Pete is among the most knowledgeable people in the world about this important school of thought and the larger context in which it exists. Highly recommended!

Read it here.

I recommend the piece because it’s highly informative – about what Austrian economics is not.

We’re off to a rocky start with this: “The Austrian school originally referred to a set of classical liberal thinkers with diverse interests who came out of the Austro-Hungarian Empire.”

The earliest Austrian economists did not make their mark by advocating free markets and other classical-liberal ideas. They did so by proffering a revolutionary positive (not normative) theoretical approach to understanding how markets work, focusing on value, price, and capital, theory. What Wikipedia says is consistent with my understanding of the matter: “When Carl Menger, Eugen von Böhm-Bawerk, and [Friedrich von] Wieser began their careers in science, they were not focused on economic policy issues, much less in the rejection of intervention promoted by classical liberalism. Their common vocation was to develop an economic theory on a firm basis.”

Economics versus Politics

Yglesias thus conflates Austrian economic theory with libertarian political theory. In fairness, he is not alone in committing this error. Many libertarians do the same, which is unfortunate. Austrian economic theory describes how purposive action by fallible human beings unintentionally generates a grand, complex, and orderly market process. An additional ethical step is required to pronounce the market process good. Economic theory per se cannot recommend but only explain markets. This is what Ludwig von Mises meant when he insisted that Austrian economics is value-free. Anyone of any persuasion ought to be able to acknowledge that economic logic indicates that imposing a price ceiling on milk will, other things equal, create a shortage of milk. But that in itself is not an argument against the policy. Mises assumed the policymaker would have thought that result bad, but the economist qua economist cannot declare it such. As Israel Kirzner likes to say, the economist’s job in the policy realm is merely to point out that you cannot catch a northbound train from the southbound platform.

Yglesias writes: “Austrians reject the idea that there is anything at all the government can do to stabilize macroeconomic fluctuations.” It’s odd to say this without also pointing out that Austrians believe that government causes the instability of inflationary booms, recessions, and depressions. In light of that point, the suggestion that government is capable of stabilizing the economy may be properly assessed.

That said, Yglesias’s statement is not quite right. Some prominent Austrian macroeconomists think that in a second-best world, the central bank (which of course wouldn’t exist in a first-best world) should counteract a sudden and substantial monetary contraction. In other words, deflation is not necessarily a cure for inflation. Mises made the point metaphorically in 1938: “If a man has been hurt by being run over by an automobile, it is no remedy to let the car go back over him in the [opposite] direction.” (See Steven Horwitz’s “Deflation: The Good, the Bad, and the Ugly.”) [Update: Though let us not forget the knowledge problem that plagues the Fed under any circumstances.]

Distorts Markets

“In the view of the Austrians,” Yglesias goes on, “practically every economic policy pursued by the federal government and Federal Reserve is a mistake that distorts markets. Rather than curing recessions, claim Austrians, stimulative policies cause them by producing unsustainable bubbles.” Well, yeah, and it’s amply demonstrated by George Selgin, William D. Lastrapes, and Lawrence H. White in “Has the Fed Been a Failure?” (See my summary, “‘F’as in Fed.”) As they put it:

Drawing on a wide range of recent empirical research, we find the following: (1) The Fed’s full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed’s establishment. (2) While the Fed’s performance has undoubtedly improved since World War II, even its postwar performance has not clearly surpassed that of its undoubtedly flawed predecessor, the National Banking system, before World War I. (3) Some proposed alternative arrangements might plausibly do better than the Fed as presently constituted. We conclude that the need for a systematic exploration of alternatives to the established monetary system is as pressing today as it was a century ago.

Yglesias understands that the Austrian theory of the business cycle has something to do with artificially low interest rates breeding malinvestment, but he thinks it can’t be right because “it’s hard to understand why business people would be so easily duped in this way. If Ron Paul and Ludwig von Mises know that cheap money can’t last forever, why don’t private investors? Why wouldn’t firms avoid making the supposedly dumb investments?”

Gerald P. O’Driscoll and Mario Rizzo addressed this long ago in The Economics of Time and Ignorance:

[T]here are profits to be made from exploiting temporary situations. . . . Though entrepreneurs understand [the macro-aspects of a cycle] they cannot predict the exact features of the next cyclical expansion and contraction. . . . They lack the ability to make micro-predictions, even though they can predict the general sequence of events that will occur. These entrepreneurs have no reason to foreswear the temporary profits to be garnered in an inflationary episode. . . . From an individual perspective, then, an entrepreneur fully informed of the Austrian theory of economic cycles will face essentially the same uncertain world he always faced. Not theoretical or abstract knowledge, but knowledge of the circumstances of time and place is the source of profits.

