a leakage, the unspent portion is loaned out in successive rounds of lending determined by the money multiplier. Therefore the second term in the constant is multiplied by m = 1/RRR, assuming that deposit expansion occurs instantaneously, or at least, before the next round of additional expenditure. The constant relating different rounds of expenditure can be rewritten as
1 – MPS + MPS/RRR – MPS = 1 – 2MPS + MPS/RRR = 1 – [2MPS – MPS/RRR].
This quantity is greater than one for any values of the MPS, MPC, or any non-zero reserve requirement, and thus the multiplier cannot be derived, because the summation never converges. If we could perform financial intermediation quickly and efficiently enough, income and expenditure could expand without limit. In this situation, the reserve requirement is not adequate by itself to limit the amount of income, even if it can limit the money supply.
- IMPLICATIONS FOR THE MULTIPLIER UNDER 100 PERCENT RESERVE BANKINGUnder 100 percent reserve banking, the reserve requirement becomes 100 percent, so the multiplier would reduce to its familiar Keynesian form given in the General Theory:
m = ∆Y/∆AE = 1/(MPS)RRR = 1/(1-MPC)RRR = 1/(MPS) = 1/(1-MPC)
However, under 100 percent reserve banking, the 100 percent reserve requirement would apply to demand deposits and other deposit instruments commonly available today. It appears highly likely that the financial services industry would respond to the imposition of 100 percent reserve banking by introducing innovative products to facilitate intermediation while rewarding depositors with higher returns. No one has claimed that implementation of 100 percent reserve banking would result in immediate and permanent disintermediation, or that this would be a desirable outcome. If savings go predominantly into instruments for which the 100 percent reserve requirement is inapplicable, the multiplier would be jointly determined by the MPS, the MPC, and the bank intermediation rate or effective reserve ratio, just as described in section 3 above.
- THE MULTIPLIER WITH HYPERBOLIC DISCOUNTINGGiven Keynes’s implicit assumption that the MPC is time invariant, it becomes interesting to see how relaxing this assumption changes the multiplier. Recall the familiar infinite convergent series:
∆Y = (MPC)0∆AE0 + (MPC)1∆AE0 + (MPC)2∆AE0 + (MPC)3∆AE0 + … + (MPC)n∆AE0 + …
This formulation assumes the more familiar exponential discounting. If the MPC diminishes over time, this can be modeled with hyperbolic discounting. Far from being an arbitrary counterfactual, hyperbolic discounting is well established in the behavioral economics literature (Strotz, 1956; Phelps and Pollak, 1967; Laibson, 1997; Angeltos, 2001, p. 50, n. 13; Frederick et al., 2002, p. 360; Ho et al., 2006, p. 21; D’Orlando and Sanfilippo, 2010). The original exponentially-convergent series can be replaced by an expression which diminishes for subsequent rounds of additional expenditure, such as
MPC’ = MPC/(1+n)
This changes the infinite series to
∆Y = (MPC)0∆AE0 + (1/2)(MPC)1∆AE0 + (1/3)(MPC)2∆AE0 + (1/4)(MPC)3∆AE0 + … + (1/1+n)(MPC)n∆AE0 + …
Which can be expressed as:
∆Y = ∑i=0,∞(1/1+n)(MPC)n∆AE0 = ∆AE0∑i=0,∞(MPC)n/(1+n)
Because each item in the summation is smaller than for the Keynesian multiplier, this series converges more rapidly, so unambiguously m’ << m, or in other words:
m’ = ∆Y/∆AE << 1/(1 – MPC) = 1/MPS
An even more extreme, though fortunately more tractable and intuitive approach is to assume future discounting is so extreme that all future consumption is ignored beyond one time period. Then the infinite sum is replaced with:
∆Y = (MPC)0∆AE0 + (MPC)1∆AE0 = ∆AE0(1 + MPC)
The multiplier is then derived as:
m = ∆Y/∆AE = 1 + MPC = 2 – MPS
This preserves the Keynesian conclusion that the higher the MPC and the lower the MPS, the higher the multiplier. The upper bound of two it suggests happens to accord well with empirical findings (Bodkin and Eckstein, 1985, Romer and Romer, 2010), however this has to be taken with a grain of salt. Many empirical estimates of the multiplier are less than one, (e.g., Barro and Redlick, 2010), implying both a negative MPC and an MPS greater than one. The deceptively simple concept of the MPC having a single, constant, time-invariant, time-consistent, and economy-wide value has to be abandoned, and Keynesian stimulus and stabilization policy along with it.
- CONCLUSIONKeynesian stabilization policy has informed and inspired government responses to the 2007 financial crisis and the 2008–2010 recession. Keynesian economics does not attempt to address the unsustainable expansions which render recessions inevitable. In fact, credit expansion and artificially low interest rates were policy choices pursued aggressively and almost unwaveringly from 1982 to the present. It is difficult for any objective observer to conclude that Keynesian economics offers plausible or especially enlightening explanations for this experience. The Keynesian resurgence is not in any way a resurgence of Keynesian economics, or in any way an intellectual resurgence of ideas that were thoroughly discredited by the stagflation in the 1970s. What we are seeing is merely a resurgence of Keynesian rhetoric in the realm of public policy, trotted out once again to justify a blatantly ineffective and indefensible expansionary policy. Credit expansion got us into this hole, and more credit expansion should not be expected to dig us out.
Sustainable economic growth depends on individual producers’ freedom to divide their income into consumption and saving in accordance with their own preferences, not the preferences assumed for them by politicians and bureaucrats. It is a bizarre delusion to argue that a sustainable outcome which reflects agent preferences can be improved by manipulating interest rates or credit markets. At best, such manipulations can only increase short-term production through inflation. As repeated experience has demonstrated, they can also bring about speculative bubbles and recurrent recessions which make welfare-maximizing consumption smoothing impossible. Monetary expansion and deficit financing should hardly be promoted as welfare-enhancing policy measures, the Keynesian resurgence notwithstanding.
Friday marks the thirtieth anniversary of the fall of the Berlin Wall. Like most historical events that are commemorated as if they took place on a single day, the fall of the Berlin Wall on November 9, 1989, was just one of many interrelated events that led to the end of the system of Soviet client states in Eastern Europe, and the end of the Soviet Union itself, in December of 1991.
With the fall of the Berlin Wall, East Germans, who had lived under severe restrictions on travel and emigration, were able to freely travel to West Berlin, which continued a chain of events already begun earlier that year in which many anti-Soviet dissidents throughout Eastern Europe became emboldened and met with unprecedented success. Meanwhile, East Germans flooded into neighboring countries by the thousands, seeking refuge from Soviet-sponsored oppression in Austria and West Germany.
Why It Was Different in 1989 Throughout the mid-twentieth century, Eastern Europe was home to numerous anti-Soviet revolts and acts of civil disobedience. In Hungary in 1956, Prague in 1968, and especially in Poland throughout the 1970s and 1980s, resistance flared up, but was reliably crushed with Soviet-sponsored martial law and outright military intervention.
But in the summer of 1989, the Poles held an election that essentially overthrew the Soviet-approved regime in Poland. This, time, however, instead of sending tanks to crush the Polish agitators, the USSR did nothing.
By November of that year, dissidents had become emboldened by Soviet inaction. Hungary and Czechoslovakia haphazardly opened their borders, allowing East Germans to stream into Austria and on to West Germany. East Berliners began to demand free passage to the West. The “fall” of the wall, soon followed.
Americans today, and especially American conservatives, like to claim that the end of the Soviet bloc and the Soviet Union was America’s doing; that the Soviet oligarchs feared American military might, and simply decided to give up and vote themselves out of existence, as they did two years later. This tale makes for nice domestic propaganda in America, but the fact that regimes virtually never just “give up” without firing a shot when faced with a threatening foreign power makes it rather unlikely.
We are far more likely to find an answer if we ask ourselves not why the American state was so strong in the 1980s, but why the Soviet state was so weak. If the Soviets were more than capable of maintaining “order” in Eastern Europe during the 50s, 60s, and 70s, why was it unable or unwilling to do the same in the 1980s?
An inquiry along these lines quickly leads us to find that by the 1980s, the soviet economy, and most of the economies of Eastern Europe were economic basket cases. Housing was in disrepair. Vehicles and appliances were incredibly old-fashioned and unreliable. The standard of living was a fraction of what it was in the “West.” Basic items like soap and women’s pantyhose were often luxuries.
In other words, the centrally-planned economies of the Soviet bloc produced little actual wealth, and as the regimes siphoned off more and more of what little wealth was being produced, the people, as well as the regimes, became poorer and poorer.
This economic weakness meant not only that the legitimacy of the regime was imperiled, but that the Soviets no longer enjoyed a military “surplus” with which they could simply roll into every rebellious neighborhood and re-establish order.
In other words, the USSR was too poor to pay the political bills.
Mises and the Calculation Problem None of this would have surprised Ludwig von Mises. Decades before, Mises had shown that a socialist economy (by which he meant a centrally planned economy) could not possibly know what to produce, when to produce it, or for whom to produce. In explaining this, Mises proved that the Soviet Union, regardless of any victories it might have in remolding human nature, was economically impossible. Rothbard explains:
Before Ludwig von Mises raised the calculation problem in his celebrated article in 1920, everyone, socialists and non-socialists alike, had long realized that socialism suffered from an incentive problem. If, for example, everyone under socialism were to receive an equal income, or, in another variant, everyone was supposed to produce “according to his ability” but receive “according to his needs,” then, to sum it up in the famous question: Who, under socialism, will take out the garbage? That is, what will be the incentive to do the grubby jobs, and, furthermore, to do them well? ...
But the uniqueness and the crucial importance of Mises’s challenge to socialism is that it was totally unrelated to the well-known incentive problem. Mises in effect said: All right, suppose that the socialists have been able to create a mighty army of citizens all eager to do the bidding of their masters, the socialist planners. What exactly would those planners tell this army to do? How would they know what products to order their eager slaves to produce, at what stage of production, how much of the product at each stage, what techniques or raw materials to use in that production and how much of each, and where specifically to locate all this production? How would they know their costs, or what process of production is or is not efficient?
Mises demonstrated that, in any economy more complex than the Crusoe or primitive family level, the socialist planning board would simply not know what to do, or how to answer any of these vital questions. Developing the momentous concept of calculation, Mises pointed out that the planning board could not answer these questions because socialism would lack the indispensable tool that private entrepreneurs use to appraise and calculate: the existence of a market in the means of production, a market that brings about money prices based on genuine profit-seeking exchanges by private owners of these means of production. Since the very essence of socialism is collective ownership of the means of production, the planning board would not be able to plan, or to make any sort of rational economic decisions. Its decisions would necessarily be completely arbitrary and chaotic, and therefore the existence of a socialist planned economy is literally “impossible” (to use a term long ridiculed by Mises’s critics).
The Soviet central planners never had an answer to this critique. Indeed, their “answer” only came in 1991 when the USSR finally shut itself down. And even up to the end, American Keynesians never figured it out either, and Paul Samuelson still claiming in 1989 that a “socialist command economy can function and even thrive.”
Why Did it Take So Long? In response to Mises’s claim of the impossibility of central planning, some then ask “well, if central planning was impossible, why did it last so long?”
The answer can be found in the fact that even in a centrally planned state, capital does not simply vanish overnight. The soviet planners were not starting with nothing. They had the accumulated capital of centuries of savings and investment by Russians, Ukrainians, Germans, Poles, and others under their control.
True, it was not possible for them to correctly plan or determine non-arbitrarily what goods should be produced. But they nevertheless had large amounts of capital at their disposal, and even if the centrally planned state produced zero wealth (which was not true since even the Soviet state produced some things people wanted), the state still had plenty of wealth to redistribute until it was all gone.
This is all the more true for regimes that are only partly centrally planned, as in the case of Venezuela, on which Nicolás Cachanosky observed:
[I]f one of the wealthiest and developed countries in the world were to adopt Cuban or North Korean institutions overnight ... [t]he wealth and capital does not vanish in 24 hours. The country would shift from capital accumulation to capital consumption and it might take years or even decades to drain the coffers of previously accumulated wealth. In the meantime, the government has the resources to ... enjoy the wealth, highways, electrical infrastructure, and communication networks that were the result of the more free-market institutional realities of the past.
Eventually, though, the “reserve fund,” as Mises called it, is used up:
An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.
In addition to this, the Soviets made money for the regime by selling oil (and other goods) in international markets, and high oil prices in the 1970s propped up the regime so well, that had it not been for Soviet oil sales, it’s quite possible the regime would have collapsed a decade earlier.
Conclusion As the mainstream news outlets cover the anniversary of the Berlin Wall’s fall this year, they will surely spend much time discussing the role of various American politicians, and military programs, and international relations. It is quite possible that all of these things had an effect on the regimes of Eastern Europe that were non-trivial. Nonetheless, such analysis ignores the huge elephant in the room which is the inevitable failure of regimes that are built on central planning and wealth re-distribution. Without markets and prices, there can be no planning, and without planning, no wealth creation, and ultimately, no political durability. The rebels and demonstrators of Eastern Europe deserve immense credit for courageously standing up to the state. But in the end, those who were successful were helped immensely by good timing and bad economics.
[Editor's Note: This article was first published in 2014 to mark the 25th anniversary of the fall of the Berlin Wall. It has been slightly updated for the 30th anniversary.]
This lecture by Bob Murphy was presented at the 2012 Mises University in Auburn, Alabama.
The entrepreneur risks, in the present, investment in productions that he thinks will produce some good or service at a profit in the future.
Archived from the live Mises.tv broadcast, this lecture by Peter Klein was presented at How Does an Economy Grow? A Seminar for High School and College Students. Special thanks to an anonymous donor for making this event possible.
Are we in a recovery? There has been no true recovery since 2008. Private savings rate went down to zero during the boom. Traditional savings rate of Americans has been ten percent.
Archived from the live Mises.tv broadcast, this question and answer period features Daniel J. Sanchez, Mark Thornton and Peter G. Klein, and was was presented at How Does an Economy Grow? A Seminar for High School and College Students. Special thanks to an anonymous donor for making this event possible.
Growth requires private saving first, then investment and then production. It cannot be accomplished through sheer credit and credit expansion. Money is not wealth.
Archived from the live Mises.tv broadcast, this lecture by Danny Sanchez was presented at "How Does an Economy Grow? A Seminar for High School and College Students". Special thanks to an anonymous donor for making this event possible.
How an Economy Grows and Why it Doesn't by Irwin Schiff can be found here.
People are generally aware of the positive power of compound interest when deferring consumption in favor of productive investments. But more important when it comes to public policy is the destructive power of compound ignorance.
According to John Rector, “Compound ignorance is the type of ignorance in which we are not aware that we are not aware.” It arises when “we don’t realize what we don’t know.” In government, however, such “unknown unknowns” often lead to untrammeled confidence among politicians, despite the certainty of error. Compound ignorance is put on display every time a “progressive” wants to turn still more individual decisions over to political processes and government bureaucrats. Blithely unaware of the immense blind spots of what they don’t know for productive social cooperation, they believe they are taking decisions from the uninformed and giving them to experts. But they have it backwards. Such expansions of government dictation actually move choices from the relevant experts, with appropriate incentives to act on that expertise, to those far less informed and facing far worse incentives.
The social costs of compound ignorance grows with government’s reach. And its many recent expansions, along with the many failures (e.g., healthcare.gov) and crises (from the VA to the IRS) that have accompanied it, illustrate that it has been taken to a new level.
Such scandals reflect the compound ignorance that separates political promises from what it takes to actually deliver on them.
The current version of that shell game typically starts with a presidential commitment, delivered with solemnity to convey “I really mean it.” But all responsibility for backing the words up (from “you can keep your doctor” to promises of cost savings to assertions that they will be the most open administration ever) is immediately swept from his teleprompter into the lap of some cabinet secretary or administrator. Then, when the promises turn out to be empty or unattainable, his delegated expert starts taking heat. There is a period of expressing confidence in their competence (which amounts to confidence that by picking the right administrator, circles can be squared), combined with efforts to focus attention elsewhere. But then political heat picks up. When it becomes worrisome, the administration expresses anger at the failure (which implies surprise) and determination to fix it. That is then demonstrated by bringing in a new fixer to replace their predecessor, transformed into the scapegoat. The president is thereby kept from ever having to put forward how he would do what he promises, firewalled from political blame, even when the multiple scandals allegedly discovered by watching the news demonstrate a compound ignorance that guarantees failure to know enough to deliver.
Obamacare’s enactment offered a good example of unwarranted confidence in the face of massive unknown unknowns. While Nancy Pelosi’s assertion that “we have to pass the bill so that you can find out what is in it” was widely lampooned (including a poster of her with the caption, “Ignorance: It’s not just bliss anymore. It’s policy”), the fact that Congress was forced to vote on what was not even available for reading creates an even higher order of ignorance — they could not even know what they were “deliberating” on, much less the degree to which it would be hamstrung by compound ignorance.
Such compounded compound ignorance offers a warning to every American to consider more carefully how frequently government “expertise” can actually make them better off by taking their resources and substituting its determinations for theirs. That is the crucial issue, as every other government act requires harming some, which is an odd way to advance anything that, with a straight face, could be called the general welfare. Unfortunately, in every area in which our desires and willing tradeoffs differ substantially, by far the most common case, such shifts inherently take decisions away from the only ones who know the details about their goals, desires, skills, alternatives, and other circumstances to make them the relevant experts.
Voluntary market arrangements incorporate the highly varied, yet overlapping, knowledge of all participants, each expert in their array of circumstances of time and place, even when the vast majority knows virtually nothing at all about them. Such specialization in knowledge and tasks that most are ignorant of, coordinated by markets is, in fact, the primary source of advancing civilization. It allows effective social cooperation even in the face of compound ignorance and constant change.
In contrast, when government fiat overrides that process, compound stupidity replaces coordinated knowledge. Inherently insufficient experts who don’t know enough to say “I don’t know enough” then demonstrate that they have been raised to a level beyond their incompetence. Government does ever more of what it cannot do well, but can do very badly. And since, as Friedrich Hayek noted, “The more civilized we become, the more relatively ignorant must each individual be of the facts on which the working of civilization depends,” the price society pays is beyond comprehension.
Image source: iStockphoto
Drug warriors rely on bad and manipulated data to make the claim that respecting private property rights in Colorado is “terrible public policy,” writes Mark Thornton. This audio Mises Daily is narrated by Keith Hocker.
Argentina’s economic minister, Axel Kicillof, has become famous for his assertion that it is possible to centrally manage the economy now because we have spreadsheets such as Microsoft Excel. This assertion comes from the mistaken view that the cost of production determines final prices, and it reveals a profound misunderstanding of the market process. This issue, however, is not new. The first half of the twentieth century witnessed the debate over economic calculation under socialism. Apparently, Argentine officials have much to learn from this old debate. The problem is not whether or not we have powerful spreadsheets at our disposal; the problem is the impossibility of successfully creating a centrally-planned market.
At the turn of the century Ludwig von Mises, Max Weber, and Boris Brutzkus independently offered critiques on the socialist commonwealth, understood to be a society where there is no privately-held means of production. Mises was simple and direct. Unlike families or small tribes, where there is intimate knowledge among members, a large society requires prices to organize efficiently. The socialists, argues Mises, are quick to point out market failures, but are silent on how to efficiently organize the socialist commonwealth without the existence of prices. Marx, who does not offer an explanation of how socialism would work once capitalism withers away, calls the socialists (i.e., Saint-Simon and Fourier), who do describe the resulting socialist community, “utopians.” Without economic calculation to reveal which activities add value to society (profits) and which do not (losses), it is an illusion to assume that efficiency would just happen. Arguments other than economic calculation can be put forward as a principle to organize society, but the question of how economic efficiency is achieved remains unanswered.
As a response to this critique, writers in the socialist literature went from describing imaginary societies and criticizing capitalism to trying to solve Mises’s challenge. Oskar Lange and Wassily Leontief are two of the most famous authors who tried to solve this problem. One of the answers offered is the assumption of perfect information (still present in economics textbooks). The argument goes, if we assume to have all the required information, then the economy can be at equilibrium, and therefore Mises’s challenge is interesting, but inadequate. A centrally-managed economy is possible, if we have perfect information. At this point in the debate, it is Hayek who responds to the socialists’ contention with four important points:
(1) The amount of information needed and the calculation constraints are prohibitive to the socialist project, even if we grant the assumption of perfect information. But this is just an illustrative point that Hayek is making. Even though socialists and Marxists usually stop at this point, Hayek’s point is much more subtle as the following points show.
(2) The assumption of perfect information is invalid. The challenge is not to be in equilibrium, but in the transition to equilibrium. Just as it is not possible to open a can of food by assuming a can opener, it is not an acceptable response to assume Mises’s challenge away by assuming perfect information. Where does this perfect information come from and to whom is it given? The assumption of perfect information does not simplify the problem to be solved; it alters it and becomes irrelevant to the debate. This is why Austrians have been traditionally more concerned with the market process and less with the equilibrium conditions.
(3) Hayek also distinguishes (admittedly with some confusion) between information and knowledge. Information is a quantitative concept, and as such, can be either complete (perfect) or incomplete (imperfect). This is what socialists refer to as the assumption of perfect information. But knowledge is a qualitative concept, and because of this it can be neither complete nor incomplete. Knowing how to ride a bike or how to successfully run a business is not the type of knowledge that can be input into an Excel spreadsheet. This distinction is important because it is entrepreneurs who are the engine of economic growth and development. In other words, Excel cannot solve the market problem that entrepreneurs have to solve because this requires interpretation and knowledge, not just numerical data. Little is achieved if all information is given to Kicillof’s team if they don’t know how to interpret it.
(4) Information and knowledge are not independent of the market process. Without private property there are no prices; without prices there is no information. Hayek is using the other side of Mises’s argument to say that by getting rid of private property one is at the same time getting rid of the information that the socialists need to assume as given.
As soon as we recognize all of Hayek’s points, we realize that to take the Excel spreadsheet approach is like building a car without an engine (the entrepreneurs) and without road signs (the market) to signal the right way to go. It is no surprise that the Argentine economy malfunctions without a clear route taken by government officials. It is a mistake to confuse market prices with regulated prices, and the prices that provide useful information are the ones that emerge from free exchanges in the market, not government imposed prices originating in an Excel spreadsheet. To use the same word “price” to describe these two different phenomena misleads him who arrogates to himself the right to decide the fate of thousands of people. It is an illusion to believe that the same information that arises from market prices will magically emerge from government-imposed prices. What Kicillof’s team inserts into the Excel spreadsheet are not prices, but expressions of desires detached from economic reality.
The success of economic policy and market regulation, however, is not evaluated on desires and intentions, but on results. The problem with the Excel spreadsheet approach is not the intentions of the policymakers, but that such tools cannot possibly replace the market process.
The undeniable economic problems of Argentina run much deeper than what number to input into Kicillof’s spreadsheet. The problem is a confused reading of how markets work, and how governments continue with deficit spending in the service of favored interest groups.
Image source: iStockphoto
The Free Market 32, no. 4 (April 2014)One of my favorite economists in the history of economic thought is the great Austrian, Carl Menger (1840–1921). While the mainstream of the economics profession acknowledges Menger’s place due to his contribution to the Marginalist Revolution in the 1870s, it otherwise ignores him because his theoretical framework does not lend itself to policy prescriptions. In an era in which the economics profession largely views itself as a shadow branch of government which is itself charged with managing the economy, thinkers like Menger (and those who work in his tradition) are not going to be extolled or studied in the same way that thinkers like Irving Fisher, John Maynard Keynes, Milton Friedman, or Paul Krugman have been.
This is true if only because the government tends not to fund academics or economic schools of thought that do not promote its central role in the economy or provide economic justifications for its interventions in market forces. Absent this connection, the study of Chicago-School Monetarism or Ivy-League Keynesianism would have much less prominence in economic science today.
Menger’s theoretical framework differs from so many of the modern interpretations of economics because he represented the culmination of a pre-Progressive Era development of economic thinking that had occurred over centuries, mostly in continental Europe by scholastic thinkers in the Middle Ages as well as French liberals such as Turgot, Cantillon, and Say. Such people may have studied economics as a form of what was known as the Moral Sciences in the nineteenth century, but their impetus for doing so was often due to the innate human desire to better understand the world and the natural laws that govern it. Their interest was in economics as economics, and not simply as a policy tool to make government appear more scientific, efficient, or benign. (Government is actually the exact opposite of these things.)
So to study economics as a science, pure and simple, especially in an era in which it seems economic confusion reigns, it is not a bad choice to start with Carl Menger.
Menger was born in Galicia, a then-Austrian region that is now in Poland, to a wealthy family with roots in Bohemia. During breaks from the study of law at the Universities of Prague and Vienna, Menger worked asa financial journalist who developed some degree of prominence for writing novels and comedies that wereserialized in newspapers.
It was during his time as a journalist that Menger first noticed the significance of the discrepancies between Classical economic doctrines on market phenomenon and the actual business market that he covered over the course of his profession. Soon after receiving his law degree from the University of Krakow in August 1867, Menger embarked on the formal study of political economy in an attempt to better understand and resolve these discrepancies — an effort that resulted in the 1871 publication of Principles of Economics.
While Menger recognized that the Classical economists had made significant contributions to the development of economic theory, he believed one of their primary shortcomings was in their analyses of the consumer, a shortcoming which was perhaps epitomized by the Classicals’ emphasis on the labor theory of value and their rudimentary and even shallow price theory that explained prices as phenomena resulting mostly from the economic calculation of businessmen. Menger’s primary contribution in Principles was to insert the primacy of the consumer in determining value and (by extension) price, not only in the marketplace but in all economic activity.
The Mengerian approach, which we today call the science of praxeology, emphasized the importance of individual human action resulting from the desire to satisfy felt needs and the relationship of those needs to the external world. Having a felt need, and the knowledge that the external world possesses some characteristics that allow the individual to satisfy it, provide the basis for logical human action and the subjective valuation of goods and services both within and apart from the market. Menger further noted that as our knowledge about the external world changes, so do individually-felt needs. Efforts to satisfy felt needs presuppose recognition of cause-and-effect relationships that provide the basis for all of human action.
Note how completely irrelevant such a framework is to modern adherents of the Keynesian or Chicago Schools. The major difference is that both schools view the individual person (or actor) as an object that needs to be manipulated in the name of policy success. For Chicagoans, this success is based on market outcomes that are closer to their pre-conceived ideals regarding market efficiency, while for Keynesians, this success is based on the achievement of arbitrary short-run employment levels that are achieved in practice by penalizing saving and rewarding consumption. To both schools, the human person is a cog in an economic machine that must be coerced to act in ways that make their systems work. Such a view is modern — its roots are in the Progressive Era — and contrasts with economics as it developed from Aristotle through Menger (and beyond through those who developed Menger’s system).
But in the 1870s, Menger boldly applied its implications to the determination of value. He noted that since goods are external to the human person and recognized subjectively as possessing qualities that allow for need satisfaction, they could be differentiated between goods of different order. In Principles, he described first-order goods as being goods that we consume to satisfy needs. These are consumption goods. Second-order goods are goods required to produce the first-order good, so that while a car may be a first-order good satisfying a felt need for transportation, the second-order goods would include the glass, rubber, chrome, and all the other inputs which make up the car. The third-order goods are all of the goods that are required to produce the second-order goods, and so on, with more complex forms of production being characterized with more distant orders of production.
Nonetheless, the values of all of the goods of whatever order are derived from the initial subjective desire on the part of the individual to satisfy a felt need, so that rubber has value not in itself or in the work effort going into its production, but because of the initial human desire for transportation, leading to a human preference for cars. This understanding of goods contrasted greatly with the Classical economist’s notion that the value of economic inputs is based on their technical usefulness in production. Menger’s value theory represents an expansion of Say’s Law that supply creates its own demand, and is the proper theoretical response to the monetary and credit cranks (of Menger’s time as well as today) who see no difference between government-created and -directed capital and privately-created and -directed capital.
In truth, government-created capital satisfies the needs of the political classes and the special interests connected to it, whereas privately-directed capital is directed at the satisfaction of consumer wants.
Absent the state’s influence in the development of twentieth-century economic thought, it is likely Menger would be known today as an important Classical economist who corrected known shortcomings of the Classical School, and it would never have been deemed necessary for Classical economics to morph over time into various neoclassical schools characterized by tools appropriate for the hard sciences.
Austrian capital theory explains why creating a more technologically-advanced society is easier said than done, writes Mark Tovey. This audio Mises Daily is narrated by Keith Hocker.
Volume 9, no. 1 (Spring 2006)The Eastern European countries have been going through a transition phase since the liberalization of their economies with the collapse of communist regimes in the early 1990s. The attempts at transition from a centrally planned economy to a market based one has provided a fascinating laboratory for research in both theory and practice. The problems of how to make the transition are not fully resolved. Economists are still debating various strategies. While the neoclassical economists focus on the macroeconomic issues of the transition process, the Austrian School puts the focus on the microeconomic issues. Part of the ongoing debate among neoclassical economists is whether state owned industries need to be restructured before they can be privatized. Romania is an interesting case.
Economists often rely on the assumption of “other things equal.” The problem arises when politicians ignore the economy and unintended results, writes Gary Galles. This audio Mises Daily is narrated by Allan Davis.
An economy cannot be successfully planned with computers and technicians. Mises and Hayek proved this decades ago, writes Nicolás Cachanosky. This audio Mises Daily is narrated by Allan Davis.
Volume 8, No. 1 (Spring 2005)The article is a much needed and long overdue acknowledgement and appreciation of Rothbard’s contributions to the theory, including the calculation debate, and practice of socialism. Rothbard ranks as one of the foremost Austrian School economists of the twentieth century, and his contributions to these, as well as other topics, clearly deserve to be better recognized and understood. Boettke and Coyne have performed an important service in presenting and analyzing Rothbard’s contributions in these areas. My remarks regarding the Boettke and Coyne article are directed toward a relatively narrow topic, specifically, the reinterpretation of the socialist calculation debate by Rothbard and others.
Volume 16, No. 2 (Summer 2013)
Friedrich Hayek and Ludwig von Mises demonstrated that central planners will be unable to manage an economy rationally due to the problems of dispersed knowledge and the impossibility of economic calculation in a centrally planned economy. This paper adds to these two problems by suggesting a third: the computation problem. Drawing from realities found in computational economics, even if all the data is given and production is ignored, the size of the computational problem makes large scale central planning a practical impossibility. The size of the problem to be solved and limitations on computer processing power do not allow for computers to provide a solution to large scale economic problems in a time that is useful. For example, even under severe simplifying assumptions, distributing 80,000 heterogeneous consumer goods among six billion heterogeneous consumers requires a calculation that would take at least 10.5 quintillion years—when the Big Bang happened just 14 billion years ago.
Volume 7, No. 2 (Summer 2004)This paper documents and articulates Murray N. Rothbard’s contribution to our understanding of the theory and practice of socialism. We summarize his theoretical contributions and then turn to his explanation of the operation of socialism in the Soviet Union. Moreover, we make and support the conjecture that Rothbard, writing in the 1950s and 60s, anticipated all the major subsequent developments in the economic analysis regarding the problems of the Soviet economy and all the major works in comparative political economy for real-existing socialism in the Soviet Union.
Volume 9, No. 2 (Summer 2006)The standard view of the socialist calculation debate is that Mises and Hayek at best demonstrated the practical impossibility of socialist economy, but that the mathematical solution of economists such as Dickinson showed that “in principle” planners could achieve a rational use of resources without private ownership of the means of production. In the present paper I hoped to show that this view is incorrect, because (if seriously implemented) a socialist planning board would need to publish a list containing an uncountably infinite number of prices. As Cantor’s diagonal argument from set theory shows, it is demonstrably impossible to construct such a list. Therefore, socialist economy is truly impossible, in every sense of the word.
Volume 11, No. 2 (2008)
In a recent article Robert P. Murphy (2006) uses Cantor's diagonal argument to prove that market socialism could not function, since it would be impossible for the Central Planning Board to complete a list containing all conceivable goods (or prices for them). In the present paper we argue that Murphy is not only wrong in claiming that the number of goods included in the list should be uncountable, but also that the number of equations/prices is irrelevant from the point of view of market socialism.
Volume 7, No. 1 (Spring 2004)Almost a decade ago Joseph Salerno, Murray Rothbard, and Jeffery Herberner (hereafter referred to as SRH) published a set of articles in Review of Austrian Economics aimed at drawing a distinction between Ludwig von Mises’s and Friedrich Hayek’s respective explanations of the problem of socialism. In brief, they argued that Mises’s calculation argument had sufficiently diagnosed the problem of socialism, prior to Hayek’s entrance into the debate. They also argued that Hayek’s analysis of the problem did not necessarily constitute an obstacle for the workings of the socialiststate.
The arguments laid out by SRH for arriving at their distinction generated a series of immediate writings that added a significant amount of confusion to the subject matter. A first phase of writings emerged in the early 1990s and ended in 1997 (Rothbard 1991; Yeager 1994, 1996, 1997; Salerno 1994, 1996; Kirzner 1996; Hoppe 1996; Herbener 1991, 1996). These writings brought very limited progress toward resolving the differences that gave rise to the controversy. In essence, the discussions never reached further than to a mere discussion over what SRH had really meant. This is exemplified by Leland Yeager’s question to SRH, which addresses their proposed distinction, as part of the final article published in the first phase of writings. Yeager asks whether or not SRH’s arguments for a distinction had been an attempt to treat Hayek’s and Mises’s respective arguments as mutually exclusive. He did so, by challenging Salerno to conceive a situation in which Hayek’s explanation “was not intimately bound up with the problem that Mises had diagnosed” (Yeager 1997). More recently, a second wave of articles addressing the subject matter has emerged, addressing the same issues that were raised in the original debate, albeit at a more detailed level (Salerno 1999, 2002; Caldwell 2002). Similar to the controversy of the 1990’s, the debate continues to draw a wedge between Hayek and Mises, rather than searching for common ground.
The attempt here is to reduce the confusion that the controversy has generated and continues to generate, by providing an explanation of how SRH came to interpret Hayek and Mises as distinct rather than complementary thinkers regarding socialism. Specifically, it is illustrated that it was their view of Hayek as a near-equilibrium-theorist or “proximal” equilibrium-theorist that allowed SRH to draw a distinction. This means that Hayek conceives the economy as operating sufficiently close to a final or a static state of equilibrium, where present (i.e., immediately past) prices contain all the information necessary to guide producers in making optimal resource allocation decisions. This view provides for a future that is not very unlike the present, and where rational resource allocation does not emphasize the indispensability of a dynamic entrepreneurial appraisement process, which operates under uncertainty and involves forecasting future market data and appraising future output prices on the basis of qualitative and fallible forecasts. Hence, SRH’s interpretation of Hayek is in sharp contrast with Mises’s view of the problem of socialism. It is also illustrated in the paper that while there is strong textual evidence to support the SRH interpretation Hayek’s view of the market, it de-emphasizes Hayek’s later writings on the broader issues of social order and progress, which emphasizes “discovery” and “learning.”
Addressing the confusion that has arisen from the controversy is important for two reasons. First, it is important for Austrian economists themselves. The main contribution of the controversy, thus far, has been to further existing differences between Austrians. This is troublesome, during an era when several Austrian economists are highlighting the importance of seeking common ground in Austrian economics. Kirzner, for example, urged the following in 1996:
if we wish to preserve and build upon the Misesian legacy, we must not generate confusion (both among Austrians and their opponents) by exaggerating perceived differences between Mises and Hayek, to the point where the centrally shared insights of both are dangerously obscured.(Kirzner 1996, p. 154)
Addressing the confusion is also important because it directly challenges the view held by a significant number of Austrian economists (in particular, those who downplay or deny the differences between the Misesian and Hayekian positions on the socialist calculation debate) in regards to the correct understanding of the problem of socialism. This issue of course is also critical, due to the importance that a correct understanding of the problem of socialism has for the study of society as a whole. Leland Yeager highlights several areas where this is true, including economic theory, the history of economic thought, and twentieth-century economic history (Yeager 1997).
The paper is organized into four sections. The first section outlines the well-known arguments concerning the problems of socialism by Hayek and Mises. Section two outlines and assesses the arguments put forth by SRH. The third section identifies common ground for facilitating “bridging” the principal differences behind the controversy. A final section offers some concluding remarks.
MISES’S AND HAYEK’S ANALYSES OF THE PROBLEM OF SOCIALISMBecause the “controversy” originates from differences in the interpretation of Hayek’s and Mises’s positions on the problem of socialism, it is important to begin by outlining these respective positions. As is well known, Mises’s and Hayek’s positions on the problem of socialism can be traced back to a handful of publications written between 1920 and 1940 in opposition to the generally held view of the time that socialism was a viable option of economic organization. In broad terms, Mises and Hayek argued that in the absence of free markets and private ownership of capital and land, a central planning authority would be unable to make efficient resource allocation decisions.
Mises’s Arguments
Mises provided two major arguments for why a central planning authority would be unable to make efficient resource allocation decisions. These were described in his renowned article “Economic Calculation in the Socialist Commonwealth” (Mises 1935) and reemphasized in his later writings (for example, see Mises 1996 and 1969).
The first argument was concerned with the lack of incentives provided in a socialist society for people to act economically. Specifically, Mises argued that the lack of private ownership of capital and land in the socialist state would provide people with less of a reason to act responsibly and to take on initiatives. Mises referred to this as a lack of “commercial-mindedness” in the socialist state. Commercial-mindedness can, according to Mises, not be replicated by central planners. He writes:
commercial-mindedness is not something external, which can be arbitrarily transferred. A merchant’s qualities are not the property of a person depending on inborn aptitude, nor are they acquired by studies in a commercial school or by working in a commercial house, or even by having been a business man oneself for some period of time. The entrepreneur’s commercial attitude and activity arises from his position in the economic process and is lost with its disappearance. (Mises 1935, p. 120)
Thus, the first problem stressed by Mises is primarily an implication of the institutional incentive structure provided in the socialist state (or lack thereof).
The second problem stressed by Mises is a result of the inherent difficulties of determining monetary values of production-goods in the socialist state; according to Mises such values can only be provided in free markets where private ownership of capital and land are allowed. Without monetary values, it is, according to Mises, “impossible” for the human mind to calculate and/or process relatively complex “profit or loss” scenarios of production. Mises writes that this “requires rather more exact estimates and some judgment of the economic issues actually involved” (Mises 1935, p. 96). Thus, in Mises’s view, monetary values provide guidance critical for individual decision-making. The problem highlighted by Mises is therefore derived from the notion that socialist economic planners do not have access to the necessary monetary values. These would therefore be restricted to making resource allocation decisions about production processes that “are relatively short and the expense and income entailed can be easily gauged” (p. 96). The implication that Mises draws from this is that the socialist state would remain at a relatively “primitive” state of development.
Hayek’s Arguments
Hayek’s arguments against socialism are less clear-cut than Mises’s. This may be explained by the fact that they originally developed as an extension to Mises’s arguments and then developed over an extended period of time. But in principle, Hayek provided two major arguments. The first was developed in direct response to a set of articles, published by mainstream economists, aimed at refuting what is referred to as Mises’s “calculation” argument (i.e., the latter of Mises’s two arguments mentioned above) (Kirzner 1987). In essence, these had argued, contrary to Mises’s position, that prices need not be provided by the market in order to provide guidance, but could be provided by nonmarket prices announced by the central authorities, and treated by socialist managers in the same way that prices are treated by producers in perfectly competitive factor and product markets.See especially Lange (1936), Dickinson (1933), and Lerner (1934). It should be noted that these economists only addressed the latter of Mises’s two arguments.
In response to this argument, Hayek published three articles that specifically addressed the “calculation” problem diagnosed by Mises. In these, he argued that even if, as alleged by mainstream economists, it would be possible to collect all relevant data, the problem of socialism would still not be solved (Hayek 1948d, 1948e, 1948f). The reason for this, according to Hayek, is due to “the nature and the amount of concrete information required if a numerical solution is to be attempted and the magnitude of the task which this numerical solution must involve in any modern community” (Hayek 1948e, p. 153). According to Hayek, the amount of information needed to make the result at least comparable with that which the competitive system provides would exceed the power of algebraic analysis (Hayek 1948f).
The second argument raised by Hayek did not surface until a couple of years after his original argument had been made, and it was raised in what is often referred to as Hayek’s knowledge articles (Hayek 1948b, 1948g, 1948c). In these, Hayek completed the argument he had started by also refuting the assumption that a central planning authority would indeed be able to collect all relevant data. To do so, Hayek emphasized the importance of knowledge in society (see esp. Hayek 1948g).
Knowledge, according to Hayek, provides the data from which the economic calculus starts. However, this data cannot be captured by a central planning authority because it is not readily available. It is to a large extent dispersed over time and place, i.e., private knowledge that depends on particular circumstances. Hayek writes:
the knowledge of the circumstances of which we must make use [to calculate] never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. (Hayek 1948g, p. 77)
The real problem of the socialist society then, according to Hayek, is “that the ‘data’ from which the economic calculus starts are never for the whole society ‘given’ to a single mind which could work out the implications and can never be so given” (Hayek 1948g, p. 77). Thus, in Hayek’s view the problem of socialism is primarily rooted in the ignorance or lack of knowledge held by the central planning authority.
THE RECENT CONTROVERSY: ARRIVING AT A DISTINCTIONIt is in regards to the above-presented arguments that SRH have sought to draw a distinction between Hayek and Mises. While it has never clearly been laid out how SRH arrived at this distinction two key propositions appear to lay the basis for this position. First, that Mises’s calculation argument had sufficiently diagnosed the problem of socialism, prior to Hayek’s entrance into the debate. And second, that Hayek’s analysis of the problem of socialism as being rooted in the lack of knowledge held by central planning authorities does not necessarily constitute an obstacle for the workings of the socialist state. The following provides a possible explanation of how SRH arrived at these propositions and how they allowed them to draw a distinction between Mises and Hayek.
SRH and Mises’s Analysis of the Problem of Socialism
SRH’s view that Mises’s calculation argument had sufficiently diagnosed the problem of socialism, prior to Hayek’s entrance into the debate, represents the least controversial issue in the controversy. SRH holds this view based on the significance that Mises attributes to the role of the appraisement process in economic calculation. This process is defined by Salerno as the
process of the market transforms the substantially qualitative knowledge about economic conditions acquired individually and independently by competing entrepreneurs, including their estimates of the incommensurable subjective valuations of individual consumers for the whole array of final goods, into an integrated system of objective exchange ratios for the myriads of original and intermediate factors of production. (Salerno 1994, p. 112)
The significance of the appraisement process, according to SRH, in Mises’s diagnosis of the problem of socialism is that it gives explicit recognition to Mises’s position that the problem of socialism is ultimately rooted in the socialist state’s inability to cope with change (i.e., to cope with economic dynamics). According to Mises, economic calculation incorporates such change by means of entrepreneurial foresight. That is, entrepreneurs anticipate and calculate profit and loss scenarios based on individual subjective judgments and past prices. The aggregate effects of these individual valuations are then transformed into objective prices that represent the market participants’ aggregate anticipations of expected facts (i.e., the appraisement process). Because economic calculation incorporates entrepreneurial foresight it is, according to Mises, intimately bound with certain social institutions that cannot be replicated in the socialist state. Salerno (1994) correctly identifies these institutions as the division of labor and private ownership of the means of production, and Rothbard (1991, pp. 52–53) refers to them as “the existence of a market in the means of production, a market that brings about money prices based on genuine profit-seeking exchanges by private owners of these means of production.” Hence, SRH’s position that Mises’s calculation argument sufficiently diagnosed the problem of socialism derives from Mises’s insight that the problem of socialism concerns private property rights, because these enable the appraisement process to effectively incorporate change.
SRH and Hayek’s Analysis of the Problem of Socialism
That the appraisement process is a crucial part of Mises’s diagnosis of the problem of socialism should come as no surprise to people familiar with Mises’s writings. What has caused confusion in this controversy, however, is that it appears to have constituted the core of SRH’s argument for drawing a distinction between Hayek’s and Mises’s respective explanations of the problem of socialism. Again, the significance of the process of appraisement in drawing such a distinction is, according to SRH, that it gives recognition to the fact that economic calculation requires entrepreneurial insight (i.e., it is performed not only with consideration to current prices, but also based on expectation about future prices).
