The Foundations of Modern Austrian Economics
Thomas Kuhn in The Structure of Scientific Revolutions (Chicago: University of Chicago Press, 1970) made a distinction between normal and extraordinary science. Normal science is the day-to-day research activity of a community of scholars working and communicating with one another on the basis of certain shared principles and methods embodied in what Kuhn called a "paradigm" for that science. From time to time such a science may undergo revolutionary change, in the course of which the prevailing paradigm is replaced by a new one. Work involved in the search for and establishment of a new paradigm, as opposed to work proceeding within the framework of an accepted paradigm, is called extraordinary science.
We need not, on this occasion, enter the debate about the strict applicability of Kuhn's analysis to the social sciences. It is enough for the moment to use his work as a source of useful analogy and metaphor. Taking this approach, we find that in contemporary economics, normal science is represented by work within the framework of the Keynesian-neoclassical synthesis. We can easily list many features characteristic of normal science. Communication among economists is primarily by means of journal articles presenting incremental contributions to knowledge rather than by means of books concerned with first principles. There is a well-established textbook tradition, and students are exposed to the original works of classical and contemporary economists only briefly and at a relatively advanced stage in their training. Economists go about their day-to-day work of establish- ing significant empirical facts, matching facts with theory, and extending applications of theory to new areas with little explicit attention to such fundamental questions as what constitutes a valid problem or a valid solution in economic analysis. Disputes arise, but underlying the disputes is fundamental agreement as to the kind of evidence or debate on which the dispute is, in principle, to be resolved.
In contrast to the majority of economists, the contributors to this volume on Austrian economics talk and act like people who are doing extraordinary science. They produce relatively more books and contribute fewer articles to established journals. They do not write textbooks; their students learn directly from the masters. They are very much concerned with methodological and philosophical fundamentals. And what makes the label extraordinary most applicable to their work is that they share a conviction that orthodox economics is at the point of breakdown, that it is unable to provide a coherent and intelligible analysis of the present-day economic world.
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.
It seems to me that the question of the status of Austrian economics is not incapable of resolution and that, in fact, the papers presented here represent a sufficient sample on which to base such a conclusion. The question is whether or not Austrian economics possesses a paradigm truly distinct from that of the Keynesian-neoclassical orthodoxy. For, as Kuhn emphasized, an extraordinary science must not simply be critical of the established normal science paradigm; it must also present an alternative.
In analyzing the Austrian paradigm, I shall focus on three particular functions that, according to Kuhn, a paradigm must perform. First, a paradigm must tell the investigator what types of entities the world does and does not contain. Second, a paradigm must define what constitutes a legitimate problem for the science at hand. Third, it must specify the methods by which legitimate solutions to these problems may be reached.
The methodological principle about which Austrian-school writers are most insistent is that the basic building block of economic theory must be the individual human action. As Murray N. Rothbard put it, the whole of Austrian economic theory is the working out of the logical implications of the fact that human beings do engage in purposeful action (Rothbard, "Praxeology" [references to papers included in this volume are in abbreviated form]).
The term action, as used by Austrian theorists, takes on a precise technical sense that is perhaps best understood by contrasting actions with events. An event may be thought of as something that "just happens"—a change that takes place in the state of the world, such as a rock falling from a cliff and killing Smith. An action, in contrast, is something that happens as a result of purposeful intervention in the "natural" course of events; for example, Jones pushes a rock off a cliff for the purpose of murdering Smith, who is standing below. An action may be thought of as consisting of two components. The first component is the event, that the rock fell killing Smith. The second is the implied counterfactual proposition that if Jones had not intervened in the situation in order to carry out his purpose of murder, the rock would not have fallen, and Smith would be alive.
Orthodox economists, influenced by positivist and behaviorist methodological principles, are uncomfortable with the concept of action because the second, counterfactual component is not directly observable. As a consequence, orthodox theories tend to be couched exclusively in terms of observable events and the so-called empirical relationships among events. The Austrians, in marked contrast to the orthodox thinkers, believe that an economic explanation in terms of events alone cannot tell the whole story, because it necessarily omits an important component of reality—the concept of purposive action (see Kirzner, "On the Method").