Spending Shifts

Puzzlingly, Yglesias also thinks he can refute the Austrian theory by noting that “[s]pending patterns shift all the time without sparking a recession.” To which, Peter Klein replies, “Of course, Yglesias’s breezy summary of the theory skips over the time structure of production, the difference between consumption and investment, the role of interest rates in securing intertemporal coordination, the problem of expectations, and the other basic elements of the theory, which ten minutes of Wikipedia browsing could have explained.”

Yglesias reveals his unfamiliarity with the Austrian literature when he writes, “Many of the original Austrians found their business cycle ideas discredited by the Great Depression, in which the bust was clearly not self-correcting.” Considering that Herbert Hoover’s and Franklin Roosevelt’s New Deal impeded the market’s correction process, one wonders how the 1930s could possibly have discredited the Austrian theory of the origin of recessions.

Finally, Yglesias contends that “the Austrian school . . . preaches despair and demands no action at all.”

Balderdash. Since it explains that busts are central-bank-caused and hence avoidable through market-based money and banking, its implicit message is one of hope and optimism. And as for demanding no action, on the contrary, it puts forth a long list of actions for those who want stable economic growth – all of them designed to dismantle the interventionist State.

Editor’s Note: This column first appeared in September 2010.

One of F. A. Hayek’s most accurate, and oft-repeated, lines about John Maynard Keynes comes from a review of Keynes’s 1930 book, A Treatise on Money.  Hayek wrote: “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.”  That Austrian macroeconomics rests firmly on the microeconomic “mechanisms of change” that ultimately comprise economic activity remains a crucial reason why that insight can better explain both the mistakes of the boom and the way out of the bust.

The Austrian insight is relevant to both capital and labor.  In standard Keynesian models (as well as most other macroeconomic models), capital is understood as an undifferentiated mass.  The Keynesian model also assumes that interest rates do not equilibrate the supply of savings and the demand for investment funds.  Thus when people save more, there’s no signal transmitted to investors that they should build more for the future.  As a result, the decline in consumption that accompanies the increase in savings causes firms to invest lessas their inventories pile up without any offsetting increase in investment elsewhere due to the lower interest rate.

In the Austrian view investment cannot be treated at this high a level of aggregation.  The production process that leads to consumption goods comprises a number of stages, starting with the “early” stages of research and development and raw materials, and finishing with the “later” stages, such as wholesaling or inventory management, which are closer to the final consumer purchase.  Looking at the structure of production this way enables Austrians to note that when saving increases and causes interest rates to fall, resources will indeed be drawn away from the late-stage investments in inventory, but they will be drawn toward investment in early stages of production, as the interest lower rate makes longer-term production processes involving more stages relatively less costly.  Over time, savings promotes those longer-term processes, which are more productive and provide us the capital base for economic growth.

By disaggregating investment, the Austrian model also reminds us that different kinds of  capital goods have to “fit together” to be productive.  This is most clear when central banks try to inflate to generate growth.  In this case, the lower interest rates produced by excess money lead to increased investment in those same early stages.  However, unlike the first story, where that increased investment is financed by reduced investment in the later stages, inflation also increases consumption as the lower interest rate reduces savings.  The credit expansion creates no new resources but leads to more investment at both the very late and very early stages of production. This is the boom of the business cycle.

However, like a railroad being built, misaligned, from two directions, the plans of both sets of investors are unsustainable and the capital projects are left unfinished.  We have a recession.

Labor Too

All that is true of capital here is also true of labor.  Most Keynesian models also treat labor as an undifferentiated aggregate, speaking of “the” labor market and “the” wage rate.  Once we look at the microeconomic processes underlying the structure of production, we see that each of these stages has its own labor market.  Thus when resources move from one stage to another, the demand for labor will shift also, leading to changes in each wage rate.  Growing sectors will attract labor, and shrinking ones lose it.

During an inflation-generated boom, labor, like capital, is misallocated across stages.  And when the boom turns to bust, workers will lose their jobs as the projects they were working on are abandoned.  Unemployment results as we enter the recession.  However, that unemployment, like the misallocation of capital, will not be evenly distributed across the economy.  To see the real costs of inflation-generated business cycles, we need to get behind the aggregates to see the fundamental mechanisms of change.

Being too focused on Keynes’s aggregates can also mislead us as to the best ways to get out of the recession once we’re in it.  It may look as if all we need more is investment or more jobs. But once we understand that the “fundamental mechanisms of change” have to do with the boom’s microeconomic misallocation of capital and labor, we see that what is needed is a reallocation of resources not just more of them.  Capital needs to move out of unproductive lines and back toward productive ones, and the same is true of labor.

