A good example of this appeared recently in a March 4 New York Times article titled “Ivory Tower Unswayed by Crashing Economy.” Reporter Patricia Cohen suggests that in spite of the apparent failure of the free market in housing and finance in 2008, supporters of the free market have been surprisingly slow to change their minds. “Free market theory, mathematical models and hostility to government regulation still reign in most economics departments at colleges and universities around the country,” the story said.

To begin with, this reveals a naive view of how intellectual paradigms shift in the academy. Does the reporter expect that professors would so quickly abandon long-cherished beliefs or that in a few short months they would be summarily replaced by professors with “better” ideas? (It may be too much to expect of someone evidently unfamiliar with university tenure to be familiar with the concepts of Thomas Kuhn.)

That aside, there were three other things that bothered me about this article because they reflect serious untruths that have been spreading into the larger public discussion in the wake of the Panic of 2008.

Blaming the Free Market: Orthogonal Mindsets

First is the all-too-common bromide that the free market is wholly or at least primarily responsible for the current economic mess. There is no need to attack this notion here, owing to the numerous articles that have already been published within the last year, including in The Freeman, thoroughly refuting this fallacy.

As I’ve debated the issue in various public forums over the past few months, I’ve realized that there are two widely held and mutually exclusive views on how the situation came about and therefore on the best way to fix the problem.

One is that to get the economy out of slump, it’s necessary to understand how and why we got to where we are. Identifying the causes of the widespread poor judgment that produced this mess requires that we look for changes in the “rules of the game” that gave investors the incentive to create it. Then, having understood that, we must change the incentive structure so as not only to revive the economy in a way consistent with sound economic principles but also to ensure that we don’t wind up back here ever again. (Since this has been addressed elsewhere, it is not my concern here.) Although consistent with several schools of thought, one might call this the “Austrian view.”

The other perspective sees markets as dominated by the irrational drives and psychological proclivities of private investors. It’s therefore a waste of valuable time during a crisis to search for the causes of perverse incentives because all incentives are in a sense perverse or at least potentially so.

One popular version of this blames the housing and financial bubbles of the recent past on an epidemic of “greed.” It argues that a psychological shift occurred under the apparently more market-friendly regimes of the 1980s and 1990s that intensified investor avarice and prompted irresponsible lending and borrowing. Since private investment is the source of the problem, the solution lies in massive government spending to stimulate confidence and restart the economy. (It is not my intent to critique this view here.) I will call this the “animal spirits” view, after John Maynard Keynes, who made the expression popular.

The interesting thing is that, because each side approaches the present situation from such divergent perspectives, neither really understands the other. The approaches aren’t “opposed” but “orthogonal”–the debate is really never joined, and each side simply doesn’t “get” the other.

“Free-Market Economics” = Mathematical Economics?

Second, and what I find just as disturbing and even more puzzling as an Austrian economist, is the way the reporter tacitly equates what she calls “free-market economics” with mathematical economics, and in particular the mathematical economics of equilibrium-obsessed neoclassical economics. This is something I’ve encountered a lot lately. It surprises me because, of course, the truth is in most ways just the opposite.

Standard economics bristles with mathematics. I routinely tell my undergraduates who express an interest in getting a Ph.D. in economics to double-major in mathematics, or at least take as many electives as they can in calculus, statistics and probability, and linear algebra. Austrian economics, which most people who have heard the term associate with “free-market economics,” does not reject mathematical methods when appropriate, such as doing economic history or illustrating economic principles of supply and demand. But mathematics is most applicable in describing situations in which all plans are coordinated and no discoveries are left to be made–that is, in an “equilibrium.”

Now economic regularities, such as prices, do emerge, and we can say some valuable things about the context–the rules of the game, if you will–in which we can expect them to do so and why. But the highly complex processes in which this happens are not usefully described as an equilibrium.

Real markets are, somewhat paradoxically, both orderly and unpredictable: orderly because entrepreneurial alertness to profit opportunities within a given market tends to reconcile inconsistencies among the plans of individual buyers and sellers; and unpredictable because there is no perfect guarantee that any profit opportunity will be discovered.

The bottom line is that Austrian economists in general are highly skeptical of attempts to mathematically model real markets, especially for the purposes of prediction. The high-powered mathematics used by financial analysts to evaluate complex derivatives and assets built on securitized mortgages, for example, are now seen as fundamentally flawed precisely because of the oversimplifications (relative to the reality to which they are applied) they had to incorporate to make them mathematically tractable. (The work of Nassim Nicholas Taleb brings this out.)

