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Friday, April 23, 2010

Learning from Austrian Economists

Since the financial meltdown of 2008 and the ensuing “Great Recession”, economists have begun to re-examine the roots of their discipline. This re-examination seems to have crystallized into a revival of hitherto discredited Keynesian doctrines that had been largely abandoned after the 1980s. The attraction of Keynesianism is that it seems to give fairly clear prescriptions which rulers and policymakers can clutch at in order that they might be seen to be doing something – anything – to mitigate a perceived economic crisis.

To the powers that be, it matters little that the Keynesian prescriptions are wrong and will do more harm than good in the long run. After all, in Keynes’ famous words, “in the long run we’re all dead”. And if you’re a politician, the short run – generally around four years – matters much more.

Other economists, more sane though fewer in number, have instead turned to a rediscovery of the ideas of another historical strand of economic thought, the so-called “Austrian School”, the most well-known exponents of which were Friedrich Hayek (1899-1992) and Ludwig von Mises (pictured, 1881-1973). Their thinking has not caught on quite as much in the current “crisis”, mainly because their advice consists largely of avoiding action, which is not a prescription likely to endear them to regulators, nor to politicians and the mob that elects them.

Nevertheless, I have been immersing myself in the literature of the Austrian economists for the past year and a half or so, and in this post I’d like to impart some of the things that I’ve learned from them. In the next post I’ll play devil’s advocate and share what I take to be some of their shortcomings.

* * * *

1. Knowledge is Distributed

Human knowledge is not contained in the mind of a single person. The knowledge we require to run our society is dispersed across the minds of some six and a half billion people. This has pretty sweeping political implications. There is no single omnipotent person or planning bureau possessing all the knowledge necessary to coordinate the economic activities of millions of people. Since that knowledge is instead distributed among those millions of people, for the most part it’s best to let them coordinate themselves. Planners and policymakers should contain their hubris within the bounds of their capabilities.

2. Prices are Subjective

In medieval times theologians debated what the “just” price for widgets was, or what the “just” rate of interest to charge for a loan was. Now, what is a widget worth? It’s worth whatever people are willing to pay for it. Now, this sounds simple, but it surpassed the knowledge of the greatest thinkers of the Middle Ages. And we must ourselves avoid the fallacy of thinking that what people are willing to pay for a widget is somehow related to the intrinsic value of widgets in general, for if that were the case the price of widgets would be unchanging. Instead, the value of a widget is conceptually related to the opportunity cost of its purchase. In other words, what people are willing to pay for a widget depends on what other things they are willing to forego in order to purchase it. If I only have $X dollars to spend, and a seller is charging $Y for a widget, then buying a widget means I would only have $X-Y to spend on other things. If there is something else I need more than I need a widget and its price is greater than $X-Y, then I will have to forego purchasing the widget, because in purchasing the widget I would thereby lose the opportunity to spend my money on something more valuable to me.

Price is a function of the subjective valuations of many individuals. It is not the expression of the intrinsic value of a good. Indeed, there is no such thing as a good’s “intrinsic value”.

3. Markets are Information-Processing Mechanisms

The only way of finding out the value of a good is by having it exchanged in a market. A socialist planning bureau would have no way of efficiently pricing the widgets it ordered to be produced because it would have no way of finding out what the effective demand is for widgets, nor of finding out the cost of those factors going into its production. Those socialist economies that have hitherto existed have achieved whatever paltry production success they have by piggybacking, in parasitic fashion, on the pricing mechanisms (i.e. markets) of capitalist nations. It was market exchanges in free countries that allowed the USSR to have some rough idea of how many pairs of eyeglasses to produce at what cost (and even then, I can remember the semi-apocryphal Soviet-era stories about, say, millions of eyeglass frames being produced without lenses to go with them!).

For Austrian economists, the market is more than a place where things are bought and sold. The very act of buying and selling involves more than an exchange of money. It is at the same time an exchange of information, namely information about the preferences of people. And it is this information, formerly dispersed, which is aggregated in markets, allowing scarce resources to be allocated to their best (i.e. most preferred) uses. As von Mises put it, “to the entrepreneur of capitalist society a factor of production through its price sends out a warning: Don’t touch me, I am earmarked for the satisfaction of another, more urgent need. But under socialism these factors of production are mute”. Too much interference by planning and regulation disrupts this complex signaling process and distorts market information.

(Incidentally, all resources with which economists are concerned are scarce. If they weren’t in limited supply, economists would have nothing to say about them. Because they would have no opportunity costs attached to them, they could neither be bought nor sold, which would put them outside the realm of properly economic phenomena. It’s hard to name such an unlimited good. Perhaps air might be such a good, but only in certain contexts. If people were fish, water might be another example. Beyond the earth’s surface, most of the space in the universe is effectively unlimited, which in part is why there isn’t much of a market for ownership of distant stars.)