Stimulus spending, bailouts, and extension of unemployment benefits only prevent the fundamental mechanisms of change from doing their work in unwinding the errors of the last decade.  The cure for macroeconomic discoordination is freeing up the entrepreneurial market process to reallocate and coordinate resources.  But 80 years after Hayek first made the point, the fascination by economists and politicians with Keynes’s aggregates continues to conceal the fundamental mechanisms of change, and in so doing, also continues to block the processes through which a sustainable recovery can take place.

Economics and business reporter David Warsh is getting much attention for suggesting that F. A. Hayek, far from being one of the two most prominent economists of the 1930s – the other being Keynes – is rather more like the woman who was thought to have won the Boston marathon in 1980 when in fact she had joined the race, mostly unnoticed, a half-mile from the finish line.

Hayek’s fans “have jumped a caricature out of the bushes late in the day and claim that their guy ran a great race,” Warsh writes. “. . . But the fact remains that Hayek just didn’t contribute very much to the development of technical economics,” he continues.

Warsh, whom we may judge by the fact that he calls The Road to Serfdom “an embarrassment,” nonetheless does have some positive things to say about the 1974 Nobel Prize laureate: “With the publication of ‘The Use of Knowledge in Society’ in the American Economic Review in 1945, he essentially won on the ‘calculation debate,’ conducted with Ludwig von Mises and Oscar Lange, concerning the possibility of central planning.”

Considering how many respectable economists favored central planning – essentially the abolition of spontaneous competitive markets — until fairly recently, that would seem to be no mean feat. And there’s more:

[I]t is pleasing to think that Hayek himself may yet turn out to have been a very great economist after all, far more significant than [Gunnar] Myrdal or [Joan] Robinson, when seen against the background of a broader canvas.  The proposition that markets are fundamentally evolutionary mechanisms runs through Hayek’s work. [Bruce] Caldwell, of Duke University, notes that, starting with the Constitution of Liberty, “the twin ideas of evolution and spontaneous order” become prominent, especially the idea of cultural evolution, with its emphasis on rules, norms, and decentralization.

These are today lively concepts in laboratories and universities around the world. ‘It could have been that Hayek was running a different race, and the fact that he didn’t do well in the [mainstream] Walrasian race was that he wasn’t running in it — he was running in the complexity race,’ says David Colander, of Middlebury College. Hayek may yet enter history as a prophet of evolutionary economics, a discipline dreamt of since the days of Thorstein Veblen and Alfred Marshall in the late nineteenth century but not yet forged, whose great days lie ahead. [Emphasis added.]

In other words, maybe Hayek’s critics judge him by an inappropriate standard. We’ll get back to this.

Krugman Pile-on

As Jacob T. Levy surmises, not everyone eager to dismiss Hayek as a lightweight read Warsh’s post to the end. Take Paul Krugman, ever ready to trash anyone who doubts that Keynes was the fount of all wisdom:

David Warsh finally says what someone needed to say: Friedrich Hayek is not an important figure in the history of macroeconomics.

These days, you constantly see articles that make it seem as if there was a great debate in the 1930s between Keynes and Hayek, and that this debate has continued through the generations. As Warsh says, nothing like this happened. Hayek essentially made a fool of himself early in the Great Depression, and his ideas vanished from the professional discussion. . . .

[T]he Hayek thing is almost entirely about politics rather than economics. Without The Road To Serfdom — and the way that book was used by vested interests to oppose the welfare state — nobody would be talking about his business cycle ideas.

Hayekians Strike Back

The Hayekian wing of the blogosphere (which really has nothing to do with the right wing) has responded in force, and properly so. A common theme is that Hayek furnished the grounds for a proper skepticism about macroeconomics, the branch of economics launched by Keynes that treats large statistical aggregates (demand, unemployment, and so on) as though  they were concrete entities that interact with each according to fixed quantitative rules rather than historical “summations” of individual purposeful actions in a particular institutional context. As Hayek wrote,  “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.” (See Steven Horwitz’s “Mr. Keynes’s Aggregates.”)

George Mason University professor (and FEE trustee) Peter Boettke at Coordination Problem wrote:

Hayek’s influence in modern economics is ubiquitous, even if sadly modern economics is not as Hayekian as I would like it to be.  Information economics, theories of dynamic competition, equilibrium theory of the business cycle, and complexity theory all owe a debt to Hayek’s economic contributions.  The work on legal origins owes a debt to Hayek’s work on law and political-social philosophy as well.  Hayek impacts the DNA of economics and political economy to such an extent that many are unaware of the pervasive influence. . . .

