Primer on Austrian Economics

Aren’t you just making a linguistic quibble? The point of Arrow’s Impossibility Theorem isn’t to reify collectives, but to show that a bunch of voters, who agree that they (a) need to reach consensus on some issue and (b) will all act in accordance with that consensus, will not be able to satisfy all three conditions that are commonly believed to be required for a fair vote. Whether or not you want to grant that collectives can “decide” something, there are certainly many instances where groups of people agree on the need for collective action and wish to decide what that collective action ought to be through democratic means.

Thanks for promoting this little book. It is excellent.

David, Hayek said it best in “Pretense of Knowledge.” Econ can make predictions of patterns of events, but the attempt to make specific predictions with math models is the pretense of knowledge.

I’ve been interested in these attempts to popularize Arrow’s impossibility theorem. I’ve started to understand Arnold’s feeling that the no-dictator assumption is arbitrary. As I’ve though about it, it seems that calling it an existence proof rather than an “impossibility theorem” might make it more intuitive and interesting. That is, if a voting system produces results that obey all the intuitive notions of preferences like transitivity, etc, then there must exist an individual in that group whose preference ordering is identical to the group ordering. That is, there exists an individual who might as well be a dictator.

We should not fall into the trap of supposing that because a pair of shoes (say) sells for a particular sum of money, that this price equals the value of the shoes. Value is personal. The person selling shoes values the cash more than the shoes; the buyer values the shoes more than the cash.

…and what is this other than the age-old idea, taught to every economics undergraduate in the country, of consumer and producer surplus? It’s true that this implies national accounts data will be an imperfect welfare measure, but that’s not exactly an earthshattering critique of modern economics. No one seriously thinks that GDP per capita is an objective yardstick for human well-being — just that it is a tangible (albeit sometimes misleading) number with some informative value, for which there isn’t any good substitute.

While some of Butler’s points are well-taken, overall I think he’s more guilty of shoddy reasoning and overconfidence than many of the economists he critiques. Clicking through to his “Austrian primer”, I flipped to a random section — “Money is Not Neutral”. What I found was a facile argument that showed virtually no understanding of the issues at hand. He claims that inflation produces a “real change” in the pattern of what is consumed because people will often spend their extra money on luxuries rather than essentials like food. Left unstated is the obvious problem with this reasoning: under economywide inflation, people don’t actually have extra money, because the price of all goods has gone up! You need some much more complicated behavioral effects or monetary dynamics to produce the effects Butler is proposing. Mainstream economists don’t have all the answers, but Butler doesn’t even seem to understand the questions.

Indeed, Butler is mainly right about one thing. Most macro is wrong. It’s an incredibly difficult field where data is scarce, experimentation is near-impossible, and individual optimizing (or non-optimizing) decisions may scale up in ways that are impossible to predict by intuition alone. Humility is essential, and true humility involves a continual desire to understand the ideas of very smart people in your field, even if they’re wrong.

That’s why I enjoy your critiques of macroeconomics: you clearly understand the basic ideas of the discipline. But Butler doesn’t, and that’s a real problem.

@kurt

What use are discernable patterns, if they can’t be used to make predictions? (Doesn’t that relegate economics to being a subspecies of History?)

If those patterns are used to make predictions, and the actual empirical data that results does not match the prediction, isn’t that some grounds for deciding that the “pattern” may not be all that it initially seemed to be? Humans are so predisposed to seeing patterns that we often see them in clouds and constellations. Rigorous statistical analysis of data saves us from ourselves in cases like those…and yet even the most rigorous statistical analysis (let along our even less rigorous praxeological determinations) can be shown to be mistaken as new data comes in.

“Economics is about how people choose, which means that it is about what they prefer, and value, and intend, and believe about the world. These are personal, individual feelings, which we cannot observe and measure – nor therefore predict.

“What we can do, though, is to explain human choices.”

In other words, Austrians view economics as a work of creative fiction. We offer explanations without any conceivable chance of falsifiability. Even Arnold doesn’t go that far.

While I agree that we cannot observe, and therefore cannot directly test, matters of values and preference, this indicates to me that we should spend less time talking about these processes, not more. Like Friedman, we should focus on finding observable choices we can predict, and use the relative quality of prediction as the metric of comparing competing claims.

liberty said “What you ascribe to Austrians is not what the quote from the book said.”

This, to me, is the final nail in the coffin of Austrian economics as a desirable school of thought. To hear Austrians tell it, not one person out there understands Austrian economics properly except for those who endorse it. To be so universally ill-understood says more about the cohesiveness of the thought system than about the errors of the detractors. I think Austrian economics has many good incites, but none that can’t be found by good reasoning elsewhere.

Norman:

not one person out there understands Austrian economics properly except for those who endorse it.

To some degree Austrians are trying to be kind. What we really see is people being dishonest about what Austrians have written. Critiques of Butler’s book in the posts above are good examples. What I see most critics of Austrian econ doing is skimming a book looking for the first apparent contradiction they can find and expounding upon it without trying to understand what the author is saying. It’s trivial to take sentences out of context and claim the author is stupid for writing it.

Take Skeptic’s post above:

What I found was a facile argument that showed virtually no understanding of the issues at hand.