While it was never clearly explained by SRH how the appraisal process justifies a distinction between Hayek’s knowledge argument and Mises’s calculation argument, Salerno provides strong indications that the underlying logic for this position is based on a view of Hayek as a static equilibrium-theorist. The most explicit illustration of this is provided in a reply by Salerno to a challenge made by Leland Yeager in 1994 to further explain the alleged distinction. In this reply, Salerno explains that the failure of Yeager to distinguish between calculation and knowledge can be attributed to the reliance that “Yeager, Hayek and equilibrium theorists of all stripes” attach to proximal equilibrium (PE). According to Salerno, the process of appraisement is unnecessary in a state where proximal equilibrium has been reached. He writes:
with the economy always in PE and current prices therefore conveying to producers virtually complete knowledge about relevant economic conditions in the present and the future, the only function that remains for entrepreneurs is to robotically compute revenue and cost functions and allocate resources so as to equate MR [marginal revenue] and MC [marginal cost]. Since the acquisition and use of knowledge is thus presented as the essence of economic calculation, should the central planners somehow or other get hold of the same knowledge in the absence of a price system, the entrepreneurial computation problem could be easily solved by the methods of linear programming. (Salerno 1994, p. 118)
The question of whether Hayek and other fourth-generation Austrians were static general equilibrium-theorists has also been the subject of more recent articles by Salerno. In these, Salerno holds his original argument but provides additional detail as a basis for the distinction, deriving the view of Hayek as a static general equilibrium-theorist from the influence Wieser had on Hayek, referring to Wieser as a “verbal” general equilibrium-theorist (Salerno 1999 and 2002).
Thus, based on this passage it is possible to understand the logic behind SRH’s distinction. In essence, they argue that in a world of near equilibrium, present prices, or rather prices that have been realized in the immediate past, can serve as roughly accurate guides for future-oriented production decisions because there is no genuine uncertainty and therefore the entrepreneurial appraisement process is rendered pointless. Consequently, they refute Hayek’s explanation of the problem of socialism based on the argument that the possibility that all relevant information could be collected and conveyed to a central authority cannot be precluded when an economy operates in close proximity to equilibrium. Hence, SRH’s referral to Hayek as a proximal equilibrium-theorist (in other passages this reference to Hayek is synonymously used, by SRH, as “near-equilibrium-theorist”) is in all-important respects equivalent to a view of Hayek as a static equilibrium-theorist (i.e., the economy has reached its final state of rest, and does not merely operate in close proximity to it). In their view, it is therefore only Mises’s explanation of the problem of socialism that sufficiently challenges the possibility of socialism, through the explicit attention that he gives to the role of the entrepreneur in the appraisement process.
INTERPRETING HAYEK: A DYNAMIC- OR A PROXIMAL-EQUILIBRIUM-THEORIST?Considering SRH’s view of Hayek as a static equilibrium-theorist, it is important to ask if this is a view that may be justified. The answer to this question is dependent on the specific approach chosen to interpret Hayek’s writings. This section illustrates how an interpretation of Hayek’s writings based on “textual” evidence, may be used to justify a view of Hayek as a static equilibrium-theorist. The section also emphasizes, however, that based on a broader interpretation of Hayek, it is difficult to deny that his primary interest was focused on the dynamic character of economic organization (or societal organization, later on in his career).
Arriving at a Static Interpretation of Hayek’s Writings
It is well known that Hayek makes numerous references in his knowledge articles to the existence of a “tendency toward equilibrium,” which is indicative of his interest in the dynamic character of economic organization (see esp. Hayek 1948b). However, Hayek never explicitly defines the magnitude or proximity by which this tendency transpires in relation to a full state of equilibrium. As a result, one may argue that the tendency toward equilibrium, proposed by Hayek, transpires in very close proximity to a full state of equilibrium. In fact, at the extreme, one could argue that it transpired in such close proximity that it is indistinguishable from a full state of equilibrium. This interpretation would lend a hand to justify SRH’s definition of proximal equilibrium (or “near equilibrium”), as being close to equivalent to that of static equilibrium. The distinction drawn by SRH between Mises’s and Hayek’s respective positions on the socialist calculation debate may therefore be traced to a view of Hayek as a near-equilibrium or “proximal”-equilibrium theorist. That is, Hayek is viewed to conceive the economy as always operating sufficiently close to a final or a static state of equilibrium, so that present (i.e., immediately past) prices contain all the information necessary to guide producers in making optimal resource allocation decisions, thus, providing for a future that is not very unlike the present. For this reason, SRH argues that Hayek (unlike Mises) does not emphasize the indispensability to rational resource allocation of a dynamic entrepreneurial appraisement process operating under uncertainty that involves forecasting future market data and appraising future output prices on the basis of these qualitative and fallible forecasts.
“Textual” evidence is also available to support the SRH interpretation of Hayek’s view of the market. For example, many of the key statements in Hayek’s knowledge articles provide explicit support for such a view of Hayek. Throughout the controversy, SRH brings attention to several of these, including a statement from Hayek’s article the Use of Knowledge in Society. Hayek writes: “The mere fact that there is one price for any commodity . . . brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information” (cited in Salerno 1994). Taken literally this statement alleges that commodity prices reflect all information, a scenario which, of course, is only possible if the economy has reached its final state of rest. Hence, part of the controversy may be attributed to the inclusion of readings. A large part of the arguments brought forward in the debates, however, de-emphasize Hayek’s later writings on the broader issues of social order and progress, which emphasize “discovery” and “learning.”
When reading Hayek in a broader context, the view of Hayek as a static equilibrium-theorist becomes harder to accept. In his later writings, Hayek frequently gives explicit attention to the importance of dynamic concepts such as “learning” and “discovery” in explaining societal progress (see, Hayek 1979b; 1979c; 1973, pp. 114–16). As is well known by Hayekians, “learning” and “discovery” represent the building blocks of Hayek’s explanations of what brings about societal “order.” According to Hayek, in the absence of order (i.e., institutions), societal progress would not occur because people would be unable to satisfy their basic needs. Satisfaction of these needs serves as a pre-requisite for people to be able to cope with “novelty” and novelty is required for societal progress to occur.See Butos and Koppl (1993) and Lewin (1997). Thus, if emphasis is turned toward these later writings, Hayek is more likely to be perceived as a dynamic equilibrium-theorist (or more correctly, Hayekian equilibrium will be perceived as dynamic).
BRIDGING DIFFERENCESConsidering the important historical role of theories on economic organization in Austrian economics, it is important that the above controversy is resolved. This paper makes a contribution to the controversy between SRH and those Austrians who downplay or deny the differences between the Misesian and Hayekian positions on the socialist calculation debate by identifying the issue of Hayek’s equilibrium tendencies as an economic theorist as the central point of the debate. Given the discussion here and the extensive amount of high-quality writings that have been generated by Austrians on the subject of economic organization, there ought to be general consensus among Austrians on, at least, two issues, in regard to economic organization. First, that the problem of economic calculation is rooted in economic dynamics, and not in statics. And second, that if we allow for an interpretation of Hayek as a static-equilibrium theorist, it is indeed possible to refute Hayek’s diagnosis of the problem of socialism and to draw a distinction between Mises and Hayek.
However, even if agreement on these two issues is reached and is sufficient to bridge the differences that resulted from the above-discussed controversy, a larger issue appears to be at stake. That is, to explain the value, from an Austrian perspective of viewing Hayek as a static-equilibrium theorist; an issue never directly addressed by SRH during the controversy. While an explanation of this issue goes beyond the scope here, it has the potential to refocus a controversy where the intellectual energy primarily was geared toward negative heuristics into something constructive. Such explanations seem important, particularly if one considers the long-run survival of Austrian economics as being dependent on its success in explaining economic and societal phenomena.
FINAL REMARKSThis paper has attempted to bridge unresolved differences remaining from the Hayek and Mises “controversy,” which materialized in the early 1990s. In achieving this, the paper sought to provide an explanation of how SRH came to interpret Hayek and Mises as distinct rather than complementary thinkers regarding socialism. It was argued that the distinction made is ultimately based on a view of Hayek as a near-equilibrium or proximal-equilibrium theorist. This means that Hayek conceives the economy as operating sufficiently close to a final or a static state of equilibrium, where present (i.e., immediately past) prices contain all the information necessary to guide producers in making optimal resource allocation decisions—an interpretation of Hayek that is in sharp contrast to Mises’s view of the problem of socialism. It was also argued that while there is strong textual evidence to support the SRH interpretation of Hayek’s view of the market, it de-emphasizes Hayek’s later writings on the broader issues of social order and progress, which emphasize “discovery” and “learning.”
The paper also points to the importance of focusing Austrian economics towards positive, rather than negative heuristics. In doing so, Austrians ought to take full advantage of both of Mises’s and Hayek’s many and excellent writings (and other Austrians). The focus on a too narrow aspect of these scholars’ thoughts, such as those of Hayek’s, holds the risk of resulting in unnecessary disagreements, among Austrians, as has been exemplified by the “Hayek and Mises Controversy.”
Volume 6, No. 2 (Summer 2003)In light of the argument presented in the present paper, it is difficult to avoid the speculation that the main argument that Hayek either half accepted or regarded as exaggerated and one-sided—at least until 1945—was, in fact, the argument that economic calculation is not possible under socialism because, either theoretically or practically, socialism has no means for placing values on higher order goods. If so, then Hayek’s emphasis on the knowledge problem of socialist planning reflected his conviction that it, not calculation, was the dominant obstacle to rational economic choices under socialism.
Volume 3, No. 2 (Summer 2000)The problem of cost is the cornerstone of economic calculation. Entrepreneurs act upon the cost implications of their decisions and depend on cost data that represent the actual pattern of resource consumption. These theoretical generalizations are essential; However, they do not elucidate the complexity of cost assignment and how cost accounting is driven to change when cost structures shift and operating segments multiply. Neither do they provide concrete illustrations of how actual decisions are influenced by the available cost information. Cost determinations, whether accurate or not, have their say about the way resources are actually directed in our economy by myriad companies like Whirlpool and Carrier. The need for improved output from cost accounting is a result of changing market conditions. More accurate costing and strategic cost management are now required and made available through advances in information technology. More costs are indirect and not unit-based—that is, more costs are fixed and tied to resources bought in large chunks of serviceability. More sophisticated cost analysis is needed to "slice and dice" cost data across diverse segments or objects. By examining fundamentally new approaches to cost accounting, we see the operation of competitive market forces upon the quality of economic calculation itself. A critical facet of Austrian analysis is elucidated and clarified, showing that economic calculation is not perfunctory or static.
Volume 16, No. 1 (Spring 2013) ABSTRACT: Non-monetary calculation of the environmental effects of action runs into the same problems of in natura calculation and commonly owned means of production. The information needed for rational economizing does not exist when we forsake the price mechanism. A legal regime based on strict private property rights solves environmental problems and minimizes conflict in the coordination of plans. Relaxed restrictions on property rights can move many currently political decisions into the realm of market exchange and improve economic coordination. Reducing restrictions on housing markets provides one example.
KEYWORDS: environment, Austrian economics, prices, profits and lossesJEL CLASSIFICATION: P1, P2, P4, B53, Q58Art CardenArt Carden (wcarden@samford.edu) is Assistant Professor of Economics in the Brock School of Business at Samford University. Students and colleagues (particularly Mike Hammock) at Rhodes College provided valuable discussions, as did session participants at the 2010 Association of Private Enterprise Education meetings. I thank an anonymous referee for valuable comments.INTRODUCTIONDo government services and even private proposals like carbon accounting, “triple bottom line” accounting, and measurement of “food miles” provide viable alternatives to monetary calculation based on profit and loss? Are they alternative ways to evaluate production and allocation, or might they merely serve the same function as advertising and image-improving or trust-enhancing charity? The necessity of monetary calculation for rational economic decision-making suggests that alternative measures of environmental impact do not provide reliable guides to policy. Even proposals that take at least some advantage of the price mechanism, like Pigovian taxes or formal markets for permits to emit substances like carbon dioxide, encounter calculation and knowledge problems. Coordination improves, and unintended negative consequences are minimized when people are able to trade voluntarily.
As Cordato (2004, p. 3) writes, environmental problems “are not about the environment per se, but about the resolution of human conflict” and the coordination of individual plans. In this light, Cordato (2004, p. 4) proposes an approach to efficiency that focuses on the processes by which goals are achieved, errors are eliminated, conflicts are reduced, and transgressions are rectified. He notes that
[e]fficiency is a “praxeological,” i.e., individual goal seeking problem, not a value maximization problem. From a policy perspective, then, social efficiency is assessed in terms of the extent to which legal institutions facilitate consistency between the ends that actors are pursuing and the means that they are choosing to accomplish those ends. (Cordato, 2004, p. 4)
Environmental problems are coordination problems. Specifically, they are problems of reconciling mutually exclusive plans by identifying and correcting individual encroachments on others’ rights: “[g]enerally formulated, a pollution or environmental problem arises when individual or group A and individual or group B are simultaneously attempting or planning to use resource X for conflicting purposes.” (Cordato, 2004, p. 7) Cordato’s approach has implications for how we understand non-market environmental planning.
PRICES, CALCULATION, AND DISCOVERYRegulation substitutes power for market, to rephrase the title of Rothbard (1970 [1977]). In a contribution that ignited the socialist calculation debate, Mises (1920 [1990]) demonstrated that rational economic calculation is impossible when the means of production are commonly owned.Some of the implications of Mises’s thesis are explored by Salerno (1990). Hayek (1945) argued that the economic problem is not the complex optimization problem implied by the thesis that a socialist economy can calculate; rather, it is a problem of assembling, evaluating, and updating dispersed knowledge. Therefore, even if a socialist economy could engage in rational economic calculation in some abstract sense, the institutions of private property are prerequisites for the creation of the necessary information.See Lavoie (1985) for a survey of the socialist calculation debate. See also Hoppe (1996, especially pp. 143–144) for a critique of Hayek.
Prices economize on the knowledge necessary for rational calculation (Hayek, 1945, p. 525), and Hayek (2002) argued that competition is “a discovery procedure” whereby information that cannot be known by a single mind is used and revealed. The market is “a procedure for discovering facts which, if the procedure did not exist, would remain unknown or at least not used” (Hayek, 2002, p. 9). Private property and unfettered exchange are necessary for rational economic calculation. Hülsmann (1997), Mahoney (2002), and Cordato (2004) augment these original contributions and lay the groundwork for a praxeological approach to environmental concerns.Hülsmann (1997), like Hoppe (1996), is critical of Hayek’s characterization of the economic problem as a problem of knowledge and coordination.
Among other things, monetary calculation reduces the cognitive overload associated with a complex reality and allows us to order and interpret the world around us. Specifically, monetary calculation
…affords us a guide through the oppressive plenitude of economic potentialities. It enables us to extend to all goods of a higher order the judgment of value, which is bound up with and clearly evident in, the case of goods ready for consumption, or at best of production goods of the lowest order. It renders their value capable of computation and thereby gives us the primary basis for all economic operations with goods of a higher order. Without it, all production involving processes stretching well back in time and all the longer roundabout processes of capitalist production would be gropings in the dark (Mises, 1920 [1990], p. 11).
Consumers might value information about the carbon emissions needed to produce a particular good, the number of miles traveled by a head of lettuce, or a firm’s record on minority hiring, but the degree to which they value these attributes will be reflected in prices, profits, and losses.
This is apparent in at least some environmental initiatives. In natura calculation is plainly impossible, but proposals for markets in tradable emissions permits do take advantage of the price mechanism to a degree. As McGee and Block (1994) argue, however, they run into the same problems associated with proposals to implement “market socialism.” Tradable permits and Pigovian taxes are market-like, but they still rest on a planner’s conceit that the optimal amount of a particular activity can be known independent of what is revealed by trade (or more generally, by consent). Cordato (2004, p. 11) criticizes the “polluter pays” principle:
Most specifically, a central authority must know in advance what the efficient outcome is. In the case of the tax, a central authority must know in advance the exact amount of the externality costs being imposed by the polluter, and the correct price and output, not only for the good in question but, since efficiency only makes sense in a general equilibrium context, for all other affected goods and services. In the case of tradable permits, the knowledge requirements are essentially the same.
Nye (2008) goes further within the confines of conventional neoclassical economics: the effects of other taxes in general equilibrium, possible monopoly power, and the possibility of Coasean side bargains mean that even the ability to observe and measure the precise size of the externality is not a reliable guide to policy. Borrowing from Coase, he writes:
Even in a world of positive transaction costs, some Coasian transfers may take place that partly mitigate the harm of an externality. Unless the Pigovian tax collector can fully account for all those transfers, any estimate of an appropriate tax based solely on the size of the externality will clearly overstate the optimally efficient tax level. (Nye 2008, p. 32)
As Nye notes, even if we can calculate an externality of gasoline consumption of $1 per gallon, for example, regulations like Corporate Average Fuel Economy standards (which economists generally dislike), possible market power for organizations like OPEC, the impact of taxes in other sectors of the economy, and a host of other considerations will move the number of gallons consumed closer to the social optimum even though we still observe $1 per gallon in external effects. Nye cites Bovenberg and Goulder (1996), who argue that the general equilibrium optimal Pigovian tax is likely to be lower than the partial equilibrium optimum (and possibly negative) when there is general taxation. Block (2003) discusses possible privatization of the roads; this could mitigate some of the external costs of fossil fuel consumption if firms with some market power control the roads (cf. Buchanan 1969).
PROPERTY AND CALCULATIONEstablishing clear private property rights over previously unowned resources makes them tradable. This allows people to calculate, or to evaluate the relative costs and benefits of different courses of action. As Cordato (2004) reminds us, environmental conflicts are always conflicts of ownership: some people wish to use a resource to achieve one set of goals. Others wish to use the same resource to satisfy a different set of goals. Property owners’ use of property and the negotiations between people bidding for property establish prices. The establishment of cardinal, money prices creates a common standard of comparison (Mises, 1920 [1990]).
Profits and losses allow entrepreneurs to appraise the results of their actions and determine whether what they have produced allows people to satisfy more urgently felt wants, or whether it causes people to satisfy less urgently felt wants. In the first case, the entrepreneur earns a profit. In the second case, the entrepreneur earns a loss. Mahoney (2002, p. 48) makes a crucial point with respect to private ownership that is directly relevant to environmental questions: while we can know physical quantities, we cannot appraise economic scarcity—or more generally, praxeological scarcity—without private ownership and the prices produced by market exchange.
Property is necessary for even the clear identification of environmental trouble and also for the solution of such troubles. Hülsmann (1997) criticizes the thesis that economics is concerned primarily with coordination and the use of knowledge and argues instead that “(i)t is property, rather than knowledge, that coordinates the separate actions of different people” (Hülsmann, 1997, pp. 28–29). Property is a prerequisite for the application of knowledge to the creation of value. Technological knowledge, even knowledge of the full range of technological combinations that might produce all possible arrays of physical output, is neither necessary nor sufficient for rational economic calculation. As Hülsmann (1997, p. 44) notes,
[W]ithout reference to our property we could not possibly select knowledge in terms of importance. Moreover, once we own property we then know which kind of knowledge could be useful. It is this property that directs our learning toward useful channels.
The property regime determines the kinds of knowledge that are sought and deployed. People generally seek and deploy knowledge that helps them better achieve their goals. With secure private property rights, such knowledge will be value-productive; i.e., the property owner will generally deploy knowledge that helps him achieve his goals without interfering with another’s ability to do the same. Errors will be weeded out through losses, and uses of property that interfere with others’ property rights will be corrected by appropriate legal institutions (Hülsmann, 1997, pp. 44–45). Hülsmann describes how the introduction of coercion and the abrogation of private property rights alters the process:
The case is different in a system featuring a coercive agency. Here, by definition, a knowledge different from value-productive knowledge is, at least sometimes, more important. (The extent of “sometimes” depends on the range of activities and on the permanence of the coercive agency). There is, for example, the knowledge of how to reap the fruits of other persons’ labor without provoking their resistance. There is also the knowledge of how to acquire control and ownership of the coercive agency. And there is the knowledge of how to persuade one’s neighbors about the utility of this system, too. One can add an infinite number of items to this list. The result, in general terms, remains the same: a violent agency necessarily affects the knowledge structure of the society upon which it is imposed. (1997, p. 45)
ENVIRONMENTAL POLICYWhat are the implications of violence’s effect on the “knowledge structure” for environmental policy? Environmentalists identify an important problem: one’s actions interfere with the property rights of another. Some gains from trade are unrealized because some of the valuable attributes of some goods and services are unowned and therefore not priced. Proposals for planning based on carbon footprint measurement replace this problem with one that is even worse: specifically, forsaking the price mechanism introduces arbitrariness into production and consumption decisions. There are ways to mitigate these problems by strengthening private property rights and thereby making more potential conflicts subject to resolution through trade or tort law (cf. Rothbard, 1982). Disharmony between individuals’ plans arises from conflicts over the use of resources; this disharmony can be eliminated or substantially reduced by, for example, eliminating building restrictions and privatizing what has been socialized.
Consider the examples of building restrictions and socialized garbage collection. Glaeser and Kahn (2008) argue for relaxing housing restrictions in California. Per capita emissions are lowest on the west coast and highest in the South, and in cities like Boston and New York per capita emissions are lower in the city whereas in Los Angeles they are lower in the suburbs (Glaeser and Kahn, 2008, p. 1). They estimate that, for example, the annual additional cost of carbon dioxide emissions from a home in metropolitan Houston is approximately $500 more than it would be in metropolitan San Francisco. They attribute this mostly to the better climate in the San Francisco Bay area. Even for all of their careful work, their knowledge is of a meager and unsatisfactory kind: they note that they do not include the carbon emissions associated with work. Land use restrictions precisely invert the practices consistent with wise environmental stewardship. Land in California and New York that would be more valuable for housing is used to grow crops, while land in Texas that would be more valuable for crops is used to build housing.See Sowell (2008, pp. 23–36; 2010) for a more detailed exploration of the economics of housing in California.
Further, Glaeser (2006), Glaeser and Gyourko (2003), Glaeser and Ward (2006), and Glaeser et al. (2005) argue that land use restrictions have artificially inflated housing prices in places like California, Boston, and New York. “Affordable housing” mandates do not work, as Powell and Stringham (2004) show; indeed, Means and Stringham (2009) estimate that affordable housing mandates have higher housing prices and smaller housing stocks in the California cities that have adopted them. Relaxing these restrictions helps us save multiple birds with a single stone: we get cheaper housing that is cheaper to operate, and we eliminate restrictions that interfere with market plan coordination.
Pollution externalities emerge from socialized garbage collection (Block, 1998, p. 1894), which means the prices for garbage collection do not reflect their costs and benefits. In many places, one can throw away a garbage can filled with toxin-laden cell phone batteries for the same price as a garbage can filled with biodegradable vegetable matter. Pricing garbage disposal might lead to more illegal dumping, but the solution in this case would be stronger enforcement of private property rights, not socialized garbage collection. Bringing garbage collection into the cash nexus of market exchange would bring them under the discipline of the process by which costs and benefits are revealed.
Cordato (2004, p. 4) describes the institutional character of the Austrian-praxeological approach to efficiency: “…social efficiency is assessed in terms of the extent to which legal institutions facilitate consistency between the ends that actors are pursuing and the means that they are choosing to accomplish those ends.” The policy problem with regard to efficiency concerns “efficient intra- and inter-personal plan formulation and execution, i.e., the internal consistency between the means that people use and the ends they desire to achieve” (Cordato, 2004, p. 7). Such efficient coordination is impossible without secure private property rights. Brätland (2006, p. 15) is explicit, pointing out that “without private property and monetary exchange, there can be no capital calculation and no rational means of maintaining either capital or income for current or future generations” (emphasis in original).
Calculation problems have further implications for how we understand the concept of “sustainable development.” Sustainable development requires praxeological, calculation-based microfoundations. Taylor (2002, p. 4) notes that what is being “sustained” may be of little value to those yet born; to adopt an example from Steven Landsburg (1996), who are we to say that our children would prefer a forest to the income generated by a parking lot? Further, as Landsburg and others have noted, since future generations will almost certainly be far wealthier than we are, conservation for future generations’ sake is an intergenerational redistribution from the relatively poor of today to our relatively rich descendants.
Non-price calculation instruments do not provide a basis for rational analysis, rational calculation, and rational action because they forsake the market (Brätland, 2006, p. 21). Private property owners have a direct interest in maintaining and increasing the value of their property. Further, the entrepreneurial process ensures that at any point in time, the best answer to Landsburg’s question about how we know whether future generations prefer a forest to a parking lot will be capitalized into the prices of the land and other resources. At every point in time, the price of an asset reflects market participants’ best estimates of the discounted present value of the income that will be generated by that asset. When private property rights are secure, anyone who values green space as such or who believes that people are making a short-sighted mistake by paving green space is free to act on these preferences and beliefs.
Should we treat future generations’ utilities as if they were our own and not discount the future? A simple reductio ad absurdum shows that this is untenable.I first heard this example from Walter Block. If we truly should not discount the future, then the relevant environmental problem is not that we may someday exhaust the Earth’s resources but that someday the sun will die out, explode, and destroy everything in our solar system. This leads us to conclude that we should increase rather than decrease the rate at which we extract resources as we look for ways to get off of this doomed rock.
Science can measure some aspects of a production process, but even these measurements produce knowledge that is of a very meager and unsatisfactory kind. Following Garrison (2000), we can simplify the discussion by dividing the structure of production into five stages of mining, refining, manufacturing, distributing, and retailing. It is possible to measure the energy inputs and carbon outputs of certain parts of certain processes in the structure of production—the carbon output of a diesel truck moving cans of Pepsi from a warehouse to a grocery store is reasonably easy to measure, for example. However, what we can measure easily represents only a fraction of what really goes into the production process.
Consider the production process that gets a can of Pepsi into our refrigerators.This is adapted from an example given by Roberts (2001). One could probably measure the carbon dioxide produced in the production and operation of the machines in the soda bottling facility. But what about the carbon dioxide emitted by workers commuting to the factory? Or the carbon dioxide emitted to brew their morning coffee? Or the carbon dioxide emitted to produce that coffee, get it to the grocery store, and then to the worker’s home? Any attempt to identify a non-price metric by which people can decide whether value is or is not being created runs into the same problem a central planning board runs into when it attempts to allocate scarce and unowned factors of production. The problem cannot be solved because the relevant information has been destroyed.
Public choice considerations are relevant, as well. Hasnas (2009, pp. 121–122) recounts the well-known case of environmental regulation in which Senator Robert Byrd intervened on behalf of coal mining interests. The regulations were not written to allow certain levels of pollution; rather, they were written to require that smokestacks at coal-burning power plants be fitted with air scrubbers “even though requiring scrubbers had greater costs and left the air dirtier” (Hasnas, 2009, pp. 121–122). Here is Hasnas (2009, p. 122): “Requiring the air to be cleaned after the coal was burned neutralized the economic advantages of the cleaner-burning coal mined in the western United States over the dirty-burning coal mined in West Virginia.” Politics also has a bias toward action, prudent and otherwise. Hasnas (2009, pp. 118–119) offers an analogy from soccer in which he says that a defender who appears to be “doing nothing” is often in fact containing the attacker while the defense gets into formation.
While the market socialism of tradable permits enables better economic calculation than command-and-control regulations, secure private property rights allow for the generation of knowledge that is essential to the solution of environmental problems. Block (1990, p. 91), for example, suggests scaling back interventions that create conflicting plans over the uses of water and air. The same problem of market socialism remains: a “bureaucratic command structure” regulates the permit-trading market (McGee and Block, 1994, p. 56).
What do we do about the well-known problems of externalities and public goods? There are several answers. First, private property rights combined with the common law of torts brings these considerations into the sphere of economic calculation (Rothbard, 1982 [1997]; Hasnas, 1996, 2009). Legal decisions in the early nineteenth century held that it was in the public interest to encourage manufacturing; therefore, pollution forensics and the abilities of people to sue polluters were sharply curtailed (Block, 1990, p. 91; 1998, p. 1890). McGee and Block (1994, pp. 61–62) discuss “reasonable” conduct and “live and let live” principles in English and American law, and indeed custom is likely to emerge in ways that encourage efficiency. Second, as Elinor Ostrom’s research shows, people are remarkably adept and managing common-pool resources without heavy-handed central planning.See Ostrom (2010) for a comprehensive summary.
Extending Caplan’s (2007) argument about the inefficiency of policies chosen by democracies, Carden and Hammock (2010) suggest that environmental policies are also likely to be flawed. Respondents to a 2007 Washington Post/ABC News Poll, for example, opposed higher gas taxes but supported stronger efficiency standards for cars, which Carden and Hammock characterize as “stick-it-to-the-man bias.” Since voters’ preferences are systematically biased they are likely not to support environmental policies that have plausible economic rationales but policies that are positively destructive (Carden and Hammock, 2010, pp. 73–74). Those who assume that regulators can fix it often commit what Otteson (2010) called “the great mind fallacy,” which assumes that someone, somewhere is possessed of sufficient moral and intellectual fiber to engineer a Great Society. Without private property, exchange, and money prices as guides, no mind—no matter how great—can begin to articulate the social problem, much less solve it.
THE “TRIPLE BOTTOM LINE:” NORMAN AND MACDONALD’S CRITIQUEIn addition to attempts to measure social and environmental issues at a national level, some activists have pushed firms to adopt “corporate social responsibility” practices like the adoption of a “triple bottom line.” The triple bottom line receives a devastating critique from Norman and MacDonald (2004), who devote most of their criticisms to the social component of a triple bottom line but note that the same criticisms also apply to the environmental component. Advocates of a triple bottom line suggest “that a corporation’s ultimate success or health can and should be measured not just by the traditional financial bottom line, but also by its social/ethical and environmental performance” (Norman and MacDonald, 2004, p. 243).
It is important to note that emphases on environmental and social prerogatives can be important elements of brand management (Norman and MacDonald, 2004), but the idea that firms should seek to let a “triple bottom line” guide their actions runs into a number of obvious problems. The most obvious problem is that there is no way to construct a social or an environmental bottom line. One can know, for example, the percentage of office paper that gets recycled, the amount of energy used by company buildings, and the percentage of company employees who drive hybrid cars. Laying aside for a moment the question of whether these represent unambiguously good environmental stewardship, there is no way to transform this information into a coherent index that represents a real environmental bottom line.
As areas of focus for a firm engaged in careful brand management, these individual pieces of information can be combined to provide a broad overview of a company. They cannot, however, be reduced to a common unit independent of monetary calculation that tells a company whether, say, recycling less office paper is wise if it means being able to use less energy in its buildings. Attempts to add up the components of an environmental bottom line are attempts to add apples to oranges. The problem of in natura calculation that formed part of the Misesian critique of socialism appears again here.
The same problem arises when we consider tradeoffs between financial, social, and environmental goals. Even if we assume that firms can construct coherent indices of their social and environmental bottom lines, there is no way to tell whether a one-unit reduction in the firm’s social bottom line is an acceptable price to pay for a two-unit improvement in the firm’s environmental bottom line, or whether the firm should sacrifice one million dollars in profits to improve its social and environmental bottom lines by one unit each. It is true that a firm could use market prices for recycled paper and energy to estimate the costs of reducing its recycling efforts in order to conserve energy, but this information goes straight to the financial bottom line. As Norman and MacDonald (2004, p. 243) summarize their conclusions, “what is sound about the idea of a Triple Bottom Line is not novel, and… what is novel about the idea is not sound.” Reporting data on corporate environmental and social citizenship might be a good way to attract customers, employees, and some shareholders, but the only coherent measure of a firm’s performance is its financial bottom line. Quite apart from whether the social and environmental indicators have the right arguments, there is no way to articulate the tradeoffs between dollars, social units, and environmental units.
CONCLUSIONEnvironmental issues have been pushed to the front of policy debates, and people have proposed a number of interventions, programs, and ideas that are supposed to provide alternatives to monetary calculation. However, monetary calculation solves these problems when property rights are clearly defined. The absence of private property rights means that we cannot have the information we would need to make production and allocation decisions that coordinate producers’ plans with consumers’ wants.
The calculation problem is fundamental to the environmentalist commonwealth just as it is fundamental to the socialist commonwealth. Mises (1990 [1920], p. 13) argues that “(e)very step that takes us away from private ownership of the means of production and from the use of money also takes us away from rational economics.” In the environmental context we can rephrase this as follows: every step that takes us away from private ownership of the means of production and monetary calculation also takes us away from rational and responsible environmental stewardship.
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Volume 1 (Fall 1979)Lawrence H. WhiteLudwig M. Lachmann
In the Spring 1979 issue of this newsletter Lawrence H. White comments on "a controversy sparked by Professor Lachmann's thought which has arisen in Austrian circles over the question of general equilibration." I have thus far refrained from commenting on an issue I could not understand. Outside the text-book industry general equilibrium has few defenders these days, and the more thoughtful among them now readily admit that it has little to do with the real world. It puzzles me that some Austrians seem ready to die in the last ditch for a cause that is not theirs and the outstanding exponents of which, from Pareto to Hahn, have never concealed their contempt for Austrians and their ideas.
Now, however, White has set down a number of points I think I can understand. In commenting on them I may hope to further the cause of clarification he has made his own, even where I disagree with him.
(1) White, quoting from my 1943 article on expectations,[1] has me note that expectations are "largely the result of the experience of economic processes." I added, however, on the next page: "This experience, before being transformed into expectations, has, so to speak, to pass through a "filter" in the human mind, and the undefinable character of this process makes the outcome of it unpredictable." (ibid, p. 67) Thirty-six years later, I adhere to this view.
(2) On the other hand, White makes me look a more extreme ex ante man than I actually am. "Lachmann has taken primarily an ex ante perspective."
I do not deny that often, where possible, ex ante views have to be compared with ex post outcomes and that agents have to judge the success of their actions in these terms, nor that economists have to take note of this fact. What I deny is that such judgments permit us to predict what agents will do next. Learning from our mistakes, as from other experience, is a problem-solving activity, and none of us can take his success in it for granted.
(3) Does White agree? In a significant passage he strikes a cautious note. "In serial expectational processes learning is possible, provided the sequence of decision, action, result, and interpretation takes place with speed sufficient to outrun significant changes in the objective circumstances. Learning can play an important role in providing accurate foresight and coordination of the decision maker's (amended) plan with the plans of other market participants." We note, first of all, that "learning is possible", not necessary, and that it depends on speed. Slow learners, we surmise, do not stand much of a chance.
The crux of the matter is that traders, by entering into those transactions from which they stand to learn most, may transform the "data" of our model, White's "objective circumstances." Are we to believe that in a world in which contracts are binding (no t?tonnement) disequilibrium transactions will not give rise to gains and losses which modify the distribution of wealth? Or that "false quantities" of goods produced in response to disequilibrium prices will not affect the freedom of subsequent action of their producers? Do we have to assume that in White's model good learners learn fast enough to prevent all malinvestment (presumably an objective circumstance), even that indulged in by the slowest learners?
Painless learning, alas, is possible only under the gentle guidance of the universal auctioneer.
(4) White, while dissociating himself from the Walras-Pareto model, wants us to accept the "affirmation that such an economy harbors a strong tendency toward an overall equilibrium." The word "tendency" denotes a constant general direction, while it is of the essence of a groping process that in successive periods,the groping takes place in different directions. In White's model there can thus be no trial and error. Nor is much comfort to be drawn from the statement that the said "tendency" is here to be interpreted "as the likelihood that the configuration of an economy (particularly its array of prices) will be near to a general equilibrium configuration." A configuration the data of which are continuously transformed as the result of disequilibrium transactions, can hardly be said to occupy any distinct "area," and thus does not permit us to describe any events as happening in the "vicinity," or at some "distance" from it.
(5) Where do we go from here? Without an auctioneer, what happens in each market as well as the movement of relative prices depends on the actual sequence of events, the temporal order of market processes. Theoretical generalizations about the outcome of such processes which fail to take account of the order in which events happen in markets are therefore unwarranted.
Fifty years ago, when the inadequacy of the Walras-Paretian general equilibrium model for our understanding of economic processes was first noticed, some Swedish economists, such as Lindahl[2] and Lundberg,[3] suggested process analysis as an alternative paradigm. Like much else that was of value in the 1930's, these ideas were swept away by the Keynesian revolution. Today we realize that these thinkers have paved the way for the notion of market process now widely accepted among Austrians.
But two points must be kept in mind. In the first place, a purely mechanical process model that has no room for choice, the subjectivism of expectations, and the interpretation of information, would be no improvement at all on general equilibrium. Secondly, different markets evolve different institutions which influence the sequence of events on them. There are even some real auction markets in the world today (wool). Hence the market process assumes different forms in different markets. We must study them with some care.
We can all agree with Lawrence White in seeing virtue "in encouraging diversity in the exploration of possible new opportunities," but we have to realize that such diversity implies the incompatibility of plans. There can be no competitive game without losers.
Ludwig M. Lachmann
I am pleased that Professor Lachmann has chosen to reply to my piece, for I believe that his reply clarifies his position. Part of the issue which he professes not to have understood was an uncertainty over whether he was prepared to affirm a belief in spontaneous order, i.e. affirm that markets do succeed in coordinating plans. It is now clear that he is not prepared to make any such general affirmation. We are told: "Without an auctioneer, what happens in each market as well as the movement of relative prices depends on the actual sequence of events the temporal order of market processes.
[T]he market process assumes different forms in different markets." One of my objectives was to show that Lachmann's writings should not, on the other hand, be construed as a blanket denial of belief in spontaneous order.
Professor Lachmann asks whether I agree with the last two sentences in his section (2). In the unqualified way in which they are put, I do not. It seems to me that it is not only possible for agents to learn, but in some cases it is also possible for the economist to predict the direction of plan amendment subsequent to feedback and interpretation. If pattern prediction of this sort were never possible, I do not see what sort of process analysis we could ever do. On the other hand, I would also answer in the negative to the three questions posed in the second paragraph of section (3).
In the first three sentences of section (4), Lachmann seems to impose on my discussion of the meaning of "a tendency toward equilibrium" a definition of the word "tendency"?namely, "a constant general direction"?that I explicitly eschew. I certainly did not want to suggest that a tendency toward an economic equilibrium is inconsistent with trial and error. I am puzzled that I could be so interpreted. I might add that I am puzzled also by the similar misinterpretation implicit in the last two sentences of Professor Lachmann's opening paragraph. The Hayekian equilibrium theory I and other Austrians would defend is quite distinct?in my mind at least?from the equilibrium theory of the Pareto-Hahn tradition.
Lawrence H. White
By specifying the contents of the "general affirmation of belief in spontaneous order" Lawrence White has helped me to understand at last what the quarrel is about and what it is that's wanted from me.
First a minor point: the difference between a tendency and trial and error. A point of semantics perhaps, rather than Austrian economics. To my mind one precludes the other. It may be possible ex post, in charting the course of a trial and error process of the past, to discover a tendency in it, but never ex ante. To say "Let us try and see, but only in a South-easterly direction" is to limit the scope of the search. See Joan Robinson in JEL, December 78, on the impossibility of finding equilibrium by trial & error (p. 1322).
Now the main point. Is the "spontaneous order" permanent? If not, how long does it last? Take the U.S. railroad system. In 1900 it certainly presented all the features of spontaneous order, coordinating the plans of millions of people, including shareholders receiving dividends from most of the railroads. But today? White says I can only master the ex ante perspective. But if we take the ex post perspective, was the U.S. railroad system a spontaneous order?
It puzzles me that White fails to see that, by pretending to see "spontaneous order" everywhere, we are playing right into the hands of our opponents who merely have to point to obvious instances of malcoordination to win debating points. Every case of malinvestment can be held against the market economy. Does it not show malcoordination? The "absence of universal futures markets" in Arrow and Hahn as an argument against the market economy makes sense only, but, alas, does makes sense, against such "universal affirmations" as I am now asked to subscribe to.
What has gone wrong? We have to distinguish between real phenomena and those ideal types we use to classify the former as "more or less - - - " Some markets coordinate plans better than others, and it is the job of us Austrian economists (and others) to study them and classify them. If we assert that "the market coordinates all plans" (always?), we substitute an affirmation of faith for what should be the outcome of serious study of the real world. In defending the market which certainly provides people with opportunities (they often miss) to orientate their plans to others, we must beware of claiming too much. Plans that often extend into the remote future, with details often as yet unspecified, cannot all be consistent with regard to every element. By the way, how can the plans of competitors be compatible?
In refusing to sign the blanket affirmation referred to I appeal to common sense. I know that among economists that is not much of an argument. It seems to me, nonetheless, that Austrian economics is more likely to prosper if common sense is not ignored.
I repeat as an empirical generalization: Learning from experience is a problem-solving activity, and none of us can take his success in it for granted.
General demand and supply equilibrium cannot serve as a "center of gravity", a source of permanent forces of constant strength as, under the impact of innovation, technical progress and simple changes of taste, relative demand and supply of various commodities are continuously changing. A planet whose composition and mass are undergoing continuous transformation could not exert a gravitational force of constant strength. If so, how can it be asserted that economic equilibrium forces, necessarily of varying strength over time, will always overwhelm and outlast all other forces?
Ludwig M. Lachmann
[1] "The Role of Expectations in Economics as a Social Science". Economica, February 1943. Reprinted in Capital, Expectations and the Market ,Process (Kansas City: Sheed An- drews & McMeel, 1977) p. 66.
[2] Erik Lindah Studies in the Theory of Money and Capital (London: Allen & Unwin, 1939) Part 1.
[3] Erik Lundberg Studies in the Theory of Eco- nomic Expansion (London: P. S. King, 1937).
Volume 16, Number 3 (Fall 1996)An Interview with Joseph T. SalernoJoseph Salerno, professor of economics at Pace University, is a leading figure in today's growing Austrian School. He has been a pioneer in many fields, including monetary theory, comparative systems, the history of thought, and the economics of war. After the death of Murray N. Rothbard in 1995, Salerno assumed the editorship of the Review of Austrian Economics, together with Hans-Hermann Hoppe and Walter Block. He is now editor of its successor and current flagship scholarly journal, The Quarterly Journal of Austrian Economics. He was interviewed by the AEN staff at the 1996 Mises University, the Mises Institutes summer instructional conference at Auburn University.
AEN: What's your take on the present state of Austrian economics?
SALERNO: How could anyone be at the Mises University and not be elated? This is my eighth. The students are more passionate and well read than ever. We've got all levels, all fields, and many different countries represented. Many students have come on the recommendation of their professors, who had attended in the past. So we're now working with the second and sometimes third generation of alumni.
AEN: What does the program contribute to the movement?
SALERNO: These kids put up with a lot of baloney in school, and the tedium of their regular classes tends to strip economics of its essential content. They go in thinking they will learn about how societies materially advance, how civilization comes about and is preserved. Instead, they end up slogging through years of pointless mathematical exercises.
I'm all for paying dues, but at some point students need to have their imaginations sparked. You can see that happening here. It reminds them why they liked economics in the first place. Teaching and formal training is the key to advancing any school, whether Austrian or Marxian. It is precisely what has been missing from Austrian economics.
AEN: Is that why most of your classes here focus on technical issues?
SALERNO: There is a myth that all Austrians are generalists. General instincts are fine, but they are not enough to sustain a school. A body of thought stands or falls on its practitioners ability to master the technical issues in particular fields. It's what distinguishes dilettantes, hobbyists, and amateur philosophers from engaged economists. I have little patience for people who want to reconstruct Austrian economics from the ground up, but then can't explain, in praxeological terms, the law of demand, much less give an account of the regression theorem.
Until we have a full-time faculty somewhere, this conference fills the gap. It provides the formal training, in a wide variety of fields, that would otherwise be unavailable. The students and faculty love it.
AEN: Is there more evidence of the healthy state of the Austrian School?
SALERNO: It's all around us. The print run of The Review of Austrian Economics gets larger every issue. The articles are sophisticated and make real contributions. They also show that we have fierce debates among Austrians, a sure sign of health. All back issues are in constant demand, from libraries, students, and others.
We also now have our own full-blown history of thought, Murray Rothbard's last gift to the world of ideas. We no longer have to think of Austrian economics as a late-19th-century idea carried forward by a handful of giants. Rothbard has placed the Austrian School in the center of the history of economic thought from the ancients to the moderns.
Today the school is so large and international that it is difficult to keep tabs on it. It has displaced the waning Chicago School in terms of representing the free-market plumbline. That's more than progress. Thats a revolution.
AEN: Do Austrian economists need to be accepted by mainstream journals before theres real progress?
SALERNO: Absolutely not. We shouldn't measure progress this way. Progress does not mean acceptance; it means the propagation and advancement of the truth. Austrian articles are appearing in mainstream journals, but this is a byproduct of our growing presence in the academic world. We shouldn't crave acceptance by the mainstream; we should seek to displace it.