4. Social Order is a Spontaneous Growth

Because knowledge is dispersed across millions of people, the best way to organize social affairs is to not organize them, at least not in the usual sense. Social order comes about by people pursuing their own goals and objectives based on whatever knowledge they have. In order for this to happen, people must be allowed to communicate and exchange freely. As social beings we subordinate ourselves to rules and institutions which are largely the product of spontaneous growth, not conscious planning; of our making, but not of our design. The freedom of the market order often seems chaotic, but there’s a complex order underlying it, an order which we are in danger of destroying by trying to “rationalize” it through centralized planning.

5. The Rule of Law and its Decay

An example of such spontaneous order, particularly emphasized by Hayek, is the rule of law, as exemplified by the common law. The common law was a gradual and spontaneous growth, built up incrementally, not consciously planned or designed by anyone in particular. Those who were subject to the common law truly lived under “the rule of laws, not of men”. However, as time went on, a penchant for government activism has led to a situation where much of the common law has been replaced by a mass of statutes, designed and enacted, but which, taken collectively, possess little or no underlying rationale.

Symptomatic of this state of affairs is the cancerous growth of that monstrosity which goes under the oxymoronic name of “administrative law”. Administrative law is really the “law” pertaining to the arbitrary exercise of power by government bureaus. Administrative law has been replacing real law for some time now. In truth, attempting to legislate the exercise of arbitrary power is akin to attempting to go mad by rules.

Another symptom of the decay of the rule of law is the growing prominence of public law over private law. Law was once mostly private, governing the relations between private citizens. The bulk of law now takes the form of an ever-growing mass of statutes governing the relations between government and private citizens; or, more properly, it takes the form of statutes promulgated by government commanding citizens to do or not do (or both) various things, so that the latter’s sphere of free activity shrinks to the point that it no longer makes sense to speak of them as private citizens as such.

The worst part about all this is that it has been going on for so long now that we barely notice it (unless, say, you’re a smoker, which I am not). We assume that it is necessary for the government to perform the countless functions it now does, which necessitates all this rule-fetishism. Critics sneeringly accuse the Austrians of advocating a “night watchman” state, whose only role is to protect property, enforce contracts, punish criminals, and keep up the military. On the other hand, said von Mises, “it is difficult to see why the night-watchman state should be any more ridiculous or worse than the state that concerns itself with the preparation of sauerkraut, with the manufacture of trouser buttons, or with the publication of newspapers”.

My personal views about the duties of government fall somewhere between these two extremes. However, with my government trying to ensure that I eat enough vegetables, I know that the pendulum has swung too far in the direction of nanny-ism. Even fascist dictators have better sense than to concern themselves with such matters.

6. Prices are Interconnected

Eyeglass frames are not worth much without an adequate number of lenses to go with them. If too few lenses are produced, the price of lenses will rise (because there aren’t enough to go around), while the price of frames will drop (because they’re useless without lenses). The prices of lenses and frames bear an inverse relation to each other. There are other goods which are similarly related, but not inversely. For example, if the price of a certain good rises, so too will the price of another good which can be used as a substitute for it.

Socialist and interventionist economists, or at least the more stupid ones, have tended to treat the prices of various goods as if they were independent of each other. Thus, when proposing a policy of price controls, they assume that fixing the price of one good will have little or no effect on the prices of other goods, and on the economy more generally. But because of what von Mises calls the “connexity of prices”, such interference can have widespread effects.

7. The Pervasiveness of Unintended Consequences

Because of phenomena like distributed knowledge, the connexity of prices, and spontaneous order, we must be wary of attempts to control phenomena through rational planning, for the consequences of our actions can be unforeseen and widespread. Thus, the Austrian analysis seems to contain an inherent tendency towards conservatism. Despite this, Hayek himself explicitly denied any tendency towards conservatism in his thought (a denial which, incidentally, I find unconvincing). Karl Popper, a friend of Hayek’s, admitted the necessity of planned change, but suggested that it ought to be done by what he called “piecemeal social engineering”, that is, the tentative implementation of small incremental changes that are reversible.

8. Money is a Commodity

According to Carl Menger (1840-1921), the founder of the Austrian tradition in economics, the use of money originated as a form of indirect barter. You might offer me a number of chickens for my pig, but I might have no use for chickens at the moment, even though I have too many pigs for my own use. But if I knew that you had gold and that I could easily exchange that gold with someone else for something that I could use, then I might accept gold as a substitute (or you might exchange your chickens for gold with someone else and then come to me with the gold). Essentially this latter transaction is still a matter of barter, only more indirect. The only thing that makes gold different from pigs or chickens is that, for various historically contingent reasons, the demand for gold is (almost) always stable and universal, enabling it to become a standard medium of exchange.

Of course, eventually, instead of accepting gold, which is attended with certain inconveniencies, people came to accept paper issued from a trustworthy source which represented a given quantity of gold and which was technically exchangeable for the latter.

