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|The Foundations of Modern Austrian Economics; Edited by: Dolan, Edwin G.|
62 paragraphs found.
Meanwhile in Vienna the marginalist revolution was proceeding on another front. In 1871 Carl Menger published his
Grundsätze der Volkswirtschaftslehre and, soon joined by Friederich von Wieser and Eugen von Böhm-Bawerk, established the Austrian school. The Austrian school, although failing to achieve dominance in the international profession, retained its own identity and did not become wholly absorbed into neoclassicism. Throughout the remainder of the nineteenth century and into the twentieth, it continued to attract a small but vigorous stream of adherents, among whom the most distinguished were Ludwig von Mises and Friedrich A. Hayek.
During the Great Depression neoclassical economics was deeply shaken. The depth and duration of the economic crisis exceeded the expectations of orthodox theorists. Government policymakers were unable to find adequate guidance in the textbooks of the day, and members of the economics profession cast about for a new theoretical insight. The two major candidates for the leadership role were Hayek, the Austrian theoretician, and John Maynard Keynes, the most prominent of Marshall's pupils. By the end of the decade of the thirties, the Keynesian system had attracted the greatest number of adherents, and the Austrian school, after a brief period of prominence, was left to pursue an independent course in relative obscurity.
|Part 1, Essay 1|
Students of contemporary economic thought ought not, however, allow the status of modern Austrian economics as extraordinary science to be settled entirely on the basis of the Austrian economist's self-image. Others have seen things differently, among them Milton Friedman, a leading articulator of the orthodox paradigm. Speaking informally at the South Royalton conference, Friedman startled his audience with the bold assertion that "there is no Austrian economics—only good economics, and bad economics." His intention, he went on to explain, was not to condemn Austrian economics as bad economics but rather to declare that the truly valuable and original contributions of Austrian-school economists (he was speaking of Friedrich A. Hayek in particular) could be smoothly incorporated into the mainstream of economic theory.
As our third illustration, let us look at the nature of Austrian-school contributions to the theory of money and economic fluctuations. The Austrian economists are characteristically averse to using the term
macroeconomics when referring to this area of study. This very term smacks of illegitimate aggregates and the type of methodological holism they seek to avoid. From the earliest days, the hallmark of Austrian work in this area has been a microeconomic approach to macroeconomic problems. Ludwig von Mises's
Theory of Money and Credit (first German edition 1912; English edition, New Haven: Yale University Press, 1963), a pioneering contribution, identified the lack of coordination between individual expectations and the supply of money and credit as a prime cause of economic disturbance. Later work by Hayek extended the Misesian analysis and integrated the theory of the business cycle with the Austrian theory of production. Let us take a brief look at Hayek's contribution in this area, as
updated and applied by Gerald P. O'Driscoll, Jr., and Sudha R. Shenoy in their paper "Inflation, Recession and Stagflation" included in this volume.
O'Driscoll and Shenoy, together with other modern Austrian economists, hold that the major anomaly facing orthodox economics and defying explanation is the seemingly intractable inflationary stagnation that has beset the major industrial countries in the seventies. In their view, orthodox theories, Keynesian and monetarist alike, are formulated at too high a level of aggregation and are thus blind to the distorting effects of overexpansionary monetary policy on relative prices and the capital structure. In barest outline, their argument is that expansionary policies inject money into the economy, not uniformly, but at a specific point. The injection of new money creates a monetary "pull" on relative prices at this point. As a result of the effect of monetary expansion on relative prices, some businesses make profits that otherwise would have made losses, and some workers find jobs in places where there would otherwise have been none. If the injection of new money is by way of commercial bank loans to businessmen, the capital goods industries, and among them firms producing specific capital goods suitable for use in processes of relatively low labor intensity, are built up first. However, the expansion of these industries cannot be sustained without a concomitant decline in the fraction of current output consumed. Barring a fortuitous shift in consumption habits, the injection of new money must be continued. Because expectations adjust to any constant rate of injection, the needed degree of monetary pull on relative prices requires an accelerating rate of monetary expansion. This leaves policymakers in a dilemma. Either they must inflate without limit, or when they cease inflating, they must face the unemployment and drop in output that will inevitably accompany the liquidation of the unjustified investments made earlier. To use Hayek's metaphor, the policymakers have a tiger by the tail.
Here again we see how the Austrian paradigm, with its principled rejection of aggregative analysis, has produced insights that in recent years orthodox economists have been quick to overlook.