AEN: Is this widening interest still the fallout from Hayek's 1974 Nobel Prize, or something entirely different?
SALERNO: The modern revival is usually dated from Hayek's award. That was also the year of the famous South Royalton conference, the first on Austrian economics in North America. Until recently, I accepted this conventional account of the "Austrian renaissance," perhaps because I was caught up in the excitement of having attended the conference.
More recently, I've come to understand that this view of events is seriously mistaken. It leaves aside what prepared the way for that conference and the boom that followed. For a full picture, we have to go back a decade earlier.
Mises's Theory and History appeared in 1957. It was to be his last major work, and meanwhile Hayek had moved on to spending full time with his social evolution theory. The Austrian School would have died over the next ten years if no new theoretical work had appeared. In retrospect, Rothbard's 1956 article "Toward a Reconstruction of Utility and Welfare Economics" was a sign that great days were ahead.
In 1962 and 1963, in amazingly rapid succession, Rothbard published his seminal works, Man, Economy, and State, Americas Great Depression, and What Has Government Done to Our Money? This last booklet is often seen as a primer on monetary theory, but it is much more. It contains his notable "progression theorem," which explains how the state caused a "progression"--actually a degeneration--from hard money to fiat currency. Such a systematic explanation of the origins of fiat currency was missing even in Mises's works.
AEN: And these three books in two years set the stage.
SALERNO: Absolutely. Rothbards astounding burst of creativity is unparalleled in the history of the Austrian School, if not in the history of economic thought. Remember too that Power and Marketwas completed in this phase as well, although it didn't make it into print until 1970.
In any case, these three books served as the model and inspiration for all future work in Austrian pure theory and applied economics. Rothbard respectfully built on the works of the acknowledged masters, especially Mises, Böhm-Bawerk, and Menger, while boldly advancing beyond them in the theory of utility and welfare, money, monopoly, taxation and interventionism, and the business cycle. Plus, he was a compelling writer and used his personal influence to nurture and sustain the movement. As a result, the young people who came to South Royalton already were, almost to a man, Rothbardians.
After this conference, there was an initial period of productivity. Rothbard again took the lead, publishing notable articles on the definition of the money supply, monetary calculation and cartels, and the pitfalls of fluctuating exchange rates.
But then a period of dormancy set in. Austrian theory got bogged down in a sterile debate over whether the market economy is equilibrating. This was pointless, since Mises had already resolved the issue. The concept of equilibrium is an indispensable analytical tool. It's not a realizable state that the economy moves closer to or further away from in history.
The theory side wasn't revived until the mid- and late-eighties. It picked up again because of political events (socialism was unraveling), the Mises Institutes founding of the first English-language journal devoted to Austrian economics (which Mises himself dreamed of), and the coalescence of a new Rothbardian circle, beginning at these summer conferences.
AEN: Why should it be important to revise the conventional view of the Austrian revival? Merely to give credit where it's due?
SALERNO: There's much more at stake. There has been an unfortunate tendency to limit the revival to the people who attended the South Royalton conference. The next step is to chart the progress of the revival by tracking the careers of some twelve or so people, all of them Americans. The result is a narrow sectarianism that squeezes out newcomers and is willfully blind to new contributions.
But if we conceive the Austrian revival in broader terms--as being the movement of a body of ideas instead of a handful of people--we gain a more realistic understanding of the present state of the school. The current Austrian boom is massive and international, and encompasses literally thousands of students, faculty, and professors the world over. Thanks to this, we are experiencing another explosive burst of creative energy.
AEN: Yet Rothbard himself never took credit for the Austrian revival.
SALERNO: He was too busy crediting past Austrians for their contributions and, at the same time, encouraging younger students to go beyond his own work. He made the tradition and the school the focus, and not his work personally. Today, it's fashionable in academia not to acknowledge intellectual debts unless it's to your advantage, but neither Murray nor Mises had this view. At the same time, whenever we younger economists tried to beef up Austrian theory, even if it meant disagreeing with him, he was delighted.
AEN: Describe how you got involved in the Austrian School.
SALERNO: My ideological awareness first came when I was in fifth grade. My mother had a cousin visit from Italy. During dinner, the visitor revealed he was a communist. My father, who was somewhat of a New Deal Democrat, nearly threw him out of the house. That sparked my curiosity. Then, in 1963, I read an article by Barry Goldwater in Life Magazine--he favored the free market in those days--and I was deeply impressed. One thing led to another, I went through the inevitable Rand phase, and by my senior year at Boston College, I was fairly well read in Mises, Hayek, and Rothbard. In graduate school at Rutgers, I met Murray.
AEN: It was your dissertation that first established you as a historian of thought. Rothbard said your study was the starting point for understanding British banking debates.
SALERNO: Actually, a good part of my thesis and argument can be found in Rothbard's Classical Economics, Volume 2 of his history of thought. My dissertation was on a slightly more narrow topic: the divisions and debates among the bullionists on the question of exchange-rate theory.
AEN: Your last major history of thought paper was on the development of Keynes's thought. Is there anything Austrian in Keynes, as Ludwig Lachmann used to claim?
SALERNO: A few perfunctory remarks about uncertainty and the chaos of capital markets do not constitute Austrian insights. I think we should leave Keynes to the Keynesians--and Lachmann to the Lachmannians for that matter. In my paper, I attempted to show that Keynes moved from Marshallianism to classic millennarianism. In the end, he was attempting to use the state to bring about a world that appealed to his personal intuition, but does not and cannot exist.
In Keynes's dreamland, the interest rate would fall to zero because there would no longer be scarcity of capital. That achieved, we would see the disappearance of "avarice, usury, and precaution." Moreover, his attack on orthodoxy wasn't limited to economics. He opposed bourgeois ethics, folkways, and institutions, and longed for a new order designed by the intellectual elites.
AEN: You have encouraged Austrians to rediscover the writings of W.H. Hutt.
SALERNO: Professor Hutt is most famous for his work on labor unions, which is great. But in response to Keynes, he developed a wonderful theory of market price coordination that is consistent with Misesian theory. I have attempted to rehabilitate his view. His idea was that in an unhampered market economy, all actual or realized prices are market-clearing prices and are coordinated to make the market work smoothly. Price coordination is an ex post concept, that is, it describes what actually occurs at every moment on the market.
What if a person withholds labor? What if a capitalist withholds investment? Then they have reason to do so: they are making rational judgments about future consumer demands. When the data change, they may withhold even longer or may choose to exchange. At each stage, they make judgments based on their predictions, and these influence the prices that emerge at each moment. Errors are happening in the market all the time, of course. But at any moment in time, all resources are priced and allocated to reflect their most highly valued uses, based on entrepreneurial anticipation of future market conditions.
AEN: What theoretical issue, besides method, most separates neoclassicals from Austrians?
SALERNO: No contest: the business cycle theory. The Austrian theory embodies all the distinctive Austrian traits: the theory of heterogeneous capital, the structure of production, the passage of time, sequential analysis of monetary interventionism, the market origins and function of the interest rate, and more. And it tells a compelling story about an area of history neoclassicals think of as their turf. The model of applying this theory remains Rothbard's Americas Great Depression.
AEN: What about the monetarist explanation of the same event?
SALERNO: Rothbard once told me an interesting story about attending a Milton Friedman lecture. This was just after Rothbard's book came out in 1963. Friedman was supposed to speak on medical licensure or some such topic, but swiftly departed from the assigned topic and launched into a diatribe against Murray's book. As far as Murray could tell, Friedman was especially incensed that Rothbard had cited a 1937 Lin Lin article arguing that savings deposits are part of the money supply, on a priori or Austrian, not positivist, grounds. Later, Friedman was peppered with questions from curious students, which further infuriated him.
AEN: Yet both Austrians and Monetarists see the economic downturn as related to Federal Reserve policy.
SALERNO: But that is where their similarities end. Rothbard argued that the stock market crash was not a market failure, but a consequence of inflationary Federal Reserve Policy during the 1920s. Monetary inflation had caused distortions in the real capital structure, and the crash and depression were the inevitable correction. Milton Friedman merely blames the Fed for not rescuing banks once they started to fail.
For the Austrian theory to apply, Rothbard had to demonstrate that a significant inflation had occurred in the 1920s. That's how the debate turned to the definition of money. Friedman understood how high the stakes were.
AEN: And this is how the accusation began that Rothbard fudged his numbers?
SALERNO: This is a longstanding Friedmanite canard. But it's made the rounds, even among some Austrians. The idea is that Rothbard cheated by including the cash surrender value of life insurance policies in his money supply. Ironically, this view is perpetuated by positivists who would include peanut butter in their monetary aggregates if it helped them "explain" nominal income.
In fact, many Keynesian economists writing after the Second World War characterized life-insurance reserves as highly liquid financial assets that perform monetary functions. When this subject last came up, I pulled some older money and banking texts off my shelf at random. Four out of six treated insurance reserves this way, on grounds that they can be withdrawn at any time and are thus readily spendable dollars.
Besides, it turns out not to matter in Rothbard's theory. Including life-insurance policies, the increase in Rothbard's money aggregate between mid-1921 and the end of 1928 totaled about 61%, yielding an annual rate of monetary inflation of 6.5%, compounded annually. Leave them out, and we get 55% over the period, or 6.0% per annum. For comparison, in the highly inflationary 1970s, the money stock grew at an average annual rate of 6.35%, including the double-digit Carter years.
In other words, it doesn't matter for Rothbard's theory whether these are included or excluded. A Hayekian-style treatment of the same events by Phillips, McManus, and Nelson does not include insurance reserves, and concludes that the Austrian explanation is the correct one. The key point is not that the banks weren't bailed out in the early thirties, but that the Fed inflated in the 1920s, even though it didn't show up in increased prices.
AEN: The dispute about the Great Depression and the business cycle goes beyond the numbers, doesn't it?
SALERNO: It goes to the core of economic theory. For most mainstream economists, inflation is not a matter of money and bank credit expansion; it is essentially a price phenomenon. If prices don't rise, there is no inflation. It doesn't matter what the monetary data say. In the 1920s, there was no substantial change in prices, due to enormous productivity and output increases. But to them, that is sufficient evidence that they don't need to look any deeper.
Only Austrians truly believe inflation is a monetary phenomenon. When you increase the amount of money in circulation, it brings many more changes than just price increases. We see a fall in the loan rate of interest. We see a boom in real estate as a higher-order good. We see a boom in the stock market, which trades titles to higher-order goods, that is, capital goods. To focus on inflation as price increases means we don't capture the fullness of the inflationary phenomenon.
AEN: Why isn't the Austrian business cycle theory modeled in an econometric form more often?
SALERNO: Praxeological theorems of cause and effect can only be applied by first establishing precisely where and when the precipitating causal phenomenon has occurred. This requires historical investigation. For example, in business cycle theory, we must first establish that an increase in the supply of fiduciary media has taken place. Only then can we identify a sequence of historical phenomena that make up the business cycle. Econometrics wastes most of its time in a rigged game searching for mysterious causes among millions of potential variables.
Austrian theory is essentially qualitative. We deny that there are any quantitative constants in human action. Therefore, we can talk about changes that bring about other changes in the economy in a qualitative sense. We can say that an increase in the money supply drives down the purchasing power of money, or, obversely, drives up overall prices. But we cannot establish quantitative constants between money and prices.
AEN: What kind of new empirical research is possible?
SALERNO: Let me give you an example. A wonderful paper is coming out in The Review of Austrian Economics by Arthur Hughes which explains the recession of 1990. He relies on a qualitative understanding of cause and effect drawn from Austrian theory. He then applies it to the inflation run-up of the eighties and its effects on the capital-goods sector. To do this, he breaks down government figures, which are constructed based on Keynesian theory. Hughes identifies the various stages of production. It works beautifully.
Now, this would not be acceptable according to current economic fashion, which requires that statistical techniques demonstrate what caused the downturn, whether technological shocks, the weather, sun spots, or the man in the moon. All this is silly. Empirical data alone, no matter how well massaged, cannot establish causation. For that we need real theory, arrived at deductively, and applied to the real world as an explanatory device.
AEN: You had a debate with Gordon Tullock on the business cycle theory. What was his objection?
SALERNO: Tullock's main point was that the typical Austrian-style business cycle would lead to an increase in GDP, while unemployment would only be a minor transitional problem. He raises this point after tracing the effects of an overinvestment theory of the boom and bust. The trouble is that Austrians do not view generalized overinvestment as the essence of the cycle. Austrians distinguish higher-order from lower-order goods, and show how a credit-induced boom stimulates malinvestment, which involves diversion of resources away from lower-order to higher-order goods. His was a common error, but as with all debates, it helps people clarify their own positions.
AEN: Youve had a number of big debates in the Review.
SALERNO: You often hear that Austrians are narrow and dogmatic, reviewing the canon all the time instead of debating or adding to the theory. That has no connection to reality. The Review has more substantive and wide-ranging debates than any journal I see. And these are fierce, exciting debates that deal with fundamental issues, and involve both Austrians and non-Austrians.
That's the way it should be. If you see a journal that merely runs article after article, with no mutual engagement among the authors, no replies or rejoinders--in short, no vibrant interchange--it is a sure sign of intellectual stagnation. It means people aren't reading the journal, which is a huge problem, or that the editors and writers don't really care about advancing the discipline. In the Review, there's ongoing debate in practically every field.
AEN: How did the knowledge/calculation debate get started in the first place?
SALERNO: It actually began with a provocative 1988 Review article by Israel Kirzner, "The Economic Calculation Debate: Lessons for Austrians." Kirzner claimed that calculation--comparing costs and benefits in monetary terms--played a very small part in the Austrian critique of socialism. He further suggested that Mises's 1920 article was deficient in not pointing to the role of economic change in making central planning impossible.
To Kirzner, Hayek's theory of knowledge acquisition, from the late thirties and forties, stated the crucial point of the debate in a more sophisticated way. The virtue of prices is the knowledge about time and place they somehow embody, to which central planners cannot have access. With Hayek, Kirzner says socialism may not be impossible, but it is radically impractical.
Israel ended his piece with a call for "a new round in the debate" to restate the Austrian position on prices and markets with clarity. That's precisely what has taken place.
AEN: How did Kirzner's article stimulate your thinking?
SALERNO: It was a thought-provoking piece, subtly argued. I considered it, reviewed the relevant literature, and realized that Mises was actually making stronger, more sophisticated, and more persuasive arguments about the role of prices than Hayek. This was directly contrary to the lesson Kirzner wanted to teach. I then began the effort to "dehomogenize" Mises and Hayek--that is, to show that they were seeking to demonstrate very different points--and argued that Mises was on firmer ground.
By the way, the editors of the Review have come across a 1938 manuscript written by Mises in German and then translated to French. Here, Mises sharply distinguishes his position from Hayeks. It is an important piece that has never appeared in English. We are working on a translation for the Review.
AEN: Also in "Mises as Social Rationalist," you further distinguished Mises's approach from Hayek's theory of social evolution. Students at this conference speak about it often.
SALERNO: That article had an interesting origin. Lew Rockwell had asked me to write about the concept of equilibrium in Mises. When I thought about it, I realized I would have to deal with the concept of spontaneous order also, since some Austrians had claimed that it is the proper replacement for all equilibrium theorizing.
Looking through Mises, however--much to my surprise at the time--I found there was no concept of spontaneous order at all. That's when my topic changed, and I began this project of replacing the entire "knowledge problem" framework with the Misesian perspective of social rationalism and monetary calculation.
AEN: Can you sum up Mises's calculation argument?
SALERNO: What Mises argued was simply this: In an industrial economy, featuring a complex division of labor, and many heterogeneous capital goods, planners would not be able to use subjective evaluations in figuring out the most valuable use of their resources, as they would in a household economy. This requires objective economic calculation using market prices. If a society does not have the benefit of market prices, arrived at through the exchange of private property, resources cannot be rationally allocated.
In analyzing socialism, Mises assumes the director of the central planning board has all the knowledge of the economic data at his fingertips. He knows the technology. He has engineers and technical support. He knows the value scales of consumers or he can substitute his own values. He has a roster of all the kinds and qualities of labor available. And he has lists of all the varieties of capital goods and their quantities at his disposal. Given all that, he is still unable to engage in economic calculation. All these data are qualitative. He still cannot derive quantitative exchange ratios from them.
AEN: Do you agree that in neoclassical models, all this information will yield prices that can be used in monetary calculation? It's merely a linear-programming problem.
SALERNO: Mathematical solutions do not obviate the need for the markets pricing process. Lets assume we can generate equilibrium prices. They are not actual prices. It still leaves the essential problem that economics deals with: judgment and appraisement in an uncertain future. In Mises's concept of calculation, the function of the price system is to permit entrepreneurs to appraise the quantitative importance of resources when confronted with constant change. Equilibrium prices--the dual values of linear programming--are completely irrelevant to a world in which the capital stock must be continually changed.
AEN: Can you give a concrete example?
SALERNO: Let's say someone needs to produce an automobile. There are hundreds of different ways to go about it. The inputs are steel, paint, labor, rubber, etc., but they are all heterogeneous magnitudes. They cannot be summed up in a single unitary cost figure--a common denominator--that can be used to compare the cost with the output of the automobile itself. He can't determine whether he is wasting resources or not because he can't calculate.
AEN: Anything even more concrete?
SALERNO: Okay, I have a friend who got married and moved from New Jersey to Montana. She had her house built in a factory in Indiana, and then shipped to the site. The reason has to do with the scarcity of labor in Montana relative to Indiana. Unlike in New Jersey, it would not be cost effective to build a house on site in Montana. It could be done, of course, but not economically. We know that because we have market prices that allow us to calculate.
But a central planning board operating without the benefit of prices might look at the situation, know all the various techniques, the value scales, and the resources, and conclude--reasonably--that on-site building is the best way. It might dismiss the idea of house shipping as absurd. It might ask: why build the house in one place only to move it to another? The board can't calculate to compare costs of shipping versus the costs of labor.
AEN: Why isn't that a knowledge problem?
SALERNO: It's not a knowledge problem because the planning board has all the qualitative knowledge. What it doesn't have is the means of calculating the value of the different methods. Remember, I am using the term "knowledge" in the pure Hayekian sense: meaning, technical knowledge, that is, general knowledge that can be gotten from engineers, and knowledge of "particular circumstances of time and place."
Hayek only refers to qualitative knowledge; he thinks gaining that knowledge is the key issue. I am not using the term knowledge as in "knowing the exchange ratio." Of course, if you know the correct resource and output prices, you can calculate, by definition. But that's precisely what the central planner, no matter what else he knows, does not have. Social rationalityrequires the on-going social appraisement of resource prices, which rests on market exchange and private property.
AEN: But didn't Mises have a peculiar definition of rationality?
SALERNO: It's only peculiar if we misunderstand what he means. Lets say your readers read this interview instead of watching tv. And at the end, they decide they wasted their time. That doesn't mean their initial decision to read this was irrational. On the contrary: they made the rational choice based on a forecast. That they turned out to be wrong, from their point of view, has no bearing on the issue. Their action was rational, but their forecast was mistaken. They will take that into account in choosing whether to read future issues of the AEN.
We regret our actions all the time. The point is that if we don't have market prices and economic calculation, we can't even begin to make purposeful choices about resource allocation. A lack of foresight is always with us. But a social planner working without the benefit of economic calculation has no idea whatsoever of where to begin or how to test his results against his forecast. That means the planner is acting irrationally.
AEN: But is it really true that socialism is inherently irrational? How could it have survived so long?
SALERNO: A good example is the Soviet Union, which instituted full-blown socialism for two years, from 1918 to 1920. It was called War Communism. They didn't check capitalist prices from international markets. They didnt use money at all. Within two years, the whole economy had broken down. There was a return to household production of the most primitive form. Lenin then introduced the New Economic Policy, which reinstated money and prices. The experience reinforces Mises's point: an industrial economy literally cannot exist without economic calculation.
AEN: What are the implications for a mixed economy like the U.S.?
SALERNO: Mises's theory of interventionism says that price controls fail to achieve the goals of those who intervene. Rothbard picked up on this, and talked about the mixed economy as containing "centers of calculational chaos." That's a good description of the mixed economy.
AEN: On another controversial area, did Mises favor 100 percent reserve banking or not?
SALERNO: The Review has published a paper by Larry White and George Selgin arguing he did not, and they make a credible case. But Ive argued the other view. Looking at the whole of his writings, we see that the very reason Mises favored free banking was mainly to suppress the issuance of fiduciary media, that is, bank notes and deposits not covered by 100 percent cash reserves.
In the monetary theory section of The Theory of Money and Credit, Mises lists the benefits of fiduciary media. Then in a later chapter on the business cycle, he demonstrates that fiduciary media are a necessary and sufficient cause of the cycle. When Mises finally addresses "basic questions" of future policy, he calls for the suppression of all further creation of fiduciary media, if not an outright ban on fractional-reserves. Even the early Mises clearly thought that the disadvantages of fiduciary media outweighed their advantages.
AEN: A more careful reading, then, should settle the issue?
SALERNO: A careful and wide reading. Mises toughened his stance even more between 1924 and 1940, with the publication of Nationalökonomie, the German language forerunner of Human Action. There he is conspicuously silent on the benefits he had once attributed to the creation of fiduciary media. Instead, he concludes that the only way to eliminate business cycles and inflation is to "suppress all further issue of fiduciary media." Only this, he says, will create the necessary safeguards. Finally, in his 1952 epilogue to The Theory of Money and Credit, he offers a detailed plan for a 100 percent backing for future increases in bank notes and deposits.
Also, it is important to recognize that Mises didn't think free banking would evolve toward a small reserve ratio of gold to liabilities. With real competition, Mises predicted, evolution would be in the opposite direction, toward 100 percent reserves, as bankers swiftly learned that any increase in fiduciary media would leave them open to bank runs and insolvency. In the balance, then, he was more of a Rothbardian than a Whiteian on the fractional-reserve question.
AEN: What are your strongest criticisms of the free banking/fractional-reserve position?
SALERNO: That any increase in the supply of fiduciary media brings about the business cycle. The free bankers have gone to great lengths to get around this point.
Also, the contagion effect--the tendency of bank runs to spread--has doomed fractional-reserve systems throughout history. As bank after bank falls, it creates the illusion that central banking is necessary to correct for a supposed "market failure." But under a 100 percent reserve system, there is no instability and no contagion effect. Bank runs have no macroeconomic consequences.
AEN: But we have fractional reserves now and the system is not plagued by runs.
SALERNO: Today's fractional reserves are a fiction of accounting, and don't exist in fact. Because of deposit insurance and the Feds power to create new money, the public correctly perceives that all deposits are guaranteed at face value. Deposits are in fact risk-free claims to currency. That means we effectively live under 100 percent reserves. If we did away with deposit insurance, we'd be better off in the long run, but the present system would quickly collapse.
AEN: You devote an enormous amount of time and energy to the Review. Is it a good investment?
SALERNO: The Review has really enhanced the prospects of the Austrian School. It has world-wide circulation. It has stimulated new interest among new people. It has provided an outlet for Austrians to get their articles published.
AEN: Why is that important, versus trying to sell articles to mainstream journals?
SALERNO: When you court the mainstream, at best, you can insert a few watered-down Austrian points while working with mainstream theoretical tools. You build up intellectual capital in this, and as the investment grows, it becomes more difficult to give it up. Before you know it, you're no longer doing Austrian work.
There must be a journal that encourages talking about and writing in the Austrian tradition. In the absence of the Review, there would be some independent interest among European Hayekians. But debate would degenerate into speaking about Austrian economics in terms of the history of thought, rather than as a living body of theory as it is discussed now. That's crucial. Austrian theory must advance or it will die.
AEN: Then there's the practical question of whether this will help anyone's career.
SALERNO: It's no longer true that being an Austrian is a career killer. The profession is in such transition that good economists of any stripe can do well. Of course, you're always better off echoing the mainline opinion. But Austrians are in this for more than professional success.
We are Austrians because we are interested in the truth. Sometimes that requires sacrifice. Menger sacrificed, as did Mises, and Rothbard, and many other seekers of truth in political economy. The point is to change history for the better, not merely to go along.
Mises wrote in Human Action that a good economist is always telling government officials what they dont want to hear. They should think of us as the bearers of bad news. I'd rather do almost anything else in life than be an economist who gives comfort to the powers-that-be.
AEN: Do you get the sense that younger Austrians agree?
SALERNO: Not only that, it is the very radicalism of the school that attracts today's best students. Think of it. Here we are in Auburn, Alabama, in August, and the conference is packed. To be sure, this is a nice town. But these students--some of the best I've encountered--could be doing anything else with the last of their summer weeks.
Instead they are competing to spend a grueling training period with us, and most of them get no credit on their transcript for doing so. What drives them? It's the sense that something is gravely wrong in the world, and that Austrian economics offers answers for doing something about it. They want to be involved. The mainstream does not inspire this kind of attitude. That is one reason we stand a good chance of winning this battle for true economic science and the future of liberty generally.
AEN: Any hints of future controversies in forthcoming issues of the Review?
SALERNO: Actually, they're a secret, locked in a file cabinet. And only the managing editor has the key. But I will give a hint: an extremely prominent neoclassical economist has blasted one of the editors. He pulls no punches. And that's just the way it should be.
Booms and busts are brewing in the real economy, but computers that can quickly solve math problems won’t tell you much about how business cycles work, writes Jonathan Newman. This audio Mises Daily is narrated by Allan Davis.
Volume 1 (Spring 1979)Lawrence H. White
In the penultimate section of his paper on "Spontaneous Order and the Coordination of Economic Activities,"[1] Gerald O'Driscoll performs a valuable service in bringing into the open a controversy, sparked by Professor Lachmann's thought, which has arisen in Austrian circles over the question of general equilibration. It is evident (especially within these same circles) that further clarification of the issues involved is required before a satisfactory avenue for resolution of this dispute can be found.
The basic question which has been raised regarding general equilibration is: to what extent does there exist a tendency toward an overall equilibrium of an economy of interconnected markets? To formulate an acceptable, answer to this question we must clearly specify at least three items: (1) the meaning given to "tendency" in this context; (2) the temporal perspective (ex ante or ex post) from which market processes are viewed, and (3) the particular conception of general equilibrium employed. There has been misunderstanding among the disputants on all three items. I shall briefly?undoubtedly too briefly?deal with each of these items in turn.
(1) The notion of a "tendency toward an overall equilibrium" has been infelicitously interpreted (by me no less than by others) as a process of movement which would, under specified conditions, eventually allow an economy to reach general equilibrium. Hayek noted years ago that "tendency" in this context is better interpreted as the likelihood that the configuration of an economy (particularly its array of prices) will be near to a general equilibrium configuration.[2] Under this interpretation no contradiction exists between the denial that general equilibrium (or complex ex ante coordination of plans) could ever be brought about in a real-world competitive economy and the affirmation that such an economy harbors a strong tendency toward an overall equilibrium. "Equilibrating forces" which possess the capability of maintaining an economic system at a high level of coordination may yet inherently lack the capability of bringing about perfect coordination.
The problem of specifying market conditions and forces sufficient to usher in the reign of perfect and final equilibrium seems ultimately insoluable, for there is a simultaneity problem involved with having each market participant finally adjust his own activities to accord with the market signals to be generated by the activities of all others. The market signals by which he orients himself must already embody the decisions taken by all others before any one agent can act in a sufficiently informed manner. Perfect foresight would allow agents to overcome the simultaneity problem, but only because perfect foresight would place them already in Hayekian general equilibrium. It would not allow a process by which they might reach that state. Imperfection of foresight forms an impassable moat around the kingdom of perfect harmony. We may nonetheless attempt to specify the essential characteristics of an overall equilibrium, as Hayek had best begun to do,[3] and to use that kingdom as an analytical point of reference in assessing the likelihood (tendency) for an economic system to be in its general vicinity (i.e. for the variables of the system to be approximately at equilibrium values) under specified circumstances.
(2) Austrian economists are in general agreement with the proposition that market forces must be traced back to the plans of market participants, particularly the plans of entrepreneurs. Analytical differences arise over whether emphasis is to be placed on the expectations and decisions in which plans originate (an ex ante perspective) or on the experience the testing of plans provides (an ex post perspective). It seems to me that both perspectives are necessary for the analysis of dynamic economic processes, and that neither should be allowed to eclipse the other permanently.
Lachmann has taken primarily an ex ante perspective, stressing the role of expectations and the pervasiveness of uncertainty in future-oriented decision-making. Yet he has also noted that expectations are "largely the result of the experience of economic processes."[4]
In serial expectational processes learning is possible, provided the sequence of decision, action, result, and interpretation takes place with speed sufficient to outrun significant changes in the objective circumstances. Learning can play an important role in providing accurate foresight and coordination of the decision-maker's (amended) plan with the plans of other market participants. Only in autonomous or unique expectation, where the decision made is unprecedented and can or will never be repeated under similar circumstances (this is the case where the taking of the decision itself significantly and irretrievably alters the circumstances), can learning play no equilibrating role. Only with regard to unique expectation can the ex post perspective be neglected.
Kirzner's focus on the pure arbitrage aspect of successful entrepreneurship amounts to the adoption of an exclusively ex post perspective, as success can be ascertained only ex post. This perspective obscures the uncertainty (surrounding future prices) faced by producer-entrepreneurs.[5] To say that intertemporal opportunities for pure profit "tend to become discovered" by "alert" entrepreneurs[6] is to slur over the fact of uncertainty, suggesting by the choice of terminology that entrepreneurs can see clearly into some aspect of the future. It is to suggest that the adoption of entrepreneurial plans depends upon knowledge of their actual outcomes (knowledge which in fact can only be gained in the future) rather than on expectations about their outcomes. Profit is then seen as the reward not for superior foresight, as Mises viewed it,[7] but for the discovery of a piece of knowledge which others lack.
(3) Kirzner's readiness to accord opportunities for profit a seemingly objective status conforms with his use of an equilibrium concept embodying Pareto-optimality.[8] The Hayekian conception of dynamic equilibrium is more appropriately subjectivist in carrying no requirement that every would-be useful fact be known to each market participant and thus carrying no requirement that optimality from the viewpoint of an omniscient observer be achieved.[9] Lachmann has framed his discussion exclusively with reference to neo-Walrasian models of temporary general equilibrium. That he (rightly enough) finds the world of these models inconceivable says little by itself about the analytical fruitfulness of the Hayekian dynamic equilibrium or the Misesian evenly-rotating economy, and says even less about the possible tendency (properly understood) of a market economy to approximate the Hayekian sort of overall equilibrium.
One final comment: O'Driscoll expresses concern that Lachmannian skepticism toward general equilibrium involves a weakening of the case for the market system. With regard to a case based on Paretian welfare considerations this may well be true, but defenders of the market system should already be wary of arguments which claim too much. The "failure" of the market system to conform to a neo-Walrasian model which strips it of essential attributes may be regarded as reflecting poorly on the model rather than on the market system, and this is the attitude which I believe Lachmann to be taking. In a world of ignorance and uncertainty, the virtue of spontaneous order lies not only in promoting uniformity in the coordination of plans, as the neo-Walrasian complete-knowledge model of the state "perfect competition" would suggest, but also in encouraging diversity in the exploration of possible new opportunities.[10]
[1] Gerald P. O'Driscoll, Jr., "Spontaneous Order and the Coordination of Economic Activities," in Louis M. Spadaro, ed., New Directions in Austrian Economics (Kansas City: Sheed, Andrews and McMeel, 1978), pp. 128-34.
[2] Friedrich A. Hayek, The Pure Theory of Capital (Chicago: University of Chicago Press, 1941; Midway Reprint 1975), p. 27 n.2.
[3] Hayek, "Price Expectations, Monetary Disturbances and Malinvestments" in Profits, Interest and Investment (London: George Routledge & Sons, 1939; Augustus M. Kelley Reprint, 1975), pp. 137-41; "Economics and Knowledge" in Individualism and Economic Order (Chicago: University of Chicago Press, 1948; Gateway Edition 1972), pp. 33-56; The Pure Theory of Capital, pp. 14-28.
[4] Ludwig M. Lachmann, "The Role of Expectations in Economics as a Social Science" in Capital, Expectations, and the Market Process (Kansas City: Sheed, Andrews and McMeel, 1977), p. 66.
[5] White, "Entrepreneurship, Imagination and the Question of Equilibration," unpublished ms. presented at the Austrian Economics Seminar at New York University (March, 1976), p. 3. For Kirzner's account of entrepreneurship see Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), esp. pp. 1-19 and 37-43.
[6] Kirzner, "Hayek, Knowledge, and Market Processes," unpublished ms. delivered at the Allied Social Science Association meetings in Dallas, Texas (1975), pp. 28-29.
[7] Ludwig von Mises, Human Action, third revised edition (Chicago: Henry Regnery, 1966), p. 871. For an acknowledgment of the difference between his own emphasis and that of Mises, see Kirzner, Competition and Entrepreneurship, p. 86.
[8] Kirzner, Competition and Entrepreneurship, p. 26.
[9] Hayek, "Economics and Knowledge," p. 53.
[10] See Brian J. Loasby, Choice, Complexity and Ignorance (Cambridge: Cambridge University Press, 1976), pp. 170, 191- 92.
Volume 21, Number 4 (Winter 2001)Dr. Alexander Kouryaev is interviewed about his translation of Human Action to Russian as well as Marxism in the USSR.
Volume 1, Number 2 (Spring 1978)Gary G. Short discusses the conference, Issues in Economic Theory: An Evaluation of Current Austrian Perspectives, which occurred on January 7-8, 1978 at New York University.
Volume 1, No. 2 (Summer 1998)To decide whether an undertaking is sound we must calculate carefully. —Ludwig von Mises, SocialismThe socialist calculation debate has been prolonged, contentious, and often confusing (Vaughn 1980; Yeager 1997). Few issues in economics are more important, yet our understanding remains muddled, judging by the work of prominent mainstream theorists (e.g., Stiglitz 1994; Roemer 1994), as well as the debate in the Austrian tradition over the dehomogenization of Mises and Hayek (Salerno 1993, 1995; Yeager 1997).If a common opinion prevails within the economics profession today, it may be that socialism is unworkable in practice but cannot be rejected on logical grounds as inherently destructive and inefficient. Some economists may not have strayed very far from Schumpeter’s faulty assessment (1954, p. 989) nearly a half century ago:
so far as its pure logic is concerned the socialist plan makes sense and cannot be disposed of on the grounds that it would necessarily spell chaos, waste, or irrationality. . . . There exists a determined set of solutions of the equations that can be realized by the method of “trial and error.”[1]
Contemporary economists and the general public are heavily influenced by the collapse of the Soviet Union and its former captive states in Eastern Europe, a deadly historical experiment.[2] Yet the failure of self-proclaimed socialist states is not strictly relevant to the question of the ability of socialism to achieve given ends economically. Why? Because state planners, just as entrepreneurs, capitalists, and everybody else, had access to real money prices to calculate low cost means to achieve their given ends (Mises 1963, pp. 698–99; Rothbard 1991, pp. 73–74). Like the U.S. Postal Service and other state bureaucracies operating in world markets, Soviet planners could borrow market prices to calculate the cost of alternative processes. A true test of socialism’s ability to economize would be far more demanding than that faced by twentieth-century socialist planners, since the system would have to find cheap ways to do things in a world without markets for capital goods.Mises (1981) was the first economist to isolate the fatal flaw in socialism at the deepest level—socialist economy is impossible because no human director in such a system could possibly find (“calculate”) the cheapest way to accomplish any given project among the infinite variety of ways to do the job. Without market prices to evaluate the opportunity costs of resource use in terms of final consumption goods, planners could not tell how best to produce outputs, nor consequently which outputs to produce. Mises’s theorem is a deeper if narrower point than Hayek’s subsequent elucidation of the “knowledge” problem. While Hayek performed a valuable service by pointing out that the immense amount of relevant data, dispersed among the population as it is, could not possibly be reliably assembled at the center, I believe that impartial observers will ultimately conclude that Hayek’s contribution is not on an intellectual par with Mises’s theorem. Hayek’s observation is one of the many reasons (incentive failures, coordination failures, etc.) that socialism cannot possibly work as well as a capitalist economy.[3] Hayek’s focus on the decentralized nature of human knowledge complements but does not replace or substitute for Mises’s breakthrough.Mises used the standard ceteris paribus approach of scientists to deduce his theorem. Mises was willing to suppose that all the production data known to every human being on earth could be assembled accurately at the center every day; even under this fantastic assumption, conceded to proponents of socialism for the sake of argument, he argued that the director still lacked a means to discover the cheapest way to accomplish his purposes; all he would have is statements “unrelated to each other. There is no means of establishing any connection between them” (1963, p. 698). Thus, there is no way to list the lost value in terms of goods ready for consumption for each method adopted.The failure of economists to clearly grasp and appreciate Mises’s proposition implies a serious defect in the profession’s understanding of the work performed by the price system, as well as of the gross inferiority of the substitutes available to replace its functions upon disabling it, wholly or partially. Apparently Mises, despite his best efforts, did not bare the fundamental flaw in socialism clearly enough for the profession to see it. The gravity of the situation is suggested by Paul Craig Roberts’s assessment (1990, p. xxvi) that “If we do not learn the lessons, the twentieth century will have been lived in vain.” The preeminent issue of our century has been capitalism versus socialism—the decentralized market economy versus centralized political direction of resources.The purpose of this article is to restate and clarify what Mises meant and to defend Mises’s conclusion against some of the challenges hurled against it. One article cannot refute all the fallacies surrounding the calculation or economizing issue, but it can recast the impossibility theorem and refute some of the key misunderstandings. I disclaim originality, but by resorting to first principles I hope I can contribute to our knowledge by amplifying and restating, much as Salerno (1993) and Rothbard (1991) have done, so that more economists understand why economy is impossible under concentrated or common “ownership” of the means of production.[4]
Preliminaries on Economics and OwnershipSo much confusion surrounds the socialist calculation debate that we had best start at the elementary level. Principles textbooks in economics claim that an economic system grinds out answers to three implicit questions: What?, How?, and For whom? Agreed. Which question, then, is the focus of the calculation debate? It is the “How” question, plain and simple. All else is secondary.Economy of means, after all, is the principal occupation of economists. How does Mises handle the other two questions? In effect, he is willing to drastically simplify and put these questions aside by positing that only “one will acts.” Despite socialism’s grave problems with the What and For whom questions, then, they are answered by the planner’s preferences, by assumption. Regarding the director’s preferences, Mises correctly asserts, “As a rule, anyone in possession of his senses is able at once to evaluate goods which are ready for consumption” (1981, p. 98). Again, the only issue is how can socialism find the cheapest way for the planner who wants to build a house, build and equip a cannery, or liquidate undesirables. It must accomplish something at the smallest lost (subjective) value of production in goods ready for consumption elsewhere for each possible method.We must also agree on a few institutional preliminaries. A prerequisite for the exchange of scarce goods and services is effective control (ownership or the right of disposal) over them by two or more potential trading partners. Such dispersed control over commodities (de facto, if not de jure) must exist for markets to operate. This necessary condition is true regardless of what legal arrangements might exist at a time and place.[5]Modern property-right theorists recognize that the efficiency of an economy (populated by human beings as we know them) depends on the institutional rules or property rights structure. Ownership is intimately connected with rewards or incentives, and therefore with individual actions and both individual and collective prosperity. A laudable feature of the Communists has long been their recognition of the primordial importance of property (compared to the tone deafness of many economists); as Marx and Engels expressed it in their celebrated Communist Manifesto: “The theory of the Communists may be summed up in the single sentence: Abolition of private property” (Tucker 1978, p. 484).
Mises’s Theorem: If No Entrepreneurs and Market Prices, Then No EfficiencyThe next order of business is to define socialism. Socialist writers and reformers have had many items on their agendas. To paraphrase Maurice Dobb, central planning means the abolition of markets or it means nothing. The most ambitious version has been called communism because it would effectively abolish money, private property and all trade in consumption (lower-order) goods, intermediate (higher-order) goods, and all factors of production, including labor. Markets would be replaced wholesale by central command. Many socialist writers have called this the “natural economy,” meaning a non-monetary, in-kind system without exchange. Less ambitious forms of socialism presumably seek an incomplete ban on private property and trade for a subset of commodities, namely, the so-called means of production we define as capital goods, including land, in favor of “socialism” in such means of production. Presumably money, property, and trade would continue to be allowed in labor services and goods ready for consumption. The exact ownership of intermediate commodities and goods in process is left unclear in socialist writings, but presumably these are socialized.To clarify the definition of socialism, Mises (1963, p. 695) wrote, “The essential mark of socialism is that one will acts. It is immaterial whose will it is. . . . The main thing is that the employment of factors is directed by one agency only.” This is consistent with the pervasive theme in Marx, socialists. As Engels said, socialist men “with full consciousness, will fashion their own history” and manage everything very simply, like a single workshop or factory (Roberts 1990, p. 14). The idea of planning, of course, grew from the socialists’ desire to abolish private property and the anarchy of the market system, and replace these with “science” applied to society.On the eve of the Communist coup in Russia, Lenin wrote in August 1917, that
to organize the whole national economy on the lines of the postal service. . . all under the control and leadership of the armed proletariat—this is our immediate aim. This is the state and this is the economic foundation that we need. (quoted in Roberts 1990, p. 28)
Surprisingly, Lenin wrote with some insight about the calculation failure of socialism before abandoning his effort to institute it in March 1921:
The difference between socialization and simple confiscation is that confiscation can be carried out by “determination” alone, without the ability to calculate and distribute properly, whereas socialization cannot be brought about without this ability. (quoted in Roberts 1990, p. 31)
Let us frankly admit our complete inability to conduct affairs, to be organizers and administrators. . . . If we are to be absolutely definite, we must know exactly what we are going to do over the year ahead. Who knows that? No one. (quoted in Roberts 1990, p. 35)
To solidify our understanding of Mises’s theorem, consider the following compact restatement. All of the following systems of socialism are identical in their key feature, namely, centralized control of the means of production: isolated socialism, universal socialism, isolated communism, universal communism, central planning, abolition of decentralized ownership and trade in the means of production, monopoly or concentrated control of inalienable means of production. Specifically, Mises’s theorem is that socialism has the following properties and consequences:1. No monetized trade in capital goods (no transferable rights).2. No money prices for capital goods.3. No money cost calculation of production methods employing capital goods.4. No alternative method of calculating the opportunity costs of various means to a given end in a vast, technically advanced society is possible.5. Only arbitrary (uneconomical, inefficient, socially irrational) allocation decisions remain possible.Therefore, socialism is necessarily wasteful, cannot serve consumer wants, and must be “planned chaos.” Q.E.D.The essence of the theorem—economical action is impossible because the lowest-cost option cannot be figured out—rests on the insight that scarce capital goods go unpriced under isolated socialism. With apologies to economists who already fully understand Mises’s theorem, Appendix A offers a numerical illustration. In socialism’s quest to free workers from the domination of private capital in favor of “empowering” them through socializing capital, socialists (inadvertently) abolish the possibility of cost calculations and therefore the ability to economize. As Milton Friedman might observe, in their normative obsession with “equality,” socialists overlook the paramount normative function served by the price system, namely, productive efficiency (Friedman 1976, pp. 197–98). Without the ability to calculate the cost of alternative production techniques, disaster looms. And Mises rightly and courageously insisted that no one has proposed a credible alternative to replace capital markets.No one can deny steps 1, 2, and 3 of the theorem; in fact, these historically have been among the basic objectives of socialists. Rational socialists (those aware of the problem of economy in resource use) must attack step 4. They must show how a real human being can figure out the lowest cost means without the aid of real prices generated by private entrepreneurs bidding for the use of assets.[6]The action in Mises’s theorem centers on step 4 of the restatement. Mises explains that this crucial step rests on two real-world features, namely, complexity and change, with the major emphasis on complexity. In effect, Mises (1981, p. 98) concedes that socialism can work (economical choice) without market prices for capital inputs if the choice problem is primitive enough. Consider this key quotation:
As a rule, anyone in possession of his senses is able at once to evaluate goods which are ready for consumption. Under very simple conditions, he should also have little difficulty in forming a judgment upon the relative significance to him of the factors of production. When, however, conditions are at all complicated, and the connection between things is harder to detect, we have to make more delicate computations if we are to evaluate such instruments. Isolated man can easily decide whether to extend his hunting or his cultivation. The processes of production he has to take into account are relatively short. The expenditure they demand and the product they afford can easily be perceived as a whole. But to choose whether we shall use a waterfall to produce electricity or extend coal mining and better utilize the energy contained in coal is quite another matter. Here the processes of production are so many and so long, the conditions necessary to the success of the undertaking so multitudinous, that we can never be content with vague ideas. To decide whether an undertaking is sound, we must calculate carefully.