Lumping Austrian economics with other “free market” approaches (leaving aside the appropriateness of this term) that use these dubious mathematical techniques thus strikes me as bizarre.

Reasoning from a False Premise

Finally, because for Cohen free-market economics equals neoclassical mathematical economics, the only alternatives she mentions in the article naturally are those that are anti-market. That is, if free-market economics is mathematical economics and if mathematical economics failed, then we must abandon free-market theory. “There are a handful of departments that have welcomed alternative theorists, like the University of Massachusetts, Amherst; the University of Massachusetts, Boston; the University of Utah; and the University of Missouri, Kansas City (where the Heterodox Economics Newsletter is published),” Cohen states.

The prevailing heterodoxy at these departments places them in opposition to free markets.

Is there an economics that doesn’t proclaim the virtues of mathematical virtuosity? Does that economics appreciate the ability of the entrepreneurial-competitive process to generate social order and cooperation? Does that economics therefore search for the causes to the present situation, not in animal spirits, but in the rules of the game that gave rise to perverse incentives? Unfortunately, Cohen never asks these questions, but the answer is in the affirmative: Austrian economics.

Economists during an economic crisis are as popular as weathermen during a hurricane. And so, like many of my colleagues, I’ve been doing more speaking before public audiences in the past several months, trying my best to clarify the situation. I’ve found, however, that there’s much hostility not only to the idea of free markets, but also to economists in general, and even much skepticism about whether economics is a science.

Fighting the public conflation of Austrian economics with the mainstream whenever the opportunity arises is one thing Austrians can do to help turn the intellectual battle around. This is an instance in which methodological issues need to take center stage.

Things have gotten so bad that no dissention can be tolerated. The German Chancellor Angela Merkel was harshly criticized for not going along, at least to the requisite degree, with the stimulus consensus. She stood out as “Frau Nein” until she went along with a “moderate” package.

I am not a macroeconomist. I am not even a financial economist. So much of my reaction to the current financial and economic problem may seem out of step with what most commentators are saying. Yet I think it is important.

Collective Irrationality

The macroeconomic frame of mind is quite peculiar. In the name of the emergency, this way of thinking dismisses most concerns about the efficient allocation of resources and throws almost total emphasis on maintaining levels of expenditure and employment. The implicit assumption is that the central problem is a collective irrationality that inhibits people from spending on consumption or investment. The root of the central problem, conceived in this way, is the initial financial meltdown. This involved a kind of domino effect in which the collapse of the housing market and of mortgage-backed securities, packaged in many complex ways, undermined the liquidity and even solvency of many financial institutions. The system’s ability to provide credit and thus expenditure was compromised, although at this writing the reduction in bank credit available has been relatively small.

Thus the solution, we are told, lies in returning to the status quo ante. Restore the condition of the financial institutions—perhaps by buying toxic assets or perhaps by infusing capital into the institutions. Restore the conditions of the housing market by getting the Fed and/or Treasury to buy Fannie and Freddie mortgage securities, thus sending capital into housing and lowering mortgage rates. Restore the condition of industries with large numbers of employees and others indirectly dependent on them. (So far, the automobile industry qualifies.) In general, restore the pattern of expenditure that prevailed before the crisis.

I realize that no economist believes that complete restoration to the previous situation is possible, but the basic philosophy is clear. Once economic agents believe something like this will take place, confidence will be restored.

The critical issue is this: Has the current situation—triggered by unsustainable levels of mortgage credit and production in the housing industry as well as in other interest-rate-sensitive areas—gone so far beyond its cause that we no longer need to worry about these previous misallocations of capital? In other words, is the correction of the cause now irrelevant to the cure?

Stimulus ex Machina

To discover the answer to this question, let’s step back a bit. We must understand the respective roles of causes and feedback effects. This is the “Keynesian” argument. Suppose a fall or collapse in markets X, Y, and Z causes F (a financial meltdown). Then F itself causes X, Y, and Z to fall further. Some of this is deleveraging, and some is the result of falling confidence in, say, the creditworthiness of counterparties. There is a general lack of clarity about what resources and financial instruments are worth. The future begins to look radically uncertain rather than simply risky. A collapse of confidence thus contributes to a fall in production and employment in areas far removed from the initial bubble-burst. The process is not dampening but explosive in the absence of the deus ex machina—that is, fiscal or monetary intervention.

