Part 4, Essay 1
Austrian Economics in the Age of the Neo-Ricardian Counterrevolution
by Ludwig M. Lachmann
It is widely acknowledged today that economics is passing through a period of crisis, though its exact nature is in dispute. Austrian economists must assess the present position of, and the outlook for, their body of thought as well. A school of thought cannot decide on what to do without taking its bearings. Even were one to decide to do nothing but let one's ship be swayed by the shifting winds, something might be said for a thorough study of weather charts! The student of contemporary affairs always suffers from the handicap that, unlike the historian, he does not know how far tomorrow's changes will nullify the model he makes of today's world. But this is a risk that has to be taken. It is not for nothing that we are living in a kaleidic society.
When making an assessment of the present situation of Austrian economics, our first task is, of course, to define it. What is Austrian economics? The perspective of the economic world that characteristically distinguishes Austrian thought from other (classical or neoclassical) thought can best be defined in terms of the three following postulates:
1. Economics has two tasks, one backward looking, the other forward looking. As G. L. S. Shackle pointed out:
Economic theory is about the sources of individual conduct and the consequences of its interaction. It is the intimate fusing together of the two questions, concerning the mode of choice of conduct and the outcome of the combination of many men's choices, that constitutes economics as a distinct body of ideas and a discipline on its own.
We cannot know whether economists in the course of time will have to shoulder tasks other than these two. However, it is characteristic of the Austrian style of thought that the backward-looking task is regarded as the more important. It is more important to make the world of action as it unfolds intelligible than it is to deduce the unintended consequences of action. This postulate entails certain limits to the degree of abstraction we may employ and to our freedom in constructing models. Abstraction is necessary, useful, even inevitable, to let our minds grasp the essentials of a situation, but we must not abstract from those acts of the mind in choice and interpretation that shape and constitute the social world. We must reject mere formal entities as elements of models. Different men finding themselves in the same situation may give it widely differing interpretations. Austrian economics is always concerned with action, never solely with reaction. It rejects as mere formalism, whether neoclassical or neo-Ricardian, all those endeavours that in a quest for "formal uniformities" are ready to assign causal roles to entities like quantities and prices, and all those models in which the economic system assumes the appearance of a "goods circus."
2. The human mind can grasp many forms and patterns, structures as well as uniformities of sequence in nature. Only individuals, however, have minds and therefore can make plans and act. Hence, if our main task is to understand the world of human action, we must reject any explanation of events other than in terms of plans and action. To be sure, individuals acting are oriented to their environment, natural and human. But this orientation is always a matter of subjective perspective and interpretation. Moreover, where the environment is human, problems arise of multiple perspectives and interpretations, hence the difficulties with any notion of equilibrium involving interaction of many minds, and hence the superiority of the market process as a model of interaction.
3. It follows from (1) and (2) that formal entities that do violence to the dazzling diversity of the social world are alien to the Austrian style of thought. This means that Austrian economists must erect several sets of limits to abstraction. The diversity that matters is diversity of tastes, interpretations, and expectations. The Ricardians ignore the first, admit (with a bad conscience) the second, and do not know what to do with the third. Their neoclassical opponents assure us with some enthusiasm that they accept the first but have to ignore the second (since their formal apparatus offers no scope for the interpretative action of the human mind), and (wrongly) think they can cope with the third by using the formal apparatus of probability theory, clear though it is that this was originally developed to deal with a quite different set of problems.
There is no need for me to deal at great length with the neo-Ricardian counterrevolution of our day. Its numerous exponents in Cambridge and elsewhere are propagating its cause with considerable enthusiasm and remarkable polemical skill. Suffice it to say that, for the first time, the neoclassical ascendancy, established by John Bates Clark, Irving Fisher, Vilfredo Pareto, and Knut Wicksell around the turn of the century, appears seriously threatened. The defensive strategy adopted by such outstanding neoclassical leaders as John Hicks and Frank H. Hahn leaves the impression that they are only too well aware of the weakness inherent in the position they have inherited.
What is the Austrian position on this battleground? Let me outline it in terms of points of Austrian agreement and disagreement with the views held by the rival schools.