In the case of business cycle theory, however, the possibility is greater than in our previous examples that the essentials of Austrian theory can be co-opted into orthodox analysis. Orthodox theorists may well wish to recast Hayek's theories in a form that would make them subject to econometric evaluation. If they are pleased with the results, one can easily imagine Hayek's relative-price mechanism being spliced onto existing Keynesian or monetarist models, just as has happened to other microeconomic insights such as the theory of job search and the theory of inflationary expectations. If this takes place, the Austrian paradigm may not succeed in replacing that of the Keynesian-neoclassical orthodoxy.
|Part 2, Essay 1|
Friedrich A. Hayek trenchantly described the praxeological
method in contrast to the methodology of the physical sciences, and also underlined the broadly empirical nature of the praxeological axioms:
The position of man...brings it about that the essential basic facts which we need for the explanation of social phenomena are part of common experience, part of the stuff of our thinking. In the social sciences it is the elements of the complex phenomena which are known beyond the possibility of dispute. In the natural sciences they can only be at best surmised. The existence of these elements is so much more certain than any regularities in the complex phenomena to which they give rise, that it is they which constitute the truly empirical factor in the social sciences. There can be little doubt that it is this different position of the empirical factor in the process of reasoning in the two groups of disciplines which is at the root of much of the confusion with regard to their logical character. The essential difference is that in the natural sciences the process of deduction has to start from some hypothesis which is the result of inductive generalizations, while in the social sciences it starts directly from known empirical elements and uses them to find the regularities in the complex phenomena which direct observations cannot establish. They are, so to speak, empirically deductive sciences, proceeding from the known elements to the regularities in the complex phenomena which cannot be directly established.
Praxeology, as well as the sound aspects of the other social sciences, rests on methodological individualism, on the fact that only individuals feel, value, think, and act. Individualism has always been charged by its critics—and always incorrectly—with the assumption that each individual is a hermetically sealed "atom," cut off from, and uninfluenced by, other persons. This absurd misreading of methodological individualism is at the root of J. K. Galbraith's triumphant demonstration in
The Affluent Society (Boston: Houghton Mifflin Co., 1958) that the values and choices of individuals are influenced by other persons, and therefore—supposedly—that economic theory is invalid. Galbraith also concluded from his demonstration that these choices,
because influenced, are artificial and illegitimate. The fact that praxeological economic theory rests on the universal fact of individual values and choices means, to repeat Dorfman's summary of Davenport's thought, that economic theory does "not need to investigate the origin of choices." Economic theory is not based on the absurd assumption that each individual arrives at his values and choices in a vacuum, sealed off from human influence. Obviously, individuals are continually learning from and influencing each other. As F. A. Hayek wrote in his justly famous critique of Galbraith, "The Non Sequitur of the 'Dependence Effect'":
Professor Galbraith's argument could be easily employed, without any change of the essential terms, to demonstrate the worthlessness of literature or any other form of art. Surely an individual's want for literature is not original with himself in the sense that he would experience it if literature were not produced. Does this then mean that the production of literature cannot be defended as satisfying a want because it is only the production which provokes the demand?
Friedrich A. Hayek, "The Nature and History of the Problem," in
Collectivist Economic Planning, ed. F. A. Hayek (London: George Routledge & Sons, 1935), p. 11.
Friedrich A. Hayek, "The Non Sequitur of the 'Dependence Effect,'" in
Studies in Philosophy, Politics, and Economics, ed. Friedrich A. Hayek (Chicago: University of Chicago Press, 1967), pp. 314-15.
|Part 2, Essay 2|
It will be helpful to cite two statements—by prominent Austrian economists—about what economics as a discipline is supposed to achieve. The first is by Friedrich A. Hayek, and the other is by Ludwig M. Lachmann. Hayek in his
Counter-revolution of Science contended that the function of social science, and by implication economics, is to explain how conscious, purposeful human action can generate unintended consequences through social interaction.
The emphasis here is on the unintended consequences of individual human decisions. To explain phenomena that are not the unintended consequences of human decision making is outside the scope of the social sciences in general and economics in particular. Hayek's position was cited by Alexander Gerschenkron in his contribution to the Akerman
Festschrift, and I think Gerschenkron was perceptive in focusing on exactly what is, in Hayek's view, the fundamental task of economic explanation.
Let us contrast the Hayek view with one expressed by Lachmann. Lachmann's position on the purpose of economic explanations is dealt with at length in his contribution to the Hayek
Festschrift, Roads to Freedom. Here, however, I shall quote from a more recent statement of his position that appeared in his review of John R. Hicks's
Capital and Time:
Economics has two tasks. The first is to make the world around us intelligible in terms of human action and the pursuit of plans. The second is to trace the unintended consequences of such action. Ricardian economics emphasized the second task, the "subjective revolution" of the 1870s stressed the urgency of the first, and the Austrian school has always cherished this tradition.