Now let us imagine a cure that ignores the original misdirection of resources to the degree that it treats the collapse in these markets as mainly due to some exogenous loss of confidence. The Federal Reserve decides, as it actually has, to buy mortgage-backed securities, causing credit to become available in the housing market at lower interest rates. This also causes the prices of homes to stop falling and to begin rising. When will the Fed stop this infusion of newly created money, and hence a relative rise in resources, into the housing market? Presumably it should stop when the sector is brought back to a level that is simply a correction of the previous excess. In other words, the Fed should prevent the additional, “irrational” decline due to “feedback” effects.

Where is the feedback-sanitized point? I doubt anyone knows. Consider what it means to know. The planners would have to know the array of housing prices corresponding to the normal fundamentals of the housing market. This would be the prices that prevailed when the market was not overexpanded. However, it would not correspond simply to the average of recent values because the housing market has been overexpanded for so long. Recently, two economists have attempted to estimate these prices. (“First, Let’s Stabilize Home Prices,” by R. Glenn Hubbard and Chris Mayer, Wall Street Journal, Oct. 2, 2008.) Unfortunately their attempt is marred by the same extrapolation of historical experience that seems to have gone terribly wrong in the assessment of the risk associated with derivatives and mortgage-backed securities. More importantly, however, it seeks to determine normal market prices in the absence of a freely functioning market.

Suppose, however, the Fed is realistic and admits it doesn’t know. It will then simply try to get the housing market (and other similar interest-sensitive markets) to such a point where general production and employment are considered non-recessionary. The standard, practically speaking, will be the status quo ante. This is because of the lack of theoretical-empirical guidance discussed above and because the various sectors, bolstered by various politically powerful pressure groups, will not be satisfied until they are made whole. At this stage we would be left with the unsustainable direction of resources more or less back in place. The direction is unsustainable because, as the original bubble revealed, it was not consistent with the preferences of consumer-saver-investors.

Why it Won’t Work

Therefore the conventional macroeconomic diagnosis and proposed cures ignore many important structural or microeconomic factors, including the following:

1. The “irrationality” is not primarily in the system’s response to the initial financial impulse but in the unsustainable expansion of the housing and other capital markets in the first place. Proposals to prop up the housing market as if its contraction is some kind of unfortunate overreaction are not credible. Too many resources went into the housing market due to the low-interest-rate policy the Fed followed for too long. While housing prices have fallen recently in many markets, they need to fall further. Markets should be allowed to equilibrate.

2. Equilibrium in the housing market would provide greater transparency to the value of mortgage-backed securities. Lack of certainty about housing prices and the ultimate extent of foreclosures only adds to the problems surrounding the illiquidity of these securities.

3. Government infusion of capital with the purpose of restoring the status quo ante ignores the facts: Fannie and Freddie were overexpanded, the domestic automobile industry is a destroyer of scarce capital, some financial firms did a poor job of allocating risk, banks extended loans under the pressure of the government to people who should not own homes, and so forth. Resources were misallocated.

Confidence Follows Correction

Recessions are not simply crises of confidence or of insufficient demand (due to increases in the demand to hold money). They also have their allocational—or microeconomic—aspects. I suggest that these systemic distortions have an important role in creating the aggregate phenomena we are witnessing. To treat these distortions and their cure as relatively unimportant is a mistake. Lasting investor and consumer confidence follows the correction of the underlying causative distortions and does not precede them. In fact, the dominant macroeconomic policy framework does not leave room for correcting distortions at all because its basic theme is to restore, prop up, and maintain the current direction of resources.

The hastily approved macroeconomic schemes of the Bush and Obama administrations will not succeed in promoting lasting recovery because they ignore the microeconomic fundamentals. The direction of spending and hence resource allocation they generate are fragile—they are not consistent with the preferences of consumers, savers, and investors. Therefore, once the putatively temporary stimulus is complete, the corrective forces that are now trying to undo previous resource misallocations will reassert themselves.

In the longer term, the threat of significant inflation looms large. After the U.S. Treasury has incurred the additional trillions of dollars in national debt (at least one trillion in George W. Bush’s response to the crisis and a minimum of one more in Obama’s response) and the Federal Reserve has completed expanding its balance sheet (thus creating new money) by some trillion or more, what will happen? Will the federal government abolish the stimulus programs, raise taxes to pay off the increases in the national debt (or even to service the debt), and cut entitlement programs? The constituencies that will be formed by the stimulus spending will resist. Will the Fed begin a contractionary monetary policy to absorb all the excess money it created in the name of the emergency? That would raise interest rates and the cost of servicing the huge national debt. What is probable is that we will see an effective repudiation of part of the national debt through inflation. The temptation will be all but irresistible to inflate ourselves out of this mess. The economic consequences of the “cure” will be worse than the disease.