Austrian economists must disagree strongly with most of the ideas flaunted by the neo-Ricardians. Any return to the classical world of economic thought would nullify Menger's work, as well as that of most of his successors. The strange dichotomy between cost of production determining price and demand determining quantity sold is quite untenable. In any circumstances other than those of constant cost, whatever the scale of output, demand must have some effect on price. The underlying methodological egalitarianism—the view of competition as a state of affairs in which all producers sell identical goods, the failure to understand that the contribution of each entrepreneur is an individual contribution—is also no more attractive. To watch neo-Ricardians handle expectations is, according to taste, a sad or an amusing spectacle: they play with them like children playing with ancient coins, the value and origin of which they fail to understand. The diversity of the world is to them a closed book. As radical subjectivists Austrians must stand in the forefront of the resistance to this counterrevolution.
We can, however, perhaps agree with them on several points: that general equilibrium is a precarious notion; that in reality it could never be attained; and that events taking place on the path to equilibrium must shape its final constellation. They, on their part, are unlikely to accept the notion of the market process.
The list of points of disagreement between Austrian and neo-classical economics is hardly shorter. A kaleidic world can offer no congenial habitat to the neoclassical mind, to which all time sequences at once appear in the familiar form of difference equations. Will they ever understand that "frequency distributions" e tutti quanti can have no place outside a homogeneous world, a world in which we are entitled to judge the unknown future by the standards of a known past? Or that "orthodox welfare analysis calmly assumes that the critically important social task of making all the scattered bits of information available to those making decisions has already been performed." Without this assumption the vaunted Pareto optimum makes little sense. From time to time neoclassical economists are apt to flaunt consumers' tastes, one of their data, as a mark of their individualism. But on closer inspection their individualism turns out to be a pseudoindividualism. The individual interests them only in his capacity as a possessor of given tastes, not as a possessor of a mind capable of probing and digesting experience, of acquiring and diffusing knowledge. Pareto saw quite clearly that real individuals, continuously having experiences bound to modify given tastes, can have no place in the neoclassical model, and that a photograph of their tastes is all that is required. It is thus only at a point in time that we can speak of utility functions of individuals. Their unpredictable change over time forms the basis of the kaleidic society and provides the rationale for the market process.
At present a good deal of soul-searching appears to be going on in the higher ranks of the neoclassical establishment. My own impression is that little will change. The very language in which criticism of neoclassical orthodoxy is presented inspires little confidence. When Hahn, after having noticed that "the argument will here turn on the absence of futures markets and contingent futures markets," observed that "practical men and ill-trained theorists everywhere in the world do not understand what they are claiming to be the case when they claim a beneficent and coherent role for the invisible hand," it is painfully obvious that he has paid no attention to Austrian economics. He apparently was unable to conceive of the function of the market in terms other than those of some kind of intertemporal Pareto optimum.
Also, we hear of a "state of nature" (but no state of culture) emanating "messages" received by the individuals acting. While admittedly individuals cannot be in equilibrium while they are learning (hence no equilibrium over time?), the neo-Darwinist language in which we are told how man, as he learns about his environment, makes a better adjustment to it, sounds rather forbidding. The fundamental obstacle to any rapprochement between Austrian and neoclassical economics is the fact that the latter cannot conceive of human action, but only of reaction to given circumstances.
What of the future? Austrian economists must evidently establish themselves as a third force outside the counterrevolution and the neoclassical establishment against which it is directed. This will be no easy task. Their numbers are small, their resources slender. The big foundations are closed to them. They have no academic foothold. Their only strategy can be to impress the world by the quality of their contributions. But this will hardly be enough. In the 1930s a hopeful flowering of Austrian economics was nipped in the bud; as Hicks put it, its "voice has been almost drowned in the fanfare of the Keynesian orchestra." This must not happen again.
Owing to the current weakness of the Austrian position in the academic world, we must make optimal use of assets and exploit every opportunity. In this regard, I have three suggestions.
In the first place, two eminent contemporaries, Axel Leijonhufvud and Shackle, who do not, to my knowledge, regard themselves as Austrian economists, within the last six years made outstanding contributions that conform to what I have described as the main body of Austrian thought. It is for Austrian economists to make full use of the implications of their ideas.
Second, at times in the course of the counterrevolution, both sides present arguments with unmistakably Austrian implications of which their authors may be quite unaware. In such cases Austrian economists must appear on the scene at once to point them out. Otherwise the lesson will be lost. For example, when Luigi L. Pasinetti in his criticism of Robert Solow stated that "the two situations a and b that Solow compared differ not only by the single 'consumption good' he has hypothesised but also by the whole structure of capital goods", the Austrian implications of this notion, are obvious. But neither of the rival sides appears to have taken much interest in them. In any case they go much beyond what is provided for in Hicks's neo-Austrian model.