At the risk of confusion, perhaps a mathematical metaphor can illuminate Mises’s meaning: we can solve very simple mathematical problems in our head but we can only solve complicated mathematical problems with the aid of pencil and paper (writing tools). In the former case, we can mentally embrace the whole problem without calculation aids while in the latter case our grasp stumbles over the many steps to solution and we require aid. Similarly, the hunter-gatherer once figured out simple allocation problems without market prices for capital goods because the decision maker succeeds “in reducing all elements in the computation to such commodities as he can evaluate immediately, that is to say, to goods ready for consumption and the disutility of labor” (Mises 1981, p. 98). Such successful intuition is impossible with lengthy and roundabout processes of production.
In the narrow circle of a closed household, where the father is able to supervise everything, he may be able to evaluate alterations in methods of production without having recourse to money reckoning. For, in such circumstances, production is carried on with relatively little capital. Few roundabout methods of production are employed. As a rule production is concerned with consumption goods, or goods of higher orders not too far removed from consumption goods. Division of labor is still in its earliest stages. . . . It is possible to survey the whole process of production from beginning to end. It is possible to judge whether one particular process gives more consumption goods than another. But, in the incomparably more complicated conditions of our own day, this is no longer possible. (Mises 1981, pp. 101–2)
So Mises’s argument boils down to the fact that the length and complexity of production relations changes the whole character of the problem. Without reliable calculation of the opportunity cost of resource use in terms of goods ready for consumption, economical choices are impossible (economy is impossible). And the only way it can be achieved is with the “aid” of the action of all in a market system. Capitalism integrates all goods, not just those ready for consumption, into a vast exchange network using a general medium of exchange. Clearly, it works pretty well, although certainly not perfectly. “True, money calculations are incomplete,” writes Mises.
True, they have profound deficiencies. But we have nothing better to put in their place. And under sound monetary conditions they suffice for practical purposes. If we abandon them, economic calculation becomes absolutely impossible. (Mises 1981, p. 105)
ObjectionsMises’s challenge to socialists is clear: Socialism can answer the “what” and “for whom” questions of economics based on one person’s preferences (who couldn’t?), but it has no means to figure out how to operate in a remotely efficient manner. Confronted with the director’s desire to build a dam, it cannot calculate the list of lost production of consumption goods elsewhere in the system for each possible method of dam construction. Which method would least decrease valuable production elsewhere? None of the engineering reports and inventories of resources gives “him any clue to the solution of this problem” (Mises 1963, p. 698). The possibilities are endless, and the planner is clueless. Concrete assignments of inputs to production processes (and more or less continuous reassignments in accord with changing conditions) must be nothing but arbitrary. As Mises wrote: “It is just a system of groping about in the dark. There is no question of a rational choice of means for the best possible attainment of the ultimate ends sought. What is called conscious planning is precisely the elimination of conscious purposive action” (1963, pp. 700–1).Socialists and mainstream economists ignored or scoffed at the Mises theorem in the 1930s and 1940s. Some economists, however, seriously tried to suggest ways around the devastating problem raised by Mises. None of the alternatives succeeded in showing how an ordinary acting mortal could calculate costs (economize) without real prices for capital goods. None of the (shadowy) alternatives proved remotely valid compared to the scarcity prices continuously generated and regenerated in the market system, though many fervently wished at least one would have proven cogent. Mises refuted many of the socialist rejoinders (1963, pp. 703–15), but apparently without persuasive success.
Fixed Factor ProportionsOne reply to Mises is to define away or trivialize the economic problem of choice among the infinite number of lengthy and roundabout techniques. If there is only one method available to produce each consumption good, then there are no serious choices of input proportions to be made (in the glib terms of mathematics, locationless and individual-less right-angle production isoquants in two-input space, or more generally, fixed production coefficients). The socialist planner need only choose a combination of consumption goods based on his subjective valuations because of the simple structure of production. Economic calculation of lowest cost means is rendered unnecessary in such a primitive economy because the connections between consumption goods and production processes are unique by assumption.Since the abandonment of Ricardian economics, few economists believe that the world is characterized by zero input choices (Sraffa, 1960, is the famous exception). Instead, most would probably agree with Mises that
the present state of technological knowledge makes it possible to produce almost anything out of everything. . . . The only reason why the synthetic production of drinking water today . . . is out of the question is that economic calculation in terms of money shows that it is a more expensive procedure than other methods. (1963, p. 699)
Mises (1963, p. 712) correctly adds, “We must take into account real conditions.”
Stationary ConditionsAnother way to define away the problem of choice of the cheapest production process is to argue that society moves from private capital ownership to socialism without further change in economic data. Then activities can merely repeat themselves, relying on the previous economies discovered by capitalism. This scenario, of course, assumes that the ruler does not wish to alter the demand for goods ready for consumption, which generally would change the value of inputs and therefore the cheapest process. Mises’s theorem still stands. The changeless society envisioned by socialists is impossible.[7]The notion of stationarity has an inkling of empirical relevance for traditionally static societies, as well as the twentieth-century socialist states, where central planning is basically reduced to annual goals of 10 percent more of everything. Nonetheless, the changeless society is a pipedream, if only because of the renewal problem for depreciating (aging) capital goods.
Simulated MarketsThis possibility departs drastically from the spirit and sentiment of most socialist speculation. Economists defending neosocialism imagine an isolated central authority that is denied real market prices for capital goods and services but who can rationally figure out least-cost processes by knowing scarcity “shadow” prices of capital goods. Socialism would only involve the elimination of real capital and financial markets. Private-ownership rights in capital disappear but the relative efficiency of capital allocation actually achieved does not suffer and may even improve.In this imaginary world, newly selected or established non-entrepreneurs, non-capitalists, non-promoters, non-speculators, and non-business managers supposedly continue their exertions as if the consequences of their actions were capitalized into their wealth, but know full well that the resulting profits and losses are delivered entirely to the agency of the commonweal.[8] Through the operation of these toy markets, neosocialism discovers non-arbitrary scarcity prices of capital services: the pretended buying and selling of pseudo-entrepreneurs and pseudo-capitalists operating with fictive coupons generates the necessary price information. Although no personal wealth consequences affect these ever-alert traders, they behave in the same way as if their own futures depend on the outcomes of these transactions.The absurdity of this proposal is transparent. First, it must be deeply disappointing to real socialists since it concedes Mises’s point: socialists cannot find least-cost production processes without capital markets. The scheme has nothing to do with socialism as originally conceived. As Polanyi (1951, p. 125) observes, “Modern Socialist theory, by adopting the principles of commerce, has quietly abandoned the cardinal claim of Socialism: the central direction of industrial production. . . . Oscar Lange (1938) makes no reference to planning in the proper sense.” Second, such behavior is unfamiliar in human history. Imaginary creatures devote their energies to selfish capitalist simulations because of their selfless devotion to the neosocialist state. Ironically, the lack of entrepreneurs and capital prices under neosocialism is remedied by selfless pseudo-entrepreneurs and pseudo-capitalists recruited (evaluated and re-selected how?) to avoid the irrationality of socialism.[9]The Mises theorem is reaffirmed again. Socialism cannot generate the necessary capital prices via simulations played out by people as we know them. How can socialists escape Mises’s iron vise? They could argue that socialism would work in a world composed of a special breed of new “socialist men and women” who selflessly re-enact the despised profit-seeking exertions of entrepreneurs and capitalists, thereby generating reliable capital prices. This vision would seem to attract few revolutionaries. In any event, the Mises theorem applies to humans with all our limitations, not extra-terrestrials.
Supercalculator (Shadow Prices)Mathematicians and mathematical economists believe that they can represent the planner’s problem and solution mathematically, and some also believe that they can make their representations relevant for real-world action. While the former has a modest element of truth, the latter is false. The idea turns out to be a blind alley, perhaps confirming for some observers the limitations of the mathematical approach to acting man.[10] Ultimately, the mathematical programming approach leads away from real-world economics into theology.The mathematical approach rests on the claim that economic problems are problems of maxima and minima. Economics, then, is thought to be a playground for mathematics, though the technique never achieved the results that it did in mechanics.[11] As Mises (1963, p. 350) points out “The better method would prove its preeminence by bringing about better results.” A major reason for the scientific failure of mathematics to improve our understanding of socialism has been its drive for both “simplicity” and “greater generality” (Debreu 1991, p. 4). Extending the number of goods and techniques from two or three with short processes, and with all the possibilities omnisciently known as might be approximated by an intrafirm transfer pricing problem, to 10100 lengthy, roundabout processes and mostly unknown interconnections, is deftly handled by a mere change in notation. Yet it is not merely a change in degree indicated by a change in notation but a change in order of magnitude so enormous that the problem is virtually different in kind. To believe otherwise is to succumb to the simplicity deceit of mathematics. As Polanyi (1951, p. 126) put it, can a cat swim? Yes. Can a cat swim across the Atlantic Ocean? No, it is strictly impossible.It is possible, of course, to describe the imaginary state of general equilibrium (the evenly rotating economy) or an optimum in terms of differential equations and visualize it in curves. But these are imaginary limiting conditions that say nothing about concrete choice, action, process, and reality. They are a “merely auxiliary construction of theoretical analysis which does not play a role in real action” (Mises 1963, p. 378). Equations and inequalities are only “useful in describing the timeless, static, never-never land of ‘general equilibrium’” (Rothbard 1973, p. 47). The real world has properties like sooner and later, cause and effect, and irreversibility of events (“path dependence”) among its vital constituents. Functional correspondence is a poor substitute for these logical categories, literally abandoned by the mathematical approach.What does mathematical activity analysis propose? It sets up the problem with three ingredients: a preference or valuation function over all goods ready for consumption, a complete inventory of available resources (presumably including all consumption goods relevant for production processes—“Leontief constraints”), and all production coefficients (the allegedly unique maximum output level associated with each conceivable production process). Granted, given enough mathematical assumptions about tractability (convexity, etc.) and data, this setup allows the socialist planner to know the impact of all (billions upon billions) conceivable factor assignments on lower order outputs and to choose a preferred combination on this hyperplane or frontier.In terms of real application, a practical person might dismiss the entire approach as naive or absurd. A more sympathetic observer might reply that some mathematical economists have gained realistic insights into the price system from this setup. Hicks, for example, says
the new [mathematical] methods are a great advance upon the old in the understanding which they convey of the raison d’être of the price mechanism. The rather inappropriate mathematical methods, which have been employed (at all levels of mathematization) by the school of Cournot and Walras—and of Marshall—did in this respect rather let us down. For they caused it to appear that the price system is just one way of organizing an economy efficiently; that it is, in a sense, exterior to the economic problem, something that is brought in from outside. . . . It has been made apparent, not only that a price system is inherent in the problem of maximizing production from given resources but also that something like a price system is inherent in any problem of maximization against restraints. The imputation of prices (or “scarcities”) to the factors of production is nothing else but a measurement of the intensities of the restraints—such intensities are always implicit—the special property of a competitive system is that it brings them out and makes them visible. It is through its power of developing the intensities (in the photographic sense of developing), so that they are available for use as instruments in the process [italics mine] of maximization, that the competitive system does its job. (1966, pp. 110–11)
Hicks might have added that the “intensities of the restraints” or shadow prices (“imputed value”) for all inputs cannot be calculated in practice by a socialist planner for a complex system with vast and lengthy production interrelations. Instead, he erroneously remarks, “One is driven to the conclusion that Linear Programming and the price mechanism are rather close substitutes—both in the things they can do and in those they cannot” (Hicks 1966, p. 99). As Pareto wisely observed in a related context, the purpose of mathematical economics cannot be “to arrive at numerical calculation of prices” because it would be “absurd” to assume that we could ascertain the data (Hayek 1989, p. 5). Of course, even if we had the data, Mises has demonstrated that there is no way for a human being to figure out the scarcity values of the means of production in a complex system.Despite his mathematical sophistication, Hicks was merely rediscovering Menger’s fundamental insight about derived or imputed value from a century earlier:
The value of goods of higher order is therefore, in the final analysis, nothing but a special form of the importance we attribute to our lives and well-being. . . . But due to the causal connections between goods, the value of goods of higher order is not measured directly by the expected importance of the final satisfaction, but rather by the expected value of the corresponding goods of lower order. (Menger 1976, p. 152)
Only a market system can achieve this coherent set of value interconnections among goods. As the late political scientist Aaron Wildavsky shrewdly noted (quoted in Roberts 1990, p. xv): “The effort of central planners to determine hierarchies of importance is hopeless.”Programming as a guide to efficient choice can only work for small, closed problems with small numbers and short, simple production processes (e.g., diet or transportation choices). But this conclusion about the successful scope for programming is entirely consistent with Mises’s contention that an isolated household can solve such simple problems tolerably well without market prices for capital goods. Therefore, the modest successes of mathematical programming are not contrary to Mises’s impossibility theorem. In addition, the existence of a solution or equilibrium condition (optimum) to a vast problem, even if obtained, would tell the dictator nothing about the most appropriate action (cost-minimization) in new circumstances. That is, an equilibrium assignment tells the director nothing about what to actually do next.To clarify further, Mises asks whether any mortal, equipped with the capacities of the human mind, would be up to mastering the following problem:1. The socialist planner has all the technological knowledge of the age at his disposal in the form of a crowd of experts and voluminous reports piled up in his office.2. He also has a complete inventory of all the material means of production, down to exact locations, and the amounts of usable labor available from another crowd of experts and reports stacked up in his office.3. He wishes to maximize his own satisfaction, which depends on outputs.The planner must decide what orders to execute to achieve the highest satisfaction. As Mises states,
He must choose among an infinite variety of projects in such a way that no want which he himself considers more urgent remains unsatisfied because the factors of production required for its satisfaction are employed for the satisfaction of wants which he considers less urgent. (1963, p. 696)
Could a mere mortal, unaided by market prices for capital goods, solve this calculation problem? Mises answers “No.” The socialist planner cannot know what specific actions will accomplish his ends efficiently. There is no known substitute for the system of money prices, the product of a kind of intellectual division of labor all over the globe, in order to achieve an acceptable degree of economy of means, whether the alternative has been proposed by socialists, Communists, mathematical economists, or Roman Catholic Bishops. This is especially true since Mises (1981, p. 121) rejects treatment of the choice problem as a conventional, static (timeless) optimization problem:
To use a popular but not altogether satisfactory terminology, we can say that the problem of economic calculation is of economic dynamics: it is no problem of statics. . . . the problem arises in an economy which is perpetually subject to change, an economy which every day is confronted with new problems which have to be solved.[12]
The debate over socialism ultimately raises the question of what economists might mean by costless or “perfect” information, knowledge and calculation. Do they mean that everybody knows and understands everything, past, present, and future? In the limit, omniscience on the part of a mere mortal would mean a complete and universal understanding, a quality theologians might attribute to a Supreme Being but not to humans. Omniscience, as Mises points out, implies that all future events already are unalterably determined. Otherwise, future happenings could not be known with certainty. This creates a logical conflict with a postulate of either individual choice or omnipotence. If the course of events is predetermined, choice by the socialist authority or anyone else is rendered fanciful. Everyone will act in a predetermined way. In this case, the economic problem again has been furtively defined away by a supercomputer device.[13]Mises’s theorem must be accepted for the earthly society in which we live. A vast and complex society with an infinite number of lengthy and roundabout production processes must rely on a real price system for a tolerable degree of economy. And all systems do, in fact, despite extensive political interference with the price system by governments around the world. There is no such thing as a socialist economy, in fact, although it has been seriously tried twice—Soviet war communism 1918–1921 and Cambodia 1975–1979—and in both cases produced chaos and death quickly, lending empirical confirmation to Mises’s theorem (Reynolds 1995, pp. 355–59). When there are no private-property rights in labor, and hence no real markets, colossal waste results in terms of the rulers’ own aims (Anderson and Tollison 1985).
ConclusionRational action requires that a decisionmaker’s goal be worth more than its costs. The expected result must have a value ranked higher than the costs. Socialism is ruinous because it cannot calculate costs and therefore cannot act rationally with respect to goals. It cannot even choose the least-cost method to accomplish a given goal.Those opposed to private property, prices, and commerce have to posit an alternative for the sake of economy. They crave planning, socialism, communism, market socialism, and such visions. Unfortunately for them, their wishes will forever be dashed on the rocks of reality. As Wildavsky (Roberts 1990, p. xv) said, an economic system performs tasks “for which central cognition is inappropriate.” In such a complicated world, altered daily, there is no alternative to real capital markets. Logic and experience in Russia in 1918–21 and Cambodia 1975–79 demonstrate that economizing is impossible without real prices for capital goods. The socialist planner or director cannot solve the problem of how to assign capital goods to those employments in which they render the best service, even if only the planner’s or director’s preferences matter. Mises reached the correct, if neglected, conclusion long ago (1981, p. 113): “Where there is no market there is no price system, and where there is no price system there can be no calculation.” Mass destruction must ensue.Economists are well aware of the inefficiencies of the so-called socialist economies observed in the twentieth century. But these nation-states, in fact, operated decentralized systems, used prices and exchange, and relied on market prices to guide decisions. These socialist governments were not a true test of Mises’s impossibility theorem. Instead, they were (and are) interventionist systems like those in the West, only more so.[14]We can infer from the impossibility of economic calculation under universal socialism that each weakening of private ownership in the means of production (plant closure laws, industrial policy, etc.) moves society further from efficiency and toward poverty and starvation. The irrationality of political assignments displaces economic calculation and value maximization. I cannot offer a general proof here, but note that serious economists continue to call for more central political planning (1977 Nobel Prize winner James Edward Meade 1995) or fixate on various brands of “market socialism” (Archibald 1992; Arnold 1994; Roemer 1994). As Mises (1981, p. 102) warned, “Every step that leads away from private ownership of the means of production and the use of money is a step away from rational economic activity.”Tolerably efficient coordination of human effort is impossible without trade in productive assets (capital markets). There is no demonstrated, superior alternative to Wall Street and the price system. Though most intellectuals recoil from the idea, a logical corollary is that each step away from capitalism is a descent into barbarism, degradation, and irrationality. Experiments in unalloyed socialism have quickly ended in failure. The bones of millions of Cambodians suggest why living human beings will never reach socialism.
ReferencesAnderson, Gary M., and Robert D. Tollison. 1985. “Life in the Gulag: A Property Rights Perspective.” Cato Journal 5 (Spring/Summer): 295–304.Archibald, G.C. 1992. Information, Incentives, and the Economics of Control. Cambridge, U.K.: Cambridge University Press.Arnold, N. Scott. 1994. The Philosophy and Economics of Market Socialism: A Critical Study. New York: Oxford University Press.Bardhan, Pranab K., and John E. Roemer. 1993. Market Socialism: The Current Debate. New York: Oxford University Press.Coase, Ronald H. 1988. The Firm, The Market, and the Law. Chicago: University of Chicago Press.Cowen, Tyler. 1994. “A Reexamination of the Socialist Calculation Debate: A Review Essay on G.C. Archibald’s Information, Incentives, and the Economics of Control.” Journal of International and Comparative Economics 4, no. 3: 243–49.Debreu, Gerard. 1991. “The Mathematization of Economic Theory.” American Economic Review 81 (March): 1–7.Friedman, Milton. 1976. Price Theory. 2nd ed. Chicago: Aldine.Hayek, Friedrich von. 1989. “The Pretence of Knowledge—Nobel Memorial Lecture, December 11, 1974.” American Economic Review 79 (December): 3–7.Herbener, Jeffrey M. 1996. “Calculation and the Question of Arithmetic.” Review of Austrian Economics 9, no. 1: 151–62.Hicks, John R. 1966. “Linear Theory.” In Surveys of Economic Theory. Vol. 3. New York: Macmillan.Hoppe, Hans-Hermann. 1989. A Theory of Socialism and Capitalism. Norwell, Mass.: Kluwer.———. 1996. “Socialism: A Property or Knowledge Problem?” Review of Austrian Economics 9, no. 1: 143–49.Meade, James Edward. 1995. Full Employment Regained. New York: Cambridge University Press.Menger, Carl. [1871] 1976. Principles of Economics. New York: New York University Press.Mises, Ludwig von. 1963. Human Action. 3rd rev. ed. New Haven, Conn.: Yale University Press.———. [1922] 1981. Socialism. Indianapolis, Ind.: Liberty Classics.Polanyi, Michael. 1951.y: Reflections and Rejoinders. London: Routled The Logic of Libertge and Kegan Paul.Posner, Richard A. 1992. Economic Analysis of Law. 4th ed. Boston: Little, Brown.Reynolds, Morgan O. 1995. “The Cambodian Experiment in Retrospect.” In Disaster in Red: The Failure and Collapse of Socialism. Richard M. Ebeling, ed. Irvington-on-Hudson, N.Y: Foundation for Economic Education. Pp. 355–59.Roberts, Paul Craig. 1990. Alienation and the Soviet Economy. 2nd ed. New York: Holmes and Meier.Roemer, John E. 1994. A Future for Sociasm. Cambridge, Mass.: Harvard University Press.Rothbard, Murray N. 1973. The Essential von Mises. Lansing, Mich.: Bramble.———. 1991. “The End of Socialism and the Calculation Debate Revisited.” Review of Austrian Economics 5, no. 2: 51–76.Salerno, Joseph T. 1993. “Mises and Hayek De-Homogenized.” Review of Austrian Economics 6, no. 2: 113–46.———. 1996. “A Final Word: Calculation, Knowledge, and Appraisement.” Review of Austrian Economics 9, no. 1: 111–42.Schumpeter, Joseph A. 1954. History of Economic Analysis. New York.: Oxford University Press.Sraffa, Piero. 1960. Production of Commodities by Means of Commodities. Cambridge, U.K: Cambridge University Press.Stiglitz, Joseph E. 1994. Whither Socialism? Cambridge, Mass.: MIT Press.Tucker, Robert C. 1978. The Marx-Engels Reader. 2nd ed. New York: W.W. Norton.Vaughn, Karen I. 1980. “Economic Calculation Under Socialism: The Austrian Contribution.” Economic Inquiry 18 (October): 535–54.Yeager, Leland B. 1997. “Calculation and Knowledge: Let’s Write Finis.” Review of Austrian Economics 10, no. 1: 133–36.
Appendix A: Socialist Calculation ExampleConsider three methods of producing the same output,
Volume 8, Number 2 (Summer 1987)Johannes Overbeek discusses the life and works of Nicolaas G. Pierson.
A special lunchtime seminar. Recorded at the Mises Institute in Auburn, Alabama, on 22 July 2014. The video discussed during this presentation may be viewed here.
A private seminar for graduate students. Recorded at the Mises Institute in Auburn, Alabama, on 21 July 2014.
The true benefits of the Louisiana and Alaska Purchases are less clear than their value to pro-government propaganda, writes David Howden and Daniel Atienza. This audio Mises Daily is narrated by Keith Hocker.
It is now clear that the Fed and the European Central Bank are hard-wired to inflate the money supply while encouraging banks to make excessively risky loans, writes Frank Hollenbeck. This audio Mises Daily is narrated by Clay Barnett.
Thanks to cheap money and malinvestment, new record-setting skyscrapers are being planned and built as the global fiat-money-induced boom continues, writes Mark Thornton. This audio Mises Daily is narrated by Clay Barnett.
Libertarians must never compromise, even if it means accepting partial victories, writes Murray N. Rothbard. Murray Rothbard (1926–1995) was dean of the Austrian School. He was an economist, economic historian, and libertarian political philosopher.
This audio Mises Daily is narrated by Clay Barnett.
Presented at the 2012 Mises Institute Supporters Summit. Recorded at Callaway Gardens, Georgia, on 26 October 2012. Includes an introduction by Llewellyn H. Rockwell, Jr., and the awarding of the 2012 Gary G. Schlarbaum Prize for Lifetime Defense of Liberty.
When fixing things, I often find myself thinking about economics. All work involves economic considerations, but there are unique aspects of repairing machines that deeply touch the core principles of economics which are inescapable for the troubleshooter.
We employ machines to fulfill our worldly wants, which are without end. Satisfying our infinite desires with our limited means has been called the “fundamental economic problem.” Thomas C. Taylor writes:
Yet despite the comparative abundance of products and services emanating from the process of social cooperation, the economic problem remains: Wants continue to exceed the means or resources for their attainment.
If we look at the contents of any landfill we quickly realize troubleshooting is a stellar example of this “fundamental problem.” Broken machines vastly outnumber the resources to fix them! Given the disparity between the quantity of breakdowns and the means to mend them, the end result is: what gets fixed is subject to a harsh but necessary triage based on people’s most pressing needs. Only the most important systems will be worthy of being fixed.
When a machine breaks down, the entirety of the economic calculation that gave rise to its purchase will be thrown into stark relief. Questions arise. What need was it fulfilling? Is the need still present? If so, what resources will be diverted to fix the machine? Will you choose a cheap, quick fix or go with a more expensive, longer-lasting solution? Or, should the machine be replaced instead?
These issues are always present for the business owner, but they are easy to ignore when a machine is happily humming away. Once a system is installed, people tend to forget about the motives behind its acquisition — that is until a malfunction occurs. Troubleshooting is deeply linked with economics because choosing a course of action demands an answer to the above questions. You can see that, if the original want is to continue being satisfied, an economic decision will need to be made in conjunction with the technical matters of fault finding and correction. In fact, the two influence each other. What is discovered by the troubleshooter informs the economics (i.e., “this is what is wrong and this is how much it’ll cost to fix”) and the economics dictate what is possible for the troubleshooter (i.e., “you have these resources with which to discover the problem and make a repair”).
Scarce ResourcesA wide array of means are available to the troubleshooter: tools, colleagues, consultants, spare parts, manuals, etc. Each of these may be optional, but, as Murray Rothbard has explained, time is needed for all repairs:
A man’s time is always scarce. He is not immortal; his time on earth is limited. Each day of his life has only 24 hours in which he can attain his ends. Furthermore, all actions must take place through time. Therefore time is a means that man must use to arrive at his ends. It is a means that is omnipresent in all human action.
The smart troubleshooter understands the spectrum of possible fixes and what resources each requires. The resolution of opposing forces, the desire for the best possible fix and the limited means to pay for it, is achieved through compromise. This dance is most prevalent in outsourced repair work, like an auto repair shop. The person bringing in his or her malfunctioning machine wants to get it working again by spending the fewest possible resources. Professional troubleshooters have their own incentives: to make a living and to pursue only those repairs that will result in long-term customer satisfaction (and therefore repeat business). This tension is healthy and ensures that both sides are better off from whatever transaction is finally negotiated. Sometimes these opposing forces will not be able to find mutual satisfaction, and therefore a whole spectrum of repairs will never happen.
As a teenager, I ran over a concrete-filled tire rim with my beloved first car. (No one believed me that the rim was knocked loose by the wind and rolled right in front of my car, but that’s what happened.) The collision left a giant hole in my exhaust system. The diagnosis was trivial: the source of the deafening noise that announced my arrival from miles away was obvious. In response, my goals were modest: to shut up that insanely loud car, on a budget of $50, long enough to sell it to another reckless teenager. The repair almost didn’t happen at all: I took the car to every repair shop in the area, explained my modest means, and heard many a derogatory chuckle in reply. I finally found a student mechanic who agreed to make the noise go away for the meager sum I could offer. If I had only $20 instead of $50, or if the damage had been greater, my car would have ended up in the junkyard and been just another example of resources falling short of what’s required to make a repair.
Opportunity CostsWhile troubleshooting, “opportunity costs” are on my mind. In the preface to his book Cost and Choice, James Buchanan illustrates the concept in a hilarious way:
You face a choice. You must now decide whether to read this Preface, to read something else, to think silent thoughts, or perhaps to write a bit for yourself. The value that you place on the most attractive of these several alternatives is the cost that you must pay if you choose to read this Preface now. This value is and must remain wholly speculative; it represents what you now think the other opportunity might offer. Once you have chosen to read this Preface, any chance of realizing the alternative and, hence, measuring its value, has vanished forever.
If you had unlimited time to muck around with a broken machine, then the choices you’d make about how to repair it would mean little. Should I use this strategy or that strategy? Who would care? You’d eventually figure it out, but there’d be no emotional weight to either a brilliant solution or a meandering slog. However, our time to make repairs is limited, as with our other resources. You can’t be turning a wrench, reading a manual, calling technical support, and shopping for a replacement all at once. You must make a choice about what direction a repair is going to take and forgo the rest.
The principles of economics have much to teach the troubleshooter. Scarce fix-it resources constrain and focus decisions about what gets repaired, and how. Being forced to choose amongst the many possibilities for repair or replacement, each with varying costs and risks, means economic matters must be considered hand in hand with technical ones. Finally, always keep in mind the concept of opportunity costs while you troubleshoot: periodically asking “what else could I being doing with my time and money?” will help to ensure that you are always on the most rewarding path.
This article is adapted from an essay at The Art of Troubleshooting.
Interviewed by "Butler on Business" host Alan Butler, Mark Thornton explains the differences between Austrian and Keynesian economics.
From the session on "Studies in Business Cycles," presented at the Austrian Economics Research Conference. Recorded 22 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
From the session on "Applied Economics," presented at the Austrian Economics Research Conference. Recorded 22 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
From the session on "Monetary Theory and Policy," presented at the Austrian Economics Research Conference. Recorded 21 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
Part of the Authors Forum, presented at the Austrian Economics Research Conference. Recorded 21 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
From the session on "Advances in the Theory of Entrepreneurship," presented at the Austrian Economics Research Conference. Recorded 21 March 2013 at the Ludwig von Mises Institute in Auburn, Alabama.
Editor's note: The following is excerpted from the textbook Life of Fred: Pre-Algebra II with Economics by Stanley Schmidt.
"The truth is that the State is a conspiracy designed not only to exploit, but above all to corrupt its citizens." — Leo Tolstoy
"None are more hopelessly enslaved than those who falsely believe they are free" — Johann Wolfgang von Goethe
In 1912, Ludwig von Mises's masterwork The Theory of Money and Credit was published; and to this day, this book is underappreciated. How can this be? After all, in this book, Mises unveiled his regression theorem demonstrating commodity money, such as gold, can have its purchasing power traced back in time to the point where gold was not a medium of exchange. Mises, accordingly, eliminated the conundrum in which the marginal-utility explanation of money demand would merely be a case of circular reasoning; money emerged out of barter and his logic is irrefutable. Mises also laid the foundation for the Austrian theory of the trade cycle, which correctly deduces that economic boom-bust cycles are caused by inflationary bank-credit expansion as enabled by central banks and their governments. While writing The Theory of Money and Credit, Mises was pondering the issue of economic calculation in a socialist state. Per Murray Rothbard,
Mises writes that he was led to consider the socialist calculation problem by his work on The Theory of Money and Credit. Here Mises realized for the first time with keen clarity that the money economy does not and cannot calculate or measure values directly: that it only calculates with money prices, the resultants of such individual valuations. Hence, Mises realized that only a market with money prices based on the evaluations and exchanges of private owners can rationally allocate resources, since there is no way by which a government could calculate values directly. Hence, for Mises his article and book on socialism was part and parcel of the development of his expanded integration of micro and macro, of direct monetary exchange, that he had begun but not completed in The Theory of Money and Credit.Rothbard (1998), pp. 37–38.
Without private ownership in the means of production, economic calculation is impossible. Per Joseph T. Salerno, "a single human mind … would be utterly incapable of determining the optimal pattern of resource allocation or even if a particular plan were ludicrously and destructively uneconomic." For an excellent analysis of Economic Calculation in the Socialist Commonwealth, read Joseph T. Salerno's postscript titled "Why a Socialist Economy is 'Impossible.'" Mises (1990), pp. 51–71. To be sure, the collapse of the USSR demonstrated the harmful, resource-misallocating, and uneconomic nature of the socialist state.
Ludwig von Mises, indisputably, was correct about the inherent irrationality of the socialist state. Because Mises, however, grudgingly believed in the necessity of the state, he did not extend his critique to the irrational essence of the state itself — after all, he believed that government was necessary for providing national defense, courts, prisons, and police protection/security.Mises (1983), p. 27. He did not see free-market solutions emerging in lieu of these state-provided services.
Given the nature of all states, is it not true that government entities are incapable of rationally allocating resources? In a socialist state, an economy cannot emerge due to the impossibility of economic calculation under collective ownership of the means of production, as prices for production goods cannot materialize. Owing to the character of all states, however, it is impossible for bureaucratic operatives to rationally allocate resources, which is due to the impossibility of applying a profit-and-loss test to the operations of the state. Such impossibility arises as a state's revenues are based not on voluntary market exchanges but are based on coercion mostly via taxation. In a world of scarcity, it stands to reason that entities which misallocate resources and destroy capital are fundamentally irrational and undesirable. Any entity that comes into existence based on coercion and theft and then is incapable of rationally allocating resources under its control is criminal in nature and harmful to mankind. This entity is the state.
The State Is AnticapitalCapital is wealth, in whatever form, and is used or is capable of being used to produce additional wealth. Farmland, seeds, tools, buildings, and draft animals are examples of capital that predate the emergence of the state. Just as there was a day when gold emerged as money, there was a day where the state was born. It is axiomatic, however, that capital existed prior to the emergence of the state. As Linda and Morris Tannehill wrote,
Wealth does not exist in nature but must be created. The only means of creating wealth is value-production and free exchange — the manufacture and trade of some desired good or service. One may obtain wealth directly, by productive work, or one may obtain it indirectly, by looting it from a producer, but the wealth must be created by production in the first place in order to exist at all.Tannehill (1993), p. 113.
For man to satisfy his needs and desires, there are the economic means and the political means.Oppenheimer (1999), pp. 24–25. Correspondingly, the "state is an organization of the political means. No state, therefore, can come into being until the economic means has created a definite number of objects for satisfaction of needs, which objects may be taken away or appropriated by warlike robbery." Ibid p. 27. The state, consequently, was born on coercion, expropriation, theft, and violence.
The most aggressive expropriator of wealth is the socialist state. Under socialism, the state takes ownership of all means of production, including land. Prior to the emergence of the socialist state, for example in the USSR, much of the means of production and land were privately owned. On the formation of the USSR, all means of production and land were collectivized and, therefore, brought under control of the Soviet Union's central planners. A more accurate way to describe this collectivization process is to call it for what it is: state-sponsored coercion and theft on the grandest scale known to mankind.
After 74 years of existence, the Soviet Union collapsed, thereby exposing socialism's devastation to its people, resources, and capital. "As the Soviet Union came to an end, the public had been reduced to a collective of hunter gatherers, barely existing at a subsistence level."Maltsev (1993), p. 25. The total state, as exemplified by the Soviet Union, led to the total impoverishment of its people — not to mention that it murdered approximately 20 million of its own citizens.Courtois, et al. (1999), p. 4.
Although states openly steal property, there are varying degrees of "respect" states concede with regard to private-property ownership. People in the United States, for instance, feel relatively secure in their ownership of private property. It is, nonetheless, a grey area as to who owns land and houses in the United States. For if someone fails to pay property taxes, then the taxing authority can legally confiscate the house or tract of land. Moreover, the 16th Amendment to the US Constitution allows for direct taxation — and, therefore, Uncle Sam has claimed prior ownership to the fruits of everyone's labor in the United States. Money is property, just as much as real estate is, and both are subject to confiscation in the United States.
The More Power a State Has, the More Its Criminal Nature Is ExposedThe very existence of the state puts humanity on a slippery slope toward state servitude, grinding poverty, and premature death:
Just as "the power to tax involves the power to destroy," the sanctioning of state authority to regulate even one percent of our conduct is to admit its authority as to the rest.Shaffer (2009), p. 282.
Ludwig and Margit von Mises escaped the clutches of the epitome of totalitarianism: Nazi Germany. It is widely known how murderous this totalitarian state was. During Ludwig von Mises's lifetime, the extent of the Communist bloc's criminality and destructiveness was not known. When The Black Book of Communism: Crimes, Terror, Repression was published in 1999, the evil and criminal nature of the total state, as laid bare by Communism, was exposed for the whole world to see.
There is an erroneous mindset that Nazism represents the extreme right of the political spectrum while Communism represents the extreme left. This is a mistake, as private-property ownership and liberty are demolished under the totalitarian state, regardless of its label. In other words, totalitarianism is totalitarianism. The authors of The Black Book of Communism drew this exact conclusion:
One thing is certain: Crimes against humanity are the product of an ideology that reduces people not to a universal but to a particular condition, be it biological, racial, or sociohistorical. By means of propaganda, the Communists succeeded in making people believe that their conduct had universal implications, relevant to humanity as a whole. Critics have often tried to make a distinction between Nazism and Communism by arguing that the Nazi project had a particular aim, which was nationalist and racist in the extreme, whereas Lenin's project was universal. This is entirely wrong. In both theory and practice, Lenin and his successors excluded from humanity all capitalists, the bourgeoisie, counterrevolutionaries, and others, turning them into absolute enemies in their sociological and political discourse. Kautsky noted as early as 1918 that these terms were entirely elastic, allowing those in power to exclude from humanity whenever they so wished. These were the terms that led directly to crimes against humanity.Courtois, et al. (1999), pp. 752–753.
Under the total state, there is no private property including ownership of one's own body. Those exercising power under a totalitarian regime see nothing wrong with killing people for the sake of the state. It is no wonder that Communist regimes killed nearly 100 million people during the 20th century.Ibid p. 4.
The 20th century, overall, was a bloody one. Dr. R.J. Rummel has coined the term democide, which means "the murder of any person or people by a government, including genocide, politicide, and mass murder."Wikipedia Rudolph Rummel.These deaths do not count combat deaths attributed to war. In the 20th century, according to Dr. Rummel, democide accounted for 262 million deaths.Ibid.
As states gain power and liberty recedes, the evil, criminal, and murderous nature of the state becomes self-evident.
All States Subsist on Coercion and Theft and Are UneconomicThere is an assertion that a social contract exists in which individuals tacitly consent to give up some of their freedoms in exchange for the benefits of a political order and security as provided by the state. In reality, who consents to being murdered by a state in the name of political order? Who consents to being taxed? Whether an individual is more likely to be murdered by a state or is merely taxed and bossed around by a state has everything to do with where someone is born and has nothing to do with consenting to the dictates of the state.
Taxes are not voluntary contributions made to the state. Figuratively speaking, taxes are collected at gunpoint and failure to pay may land one in prison or worse. Per Lysander Spooner,
If the government can take a man's money without his consent, there is no limit to the additional tyranny it may practise upon him; for, with his money, it can hire soldiers to stand over him, keep him in subjection, plunder him at discretion, and kill him if he resists.Spooner (1852), Appendix.
What Spooner described is the unvarnished reality that the state represents the negation of liberty. For if an individual does not fully own the fruit of his labor (i.e., money income), then he lives in a condition of tax slavery.
Taxation also depresses production. It is a natural response to prevent a thief from stealing one's belongings. Yet if the thief is the state, mankind has the inclination to keep as much as possible away from the government and the economic impact is deleterious. On this matter, let's turn to Frank Chodorov:
Taxes of all kinds discourage production. Man works to satisfy his desires, not to support the state. When the results of his labor are taken from him, whether by brigands or organized society, his inclination is to limit his production to the amount he can keep and enjoy.Chodorov (2007a), p. 225.
Chodorov further comments,
While we are on the subject of discouragement of production by taxation, we should not overlook the greater weight of indirect taxes, even though it is not so obvious. The production level of a nation is determined by the purchasing power of its citizens, and to the extent that this power is sapped by levies, to that extent is the production level lowered. It is a silly sophism, and thoroughly indecent, to maintain that what the state collects it spends, and that therefore there is no lowering of total purchasing power. Thieves also spend their loot, with much more abandon than the rightful owners would have spent it, and on the basis of spending one could make out a case for the social value of thievery. It is production, not spending, that begets production. It is only by the feeding of marketable contributions into the general fund of wealth that the wheels of industry are speeded up. Contrariwise, every deduction from this general fund of wealth slows down industry, and every levy on savings discourages the accumulation of capital. Why work when there is nothing to it? Why go into business to support politicians?Chodorov (2007a), pp. 225–226.
A private company's revenues are derived from spontaneously emergent, market-based demand (in other words "organic" demand), whereas a state's revenues arise from theft. States are anticapital, irrational, and uneconomic in and of themselves.
If there is any contract that must be broken, it is the alleged social contract between individuals and the state. Living standards would rise, due to increased capital accumulation and savings, which in turn would result in more goods and services being brought to the market.
Economic CalculationWhat is economic calculation and why is it important? In Human Action, Ludwig von Mises succinctly answers these questions:
The task which acting man wants to achieve by economic calculation is to establish the outcome of acting by contrasting input and output. Economic calculation is either an estimate of the expected outcome of future action or the establishment of the outcome of past action. But the latter does not serve merely historical and didactic aims. Its practical meaning is to show how much one is free to consume without impairing the future capacity to produce. It is with regard to this problem that the fundamental notions of economic calculation — capital and income, profit and loss, spending and saving, cost and yield — are developed. The practical employment of these notions and of all notions derived from them is inseparably linked with the operation of a market in which goods and services of all orders are exchanged against a universally used medium of exchange, viz., money. They would be merely academic, without any relevance for acting within a world with a different structure of action.Mises (1998), pp. 211–212.
In a territory where the institutions of private property and sound money are honored, all goods and services can be coherently exchanged on the free market. Under these conditions, money prices emerge for both consumer goods and producer goods. Prices for producer goods are a derivative of the prices of consumer goods, with the prices of producer goods emerging through price imputation.See Dan Mahoney On Austrian Value Theory and Economic Calculation.
With private ownership in the means of production, an economy can flourish. Entrepreneurs can make rational business decisions and subject such decisions to the profit-and-loss test:
Monetary calculation is the guiding star of action under the social system of division of labor. It is the compass of the man embarking upon production. He calculates in order to distinguish the remunerative lines of production from the unprofitable ones, those of which the sovereign consumers are likely to approve from those which they are likely to disapprove. Every single step of entrepreneurial activities is subject to scrutiny by monetary calculation. The premeditation of planned action becomes commercial precalculation of expected costs and expected proceeds. The retrospective establishment of the outcome of past action becomes accounting of profit and loss. Mises (1998), p. 230.
A tool businessmen use to determine the success or failure of past actions is a financial statement, which includes a balance sheet and an income statement. It is important to understand that all entries in the balance sheet and income statement are expressed in terms of money. A businessman can directly correlate whether his company's capital base (i.e., the company's net worth as reflected in the balance sheet) is expanding or contracting depending on if the company turned a profit or made a loss. Such monetary calculation assists a businessman in deciding to maintain or change a business plan based on satisfying the ever-sovereign consumer.
In business, a private company can gauge the demand for its products through its sales volume. Using generally accepted accounting principles (GAAP), sales are recorded as the very top entry of an income statement (also known as a profit-and-loss statement) using the term "revenues." Revenues are generated through the voluntary exchanges of money, from customers, in return for the products sold to customers. A company will know quickly if there is a demand for its product — for if sales do not materialize or are significantly below expectations, then the company's revenues will reflect this lack of customer demand. A revenue shortfall, in turn, most likely will reveal a company with an unprofitable business model in which revenues fall short of covering production and overhead costs. Hence, the income statement will reveal a net loss. The company's capital base will shrink as a result of this loss.
A GAAP income statement, for a private company, would look like the following:
RevenuesCost of Revenues EarnedGross ProfitGeneral and Administrative ExpensesNet Income from OperationsOther Income (Expenses)Net Income (Loss)Retained Earnings, Beginning of YearRetained Earnings, End of YearIf the company turns a net income, its retained earnings will increase, thus resulting in an increase of the company's capital base. If the company turns a net loss, then retained earnings will shrink and this results in the diminution of its capital base. This is the elegance of economic calculation.
The State Cannot CalculateAll states are extramarket constructs and are always and everywhere incapable of economic calculation. Without the profit-and-loss test, with private property being a prerequisite, socialism does not allow an economy to emerge. Socialism is, therefore, irrational. If a state allows private-property ownership within its territory, and a free-market economy emerges, it does not follow that such a state is rational. For such a state is incapable of rationally allocating resources under its command, as public entities do not have the ability to measure their performance through the profit-and-loss test. Public entities, ultimately, depend on coercion and theft to fund themselves and their programs. Hence, the mindset of bureaucrats is political and not economic in character.