After the passing of its three founders—Carl Menger, Friedrich von Wieser, and Eugen von Böhm-Bawerk—Austrian economics fell for a long time into eclipse. It was not so much refuted as neglected. English-speaking economists began devoting themselves to such matters as mathematical treatment of problems of “general equilibrium.” The Austrian view was revived mainly by one man, an Austrian by birth as well as an “Austrian” by conviction—Ludwig von Mises (1881–1973). He made his influence felt both by his written works and by his oral teachings. Among his early distinguished students and followers were Gottfried Haberler, Fritz Machlup, Oskar Morgenstern, Lionel (subsequently Lord) Robbins, and, most influential of all, F. A. Hayek.

Ludwig von Mises was prolific, but his principal contributions were made in three masterpieces. These were The Theory of Money and Credit, first published in German in 1912, Socialism: An Economic and Sociological Analysis, also first published in German in 1922, and Human Action, which grew out of a first German version appearing in 1940, but was not published in Mises’s own rewritten English version until 1949.

Mises on Human Action

Though there is now a gratifying number of able young American economists writing in the Austrian tradition, Human Action still stands as the most complete, powerful, and unified presentation of Austrian economics in any single volume. Mises always generously acknowledged his indebtedness to his predecessors. He recalled in a short autobiography Notes and Recollections, 1978) that around Christmas 1903 he read Menger’s Principles of Economics for the first time. “It was the reading of this book,” he wrote, “that made an ‘economist’ of me.”

It would carry me to too great length to itemize and explain all the contributions to economics that Mises made, and I will content myself with mentioning only two. He was the first to prove that it was impossible for socialism to undertake “economic calculation”; and he made one of the most important contributions of any economist toward solving the problem of “the trade cycle.”

Because Mises so uncompromisingly rejected government interventionism in all its forms, he acquired the reputation of a “laissez-faire extremist” during most of his lifetime, and was scandalously neglected by the majority of academic economists. But because Hayek elaborated his own ideas in a more conciliatory form, his writings attracted more attention from the academic world, and he leapt into prominence in 1931 with his own contribution to the theory of the trade cycle, Prices and Production, along lines similar to Mises’s. The result is entitled to be called the “Mises-Hayek” theory.

Hayek is also a prolific writer, but though he has written volumes on money, on the trade cycle, on inflation, and on The Pure Theory of Capital (1941), he has never attempted a comprehensive book on economic principles. Of late years he has turned his attention mainly to the realms of politics, ethics, and law, and has written profound and widely discussed treatises on The Constitution of Liberty (1960) and a three-volume work on Law, Legislation and Liberty, completed in 1979. He has been more widely influential in his own lifetime than was Mises, and was awarded the Nobel Prize in Economics in 1974.

Today’s zealous group of younger “Austrian” economists, though all acknowledging their great debt to Mises, do not treat his Human Action as the final word on the subject, but are exploring a whole range of economic problems with a new vigor. Murray Rothbard [1926–1995], a student of Mises, produced a two-volume treatise, Man, Economy, and State (1962), along Misesian lines, with notable clarity of exposition, and making important contributions of his own, pointing out the fallacies, for example, in the prevailing theories of “monopoly price.”

Israel M. Kirzner (b. 1930), professor of economics at New York University, another former Mises student, although he has not undertaken a comprehensive book of “principles,” has explored individual problems in five separate volumes: The Economic Point of View (1960), Market Theory and the Price System (1963), An Essay on Capital (1966), Competition and Entrepreneurship (1973), and Perception, Opportunity, and Profit (1979). His work is distinguished by great scholarship, systematic thoroughness, and precision of statement. He has brought further illumination to every problem he has dealt with.

Finally, no reference to individual writers would be adequate that did not include Professor Ludwig M. Lachmann [1906–1990]. Though he is one of the most original and profound among living Austrian economists, his work has not yet nearly achieved the recognition it merits. Among his principal books are Capital and Its Structure (1956; republished in 1978), The Legacy of Max Weber (1971) and Capital, Expectations, and the Market Process (1977). His writings are notable for their emphasis on the role of expectations and for their thoroughgoing application of a “radical subjectivism.”