Thus, we have here two tasks for economics. Besides the task that Hayek emphasized—the tracing out of the unintended consequences of action—we have the requirement that it make the world around us intelligible in terms of human action.
It is worth reminding ourselves that the two tasks Lachmann identified are to be found in Carl Menger's writings. In the third
part of his 1884 book on methodology Menger pointed out that actions do have unintended consequences, and he made it very clear, as Hayek had done, that economics is the science that is able to explain how these unintended consequences emerge in the market place.
But Menger was also aware of the other task Lachmann emphasized. In a letter Menger wrote Léon Walras, cited by T. W. Hutchison in several of his writings,
Menger insisted that the economist is not merely after the relationships between quantities, but the
essence of economic phenomena: "the essence of value, the essence of land rent, the essence of entrepreneurs' profits, the essence of the division of labor."
This view is what Kauder meant when he described Menger as holding that economics deals with social essences,
and what Hutchison called "methodological essentialism."
Let us try to understand the role these basic tenets of Austrian economics play in the Lachmann-Hayek discussions concerning what economic explanation is all about. In 1938 T. W. Hutchison published
The Significance and Basic Postulates of Economic Theory. The book received a blistering Austrian-like critique from the pen of Frank H. Knight, who was on most other issues, such as capital theory, not in sympathy with the Austrian school. In that article Knight conveyed some brilliant insights about the
relationship of economics to the study of human action. Knight noted that "the whole subject of conduct—interests and motivation—constitutes a different realm of reality from the external world." In addition to the external world, with which the natural sciences are conversant, there is a different realm of reality, a realm no less real than the external world, but nevertheless different from it. This other realm is that of human conduct, which Knight identified as interests, motivation, and purpose.
The first fact to be recorded is that this realm of reality exists or "is there." This fact cannot be proved or argued or "tested." If anyone denies that men have interests or that "we" have a considerable amount of valid knowledge about them, economics and all its works will simply be to such a person what the world of color is to the blind man. But there would still be one difference: a man who is physically, ocularly blind may still be rated of normal intelligence and in his right mind.
Here, surely, we have the first of the basic tenets of Austrian theory, that there is a realm of reality constituted of human motives, interests, and purposes, and that, although purposes cannot be seen or touched, they are nonetheless "there."
A memorable passage in Hayek's
Counter-revolution is the one in which he explained that objects useful to human beings are simply not objective facts.
In fact most of the objects of social or human action are not "objective facts" in the special narrow sense in which this term is used by the [natural] Sciences...they cannot be defined in physical terms.... Take the concept of a "tool" or "instrument," or of any particular tool such as a hammer or a barometer. It is easily seen that these concepts cannot be interpreted to refer to "objective facts," i.e. to things irrespective of what people think about them.
Pursuing this point Hayek asserted (in a footnote reference to the work of Ludwig von Mises) that every important advance in economic theory in the preceding century had been a result of the consistent application of subjectivism.
Lachmann's advice to economists paralleled Hayek's. According to Hayek, when we deal with artifacts—with tools and instruments or other products of human beings—we have not exhausted the description of what it is that we are describing if we stubbornly confine ourselves to their physical entities. We have not described a hammer until we have drawn attention to its purpose. Lachmann, similarly, instructed us that when we deal with broader questions, with institutions and regularities in economic affairs, we have not completed our task if we have not called attention to the purposes and motives and interests that underlie these phenomena. A hammer is more than a handle with a metal head; so is a price more than a number, milk consumption more than a number of gallons, and its relationship to price more than a simple functional relationship. A whole world of interests and motives is "there," is real, and it is surely our responsibility as scientists to make it clear.
Critics of Austrian methodology often argue that since praxeology deals with unobservables, it is inherently incapable of telling us anything scientific about observables. The latest (and perhaps the clearest and most sympathetic) statement of
this argument was by James Buchanan, in his contribution to the Hayek
Festschrift, when he drew attention to the distinction between (1) the logic of choice (what he called the abstract science of economic behavior) and (2) the predictive science of human behavior. Buchanan argued that if we treat economics as the logic of choice, it cannot in principle lead to refutable hypotheses because no particular preference ordering has been specified, and to that extent it cannot tell us anything about the real world.