In a world of scarcity, rational resource allocation is critical to supporting human life. For those of a political mindset, should we expect rationality and logic with respect to matters of economics?
Rational conduct would be divorced from the very ground which is its proper domain. Would there, in fact, be any such thing as rational conduct at all, or, indeed, such a thing as rationality and logic in thought itself? Historically, human rationality is a development of economic life. Could it then obtain when divorced therefrom?Mises (1990), p. 21.
In states where private property is allowed, there exists a false perception that state bureaucrats can rationally allocate resources. This is an illusion foisted on a gullible public. If a public entity runs a surplus, it is hailed as being operated responsibly. If the public entity runs a deficit, it is seen as a problem that must be rectified by the bureaucrats in charge.
Public-sector accounting does measure revenues and expenses. There is, however, no profit-and-loss test precisely because a state or public entity is not a market-based phenomenon. Public-sector accounting, accordingly, is purely self-referential in that state operatives desire to know if enough money is being skimmed from its subjects in order to remain viable. Public-sector accounting also provides an air of respectability in that public entities want to promote the illusion of accountability to the populace. The objectives of public-sector accounting are conveyed as follows:
Traditional objectives:
To provide a financial summaryTo enable detailed comparisons of spending to be made with the budgetTo allow the identification of spending to ensure it complies with the law and other legal authoritiesTo provide the basis for the next budgetModern objectives:
To inform the stakeholders about the financial situation of the governmentTo provide possible investors with information about creditworthinessTo aid management decision makingTo identify assets and liabilitiesTo facilitate democratic transparencySee Noel Hepworth: Chartered Institute of Public Finance and Accountancy, University of Malta, February 2003Note such terms and concepts as compliance with the law, budgeting, stakeholders, creditworthiness, and democratic transparency; throw in the term "sustainability" and public-relations perfection will have been achieved.
Services most often associated with the public sector are police protection, security, legal system, roads, national defense, and money production. Of course, there are numerous welfare programs such as Social Security and Medicare — but these are not services in that they are pure transfers of wealth.
To reiterate, because a state's revenues are generated through coercion, via taxation, there is no way of gauging any organic demand for the services the state provides to its populace. Without a legitimate gauge for measuring the demand for a state's services, as there is no connection between demand and revenues (such as there is in private enterprise), a state has absolutely no means of calculating if it is rationally allocating resources.
It also follows that because state services cannot be tested against the metrics of organic demand, then it is impossible for state bureaucrats to know if they are meeting the most urgent needs of the populace; it is impossible for taxes to act as a substitute for market-generated revenues. Only market-based revenues serve to provide the signals of how much and what type of services are actually demanded by people.
In the United States, for example, there has materialized a web of public entities — municipal, state, and national — that has parasitically fastened to a market society — siphoning resources away from where countless individuals would have otherwise directed their own money and resources. How many smart bombs, drones, fighter jets, military bases, policemen, judges, social workers, CIA spies, and IRS agents are demanded by John Q. Public? Whether or not a public entity runs a surplus or a deficit does not answer this question. Because a state is not a market-based phenomenon, although it still may be able to gauge its expenses using prices that have emerged on the free market, it can never gauge the demand for its services as a state's top-line income is derived from theft and not from free-market demand. This lattice work of public entities, therefore, serves to misallocate resources on an enormous scale.
State-Controlled Money versus the Free MarketPer Ludwig von Mises's regression theorem,
money, in any society, can only become established by a market process emerging from barter. Money cannot be established by a social contract, by government imposition, or by artificial schemes proposed by economists. Money can only emerge, "organically" so to speak, out of the market.Rothbard (1988), p. 19.
Contra to what public officials and statists assert, there is no economic law prohibiting the private production of money,See Jorg Guido Hulsmann's The Ethics of Money Production "Monetary Reform" pp. 240–242. let alone security services, See Linda and Morris Tannehill's The Market for Liberty Chapter 8 "Protection of Life and Property."defense,See Hans-Hermann Hoppe's Chapter 10 "Government and the Private Production of Defense" in The Myth of National Defense: Essays on the Theory and History of Security Production. justice,See Michael van Notten's The Law of the Somalis Chapters 3, 4, and 5. and roads.See Walter Block's chapter "Road Socialism" in The Privatization of Roads and Highways edited by Walter Block. Yet governments, being the criminal enterprises that they are, have succeeded in supplanting market-based money (gold and silver) with fiat money.
With the emergence of the state came the multicentury process of governments gaining control over monetary systems. Such usurpations typically began with the state seizing absolute control of the minting business — with the state naming the monetary unit to separate it from the underlying weight of the coin (which opens the door for coinage debasement). The next step was for states to enact legal-tender laws dictating what money could be. As money substitutes were brought into widespread use, in recent centuries, governments gave banks the privilege of suspending payment in specie. All of this set the table to bring central banking into the picture, whereby governments grant central banks a monopoly on the note of issue.Rothbard (1990), pp. 57–69.
Directly due to the effects of central banking, stock-market bubbles arose in the United States in the 1920s, the 1980s, and the late 1990s /early 2000s. Each bubble was fueled by the Federal Reserve's easy-money policies and led directly to the Great Depression,See Murray Rothbard's America's Great Depression. the record stock-market crash of 1987, and the crash of the NASDAQ/dot-com bubble, which imploded over the period of 2000–2001.See Mark Thornton's The Economics of Housing Bubbles. p. 21.The Austrian theory of the trade cycle provides the only explanation for these booms and busts. As Roger Garrison explains,
The Austrian theory of the business cycle emerges straightforwardly from a simple comparison of savings-induced growth, which is sustainable, with a credit-induced boom, which is not. An increase in saving by individuals and a credit expansion orchestrated by the central bank set into motion market processes whose initial allocational effects on the economy's capital structure are similar. But the ultimate consequences of the two processes stand in stark contrast: Saving gets us genuine growth; credit expansion gets us boom and bust.Garrison (1996), p. 112.
Famously, after the attacks of 9/11, Federal Reserve Chairman Alan Greenspan reduced the federal-funds rate (which stood at 6.5 percent in November of 2000) to 1 percent in July of 2003. The federal-funds rate remained at 1 percent until June of 2004.See Mark Thornton's The Economics of Housing Bubbles. p. 15. Such artificially low interest rates stimulated a housing bubble as enabled by the government-sponsored enterprises of Fannie Mae and Freddie Mac.
Frank Shostak eloquently describes how loose monetary policy was the proximate cause of America's housing bubble:
We can define a bubble as activities that spring up on the back of loose monetary policy of the central bank. In other words, in the absence of monetary pumping these activities would not emerge. Since bubble activities are not self-funded, their emergence must come at the expense of various self-funded or productive activities. This means that less real funding is left for productive activities, which in turn undermines those activities. In short, monetary pumping gives rise to the misallocation of resources, which as a rule manifests itself through a relative increase in non-productive activities against productive activities.Shostak (2003), p. 1.
Accordingly, the mass delusion that a long-term consumer durable, such as a house, will increase in price, year after year, directly emanated from the Federal Reserve's monetary pumping. The bubble-headed assumption that housing prices would never decline demonstrates that easy money certainly led to a massive clustering of error, culminating in a terrible bust in the housing market.
By September of 2008, the Federal Reserve's easy-money policy came home to roost when major American financial institutions recognized that their balance sheets were in tatters. Reckless lending for home mortgages led to widespread mortgage-loan defaults. Because Wall Street had turned into a mortgage-debt securitization machine and American financial institutions' balance sheets were stuffed full of such mortgage-backed securities — whose prices dropped precipitously, due to the aforementioned loan defaults — money-center banks and powerhouse Wall Street firms were brought to their knees.
On October 14, 2008, "the U.S. government announced a series of initiatives to strengthen market stability, improve the strength of financial institutions, and enhance market liquidity."See Board of Governors of the Federal Reserve System Troubled Asset Relief Program (TARP) Information. The cornerstone initiative was the "Troubled Asset Relief Program (TARP), in which the secretary of the Treasury would expend as much as $700 billion in two installments to purchase rotten paper, such as mortgage-backed derivatives, from banks and other financial institutions."Higgs (2008), p. 1.
Wall Street titans such as Citigroup, Goldman Sachs, and JPMorgan Chase initially felt the pain of the 2008 economic collapse. However, because such financial institutions were deemed "too big to fail," Secretary of the Treasury Hank Paulson saw to it that these insolvent behemoths were bailed out at the expense of Main Street. Robert Murphy concludes,
The TARP was crooked from the very start, using taxpayer funds to bail out some of the world's richest people from their own foolish investments. The claims that it made taxpayers money are unfounded. Even worse, TARP taught investment bankers an important lesson: During a boom, make as much money as you can, no matter how short-term the profits will be. When the bubble pops, the Treasury and Fed will be there with a taxpayer-funded pillow.Murphy (2010), p. 7.
When government controls money, through a central bank, combined with the power to tax, the criminal activities undertaken by the state can be nothing short of audacious and supremely damaging.
Under a free market, where gold and silver coins are privately minted and used as money, such state-induced boom-bust cycles, as exemplified by America's housing bubble, could not emerge. Conversely, when the criminal enterprise, known as the state, controls the production of money, history illustrates how economically destructive the state can be.
ConclusionAs a state grows, the free market becomes hampered and recedes. Because all states are incapable of rationally allocating resources under their command, it logically follows that the total state must snuff out an economy altogether. When Economic Calculation in the Socialist Commonwealth was published, Mises's "seminal journal article in 1920 on the impossibility of economic calculation under socialism was the most important critique ever leveled at socialism."Rothbard (1988), p. 25. Fundamental to this critique was the absolute necessity of private ownership in the means of production.
Ludwig von Mises, therefore, was a fierce defender of private-property ownership. For without private property, an economy cannot emerge:
It is an illusion to imagine that in a socialist state calculation in natura can take place of monetary calculation. Calculation in natura, in an economy without exchange, can embrace consumption goods only; it completely fails when it comes to dealing with goods of a higher order. And as soon as one gives up the conception of a freely established monetary price for goods of a higher order, rational production becomes completely impossible. Every step that takes us away from private ownership of the means of production and from the use of money also takes us away from rational economics.Mises (1990), pp. 19–20. (Emphasis in the original)
Mises did not, however, view socialism as systematized robbery.Hulsmann (2007), p. 445. Had he been aware of the Soviet Union's brutal treatment of kulaks during its collectivization process, it is possible he would have changed his mind. Per The Black Book of Communism,
Recent research in the newly accessible archives has confirmed that the forced collectivization of the countryside was in effect a war declared by the Soviet state on a nation of smallholders. More than 2 million peasants were deported (1.8 million in 1930–31 alone), 6 million died of hunger, and hundreds of thousands died as a direct result of deportation.Courtois, et al. (1999), p. 146.
Such shocking information may have jarred Mises into grasping that all states, by definition, exist based on systematized robbery and violence. In turn, any entity whose very existence depends on systematized theft and coercion inherently must misallocate resources and destroy capital. In a world of scarcity, such an institution must be deemed antihuman and irrational. Socialism, accordingly, isn't the problem; the state itself is.
Mises, to be sure, had serious misgivings about the state:
Private property creates for the individual a sphere in which he is free of the state. It sets limits to the operation of the authoritarian will. It allows other forces to arise side by side with and in opposition to political power. It thus becomes the basis of all those activities that are free from violent interference on the part of the state. It is the soil in which the seeds of freedom are nurtured and in the autonomy of the individual and ultimately all intellectual and material progress are rooted.Mises (1985), pp. 67–68.
Inherent to private property is the right to self-ownership, "a right held by everyone by virtue of being a human being."Rothbard (2006), p. 35. Every person, in other words, has a property right in his own body. By extending Mises's view of private property to each person's body, the sphere in which mankind would maximize freedom along with intellectual and material progress would be where no state exists at all.
This lecture by Gary North was presented at the 2012 Mises University in Auburn, Alabama.
All material goods (Sachgüter) are of use to mankind through the action of the natural powers that reside in them. They are a part of the material world, and for that reason all their working, including their useful working, must bear the character that working generally has in the material world; it is a working of natural powers according to natural laws. What distinguishes the working of material goods from the working of other kinds of natural things, harmless or hurtful, is the single circumstance, that the results of such working admit of being directed towards the advantage of man, this direction also being under the rule of natural laws. That is to say, all things are endowed simply with working natural powers, but experience shows that these powers only admit of being directed to a definitely useful end, when the matter which possesses these powers has taken on certain forms that are favorable to them being so directed. All matter on the surface of the earth, for instance, among other forms of energy, possesses an amount of energy corresponding to its distance from the centre of the earth. But while men can do nothing with this form of energy when stored up in a mountain, that same energy is useful to them when the matter possessing it has taken on some form they wish — that is, some form in which the energy is available; say, that of a clock pendulum, or a paper weight, or a hammer. The energy of chemical affinity which carbon possesses is identical in every molecule of it. We get a direct economic utility, however, from the results of this energy only when the carbon has taken such forms as that of wood or coal; not when it exists as part of one of the constituents of the air. We may therefore say that the nature of material goods, as opposed to those material things that are not useful, is that they are such special forms of matter as admit of the natural powers they possess being directed to the advantage of man.From this follow two important inferences, of which one concerns the character of the useful functions of material goods, and the other concerns the character of the use (Gebrauch) of goods.
The function of goods can consist in nothing else than in a giving off, or rendering up, or putting forth of power; or, to use the terminology of physical science, the passing of energy into work. On the natural side it shows a complete parallelism with the character of the useful function performed by a manual laborer. In the same way as a porter or a navvy is of use, when he puts forth the natural power residing in his body in the form of rendering useful services, so are material goods of use through concrete forthputting of the natural powers inherent in them and capable of direction — physically speaking, through the forthputting in work of the available forms of energy they possess. It is by the passing of available energy into work that the "use" of goods is obtained by man.I may remind the reader that, according to the scientific conception of energy — energy being that quality the possession of which confers upon a body the power of doing work — it may exist either as available or unavailable energy; that is, the body may possess energy of which a use can be made, or it may possess energy of which no use can be made. Thus the storage of energy in certain material bodies in an unavailable form, and the change of this unavailable into available energy, by means of which work is done that has a direct influence on the satisfaction of human wants, is just the physical conception applied to economics. — W. S.
The use (Gebrauch) of a thing then is realized in this way: man takes the peculiar forms of energy of the good at the proper time, supplies the conditions necessary to render them available where they previously existed in an unavailable form, and then brings these forms of energy into proper connection with that object in which the useful effect is to take place. For instance, in order to "use" the locomotive the stoker fills the boiler with water, applies heat, and thus obtains in an available form the heat energy of the steam, which is transferred into energy of motion of the locomotive. This last-named energy is then transferred by connection to the carriages that convey persons or goods. Or one brings a book into the necessary relation with his eye for the image, which is continually being formed by reflection, to fall on the retina; or brings the house which continually offers shelter into proper relation with his whole person. But any "use" of material goods which does not consist in the receiving from them of useful results due to their inherent powers or forms of energy, is absolutely unthinkable.
I think I need have no fear of the propositions I have just advanced meeting with any scientific opposition. The conception laid down is no longer strange in our economic literature;Schäffle, in particular, in the third volume of his Bau und Leben, very beautifully puts the same point of view. Schäffle, I may say, forms an honorable exception among economists as regards this objectionable habit of not taking any trouble with the principles that regulate the working of goods. and in the present state of the natural sciences the acceptance of it has indeed become a peremptory necessity. If by any chance it should be objected that this conception is one that belongs to the natural sciences and is not an economic one, I answer that in these questions economic science must leave the last word to natural science. The principle of the unity of all science demands it. Economic science does not explain the facts that belong to its province to the very bottom, any more than any other science does. It solves only one portion of the causal connection that binds together the phenomena of things, and leaves it to other sciences to carry the explanation farther. Not to mention other limiting sciences, the sphere of economic explanation lies between the sphere of psychological explanation on the one hand, and that of the natural sciences on the other. To give a concrete example. Economic science will explain thus far the circumstance that bread has an exchange value: it will point out that bread is able to satisfy the want of sustenance, and that men have a tendency to ensure the satisfaction of their wants, if necessary by making a sacrifice. But that men have this tendency, and why they have it, is not explained by economic science but by psychology. To explain that men want sustenance and why, falls within the domain of physiology. Finally, it also falls within the sphere of physiology to explain that bread is able to satisfy that want, and why it is able to do so, but physiology does not finish the explanation within its own sphere; it has to call in assistance from the more general physical sciences.
Now it is clear that all explanations given by economic science have a value only under this condition, that they are continuous with the related sciences. The explanations of economics cannot rest on anything that a science related to it is bound to declare untrue or impossible; otherwise the thread of the explanation is broken from the first. It must on that account keep exactly in touch with the related sciences at the points where they limit it, and one such point is just this question as to the working of material goods.
The one thing of which I have, perhaps, some reason to be afraid is, that the employment of this physical conception in regard to a certain limited class of material goods, especially to the so-called "ideal goods," may be somewhat startling at the first glance to some readers. That, e.g. a fixed and stationary dwelling-house, a volume of poems, or a picture of Raphael should be of use to us through the forthputting of inherent properties connected with one or other of the forms of energy, or, as we may shortly express it, the forthputting of its natural powers, may at first, I admit, be a little strange. Objections like these, however, which have their origin more in feeling than in understanding, may be removed by a single consideration. All the things that I have named enter into the relation which makes them "goods" only in virtue of the peculiar natural powers which they possess, and possess, indeed, in peculiar combination. That a house shelters and warms, is nothing else than a result of the forces of gravity, cohesion, and resistance, of impenetrability, of the non-conducting-quality of building materials. That the thoughts and feelings of the poet reproduce themselves in us is mediated, in a directly physical way, by light, color, and form of written characters; and it is this physical part of the mediation which is the office of the book. There must of course have been a poet soul in whom ideas and feelings waked, and, again, it is only in a spirit and through spiritual forces that they can be reawakened; but the way of spirit to spirit lies some little distance through the natural world, and over this distance even the spiritual must make use of the vehicle of natural powers. Such a natural vehicle is the book, the picture, the spoken word. Of themselves they give only a physical suggestion, nothing more; the spiritual we give of our own on accepting the suggestion; and if we are not prepared beforehand for a profitable acceptance of it — if we cannot read, or, reading, cannot understand, or cannot feel — it remains simply a physical suggestion.
With these explanations perhaps I may consider it established beyond question that material goods exert their economical use through the forthputting of the natural powers residing in them.
The individual useful forthputtings of natural powers that are obtainable from material goods I propose to designate as "Material Services."I have already introduced this term Nutzleistung in my Rechte und Verhältnisse; before that I used it in a work written in 1876 but not printed. It is employed by Knies several times in the second portion of his Kredit, but unfortunately in the same ambiguous sense in which on other occasions he uses the word Nutzung. (Note by Translator: After much deliberation material service is the nearest rendering I can give to the word Nutzleistung, introduced by Professor Böhm-Bawerk. Every translator finds the difficulty of rendering scientific terms from one language into another, but this difficulty is greater in political economy, where we are bound to use words "understanded of the people." The word Nutzleistung is one of these happy combinations which, as compounded of two familiar words, do not strike a German as peculiar or clumsy, and are yet strict enough to satisfy scientific requirements. But our language does not admit of many such combinations — the literal translation "use rendering " at once shows the impossibility in the present case — and in a translation one does not feel justified in coining a new word. In rendering the word thus it becomes necessary to eliminate a note that follows in the German edition, where Professor Böhm-Bawerk congratulates himself on having escaped Say's services productifs, which might be objected to on the ground that " only a person, not a thing, can render services." The prefix "material" seems to me fairly to meet this objection, as the total expression now implies a service — a forthputting of natural powers in the service of man — rendered by a material object. — W. S.) In itself, indeed, the word Use (Nutzung) would not be inappropriate, but to adopt it would be to surrender our conception to all the obscurity that now, unfortunately, hangs over that ambiguous expression.After this clause, in the German edition, come the words: "Und andererseits scheint mir der Name Nutzleistung in der That ausserordentlich prägnant zu sein: es sind im eigenstlichen Wortsinn nützliche Kräfteleistungen, die von den Sachgütern ausgehen." — W. S.
The conception of material services is, in my opinion, destined to be one of the most important elementary conceptions in economic theory. In importance it does not come behind the conception of the economic good.It is unfortunate that in English economics we have devoted so little attention to this most elementary conception, on which Menger, in particular, has bestowed so much pains. The poverty of our scientific nomenclature shows this defect very markedly: the word "commodity" is really the only singular equivalent we have for the familiar and suggestive word "goods," although I personally have not scrupled to translate the German Gut by the English "good." There is, indeed, reason for Mr. Ruskin's sarcasm that our most famous treatise on Wealth does not even define the meaning of the word "wealth." — W. S. Unfortunately up till now it has received little attention and little development. From the nature of our task it is indispensable that we should repair this neglect, and follow out some of the more important relations into which the material services enter in economic life.
First of all, it is clear that everything which would lay claim to the name of a "good"must be capable of rendering material services, and that, with the exhausting of this capability, it ceases to have the quality of a good; it falls out of the circle of "goods" back into the circle of simple "things." An exhaustion of this capability must not be thought of as an exhaustion of the capability to exert or to put forth energy in general; for what we have called the "natural powers "of the material are as imperishable as the material itself. But although these powers or forms of energy never cease to exist in some form or other, they may very well cease to be available for material services in this way, that the original good, in the course of doing work, has undergone such a change — be it separation, dislocation, or uniting of its parts with other bodies — that, in its changed form, its energy is no longer available for human use. For instance, when the carbon of the wood burned in the blast furnace has combined with oxygen in the combustion process, its powers cannot again be employed to smelt iron, although these powers are constant, and continue to work according to natural laws. The broken pendulum retains its energy due to gravity just as it did before, but the loss of the pendulum form does not allow of this energy being directed to regulate the clock. The exhaustion of capability to render material services we are accustomed to call the using up or consumption of goods.
While all goods thus agree and must agree in this, that they have to render material services, they differ essentially from one another in the number of services that they have to render. On this rests the familiar division of goods into perishable and nonperishable, or better, into perishable and durable.Even the so-called nonperishable goods are perishable, however gradually they perish. Many goods are of such a nature that, to render the uses peculiar to them, they must give forth their whole power, as it were, at a blow, in one more or less intense service, so that their first use quite exhausts their capability of service, and is their consumption. These are the so-called perishable goods, such as food, gunpowder, fuel, etc. Other goods, again, are, in their nature, capable of rendering a number of material services in the way of giving off these services successively, within a shorter or longer period of time; and thus after a first, or even after many acts of use, they may retain their capability of rendering further services, and so retain their character of goods. These are the durable goods, such as clothing, houses, tools, precious stones, land, etc.
Where a good successively gives off a number of material services, it may do so in one of two ways: either the services following each other evidently separate themselves from each other, as clearly marked single acts, in such a way that they are easily distinguished, limited, and counted — as, e.g. the single blows of a coining press, or the operations of the automatic printing press of a great newspaper; or they issue from the goods in unbroken, similar continuance — as, e.g. the shelter silently given over long periods of time by a dwelling-house. If, however, it is desired, in cases of this sort, to separate and divide the continuous amount of services — and practical need often requires this — the expedient is adopted that is generally taken in the dividing of continuous quantities; the dividing line that does not suggest itself in the phenomena under consideration is borrowed from some outside circumstance, e.g. from the lapse of a definite time; as when one delivers over to the hirer of a house the services to be rendered by the house during the year.
Another essential feature that meets us in the analysis of material services is their capability of obtaining complete economical independence. The source of this phenomenon is that in very many, indeed in most cases, the satisfaction of a concrete human want does not demand the exhaustion of the entire useful content of a good, but only the rendering of a single material service. In virtue of this the single service in the first instance obtains an independent importance as regards the satisfaction of our wants, and then in practical economic life this independence is fully recognized. We give the recognition (1) wherever we make an independent estimate of the value of isolated services; and (2) wherever we make them into independent objects of business transactions. This latter happens when we sell or exchange single services, or groups of services, apart from the goods from which they proceed. Economical custom and law have created a number of forms in which this is effectuated. Among the most important of these I may name the relations of tenancy, of hire, and of the old commodatum;Not of the loan; see below. further, the institution of easements, of fee farm, of copyhold (emphyteusis and superficies). A little consideration will convince us that, as a fact, all these forms of transaction agree in this, that one portion of the services of which a good is capable is divided off and transferred separately, while the rest of the anticipated services, be they many or few, remain with the ownership of the body of the good, in the hands of the owner of the good.See also my Rechte und Verhältnisse, p. 70, etc.
Finally, it is of great theoretic importance to determine the relations that exist between the material services and the goods from which they proceed. On this point I may put down three cardinal propositions, all of which appear to me so obvious that we may dispense here with any detailed proof of them; more especially as I have gone thoroughly into the subject on another occasion.In my Rechte und Verhältnisse, p. 60, where, in particular, I have stated the character of the material services as primary elements of our economic transactions, and have deduced the value of goods from the value of the material services.
It seems to me clear that we value and desire goods only on account of the material services that we expect from them. The services, as it were, form the economical substance with which we have to do. The goods themselves form only the bodily shell.
It follows from the above, and appears to me equally beyond doubt, that, where entire goods are obtained and transferred, the economical substance of such transactions always lies in the acquisition and the transference of material services — indeed of the totality of these services. The transference of the goods themselves constitutes only a form — certainly a form that, in the nature of things, is very prominent, but still only an accompanying and limiting form. To buy a good can mean nothing, economically speaking, but to buy all its material services.This idea, though put somewhat differently, is explicitly recognized by Knies, Der Kredit, part ii. pp. 34, 77, 78. He expressly calls the selling price of a house the price of the permanent use of a house in opposition to the hire price, which is the price of the temporary uses of the same good. See also his Geld, p. 86. Schäffle too (Bau und Leben, second edition, iii. ) describes goods as "stores of useful energies" (p. 258).
From this, finally, comes the important conclusion that the value and price of a good is nothing else than the value and price of all its material services thrown together into a lump sum; and that accordingly the value and price of each individual service is contained in the value and price of the good itself.For more exact statement, see my Rechte und Verhältnisse, p. 64.
Before going farther let me illustrate these three propositions by a concrete example. I think all readers will agree with me when I say that a cloth manufacturer values and demands looms only because he expects to get from the looms the useful energies peculiar to them; that not only when he hires a loom, but when he buys it, he looks, as a fact, to the acquisition of its services; and that the ownership he acquires at the same time in the body of the machine only serves as greater security that he will obtain these services. Even if this ownership in point of law appears to be the primary thing, economically it is certainly only the secondary. And, lastly, it will be granted, I think, that the use which the whole machine renders is nothing else than the use of all its material services thrown together into one sum; and that similarly the value and price of the whole machine is nothing else, and can be nothing else, than the value and price of all its material services thrown together into one sum.
Since recent events helped socialist parties to obtain power in Russia, Hungary, Germany and Austria, and have thus made the execution of a socialist nationalization program a topical issue, Marxist writers have themselves begun to deal more closely with the problems of the regulation of the socialist commonwealth. But even now they still cautiously avoid the crucial question, leaving it to be tackled by the despised "Utopians." They themselves prefer to confine their attention to what is to be done in the immediate future; they are forever drawing up programs of the path to Socialism and not of Socialism itself. The only possible conclusion from all these writings is that they are not even conscious of the larger problem of economic calculation in a socialist society.
To Otto Bauer the nationalization of the banks appears the final and decisive step in the carrying through of the socialist nationalization program. If all banks are nationalized and amalgamated into a single central bank, then its administrative board becomes
the supreme economic authority, the chief administrative organ of the whole economy. Only by nationalization of the banks does society obtain the power to regulate its labor according to a plan, and to distribute its resources rationally among the various branches of production, so as to adapt them to the nation's needs.Cf. Otto Bauer, Der Weg zum Sozialismus (Vienna: Ignaz Brand, 1919), p. 26f.
Bauer is not discussing the monetary arrangements which will prevail in the socialist commonwealth after the completion of the nationalization of the banks. Like other Marxists he is trying to show how simply and obviously the future socialist order of society will evolve from the conditions prevailing in a developed capitalist economy. "It suffices to transfer to the nation's representatives the power now exercised by bank shareholders through the Administrative Boards they elect,"Cf. Otto Bauer, Der Weg zum Sozialismus (Vienna: Ignaz Brand, 1919), p. 25. in order to socialize the banks and thus to lay the last brick on the edifice of socialism. Bauer leaves his readers completely ignorant of the fact that the nature of the banks is entirely changed in the process of nationalization and amalgamation into one central bank. Once the banks merge into a single bank, their essence is wholly transformed; they are then in a position to issue credit without any limitation. In this fashion the monetary system as we know it today disappears of itself.
When in addition the single central bank is nationalized in a society, which is otherwise already completely socialized, market dealings disappear and all exchange transactions are abolished. At the same time the Bank ceases to be a bank, its specific functions are extinguished, for there is no longer any place for it in such a society. It may be that the name "Bank" is retained, that the Supreme Economic Council of the socialist community is called the Board of Directors of the Bank, and that they hold their meetings in a building formerly occupied by a bank. But it is no longer a bank; it fulfills none of those functions which a bank fulfills in an economic system resting on the private ownership of the means of production and the use of a general medium of exchange-money. It no longer distributes any credit, for a socialist society makes credit of necessity impossible. Bauer himself does not tell us what a bank is, but he begins his chapter on the nationalization of the banks with the sentence: "All disposable capital flows into a common pool in the banks."Cf. Otto Bauer, Der Weg zum Sozialismus (Vienna: Ignaz Brand, 1919), p. 24f. As a Marxist must he not raise the question of what the banks' activities will be after the abolition of capitalism?
All other writers who have grappled with the problems of the organization of the socialist commonwealth are guilty of similar confusions. They do not realize that the bases of economic calculation are removed by the exclusion of exchange and the pricing mechanism, and that something must be substituted in its place, if all economy is not to be abolished and a hopeless chaos is not to result. People believe that socialist institutions might evolve without further ado from those of a capitalist economy. This is not at all the case. And it becomes all the more grotesque when we talk of banks, banks management, etc. in a socialist commonwealth.
Reference to the conditions that have developed in Russia and Hungary under Soviet rule proves nothing. What we have there is nothing but a picture of the destruction of an existing order of social production, for which a closed peasant household economy has been substituted. All branches of production depending on social division of labor are in a state of entire dissolution. What is happening under the rule of Lenin and Trotsky is merely destruction and annihilation. Whether, as the liberals hold, socialism must inevitably draw these consequences in its train, or whether, as the socialists retort, this is only a result of the fact that the Soviet Republic is attacked from without, is a question of no interest to us in this context. All that has to be established is the fact that the Soviet socialist commonwealth has not even begun to discuss the problem of economic calculation, nor has it any cause to do so. For where things are still produced for the market in Soviet Russia in spite of governmental prohibitions, they are valued in terms of money, for there exists to that extent private ownership of the means of production, and goods are sold against money. Even the government cannot deny the necessity, which it confirms by increasing the amount of money in circulation, of retaining a monetary system for at least the transition period.
That the essence of the problem to be faced has not yet come to light in Soviet Russia, Lenin's statements in his essay on Die nächsten Aufgaben der Sowjetmacht best show. In the dictator's deliberations there ever recurs the thought that the immediate and most pressing task of Russian communism is "the organization of bookkeeping and control of those concerns, in which the capitalists have already been expropriated, and of all other economic concerns.Cf. V.I. Lenin, Die nächsten Aufgaben der Sowjetmacht (Berlin: Wilmersdorf, 1919), pp. 12f, 22ff. Even so Lenin is far from realizing that an entirely new problem is here involved which it is impossible to solve with the conceptual instruments of "bourgeois" culture. Like a real politician, he does not bother with issues beyond his nose. He still finds himself surrounded by monetary transactions, and does not notice that with progressive socialization money also necessarily loses its function as the medium of exchange in general use, to the extent that private property and with it exchange disappear.
The implication of Lenin's reflections is that he would like to reintroduce into Soviet business "bourgeois" bookkeeping carried on on a monetary basis. Therefore he also desires to restore "bourgeois experts" to a state of grace.Cf. V.I. Lenin, Die nächsten Aufgaben der Sowjetmacht (Berlin: Wilmersdorf, 1919), pp. 15. For the rest Lenin is as little aware as Bauer of the fact that in a socialist commonwealth the functions of the bank are unthinkable in their existing sense. He wishes to go farther with the "nationalization of the banks" and to proceed "to a transformation of the banks into the nodal point of social bookkeeping under socialism."Cf. V.I. Lenin, Die nächsten Aufgaben der Sowjetmacht (Berlin: Wilmersdorf, 1919), pp. 21 and 26. Compare also Bukharin, Das Programm der Kommunisten (Zürich: no pub., 1918), pp. 27ff.
Lenin's ideas on the socialist economic system, to which he is striving to lead his people, are generally obscure.
"The socialist state," he says,
can only arise as a net of producing and consuming communes, which conscientiously record their production and consumption, go about their labour economically, uninterruptedly raise their labour productivity and thus attain the possibility of lowering the working day to seven or six hours or even lower.Cf. V.I. Lenin, Die nächsten Aufgaben der Sowjetmacht (Berlin: Wilmersdorf, 1919), pp. 24f.
Every factor, every village appears as a production and consumption commune having the right and obligation to apply the general Soviet legislation in its own way ('in its own way' not in the sense of its violation but in the sense of the variety of its forms of realisation), and to solve in its own way the problems of calculating the production and distribution of products.Cf. V.I. Lenin, Die nächsten Aufgaben der Sowjetmacht (Berlin: Wilmersdorf, 1919), pp. 32.
"The chief communes must and will serve the most backward ones as educators, teachers, and stimulating leaders." The successes of the chief communes must be broadcast in all their details in order to provide a good example. The communes "showing good business results" should be immediately rewarded "by a curtailment of the working day and with an increase in wages, and by allowing more attention to be paid to cultural and aesthetic goods and values."Cf. V.I. Lenin, Die nächsten Aufgaben der Sowjetmacht (Berlin: Wilmersdorf, 1919), pp. 33.
We can infer that Lenin's ideal is a state of society in which the means of production are not the property of a few districts, municipalities, or even of the workers in the concern, but of the whole community. His ideal is socialist and not syndicalist. This need not be specially stressed for a Marxist such as Lenin. It is not extraordinary of Lenin the theorist, but of Lenin the statesman, who is the leader of the syndicalist and small-holding peasant Russian revolution. However, at the moment we are engaged with the writer Lenin and may consider his ideals separately, without letting ourselves be disturbed by the picture of sober reality.
According to Lenin the theorist, every large agricultural and industrial concern is a member of the great commonwealth of labor. Those who are active in this commonwealth have the right of self-government; they exercise a profound influence on the direction of production and again on the distribution of the goods they are assigned for consumption. Still, labor is the property of the whole society, and as its product belongs to society also, it therefore disposes of its distribution. How, we must now ask, is calculation in the economy carried on in a socialist commonwealth which is so organized? Lenin gives us a most inadequate answer by referring us back to statistics. We must bring statistics to the masses, make it popular, so that the active population will gradually learn by themselves to understand and realize how much and what kind of work must be done, how much and what kind of recreation should be taken, so that the comparison of the economy's industrial results in the case of individual communes becomes the object of general interest and education.Cf. V.I. Lenin, Die nächsten Aufgaben der Sowjetmacht (Berlin: Wilmersdorf, 1919), pp. 33.
From these scanty allusions it is impossible to infer what Lenin understands by statistics and whether he is thinking of monetary or in natura computation. In any case, we must refer back to what we have said about the impossibility of learning the money prices of production-goods in a socialist commonwealth and about the difficulties standing in the way of in natura valuation. Statistics would only be applicable to economic calculation if it could go beyond the in natura calculation, whose ill-suitedness for this purpose we have demonstrated. It is naturally impossible where no exchange relations are formed between goods in the process of trade.
This article is excerpted from Economic Calculation In The Socialist Commonwealth (1920), chapter 5, "The Most Recent Socialist Doctrines and the Problem of Economic Calculation."
"While flash trading can lead to sudden dips in the market, the market has proven to be quick in correcting itself."It's fascinating to watch footage of a trading floor on Wall Street. Here men and women spend hours with their eyes glued to computer monitors while furiously calculating trades that often yield small profits or minimal losses. In the case of Swiss bank UBS trader Kweku Adoboli, it can result in a $2 billion loss and an unfortunate incarceration. The risks run high as trading requires a sizeable amount of dexterity and concentration to be successful in a network of like-minded profit seekers. Still, there is an underlying beauty to the process, as thousands (perhaps millions) of individuals coordinate their knowledge on the allocation of limited resources throughout the world.
Nobel laureate Friedrich Hayek dedicated much of life's work (brilliantly summed up in his classic essay "The Use of Knowledge in Society") showing us how knowledge and expertise are widely dispersed throughout society and can never reside in a single mind. That is to say, while individuals may use their own expertise and labor to create, they will never be in full possession of all available knowledge to account for the nuances of market and societal demands. The same concept applies to a government composed of fallible men — much to the dismay of statist ideologues such as Elizabeth Warren.
The limit of individual knowledge is what provided the initial need for social cooperation. Primitive man banded together with others, not under the auspices of creating one great state, but as a desire to utilize more resources and raise their own standard of living. Out of this grew the division of labor and increased sharing of knowledge and information. As Mises said, "one must never forget that the characteristic feature of human society is purposeful cooperation; society is an outcome of human action."
When it comes to the disbursement of information, nothing is more controversial than high-speed "flash" trading. A recent New York Times article documented the trend:
Regulators in the United States and overseas are cracking down on computerized high-speed trading that crowds today's stock exchanges, worried that as it spreads around the globe it is making market swings worse.
The cost of these high-frequency traders, critics say, is the confidence of ordinary investors in the markets, and ultimately their belief in the fairness of the financial system.
"There is something unholy about them," said Guy P. Wyser-Pratte, a prominent longtime Wall Street trader and investor. "That is what caused this tremendous volatility. They make a fortune whereas the public gets so whipsawed by this trading."
The public gets whipsawed by this trading? Funny how those on Wall Street no longer classify as the "public" in the eyes of populism.
What this demonization of flash trading really comes down to is the inability of regulators to monitor and control such a phenomenon. What the state can't control, it exerts more power and authority to tame. Like a vampire to blood, the state never gets its fill of supremacy.
The justification for regulating flash trading comes down to a brief market crash back on May 6, 2010. In the course of just 16 minutes, the Dow Jones Industrial Average dropped 1,000 points, only to rebound to its original level. It was the largest intraday decline in the history of the Dow Jones. Despite the market's quick correction to the crash, a joint panel was created and headed by the chairmen of the Security and Exchange Commission and Commodity Futures Trading Commission to investigate the matter. Their report, which was released back in February, recommended that new rules and regulations be adopted to address flash trading. Considering how successful the SEC and CFTC were at recognizing the housing bubble, it's a wonder anyone still takes their recommendations seriously.
While flash trading can lead to sudden dips in the market, the market has proven to be quick in correcting itself. The rapid disbursement of information that encompasses the stock market becomes its own self-correcting mechanism.
As society and technology progress, the instantaneous sharing of knowledge and information is not something to fear but to celebrate. In a world where, to borrow a phrase from John Tamny, "capital moves at the speed of light," flash trading ensures that resources will continue to meet more deserving hands and be put to more efficient use.
Clamping down on such a practice doesn't just limit capital flow; it limits the market's mechanism by which to progress. Like all government regulation, it will put the brakes on productivity and the achieving of a better standard of living. Attempting to level the field in the name of "fairness" is nothing but a government power grab destined to bring about destructive consequences. As Hayek pointed out in his Nobel acceptance speech, The Pretense of Knowledge,
In the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process … will hardly ever be fully known or measurable.
Knowledge is best utilized when it reaches as many people as possible. Hayek's lesson must not be forgotten as it not only shows the fallacy of central planning but the incredible benefits derived from social cooperation through instantaneous communication.
"Practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made." [September 1945]What is the problem we wish to solve when we try to construct a rational economic order? On certain familiar assumptions the answer is simple enough. If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic. That is, the answer to the question of what is the best use of the available means is implicit in our assumptions. The conditions which the solution of this optimum problem must satisfy have been fully worked out and can be stated best in mathematical form: put at their briefest, they are that the marginal rates of substitution between any two commodities or factors must be the same in all their different uses.
This, however, is emphatically not the economic problem which society faces. And the economic calculus which we have developed to solve this logical problem, though an important step toward the solution of the economic problem of society, does not yet provide an answer to it. The reason for this is that the "data" from which the economic calculus starts are never for the whole society "given" to a single mind which could work out the implications and can never be so given.
The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess. The economic problem of society is thus not merely a problem of how to allocate "given" resources — if "given" is taken to mean given to a single mind which deliberately solves the problem set by these "data." It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know. Or, to put it briefly, it is a problem of the utilization of knowledge which is not given to anyone in its totality.
This character of the fundamental problem has, I am afraid, been obscured rather than illuminated by many of the recent refinements of economic theory, particularly by many of the uses made of mathematics. Though the problem with which I want primarily to deal in this paper is the problem of a rational economic organization, I shall in its course be led again and again to point to its close connections with certain methodological questions. Many of the points I wish to make are indeed conclusions toward which diverse paths of reasoning have unexpectedly converged. But, as I now see these problems, this is no accident. It seems to me that many of the current disputes with regard to both economic theory and economic policy have their common origin in a misconception about the nature of the economic problem of society. This misconception in turn is due to an erroneous transfer to social phenomena of the habits of thought we have developed in dealing with the phenomena of nature.IIIn ordinary language we describe by the word "planning" the complex of interrelated decisions about the allocation of our available resources. All economic activity is in this sense planning; and in any society in which many people collaborate, this planning, whoever does it, will in some measure have to be based on knowledge which, in the first instance, is not given to the planner but to somebody else, which somehow will have to be conveyed to the planner. The various ways in which the knowledge on which people base their plans is communicated to them is the crucial problem for any theory explaining the economic process, and the problem of what is the best way of utilizing knowledge initially dispersed among all the people is at least one of the main problems of economic policy — or of designing an efficient economic system.
The answer to this question is closely connected with that other question which arises here, that of who is to do the planning. It is about this question that all the dispute about "economic planning" centers. This is not a dispute about whether planning is to be done or not. It is a dispute as to whether planning is to be done centrally, by one authority for the whole economic system, or is to be divided among many individuals. Planning in the specific sense in which the term is used in contemporary controversy necessarily means central planning — direction of the whole economic system according to one unified plan. Competition, on the other hand, means decentralized planning by many separate persons. The halfway house between the two, about which many people talk but which few like when they see it, is the delegation of planning to organized industries, or, in other words, monopoly.
Which of these systems is likely to be more efficient depends mainly on the question under which of them we can expect that fuller use will be made of the existing knowledge. And this, in turn, depends on whether we are more likely to succeed in putting at the disposal of a single central authority all the knowledge which ought to be used but which is initially dispersed among many different individuals, or in conveying to the individuals such additional knowledge as they need in order to enable them to fit their plans with those of others.
IIIIt will at once be evident that on this point the position will be different with respect to different kinds of knowledge; and the answer to our question will therefore largely turn on the relative importance of the different kinds of knowledge; those more likely to be at the disposal of particular individuals and those which we should with greater confidence expect to find in the possession of an authority made up of suitably chosen experts. If it is today so widely assumed that the latter will be in a better position, this is because one kind of knowledge, namely, scientific knowledge, occupies now so prominent a place in public imagination that we tend to forget that it is not the only kind that is relevant. It may be admitted that, as far as scientific knowledge is concerned, a body of suitably chosen experts may be in the best position to command all the best knowledge available — though this is of course merely shifting the difficulty to the problem of selecting the experts. What I wish to point out is that, even assuming that this problem can be readily solved, it is only a small part of the wider problem.
Today it is almost heresy to suggest that scientific knowledge is not the sum of all knowledge. But a little reflection will show that there is beyond question a body of very important but unorganized knowledge which cannot possibly be called scientific in the sense of knowledge of general rules: the knowledge of the particular circumstances of time and place. It is with respect to this that practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active coöperation. We need to remember only how much we have to learn in any occupation after we have completed our theoretical training, how big a part of our working life we spend learning particular jobs, and how valuable an asset in all walks of life is knowledge of people, of local conditions, and of special circumstances. To know of and put to use a machine not fully employed, or somebody's skill which could be better utilized, or to be aware of a surplus stock which can be drawn upon during an interruption of supplies, is socially quite as useful as the knowledge of better alternative techniques. And the shipper who earns his living from using otherwise empty or half-filled journeys of tramp-steamers, or the estate agent whose whole knowledge is almost exclusively one of temporary opportunities, or the arbitrageur who gains from local differences of commodity prices, are all performing eminently useful functions based on special knowledge of circumstances of the fleeting moment not known to others.