The final problem I have with both Krugman and Warsh is that they don’t actually consult the historical record and the accounts of those who were there in the 1930s when the battle was engaged or the direct citation evidence from post-WWII thinkers. . . . Instead they rely on impressionistic accounts from their education and discourse communities, and cherry pick from recent journalistic histories of economics.

Back with a Vengeance

And there’s this from GMU professor Alex Tabarrok at Marginal Revolution:

It is true that many of Hayek’s specific ideas about business cycles vanished from the mainstream discussion under the Keynesian juggernaut but what Krugman and Warsh miss is that Hayek’s vision of how to think about macroeconomics came back with a vengeance in the 1970s. . . .

Hayek was an important inspiration in the modern program to build macroeconomics on microfoundations.

Tabarrok notes that “in an interesting exercise David Skarbek finds that Hayek is cited by other Nobel laureates in their Nobel talks more than any other Nobel laureate with the exception of [Kenneth] Arrow.”

GMU’s Russ Roberts responded this way at Café Hayek:

Was Hayek an important macroeconomist? I would argue that the macroeconomic skepticism of the later Hayek is more valuable than the macroeconomic theorizing of the early Hayek. But he wasn’t an important macroeconomist in the mainstream sense of the title. So what? That’s a badge of honor. He was merely a great economist, without any prefix.

Rejecting the Rules

There are others, but I will close with a post from New York University’s Mario Rizzo at ThinkMarkets, one of the most perceptive people I know. Remember the remark above that “It could have been that Hayek was running a different race”? That’s Rizzo’s take.

I think the real issue is this. Hayek’s approach attacks, root-and-branch, the macroeconomic way of thinking. It is not simply a challenge to a particular theory of the determinants of mass unemployment, inflation, business cycles and the like. Hayek is not accepting the rules of the game or the parameters of the sub-discipline of modern macroeconomics. . . .

In short, he does not want to focus on aggregate spending and aggregate consequences. Hayek’s approach says: Let us pierce the veil of aggregates and look at the distortive effects on relative prices and relative output produced by boom-time credit expansions. Let us look at the distortive effects that booms leave us as we work our way through a recession. . . .

Suffice it to say this greatly erodes the intellectual capital of a field of economics – although one not noted for its successes. It mocks the claim that Keynes was a true revolutionary in economic thought. It opens the possibility that he was muddled, inconsistent and unaware of the contributions to monetary and business cycle theory made by the “classical economists” on the eve of the General Theory.

(By cutting out many details, I have not done these blog posts justice. Follow the links for the particulars.)

Hayek was important politically for demonstrating the practical social necessity of individual freedom. But he is just as important for what he taught us about markets: namely, that they provide the only way for human beings to overcome their individual deficiencies in knowledge, which would otherwise keep them from flourishing through social cooperation and the division of labor.

I think so. It is best seen in the way mainstream economics tends to define the fundamental question concerning the “optimal allocation of resources.” Economics tries to explain how resources might (or might not) get optimally allocated to their various possible uses. In a world of limited resources and unlimited wants, how do we ensure that resources are devoted to people’s most urgent wants?

Most standard economic models seek to demonstrate how, under certain conditions, resources will be allocated optimally by the free market. Those same models can also show that if the specified conditions do not hold, then resources will be less than optimally allocated. This generally referred to as “market failure” because free markets fail to achieve that optimal allocation. Many mainstream economists argue that government can step in and either change the conditions under which the market operates, or directly allocate resources itself, so that society reaches that optimal allocation pattern.

Notice that optimal allocation is the goal. In other words, what is valuable about markets is the degree to which they “get it right,” with the “it” being the resource allocation. Government intervention is deemed justified by people who believe that, in some cases, it can allocate resources better than markets can.

Fundamentally Different

For Austrians, the fundamental issue is not whether markets get it right. True, Austrians think markets are pretty good and governments quite bad in that respect. And even though Austrians might explain things differently from the mainstream, there are plenty of mainstream economists who would agree with those general conclusions. Note, though, that the question here is still about getting it right.

Where the Austrian view differs, I would argue, is in understanding that markets are also really good at helping people to know when resources are not optimally allocated and providing the signals and incentives needed to correct the mistakes. Being adept at getting things right at a given point is of course a good thing. But it is probably more valuable — given that we aren’t likely to get things perfectly right on a regular basis — to be able both to know when we are wrong and to have an incentive to do better.