Restrictions of space permit me merely to list the names of half a dozen of the now- increasing group of important “Austrian” economists: S. C. Littlechild, Gerald P. O’Driscoll, Jr., Mario J. Rizzo, Hans Sennholz, Sudha R. Shenoy, and Lawrence H. White. But so arbitrarily short a list must omit a number of names unjustly.

The “Austrian” economists, more consistently than those of any other school, have criticized nearly all forms of government intervention in the market—especially inflation, price controls, and schemes for redistribution of wealth or incomes—because they recognize that these always lead to erosions of incentives, to distortions of production, to shortages, to demoralization, and to similar consequences deplored even by the originators of the schemes. But personal value judgments of government policy are of course not an essential part of Austrian theory.

The present vigorous Austrian School is not content merely to keep re-expounding the principles developed by Menger and Mises, but is addressing itself constantly to new problems, or a more thorough probing of old ones. This is dramatically evident in a recent volume, New Directions in Austrian Economics (1978), edited by Louis M. Spadaro, with contributions from eleven writers. Professor Spadaro himself, in his concluding essay, outlines some of the still unresolved problems that Austrians ought to explore. In some sense, however, practically all eleven contributions do the same thing.

I have heard it said (by an economist of another school) that there is no such thing as Austrian economics; there is only good economics or bad. But in the same way we could say that there is no such thing as Ricardian economics, Marxist economics, Keynesian economics, and so on. This sort of statement, though true in one sense, is false in another. It is fallacious in implying that if anything is classified in accordance with one characteristic, it cannot be classified in accordance with any other. It is like saying that there are no such persons as Americans or Japanese; there are only men and women. Those who call themselves “Austrian” economists give themselves this label because of its historic origins; but they happen also to believe that its fundamental theses are true, and offer more promise than any other for further progress in economic science.

Perhaps something should be said about the chief differences today between Austrian economics and what we may call “orthodox” or “mainstream” economics. The difficulty here is that “mainstream” economics itself would be hard to define. Economists are still divided into a number of recognizable “schools”—neoclassicists, Keynesians, the Chicago school, the Lausanne school, and so on. The limits of space forbid me to go into the distinguishing doctrines of each of these schools. But one outstanding difference of the Austrians from all of these lies in their method of reasoning. The Austrians emphasize methodological individualism. That is, they not only begin by emphasizing human actions, preferences, and decisions, but individual actions, preferences, and initiatives. Mainstream economists are concerned with “macroeconomics,” with averages and aggregates; and those of the Lausanne school, trying to reduce economics to an “exact” science, and therefore seeking to quantify everything, are obsessed with complicated mathematical equations that try to stipulate the conditions of “general equilibrium.”

Equilibrium a Useful Concept, Though Never a Reality

Now “general equilibrium” is defined by these economists (when it ever is) in highly abstract and obscure phrases; but for laymen it might be defined as a condition in which all the tens of thousands or millions of commodities and services are being turned out in the exact quantities and proportions in which they are relatively wanted by producers or consumers, so that there are no “shortages” or “surpluses.” All prices reflect costs, and there is no more profit in making one commodity than any other. (In fact, there is no “pure” profit at all.) These economists admit that at any moment this condition does not exist, but they contend that there is a constant long-run tendency toward equilibrium, because when there is an unusual profit in turning out some one product, producers will turn out more of it, and when there is a loss in turning out some other product, producers will make less of it, or transfer to making something else.

Now the concept of equilibrium (or much better, the Mises concept of an “evenly rotating economy”) can have great usefulness as a tool of thought. We are often better able to analyze the problems of change if we begin with the fictitious assumption of a state of affairs in which certain changes are hypothetically eliminated. But this is a purely imaginary construction, a useful fiction. It should never be confused with reality.

While a true “equilibrium” between the marginal cost of production and the market price of any one commodity is a condition that is seldom reached, even momentarily, a “general equilibrium” in the relative production, supply price, and demand price of all commodities and services is a condition that is never reached, even for an instant of time.

The concept itself is extremely nebulous. Neoclassical economists seem obsessed today with setting up complicated algebraic equations stipulating the conditions of equilibrium or functional relations under “perfect competition” and the like, but it is difficult to specify precisely what their x’s and y’s stand for. They cannot refer to physical quantities, because you cannot add apples to horses, or a ton of gold watches to a ton of sand. One might add or compare quantities times prices, but what would be the meaning of the total, or any of the parts that make it up? The price, even of one commodity, differs from hour to hour, place to place, and transaction to transaction. The value of the currency itself fluctuates and constantly changes its exchange ratio with commodities. If we simply add or compare “values,” then we must recognize that values are purely subjective. They are impossible to measure or to total because they differ with each individual.