There is a passage in an essay by Hayek that deals with this very question. In that essay Hayek discussed the concept of equilibrium and raised the problem of whether or not there is a tendency toward equilibrium in the economic world. Hayek remarked:
It is clear that, if we want to make the assertion that, under certain conditions, people will approach that state, we must explain by what process they will acquire the necessary knowledge. Of course, any assumption about the actual acquisition of knowledge in the course of this process will also be of a hypothetical character. But this does not mean that all such assumptions are equally justified. We have to deal here with assumptions about causation, so that what we assume must not only be regarded as possible...but must also be regarded as likely to be true; and it must be possible, at least in principle, to demonstrate that it is true in particular cases. The significant point here is that it is these apparently subsidiary hypotheses or assumptions that people do learn from experience, and about how they acquire knowledge, which constitute the empirical content of our propositions about what happens in the real world.
Hayek, then, asserted that when postulating a tendency toward equilibrium, we do have to resort to a particular empirical proposition. Moreover, the empirical proposition in question would seem to contradict the other idea that there are an inherent unpredictability and an indeterminacy about human preferences and human knowledge. If we are to be able to say anything
about the process of equilibration, especially if we are to say something about the course by which human decisions lead to unintended consequences, we shall have to rely upon the particular empirical proposition that men learn from market experience in a systematic manner. This is inconsistent with the second tenet underlying Austrian economics that there is an inherent indeterminacy in the way by which human knowledge changes.
Hayek's argument is straightforward. In disequilibrium man's knowledge is imperfect, some people are making mistakes; equilibrium is the situation in which nobody is making mistakes. A movement from disequilibrium to equilibrium must therefore be one in which men gradually learn to avoid mistakes, so that their actions become more and more coordinated. Where do we derive our confidence that this type of learning in fact takes place? Hayek stated very clearly that this is an empirical hypothesis. If we reject this hypothesis, then we reject the basis for viewing the market process as an equilibrating mechanism—that is, reject the claim that economics can tell us anything definite about the unintended market consequences of human actions. We may still be able to make the world intelligible—that is, we may explain that what happens happens because human beings pursue their purposes. We can assert that their interacting decisions generate certain changes in knowledge, but we shall no longer be able to say in which particular directions knowledge changes, and we can no longer postulate a determinate process toward equilibrium. We shall, to put the matter succinctly, not be able to go beyond the first Lachmann task in order to pursue the program advanced by Hayek. If, however, we confine ourselves to the enormously important task of making the world intelligible in terms of human purposes, we need not accept Hayek's empirical proposition about the coordination of plans and the progressive elimination of mistakes. But if we are to explain the unintended consequences of human action, that is, if we are to assert that there is a tendency for entrepreneurial profits to be eliminated, or for prices to move in one direction rather than another, we must be able to say something
about the manner in which human knowledge and human expectations undergo modification. If one accepts this particular empirical hypothesis, one has surely weakened, perhaps irreparably, the second basic tenet underlying Austrian methodology.
Friedrich A. Hayek,
The Counter-revolution of Science: Studies on the Abuse of Reason (Glencoe, Ill.: Free Press, 1955), p. 39.
Ludwig M. Lachmann, "Methodological Individualism and the Market Economy," in
Roads to Freedom: Essays in Honour of Friedrich A. von Hayek, ed. Erich Streissler et al. (London: Routledge & Kegan Paul, 1969), pp. 93-104.
The Counter-revolution, pp. 26-27.
James M. Buchanan, "Is Economics the Science of Choice?" in
Roads to Freedom: Essays in Honour of Friedrich A. von Hayek, ed. Erich Streissler et al. (London: Routledge & Kegan Paul, 1969), pp. 47-65; see also James M. Buchanan,
Cost and Choice (Chicago: Markham Publishing Co., 1970).
Friedrich A. Hayek
, "Economics and Knowledge," in
Individualism and Economic Order
(London: Routledge & Kegan Paul, 1952), p. 46.
Part 2, Essay 3, New Light on the Prehistory of the Austrian School
|Part 2, Essay 4|
Statements by non-Austrian economists on economic policy are made against the background of the theory of welfare economics. Crucial to this theory is the attempt to aggregate, in
some sense, the tastes, the purposes, or the satisfactions of individuals into an entity that it is the ideal of economic policy to maximize. The principal conceptual difficulties involved in this procedure are two. The first is well known: the problem of interpersonal comparisons of welfare inevitably stands in the way of any kind of aggregation. The second difficulty, less well known but no less serious, was pointed out by Hayek many years ago: welfare economics, in discussing efficiency at the aggregate level, is compelled to make the illegitimate assumption that the bits of information scattered throughout society concerning individual tastes (and everything else) can somehow be spontaneously integrated and fed into a single mind in order for the notion of aggregate welfare maximization to be meaningful.
