The Foundations of Modern Austrian Economics

In reconstructing Austrian economics, I have recommended the concept of market process as the foundation of all economic life (see my paper “On the Central Concept,” included in this volume). In other words, we must start at the microlevel. How, then, shall we deal with such aggregates as income, consumption, and wages, which, according to the same terminology, must be regarded as macroeconomic magnitudes?

In my paper “On Austrian Capital Theory” (also included in this volume) I said that we may regard the relationship between the capital structure of society and its capital combinations as the prototype of the relationship between a macroeconomic magnitude and its microelements. In other words, the former must never be brought into an argument without giving a careful account of the latter; for changes in the constellation of the microelements will affect the macromagnitude itself.

However, in modern macroeconomic literature, whether neoclassical or neo-Ricardian, there is little awareness of this fundamental postulate. From the moment of inception, the macroeconomic aggregates in these writings seem to lead a life of their own, to be endowed with qualities sufficient to allow their adjustment to change in their environment, but change within them is ignored.

In stationary equilibrium capital
can be measured; for here, but only here, the discounted present value of the highest income stream obtainable from a given capital resource must be exactly equal to its cost of reproduction if the same interest rate is used for both calculations. Otherwise there would be investment or disinvestment, neither of which is compatible with a stationary state.

Outside the equilibrium of the stationary state, replacement cost and present value of a discounted future income stream will diverge. If we regard the latter as the economically significant value—and few economists doubt that (bygones are bygones)—we still have no yardstick by which to measure the assets of different firms. The neo-Ricardians stress the role of the interest rate as a discount factor; every time it changes, so does capital value. True as this may be, the real reason for our inability to measure capital lies in the subjective nature of expectations concerning future income streams. If we tried to measure capital by asking each owner for his valuation of his capital stock (for example, fire insurance value), we would get a set of consistent answers, but every change in ownership would invalidate at least one answer. Such an attempt to extract measurable objective value from subjective valuation must fail. This does not mean, however, that in a more limited context and for more limited purposes similar attempts may not be more sucessful.

The second part of the argument is that, while stocks cannot be measured, flows can. All of modern macroeconomics—the theories about investment, income, exports, and wages, as well as the social accounting systems that are widely regarded as one of its triumphs—rests on the assumption that output and income streams can be measured. Can they? As we shall see, the main support for this assumption is superficial as well as highly misleading.

The market prices on which national income measurement is ostensibly based are presumably equilibrium prices. But what kind of equilibrium prices are they? Is consistent aggregation, which macroeconomic thought requires to make sense, possible on the basis of prices that may not be consistent? Walrasian-Paretian long-run equilibrium does provide a consistent price system, but the market prices at which output flows are evaluated in the national income statistics are no such long-run equilibrium prices. They are market-day-equilibrium prices at best. There is no reason why they should be consistent with each other. The whole argument for using average market prices over a year as a basis for the valuation of output flows appears to rest on a confusion between long-run, short-run, and market-day equilibrium. Only prices belonging to the first category are elements of a coherent price system and might be used for the purpose of consistent aggregation. All the others are not. An average of market-day-equilibrium prices over a long period is not the same thing as a Walrasian long-run equilibrium price. Yet the computation of the macroeconomic aggregates that are released daily by the media and are so prominent in the products of the textbook industry rests on such elementary confusion.

Even if such a coherent long-run equilibrium price system did exist and could be known, it would not last. Its data would not remain the same for long. The steady flow of knowledge will tomorrow produce a pattern of knowledge different from today’s, and apparent changes in demand and supply will entail a new set of equilibrium prices. Not without reason are we compelled to look for a paradigm to replace the general-equilibrium model.

Stock exchange equilibrium is market-day equilibrium. Tomorrow’s set of equilibrium prices will be different from today’s. But as we are dealing with an exchange economy, not a production economy, the fact of change does not impair the consistency and significance of market valuation. Free access to all parts of the market, together with the speed at which brokers carry out their clients’ instructions, makes it possible to be at once a buyer of one kind of security and a seller of another. Arbitrage does the rest to produce a valuation of all company-owned assets that is consistent in that it reflects a balance of expectations between bulls and bears. The fact that tomorrow’s balance will be different from today’s faithfully reflects the flow of knowledge.

We find here another reason why steady growth—uniform motion of that supermacroaggregate, the economic system—has to be regarded as absurd. Equilibrating forces in different markets, even if none is affected by unexpected change, require different time periods to do their work. This is obvious if we contrast agricultural produce markets with those for industrial goods. Steady growth, however, requires all equilibrating forces to operate within the same time period.

Perhaps the most important economic function of the stock exchange is the redistribution of wealth by means of the capital gains and losses it engenders in accordance with the market view about the probable success or failure of present multiperiod plans. In certain neoclassical writings the present distribution of resources is a datum of the set of equilibrium prices and quantities at each point of time. Over time, however, the mode of distribution of wealth changes as reflected in capital gains and losses. In fact, the present mode of distribution of wealth is nothing less than the cumulative result of the capital gains and losses of the past. Devotees of a redistribution of wealth in the name of social justice should be aware that, even if the state by the use of coercion were able to produce a supposedly socially desirable mode of distribution today, the market, if permitted to exist, via capital gains and losses would produce a different mode tomorrow.

I have tried to show that—in contrast to an opinion apparently widely held—flows in a multicommodity world are all too often inconsistent aggregates, whereas stocks, while unmeasurable in an uncertain world, may in favorable circumstances be subjected to consistent evaluation. The former is particularly true of the Keynesian I=S, current investment, the “net addition to the capital stock.” If the stock is unmeasurable, how can we tell what is an addition to it? Gross investment is in principle measurable and would be in practice if we had a consistent price system for capital goods. But to divide this flow into net investment and replacement, we need an objective criterion.