Now Eamonn Butler is an outstanding economist and I can guarantee you that he understands the intricacies of money far better than Skeptic ever will. Skeptic merely searched for the first sentence that didn’t make sense to him and held it up as evidence of Butler’s ignorance. If Skeptic will re-read Butler, he will find that Butler was perfectly right about what he actually wrote.

Milton Friedman wrote of Hayek’s “Pure Theory of Capital” that it was incomprehensible. Now Friedman was a great economist. I’m not, but I have read Hayek’s book twice and understood it and thought it is brilliant. What’s the difference? Friedman was trying to reconcile Hayek’s economics with is own, essentially Keynesian outlook and that’s impossible. Mainstream econ has no capital theory at all. To mainstream, including Friedman, capital is a homogenous mush that they don’t like to think about. Austrian econ is all about capital theory. It’s next to impossible for merge the two. So a lot of criticism from mainstream economists happens because they measure Austrian econ by Keynesian assumptions, which is either stupid or dishonest.

I have an MA in Keynesian/neo-classical economics from a good state school. I had a hard time getting my head around Austrian econ because it is so different. I am a convinced Austrian today, but it took me several years to get there. A book that helps a lot is Roger Garrison’s “Time and Money” because he lays the Keynesian, neo-classical, monetarist and Austrian theories side by side and compares them.

fundamentalist:

What we really see is people being dishonest about what Austrians have written. […] It’s trivial to take sentences out of context and claim the author is stupid for writing it.

I completely admit that this happens, which is why I periodically defended Austrian econ over at Brad DeLong’s blog (before he banned me from commenting). But I also see a lot of people genuinely trying to point out problems in the argument. I have never once seen an Austrian say “this is an area we don’t understand well / where more work needs to be done.” Their response is always “you’re misinterpreting / this is an area you don’t understand well.” While some of that may be due to misapplying Keynesian assumptions as you mention, to put it all on the shoulders of the opposition feels dishonest.

Mainstream econ has no capital theory at all. To mainstream, including Friedman, capital is a homogenous mush that they don’t like to think about.

Now who’s caricaturing someone else’s view? I may not come from a top state school, but I’ve seen plenty of work over the past decade that deals with heterogeneity in capital, labor, preferences, etc. Of course empirical work gets harder because of data limitations, but the point is it isn’t impossible. I see mainstream econ as being able to assimilate insights from Austrian economics much more readily than Austrian econ can assimilate insights from other schools of thought.

Norman, Here is a typical example of the silliness that passes for serious critique of the Austrian business cycle from John Quiggon http://johnquiggin.com/index.php/archives/2009/05/03/austrian-business-cycle-theory/:

Quiggon:

“If investors correctly anticipate that a decline in interest rates will be temporary, they won’t evaluate long-term investments on the basis of current rates. So, the Austrian story requires either a failure of rational expectations, or a capital market failure that means that individuals rationally choose to make ‘bad’ investments on the assumption that someone else will bear the cost. And if either of these conditions apply, there’s no reason to think that market outcomes will be optimal in general.”

Most investors do correctly anticipate the temporary nature of low interest rates. That’s why less than half of businesses fail in depressions. But for many businessmen the temptation to borrow is too great. Their ventures simply will not work with higher rates and they take the gamble that they can beat the system. The Feds rely on human frailties. If someone didn’t borrow after a rate reduction, the Feds would continue to reduce interest rates until someone did. At some point they will find desperate businessmen with marginal businesses who will take the gamble.

And that’s true only if they understand Austrian economics. But Keynesian, monetarist and neo-classical economists have succeeded in deluding most businessmen into believing that interest rates don’t matter at all. So if businessmen succumb to the lure of temporarily low interest rates it’s not because they are irrational, but because they follow mainstream economics.

Finally, Hayek demonstrates that in fact businessmen do not fixate on interest rates at all. They focus on profits. Changing interest rates change the relative prices of capital and consumer goods and thereby change the profit structure of both. It’s the profits available in capital goods resulting from the low interest rates, and not the low interest rates directly, that cause malinvestment in capital goods.

Quiggon:

“…the Austrian model implies that consumption should be negatively correlated with investment over the business cycle, whereas in fact the opposite is true. To the extent that booms are driven by mistaken beliefs that investments have become more profitable, they are typically characterized by high, not low, consumption.”

Quiggon completely ignores the ex-post and ex-ante distinctions. Austrians demonstrate that ex-ante savings is negatively correlated with investment, but only in an economy with a fixed money supply. With a fixed money supply, increased investment can come only with increased savings (less consumption).With an increasing money supply there is no correlation at all according to Austrian econ. Ex-post investment and savings are equal only because they form an accounting identity.

In fact, I would suspect that most mis-understanding of Austrian econ results from the fact that Austrians develop theory with the assumption of a fixed money stock. Mainstream econ have no idea what that means and assume Austrians are operating under their assumption of a totally elastic money supply.

Quiggon:

“Finally, the Austrian theory didn’t say much about labour markets, but for most people, unemployment is what makes the business cycle such a problem. It was left to Keynes to produce a theory of how the non-neutrality of money could produce sustained unemployment.”

That’s simply nonsense. Austrians talk about the labor markets all the time. I can only guess that Quiggon has merely read the blurbs on the jacket and never actually read whole books.

My latest critique of the Austrian Business Cycle Theory is at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1671886. I have gone through many iterations mainly because the Austrian school reviewers always said I didn’t understand the theory in some way or another. I have also received some less defensive comments on previous versions.