If we pass over these fundamental difficulties, where do we arrive? Even if we assume that there may be a persistent long-run tendency toward general equilibrium, we must admit that there is also a persistent short-run and long-run tendency toward the persistence of disequilibrium.

This is not only because there is a tendency of entrepreneurs, in increasing or reducing production in response to market and profit signals, to overshoot the mark, but because individual entrepreneurs, so far from making merely automatic responses, are constantly gaining new knowledge, alert to new opportunities, changing methods and reducing production costs, improving products, innovating—turning out entirely new products or inventions. And consumers too are constantly learning, changing tastes, and demanding new products to meet new wants. So Austrian economists seldom speak of market equilibrium, but of the market process.

My own suspicion is that the enormous attention now being devoted to stipulating the mathematical conditions of “general equilibrium” is a pursuit of a will-o’-the-wisp, of questionable help in solving any real economic problem.

But space forbids me to go into too many detailed contrasts. Let me sum up briefly the main Austrian theses once again, this time not in my own words or in Menger’s, but in those of two prominent living [1981] “Austrians.”

“Beginning in the 1870′s in Vienna, Austria,” writes Professor Kirzner, “the school was distinguished by its emphasis on the subjective elements in economic analysis, on the significance of time in production processes, and on the role of error and uncertainty in economic phenomena” (his italics).

The summarization by Professor Lachmann is remarkably similar: “The first, and most prominent, feature in Austrian economics is a radical subjectivism, today no longer confined to human preferences but extended to expectations. . . . Secondly, Austrian economics displays an acute awareness of the many facets of time that are involved in the complex network of interindividual relations. . . . In the subjective revolution of the 1870′s the first step in the direction of subjectivism was taken when it was realized that value, so far from being inherent in goods, constitutes a relationship between an appraising mind and the object of its appraisal” (New Directions in Austrian Economics, pp. 1–3).

All the rest of Austrian economics follows from these basic insights. Let me conclude with my own opinion that any economic analysis that fails to embody such insights cannot be entirely sound.

Recommended Reading

Those who have no previous acquaintance with Austrian economics, and would like a short and simple text written along Austrian lines, might begin with Essentials of Economics by Faustino Ballvé (126 pages; Irvington-on-Hudson, N.Y.: Foundation for Economic Education). A more advanced . . . introduction (1979), specifically explaining the Austrian point of view, is The Fallacy of the Mixed Economy, by Stephen C. Littlechild [out of print].

Surprisingly, the original Principles of Economics, first published in 1871 by Carl Menger, the founder of Austrian economics (328 pages), still makes an excellent, very readable, and not too technical introduction to the school’s basic principles.

Of course, the authoritative and most complete work on modern Austrian theory is Human Action, by Ludwig von Mises (907 pages, first published in 1949 [fourth edition, FEE, 1996]). Some may find this difficult reading. A very clear two-volume work written thirteen years after Human Action by a student of Mises is Murray N. Rothbard’s Man, Economy, and State [Ludwig von Mises Institute, 987 pages].

For the reader interested in the latest developments in Austrian economics I can highly recommend two books: One is The Foundations of Modern Austrian Economics, edited by Edwin G. Dolan, which contains contributions by half a dozen writers [1976, 238 pages, out of print]. The other is New Directions in Austrian Economics, edited by Louis M. Spadaro (1978), 239 pages, with contributions by eleven writers [out of print].

Most of these foregoing books have already been mentioned in the text. The reader may also profitably consult others mentioned there, especially the volumes by Kirzner and Lachmann.

Reviewed by Pierre Lemieux

In his latest book, Open Society, retired billionaire speculator George Soros continues to argue against capitalism and its justification in economic theory. The book doesn’t put a dent in capitalism, but shows that billionaire financiers don’t necessarily understand the first thing about economic systems.

Soros opens with an indictment of the concept of equilibrium. In the real world, equilibrium is compromised by what Soros calls “reflexivity.” Reflexivity (“the cornerstone of my conceptual framework”) refers to the fact that people’s opinions about social phenomena affect those very phenomena. All knowledge is therefore imperfect, and all social events unpredictable, he concludes.