The best opportunity for the rehabilitation of Austrian economics today is, I regret to say, to be sought in the permanent inflation the Western world has suffered since the Second World War. This is certainly not the fault of Austrian economists; there has been no lack of warnings from their side.
We live in a world in which prices can only rise and never fall, because the public has come to believe that a widespread fall of money wage rates in the face of a falling demand for goods and services would be intolerable. A world, however, in which all relative price adjustments have to be made against a background of continuously rising money prices and wages is one in which money is no longer a store of value: it can only depreciate, never appreciate. The process of inflation must accelerate once everybody understands what is happening.
Faced with this situation neoclassical economists, on the whole, have (predictably?) behaved badly. Some have distinguished between cost-push and demand-pull inflations as though we were dealing with a succession of historical processes of inflation and not one indivisible process. Some would have us believe that there is a choice between a little more unemployment and a little more inflation. The facts of the inflation now accelerating all over the Western world speak for themselves, though the econometricians may not understand the language. A mind for which the economic world is a complex system of given variables seems quite unable to grasp a kaleidic world. The facts of a world of accelerating inflation elude it.
Some neoclassical economists have shown themselves to be rather uninhibited inflationists. According to Kenneth J. Arrow:
The rates of inflation with which we have had to contend impose no insuperable problem or even major difficulty to the operation of the economic system, nothing comparable to the major depressions of the past. Individuals will learn and have learned to deal with inflation making their plans to take expected inflation into account. The economic system and the government will create and are creating methods of mitigating the effects.... Some analysts feel that inflation will inevitably accelerate, but others will note that in the past peacetime inflation has tapered off.
Second, we may have some reasonable hope that economic research and experimentation in policymaking, between them, will evolve more sophisticated means of managing the overall economy.
Solow expressed an even more striking view: "In a monetary economy, it is natural to amend the definition of a steady state to require a constant rate of inflation; since everything else is growing exponentially, the price level ought to be no exception."
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."
Faced with this terrible but challenging situation Austrian economists today have a triple duty. They must tell the public that:
1. The real cause of the accelerating inflation lies in a change in the social climate that, engineered by the left intelligentsia, took place about a half-century ago and resulted in a taboo on downward adjustments of money wage rates.
2. A market economy requires a money that can serve as a store of value, a money in terms of which prices are as likely to fall as they may be to rise. (An absolutely stable price level is impossible.) No such money exists today.
3. None of the nostrums peddled by economists in many countries today involving price and wage controls will work, and they may well paralyze the market process.
G. L. S. Shackle, "Marginalism: The Harvest," History of Political Economy, Fall 1972, p. 587.
For an excellent example of what I mean by neoclassical formalism, consider the following: "Implicit in such analyses there are certain recognizable formal uniformities, which are indeed characteristic of all scientific method. It is proposed here to investigate these common features in the hope of demonstrating how it is possible to deduce general principles which can serve to unify large sectors of present-day economic theory" (Paul A. Samuelson, Foundations of Economic Analysis [Cambridge: Harvard University Press, 1947], p. 7).
Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), p. 214.
"L'individu peut disparaitre, pourvu qu'il nous laisse cette photographie de ses goûts" (Vilfredo Pareto, Manuel d'Economie Politique, 2d ed. [Paris, 1927], p. 170).
Sometimes the neoclassical formalists remember it in the formulation of their principles—more often they forget it in practice. Consider the following: "In every problem of economic theory certain variables (quantities, policies, etc.) are designated as unknowns, in whose determination we are interested. Their values emerge as a solution of a specific set of relationships imposed upon the unknowns by assumption or hypothesis. These functional relationships hold as of a given environment and milieu" (Samuelson, Foundations, p. 7; italics mine).
Frank Horace Hahn, On the Notion of Equilibrium in Economics: An Inaugural Lecture" (Cambridge: Cambridge University Press, 1973), p. 14.
John R. Hicks, Capital and Growth (Oxford: Clarendon Press, 1965), p. 185.
Luigi L. Pasinetti, "Again on Capital Theory and Solow's 'Rate of Return,'" Economic Journal, June 1970, p. 429 (Pasinetti's italics).
Kenneth J. Arrow, "Capitalism, for Better or Worse," in Capitalism: the Moving Target, ed. Leonard Silk (New York: Quadrangle, 1974), pp. 105-113.
Robert M. Solow, Growth Theory: An Exposition (Oxford: Oxford University Press, 1970), p. 66.
Joan Robinson, 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.