Short of coin clipping and other crude traditional ways of debasing the currency, when money is tied to a commodity it is difficult for a government to interfere with the money supply for its own nefarious purposes ― sooner or later the market catches on and price levels adjust accordingly. Gresham’s Law (“bad money drives out good”) will take over: people will pay their debts in devalued money, hoard gold and avoid lending, and prefer to consume their capital rather than invest it. Manipulation of a commodity-based money supply will be thwarted in the long run, one way or another.

However, when currency is decoupled from its commodity basis and the money supply is treated as if it were something that can be expanded indefinitely, the government is free to manipulate it for its short-term interests. These interests will usually involve inflating the currency through credit expansion, which – thanks in part to the false ideas of Keynes and his school – it believes it can do indefinitely. Keynesian economics seems to imply the existence of free lunches. Austrian economics prefers to “go Dutch”.

The Austrians adhered to a “sound money” policy. Such a policy limits the ability of governments to interfere with the normal operations of the market. For adherents of Austrian economics, the abandonment of the gold standard by the US in 1971 represented something close to the beginning of the end of capitalism. Who knows? They might turn out to be right. Such alarmism certainly seemed warranted during the great stagflation of the 1970s.

9. Beware the Boom, not the Bust

Keynesianism is all about shortening and mitigating economic downturns. For them, busts are caused by a lack of aggregate demand. They are unnatural. The cure for them is to increase consumption, even if this requires deficit spending by the public sector. The obvious danger to such a policy is inflation. But until the 1970s it was believed that there was an inverse relation between inflation and unemployment (the so-called “Phillips curve”), so a little inflation seemed a worthwhile tradeoff. As it turned out, this belief was mistaken: it was possible to have both inflation and high unemployment.

For the Austrian School, downturns are natural and inevitable, and the more you do to avoid them, the worse and more protracted you make them. Again, there’s no such thing as a free lunch.

It’s actually booms that are unnatural, especially when they’re fuelled by the expansion of credit and the money supply. When markets are awash in capital (or seemingly so, due to the short-term cognitive illusion caused by inflation), capital and resources get allocated inefficiently. Rather than investing in viable business enterprises, money is invested in imprudent schemes (like housing bubbles?). On the aggregate level, all of this represents a huge misallocation (or in von Mises’ jargon, a “malinvestment”) of resources.

Such misallocation will be felt sorely in the inevitable bust. Money stupidly invested in certain enterprises during flush times cannot be instantly taken out and reinvested more profitably elsewhere. Investment is not a perfectly reversible process. Capital gets tied up precisely when it needs to be freed up for use elsewhere, thereby exacerbating the bust. Eventually these effects will work themselves out, but this takes time, and the longer the boom lasts, the longer it will take to recover from the hangover.

Further to be considered are the effects of inflation during the boom. Most of these, including liquidity preference (i.e. cash hoarding), reduced lending, and preference of capital consumption over investment, are well-known, but the Austrians added a new twist. Keynesians often speak as if inflation is a phenomenon that works the same effects on the prices of all goods, across the board. They talk in terms of the rising price level. In contrast, the Austrians noted that, thanks in part to the connexity of prices, the effects of inflation will not spread themselves evenly throughout the economy. Some prices will go up (at different rates) while others will actually go down. This state of affairs amounts to a serious distortion of market signals, leading investors and consumers to make bad choices. Again, inflation leads to the misallocation of resources and market inefficiency.

All of this may sound too much as if I’m offering an unqualified defense of Austrian economics. Perhaps I am being too liberal in my praise, if only to offer a counterbalance to all the Keynesian “conventional wisdom” floating around right now. As promised, my next post will be devoted to an exposition of some of the shortcomings I’ve found in reading the Austrian literature.


  1. 2 contrasting articles. Both compelling in their way. Both fairly knee-jerk, although it's interesting that Stanford echoes Reynolds' point about regulation qua regulation being better for actual regulation than a tax would be. Reynolds, as usual, can't resist a cheap ad hominem attack on Keynes, but my guess is that will make you chuckle anyway.



  2. I've never figured out why Stanford has been accorded the moniker "economist"; his errors are many and basic. Nonetheless, he's right that banks ought (the MORAL "ought") to pay more tax. However, Reynolds is correct to say that at the end of the day they won't.

    Yes, the attack on Keynes was ad hominem (and untrue - mostly).

  3. And an odd (and slightly off balance) youtube video showing a rap battle between Hayek and Keynes: http://www.youtube.com/watch?v=d0nERTFo-Sk

  4. Yes, I love that video (although it's a little thin on economic doctrine -- but it gives the general gist). I particularly like the fact that the two bartenders pouring shots have name tags that say "Ben" (Bernanke) and "Tim" (Geitner). Nice touch!