Government Failure

This approach provides a way to see the problems government has in allocating resources even remotely well: It’s not just that government gets it wrong at various points but that political processes do not have the same error detection and correction abilities that markets have. Political actors are far less likely to know when they’ve erred and to have the right incentives to correct things. Government is not only less able to get it right; it’s also less able to know when it’s got it wrong.

A whole new light is now shed on the idea of “market failure.” In this more Austrian view, markets frequently “fail” by not allocating resources optimally at a given time. But calling this a “failure” ignores the Austrian point that what markets are particularly good at is telling us that resources are not optimally allocated and providing the knowledge and incentives necessary to correct the errors. From the Austrian perspective, “failure” should refer not to suboptimal allocation at a given time, but rather the inability to detect and correct error. If we understand that the crucial question is how well alternative processes do those things, we realize that supposed market “failures” are better seen as opportunities for market successes.

But like all caricatures, the picture is an imperfect reflection of reality. Regarding the classicals, it will suffice to quote David Ricardo: “[C]orn is not high because a rent is paid [but] a rent is paid because corn is high.” So whatever else he might have written on the subject, he was aware (at least with respect to land) that the means ultimately get their value from final consumer goods. We value the means because we value the end, not vice versa.

And then there is this quotation: “A thing cannot have value, if it is not a useful article. If it is not useful, then the labor it contains is also useless, does not count as labor and hence does not create value.”

Karl Marx wrote that in Das Kapital, volume one. I found the quote in a footnote in Eugen von Böhm-Bawerk’s writings refuting Marx’s exploitation theory. It should put to rest the claim that according to Marxian economics, a mud pie requiring one hour’s labor should have the same price on the market as a cherry pie requiring the same amount of labor. Somebody has to find the darn thing useful first.

The question is: What forces govern value and price on the market (assuming a freed market without government privilege and monopoly)?

Böhm-Bawerk (1851-1914), one of the pioneers of Austrian economics, Ludwig von Mises’s teacher, and an unrivaled authority on the theory of subjective marginal utility, had an answer that has received surprisingly little attention since he first offered it. I draw on his paper “Value, Cost, and Marginal Utility” (1892; pdf). (One economist who has given this matter a great deal of attention is George G. Reisman. See his commentaries here [pdf] and here. Reisman received his Ph.D. under Ludwig von Mises and is the author of Capitalism: A Treatise on Economics, which, among other objectives, attempts the seemingly impossible task of integrating Misesian and Ricardian economics. See Israel M. Kirzner’s critical review of the book [pdf].)

“Costs Govern Value”

We learn from Böhm-Bawerk that it is misleading to say that marginal utility always or usually directly governs the price and value of consumer goods, which in turn governs the prices of the factors used to produce those goods.  “One is in fact correct, when one says that costs govern value,” Böhm-Bawerk wrote (emphasis added).

That got my attention.

He elaborated in response to criticism that the marginal-utility school rejected the law of costs,

We too recognize the necessity of “supplementing” the universal law of marginal utility by means of special provisions that relate to the value of goods reproducible at will and that the substance of these is precisely the law of costs. And we have accomplished this “supplementing” in full detail, both for the field of subjective value and for that of objective value and prices. [Emphasis added.]

But he quickly pointed out that this is not the end of the story:

The law of costs is no fulcrum on the basis of which the rest of the explanation can be supported, without it itself needing a support. Rather, it stands in the middle of the course of explanation: it explains certain phenomena, but must itself be first further explained on the basis of certain other, more general phenomena. In order to provide the explanation with this necessary conclusion, we marginal-value theorists make an addition. Be it noted, not an addition which would run counter to or detract from the validity of the law of costs, but one which supports it and makes it intelligible. Namely, we supplement the theory of the value of products with a theory of the value of the means of production, or cost goods, whereby we reach the conclusion that this value itself is ultimately once again grounded in marginal utility. As far as we are concerned, therefore, costs apply not as an ultimate cause, but only as an intermediate cause of the value of products—though a very important and widespread one. [Emphasis added.]

So by a roundabout route, Böhm-Bawerk ends up where he started: at subjective marginal utility. Cost of production governs price. Marginal utility governs costs. How so?

What’s an iPod Worth without Earbuds?

An example will be helpful. Imagine the earbuds that came with your beloved iPod have broken. Now an iPod with no earbuds is useless (for private listening). Therefore, other things equal, you would be willing to pay almost as much for replacement buds as you would for a new iPod. In other words, if the price of replacement earbuds were governed by the marginal utility of the iPod, that price would have to be only as far below the price of a new iPod as necessary to attract you. So if a new iPod costs $300, those replacement buds might cost, say, $200.