These difficulties make it clear that, for policy statements to be made without these embarrassments, an analytical framework is needed
that preserves the individuality of individual purposes. If policies or institutions can be judged on the extent to which they permit individual purposes—seen simply as the unaggregated preference structures of individuals—to be fulfilled, then both of the aforementioned difficulties can be avoided. Such an approach has been found, on Austrian lines, in the notion of
See Israel M. Kirzner,
Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), pp. 213-22. Hayek's critique of welfare economics was presented in "The Use of Knowledge in Society,"
American Economic Review 35(September 1945):519-30.
|Part 3, Essay 1|
Ludwig M. Lachmann, "Methodological Individualism and the Market Economy," in
Roads to Freedom: Essays in Honour of Friedrich A. von Hayek, ed. Erich Streissler et al. (London: Routledge & Kegan Paul, 1969), p. 89.
|Part 3, Essay 2|
Ludwig M. Lachmann, "Methodological Individualism and the Market Economy," in
Roads to Freedom: Essays in Honour of Friedrich A. von Hayek,
ed. Erich Streissler et al. (London: Routledge & Kegan Paul, 1969), p.91.
Part 3, Essay 3, The Theory of Capital
|Part 3, Essay 3|
Now Hicks's use of the label
fund to identify that notion of capital
not viewed as physical goods is puzzling and could cause much confusion about the meaning of his discussion. Hicks declared that he "of course" borrowed the term
fund from the history of economic thought; it is here that the confusion begins. The notion of capital as a fund is well known in the history of capital theory. It was carefully developed by John Bates Clark
and repeatedly expounded by Frank H. Knight.
Those who objected most vigorously to this view of capital were Eugen von Böhm-Bawerk in the first decade of the century and Friedrich A. Hayek in the fourth decade. Böhm-Bawerk declared that Clark's concept of capital was mystical, and he insisted that to measure a stock of capital in value units in no way implies that what is being measured is an abstract quantity apart from the physical goods themselves.
Hayek, in his debate with Knight, argued against the notion of capital as a fund of value, that is, a quantity apart from the particular goods making up the capital stock.
Hicks's list of fundists must include Clark and Knight, and Böhm-Bawerk and Hayek must be on his list of materialists (certainly not on the list of fundists).
However, this was not the way Hicks classified these economists. J. B. Clark was "clearly" a materialist, and Hayek "of course, was a fundist."
Also, Böhm-Bawerk. "kept the fundist flag flying!"
A basic familiarity with the history of capital theory leaves one puzzled, if not startled, by Hicks's choice of terminology. Let us look more closely at how he employs his definitions.
Hicks apparently was inspired in his novel use of the term
fund by Böhm-Bawerk's notion of a subsistence fund.
Despite my criticism of Hicks's usage of the term
fund, I must agree that Böhm-Bawerk did set a precedent for using it in this way. Moreover, by insisting that the notion of a subsistence fund is
characteristic of Böhm-Bawerk's approach, Hicks preserved what we must consider to be the essentially pure Austrian element in Böhm-Bawerk's theory. Some effort has been made in recent work to ignore the forward-looking, multiperiod-planning aspect of Böhm-Bawerk's theory. The productivity side of his system has been emphasized, and the time-preference aspect has been either suppressed altogether or treated as an inessential encumbrance.
However, as Hicks recognized, the notion of a subsistence fund is an essential element of Böhm-Bawerk's thinking about capital. This notion embodies the insight that, in choosing between processes of production of different durations, men appraise the prospective sacrifices these processes call for in terms of abstaining from more immediate consumption. Crucial to such appraisals is the size of the available capital stock, because it influences the prospective disutility associated with each of the alternatively required periods of waiting. Not only is this notion of a subsistence fund central to Böhm-Bawerk's theory of capital, but it also is—in spite of his disconcerting concessions to the productivity-interest theorists
—the essentially "Austrian" element in his thought. In the subsistence-fund concept is encapsulated Böhm-Bawerk's concern for forward-looking, multiperiod human decision making; here the influence of subjective comparative evaluation of alternative future streams of income makes itself felt; and here there is room for a discussion of expectations and uncertainty. Hicks recognized all this when he identified the Austrians as fundists. Not only does the notion of the subsistence fund qualify Böhm-Bawerk as a Hicksian fundist, but it also, as Hicks implied, epitomizes what is "Austrian" in Böhm-Bawerk's theory. I heartily agree with all this. At the same time, to emphasize the differences between the fund notion as used by Hicks and as usually associated with Clark and Knight, we may recall Hayek's powerful criticisms of the subsistence-fund idea.