At the same time the Austrian economists criticize orthodox writers for omitting the concept of purposive action from their set of basic entities, they criticize them for admitting certain illegitimate constructs into their economic theories. Austrian writers are characteristically critical of the use of macroeconomic aggregates, especially when these appear as arguments in mathematical formulations that imply functional and/or causal relationships between aggregates. The concept of the quantity of capital is especially singled out for criticism in this regard (see Lachmann, "Toward a Critique").
The question of what constitutes a legitimate problem for analysis receives careful attention in Kirzner's paper on the methodology of Austrian economics (see his "On the Method," below). Kirzner noted that the Austrian tradition assigns two tasks to economics. The first is that of "making the world intelligible in terms of human action." The second is "to explain how conscious, purposeful human action can generate unintended consequences through social interaction" and to trace these unintended consequences. These tasks are both more and less ambitious than the tasks undertaken by orthodox economics. The Austrian-type explanation is more ambitious than the orthodox explanation in the sense that a picture painted in terms of human purposes is more complete than one painted only in terms of events. The Austrian enterprise is also more ambitious because it insists on laying bare the true causal relationships at work in the social world and is not content to simply establish empirical regularities among dubious statistical aggregates.
At the same time, Austrian explanatory systems are less ambitious precisely because they do not seek to establish quantitaive relationships among economic magnitudes. The Austrians are, in fact, quite insistent about the exclusion of such quantitative determinations from the range of legitimate economic problems. As Ludwig von Mises put it, in a passage quoted approvingly by Rothbard in his essay "Praxeology":
The impracticability of measurement is not due to the lack of technical methods for the establishment of measure. It is due to the absence of constant relations.... Economics is not, as...positivists repeat again and again, backward because it is not "quantitative." It is not quantitative and does not measure because there are no constants (Ludwig von Mises, Human Action: A Treatise on Economics [New Haven: Yale University Press, 1963], pp. 55-56).
The nature of the problems the Austrians undertake to solve and the entities which they employ determine the permissible methods of solving problems under the Austrian paradigm. The Austrian method, simply put, is to spin out by verbal deductive reasoning the logical implications of a few fundamental axioms. First among the axioms is the fact of purposeful human action. Supplementary axioms are that human beings are diverse in tastes and abilities, that all action takes place through time, and that people learn from experience. The epistemological status of these axioms is a matter of some dispute among Austrians, but Rothbard's position—that they are in the last analysis empirical—appears to be the most acceptable (see his essay "Praxeology," below).
Acceptance of the Austrian paradigm entails a radical rejection of econometrics as a tool of economic theory. It is easy to see why Austrians find econometrics useless as a tool for discovering or establishing economic laws. First, since the axioms from which economic laws are deduced are taken to be apodictically true (barring logical errors in the deductive process), the theories themselves must also be true and consequently cannot and need not be subjected to falsification by statistical methods. Second, Austrian theories are formulated in terms of action, and action, as was argued above, contains a counterfactual element, which is in principle not subject to direct observation or confirmation. Finally, the absence of constants in economic life makes any attempt at econometric determination of such constants futile.
In the abstract, such are the characteristics of the paradigm the Austrians, as would-be scientific revolutionaries, hold out as an alternative to the Keynesian-neoclassical orthodoxy. Whether this paradigm is to remain an empty program or has the substance for an alternative normal science tradition depends on its application to concrete analytical problems. With this in mind, let us briefly look at recent contributions of the Austrian school to the theory of prices and markets, of capital, and of money and economic fluctuations, as presented in the essays in this volume.
In the subject area orthodox theorists refer to as "microeconomics," Israel Kirzner has made several recent and important contributions. In his book Competition and Entrepreneurship (Chicago: University of Chicago Press, 1974) and again in his essay "Equilibrium versus Market Process" (see below), Kirzner criticized neoclassical economics for devoting too much attention to the elaboration of the formal conditions for general equilibrium, and too little to an understanding of actual market processes through which resources are moved from lower to higher valued uses during periods of market disequilibrium. (Lachmann in his paper "On the Central Concept" went further than Kirzner and rejected the practical relevance of the concept of equilibrium altogether.) To understand market process, according to Kirzner, two types of economic decision making must be differentiated. The first is what he called "Robbinsian economizing," that is, using known available resources in the most efficient manner to achieve given purposes with the object of allocating these resources so that no transfer of a marginal unit from one use to another can promise a net benefit. The second is entrepreneurial decision making, that is, being alert to previously unknown opportunities for buying low and selling high in situations where the planned activities of Robbinsian economizers are imperfectly coordinated. A theory couched purely in terms of Robbinsian economizing can at best identify the price-quantity configurations necessary to sustain an equilibrium. But it is only by introducing the concept of entrepreneurial action that one can explain how systematic changes in the information and expectations upon which market participants act lead them in the direction of the postulated equilibrium price and quantity relationships.