But earbuds can be purchased for under $10. [Update: Under $4.] How can that be? Here’s the Böhm-Bawerkian explanation: In a competitive market for earbuds (even a hampered one), anyone who tried to charge $200 for (basic) buds would invite competitors who would charge less. The competitive process would drive the price further and further below the price that the marginal utility of iPods would set.

But how low could the price go? To answer that, imagine that you wanted to go into earbud manufacturing. You would need to buy inputs such as wire and plastic, and you would need to hire labor. To bid those inputs away from their current uses, you would only need to outbid the manufactures of the marginal products made from those inputs, that is, of consumers’ least-valued alternative products.

Thus the marginal utility of the marginal product governs the prices of those materials. And under competition, those prices – those costs of production – provide the lower limit toward which the price of above-marginal (supra-marginal) products will tend.

As Böhm-Bawerk wrote:

[T]he value of all production-related goods together is determined by the utility of the “last,” most easily dispensable product which is brought forth from the common production source, or, as we call it, by the marginal utility of the “marginal product.” This provides the measure both for the value of the common cost good as well as, via this last, the value of all other products produced by means of same.

In the market, everything is interrelated with everything else. It’s the original World Wide Web.

Marginal Utility Intact

Reisman emphasizes that Böhm-Bawerk’s theory in no way violates the theory of marginal utility: “[C]lassical economics mistakenly held cost of production to be the ultimate explanation of the value and price of goods, which it is not, being in fact, as Böhm-Bawerk shows, merely the vehicle for the transmission of marginal utility from the value of marginal products to that of supra-marginal products” (emphasis added).

Friedrich von Wieser, the other second-generation giant of Austrian economics, agreed: “Between cost and utility there is no fundamental opposition. Utility remains the sole source of value, and the law of cost is the most usual form of the general law of value” (Natural Value, 1889).

We’ve been talking about price, but what about value? Just as the cost of production governs price, so it governs value. This might seem un-Austrian, but remember the law of diminishing marginal utility: As the supply of a homogeneous good increases, other things equal, the value of any given unit falls and vice versa. Here’s Böhm-Bawerk:

[T]he less the material and labor that the production of a jacket costs, the more jackets, of course, can one produce with the means of production available. Thus the more completely can the need for clothing be satisfied. And thus, other things being equal, the lower will be the marginal utility of a jacket. The technical conditions of production are, therefore, to be sure a cause of the value of goods lying further back, a “more ultimate” cause, than marginal utility.

Thus marginal value varies with supply, which is governed by the cost of materials and labor, which is governed by the marginal utility of the marginal product of those inputs. (I realize I’ve left out the disutility of labor, or the value of leisure, another subjective element.)

Austrian economics never fails to fascinate.

Now a colleague of mine, a respected Austrian economist, has expressed profound skepticism that “abstract theorizing” could “save the world.”  I was inclined to agree – although I think it can profoundly change the world. Still the exchange has forced me to articulate my thoughts.

What I Think It Means

Will an economic argument stop someone from firing a bullet at my heart or keep an army from destroying my community?  I doubt it very much.  Whether the weapon is a gun, an army, or even monetary policy, abstract theorizing or indeed any kind of rational argument, economic or otherwise, would be unlikely to stop anyone who is determined to do harm.  Does that make Kirzner’s assertion — that economics is a matter of life and death — wrong or naïve?

Perhaps Mises conveyed this lesson merely to make the economist feel good about herself because abstract theorizing can help her understand social reality more clearly, even while the bullet pierces her heart or troops raze her city.  Perhaps Mises only wanted to motivate his students to commit their lives to the serious study of economics instead of, say, theoretical physics or the law.

Mises probably made two of the more important arguments proposed by any economist of the twentieth century. One was that it would not be unusual under socialism for, say, large food surpluses to coexist with mass starvation because, in the absence of private ownership of capital and labor, entrepreneurs could not use market prices to calculate profits and losses.  Rational economic calculation would be impossible.

Interventionism

The other is that interventionism, the doctrine of the mixed economy, is inherently unworkable because knowledge and incentive problems will generate negative unintended consequences that will tend to elicit even more intervention.  So price controls produce chronic shortages or surpluses, credit expansion ignites booms and busts, and income redistribution raises unemployment and lowers productivity.

A video making the rounds on the Internet the past few weeks shows how in the past 150 years or so, since the spread of free trade and free markets, life expectancy and per-capita income have gone through the roof all around the world. Ideas have consequences, and this development is the fruit of free-trade arguments made by nineteenth-century pamphleteers, many of whom were inspired by the “abstract theorizing” about free trade and the Invisible Hand propounded by classical economists such as Adam Smith and David Ricardo. (I thank Pete Boettke for introducing the video in relation to this topic.)