Hayek's extreme opposition to the Clark-Knight notion of a fund led him to point out some difficulties in Böhm-Bawerk's original presentation of the subsistence-fund idea. While we can understand why Hicks labeled Böhm-Bawerk a fundist, we must still decide whether
Hicks was correct in naming Hayek and modern-day Austrians fundists as well.
John Bates Clark,
The Distribution of Wealth (1899; reprinted., New York: Kelley & Millman, Inc., 1956), p. 117; Friedrich A. Hayek,
The Pure Theory of Capital (London: Routledge & Kegan Paul, 1941), p. 93; George J. Stigler,
Production and Distribution Theories: The Formative Period (New York: Macmillan Co., 1941), pp. 308-10.
See Frank H. Knight, "Capital, Time, and the Interest Rate,"
Economica 1(August 1934):259; idem, "The Theory of Investment Once More: Mr. Boulding and the Austrians,"
Quarterly Journal of Economics 50 (November 1935):57; and idem, "The Ricardian Theory of Production and Distribution," in
On the History and Method of Economics, ed. Frank H. Knight (Chicago: University of Chicago Press, 1956), p. 47; see also Hayek,
Pure Theory, pp. 93-94.
See particularly Friedrich A. Hayek, "The Mythology of Capital,"
Quarterly Journal of Economics 50(February 1936): 199-228.
Hayek, "Mythology," pp. 204-10; idem,
Pure Theory, pp. 93, 146-53, 189-92.
|Part 3, Essay 4|
Carl Menger, "Zur Theorie des Kapitals," in
The Collected Works of Carl Menger, ed. Friedrich A. Hayek, 4 vols.(London: London School of Economics, 1936)3: 135-83.
|Part 3, Essay 6|
In contrast to the Misesian "monetary overinvestment" theory of business cycles, on which considerable work has been done by F. A. Hayek and other Austrian economists, almost nothing has been done on the theory of money proper except by Mises himself. There are three cloudy and interrelated areas that need further elaboration. One is the route by which money can be released from government control. Of primary importance would be the return to a pure gold standard. To do so would involve, first, raising the "price of gold" (actually, lowering the definition of the weight of the dollar) drastically above the current pseudoprice of $42.22 an ounce and, second, a deflationary transformation of current bank deposits into nonmonetary savings certificates or certificates of deposit. What the precise price or the precise mix should be is a matter for research. Initially, the Mises proposal for a return to gold at a market price and the proposal of such Austrian monetary theorists as Jacques Rueff and Michael Heilperin for a return at a deliberately doubled price of $70 an ounce seemed far apart. But the current (1975)
market price of approximately $160 an ounce brings the routes of a deliberately higher price and the market price much closer together.
|Part 3, Essay 7|
Those who are sufficiently steeped in the old point of view simply cannot bring themselves to believe that I am asking them to step into a new pair of trousers, and will insist on regarding it as nothing but an embroidered version of the old pair which they have been wearing for years (John Maynard Keynes, "The Pure Theory of Money: A Reply to Dr. Hayek,"
Economica 11 [November 1931]:390).
We shall also offer an exposition of an alternative analysis derived from the Austrian school of economic thought, especially from the writings of Friedrich A. Hayek. In so doing, we shall indicate how a Hayekian analysis of the effects of monetary changes on the structure of prices and outputs enables us to delve beneath the monetary surface to the real underlying phenomena and thereby call attention to the misallocation resulting from a monetary system that discoordinates economic activity.
Not all possible alternatives to the Austrian view will be covered. For instance, we shall not examine the extensive neo-Ricardian critiques of the current orthodoxy advanced by Joan Robinson, Nicholas Kaldor, and Piero Sraffa, since we regard these criticisms as part of a more general attack on subjectivist marginalist economics. Nor shall we consider in detail the work of Robert W. Clower and Axel Leijonhufvud, which in part complements our own work here.
We would argue, however, that virtually all writers and all non-Austrian schools of thought have ignored the importance of Hayek's work in explaining important features of the business cycle.
The monetarist position may be restated as follows: in real terms, prices are always tending to their long-term equilibrium level; monetary changes affect only their nominal height and have no lasting impact on production. Because Friedman viewed underlying economic reality as being adequately described by long-run Walrasian equations, such a position is the only reasonable one—since long-run equilibrium by definition excludes any
real disequilibrium! Nor could Friedman consistently superimpose imperfect anticipations onto a system in which all expectations are by definition consistent and realized. Finally, in the ad hoc "adjustment process" Friedman postulated, he failed to distinguish between price changes that coordinate production and those that do the opposite! In other words, he assumed that price changes represent movements from one equilibrium to another. But the proposition under question is precisely whether price changes can be assumed to automatically coordinate: the Hayekian analysis, as will be shown, demonstrates that under certain monetary conditions some price changes may seriously discoordinate production. In short, in the terminology originally introduced by Hayek, money is not always "neutral." In any case, general equilibrium equations, being solely definitional, leave out of consideration the whole market process—indeed, such equations can tell us nothing about this intertemporal process.