It is a curious fact that this sort of knowledge should today be generally regarded with a kind of contempt and that anyone who by such knowledge gains an advantage over somebody better equipped with theoretical or technical knowledge is thought to have acted almost disreputably. To gain an advantage from better knowledge of facilities of communication or transport is sometimes regarded as almost dishonest, although it is quite as important that society make use of the best opportunities in this respect as in using the latest scientific discoveries. This prejudice has in a considerable measure affected the attitude toward commerce in general compared with that toward production. Even economists who regard themselves as definitely immune to the crude materialist fallacies of the past constantly commit the same mistake where activities directed toward the acquisition of such practical knowledge are concerned — apparently because in their scheme of things all such knowledge is supposed to be "given." The common idea now seems to be that all such knowledge should as a matter of course be readily at the command of everybody, and the reproach of irrationality leveled against the existing economic order is frequently based on the fact that it is not so available. This view disregards the fact that the method by which such knowledge can be made as widely available as possible is precisely the problem to which we have to find an answer.IVIf it is fashionable today to minimize the importance of the knowledge of the particular circumstances of time and place, this is closely connected with the smaller importance which is now attached to change as such. Indeed, there are few points on which the assumptions made (usually only implicitly) by the "planners" differ from those of their opponents as much as with regard to the significance and frequency of changes which will make substantial alterations of production plans necessary. Of course, if detailed economic plans could be laid down for fairly long periods in advance and then closely adhered to, so that no further economic decisions of importance would be required, the task of drawing up a comprehensive plan governing all economic activity would be much less formidable.
It is, perhaps, worth stressing that economic problems arise always and only in consequence of change. So long as things continue as before, or at least as they were expected to, there arise no new problems requiring a decision, no need to form a new plan. The belief that changes, or at least day-to-day adjustments, have become less important in modern times implies the contention that economic problems also have become less important. This belief in the decreasing importance of change is, for that reason, usually held by the same people who argue that the importance of economic considerations has been driven into the background by the growing importance of technological knowledge.
Is it true that, with the elaborate apparatus of modern production, economic decisions are required only at long intervals, as when a new factory is to be erected or a new process to be introduced? Is it true that, once a plant has been built, the rest is all more or less mechanical, determined by the character of the plant, and leaving little to be changed in adapting to the ever-changing circumstances of the moment?
The fairly widespread belief in the affirmative is not, as far as I can ascertain, borne out by the practical experience of the businessman. In a competitive industry at any rate — and such an industry alone can serve as a test — the task of keeping cost from rising requires constant struggle, absorbing a great part of the energy of the manager. How easy it is for an inefficient manager to dissipate the differentials on which profitability rests, and that it is possible, with the same technical facilities, to produce with a great variety of costs, are among the commonplaces of business experience which do not seem to be equally familiar in the study of the economist. The very strength of the desire, constantly voiced by producers and engineers, to be allowed to proceed untrammeled by considerations of money costs, is eloquent testimony to the extent to which these factors enter into their daily work.
One reason why economists are increasingly apt to forget about the constant small changes which make up the whole economic picture is probably their growing preoccupation with statistical aggregates, which show a very much greater stability than the movements of the detail. The comparative stability of the aggregates cannot, however, be accounted for — as the statisticians occasionally seem to be inclined to do — by the "law of large numbers" or the mutual compensation of random changes. The number of elements with which we have to deal is not large enough for such accidental forces to produce stability. The continuous flow of goods and services is maintained by constant deliberate adjustments, by new dispositions made every day in the light of circumstances not known the day before, by B stepping in at once when A fails to deliver. Even the large and highly mechanized plant keeps going largely because of an environment upon which it can draw for all sorts of unexpected needs; tiles for its roof, stationery for its forms, and all the thousand and one kinds of equipment in which it cannot be self-contained and which the plans for the operation of the plant require to be readily available in the market.
This is, perhaps, also the point where I should briefly mention the fact that the sort of knowledge with which I have been concerned is knowledge of the kind which by its nature cannot enter into statistics and therefore cannot be conveyed to any central authority in statistical form. The statistics which such a central authority would have to use would have to be arrived at precisely by abstracting from minor differences between the things, by lumping together, as resources of one kind, items which differ as regards location, quality, and other particulars, in a way which may be very significant for the specific decision. It follows from this that central planning based on statistical information by its nature cannot take direct account of these circumstances of time and place and that the central planner will have to find some way or other in which the decisions depending on them can be left to the "man on the spot."VIf we can agree that the economic problem of society is mainly one of rapid adaptation to changes in the particular circumstances of time and place, it would seem to follow that the ultimate decisions must be left to the people who are familiar with these circumstances, who know directly of the relevant changes and of the resources immediately available to meet them. We cannot expect that this problem will be solved by first communicating all this knowledge to a central board which, after integrating all knowledge, issues its orders. We must solve it by some form of decentralization. But this answers only part of our problem. We need decentralization because only thus can we insure that the knowledge of the particular circumstances of time and place will be promptly used. But the "man on the spot" cannot decide solely on the basis of his limited but intimate knowledge of the facts of his immediate surroundings. There still remains the problem of communicating to him such further information as he needs to fit his decisions into the whole pattern of changes of the larger economic system.
How much knowledge does he need to do so successfully? Which of the events which happen beyond the horizon of his immediate knowledge are of relevance to his immediate decision, and how much of them need he know?
There is hardly anything that happens anywhere in the world that might not have an effect on the decision he ought to make. But he need not know of these events as such, nor of all their effects. It does not matter for him why at the particular moment more screws of one size than of another are wanted, why paper bags are more readily available than canvas bags, or why skilled labor, or particular machine tools, have for the moment become more difficult to obtain. All that is significant for him is how much more or less difficult to procure they have become compared with other things with which he is also concerned, or how much more or less urgently wanted are the alternative things he produces or uses. It is always a question of the relative importance of the particular things with which he is concerned, and the causes which alter their relative importance are of no interest to him beyond the effect on those concrete things of his own environment.
It is in this connection that what I have called the "economic calculus" proper helps us, at least by analogy, to see how this problem can be solved, and in fact is being solved, by the price system. Even the single controlling mind, in possession of all the data for some small, self-contained economic system, would not — every time some small adjustment in the allocation of resources had to be made — go explicitly through all the relations between ends and means which might possibly be affected. It is indeed the great contribution of the pure logic of choice that it has demonstrated conclusively that even such a single mind could solve this kind of problem only by constructing and constantly using rates of equivalence (or "values," or "marginal rates of substitution"), i.e., by attaching to each kind of scarce resource a numerical index which cannot be derived from any property possessed by that particular thing, but which reflects, or in which is condensed, its significance in view of the whole means-end structure. In any small change he will have to consider only these quantitative indices (or "values") in which all the relevant information is concentrated; and, by adjusting the quantities one by one, he can appropriately rearrange his dispositions without having to solve the whole puzzle ab initio or without needing at any stage to survey it at once in all its ramifications.
Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to coördinate the separate actions of different people in the same way as subjective values help the individual to coördinate the parts of his plan. It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose — and it is very significant that it does not matter — which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all this without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity — or rather that local prices are connected in a manner determined by the cost of transport, etc. — brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process.
VIWe must look at the price system as such a mechanism for communicating information if we want to understand its real function — a function which, of course, it fulfils less perfectly as prices grow more rigid. (Even when quoted prices have become quite rigid, however, the forces which would operate through changes in price still operate to a considerable extent through changes in the other terms of the contract.) The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.
Of course, these adjustments are probably never "perfect" in the sense in which the economist conceives of them in his equilibrium analysis. But I fear that our theoretical habits of approaching the problem with the assumption of more or less perfect knowledge on the part of almost everyone has made us somewhat blind to the true function of the price mechanism and led us to apply rather misleading standards in judging its efficiency. The marvel is that in a case like that of a scarcity of one raw material, without an order being issued, without more than perhaps a handful of people knowing the cause, tens of thousands of people whose identity could not be ascertained by months of investigation, are made to use the material or its products more sparingly; i.e., they move in the right direction. This is enough of a marvel even if, in a constantly changing world, not all will hit it off so perfectly that their profit rates will always be maintained at the same constant or "normal" level.
I have deliberately used the word "marvel" to shock the reader out of the complacency with which we often take the working of this mechanism for granted. I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind. Its misfortune is the double one that it is not the product of human design and that the people guided by it usually do not know why they are made to do what they do. But those who clamor for "conscious direction" — and who cannot believe that anything which has evolved without design (and even without our understanding it) should solve problems which we should not be able to solve consciously — should remember this: The problem is precisely how to extend the span of our utilization of resources beyond the span of the control of any one mind; and therefore, how to dispense with the need of conscious control, and how to provide inducements which will make the individuals do the desirable things without anyone having to tell them what to do.
The problem which we meet here is by no means peculiar to economics but arises in connection with nearly all truly social phenomena, with language and with most of our cultural inheritance, and constitutes really the central theoretical problem of all social science. As Alfred Whitehead has said in another connection, "It is a profoundly erroneous truism, repeated by all copy-books and by eminent people when they are making speeches, that we should cultivate the habit of thinking what we are doing. The precise opposite is the case. Civilization advances by extending the number of important operations which we can perform without thinking about them." This is of profound significance in the social field. We make constant use of formulas, symbols, and rules whose meaning we do not understand and through the use of which we avail ourselves of the assistance of knowledge which individually we do not possess. We have developed these practices and institutions by building upon habits and institutions which have proved successful in their own sphere and which have in turn become the foundation of the civilization we have built up.
The price system is just one of those formations which man has learned to use (though he is still very far from having learned to make the best use of it) after he had stumbled upon it without understanding it. Through it not only a division of labor but also a coördinated utilization of resources based on an equally divided knowledge has become possible. The people who like to deride any suggestion that this may be so usually distort the argument by insinuating that it asserts that by some miracle just that sort of system has spontaneously grown up which is best suited to modern civilization. It is the other way round: man has been able to develop that division of labor on which our civilization is based because he happened to stumble upon a method which made it possible. Had he not done so, he might still have developed some other, altogether different, type of civilization, something like the "state" of the termite ants, or some other altogether unimaginable type. All that we can say is that nobody has yet succeeded in designing an alternative system in which certain features of the existing one can be preserved which are dear even to those who most violently assail it — such as particularly the extent to which the individual can choose his pursuits and consequently freely use his own knowledge and skill.
VIIIt is in many ways fortunate that the dispute about the indispensability of the price system for any rational calculation in a complex society is now no longer conducted entirely between camps holding different political views. The thesis that without the price system we could not preserve a society based on such extensive division of labor as ours was greeted with a howl of derision when it was first advanced by von Mises twenty-five years ago. Today the difficulties which some still find in accepting it are no longer mainly political, and this makes for an atmosphere much more conducive to reasonable discussion. When we find Leon Trotsky arguing that "economic accounting is unthinkable without market relations"; when Professor Oscar Lange promises Professor von Mises a statue in the marble halls of the future Central Planning Board; and when Professor Abba P. Lerner rediscovers Adam Smith and emphasizes that the essential utility of the price system consists in inducing the individual, while seeking his own interest, to do what is in the general interest, the differences can indeed no longer be ascribed to political prejudice. The remaining dissent seems clearly to be due to purely intellectual, and more particularly methodological, differences.
A recent statement by Professor Joseph Schumpeter in his Capitalism, Socialism, and Democracy provides a clear illustration of one of the methodological differences which I have in mind. Its author is pre-eminent among those economists who approach economic phenomena in the light of a certain branch of positivism. To him these phenomena accordingly appear as objectively given quantities of commodities impinging directly upon each other, almost, it would seem, without any intervention of human minds. Only against this background can I account for the following (to me startling) pronouncement. Professor Schumpeter argues that the possibility of a rational calculation in the absence of markets for the factors of production follows for the theorist "from the elementary proposition that consumers in evaluating ('demanding') consumers' goods ipso facto also evaluate the means of production which enter into the production of these goods."*1
Taken literally, this statement is simply untrue. The consumers do nothing of the kind. What Professor Schumpeter's "ipso facto" presumably means is that the valuation of the factors of production is implied in, or follows necessarily from, the valuation of consumers' goods. But this, too, is not correct. Implication is a logical relationship which can be meaningfully asserted only of propositions simultaneously present to one and the same mind. It is evident, however, that the values of the factors of production do not depend solely on the valuation of the consumers' goods but also on the conditions of supply of the various factors of production. Only to a mind to which all these facts were simultaneously known would the answer necessarily follow from the facts given to it. The practical problem, however, arises precisely because these facts are never so given to a single mind, and because, in consequence, it is necessary that in the solution of the problem knowledge should be used that is dispersed among many people.
The problem is thus in no way solved if we can show that all the facts, if they were known to a single mind (as we hypothetically assume them to be given to the observing economist), would uniquely determine the solution; instead we must show how a solution is produced by the interactions of people each of whom possesses only partial knowledge. To assume all the knowledge to be given to a single mind in the same manner in which we assume it to be given to us as the explaining economists is to assume the problem away and to disregard everything that is important and significant in the real world.
That an economist of Professor Schumpeter's standing should thus have fallen into a trap which the ambiguity of the term "datum" sets to the unwary can hardly be explained as a simple error. It suggests rather that there is something fundamentally wrong with an approach which habitually disregards an essential part of the phenomena with which we have to deal: the unavoidable imperfection of man's knowledge and the consequent need for a process by which knowledge is constantly communicated and acquired. Any approach, such as that of much of mathematical economics with its simultaneous equations, which in effect starts from the assumption that people's knowledge corresponds with the objective facts of the situation, systematically leaves out what is our main task to explain. I am far from denying that in our system equilibrium analysis has a useful function to perform. But when it comes to the point where it misleads some of our leading thinkers into believing that the situation which it describes has direct relevance to the solution of practical problems, it is high time that we remember that it does not deal with the social process at all and that it is no more than a useful preliminary to the study of the main problem.This article was first published in American Economic Review, Vol. XXXV, No. 4 (September 1945), pp. 519–30.
One criticism of Austrian business-cycle theory is that it gives little insight as to what should be done to push an economy out of recession. Even accepting the premise that monetary overexpansion leads to a misallocation of capital goods, detractors claim that this says little in regards to the nature of the depression period. Leland Yeager, for example, argues that "Austrian economists can explain the continuing depression only lamely."Leland B. Yeager, The Fluttering Veil: Essays on Monetary Disequilibrium (Indianapolis, Indiana: Liberty Fund, 1997), p. 232. Lord Robert Skidelsky once made a similar comment in a live debate with George Selgin and Jamie Whyte.
It is somewhat true that most Austrian literature on intertemporal coordination deals with the allocation of capital goods either during periods of healthy growth or during extensive fiduciary expansion. This does not mean, though, that none of this research provides anything of use when describing the consequent depression. The laws of economic coordination, after all, do not cease to apply during eras of economic difficulty.
It is the understanding of economic calculation and coordination that leads most Austrians to argue in favor of what critics call "do-nothing" policies. Opposition to fiscal and monetary policy is based, not on a blind faith in markets, but rather on the idea that the recovery must rely on the same principle that governs the allocation of resources during times of prosperity: economization. It is because of this understanding that Austrians argue that government spending and monetary expansion are counterproductive and handicap economic calculation.
Coordination Theory Briefly ReviewedI have discussed macroeconomic coordination at some length in a prior article, "The Foremost Austrian Contribution to Economic Science." The basic premise of calculation theory is that money prices, formed on the basis of consumer preferences, convey certain pieces of knowledge to market agents. These prices allow individuals to economize the use of resources by providing a tool by which to calculate the merit of a certain action. That is, if an action is defined by using means to achieve an end, prices allow the economization of both means and ends based on the subjective valuation of the individual.
For instance, a person may want to buy an ebook reader, but the price may make it prohibitively expensive. That person may consider a different end a better use of that money. To put it concisely, money provides a standard to compare the values of different economic goods in a society characterized by advanced indirect exchange.
Money prices play an important role in intertemporal calculation. Without money prices, it is questionable whether advanced intertemporal calculation would even be possible.
Entrepreneurs also use these prices as a basis of economization, by exploiting differences between the present prices of relevant capital goods and the expected future prices of the goods they plan to produce. It is this constellation of prices in conjunction with entrepreneurial action, all of which finds its genesis in consumer preferences, that dictates the allocation of economic goods throughout the structure of production.
Austrian intertemporal-discoordination theory is an extension of coordination economics. It explains why there occurs a miscoordination of goods and why such a phenomenon must necessarily lead to a period of industrial depression. In its simplest form, the theory suggests that changes in the supply of fiduciary media in the loanable-funds market will impact the distribution of money throughout the structure of production.
Specifically, it will lead to a higher amount of nominal investment in the capital-goods sector. This is because low interest rates make it cheaper for entrepreneurs to invest in capital-good stages directly before the final consumer-good stage, which in turn increases the profitability of investment in preceding stages. Such investments, however, require real capital goods. Because these goods have not been set aside by a rise in savings, there is an insufficient amount of capital goods to complete ongoing productive processes. There follows a necessary liquidation and an industrial fluctuation.
Depression EconomicsWhat we know about the boom can tell us a lot about the bust. We know that the boom is characterized by a misallocation of economic goods, and that the bust is a product of the necessary liquidation of this malinvestment. Liquidation is necessary as a means of cutting one's losses. If the investment is unprofitable, and you will lose less if you end the investment rather than complete it, then it makes sense to do just that. It is this process that underlies the unfolding secondary events of the depression period.
The liquidation of investment causes the credit contractions typical of these sorts of fluctuations through three processes: a broad default on loans, a contraction of fiduciary media on the part of banks suffering from insufficient capital balances to deal with widespread financial losses, and an increase in the demand for money to deal with a rise in uncertainty. The causal relationship between malinvestment and credit contraction is an important one, because it sheds light on the (lack of) value of attacking what is not the root of the problem.
Within the context of the pricing process, this is a period of substantial chaos. Prices have to recalibrate based on consumer preferences amid credit contraction. How much time this will take is impossible to answer with any accuracy, but generally it will be roughly equal to the amount of time necessary to liquidate the malinvestment that pervades the market at the point of collapse — that is, the amount of time for total unaffordable debt to be defaulted on and for banks to stabilize.
Whether this process is "painful" is not relevant to its necessity; if resources have been misallocated, what purpose can maintaining this misallocation possibly serve? Liquidation of real investments and of unaffordable financial assets, therefore, is one aspect of the Austrian "policy" to restore health to the market.
While prices are adjusting, entrepreneurs must allocate capital goods toward production processes that are coordinated with consumer preferences. This may require a dramatic change in the structure of production. Capital goods are heterogeneous: nails cannot be turned to glass, nor hammers to automobile carburetors. How flexible an economic good is in its ability to move from one process of production to another varies, and this flexibility plays an important role in determining how the postboom stock of capital goods can be rearranged toward new lines of investment.
There may be a substantial amount of specific capital goods produced during the expansionary period that are no longer useful — that is, their purposes are no longer relevant to satisfying consumer demand. An example would be a machine that produces a very specific capital good useless for anything other than the original project it was intended for.
Some capital goods may not be useful at all, and they will lose their status as economic goods. Others may have to remain "idle" until their owners find it worthwhile to use them. These entrepreneurs may find it more profitable to invest in other capital goods instead of opting for means and ends with higher opportunity costs.
The rearrangement of the structure of production is not a simple process. Specificity aside, some capital goods require other capital goods for production purposes. If complimentary goods are unavailable or unaffordable, it may jeopardize the usefulness of the good in question. Or the product that can be produced with what is affordable will be much different from that produced when prices were skewed by fiduciary expansion. Goods that are substitutable for each other may alleviate some of the transition pains, but these too will impact the various production processes they are related to.
Another important aspect of depressions is the high unemployment that usually comes with a mass liquidation of productive processes. Like capital goods, labor must be reallocated. However, it is a grave error to prescribe policy based on unemployment alone. Employment of workers toward processes that do not satisfy the highest-valued consumer preferences is either unsustainable or comes at the cost of subpar productivity.
"Improvement in the labor market, therefore, is unquestionably tied to the capital structure."Sustainable employment can only be accomplished by mixing labor with capital goods toward production processes that are based on consumer valuations. Improvement in the labor market, therefore, is unquestionably tied to the capital structure. Without a structural readjustment, there can hardly be a sustainable or economical reduction of unemployment.
This structural readjustment is the Austrian "recommendation" of what needs to occur to restore healthy productivity to an economy. There are two main components: a correction in the pricing process and a readjustment in the capital structure. Whether these would be "unfair" or "painful," frankly, does not matter. Rather than blaming the readjustment, guilt should be associated with the interventions that made the liquidation and restructuring necessary in the first place — the inflationary policies that led to the depression. Any step taken to avoid the readjustment will at best prolong the recession, or at worst aggravate the problem.
Interventionism and Its ConsequencesOn the surface, fiscal stimulus seems like a sensible policy prescription for reinvigorating industrial productivity. The general idea is to put "idle" resources to work. But those who are trained within the Austrian framework know that this idea has no basis in reality. As explained above, the issue is not about merely putting resources to work; it is about putting resources to work in the right areas as to best service consumer desires. This requires economization. A more comprehensive theoretical argument as to why government cannot economize is provided in my article "Government Spending is Bad Economics."
The market rewards those who economize well with profits, and it punishes those who do not with losses. Therefore, there is a tendency for capital to be distributed to those who use it best. Once one entrepreneur ceases to use capital wisely, it flows toward a better one. Government taxation disrupts this process by expropriating capital from those who earned it through the market. It then invests it in projects that are based, not on calculation, but rather on political whim, such as building highways or whatever make-work program the government concocts. Government spending represents a waste. The waste is the production foregone in favor of opting for a subpar investment opportunity.
Part of the problem is theoretical. The Austrian School, so far, is the only one characterized by an accurate theory of intertemporal pricing and distribution (that is, capital theory). Other schools, including the mainstream neoclassical and Keynesian schools, do not enjoy this body of theory. Instead, for them capital is an aggregated concept. They believe capital goods to be homogeneous; they do not differentiate among nails, hammers, glass, and carburetors.
One can see, then, how economization fails to play an important role in these schools' alleged solutions to the depression period of an industrial fluctuation. All goods are homogeneous and therefore flexible and substitutable. If there is scarcity, there still needs to be some form of economization, but it becomes less important: there is no distinguishing what goods should be economized toward what ends. Furthermore, if there are idle resources then the issue becomes almost one of nonscarcity.
Capital goods are not homogeneous, and they cannot be aggregated. Buying resources through taxation and then investing them based on a government policy has underlying economic implications that impact the structure of production. Furthermore, as noted above, any investment undertaken by the government is necessarily inferior to the investment that would have occurred otherwise, because government investment is not part of the market process.
Fiscal policy is not a legitimate response to a fall in industrial productivity caused by a previous misallocation of resources. The consequence of such policy is an inferior structure of production or, worse yet, one that is completely unsustainable.
Instead, what an economy in depression needs is an adjustment period, characterized by deflation, price adjustment, and structural change. This is not a "do-nothing" policy; the dichotomy between government response and "do nothing" is a false one. The alternative is this: let the relevant market agents and the market process readjust to cope with the problems caused by government intervention.
Archived from the live Mises.tv broadcast, this lecture by Hans Hoppe was presented at the 2011 Mises University in Auburn, Alabama.
Mathematics can sometimes make smart people dumb. Let me explain what I mean by this. I don't mean that it is dumb not to be good at mathematics. After all, mathematics is a highly abstract and challenging discipline requiring many years (decades even) of study, and there are plenty of very smart people who have little understanding of it, and little ability to use it. What I mean is that mathematics quite often bamboozles people into accepting very silly arguments — arguments that are so silly that if you stated them without draping them in mathematical negligee, you would instantly become an object of ridicule to all those people who flunked out at basic algebra back in high school.
The danger of mathematical arguments is that a person can sometimes follow an absurd path of reasoning without being alerted to its absurdity, due to the fact that their mind is so lost in the verbiage of mathematical equations that their common sense fails to penetrate it. As a statistics teacher, I have to guard against this problem constantly in my students.In my own teaching, I like to keep students on their toes by occasionally presenting them with a flawed statistical argument that leads to a conclusion that is quite obviously absurd. My favorite practice is to give them statistical questions that invite them to conflate correlation and cause — leading to some obviously absurd conclusions — and then see if they notice the absurdity of the conclusion they are getting, rather than plowing ahead blindly with their equations. One of the main difficulties in teaching applied mathematics is that students can become bamboozled by the mathematical machinery they are using, to the detriment of their ability to reason sensibly about the nature of the problem that the mathematics is designed to describe.
One of the most common errors in applied mathematical analysis is to fail to notice when a mathematical argument proves too much. This occurs when the same argument can be deployed more generally than in the particular case being considered, and in other cases where it can be deployed it leads to conclusions that are clearly absurd.A warning against acceptance of this kind of argument is captured in the Latin maxim, quod nimis probat, nihil probat, which means, "What proves too much proves nothing." Though this can occur more generally — in nonmathematical reasoning — it is a particularly acute danger in applied mathematics, due to the fact that understanding mathematical arguments generally requires a high level of training and intellectual effort. It is very easy to get lost in equations and theorems and fail to see the forest for the trees.
An Example of Applied Mathematics Going Horribly WrongLet me give you an example of this phenomenon in action. The Australian government recently announced that it will attempt to enact legislation to impose a tax on industrial carbon-dioxide emissions, with some of the revenue being earmarked as compensation for affected consumers. At a pro-government political rally in Sydney, a young activist proudly displayed what he clearly thought to be a devastating economic argument in favor of this "carbon-pricing" scheme. See for yourself:
The "Say Yes" rally to support a proposed carbon-dioxide-emissions tax (June 5, 2011, Sydney, Australia)Picture taken from http://twitpic.com/57awlj. I have cropped out the young man's face, since it is not my intention to embarrass him. Scrutiny of his sign is mainly for the purposes of showing a more general problem pertaining to attempts at applied mathematical analysis, though it is certainly worthy of criticism, especially for its rude and pretentious demeanor.To those readers who have not studied neoclassical microeconomics, this is probably just a big bunch of gibberish. But to those who have, it should look quite familiar. The graph is a "utility analysis," which purports to show that imposing a tax on polluting products (which increases their price) and simultaneously giving compensation back to consumers would make them better off than they were initially — in other words, it purports to show that the Australian government's proposed scheme, or something like it, would make people better off.
This is a classic example of a mathematical analysis that proves too much. Notice, in the graph in the sign, that the two products are labeled "C" (for clean products) and "P" (for polluting products). Although they are labeled in this way, the fact that the horizontal axis represents the consumption of polluting products plays absolutely no part in the analysis. There is nothing in the graph representing the pollution that these products cause, and so the label is merely a name. The letter "P" is nothing more than an algebraic symbol, one that could just as easily stand for pies, pastries, printers, pizzas, polka lessons, picture frames, pole dancing, ponies, popcorn, pool tables, poppy-seed muffins, pornography, postcards, potatoes, potpourri, poultry, pumpkins, puppies, pudding, or any other good or service (including goods and services that don't start with the letter "P").
Thus, by the exact same mathematical argument, the graph implicitly purports to show that a government can make people better off by taxing any good and then compensating the consumers of that good. Though the government taxes the polluting products in the graph, the sign maker could just as easily have switched the labels on the axes so that the government taxes the clean products, and the result, according to the same analysis, would still be a consumer who is better off.
In fact, the analysis in the graph could be taken further than this. Why stop taxing there? Repeating the same analysis, the government could increase the happiness of their subject population further still by imposing a tax-and-compensation scheme on the polluting goods, and then the clean goods. But why even stop there? They could then impose another tax-and-compensation scheme on the polluting goods, then on the clean goods, then on the polluting goods, and so on. Each time, the same analysis would purport to show that the consumer would become better off. In fact, the analysis could be repeated ad infinitum, allowing the government to completely transcend the problem of scarcity by boundlessly increasing the possible consumptions sets of the consumer.Assuming that the utility function in the analysis is strictly quasi-concave (a common assumption in neoclassical microeconomic analysis), infinite repetition of the scheme in the graph would lead to an infinite series of strictly positive utility changes. Some further assumptions about the utility function would then be needed to ensure that this series diverges to infinity, so that utility (and the budget constraint and consumptions sets) can be boundlessly increased. In particular, a homothetic utility function is a sufficient but not necessary condition for this result. How wonderful!
But wait a minute. You don't need to be a mathematician, or an economist, to figure out that there is something funny going on here. Either some step in the analysis or some starting assumption must be faulty. In a moment I will explain what this is, but really, this exercise is largely academic. The point here is that the conclusion from the analysis is so absurd that something in the analysis must obviously be wrong, even if we are unable to pinpoint exactly what it is. It proves far too much.
Suppose that this young fellow had eschewed mathematical explanation in this instance, and instead simply stated his argument verbally: "If you have two types of goods (let's call them C and P) and the government taxes one of those goods (say, good P) and then pays consumers of that good compensation, then those consumers will be better off than they were to start with." A question would immediately spring to the listener's mind: How much compensation is needed for this to happen? And in particular, is the revenue from the tax enough to cover it? Isn't this important in deciding whether this argument is a valid reason to support the tax? In verbal form, these questions would present a serious challenge to the analyst, and an opportunity for him to discover a serious flaw in his assumptions.
The Error with This AnalysisIn fact, these questions are the key to the flaw in the analysis. Notice that in the second step listed on the sign, the consumer is given compensation that allows him to afford the same bundle of goods that he initially started with. Since the price of the polluting products has increased, this means that the cost of the compensation being paid in the analysis is equal to the amount of polluting products initially being consumed, multiplied by the increase in price from the tax. (In mathematical parlance, this is t × P0, where 0 < t < 1 is the price increase due to the tax.)
Can the government afford this, using the revenue it extracts indirectly from these consumers? Well, let's start by being as generous as we possibly can to the argument, by invoking some fanciful assumptions in its favor. Let's assume — contrary to every sensible understanding of government — that the tax-and-compensation scheme can be enacted and administered without any costs at all. In this case, the net revenue taken from the consumers would be equal to the gross takings, which is equal to the amount of polluting products being consumed after the imposition of the tax, multiplied by the increase in price. (In mathematical parlance, this is t × P1, where 0 < t < 1 is the price increase due to the tax.)
See a problem? The gross revenue taken from consumers uses the actual consumption level after the imposition of the tax, but the compensation payment given to consumers is based on the amount of revenue that would have been raised based on the consumption of polluting products before the imposition of the tax. Since the analysis shows that the consumer is consuming less of the polluting products after the imposition of the tax than before, this means that the revenue taken from consumers cannot possibly cover the compensation payments being made. (Since P0 > P1 we have t × P0 > t × P1.)
In fact, using the exact kind of mathematical model being used in the sign, it can actually be shown that the amount of compensation required to fully compensate a consumer for a price rise (called the "compensating variation"), just to make them as well off as they started, is larger than the gross revenue extracted from the price rise.For a demonstration of this, using standard neoclassical utility analysis (as is used in the sign), see Example 3.I.1 of Mas-Colell, A., Whinston, M.D. and Green, J.R. (1995) Microeconomic Theory. Oxford University Press: New York, pp. 84-85. Discussion of the same kind of example can be found in Jehle, G.A. and Reny, P.J. (2001) Advanced Microeconomic Theory (2nd Edition). Addison-Wesley Longman: Boston. pp. 53, 166–171. Such an analysis uses standard neoclassical microeconomic assumptions; it assumes that the preference relation of the consumer is complete, transitive, continuous, strictly monotonic, and strictly convex (the last two assumptions ensure a strict loss of revenue to the government, but these can be relaxed to still yield a nonstrict loss). That is, there is always some loss in consumer "utility" in this kind of scheme, even if we ignore any administrative costs to impose and run it, and devote the entire gross revenue from the price increase to compensation. Thus, the only possible argument that could be made along these lines is that giving consumers more money than they are paying in and shifting these excess costs onto others (e.g., producers) could potentially make them better off. But even then, an honest economic analysis of this situation would also need to look at the costs to others from this scheme, rather than obscuring the loss of revenue.
Obviously, the situation becomes much worse if we make more realistic assumptions about the administrative costs of the scheme, since this reduces the net revenue available for payment as compensation. In reality, a taxation scheme of this kind would require very large amounts of money for the government to create and administer, and would also impose compliance costs on the taxpayers. The situation also becomes worse for the consumer if he receives only part of the tax revenue in compensation, rather than the full amount. There would also be disparities in the compensation between consumers, so that some would be worse off, even if others got a large amount. Possible rent-seeking behavior and other economic issues could make the situation worse still, until a very grim picture of the scheme starts to emerge.
In the sign in the picture, the compensation required to get to the blue utility curve (making the consumer better off) would cost more than the gross revenue from the tax. In fact, even the compensation required to get back up to the black utility curve (making the consumer as well off as they were before the tax) would cost more than the gross revenue from the tax. Add administration costs for the scheme to this, and other realistic issues, and now you need to come up with an awful lot of extra money that is nowhere to be seen.
In fact, regardless of the findings of a utility analysis of this kind, there is one overriding economic argument against a coercive scheme such as the one being proposed. If it were possible to increase consumer satisfaction by taking people's money and then giving it back to them in a revenue-neutral fashion in this way, then presumably consumers would be able to do this themselves — they could make voluntarily contractual arrangements for a scheme like this without any coercion being applied. The fact that they do not, and that they need to be coerced into compliance, demonstrates, by virtue of the principle of revealed preference, that they are not better off under such an arrangement, regardless of the purported findings of any economic models.
Using Mathematics to Make the Dumbest Argument PossibleIf one were a supporter of a carbon-dioxide-emissions tax (I am not) then I doubt one would be too pleased with the above argument being presented in its favor if it were expressed in verbal form. Yet, add some mathematical bells and whistles to this absurdity, and you get a sign that was described by one sympathetic observer as the "Best Sign" at the rally.See picture caption at http://twitpic.com/57awlj. In fact, not only is the analysis in the sign flawed, but when it is done properly, it actually leads to the exact opposite conclusion from the one asserted to be true; it alerts us to the fact that the tax-and-compensation scheme will leave the consumer worse off, unless they are given additional money, plucked like manna from heaven.
Aside from the above instance where this argument is made in mathematical form, I do not recall ever hearing a single advocate of a carbon-dioxide-emissions tax make the asinine assertion that tax-and-compensation schemes of this kind would increase the happiness of consumers regardless of the good being taxed. They are not quite that silly. Almost all arguments in favor of taxation schemes of this kind are based on completely different reasoning from this, usually using "negative externality" arguments that assert actual pollution problems. These arguments cannot really be captured in a single consumer-utility graph, since they involve assertions of interactions between the actions of one consumer and the preferences of another. The mathematical argument presented in the picture above is therefore not an advancement of the pro-tax position. It actually does a serious disservice to this position by presenting an incorrect and very ill-considered justification for it.
This shows the particular danger of getting bamboozled by applied mathematical analysis, to the extent that absurd premises slip through the net undetected. It allows a person to make the dumbest argument possible for a particular proposition, while maintaining a supreme measure of confidence, and indeed cockiness, in his own position.
When doing applied mathematical analysis we need to be careful not to fall into this trap. Though mathematics is a specialized discipline, beyond the understanding of many people, a sound analysis in applied mathematics should generally be translatable into a sound verbal argument, at least in a heuristic form. Its arguments are progressions from premises to conclusions based on logic, and hence, if you cannot explain the structure of your argument and its premises (at least in heuristic terms) to people without much mathematical training, you probably do not have a broad enough understanding of the structure of the argument to warrant reliance on it.
The Purpose and Value of Mathematical ArgumentsI have not shown this example simply to demonstrate the dangers of having inept economics students present their ham-fisted policy analysis in public. It is actually demonstrative of a wider point regarding the use and abuse of mathematical arguments: mathematics cannot do scientific problems for you. All that mathematics can do is to allow you to state problems in quantitative form and find the logical consequences of various assumptions about the problem you are trying to solve. A mathematical argument shows that certain premises lead logically to certain conclusions. But it does not guarantee that those premises bear any resemblance to reality. Whether or not they do is an important matter, deserving the utmost consideration.
Mathematics is meant to augment logical argument, by providing the ability to clearly define a problem, and to ensure that all necessary assumptions are made explicit in the analysis. Its advantage over "literary" argumentative methods (when used properly) is that it ensures that the analyst is not making assumptions that he is unaware of, and is not making leaps in argument that are illogical. However, when mathematical arguments are used to obscure, rather than enlighten, the result is that they tend to hide assumptions that are being made.
The argument presented in the sign above hinges on the fact that it hides any discussion of the amount of revenue needed for the compensation payment that is assumed to be made. It does not compare this amount to the actual amount of revenue taken from consumers due to the price rise, and as soon as this issue is considered, we see that the argument presented in the sign is either wrong or at the very least highly misleading. Actually, the real purpose of the sign above is not to convince but to obscure. The purpose is to prevent rational debate on the subject by warding off the approaches of anyone who has not studied mathematical economics and is unable to penetrate the meanings of the various lines on the graph. Like so many purported scientific justifications of government power and intervention, the argument in the sign needn't be remotely sensible so long as it is arcane enough to keep the riffraff from understanding the argument that is being made — and the premises of that argument.
It is an appeal to authority, with the authority in this case being a bunch of fancy graphical work. Like so many purported scientific justifications of government power, it is based on false premises and/or shoddy logic, masquerading as bona fide scientific analysis. It is the voice of a pretentious elite saying, We couldn't possibly explain our reasoning to you in a way that you could understand, so just defer to our clearly superior intelligence, bitches. (Note: mathematics can sometimes make smart people dumb, but it cannot make them pretentious mediocrities; they do that on their own.)
When mathematical arguments prove too much, it is often as a result of faulty assumptions. If an applied mathematical argument leads to a conclusion that is highly counterintuitive, or if the form of argument can be deployed just as effectively to prove other conclusions that are highly counterintuitive, then this is good reason to further scrutinize the assumptions made in the argument.
Mathematics is a fascinating and powerful discipline, and one that I love a great deal. Enjoy it to the extent that you are able. But, as Ayn Rand used to say, check your premises!
Why the sudden pressure against drug prohibition? It is a burden on taxpayers. It is a burden on government budgets. It is a burden on the criminal-justice system. It is a burden on the healthcare system. The economic crisis has intensified the pain from all these burdens, writes Mark Thornton.
This audio Mises Daily is narrated by the author.
Disputants would be far better off if they could choose among competing arbitration agencies and thereby reap the benefits of competition and specialization, writes Morris and Linda Tannehill.
This audio Mises Daily is narrated by Holly Hinton and Joel Sams.
Every time we object to a thing being done by government, they conclude that we object to its being done at all, writes Frédéric Bastiat (1801–1850).
This audio Mises Daily is narrated by Joel Sams.
Scott Patterson, reporter for the Wall Street Journal and author of The Quants (2010), tells the story of
traders and financial engineers who used brain-twisting math and superpowered computers to pluck billions in fleeting dollars out of the market. Instead of looking at individual companies and their performance, management and competitors, they use math formulas to make bets on which stocks were going up or down. By the early 2000s, such tech-savvy investors had come to dominate Wall Street, helped by theoretical breakthroughs in the application of mathematics to financial markets, advances that had earned their discoverers several shelves of Nobel Prizes.[1]
The fall of the quants in 2007 was even more precipitous than their rise. Patterson tells of the experience of one outfit in particular, Morgan Stanley's Process Driven Trading, during the week of August 6.
PDT, one of the most secretive quant funds around, was now a global powerhouse, with offices in London and Tokyo and about $6 billion in assets (the amount could change daily depending on how much money Morgan funneled its way). It was a well-oiled machine that did little but print money, day after day.
That week, however, PDT wouldn't print money — it would destroy it like an industrial shredder.
The unusual behavior of stocks that PDT tracked had begun sometime in mid-July and had gotten worse in the first days of August. The previous Friday, about half a dozen of the biggest gainers on the Nasdaq were stocks that PDT had sold short, expecting them to decline, and several of the biggest losers were stocks PDT had bought, expecting them to rise. It was Bizarro World for quants. Up was down, down was up. The models were operating in reverse.
The market moves PDT and other quant funds started to see early that week defied logic. The fine-tuned models, the bell curves and random walks, the calibrated correlations — all the math and science that had propelled the quants to the pinnacle of Wall Street — couldn't capture what was happening.[2]
The quants were among the first of many victims of the bursting of that decade's economic bubble. Patterson would have us believe that they were also among the chief causes of the financial crisis that ensued. But the bubble and its bursting were made virtually inevitable by the prior actions of the Federal Reserve, as anyone who adheres to the Austrian business-cycle theory will tell you.[3] However, exactly who is involved the most in the inflating of the bubble, and exactly who suffers the most when it bursts, depends on the actions of the market participants in question. And undoubtedly the quants were foremost among their own gravediggers.
The ultimate test of market strategies should always be profit and loss, and therefore it is worse than useless to regulate such investment strategies as President Obama has tried to do.[4] But if Ludwig von Mises were alive today, he probably would not have been in the least surprised that the quants' methods ultimately bore such bitter fruit. Their models "couldn't capture what was happening" for two fundamental reasons:
They did not integrate an accurate understanding the business cycle.
They treated a matter of case probability as if it were a matter of class probability.
Mises's distinction between these two kinds of probability is the cornerstone of his theory of uncertainty, which in turn hinges on his theory of "the specific understanding." In this article, I will endeavor to explain both of these little-understood areas of Mises's thought.
Class Probability and Case ProbabilityAccording to Mises, there are two approaches that the human mind can take concerning incomplete knowledge of real affairs: class probability and case probability.
The most important thing to note about this distinction is that class probability has to do with frequency, and case probability does not. Another important thing to note is that class probability has to do with causality and nature, while case probability has to do with teleology and human choice.[5]
Mises defines the two kinds of probability in Human Action.
Class probability means: We know or assume to know, with regard to the problem concerned, everything about the behavior of a whole class of events or phenomena; but about the actual singular events or phenomena we know nothing but that they are elements of this class.[6]
Case probability means: We know, with regard to a particular event, some of the factors which determine its outcome; but there are other determining factors about which we know nothing.[7]
Here are some examples Mises gives of each type.
Class ProbabilityCase ProbabilityGambling (Lottery Tickets, Roulette, etc.)Betting (Sports Wagers, Political Bets, etc.)Engineering Margins and Medical PrognosesHistorical ScholarshipBusiness-Inventory VicissitudesEntrepreneurial SpeculationPurchasing Insurance To take the example of a lottery, a prospective ticket buyer may know everything about the class "Tickets for the MegaMillions Lottery Ending May 31." He may know exactly how many tickets there are, and exactly how many will be winning tickets. He would thus have complete knowledge concerning the "winning frequency" about the class in question. However, as he looks at four tickets hanging on the wall behind the drugstore counter, he would know absolutely nothing about the cases in question (the particular tickets he is considering) except that they are members of the MegaMillions-Tickets class. He has relevant (and, in this situation, complete) class knowledge, but no relevant case knowledge. Placing a stake according to class probability is Mises's definition of a gamble.[8]
Now, the state of affairs would be very different if one were placing a stake on human action. For example, let us say an ancient Roman named Quintus is placing a wager on whether Caesar will lead his army across the River Rubicon toward Rome, an act that will commit the Roman commander to war against the forces of Pompey and the Roman Senate, thus plunging Rome into a civil war.
Unlike the situation with the lottery ticket, Quintus has no relevant class knowledge concerning Caesar. Quintus can classify Caesar according to any number of class distinctions (or "real types," as discussed further below) his mind can conceive of: "Roman consul," "Roman of patrician rank," "human born on 13 July." But any survey he makes of members of such classes would be useless to him for predicting his choice. That is because, as Mises says,
the distinctive mark of what we call the human sphere or history or, better, the realm of human action is the absence of … a universally prevailing regularity. Under identical conditions stones always react to the same stimuli in the same way; we can learn something about these regular patterns of reacting, and we can make use of this knowledge in directing our actions toward definite goals. Our classification of natural objects and our assigning names to these classes is an outcome of this cognition. A stone is a thing that reacts in a definite way. Men react to the same stimuli in different ways, and the same man at different instants of time may react in ways different from his previous or later conduct. It is impossible to group men into classes whose members always react in the same way.[9]
So when we are dealing with uncertainty concerning any event determined by human choice, we are
grappling with an individual, unique, and nonrepeatable case. The case is characterized by its unique merits, it is a class by itself. All the marks which make it permissible to subsume it under any class are irrelevant for the problem in question.[10]
Therefore Quintus's wager on whether Caesar will cross the Rubicon is not a matter of class probability.