By contrasting the theory of general equilibrium with the theory of market process, we can understand more clearly the differences between the orthodox and the Austrian paradigm. The theory of general equilibrium poses a number of attractive puzzles for neoclassical economists, particularly those wishing to display their virtuosity in mathematical analysis. The variables of a general equilibrium model are all, in principle at least, empirically observable, and the types of decisions made by Robbinsian economizers can be neatly and accurately expressed in functional notation. But from the point of view of an Austrian theorist bent on making the world intelligible in terms of human action, the puzzles of general equilibrium are simply not the whole story. Far from being deterred by the fact that the decision-making processes of the entrepreneur are not easily expressed in mathematical notation, a writer like Kirzner is able to exercise his own virtuosity at verbal-deductive analysis and produce a variety of useful insights.
Lest it be thought that the matter of equilibrium versus market process is of no practical significance, the reader's attention is directed to Kirzner's discussion of the role of advertising. Neoclassical economics, with its emphasis on decision making based on given information and under perfect competition, has had difficulty finding a place for advertising in the economic world. Frequently, this theoretical untidiness has led the neoclassical economist to become critical of advertising on the policy level. Kirzner's analysis, which at last makes advertising an integral part of the entrepreneurial role in the market process, provides the basis for a rather different and more supportive attitude toward advertising.
Turning now to recent Austrian work on capital theory, let us single out for attention the issue of the nature and measurability of an economy's stock of capital. Sir John Hicks (in his paper "Capital Controversies: Ancient and Modern," American Economic Review 64(May 1974): 307-16; and discussed by Kirzner, "The Theory of Capital") divided economists into two broad groupings according to their definition of capital. According to Hicks, the "materialists" contend that the stock of capital is nothing more than an inventory of the stock of physical capital goods in an economy. This view has as a corollary that, in any two economies with identical physical stocks of capital goods, the economic measure of capital must be identical. To the "fundists," on the other hand, capital is something other than mere physical goods, and the measure of capital must be a value measure derived in some way from the flow of future output.
According to Kirzner, Austrian economists can accept neither the materialist nor the fundist position on the question of the nature and measurement of capital. Materialism is rejected out of hand on the grounds that the physical heterogeneity of capital goods prohibits simply adding them up. The fundist point of view receives somewhat more sympathy, because it at least recognizes that the nature of capital goods is intimately bound up with valuation, that is, with future plans for the production of output. Nonetheless, Kirzner denied that there is any legitimate way of adding together these streams of future output to provide a meaningful measure of a nation's capital stock. One problem, often discussed in the literature on capital theory, is that it is hard to find a unit of measurement for capital that is invariant to changes in relative prices. Equally important is the problem that at a given moment the plans of various individual economic agents, of which existing capital goods form a part, may well be incompatible. Suppose, for example, that individual A builds a house with the intention of living in it, and individual B builds a bomb for the purpose of blowing up A's house. A counts on a future stream of housing services having a certain determinate value, and B counts on a future stream of destruction services also having a certain determinate value. But surely these two future value streams cannot legitimately be added together to get a measure of the economy's current stock of capital, because it is logically impossible that both could be realized simultaneously. Thus, any attempt at adding up (future) value streams to get a measure of capital necessarily overstates the quantity of capital to the extent that current plans are imperfectly coordinated, which is equivalent to saying that a consistent measure of capital is possible only when the economy is in full equilibrium. The Austrian economists, of course, emphasize that it never is in full equilibrium.