Now did Mises’s argument about the impossibility of rational economic calculation under socialism prevent the Spanish flu from killing millions just after World War I?  Of course not.  Did it delay the onset of World War II?  Probably not.  But did it prevent some governments after the war from becoming communist?  Well, in his posthumously published Notes and Recollections, Mises boldly claims:  “It was solely through my efforts that Bolshevism did not prevail in Vienna” (77).  If this is true, then the answer is yes.  Is that a good thing?  I certainly think so because economic theory provably saved lives from the ruin and poverty that Mises predicted would follow the implementation of socialism or extreme economic interventionism, not to mention the terrible moral and psychological consequences described by F.A. Hayek in The Road to Serfdom.

Although it may not be possible to say definitively, Mises’s and other market economists’ abstract theories probably laid the intellectual foundation of the Thatcher and Reagan revolutions in the 1980s that, again, significantly improved well-being, at least for as long as they were consistently followed.  The story is told that when Margaret Thatcher became the leader of the Conservative party in 1975, she produced a copy of Hayek’s The Constitution of Liberty during a meeting at the Institute of Economic Affairs, banged it on the table, and proclaimed, “[T]his is what we believe!”

Readers of The Freeman are already aware that the arguments of Mises and Hayek (among others) are informing the case today against so-called “quantitative easing” and intervention in health care in the United States.  Will these arguments prevail and stem dangerous policies?  Will they reduce human misery and increase human happiness?  Obviously, no one knows, but if those of us who write for this publication and others like it didn’t believe it were possible, well, we would be wasting our time.  I don’t think we are.

The Relative Importance of Economics

Proponents of Shakespeare or medical research or even Pilates might also say, perhaps with some justification, that the study of these things is also a matter of life and death.  But in the final paragraph of Human Action (hat tip again to Pete Boettke), Mises writes:

The body of economic knowledge is an essential element in the structure of human civilization; it is the foundation upon which modern industrialism and all the moral, intellectual, technological, and therapeutical achievements of the last centuries have been built.

Thus the flourishing of the arts and sciences itself presupposes a system that respects the basic lessons of economics:  that people follow incentives, knowledge is not perfect, and market prices promote social cooperation. Mises concludes:

But if [men] fail to take the best advantage of [economic knowledge] and disregard its teachings and warnings, they will not annul economics; they will stamp out society and the human race.

Of course, while some abstract theorizing in economics produces prosperity, other theorizing has produced and will produce disaster, and it may be hard sometimes to tell the difference between them.  Either way, though, economics is still a matter of life and death.

Professor Kirzner’s talk made me remember why I wanted to become an economist in the first place (apart from its being a mostly honest way to make a living).

Bastiat loved the market economy, and badly wanted it to blossom in full — in France and everywhere else. When he described the blessings of freedom, his benevolence shined forth. Free markets can raise living standards and enable everyone to have better lives; therefore stifling freedom is unjust and tragic. The reverse of Bastiat’s benevolence is his indignation at the deprivation that results from interference with the market process.

He begins his book Economic Harmonies (available at the FEE store) by pointing out the economic benefits of living in society:

It is impossible not to be struck by the disproportion, truly incommensurable, that exists between the satisfactions [a] man derives from society and the satisfactions that he could provide for himself if he were reduced to his own resources. I make bold to say that in one day he consumes more things than he could produce himself in ten centuries.

What makes the phenomenon stranger still is that the same thing holds true for all other men. Every one of the members of society has consumed a million times more than he could have produced; yet no one has robbed anyone else.

Bastiat was not naïve. He knew he was not in a fully free market. He was well aware of the existence of privilege: “Privilege implies someone to profit from it and someone to pay for it,” he wrote. Those who pay are worse off than they would be in the free market. “I trust that the reader will not conclude from the preceding remarks that we are insensible to the social suffering of our fellow men. Although the suffering is less in the present imperfect state of our society than in the state of isolation, it does not follow that we do not seek wholeheartedly for further progress to make it less and less.”

He wished to emphasize the importance of free exchange for human flourishing. In chapter four he wrote,

Exchange is political economy. It is society itself, for it is impossible to conceive of society without exchange, or exchange without society. …For man, isolation means death….

By means of exchange, men attain the same satisfaction with less effort, because the mutual services they render one another yield them a larger proportion of gratuitous utility.

Therefore, the fewer obstacles an exchange encounters, the less effort it requires, the more readily men exchange.

How does trade deliver its benefits?