Now, while the prospective lottery ticket buyer has no case knowledge about particular tickets, is it possible to have case knowledge about the particular man Caesar? Is it possible to have insight into the individual, unique, and nonrepeatable cases we call human beings?
Case Probability, the Specific Understanding, and ThymologyYes, case knowledge is undeniably possible. In our daily lives, we all have experience in achieving psychological insight into the emotions, motivations, ideas, judgments of value, and volitions of unique individuals. Mises calls such knowledge "thymology," and he calls the mental process that results in such knowledge "the specific understanding" (or, in German, "verstehen").[11]
Because it is possible to achieve psychological insight into the emotions, motivations, ideas, judgments of value, and volitions of the individual named Caesar, Quintus can have case knowledge: That is, as Mises defined it, knowledge of, with regard to a particular event (the crossing or noncrossing of the Rubicon), some of the factors which determine its outcome. Placing a bet based on case probability is Mises's definition of a bet.[12]
The specific understanding, as well as the thymological knowledge which it produces,
is applied by everybody in daily intercourse with all his fellows. It is a technique employed in all interhuman relations. It is practiced by children in the nursery and kindergarten, by businessmen in trade, by politicians and statesmen in affairs of state. All are eager to get information about other people's valuations and plans and to appraise them correctly.[13]
Thymology is the insight that people refer to when they speak of a biographer's insight into the "psychology" of his subject or an advertiser's insight into the "psychology" of the potential consumers of his product. However, to avoid confusion, Mises used the term "thymology" instead of "psychology" because the latter term had already, by his time, come to be associated with naturalistic disciplines like psychopathology and neuropathology, which deal with physiological states and outward behaviors, but not the "inner life" of ideas and values.
It must be understood that the specific understanding is not some kind of magical inspiration. In producing thymological knowledge, the specific understanding does depend on experience — just not on controlled experiments or quantitative data.
Thymology is on the one hand an offshoot of introspection and on the other a precipitate of historical experience. It is what everybody learns from intercourse with his fellows. It is what a man knows about the way in which people value different conditions, about their wishes and desires and their plans to realize these wishes and desires.[14]
For example, for Quintus to understand anything about Caesar, or anybody else, requires some introspection. Our direct experience of our own emotions, ideas, values, and volitions is the root of our understanding of what it means to have emotions, ideas, values, and volitions in the first place. Furthermore, through introspection, we can empathize with, and thus better understand, the mental states of other individuals. But introspection by itself is not enough. Understanding also requires experience. This experience can be personal conversation with Caesar himself, or it can be hearing from others about the character and actions of Caesar.
Maybe Quintus judges based on these sources that Caesar has longed to be a dictator, either out of lust for power or a desire to reconstitute the republic. And maybe he judges that if Caesar does not cross the Rubicon, and instead relinquishes control of his army, that he will never be able to enter Rome again without being prosecuted. And perhaps Quintus judges that Caesar himself is fully aware of that. These factors may contribute toward the likelihood of Caesar crossing the Rubicon.
But then there may be counterfactors. Quintus may expect Caesar to abhor the prospect of the bloodletting among his fellow Romans that would ensue in a civil war, and to be concerned particularly for his loved ones.
There may be dozens of such factors that Quintus may think will weigh on Caesar's mind in making the decision. Quintus must try to estimate as best as possible, using his own judgments concerning the importance of each factor for Caesar, which factors will ultimately hold sway.
As illustrated above, the specific understanding has two tasks in constructing thymological knowledge for use in forecasting human choice:
It must establish the factors (goals, judgments of value, ideas, etc) that may influence the choice.
It must establish the relative importance of each factor.
But of course this is all necessarily educated guesswork. Quintus may be wrong about what factors exist, or (and this is the trickiest issue) about the importance of each factor, or both.
Understanding is always based on incomplete knowledge. We may believe we know the motives of the acting men, the ends they are aiming at, and the means they plan to apply for the attainment of these ends. We have a definite opinion with regard to the effects to be expected from the operation of these factors. But this knowledge is defective. We cannot exclude beforehand the possibility that we have erred in the appraisal of their influence or have failed to take into consideration some factors whose interference we did not foresee at all, or not in a correct way.[15]
$40 $20
For this reason, the operation of the specific understanding always deals with probabilities, and not certainties.
Thymology … can never predict in the way the natural sciences can. It can never know in advance with what weight the various factors will be operative in a definite future event.[16]
Because choice factors and their relative importance are unquantifiable, the probability dealt with by the specific understanding (case probability) is also necessarily unquantifiable, and therefore it can have nothing to do with quantitative frequency.
The term "probability" in philosophical discourse used to include such nonquantitative uncertainties, but, according to the quantophrenetic[17] trend of modern thought, the term now often is given an exclusively mathematical connotation. Due to this, Mises also suggested referring to "case probability" as a "likelihood" instead, if that helps avoid confusion.[18]
In dealing with case probability, people may speak of one human event having a "greater" or "lesser" likelihood of occurring than another human event. But just as there is no way of measuring how much "greater" is one's valuation of apples over oranges,[19] there is no way of even crudely measuring such "differences" in likelihood.
Also, in dealing with uncertainty in human affairs, people may verbally assign quantitative probabilities to their judgments of likelihood. But this does not mean class probability has any bearing on human affairs. Mises gives the example of someone, on the eve of the 1944 US presidential election saying that they estimate the chances of Franklin Roosevelt winning to be 9 to 1.
This is a proposition about the expected outcome couched in arithmetical terms. It certainly does not mean that, out of ten cases of the same type, nine are favorable for Roosevelt and one unfavorable. It cannot have any reference to class probability. But what else can it mean?
It is a metaphorical expression. Most of the metaphors used in daily speech imaginatively identify an abstract object with another object that can be apprehended directly by the senses. This is not a necessary feature of metaphorical language, but merely a consequence of the fact that the concrete is as a rule more familiar to us than the abstract. As metaphors aim at an explanation of something that is less well known by comparing it with something better known, they consist for the most part in identifying something abstract with a better-known concrete. The specific mark of our case is that it is an attempt to elucidate a complicated state of affairs by resorting to an analogy borrowed from a branch of higher mathematics, the calculus of probability. As it happens, this mathematical discipline is more popular than the analysis of the epistemological nature of understanding.
There is no use in applying the yardstick of logic to a critique of metaphorical language. Analogies and metaphors are always defective and logically unsatisfactory. It is usual to search for the underlying tertium comparationis. But even this is not permissible with regard to the metaphor we are dealing with, for the comparison is based on a conception that is in itself faulty in the very frame of the calculus of probability, namely the gambler's fallacy. In asserting that Roosevelt's chances are 9:1, the idea is that Roosevelt is in regard to the impending election in the position of a man who owns 90 percent of all tickets of a lottery in regard to the first prize. It is implied that this ratio 9:1 tells us something substantial about the outcome of the unique case in which we are interested. There is no need to repeat that this is a mistaken idea.[20]
Ideal TypesThere are other sources besides personal experience with, and hearsay about, Caesar that Quintus could draw from to try to forecast his choice. Quintus could also draw from his experience with human nature, Roman civilization, patrician culture, or, "the military man."
Now, this may seem to run contrary to what was said above about the irrelevance of class concepts with regard to understanding and predicting human action. However, such terms are not "class concepts," but instead they are what Mises called "ideal types."
Mises distinguished the ideal types used in contemplating human action from the class concepts used in contemplating natural phenomena.
The natural sciences classify the things of the external world according to their reaction to stimuli. Since copper is something that reacts in a definite way, the name copper is denied to a thing that reacts in a different way. In establishing the fact that a thing is copper, we make a forecast about its future behavior. What is copper cannot be iron or oxygen.[21]
Individual humans, on the other hand, do not react in definite, fixed ways to given stimuli, and so men, ideas, customs, institutions, and artifacts cannot be classified according to stimulus reaction. Instead, they can only be grouped according to human meaning.
Some human things can be grouped according to human meaning into rigidly definable class concepts. Mises calls such class concepts in human affairs "real types."
In acting-in their daily routine, as well as in technology and therapeutics, and also in history-people employ "real types," that is, class concepts distinguishing people or institutions according to neatly definable traits. Such classification can be based on concepts of praxeology and economics, of jurisprudence, of technology, and of the natural sciences. It may refer to Italians, for example, either as the inhabitants of a definite area, or as people endowed with a special legal characteristic, viz., Italian nationality, or as a definite linguistic group. This kind of classification is independent of specific understanding. It points toward something that is common to all members of the class.[22]
But as discussed above, class concepts constructed concerning human affairs (real types) are useless with regard to dealing with uncertainty in human affairs.
Ideal types are distinct from real types in that
The characteristic mark of an "ideal type," on the other hand, is that it implies some proposition concerning valuing and acting. If an ideal type refers to people, it implies that in some respect these men are valuing and acting in a uniform or similar way. When it refers to institutions, it implies that these institutions are products of uniform or similar ways of valuing and acting or that they influence valuing and acting in a uniform or similar way.[23]
Ways in which people concretely value and act are often noticeably similar, but their marks of similarity are not such that they can be abstracted in order to construct neatly definable class concepts (real types). The specific understanding, however, can perceive such resemblances and make judgments concerning their importance. Based on such perceptions and judgments, the specific understanding can recognize affinity between various instances in human affairs, and construct an enumeration of connected traits based on this "meaning affinity." Such a construction is an "ideal type."
An ideal type is not a class concept, because its description does not indicate the marks whose presence definitely and unambiguously determines class membership. An ideal type cannot be defined: it must be characterized by an enumeration of those features whose presence by and large decides whether in a concrete instance we are or are not faced with a specimen belonging to the ideal type in question. It is peculiar to the ideal type that not all its characteristics need to be present in any one example. Whether or not the absence of some characteristics prevents the inclusion of a concrete specimen in the ideal type in question depends on a relevance judgment by understanding. The ideal type itself is an outcome of an understanding of the motives, ideas, and aims of the acting individuals and of the means they apply.[24]
For example Quintus may consider Caesar to possibly be a "demagogue/striver" — an ideal type constructed in his mind characterized by these traits:
Love of powerLove of prestigeHigh self-esteemRestlessnessDaringOpportunismUnscrupulousnessAbility to sway the masses (rank-and-file soldiers as well as city mobs)Quintus may have constructed this ideal type in his mind when reading about Pisistratus, an ancient Greek who never ceased his dramatic machinations until he was tyrant of Athens.[25] He may see much of the character of Pisistratus and other Greek tyrants in the character of Caesar. Again, "demagogue/striver" is not a class concept with a rigid definition. Quintus may even consider some of the enumerated traits to be wholly inapplicable to Caesar. For example, Quintus may consider Caesar not to be unscrupulous, unlike Pisistratus. But he may consider Caesar to fit the type well enough for it to be applicable to him.
Also, Quintus may not be able to judge from personal experience or hearsay whether some of the enumerated traits apply to Caesar or not: for example, whether Caesar is personally daring. But he may infer from how Caesar fits the type in other regards that he likely fits the type in that regard as well.
What thymology achieves is the elaboration of a catalogue of human traits. It can moreover establish the fact that certain traits appeared in the past as a rule in connection with certain other traits.[26]
This may seem like a prejudicial simplification on the part of Quintus, and it is. But such simplifications are pragmatic necessities in our daily task of carving meaning out of the bewildering profusion of data in human affairs.
In referring to ideal types the historian of the past as well as the historian of the future, i.e., acting man, must never forget that there is a fundamental difference between the reactions of the objects of the natural sciences and those of men. Ideal types are expedients to simplify the treatment of the puzzling multiplicity and variety of human affairs. In employing them one must always be aware of the deficiencies of any kind of simplification.[27]
According to Mises, ideal types, unlike class concepts (including real types), can be used to forecast the future in human affairs.[28] How can this be? Well, the use of an ideal type may help us infer a trait that we could not discover through personal experience or hearsay. For example, as discussed above, the use of the ideal type "demagogue/striver" may lead Quintus to conclude that Caesar was a daring person. And considering Caesar to be a daring person might lead Quintus to expect the former to cross the Rubicon.
It must always be noted that ideal types are highly tentative tools for the highly tentative sciences of history and human forecasting, and that the usefulness of an ideal type depends on the insight and judgment used in formulating and applying it.
The service a definite ideal type renders to the acting man in his endeavors to anticipate future events and to the historian in his analysis of the past is dependent on the specific understanding that led to its construction. To question the usefulness of an ideal type for explaining a definite problem, one must criticize the mode of understanding involved.[29]
More on Class Probability and Case ProbabilityIt is not only bet-placers who deal with case probability. Everybody does in dealing with his fellow man. For example, Pompey himself was most likely vitally concerned with whether Caesar would cross the Rubicon or not, and thus would have had to use his imperfect specific understanding to try to glean incomplete thymological knowledge from introspection and experience about Caesar's ideas and aims in order to prepare as best he could.
And it is not only forecasters that deal with case probability. Historians do too. A historian may be virtually certain, based on documentary evidence, that Caesar did indeed cross the Rubicon. But to glean why he crossed the Rubicon, the historian must use his specific understanding to try to glean from introspection and experience (including experience with the documentary evidence) thymological knowledge about Caesar's desires and beliefs in order to judge what motivated him. Of course, such conclusions can only ever be probabilities, and never certainties. And, as with anticipations of future human action, such probabilities can have nothing to do with quantitative frequency.
Economics is immensely concerned with one kind of forecaster of human action in particular: the entrepreneur. The entrepreneur tries to forecast the patterns in which future consumers will buy and abstain from buying (consumer demand). Based on these uncertain forecasts, he seeks to buy and sell on the market so as to attain profits and avoid losses.
The only source from which an entrepreneur's profits stem is his ability to anticipate better than other people the future demand of the consumers.[30]
This kind of speculation too is a matter of case probability. The entrepreneur must use his specific understanding to glean thymological knowledge about the desires and values of consumers. Again, such conclusions can only ever be probabilities, and never certainties. And, again, such probabilities can have nothing to do with quantitative frequency.
However, not all incomplete knowledge in business affairs is a matter of case probability. Mises characterizes the vicissitudes of inventory management as a matter of class probability.
Every businessman includes in his normal cost accounting the compensation for losses which regularly occur in the conduct of affairs. "Regularly" means in this context: The amount of these losses is known as far as the whole class of the various items is concerned. The fruit dealer may know, for instance, that one of every fifty apples will rot in this stock; but he does not know to which individual apple this will happen. He deals with such losses as with any other item in the bill of costs.[31]
Uncertainty in the realm of human action (case probability) is, by definition, in the province of the entrepreneurial function. Uncertainty in the realm of natural events (class probability) is not.
One must not confuse entrepreneurial profit and loss with other factors affecting the entrepreneur's proceeds.
The fact that the bursting of bottles reduces the output of champagne does not affect entrepreneurial profit and loss. It is merely one of the factors determining the cost of production and the price of champagne.
Accidents affecting the process of production, the means of production, or the products while they are still in the hands of the entrepreneur are an item in the bill of production costs. Experience, which conveys to the businessman all other technological knowledge, provides him also with information about the average reduction in the quantity of physical output which such accidents are likely to bring about. By opening contingency reserves, he converts their effects into regular costs of production. With regard to contingencies the expected incidence of which is too rare and too irregular to be dealt with in this way by individual firms of normal size, concerted action on the part of sufficiently large groups of firms take care of the matter. The individual firms cooperate under the principle of insurance against damage caused by fire, flood, or other similar contingencies. Then an insurance premium is substituted for an appropriation to a contingency reserve. At any rate, the risks incurred by accidents do not introduce uncertainty into the conduct of the technological processes. If an entrepreneur neglects to deal with them duly, he gives proof of his technical insufficiency. The losses thus incurred are to be debited to bad techniques applied, not to his entrepreneurial function.[32]
Implicit in the above are these conclusions:
Insofar as the businessman is dealing with forecasts of consumer choices (which are human events, and therefore are a matter of case probability) he is an entrepreneur, and those parts of his net returns that are dependent on the success of such forecasts are his profit/loss.
Insofar as the businessman is dealing with forecasts of natural events (which are a matter of class probability), he is a technician (a kind of laborer), and those parts of his net returns that are dependent on the success of such forecasts are wages.
The businessmen confronting class probability with regard to rotting apples and bursting bottles brings up another important point: class probability does not require the certainty and precision concerning frequency that you find in the case of a lottery or a dice throw. The apple businessman above may not know with certainty that exactly one of every fifty apples will certainly rot. But because the rotting of apples is a process of nature, in which universal regularity does prevail, class concepts can provide relevant knowledge concerning frequency, even if technical knowledge of the natural phenomenon in question is not yet sufficient for perfect knowledge concerning frequency to be had. For this reason, the margins of error of the engineer and the prognoses of the physician are also matters of class probability, as are even the rough judgments laymen make every day: for example, a fellow judging the chance of rain, and whether he should bring his umbrella, based on nothing but eyeballing the sky. Class probability forecasts concerning natural events,
are based either on statistical information or simply on the rough estimate of the frequency derived from nonstatistical experience.[33]
As Donald Rumsfeld might put it, class probability is not only a matter of "known unknowns," but also a matter of "unknown unknowns."
Of course, human actions and natural phenomena both occur in the same universe, and affect each other. So acting men often have to deal with both class probability and case probability concerning the same choice, as Mises points out:
The outcome of horse racing depends both on human action — on the part of the owner of the horse, the trainer, and the jockey — and on nonhuman factors — the qualities of the horse. Most of those risking money on the turf are simply gamblers. But the experts believe they know something by understanding the people involved; as far as this factor influences their decision they are betters.[34]
And, again, gambling is a matter of class probability and betting is a matter of case probability.
Furthermore, as discussed above, business forecasting can involve both class probability (as in the case of forecasting inventory vicissitudes) and case probability (as in the case of forecasting consumer demand). And sometimes a single business decision may depend on both kinds of forecasts. For example, in deciding how much to invest in the rice market, an investor may try to forecast the natural events that affect the rice market (future rainfall, etc.) as well as human factors (consumer tastes, institutional factors such as tariffs, etc.).
Nonetheless, in all such cases, the natural factors can only be dealt with successfully by the human mind as matters of class probability. And the human factors can only be dealt with successfully as matters of case probability. The ultimate choice may be a simple "do" or "do not," but the deliberation leading up to the choice may be a composite of different modes of reasoning.
ConclusionClass probability and case probability are similar in that they both deal with incomplete knowledge. In all other regards, they are worlds apart, and thus require different approaches ("methodological dualism"). Until mainstream scholars take such differences seriously, and give due regard to the distinct methodological challenges of the sciences of human action, they will always be at best, stymied, or at worst, lost.
Businessmen too would benefit by paying due regard to such distinctions. By dealing only in class "patterns" and ignoring the specific characteristics of
the "individual companies and their performance, management and competitors" within those classes,
the consumers those companies served,
and the institutional factors which constrained those companies,
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the Wall Street quants completely abjured case probability, the specific understanding, and thymology. And entrepreneurship is at bottom all about the application of these tools, even if the entrepreneur himself is wholly ignorant of the distinct nature of the cognitive tools he is using, or of the Misesian terms for them.
But even now the enthusiasm for heavily class-probability-reliant approaches seems little abated among many investment strategists. For some, the lesson of the financial crisis is the need to prepare for low-frequency "black swan" market catastrophes with statistical "tail-risk hedging."[35] Again, the proof in the market pudding is in the eating of profit and loss, so the SEC has no business sticking its nose in the matter. But buyer beware of class-probability gamblers posing as case-probability entrepreneurs.
Notes[1] Scott Patterson, "The Minds Behind the Meltdown" The Wall Street Journal, January 22, 2010.
[2] Ibid.
[3] See Ersan Bocutoglu and Aykut Ekinci, "Austrian Business Cycle Theory and Global Crisis."
[4] For more on this point, see Robert P. Murphy, "Anne Hathaway and Automatic Trading."
[5] Ludwig von Mises, Human Action (HA), Chapter 6, Section 2.
[6] HA, Chapter 6, Section 3.
[7] HA, Chapter 6, Section 4.
[8] HA, Chapter 6, Section 6.
[9] Ludwig von Mises, Theory and History (TH), Introduction.
[10] HA, Chapter 6, Section 4.
[11] By Mises's time, the concept of verstehen already had a long tradition in German epistemology.
[12] HA, Chapter 6, Section 6.
[13] TH, Chapter 12.
[14] Ibid.
[15] HA, Chapter 6, Section 4.
[16] TH, Chapter 12.
[17] Inappropriately relying on statistics and mathematical results for their own sake.
[18] TH, Chapter 14.
[19] Robert P. Murphy, Subjective Value and Market Prices
[20] Mises, HA, Ch. 6, Sec. 5.
[21] Ibid.
[22] Ibid.
[23] Ibid.
[24] HA, Chapter 2, Section 9.
[25] According to Herodotus (The Histories, Book 1), Pisistratus even went so far as ride into Athens in a golden chariot, accompanied by an unusually tall woman impersonating the goddess Athena, so that the Athenians would believe she favored him.
[26] TH, Chapter 12.
[27] TH, Chapter 14.
[28] Ibid. "Ideal types are constructed and employed on the basis of a definite mode of understanding the course of events, whether in order to forecast the future or to analyze the past."
[29] Ibid.
[30] HA, Chapter 15, Section 8.
[31] HA, Chapter 6, Section 3.
[32] HA, Chapter 15, Section 8.
[33] HA, Chapter 6, Section 4.
[34] HA, Chapter 6, Section 6.
[35] "Fat-tail Attraction," The Economist, March 24, 2011.
I. How do we know about the outer world — or reality, for that matter? Where does our knowledge about it come from? The attempt to answer these questions leads to epistemology, the branch of philosophy dealing with the origin, scope, and validity of human knowledge.
In the epistemological debate, there are two archetypal and actually diametrically opposed concepts: empiricism and rationalism. Empiricism claims that sensory experience (observation) is man's main (or even sole) source of knowledge, while rationalism claims that his knowledge stems from human reason.
Hardly anyone would deny that there is knowledge that comes to us from sensory experience. Take, for instance, the knowledge that water freezes at zero degrees Celsius. It actually takes observation(s) to acquire such knowledge.
However, in the field of science, which formulates knowledge that applies universally, irrespective of time and place, rationalism holds that empirical knowledge gained through sensory experience doesn't have the same validity as knowledge deduced from reasoning.
Take, for instance, the following two observations:
In the last decades, the fiat-money supply rose 200 percent year to year, while real GDP increased 50 percent year to year.
In the last decades, government tax revenues rose from 10 percent to 50 percent of GDP, while per capita income increased 40 percent.
How can we make sense of these findings? Did real GDP increase because of a rise in the fiat-money supply, or did real GDP go up despite a rise in the fiat-money supply? Likewise, one can ask, Did real GDP increase because or despite a rise in taxes?
Each of these explanations appears equally plausible. So which is the correct one? The first step towards answering this question is the understanding that employing a theory (an idea of putting together in a systematic fashion the knowledge one has of aspects of reality) is indispensible for observing "facts."
II. Indeed, there is no "presuppositionless observation of 'facts,'"[1] as Ludwig von Mises (1881–1973) pointed out:
There is no such thing as a mere recording of unadulterated facts apart from any reference to theories. As soon as two events are recorded together or integrated into a class of events, a theory is operative.[2]
The notion of "letting the facts speak for themselves" without taking recourse to a theory is nonsensical.[3] Mises was aware that people's "reasoning may be faulty and the theory incorrect; but thinking and theorizing are not lacking in any action."[4]
How do we know, and how can we make sure, that we employ a correct theory? Fortunately, in social science a satisfactory answer can be given to these questions by taking recourse to a priori theory — meaning propositions that provide true knowledge about reality, and whose truth value can be validated independent of experience.
To explain, we have to turn briefly to the Prussian philosopher Immanuel Kant (1724–1804) and his groundbreaking The Critique of Pure Reason (1781). A central outcome of what Kant called transcendental investigation is his discovery of so-called a priori synthetic judgments.[5]
A priori denotes a proposition (a declarative statement) expressing knowledge that is acquired prior to, or independently from, experience. In contrast, a posteriori denotes knowledge that is acquired through and on the basis of experience.
A synthetic judgment refers to knowledge that is not contained in the subject matter. An example is All bodies are heavy. Here, the predicate "heavy" conveys knowledge that goes beyond the mere concept of body in general. A synthetic judgment thus yields new knowledge about the subject matter.
Analytical judgments repeat what the concept of the subject matter already presupposes. An example is All bodies are extended. In order to know that bodies are extended one does not need experience, as this information is already in the concept of bodies.
One would expect that analytical judgments are a priori, while synthetic judgments are a posteriori. However, Kant claims that there exist a priori synthetic judgments — knowledge that neither merely repeats the meaning of the concept under review nor requires experience to say something new about the subject matter.
How can a priori synthetic judgments be identified? According to Kant, a proposition must meet two requirements in order to qualify as an a priori synthetic judgment. First, it must not result from experience, but from reasoning. Second, it cannot be denied without causing an intellectual contradiction.
III. Mises realized that the axiom of human action is an a priori synthetic judgment. The axiom of human action says that humans act. This might sound trivial at first glance. At second glance, however, it becomes obvious that the axiom of human action has far-reaching implications.[6]
The axiom of action meets the requirements of an a priori synthetic judgment. First, one cannot observe that humans act in the first place. For doing so, one needs an understanding of what human action is. This knowledge cannot be acquired through experience, because it comes from reason and not from experience.
Second, one cannot deny that humans act, for doing so would result in an intellectual contradiction. Saying "humans cannot act" is itself a form of human action, and it would thus contradict the statement's truth claim.
Mises also realized that, by using formal logic, other truth claims can be deduced from the irrefutably true axiom of human action. This approach he termed praxeology: the logic of human action. Mises reconstructed economics on the basis of praxeology.
Praxeology is a priori theory. It yields propositions about reality that are irrefutably true — propositions that can be validated without taking recourse to experience. Take, for instance, the concept of causality — the idea that each effect has a cause. It is logically implied in the axiom of human action.
As Mises put it,
Acting requires and presupposes the category of causality. Only a man who sees the world in the light of causality is fitted to act. In this sense we may say that causality is a category of action. The category means and ends presupposes the category cause and effect. In a world without causality and regularity of phenomena there would be no field for human reasoning and human action. Such a world would be a chaos in which man would be at a loss to find any orientation and guidance. Man is not even capable of imagining the conditions of such a chaotic universe. Where man does not see any causal relation, he cannot act.[7]
A priori theory offers an approach for reviewing, criticizing, and possibly revising commonly held theoretical explanations of historical events.[8] When (re)viewed from point of a priori theory, what can be said about the two observations that were rolled out at the beginning of this article?
Re 1: From the viewpoint of a priori theory, we can say with certainty that a rise in the fiat money supply does not raise a society's standard of living. A rise in the fiat money stock does not confer a social benefit, because money's sole function is as the means of exchange.
Furthermore, a priori theory shows that fiat money exerts economically detrimental effects on the economy. Fiat money is typically created through bank circulation credit, thereby necessarily causing capital consumption and malinvestment.
The fiat-money injection lowers the market interest rate to below the natural interest rate (as determined by societal time preference), thereby enabling firms producing goods and services that do not correspond to the market's true demand. It induces a boom, which must then result in a bust.
The increase in production that comes with fiat-money expansion is unsustainable and will be corrected sooner or later. Output gains from fiat-money-induced activities may tend to show up earlier than the output losses that come with it, giving the sensory impression that an increase in fiat money can increase output. The truth is, however, that fiat-money creation does not increase peoples' standard of living, but rather lowers it compared to a situation in which there is no rise in the fiat-money supply.
Re 2: We can say with certainty that imposing (higher and higher) taxes on income earners will lower, rather than raise, peoples' standard of living. This is because (higher) taxes (increasingly) divert scarce resources from homesteaders, producers, and contractors to nonhomesteaders, nonproducers, and noncontractors.
This lowers the incomes of homesteaders, producers, and contractors, and thus necessarily raises their respective time preference. As a result, savings and investment will decline, and capital stock and real wages will grow slower (or may even decline) compared with a situation where there is no taxation.
IV. A priori theory provides true knowledge about the outer world, and the truth of knowledge derived from a priori theory can be validated independent of sensory experience.
By no means less important, a priori knowledge trumps empirical knowledge: "A proposition of an aprioristic theory can never be refuted by experience."[9]
Praxeology, the a priori science of human action, and, more specifically, its up to now best-developed part, economics, provides in its field a consummate interpretation of past events recorded and a consummate anticipation of the effects to be expected from future actions of a definite kind.[10]
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An a priori theorist can thus decide in advance (that is, without engaging in social experimentation, or testing, for that matter) whether or not a given action — policy measure — can bring about the promised effects.
For instance, we know a priori that issuing fiat money does not create economic prosperity, that tax- or debt-financed government spending does not improve society's material well-being, and that these measures are actually economically harmful.
A priori theory is an intellectually powerful defense against promises made by false theory and its detrimental (even disastrous) economic consequences if put into practice. Students of social sciences should therefore be increasingly encouraged to engage in a priori theory.
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Notes [1] Mises, L. (2003), Epistemological Problems of Economics, 3rd ed., "The Task and Scope of the Science of Human Action," Ludwig von Mises Institute, Auburn, US Alabama, p. 29.
[2] Mises, L. (1996), Human Action, 4th ed., Fox & Wilkes, San Francisco, p. 647.
[3] See, for instance, Cohen, M.R., Nagel, E. (2002 [1934]), An Introduction To Logic And Scientific Method, Simon Publications Inc., Safety Harbor, Chapter XI, esp. p. 199.
[4] Mises, L. (1996), Human Action, 4th ed., Fox & Wilkes, San Francisco, p. 177.
[5] A highly recommendable introduction is written by Marcus Weigelt in his Introduction to Kant, I. (2007 [1781]), Critique of Pure Reason, Penguin Books, pp. xv–lxix.
[6] See in this context a "must read" is Hoppe, H.H. (2007 [1995]), Economic Science and The Austrian Methodology, Ludwig von Mises Institute, Auburn, US Alabama.
[7] Mises, Human Action, 4th ed., Fox & Wilkes, San Francisco, p. 22.
[8] See, for instance, Hoppe, H.H. (2006), Democracy, The God That Failed: The Economics and Politics of Monarchy, Democracy, and Natural Order, Transaction Publishers, New Brunswick (US) and London (UK), in particular his Introduction, pp. xv–xix.
[9] Mises, L. (2003), Epistemological Problems of Economics, 3rd ed., "The Task and Scope of the Science of Human Action," Ludwig von Mises Institute, Auburn, US Alabama, p. 30.
[10] Mises, L. (1985), Theory and History: An Interpretation of Social and Economic Evolution, Ludwig von Mises Institute, Auburn, US Alabama, p. 309.
What they don't understand: aggregation, relative prices, interest rates, capital structure, money pumping, and regime uncertainty, writes Robert Higgs.
This audio Mises Daily is narrated by Colin Hussey.
I have a confession to make. I am a geek. I have been for years. I love reading articles on all the latest gadgets and gizmos, the new apps and software, all the hacks, and all the technological breakthroughs that happen daily. I can't get enough of it, but I often come to find that when a tech author is reporting on certain events, he lacks a proper understanding of economic theory.
This is understandable in a world where specialization is necessary; but in a world with government, a lack of knowledge in the field of economics often leads to people advocating government action that will make us all worse off rather than better. This applies especially to geeks. Geeks need to know that advocating certain government policies meant to help the advancement of technology will in fact hinder it or cause it to retrogress.
AT&T and T-Mobile: Microsoft All Over Again? When on March 20, 2011, Deutsche Telekom AG agreed to sell T-Mobile USA to AT&T Inc. for $25 billion in cash and $14 billion in AT&T stock, giving Deutsche Telekom an 8 percent share in AT&T and a representative on AT&T's board of directors, it was huge for the tech market. It was like hearing that Ford and GM were going into a merger. Immediately, the geek pundits began crying, "Monopoly!"
In blogpost after blogpost, statistics were thrown up about how acquiring T-Mobile would make AT&T the "biggest" wireless provider in the United States. One article on Engadget uses such scary nouns as "behemoth" and such ominous claims as "we don't have to wait that long to start discussing life with only three major US carriers."
AT&T rightly saw this kind of hysteria coming, and the company mentions in its own press release,
The U.S. wireless industry is one of the most fiercely competitive markets in the world and will remain so after this deal. The U.S. is one of the few countries in the world where a large majority of consumers can choose from five or more wireless providers in their local market. For example, in 18 of the top 20 U.S. local markets, there are five or more providers. Local market competition is escalating among larger carriers, low-cost carriers and several regional wireless players with nationwide service plans. This intense competition is only increasing with the build-out of new 4G networks and the emergence of new market entrants.
AT&T also felt the need to point out its progressive track record by mentioning that it is "the only major U.S. wireless company with a union workforce, offering leading wages, benefits, training and development for employees."
The most astounding part of this story is that only a week after the deal was announced, Sprint openly declared its opposition to the deal.
The transaction, which requires the approval of the Department of Justice and the Federal Communications Commission, and will likely spark a host of hearings in the U.S. Congress, would reverse nearly three decades of actions by the U.S. government and the courts that modernized and opened U.S. communications markets to competition. The wireless industry has sparked unprecedented levels of competition, innovation, job creation and investment for the American economy, all of which could be undone by this transaction. … "Sprint urges the United States government to block this anti-competitive acquisition," said Vonya McCann, senior vice president, Government Affairs. … "So on behalf of our customers, our industry and our country, Sprint will fight this attempt by AT&T to undo the progress of the past 25 years and create a new Ma Bell duopoly."
Contrast this with Verizon's much earlier response to the deal. Verizon's CEO, Daniel Mead, announced that his company is neither opposed to nor worried about AT&T acquiring T-Mobile. Attempting to use the government to squash their competition would distract the company from being "the most profitable wireless carrier in the country." When asked if Verizon would seek to acquire Sprint in response, Mead said, "We're not interested in Sprint. We don't need them." Zing!
Thankfully, in addition to Verizon's Daniel Mead, there are a few cooler heads in the geek realm. Brian Osborne, writing for the appropriately named geek.com, shows that there is little to be alarmed about when you compare the US telecom market to other markets.
Looking at the Japanese picture, post-merger AT&T's new market share with T-Mobile would still be about 10% less than what Japan's leading wireless carrier, NTT DoCoMo, currently enjoys. While it is safe to say that any acquisition by Verizon Wireless, AT&T or Sprint bringing a single carrier closer to 50% market share would be more criticized by federal regulators, an argument can be made that AT&T's new market share won't be as dominant as NTT DoCoMo's in Japan. …
If we look at the average market share enjoyed by leading operators in Europe and compare that once again to the expected market share AT&T would enjoy if an acquisition of T-Mobile is approved, the result would be that AT&T's market share would only have a variance of above 1%.
While Sprint's CEO (Dan Hesse) brings up the statistic that AT&T and Verizon Wireless would together hold 79% of the U.S. market, the reality is that it is not uncommon for the #1 and #2 wireless carrier in international markets to hold around 70% or more of their perspective markets. AT&T's new market share also wouldn't be significantly more than the average market share of leading operators in Europe and it would be significantly less than the leading operator in Japan. In the end, Hesse will have to make his case not based on big picture numbers alone, but on specific markets where there will be limited competition as a result of AT&T's acquisition of T-Mobile.
Background: The Rise of the Verizon iPhone Yes, AT&T will indeed become the largest wireless provider in the United States (provided that the market shares of both AT&T and T-Mobile do not drastically fall between now and when the deal is completed) but a big company does not a monopoly make. Nor does that "bigness" in any way preclude any sort of success on the part of AT&T after it becomes the largest provider. Even among those who are not panicking over T-Mobile coming under new ownership, there seems to be little understanding as to why this might be a good thing for the two companies and consumers as a whole. To really understand why this is taking place, we need to look back a little ways and see the journeys that these two companies took to reach this point.
The current uproar notwithstanding, AT&T has been having a bit of an image problem among consumers. The problem is that AT&T is not seen as a great cell-phone service provider. In a 2008 consumer report, one year after the release of the first iPhone, AT&T was ranked second to last in terms of customer satisfaction, with Verizon on top. In 2009, AT&T was dead last, and Verizon held on to its lead.
The primary reason for dissatisfaction cited among AT&T's customers is the high rate of dropped calls. While there are several reasons why any one call may be dropped, the most common reason is when one enters a "dead zone," an area out of range of any nearby cell-phone towers. Lack of cell-tower coverage is precisely what has been AT&T's problem, a fact Verizon pointed out in its infamous "There's a map for that" ad.
With such low customer satisfaction, you might think that customers would simply stop using AT&T. Perhaps they would have, were it not for the fact that in order to get your new iPhone for the $200 price you had to sign on to a two-year, $60-per-month service contract with AT&T. While the flame wars rage on over whether iOS or Android is the better operating system, in terms of hardware the iPhone is considered the very best. (Besides, hacking makes these arguments moot.) If you wanted the best, and you didn't want to pay the extra $300 or more for a contract-free iPhone, you were stuck with AT&T.
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It wasn't long until the masses started to get vocal. Owners of the best cell phone wanted the best service provider to go with it. They wanted Verizon. Soon rumor mills were buzzing about a Verizon iPhone. By the spring of 2010, things were getting a little out of hand. Comedy superstar Jon Stewart (warning: strong language) even publicly criticized Apple and AT&T on his own show.
The final nail in the coffin came that summer, during Apple's 2010 Worldwide Developers Conference. While on stage in front of several thousand people, Steve Jobs began to experience some technical difficulties. When he asked, "Any suggestions?" there was a very audible response of "Verizon!" The audience laughed and applauded, as did the Internet. Another consumer report at the end of the year, yet again, had Verizon at number one and AT&T dead last.
In January of 2011, the Verizon iPhone was officially announced, along with a new commercial from Verizon. In the commercial there is a series of ticking clocks with a voice saying, "To our millions of customers, who never stopped believing this day would come, thank you." It was the first of its kind. It wasn't just an ordinary commercial advertising a new product; it was a visual thank-you letter to a movement that was also the first of its kind. Consumers literally, audibly, demanded a particular product into existence.
Now that iPhone users have the option to choose Verizon, AT&T is at risk of losing a major portion of its current market share. A recent study by ChangeWave Research showed prospective iPhone buyers wanting Verizon over AT&T 46 percent to 27 percent. While current owners of both iPhones seem fairly satisfied, Verizon beating AT&T at just 82 percent versus 80 percent, AT&T still has the highest dropped call rate; and data actually shows that AT&T's dropped call rate was increasing between September of 2008 and September of 2010, whereas Verizon's was steadily decreasing.
AT&T seems set to lose big to Verizon this summer when the new iPhone 5 comes out. By the summer of 2012, even more two-year AT&T contracts will be expiring. Regardless of any improvements in AT&T's service from here on out, the damage has been done, and it will take some time before AT&T can recover its image.
T-Mobile's Push into the 4G Market Meanwhile, T-Mobile USA had its own goals. It needed to upgrade its network from 3G (3rd Generation) to 4G. There were two different ways it could go about this. It could continue using its High Speed Packet Access (HSPA) method, or it could convert over to the Long Term Evolution (LTE) standard used by AT&T and Verizon. To the surprise of many, T-Mobile announced in December of 2010 that it would do both.
The first part of this project involved a partnership with Nokia Siemens Networks. The two companies would develop new antennas to upgrade their existing cell-phone-tower infrastructure. This would allow T-Mobile to provide 4G that is comparable to, or even faster than, AT&T and Verizon's LTE 4G. HSPA 4G also gives T-Mobile a great cost advantage over its competitors, because it won't have to build a whole new cell-phone-tower infrastructure to support it as AT&T and Verizon must do with their LTE network. However, T-Mobile still wants to develop LTE technology for the future.
This is where AT&T comes in. Joining with AT&T gives T-Mobile access to all the research and development that AT&T has done over the past several years. It also gives T-Mobile access to AT&T's much-larger portion of licensed spectrum. (T-Mobile has a much smaller spectrum than either AT&T or Verizon, which is why it developed HSPA to begin with. HSPA makes use of the electromagnetic spectrum much more efficiently than LTE.) AT&T in return gains access to T-Mobile's technology as well as its vast network of upgraded towers. This essentially fixes AT&T's coverage problem without the time and money needed to build new towers.
How the Free Market Works For any geek still concerned about a possible reemergence of the old Ma Bell monopoly, it is important to remember that it was government that created the monopoly in the first place. This knowledge is so common and undisputed, you would think that someone would have brought it up by now. A simple Google search could clear that fact up for anyone, but actually acknowledging this fact in any discussion would require a radical paradigm shift from what one is taught in government schools.
The primary factor in what causes any particular market to become monopolized is neither the number of companies providing the service nor the size of those companies but rather freedom of entry into that market. So long as there is at least a threat of competition from new entrants into the telecommunications market, there will be a pressure on all wireless providers to keep increasing their efficiency and decreasing their prices.
If any conclusion can be drawn from all this, it is not that AT&T is on the verge of achieving total control over the telecommunications market. If anything, this ought to be interpreted as a sign of AT&T's imminent decline. AT&T has consistently provided poor service relative to other wireless providers, and it is now beginning to pay the price. Now that AT&T is no longer exclusively subsidized by iPhone sales, it is possible that AT&T's projected four percent size advantage over Verizon will disappear within the next year.
Firms that provide their customers with superior service are rewarded, while those that provide inferior service are not. We don't need the government to forcibly keep AT&T as only the second-largest wireless-service provider. Rather, it seems perfectly capable of doing that itself.
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The merger with T-Mobile is AT&T's attempt to get back on its feet. It will allow AT&T to provide faster service with wider coverage and fewer dropped calls at a more competitive price. Will AT&T succeed in winning back the hearts of iPhone users? It's a possibility, but nothing is for certain. All an FCC blocking of the acquisition will do is stop AT&T from even trying to please its customers.
The amount of choice and variety in the wireless market is not shrinking but increasing exponentially. While government forces us to choose between the lesser of two evils, the market allows us to freely choose from a massive spectrum of goods. Those who think there is too much variety are free to not even bother. This is how the market works, and I can't help but geek out over it.
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If a prominent politician hires a hall to make a speech, stay away; the absent audience will bring him to a realization of his nothingness, writes Frank Chodorov (1887–1966).
This audio Mises Daily is narrated by Colin Hussey.
Nock was perhaps the finest stylist in 20th-century American literature, writes Frank Chodorov (1887–1966).
This audio Mises Daily is narrated by Steven Ng.
[Excerpted from chapter 16 of Theory and History (1957).]
A realistic philosophical interpretation of history must abstain from any reference to the chimerical notion of a perfect state of human affairs. The only basis from which a realistic interpretation can start is the fact that man, like all other living beings, is driven by the impulse to preserve his own existence and to remove, as far as possible, any uneasiness he feels. It is from this point of view that the immense majority of people appraise the conditions under which they have to live. It would be erroneous to scorn their attitude as materialism in the ethical connotation of the term.
The pursuit of all those nobler aims that the moralists contrast with what they disparage as merely materialistic satisfactions presupposes a certain degree of material well-being.
The controversy about the monogenetic or polygenetic origin of Homo sapiens is of little importance for history. Even if we assume that all men are the descendants of one group of primates, which alone evolved into the human species, we have to take account of the fact that at a very early date dispersion over the surface of the earth broke up this original unity into more or less isolated parts. For thousands of years each of these parts lived its own life with little or no intercourse with other parts. It was finally the development of the modern methods of marketing and transportation that put an end to the isolation of various groups of men.
To maintain that the evolution of mankind from its original conditions to the present state followed a definite line is to distort historical fact. There was neither uniformity nor continuity in the succession of historical events. It is still less permissible to apply to historical changes the terms growth and decay, progress and retrogression, improvement and deterioration, if the historian or philosopher does not arbitrarily pretend to know what the end of human endeavor ought to be. There is no agreement among people on a standard by which the achievements of civilization can be said to be good or bad, better or worse.
Mankind is almost unanimous in its appraisal of the material accomplishments of modern capitalistic civilization. The immense majority considers the higher standard of living which this civilization secures to the average man highly desirable. It would be difficult to discover, outside of the small and continually shrinking group of consistent ascetics, people who do not wish for themselves and their families and friends the enjoyment of the material paraphernalia of Western capitalism.