But it is precisely these interrelated price changes that guide production over time and therefore cannot be overlooked.
The aggregative macro constructs, on which Friedman and the monetarists base their analyses, are in the end similar to other orthodox schools of thought (including the Keynesians, as Friedman readily acknowledges).
In relying on these constructs the monetarists appear to be unaware of the real effects of money on the economic system—money's effect on individual prices and price interrelationships and hence on the whole structure of outputs and employments. By ignoring the structure of production and the influences of prices on production, the monetarist analysis shares a common deficiency, not only with the Keynesians, but indeed with the entire analytic framework of the current orthodoxy. The monetarists no less than the Keynesians lay themselves open to Hayek's criticism that such thinking takes "us back to the pre-scientific stage of economics, when the whole working of the price mechanism was not yet understood, and only the problems of the impact of a varying money stream on a supply of goods and services with given prices aroused interest."
Carl Menger provided the theoretical framework for explaining why a medium of exchange was used.
Then, after Knut Wicksell drew attention to the failure of the classical quantity theory to explain how changes in the money supply affect prices,
Mises, building on Menger and Wicksell, showed more completely how money could be integrated into general economic theory. He went on to outline a theory of cyclical fluctuations in which monetary disturbances lead to misallocations.
Hayek built on the theories of Menger, Böhm-Bawerk, Wicksell, and Mises to amplify and expand the Austrian monetary tradition, especially in capital and business cycle theory.
The analysis that follows builds on this tradition.
Hayek likened the effects of money on pricing to the process of pouring a viscous liquid (honey in his example) into a vessel:
There will, of course, be a tendency for it to spread to an even surface. But if the stream (of honey) hits the surface at one point, a little mound will form there from which the additional matter will slowly spread outward. Even after we have stopped pouring in more, it will take some time until the even surface will be fully restored. It will, of course, not reach the height which the top of the mound had reached when the inflow had stopped. But as long as we pour at a constant rate, the mound will preserve its height relative to the surrounding pool.
We may now see the inadequacies of the Keynesian approach that argues that, when there is excess capacity and unemployed labor in both capital and consumption goods industries, credit expansion permits higher employment and output. If the excess capacity is idle because it has been malinvested and hence cannot be fitted into the capital structure, the increased credit can only add to these misallocations and thus create further potential future idleness for both capital and labor resources. As Hayek incisively noted:
It has of course never been denied that employment can be rapidly
increased, and a position of 'full employment' achieved in the shortest possible time by means of monetary expansion—least of all by those economists whose outlook has been influenced by the experience of a major inflation. All that has been contended is that the kind of full employment which can be created in this way is inherently unstable, and that to create employment by these means is to perpetuate fluctuations. There may be desperate situations in which it may indeed be necessary to increase employment at all costs, even if it be only for a short period.... But the economist should not conceal the fact that to aim at the maximum of employment which can be achieved in the short run by means of monetary policy is essentially the policy of the desperado who has nothing to lose and everything to gain from a short breathing space.
Truly, inflation does leave us holding a "tiger by the tail," as Hayek remarked:
Now we have an inflation-borne prosperity which depends for its
continuation on continued inflation. If prices rise less than expected, then a depressing effect is exerted on the economy....to slow down inflation produces a recession. We now have a tiger by the tail: how long can this inflation continue? If the tiger (or inflation) is freed, he will eat us up; yet if he runs faster and faster while we desperately hold on, we are
still finished! I'm glad I won't be here to see the final outcome.
Friedrich A. Hayek,
The Pure Theory of Capital (London: Routledge & Kegan Paul, 1941), pp. 409-10.
Hayek first presented his monetary analysis of the business cycle to the English-speaking world in four lectures at London University in 1931; see Friedrich A. Hayek,
Prices and Production (London: Routledge & Kegan Paul, 1935). His earlier German work on monetary theory was translated and published in 1933; idem,
Monetary Theory and the Trade Cycle (New York: Augustus M. Kelley, 1966). In 1939 Hayek developed his theory further in an essay entitled "Profits, Interest, and Investment," which he published along with some of his earlier articles under the same title; see idem,
Profits Interest and Investment (New York: Augustus M. Kelley, 1970); see also idem, "Three Elucidations of the Ricardo Effect,"
Journal of Political Economy 77 (March-April 1969):274-85.