Exchange produces two phenomena: the joining of men’s forces and the diversification of their occupations, or the division of labor.

It is very clear that in many cases the combined force of several men is superior to the sum of their individual separate forces.…

Now, the joining of men’s forces implies exchange. To gain their co-operation, they must have good reason to anticipate sharing in the satisfaction to be obtained. Each one by his efforts benefits the others and in turn benefits by their efforts according to the terms of the bargain, which is exchange.

But isn’t something missing from this account?

Indeed, there is: the subjectivist Austrian insight that individuals gain from trade per se. For an exchange to take place, the two parties must assess the items traded differently, with each party valuing what he is to receive more than what he is to give up. If that condition did not hold, no exchange would occur. There must be what Murray Rothbard called a double inequality of value. It’s in the logic of human action – which Ludwig von Mises christened praxeology. Bastiat, like his classical forebears Smith and Ricardo, erroneously believed (at least explicitly) that people trade equal values and that something is wrong when unequal values are exchanged.

Perhaps I am too hard on Bastiat. After all, he was writing before 1850. Carl Menger did not publish Principles of Economics until 1871. Yet the Austrians were not the first to look at exchange strictly through subjectivist spectacles, that is, from the economic actors’ points of view. The French philosopher Étienne Bonnot de Condillac (1715-1780) did so a hundred years before Bastiat wrote:

The very fact that an exchange takes place is proof that there must necessarily be profit in it for both the contracting parties; otherwise it would not be made. Hence, every exchange represents two gains for humanity.

Well, perhaps Bastiat was unaware of Condillac’s argument. That is not the case. He reprints the quote above in his book and responds:

The explanation we owe to Condillac seems to me entirely insufficient and empirical, or rather it fails to explain anything at all….

The exchange represents two gains, you say. The question is: Why and how? It results from the very fact that it takes place. But why does it take place? What motives have induced the two men to make it take place? Does the exchange have in it a mysterious virtue, inherently beneficial and incapable of explanation?

We see how exchange … adds to our satisfactions.… [T]here is no trace of … the double and empirical profit alleged by Condillac.

This is perplexing. Clearly, the necessary double inequality of value is not empirical or contingent. Contra Bastiat, the double inequality explains quite a lot, and his questions all have easy answers.

Yet more perplexing still is Bastiat’s statement in the same chapter: “The profit of the one is the profit of the other.” This seems to imply what he just denied.

Bastiat’s failure to grasp this point had consequences for his debates with other economists. For example, he and his fellow “left-free-market” advocate Pierre-Joseph Proudhon engaged in a lengthy debate over whether interest on loans would exist in the free market or whether it was a privilege bestowed when government suppresses competition. Unfortunately, the debate suffers because neither Bastiat nor Proudhon fully and explicitly grasped the Condillac/Austrian point about the double inequality of value. As Roderick Long explains in his priceless commentary on the exchange,

[E]ach one trips up his defense of his own position through an inconsistent grasp of the Austrian principle of the “double inequality of value”; Proudhon embraces it, but fails to apply it consistently, while Bastiat implicitly relies on it, but explicitly rejects it….

Proudhon’s case against interest seems to depend crucially on his claim that all exchange must be of equivalent values; so pointing out the incoherence of this notion would be a telling reply. But Bastiat cannot officially give this reply (though he comes tantalisingly close over and over throughout the debate) because elsewhere – in his Economic Harmonies – Bastiat explicitly rejects the doctrine of double inequality of value.

How frustrating! Bastiat has so much to teach. But here is one blind spot that kept him from being even better.

Also, the Fall 2010 issue of The Journal of Private Enterprise consists entirely of articles in honor of Boettke, who is renown not only for his dedication to the development of Austrian economics but also for his passion for economic education and mentoring students.

Peter Boettke, professor of economics at George Mason University, FEE trustee, and a great champion of Austrian economics, was profiled in the Wall Street Journal this past weekend (subscription site). A sample:

[T]he 50-year-old professor of economics at George Mason University in Virginia is emerging as the intellectual standard-bearer for the Austrian school of economics that opposes government intervention in markets and decries federal spending to prop up demand during times of crisis. Mr. Boettke, whose latest research explores people’s ability to self-regulate, also is minting a new generation of disciples who are spreading the Austrian approach throughout academia, where it had long been left for dead….

In the last decade at George Mason, he has helped recruit the Austrian school’s leading scholars and drawn students from around the world. Roughly 75% of his students have gone on to teach economics at the college or graduate level.

FEE also got a plug in the article: “The Austrian think tank Foundation for Economic Education had to turn students away this summer from its overflowing seminars.”

Congratulations, Professor Boettke!