In the controversy over the measurability of capital, the differences between the Austrian and the orthodox paradigm are once again evident. Neoclassical theorists, intent on constructing mathematical models of economic reality, are unable to proceed without grasping some single number, or "index," and calling it the "quantity of capital." Since they cannot dispense with such a number, they brush aside all theoretical objections and resort when pressed to such contrivances as the single product economy. To the Austrian economists, such constructions are the most arid of formalisms and do more to mask the true nature of economic reality than to provide useful insight. Instead, they prefer a concept of capital that identifies capital goods as physical objects directed toward specific purposes by individual agents, even if this approach means abandoning the possibility of measuring a nation's capital stock altogether.
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.
Despite the fact that the gap between Austrian and orthodox economics may be narrower in the area last discussed than elsewhere, I think the evidence indicates that the modern Austrian school does present a truly distinct paradigm against the alternative of a distinction only between good economics and bad economics. The possession of a distinct paradigm may be thought of as necessary for a successful scientific revolution. It goes without saying, however, that it is not a sufficient condition. In concluding our analysis of Austrian economics as extraordinary science, let us consider some remarks Kuhn made regarding the nature of the debate between advocates of alternative paradigms:
The choice between competing paradigms regularly raises questions that cannot be resolved by the criteria of normal science. To the extent, as significant as it is incomplete, that two scientific schools disagree about what is a problem and what is a solution, they will inevitably talk through each other when debating the relative merits of their respective paradigms. In the partially circular arguments that regularly result, each paradigm will be shown to satisfy more or less the criteria that it dictates for itself and to fall short of a few of those dictated by its opponent. There are other reasons, too, for the incompleteness of logical contact that consistently characterizes paradigm debates. For example, since no paradigm ever solves all the problems it defines and since no two paradigms leave all the same problems unsolved, paradigm debates always involve the question: Which problems is it more significant to have solved? [Kuhn, Structure, pp. 109-10.]
The tendency of the advocates of alternative paradigms to talk through, rather than to, each other may be seen in the various Austrian critiques of mathematical economics and econometrics. In their attack on mathematical economics, at least two separate arguments can be discerned. One is that mathematical economics does not really achieve greater theoretical precision; instead it requires the translation of simple concepts into mathematical language followed by arduous retranslation into English (see Rothbard's discussion in "Praxeology," below). This line of criticism is not found only among Austrian economists; it was given a most eloquent expression by Alfred Marshall. The other strand of the Austrian critique of mathematical economics is the contention that those problems most amenable to mathematical treatment—general equilibrium theory, formal growth models, and the like—are in principle not interesting or legitimate economic problems. The problems important to Austrian theorists (for example, the puzzle of the nature of entrepreneurship) neither can be nor need be dealt with mathematically.
In the critique of econometrics, the tendency to talk through the opposition is perhaps more evident than anywhere else. Here again we can distinguish two strands of thought in Austrian writing. One, already discussed, concerns the absence of constants in human action and the absurdity of subjecting valid deductions from true axioms to superfluous empirical tests.
The other strand of the Austrian critique concerns the definition of the legitimate boundaries of economics as a science. At one point in discussing Austrian methodology, Rothbard (see his paper "Praxeology") distinguished among three branches of intellectual inquiry. Economics is the discipline devoted to the logical implications of the axiom of human action. Technology deals with the choice of certain means for the achievement of certain ends. History deals with ends adopted in the past and means used (to try) to achieve them. Now, from these definitions, it is immediately clear that econometrics can serve no purpose in economics per se. That is the substance of the previously mentioned line of criticism. Yet this argument leaves open the possibility that econometrics could be a legitimate tool of technology and history. In collecting statistics on, say, past fluctuations in the prices and quantities of cotton, econometricians are not measuring constants in human behavior or testing economic theory, and they delude themselves if they think they are. Nonetheless, in principle the econometricians' work, properly interpreted, may be valuable to noneconomists. For example, a historian trying to interpret patterns of economic activity in the southern United States might want to know the approximate ex post elasticity relationships in the cotton market in certain periods. Alternatively, a textile manufacturer, seeking profit maximization by the best means available, might employ an econometrician as a technologist to advise him concerning inventory strategy. In short, if econometricians would stop insisting that they were engaging in the discovery of economic laws, a variety of purely instrumentalist justifications for their work could be found without forcing a head-on confrontation with Austrian doctrine.
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