Prices and Production.
Hayek referred to this effect as the "Ricardo effect." For references to Hayek's writings and further explanations, see Gerald P. O'Driscoll, Jr., "The Specialization Gap and the Ricardo Effect: Comment on Ferguson,"
History of Political Economy 7(Summer 1975): 261-69.
The physical durability of a capital good is not the only determining factor in its demand price; also important is its position in the overall capital structure (Hayek,
Pure Theory, pp. 46-49).
Pure Theory, pp. 33-34.
See Hayek, "Three Elucidations," pp. 284-85.
Profits, Interest, and Investment, pp. 63 n, 64 n.
's remarks at the Mont Pelerin Conference, Caracas, September 1969; these remarks are on record only in Friedrich A. Hayek
A Tiger by The Tail,
ed. Sudha R. Shenoy, Institute of Economic Affairs, Hobart Paper no. 4 (London, 1972), p. 112.
Part 4, Essay 1, Austrian Economics in the Age of the Neo-Ricardian Counterrevolution
|Part 4, Essay 1|
Neo-Ricardians have been far more cautious about inflation. Hayek and Joan Robinson not merely agreed on the substance of the matter but actually, though no doubt unwittingly, used the same metaphor: "An inflationary economy is in the situation of a man holding a tiger by the tail."
Economic Heresies (London: Macmillan & Co., 1971), p. 95; Friedrich A. Hayek,
A Tiger by the Tail, ed. Sudha R. Shenoy, Institute of Economic Affairs, Hobart Paper 4 (London, 1972), p. 112.
Buchanan, James M. "Is Economics the Science of Choice?" In
Roads to Freedom: Essays in Honour of Friedrich A. von Hayek, edited by Eric Streissler, et al., pp. 47-64. London: Routledge & Kegal Paul, 1969.
Hayek, Friedrich A.
A Tiger by the Tail. Edited by Sudha R. Shenoy. London: Institute of Economic Affairs, 1972.
Collectivist Economic Planning. 1935 Reprint. London: Routledge & Kegan Paul, 1963.
Individualism and Economic Order. London: Routledge & Kegan Paul, 1952.
Monetary Theory and the Trade Cycle. Translated by N. Kaldon and H. M. Croome. London: Jonathan Cape, 1933.
Prices and Production. 2d rev. ed. London: Roudedge & Sons, 1935.
Profits, Interest, and Investment and Other Essays on the Theory of Industrial Relations. 1939. Reprint. New York: Augustus M. Kelley, 1969.
Studies in Philosophy, Politics, and Economics. Chicago: University of Chicago Press, 1967.
The Counter-Revolution of Science: Studies on the Abuse of Reason. Glencoe, Ill.: Free Press, 1955.
The Pure Theory of Capital. London: Routledge & Kegan Paul, 1941.
"Three Elucidations of the Ricardo Effect."
Journal of Political Economy 77(March/April 1969):274-85.
Lachmann, Ludwig M.
Capital and Its Structure. London: London School of Economics, 1956.
Macroeconomic Thinking and the Market Economy. London: Institute of Economic Affairs, 1973.
——. "Methodological Individualism and the Market Economy," In
Roads to Freedom: Essays in Honour of Friedrich A. von Hayek, edited by Eric Streissler, et al., pp. 89-104. London: Routledge & Kegan Paul, 1969.
——. "Sir John Hicks as Neo-Austrian."
South African Journal of Economics 41(September 1973):195-207.
The Legacy of Max Weber. Berkeley, Calif.: Glendessary Press, 1971.
Gerald Patrick O'Driscoll, Jr., is Assistant Professor of Economics at Iowa State University. His dissertation is entitled "F. A. Hayek's Contributions to Economics" (University of California, 1973). His recent publications include "The Specialization Gap and the Ricardo Effect: Comment on Ferguson,"
History of Political Economy 7(Summer 1975):261-69.
Sudha R. Shenoy is Lecturer in Economics at The Cranfield School of Management at Bedford, United Kingdom. Her major writings on economics include "A Note on Mr. Sandesara's Critique,"
Indian Economic Journal, April-June 1967;
India: Progress or Poverty? A Review of Central Planning in India, 1951-69, Institute of Economic Affairs Research
Paper No. 27 (London) 1971. She has edited F. A. Hayek's major pronouncements on the theory of inflation and the economics of J. M. Keynes under the title
A Tiger by the Tail, Institute of Economic Affairs, Hobart Paper no. 4 (London, 1972).