The first problem is that Soros’s theorizing is confused. “Our thinking guides us in our actions,” he writes, “and our actions have an impact on what happens.” The actions of all individuals certainly have an impact on social reality, but a single individual can safely take the environment as given when making his own plans. The price of tomatoes depends on all individual demands, but an individual buyer can take prices as fixed. In cases where one individual’s actions influence another’s, strategic behavior (taking into account other people’s reactions) becomes rational, but this does not imply that the system is unstable. “Reflexivity” is much ado about nothing.

Secondly, Soros does not seem aware that many economists—the Austrians foremost among them—have developed similar critiques against orthodox neoclassical economics. Ludwig von Mises, Murray Rothbard, and Israel Kirzner, among others, have attacked the concept of equilibrium and showed the importance of entrepreneurship in market processes. It is because social reality depends on what people think that economists try to trace the unintended consequences of individual actions. Consider another example of Soros’s ignorance: “The idea that some values may not be negotiable is not recognized,” he writes about economic theory, “or, more exactly, such values are excluded from consideration.” This is patently false. Any “value” can be included in individual preferences. And when private property rights are recognized, anybody can decide that something belonging to him is not negotiable.

Criticizing the Efficient Market Hypothesis (the theory that financial prices incorporate all available information), which he confuses with rational expectations in general, he admits: “I never studied it. I dismiss it out of hand because it is so blatantly in conflict with the concept of reflexivity.” It is true that this theory doesn’t account for the entrepreneurial behavior of speculators who look for, and jump on, new information and, by acting on it, actually incorporate it in market prices. Like Mr. Jourdain speaking prose without knowing it, Soros has been a Kirznerian entrepreneur helping to stabilize financial markets through his contrarian speculation.

Soros believes that central banks regularly save developed countries from depressions, and that a similar institution is required at the world level. He proposes the creation of the “Open Society Alliance,” a new state association that would aim at coordinating existing international organizations. Like all statists, he envisions only benefits from this further centralization of power and sees none of the dangers.

The thrust of the book is an argument in favor of the “open society” and against capitalism. Soros takes capitalism to mean “the unbridled pursuit of self-interest,” while it is actually a specific set of institutions that channels self-interest toward efficient social cooperation. He defines the muddled concept of “open society” as a one where there is no monopoly on truth, but he wants state coercion to impose his own ideas, “social justice” included.

Soros deems “market fundamentalism” more dangerous than communism for the “open society,” because free-market ideas appear everywhere triumphant. This would be good news if it were true—that is, if the state had not grown virtually nonstop during the twentieth century. Soros even sees a “dismantling of the welfare state” from 1980 on, which is not borne out by official statistics. And who are these “market fundamentalists”? He cites Milton Friedman twice, and F. A. Hayek once, mistakenly identifying the latter with the Chicago School. He doesn’t seem to know the real market radicals—people like David Friedman or Murray Rothbard—much less understand them.

By backing his opinions with his money, Mr. Soros is tilting the playing field to his side. What about the “level playing field” that pops up in his discourse? Not for him, it seems. Of course, he has the right to express his opinions, but not to use state coercion to dictate how we live our lives. This is what his espousal of all politically correct causes amounts to.

“Not many people,” Soros writes with his usual good-heartedness, “share my predilection for identifying error, and even fewer share my joy in finding it in themselves.” Let him now seize the opportunities for intellectual joy as efficiently as he seized profit opportunities in correcting market errors.

Pierre Lemieux is an economist, author, teacher, and consultant.

In the church of economic theory, as in that other church, the central symbol of the faith is a cross. Only this one is tilted and looks like an “x” not a “t.” As any communicant learns early on, the x represents supply and demand “curves” (usually portrayed as straight lines) . . . . [W]here the two lines cross is the blessed point of “equilibrium,” where the price is exactly what is needed for supply to equal demand. At that point markets clear, utility is maximized, lions are beaten into plowshares, bread walks on wine, and so on.

Kinsley then makes a remarkably brave confession: “Having been inducted into the faith in college, I’m a fairly devout believer in the basic doctrines. But I have always been troubled by doubts on one item: In my innermost heart, I wonder if the supply curve really slopes upward. (There, I’ve said it.)”

Those of us who have been excommunicated from the mainstream must applaud Kinsley’s courage. He recognizes, as we do, the utter absurdity of the doctrine of entrepreneurial infallibility. Kinsley is perfectly correct to challenge the standard assumption that marginal costs always rise. But that’s not the half of it.