If, from this point of view, people assert that "we" have progressed beyond the conditions of earlier ages, their judgment of value agrees with that of the majority. But if they assume that what they call progress is a necessary phenomenon and that there prevails in the course of events a law that makes progress in this sense go on forever, they are badly mistaken.
To disprove this doctrine of an inherent tendency toward progress that operates automatically, as it were, there is no need to refer to those older civilizations in which periods of material improvement were followed by periods of material decay or by periods of standstill. There is no reason whatever to assume that a law of historical evolution operates necessarily toward the improvement of material conditions or that trends which prevailed in the recent past will go on in the future too.
What is called economic progress is the effect of an accumulation of capital goods exceeding the increase in population. If this trend gives way to a standstill in the further accumulation of capital or to capital decumulation, there will no longer be progress in this sense of the term.
Everyone but the most bigoted socialists agrees that the unprecedented improvement in economic conditions that has occurred in the last two hundred years is an achievement of capitalism. It is, to say the least, premature to assume that the tendency toward progressive economic improvement will continue under a different economic organization of society.
The champions of socialism reject as ill-considered all that economics has advanced to show that a socialist system, being unable to establish any kind of economic calculation, would entirely disintegrate the system of production. Even if the socialists were right in their disregard for the economic analysis of socialism, this would not yet prove that the trend toward economic improvement will or could go on under a socialist regime.
Man the producer must have freedom, while man the predator puts limitations on freedom, writes Frank Chodorov (1887–1966).
This audio Mises Daily is narrated by Keith Hocker.
Voters are faced with bundled choices, they vote infrequently, no individual's vote will affect the election, voters have little incentive to be highly informed about the candidates' policy positions, and the winning candidate is not obliged to deliver on his promises. Candidates who understand these simple facts will have an advantage over political opponents, writes Mark Brandly.
This audio Mises Daily is narrated by Steven Ng.
The use of mathematics necessarily leads the economist to distort reality by making the theory convenient for mathematical symbolism and manipulation. Mathematics takes over, and the reality of human action loses out, writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
It is man's nature to strive ceaselessly after the substitution of more satisfactory conditions for less satisfactory. This motive stimulates his mental energies and prompts him to act. Life in a perfect frame would reduce man to a purely vegetative existence, writes Ludwig von Mises (1881–1973).
This audio Mises Daily, excerpted from the audiobook version, is narrated by John Pruden.
Human beings do not possess a mystical property of "probability" inside them; rather, they always act on their subjective beliefs and values. Probability in the human world is thus merely a measure of man's uncertainty about the subjective beliefs and values that influence the actions of other men, writes Mark R. Crovelli.
This audio Mises Daily is narrated by Steven Ng.
A grabs B to use as a shield; A forces B to stand in front of him, and compels him to walk wherever A wishes. A then hunts C in order to murder the latter by shooting him. C also has a gun. Is it legally permissible for C to shoot at A in self defense under libertarian law? Were C to do so he would have to kill B, the innocent shield, in order to defend himself against the perpetrator, A. Assume that this tableau takes place on unowned property, so that the issue of the owner’s rules does not come into play.
Volume 22, Number 1 (2011)
The present paper is the continuation of an intra-libertarian debate over immigration. Previous contributions to this dialogue on the open borders side include Block, 1998, 2004A, 2011; Block and Callahan, 2003; Gregory and Block, 2007. The restricted borders argument includes Hoppe 1995, 1998, 1999, 2001, 2002.
Volume 22, Number 1 (2011)
Kinsella and Tinsley (2004) is beautifully written, infused with keen insights, in some ways solidly predicated upon libertarianism and praxeology, and yet, and yet, much as I enthusiastically agree with goodly portions of it and am even inspired by them, I cannot see my way clear to accepting all of their insights.
The present paper is devoted to a critique of those parts of the paper with which I cannot agree.
Volume 22, Number 1 (2011)
As regards the views about probability of Ludwig von Mises, it is undeniably true that these display considerable nuance and that they can be considered as being of a sui generis variety. Even if Ludwig von Mises’s views on probability exhibit a closer conceptual affinity with Keynes’s philosophy of probability than with the frequency interpretation espoused by his brother Richard von Mises, an important difference between the views of Ludwig von Mises and those of John Maynard Keynes in this respect will nevertheless be acknowledged.
Volume 22, Number 1 (2011)
The envy-driven masses do not care a whit for what the demagogues call the "bourgeois" concern for freedom of conscience, of thought, of the press, for habeas corpus, trial by jury, and all the rest. They long for the earthly paradise that the socialist leaders promise them, writes Ludwig von Mises (1881–1973).
This audio Mises Daily, excerpted from the audiobook version, is narrated by John Pruden.
The honor of being called the "father of modern economics" belongs not to its usual recipient, Adam Smith, but to a gallicized Irish merchant, banker, and adventurer who wrote the first treatise on economics more than four decades before the publication of the Wealth of Nations, writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
Three weeks ago I read the news that a 24.78 carat "fancy intense pink" diamond sold for $46,158,674 at an auction held by Sotheby's in Geneva, Switzerland. The winning bid for "The Graff Pink," as it was named immediately after its purchase by London jeweler Laurence Graff, was the highest price ever recorded for a jewel at auction and more than double the $24.3 million price paid for the 35.56 carat Wittelsbach blue diamond purchased by Graff in 2008. Nowhere in the article was there any mention of the monetary costs of producing either gem, although I presume that in each case they were a negligible fraction of the diamond's price — if anyone alive today even knows those costs.
Last week I accompanied my wife to Walgreen's to buy lighted outdoor Christmas figures for display in my front yard. A snowman on display in the store caught our eye and we decided to purchase it only to be told by the manager that it was already out of stock. My wife, ever the negotiator, proposed that the manager sell us the figure at a $5 discount from the advertised price of the snowman. He agreed, even though the snowman on display probably cost the store $5 or $10 more to produce than the unavailable packaged item because it involved an additional hour of a stock clerk's labor to remove it from the packaging and assemble it.
Last night I was shopping online for tickets to a New Jersey Nets basketball game as a Christmas gift. The Nets are an NBA franchise in transit from New Jersey to Brooklyn, New York, and their temporary home for the next two years is the Prudential Center in Newark, New Jersey. On December 12, the Nets play the Los Angeles Lakers. Prices for individual tickets in the upper corner sections (the "nosebleed" seats) start at $24, in the lower center at $160, and in the courtside section frequented by celebrities at $400. Two days later, the Nets take on the Philadelphia 76ers: starting prices for tickets in exactly the same sections are $1.00, $29, and $150, respectively. So the price differential between the same seats at the Lakers' and 76ers' games ranges from two-and-a-half times higher for the priciest seats to 24 times higher for the cheapest seats. Presumably the average money cost of producing a basketball game for an individual occupying the same seat is identical for both games and does not differ much for individuals occupying different seats at the same game.
Now despite countless instances like these that we all regularly encounter in our market activities, most people still take for granted the view that costs of production basically determine prices. Furthermore, they believe that if prices greatly exceed costs, it is the result of price gouging, monopoly, or some other nefarious scheme on the part of producers. But as Carl Menger, the founder of the Austrian School of economics, brilliantly explained nearly 140 years ago, past expenses incurred during the production of a good are completely irrelevant to the determination of the current price of a good. For Menger, the market price of a good is determined solely by the relative valuations of goods and money by the buyers and sellers of the good, in conjunction with the number of units of the good currently in existence. The records and memories of how much money was spent to enlist the labor and other resources needed to produce the good have absolutely no effect on how much money people are currently willing to exchange for a unit of the good.
But Menger went even further and demonstrated that the (anticipated) selling prices of goods actually determine the costs of production for a good. Using the example of tobacco, Menger argued that if people completely lost their desire for consuming tobacco, not only would the prices of cigarettes, cigars, and pipes fall to zero, but raw tobacco and the machines specifically designed to produce these items would cease to command a price greater than zero, no matter how much it cost to produce them.
For Menger and modern Austrians, then, the ultimate source of value is the ceaseless efforts of individual human beings to use their scarce resources and money to improve their well-being by interacting with one another on the market to achieve their most cherished goals and desires while renouncing less-important desires and satisfactions. The actual market prices and costs of production we observe are simply the objective manifestation of this war of scarcity in the human soul. It is the current or future goods we have to sacrifice and the opportunities for satisfaction that we have to renounce that are the only relevant "opportunity costs" of the things that we purchase. These subjective and immediate experiences of renunciation and sacrifice — and not some recorded sum of money that one guy paid another guy to perform a production task last month or last year — these are the costs that will influence our decisions about what to buy and what not to buy and, thereby, determine the prices we pay during this Christmas shopping season.
Modern mainstream economists portray the Mengerian-Austrian theory of price as "extreme" and "one-sided," supposedly over-emphasizing subjective value while ignoring money costs of production. But it is precisely the one-sidedness of Austrian theory that makes sense of our market experiences. The higher cost "display" snowman sells for a lower price than the packaged snowman because most consumers view the former as a less-valuable "used" item. They do not care about the stock clerk's past exertions or wages. The Graff Pink commanded such a high price at auction because it is so scarce in relation to the number of people who want to possess it and the intensity of their desires for it relative to money and other things. Even if the production costs of the diamond were the same, the sudden discovery of 10,000 diamonds identical to the Graff Pink would drive its price down far below the recorded auction price. And I need not belabor the point that the price differential of up to 2,300 percent for the same seat in the same arena two days apart exists because, for most basketball fans, the experience of watching the talent-laden Lakers with their coaching icon and glorious tradition shred the dreadful and itinerant Nets is vastly preferable to witnessing a dreary contest between the Nets and the equally woeful 76ers.
The laws of value and price discovered by Carl Menger are universal and immutable. They are true and apply everywhere and at all times, so long as human beings consciously seek to improve their well-being by using their scarce time, energy, money, and material resources to attain their most important goals.
Now, let me go back online and check if the price of those unsold Nets-76ers tickets has plunged below a dollar yet.
The environment determines the situation but not the response. To the same situation different modes of reacting are thinkable and feasible. Which one the actors choose depends on their individuality, writes Ludwig von Mises (1881–1973).
This audio Mises Daily, excerpted from the audiobook version, is narrated by John Pruden.
[Speech given at The Economic Recovery: Washington's Big Lie, the Supporters Summit for the Ludwig von Mises Institute, October 8, 2010.]
When I first offered this title for my talk, it was suggested that I add the question "how do we know when the state is lying?" I don't know if this was an effort to limit my presentation to 30 seconds, for I could summarize my answer in the classic words of my favorite stand-up philosopher, George Carlin, "my first rule: I don't believe anything the government tells me."
Kurt Vonnegut offered similar advice. While traveling back to America at the end of World War II, Vonnegut asked a friend what he had learned from his wartime experiences. "Never to believe anything my government tells me," the friend answered. Because the state is grounded in such a network of lies, contradictions, deceptions, and conflicts, it is safe to say that political systems are inherently in conflict with reality and must resort to intentional distortions of truth as a way of trying to appear coherent to a gullible public.
The "big lie," as defended by Adolf Hitler, has long been a tool of statism. The more "colossal" the lie, Hitler intoned, the greater the propensity for Homo boobus to believe it. Because human beings are accustomed to telling small lies, but would be embarrassed to tell outlandish ones, so Hitler reasoned, the great lie acquires credibility.
For this reason, the lies that have been inseparable from the truth surrounding 9/11 continue to be accepted by vast numbers of Americans. Likewise, the state-serving myth that global warming is the product of human activity continues to be recited by politicians and other government officials, academics, and members of the media, despite the refutations offered by literally hundreds of highly respected scientists who have refused to be baptized into the secular religion of Algoreism. With the surface temperatures of Mars increasing, and its polar ice melting, I have heard none of the high-church environmentalists respond to my claim that this proves the existence of humanlike beings — with their SUVs and aerosol sprays — on Mars! In so many ways are intelligent people reminded to be skeptical of consensus-based definitions of reality.
State action does to the harmonious order of human society what the throwing of a rock through the network of a spider web does: it disrupts — and sometimes destroys — existing patterns of interconnectedness. Nowhere is this more evident than in the political manipulation of and interference with the informal order of the marketplace. With the help of a mainstream media and academia, the state resorts to all kinds of fabrications to convince us of the magnificence of the emperor's new clothing.
Alternative technologies — particularly the Internet — make it so much easier to uncover and reveal the systematic lying necessary to the success of political entities. A libertarian newscaster friend once told me, "I have been tempted to go on the air and say 'good morning, and here are the lies your government would like you to believe today.'" Jon Stewart's The Daily Show is now a perennial award winner for television news reporting; the habitual lying engaged in by government official continues to erode the credibility of the media, the state, and its academic lackeys. The respect once enjoyed by these major sources of information in our world has been in sharp decline in the Internet years.
The rapidly diminishing circulations of major newspapers and viewers of network-television newscasts are due not only to the parallel competition provided by the Internet but also to a widespread awakening of the dishonest nature of what the established media report. Nor can we forget the widespread challenge to statism reflected in Ron Paul's efforts, an undertaking that the political parties and the media try to deflect into the harmless babblings of Sarah Palin. I don't know which is the more fitting metaphor for our times: (a) the manner in which the Russian people regularly laughed at government "newscasts," or (b) that poignant scene at the end of Orwell's Animal Farm, as the powerless farm animals look in the window of the farmhouse to see the ruling pigs partying with the hated humans.
In these early years of the fourth stage of the "information revolution," we are once again encountering a truth made evident by Johann Gutenberg: information is very liberating. For this same reason, the political establishment has long adhered to Mark Twain's advice: "Truth is the most valuable thing we have. Let us economize it."
As it always has, the state seeks to protect itself from the harsh realities of truth by warring against persons and systems that contradict the self-serving mindset it requires for an obedient and servile public. Proposals have been made, by those in power, to give the president the authority to shut down the Internet — in the name of "national security," of course. One of the proponents of this measure, Senator Joe Lieberman, went so far as to make a favorable comparison to the Chinese government, which "can disconnect parts of its Internet in case of war and we need to have that here too."
That little criticism of this plan — or of Lieberman's defense of it — has been offered within the mainstream media (for whom the demise of the Internet would be competitively advantageous) provides insight into the confrontation between those whose desire it is to inform others and those who want to be keepers of the thoughts of others. As there will always be practitioners of free expression and seekers of truth among us, and as I have more trust and confidence in the nerds, geeks, and hackers who are forever looking to expand the capacities of computer technologies, I suspect that the efforts of the established order to silence those who ask questions will fail.
The state's war against truth seeking is also seen in its reptilian reaction to the Wikileaks phenomenon; the state's continuing efforts to classify its activities as "secret" — lest boobus discover the real nature of the state; and, more recently, the Pentagon's buying and destroying all of Anthony Shaffer's (no relation) revelatory book about the underside of US activities in Afghanistan. That members of the political establishment are so economically illiterate as to fail to see how this book burning will only increase demand for the book — a demand I suspect the publisher will be eager to satisfy — should encourage those of us who love the marketplace!
In this respect, the Pentagon has placed itself in the same position that Bill O'Reilly did when, at the outset of the war against Iraq, he urged all good patriotic types to buy French wines and pour them down the sewer to punish the French for not having joined in the war effort! That will teach them a lesson! I have three books that have been published, none of which have received much attention. Perhaps I can persuade the Pentagon and Bill O'Reilly to undertake a campaign to have Americans buy copies of my books and conduct highly publicized book burnings thereof!
All in all, I found Karen Kwiatkowski's recent LRC blog post more to my liking. In explaining the efforts of those in power to suppress uncomfortable information, she reminded us that
those boys and girls in DC are just like us! They just want to be left alone, to conduct their business and nurture their friendships, to make their way in the world without having someone always looking over their shoulder, and judging them. It's actually kind of sweet, don'tcha think?
For the aforesaid reasons, the systematic lying associated with political systems troubles me less than do the efforts of statists to undertake their programs even with the very best of intentions. I am willing, for the sake of discussion, to grant the political classes the most honest and sincere of motives — to presume that they really want to promote the best possible conditions in the world for all of mankind. That I don't truly believe this is another matter. For my purposes, here, I am prepared to give the statists the benefit of the doubt as to their motivations.
The most damaging falsehood associated with government action is the belief — common to the entire institutional order — that social order is dependent upon pyramidal, vertical power structures. This premise generates societal disorder because of two factors: (1) the refusal of the system to respect the inviolability of property interests, which, in turn, is destructive of individual liberty — about which I have written extensively elsewhere — and (2) the point upon which I am focusing today: the epistemological problems associated with presuming the capacity to predict the outcomes of complex relationships.
If we understood the lesson from the study of chaos, namely, that complex behavior always produces unpredictable consequences, we might be less arrogant in our efforts to mandate the behavior of people. More than that, if we understood just how inherently and unavoidably limited is our knowledge of the world, we might be less hubristic in our insistence upon managing the lives of others.
For example, as the federal government was finalizing its plans for the construction of a nuclear-waste-storage facility in Yucca Mountain, Nevada, a federal court directed the Department of Energy to predict the consequences that would be generated for a period of time ranging from 300,000 to 1,000,000 years. To most of us who have a sense of responsibility for our actions, it seems that the court's order was premised on the importance of considering long-term costs. The troublesome implications of this judicial response have to do with the court's sense that governments are capable of accurately predicting the course of events for the next 1,000,000 years. My study of geology, as well as of human existence on earth, convinces me otherwise.
Bearing in mind that human beings have likely been on this planet for anywhere from 200,000 to 1,000,000 years (depending upon whether various skeletal remains are to be defined as "human" or of earlier species), the court is attempting to direct the outcome of human action for a time period equal to mankind's entire history. Furthermore, the court is presuming a kind of geologic and climatic stability that fails to consider such factors as plate tectonics, earthquakes, and volcanoes; of continental drift and the magnetic reversals of the poles; periodic ice ages and massive flooding; periods of solar flares; the comets and asteroids that have occasionally hit the earth; the cutting-and-filling nature of rivers which, along with the continuing processes of wind and water erosion, continually refigure the face of the planet.
To put such inconstancies into the context of the court's order, you should know that, during the last one million years, there have likely been ten major ice ages; the meteor that hit in Arizona and created the giant crater there probably did so about 200,000 years ago; the volcanic eruption that destroyed the island of Krakatoa and produced long-term and worldwide climatic effects, including tsunamis as distant as South Africa, occurred but 127 years ago. Yucca Mountain itself was created by a number of volcanic eruptions.
There are so many interconnected, variable, and unknown factors at work in nature — including the myriad consequences of human action — that it borders on magical thinking to believe that one can anticipate the playing out of this constantly changing interplay over such an extended period of time. We are fortunate to get accurate predictions of next week's weather; expecting government agencies to prognosticate over a one-million-year period becomes a test of our sense of humor!
A belief in absolute truths, coupled with a self-righteous resolve to enforce such views upon the world, is a pathology that must be confronted head on if we are to preserve any semblance of humanity. If we are to overcome our lemming-like march into mutual self-destruction, we must begin at the source of the problem. The relevant question, in my view, is this: is it possible for us to have an empirical understanding of the world, or to act upon the basis of philosophical principles and values, other than through our subjective understanding? Are there such qualities as "objective" truths — be they empirical or moral — that operate in the world outside of our own mind?
In the realm of economics, are there objective values to be ascribed to goods and services that are apart from the values given them by freely contracting parties? Indeed, though we can speak of the "price" arrived at in a transaction as objective, is it not evident that the value given to that item is not only subjective — differing in the minds of each contracting party — but, further, (a) can never equal the objective price, and (b) can never be known even to the parties involved? Is it possible for us to extend this awareness of the subjective underpinnings of economic transactions into our efforts to understand and function in the world in all other areas?
Using a dictionary definition, are there "truths" in the world that "exist independently of mind?" If there are, can we know of such matters other than through our individualized opinions? I believe that everything you or I can know about the world — whether in the form of empirical information or philosophic principles — derive from our subjective experiences, and nothing more.
To begin with, the very concept of "knowledge" necessarily implies a knower. Whatever the reality that exists in the universe, there can be no knowledge of it without an observer. This is the meaning of Bishop Berkeley's teaser about the sound of a falling tree in a deserted forest: sound is something received by auditory senses. Heisenberg's uncertainty principle reminds us of the inseparable ties between the "observer" and the "observed."
"The most damaging falsehood associated with government action is the belief that social order is dependent upon pyramidal, vertical power structures." From the moment of our birth until our death, we experience ourselves and our world — including other people — but not in the mechanistic fashion of a video camera recording sensory impressions. Rather, we interact with our world, organizing our experiences into categories and concepts by which we make comparisons and contrasts. It is the mind alone that creates these categories; they do not exist beyond the boundaries of our mind. What we think of as the world is simply that: thoughts about the world.
Learning is an art form, and, like painters and sculptors, we outwardly manifest our inner visions of the world and ourselves. We learn only because our mind is dissatisfied with its existing patterns of understanding, and wishes to create more sophisticated patterns with which to both inform and amuse itself. In accepting dogmas about "the good, the true, and the beautiful" residing outside ourselves, we have surrendered to institutions the perceptive, creative, and spiritual essence of what it means to be human.
We are seekers of information. The word "inform" means to give shape within. Within what, other than the mind? Gregory Bateson defined "information" as "differences that matter." Matter to whom? Who is it that notices the "differences," and by what criteria — and where — are distinctions and similarities to be evaluated? The current study of "chaos," or "complexity," is making us aware that conditions we have heretofore regarded as "disordered turbulence," have regularities to them that we had not previously seen. But has nature suddenly become more orderly, or has our subjective mind — with the help of computer technologies — only developed more sophisticated ways of organizing its experiences with nature?
We are also not simply the seekers but the creators of the moral and aesthetic measures by which we live what Socrates called "the examined life." We are, as the poet Seamus Heaney expressed it, the "hunters and gatherers of values." But the quest takes place within the vast expanse of the subjective mind, wherein the hunter negotiates with the world as a means of pursuing his or her sense of being.
We think dualistically and abstractly, dividing our experiences into mutually exclusive categories. The hard wiring of our brains probably prevents us from dealing with reality in any other way. Our mind needs to become aware of this inherent limitation on its capacities for dealing with the world. But the conscious mind enjoys its monopolistic position in directing our lives.
The dualistic categories we employ are determined not by the inherent nature of anything we are observing but by systems of thought that others have taught us. Are avocadoes and tomatoes "fruits" or "vegetables"? A botanist will give you one answer, while the produce manager of your local supermarket will give you another. Which one is "objectively" correct, or is there no "correct" answer beyond the subjective thoughts of the person addressing the question?
We deal with the universe abstractly, as images and concepts that our mind has created. When we are engaged in abstraction, our understanding becomes — in the words of one dictionary — "considered apart from matter or from specific examples; not concrete." Such a process is about the world, but not of it. To even distinguish a "thing" from its environment is to conceptualize it, to convert the experience into an idea. What are the qualities of any of these identified "things" that tell us what they are apart from the abstract definitions we have created in our minds?
I suspect that the main reason we do not have memories of our first days and weeks out of the womb is that we had the numerous experiences but no conceptual tools — no words — that would allow us to define, categorize, and organize these experiences. We did not have labels to attach to our world. Because of this interplay between our experiences and how those experiences have been recorded and organized through the abstractions in which we have been trained, what we are capable of knowing about the world may rise no higher than how we have subjectively defined that world.
The problem this creates for us is that our lives get so wrapped up in conceptualization, ideation, and other abstractions, that we learn to confuse how our mind has organized the world with "reality" itself. The words that we use to describe things are fundamentally different from what it is we are describing. Lest you have not learned this important lesson, let me inform you that the word water will not quench your thirst. Let me also remind you that these drinking glasses and my eye glasses are not synonymous terms, and that both are made of plastic, not glass.
The world does not inform us of its meaning — if, indeed, there is such a thing as some objective "meaning" to existence. Rather, we project onto the world the patterns we find meaningful — the ones we have put together that best explain our experiences in the world. These patterns differ from one human to another, depending upon our unique experiences. Whatever "meaning" we find in our world derives from a composite of the individual pictures each of us has put together in forming our experiences.
A classroom exercise I have used is to ask students to draw a picture of a previously undiscovered life form — one that is not simply a composite of life forms already familiar to them. They quickly discover the difficulty associated with "seeing" the universe other than in patterns that are already familiar to them.
We have all seen a small baby put some item in his mouth — and seen Aunt Edith shriek, "Look out, he's going to eat that pen!" and grab it from him. Babies are not trying to eat everything they encounter, but they are trying to discover the nature of pens — and other objects — by testing them through the sensory tool with which they have many of their earliest experiences: the sense of taste. The baby, having found out that other things placed in his mouth produced a pleasurable effect, now discovers that the pen does not and so puts it aside. He has learned an important conceptual lesson: things with nipples taste good, things with lids do not. He has also learned an important social lesson: the world is plagued by a variety of Aunt Ediths, who insist upon interfering with and restraining his life experiences!
Let me emphasize that I am not suggesting that what we think we "know" does not reflect the "real world," nor am I suggesting that there is no objective universe. I am convinced that reality does exist, for if it is only an illusion it seems to be one that we all share. I am not taking a solipsistic approach to things: I have had too many friends and relatives die — for whom I suspect reality has come to an end — while I have gone on living.
I am also not subscribing to a belief in moral relativism. Under no circumstances am I prepared to acknowledge that your values — to the degree they differ from my own — are as "good" as my values! I will go even further and assert that my values, and my principles, and my understanding of the world are superior to those of everyone else in this room. If I thought that you had knowledge, values, or principles that were superior to mine, I would adopt yours. Obviously! This is one of the ways in which we learn from one another. We deal with the world as opinion, but most of us subscribe to the view that some people's opinions (i.e., our own) are better than others. But until you are in a position to provide what my mind informs me is an improvement upon my understanding, I shall stick with my own subjective opinions — just as you will.
"Learning is an art form, and, like painters and sculptors, we outwardly manifest our inner visions of the world and ourselves." I am insisting, however, that my understanding of whatever the universe may consist of is entirely dependent upon the content of my subjective mind, and that my expression of that understanding is but an internally constructed network of opinions. My opinions may or may not conform to the outer world, but they nonetheless remain opinions. Do we live in a geocentric or heliocentric universe, and how would we find out? How would the sky appear to us if the sun did orbit the earth? And if we are so convinced that it does not, why do we still speak of "sunrises" and "sunsets?"
I once had a discussion of this topic with a friend of mine, a man with a good understanding and confidence in the physical and biological sciences. I asked him why he believed in a heliocentric universe, when our visual observations seem to support a geocentric position. "The math supports the heliocentric view," he said. I responded: "this raises two points: (1) why do you rely upon mathematics to validate your view? After all, the Bible suggests a geocentric view. Why do you accept one source over another? Furthermore, (2) have you done the math, or have you only relied upon those who told you they have?" He knew that I agreed with his point of view, but I was desirous of prodding him with the same question I am giving to you today: how do you know what you know? How do you know that your understanding of the world is valid?
Political behavior is not the only realm in which I maintain my skepticism. In matters of religion, the sciences, politics, philosophy, etc., I remain an agnostic; I am skeptical of all that I read and hear. I must be convinced of the truth of what you tell me. But I am unable to judge the truth of any point of view other than by comparing it with the opinions I have previously put together in my mind.
While I have strong opinions on all kinds of topics, I also have a strong skepticism about my own mind, because I am aware of its limitations. It is this skepticism that underlies my anarchist sentiments, because I know that I lack the omniscience necessary for the running of your life; that your preferences and your visions are not my own; and that if we are to live free, peaceful, creative, and cooperative lives, we must abandon the kind of thinking that causes us to see others as objects to be reformed.
My science friends become ruffled when I suggest to them that, like the religionists, they ground much of their understanding in faith, as do I, as do you. My understanding of ancient history is based entirely upon what others have informed me: I was not around during the Punic Wars, nor have I had any direct experiences with the American Revolutionary War. If I had had such experiences, I would doubtless have interpreted their meaning according to my prior learning, which might very well have differed from that of a man standing next to me.
So much of what we know is based upon trust: a confidence that our parents, friends, teachers, scientists, historians, religious figures, and others have provided us with accurate and truthful information. But we must remain skeptical of all such learning, lest such sources were in error. Did King Arthur actually exist? What about Buddha, or Dracula, or Santa Claus?
After all of these years, I am convinced that human beings are driven by a need for spiritual or religious experiences — a need to transcend one's individual existence and to connect up with the universe in some way. I do not think of such needs in the way they are usually defined — as organized churches, although they might include that. These needs find expression in many ways: the need for understanding, fame, riches, and power, being among them.
The sciences are one expression of this need. When I put the book of Genesis alongside a physics book that speaks of the "big bang," I am amazed at the similar explanations for the creation of the universe: the great void followed by a great explosion of light. When my science friends remind me that echoes of this "big bang" are to be found in background radiation in the universe, I muse "perhaps God has a giant microwave." But whether we think of ourselves as "religionists" or "scientists," I believe we are engaged in the same pursuit, answers to the questions: where did it all come from, where is it all going, and what rules are in place in the present?
"While I have strong opinions on all kinds of topics, I also have a strong skepticism about my own mind, because I am aware of its limitations. It is this skepticism that underlies my anarchist sentiments." Based upon our prior experiences, each of us has a different approach to such questions. I do not believe in a God but I do believe there is a life force in the universe. Consistent with my philosophic views generally, I do not see this life force centralized in a universal authority figure, but decentralized among us all, including — as part of the all — the flowers I watch turn their faces each day to catch the nourishment provided by the sun.
We humans are destroying ourselves through a self-righteousness grounded in a belief in objective truths, whether it comes from religious fundamentalists, advocates of "politically correct" speech and behavior, or ideologues who seek to forcibly redesign economic and social systems to suit their visions of how the world should perform. I will go even further and suggest to you that a belief in objective truths and values is consistent with political collectivism and inconsistent with individual liberty.
If "truth" and "moral principles" reside beyond the individual — and there has never been a shortage of men and women prepared to define and describe this moral order for the rest of us — why should we not want to mandate uniform, standardized social systems and practices to forcibly direct people to comply with such eternal and transcendent principles? Why would we be expected to show any tolerance for those whose ideas or conduct differed from the objective truths?
We are unable to transcend the limited capacities of our mind other than, perhaps, by becoming and remaining constantly aware of those limitations. If we can do that, we may put an end to our horribly destructive habits while, in so doing, transfusing those antilife energies into the wonderfully creative pursuits that have generated a life-sustaining civilization.
For the sake of living honestly, peacefully, and in a condition of liberty, let us turn our minds inwardly, like a mirror, so that we may reflect upon the creative capacities that lie within us, through which we inwardly construct our images of the world. Let us acknowledge the complementary nature of our minds: that we can subjectively comprehend and act upon the universe without, at the same time, having our understanding precisely correlate with the world in which we live. Let us have the humility to recognize that we are generally able to function well in a complicated universe in spite of never having complete and certain knowledge. Let us recognize that one who believes in a flat-earth, geocentric world can still farm a good field of wheat, and that a man who rejects your moral philosophy may still be a good neighbor.
We have been trained to look for godliness, virtue, direction, and truth outside ourselves, in some agency external to ourselves. Such beliefs have been generated largely by those who have either a religion or a political system to fasten upon the necks of their fellow beings. It is through such thinking that some have been able to control the thoughts and actions of others by attacking their victims' sense of self-capacity and worthiness to function in the world.
It is time that we discovered the inner sense of what it means to be a free and responsible individual. We are destroying ourselves through processes by which we have allowed others to define both reality and propriety for us. Like dogs, we have learned to beg and roll over upon command from our masters, to slobber in anticipation of some small morsel, and to carry our leashes in our own mouths. None of this could have been accomplished without our willingness to believe that we are inwardly incapable of defining our own purposes in life or pursuing our own interests without the supervision of others. It has been our lack of confidence in the sufficiency of our inner being that permits such psychic self-flagellation. Why do we persist in living irresponsibly, by allowing others to form our judgments? Why do we fear our own minds but insist on believing the thinking of others?
What powers lie within the creative processes of our subjective minds! We have been able to discover the secrets of nature, make sophisticated tools, produce great music and other art forms, create agricultural and industrial methods of producing goods and services, generate languages and mathematical systems, and form organizations that allow us to cooperate for our mutual interests. But even more impressive has been our minds' capacities for generating moral principles and even gods.
Within the complexities of our minds are to be found the engines of creation that have made mankind both the creative genius and the destructive beast that we are. It gives me a sense of liberated exhilaration to know that, because of the processes of my subjective mind, I am the source of the knowledge, values, and decision-making effectiveness upon which I rely for my short stay on this planet. What greater expression than this of what it means to be a free individual?
For the sake of living well — in the fullest material and spiritual meaning of that phrase — we must rediscover that inner, subjective sense of wonder and exploration that we knew as small children: when we could marvel at a spider as she spun her web, without having to make judgments about her; when our response to taking a fall while reaching for something beyond our grasp was to get up again and reach a little higher; when we knew that our emotions were not reactive impulses to be suppressed, but signals — coming from within our soul — warning us of the hidden implications of our actions. Is it possible for us to relearn how to observe without being restricted by labels that suck the meaning out of our experiences? Can we learn, once again, how to trust our own minds — including our emotions — and to resist those who insist upon putting chains on our thinking?
This is a transcript of a talk given at the Mises Institute, on October 9, 2010, at a conference titled "Economic Recovery: Washington’s Big Lie."
The technique of the historicists' indictment of capitalism is simple indeed. They take all its achievements for granted but blame it for the disappearance of some enjoyments that are incompatible with it and for some imperfections that still may disfigure its products, writes Ludwig von Mises (1881–1973).
This audio Mises Daily, excerpted from the audiobook version, is narrated by John Pruden.
The leading Baconian in political economy, who was also, fittingly, a pioneer in statistics and in the alleged science of "political arithmetic," was the fascinating opportunist and adventurer Sir William Petty (1623–1687), writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
Modern economics traces all human actions back to the value judgments of individuals. It never was so foolish, as Myrdal charges, as to believe that all that people are after is higher incomes and lower prices, writes Ludwig von Mises (1881–1973).
This audio Mises Daily, excerpted from the audiobook version, is narrated by John Pruden.
The status and reputation of Sir Francis Bacon (1561–1626) is one of the great puzzles in the history of social thought. What had he actually accomplished to warrant all the accolades? Essentially, he was the metaempiricist, the head coach and cheerleader of fact grubbing, exhorting other people to gather all the facts, writes Murray N. Rothbard (1926–1995).
This audio Mises Daily is narrated by Jeff Riggenbach.
Canadian emergency rooms are infamous for their long wait times.The long wait times, in fact, prevail in most of the Canadian healthcare services, not only emergency rooms. A recent study has shown that in most of them the average wait time exceeds 6 hours and sometimes reaches up to 23 hours. While some call for action in reducing these extremely high figures by increasing the supply of healthcare services, others try to present the situation as, in principle, an unavoidable fact of life.
Both of these arguments are missing the target. The long wait times are unlikely to be significantly reduced under the current institutional arrangement, because any serious reduction would require transferring a formidable amount of resources from the other sectors of the economy. At the same time, constantly full waiting rooms are not an unavoidable fact of life but a product of a "priceless" supply system, where waiting for service acts as a rationing substitute for the market price. The incentive structure created by this institutional arrangement is not conducive to providing shorter wait times.
The purpose of this article is to provide more clarity when it comes to these important points and their implications. I will first describe the dynamics of a typical emergency waiting room and then use economic theory to explain the persistence of these dynamics, the high costs of changing the situation under the current system, and some of the benefits of an alternative, money-price mechanism.
The Dynamics of a Waiting RoomLike most parents of young children in Canada, my wife and I have spent a fair share of our first six years of parenthood waiting for service in emergency rooms. Without any exaggeration, it can safely be said that we had ample time to observe and analyze the waiting process in a typical Canadian waiting room. One thing that we noticed is that there is a remarkable regularity and stability in this waiting process. This suggests that the long waiting times in the current system are in fact a stable equilibrium outcome rather than an unplanned disruption.
During our usual six or more hours of waiting, I noticed the following process over and over again: There were about 30 people waiting at all times (which is a relatively small number considering that this is the main emergency room for Kitchener-Waterloo, a city of 300,000 inhabitants). About once an hour, a nurse would come out and call in about 5 people to go from the main waiting room into the next room where they would, eventually, be seen by a doctor. About the same number of new patients would come to the waiting room over the course of an hour. Thus, the total number of people in the room would remain fairly stable.
However, there is an order in which different people are called in. Only if one has an extremely severe, life-threatening condition (which seemed to be quite rare) could he or she be admitted immediately upon arrival. Otherwise, one would need to wait until those that came before were taken care of.
The arithmetic of waiting is as follows: Whenever a new person comes into the waiting room, there are about 30 people waiting in front of him or her. Because the doctor examines about 5 people per hour, it takes approximately six hours until this new person is admitted. But, in six hours, there will be 30 new people in the room, because about 5 new people enter the room over the course of an hour.
Consequently, the waiting room could be likened to a pool that is being emptied at the same rate as it is being filled. The level of water in such a pool remains unchanged over time.
A person that does not understand the laws of economics might come to a "revelation" and proclaim that we just need to add a small amount of resources in order to increase the rate of the emptying of the "waiting pool" just slightly above the rate at which the pool is being filled up. This would solve the waiting problem permanently! However, this is not true.
Unlike many hospital brochures, which offer merely a description of the waiting process, the following section offers a real explanation based on the principles of economics.
Time as Price in a "Priceless" SystemPrices have multifaceted functions in the market economy. First, they reveal some of the subjective and dispersed knowledge about the individual values of the millions of people constantly making production and consumption decisions. High prices send signals to entrepreneurs about the kinds of goods that are highly valued by the consumers. This in turn directs the allocation of resources into more highly valued purposes.
Another important function of the price mechanism is that it brings about the harmony between the quantity of goods that is demanded and the quantity that can be supplied at any given point in time. If a store keeper — let's call him Jim — sees people piling up in front of his store, he will interpret this as a signal that the price he is charging might be too low. By increasing the price, Jim achieves two outcomes at the same time: (1) he reduces the number of people piling up in front of the store without significantly reducing the number of customers per unit of time and (2) he increases his revenue.
"When the price is not allowed to perform its function of supply-and-demand rationing, something else will."The money price of a particular good or service acts as a lever that determines the amount of other goods and services one needs to give up in order to acquire that particular good. As the money price increases, only those people that are willing to give up a lot of other things keep buying the particular product.
If Jim was not allowed to charge a money price for his services, he would have no way of affecting the number of people entering his store, other than locking the door from time to time and making the interested buyers wait. Those that value the products in the store highly would be willing to wait a long time to save their spot in line.
Some people would be willing to wait because their time (or, more specifically, the foregone use of that time) would now be the only price they are paying for the service. Others might just look for another store offering similar products. However, if the products offered by this particular store are unique or if others are prohibited by law from providing a similar service in exchange for money, the wait time people would be willing to accept might be quite high.
The same laws of economics apply to any other service, such as, for example, healthcare services that are very specific and, in Canada, provided by a centrally planned, legalized monopoly that does not charge a direct per-unit price. Instead of the money price, this organization must rely on a nonmonetary mechanism of managing the demand for its services, such as administrative procedures and, unavoidably, waiting times.
Most people have some mild health-related problem most of the time, but it would not be worth it to them to wait for six hours to receive treatment. They might, however, be willing to wait 20 or 30 minutes or even an hour. The wait time is the only price they pay for the service, but if the price is too high, these people will choose not to use the service offered by the healthcare provider.
However, there are always a small number of people that would be willing to wait six or more hours because the value they put on their particular health problem is quite high. Generally, as the wait time decreases, the number of people willing to wait increases. For example, in our city of 300,000 people, I would expect far more than 5 (or even 30) persons per hour coming into the emergency waiting room if they had to wait only five minutes to receive a service and not provide any money in return.
While the exact relationship between the wait time and the number of people willing to wait for service is an empirical question, it could be conceptually represented as in figure 1. The figure shows a hypothetical demand curve for an emergency room services in a medium-sized Canadian city. It indicates that, as the wait time decreases, more people would be demanding service. We say that the quantity demanded increases as the price (i.e., the waiting time) goes down.
Figure 1. The inverse relationship between the wait time and the quantity of medical service demandedThe current minimum average waiting time of six hours is probably somewhere at the steep end of the curve (point A). For example, most people would probably be willing to wait that long if their child split her eyebrow open, broke her arm, or if she was vomiting all night. But most people would probably refrain from going to the emergency room for a health problem that they believed might go away on its own in a few days or weeks. On the other hand, most people would likely show up at the emergency room even for mild problems if they knew it would only take 10 or 20 minutes to get admitted.
Now, if we wanted to put in practice the "revelation" that a noneconomist could have about adding some additional capacity to eliminate the wait time, figure 1 would show us where we could be going wrong.
Suppose we wanted to double the capacity of the emergency room from five (point A) to ten people per hour (point B) for a short period of time in order to empty the "pool" of people in the waiting room. In our city, that would only involve adding another doctor (provided there is an idle doctor somewhere). This is because, currently, there are ten small individual examination rooms behind the main waiting room served by only one doctor. Most people spend an hour or two just sitting in one of these rooms waiting to be examined. Thus, there is infrastructural capacity available to accommodate an additional doctor.
Adding one more doctor would allow for ten people to be admitted every hour. This would initially reduce the wait time. However, the shorter wait time would induce some additional people to seek medical service. These are the people that were not willing to wait six hours but might be willing to wait, say, four hours. Thus, the two doctors would now face a new wave of patients — all those with the waiting tolerance lower than six hours but higher than the newly established, shorter waiting period.
"While paying for a service with money represents an exchange of claims over resource ownership, paying for the same service with time represents outright resource destruction."Suppose that the wait time of four hours is required to limit the number of new entrants to the total number of 10 people per hour. Then we would end up with the following situation: Two doctors are examining 10 people per hour. Ten new people are coming every hour. And, there are now 40 people in the waiting room, each being admitted after four hours of waiting. Thus, even though the waiting time is reduced, the reduction was not dramatic. Additionally, the number of people in the waiting room increased from 30 to 40, and the number of doctors needed to serve this demand would have to be doubled permanently.
Imagine now that every emergency room, every walk-in clinic, every MRI and CAT-scan clinic, and all other providers of medical services decided to double their capacity in the hope that they would significantly reduce the excess demand for their services. As shown in figure 1, a reduction in the wait time would be accompanied by an increase in the quantity demanded, in the same way a reduction in a money price would be. The higher the increase in supply and the corresponding reduction in the wait time, the greater the increase in the quantity demanded.
This indicates that the amount of resources needed to reduce the wait time in a system that does not directly charge a money price for specific units of service may be quite high. Moreover, the benefits to the healthcare-system employees and managers are not that clear, leading to weak incentives to alleviate the problem.
However, the healthcare employees are the last to be blamed for this situation, because they are just responding rationally to the incentive structure created by the given institutional framework. Who would want to stretch themselves beyond their capacity, for no apparent benefits? At the same time, starving the other sectors of the economy in order to provide the resources needed for a wait-free, priceless healthcare system would not be the wisest decision either.
Another issue that is often overlooked is the destructive nature of a system devoid of money prices. While paying for a service with money represents an exchange of claims over resource ownership, paying for the same service with time represents outright resource destruction. The time spent in waiting is lost forever and cannot be used in any productive activity, whereas the money paid for service could be used for purchasing goods and services that had already been produced. The time not spent in waiting could be used for the production of new resources.Note that some people would not be able to perform any other productive activity due to their poor health. However, there are many people who would know how to better use their time if they had this option. These are the people with less severe health conditions, and the people that accompany those with more severe conditions, as well as parents with sick children. In addition, spending time resting at home instead of in a crowded waiting room would likely have positive health effects.
ConclusionGiven the current structure of the Canadian healthcare system, the long patient wait times are here to stay. Those that believe the problem could be solved by increasing the supply of health services ignore the large demand effect of a reduction in wait times. Others, who believe that waiting is an unavoidable fact of life, ignore the fact that the long wait times are an artifact of the "priceless," politically administered supply system.
When the price is not allowed to perform its function of supply-and-demand rationing, something else will.Alchian, A.A. and H. Demsetz. 1973. "The Property Right Paradigm." Journal of Economic History, Vol. 33, No. 1, pp. 16–27. In the case of the Canadian healthcare system, this price substitute is our time. But many of us may not be aware of the destructive nature of this hidden and steep price tag. While the unseen costs are always easily ignored, they are constantly eating up the economy's productive resources.