The really radical response to the neoclassical practice of drawing all sorts of elegant cost curves is not simply to wonder whether they rise. The first question must be: What are these curves supposed to mean? They do not accurately describe the decision-making process of real businesspeople; nor do these unrealistic models make accurate predictions. The entire enterprise of modern mainstream economics can only offer a simplified analogy to the real economy in hopes that the study of this theoretical world can offer us insights into the real one.

It is a common mistake to say that economics is about money. As such, when people talk about the “marginal cost” of production, it is believed that this refers to the dollar amount spent on raw materials, labor, and so forth. But cost is the value of opportunities forgone, and it is always estimated in an ex ante sense; cost is never “realized.” A woman chooses one out of many competing suitors. The benefits of her choice are clear enough. But the costs are not the money spent on the wedding and dowry—these would have been spent anyway if a different man had been selected. Rather, the true cost is the subjective value she places on a lifetime spent with the next best suitor. It is clear that this value will never be known, for it is a lost opportunity; a fortiori, no outsider can calculate it.

After his confession, Kinsley elaborates further on neoclassical theory. In a competitive market, price equals marginal cost. (If it were higher, a rival would cut prices to capture the entire market, and if it were lower, firms would make more money by restricting production; only when P=MC is everyone happy.) Marginal costs have to be rising “to avoid the embarrassment of supply and demand curves that never cross.” Further, at the point where supply and demand intersect, it had better be the case that marginal cost exceeds average total cost—otherwise the firm would be losing money. Kinsley finally gets to his point: “[T]he news these days is full of controversies where the basic problem is that marginal costs do not rise. They start out below average cost and stay that way.”

Already the reader should be skeptical. When someone laments that costs are not higher than they already are, chances are this person is drawing an illegitimate conclusion from an economic model. (This same phenomenon occurs when critics lament that Microsoft did not charge enough for its browser. These people are afraid of low prices, just as Kinsley is afraid of low costs.) Airline seats, says Kinsley, are a good example of this: Once the first 20 seats have been sold, it costs the airline virtually nothing to sell the 21st seat. But clearly each person can’t be charged this marginal cost, for the average cost of an airline seat is much higher.

One wonders what the big fuss is about. Kinsley himself acknowledges the airlines’ solution: Charge different amounts for the “same” seats. On any given flight—even restricting ourselves to those flying coach—each passenger does not pay the same price for his or her seat. Already we have abandoned the world of neoclassical models, where P is uniform. Moreover, the seats really aren’t the “same” good; those who bought their tickets well in advance presumably paid much less since, unlike those who procrastinate, they were willing to forgo flexibility and commit to a certain date. Taken to the other extreme, discount theater tickets are always available to those who forgo the luxury of knowing which show they will actually attend that night.

Most of the problems Kinsley raises are due to the necessity of avoiding the “embarrassment” of disequilibrium. But whenever a plane, bus, or subway has empty seats, that’s a surplus, or glut, in the neoclassical’s book. As one who frequently uses public transportation, I can attest that I am absolutely delighted by disequilibria. And the owners are not hurt either. It is true that they would prefer to sell all the seats at a high price, but the demand is lacking. If the choice is between “clearing the market” (selling all seats) at a low price, and leaving a few empty at a higher price, which earns them greater profits, it is quite likely the airlines will adopt the latter strategy.

Kinsley believes the features of the New Economy “[undermine] the case for a free market.” By this he undoubtedly refers to the mainstream definition of efficiency: If there exists a technologically feasible alternative arrangement of society’s economic affairs, an arrangement that is unanimously preferred to the current arrangement, then the status quo is “inefficient.” But this definition tells us nothing about how to improve the situation. Indeed, all the “market failure” literature teaches us is that if certain industries behaved in the way assumed in the various models, then we could logically imagine the world being a better place. Any argument that uses these results to justify government intervention is a complete non sequitur.

Such condemnations of the free market are even more dubious when it is realized that these models do not at all capture the ingenuity and resilience of unshackled entrepreneurs. Low marginal costs were no problem for Sam Walton or other founders of wholesale clubs, in which the customer pays a flat membership fee for the right to purchase goods at huge discounts.

Kinsley is right to challenge the realism of mainstream economics. But he must realize that the problems of “the one true faith” (as he calls it) run far deeper than he has imagined.

—Robert P. Murphy
Ph.D. candidate in economics
New York University