One of the first things I have to disabuse my students of in introductory microeconomics is the belief that microeconomics is about the “little picture,” while macroeconomics is about the “big picture.” First, what self-respecting scientist would deliberately choose only to study the little picture? Even microbiologists believe they’re dealing with major problems such as the nature of life and disease. Beyond that, the prefixes “macro” and “micro” don’t refer to the scope of the subject but to, you guessed it, the unit of analysis.

(To be fair, those prefixes are unfortunate choices, but it seems for the time being we’re stuck with them.)

This confusion is understandable because traditionally at the undergraduate level macroeconomics courses do deal with economy-wide output, employment, inflation, and the like, all of which are indeed big-picture issues. And courses in microeconomics usually cover things like value theory, individual choice, and market demand and supply, which, while important, do seem smaller in scale than macroeconomic problems.

However, my colleague Roger Garrison captures the relevance of making the right choice in the unit of analysis in his phrase, “There are macroeconomic problems, but only microeconomic solutions.” To understand the “big picture,” you’ve got to begin with the microfoundations.

Macroeconomic Problems

One of the great differences between, say, a contemporary Keynesian economist like Paul Krugman and a modern Austrian macroeconomist like Garrison is that Krugman sees the current recession as chiefly a problem of aggregate spending: If only economy-wide spending by consumers and especially businesses would increase, the economy would wake from its doldrums. Because Krugman doesn’t think it’s helpful to look behind these aggregates – to the fact that not all labor is substitutable or that residential construction is significantly different from bridge building – it doesn’t much matter what people spend their incomes and savings on. For him the problem is that for whatever reason people aren’t spending voluntarily.

Government spending via stimulus packages or “quantitative easing” is a blunt instrument, but because in standard Keynesian macroeconomics the variables to be manipulated are themselves pretty blunt – aggregate demand and aggregate supply – these policy tools are entirely appropriate for the task at hand. You wouldn’t think that having only a sledgehammer in your toolbox is a problem if you think your job is only to pound giant spikes. But when the job actually requires a crosscut saw or a Phillips screwdriver, then you’ve got a problem.

Microeconomic Solutions

From the Austrian viewpoint, while the recession and persistently high unemployment are indeed macroeconomic problems, that doesn’t mean the sources and the solutions are also at the macroeconomic level. In the field of public health, epidemiologists are beginning to understand something similar.

If there’s a threat of a flu epidemic, the best solution is not to spend resources inoculating everyone in sight. The social-network theorists Christakis and Fowler report that it would be more sensible to find out how flu spreads, that is, who are the most likely carriers and spreaders – say, those who come into contact with a lot of potential victims: doctors, nurses, and teachers – and make sure that they get the vaccine first.

Similarly, for an Austrian, just increasing aggregate demand is not only ineffective, it’s potentially dangerous. For example, government spending to re-stimulate the housing market, which is a sector within the macroecomy that isn’t doing too well right now in some (but not all) places, is from this perspective a bizarre remedy for a recession whose immediate cause was a housing bubble. Yet, guided by Keynesian thinking and the aggregate unit of analysis, this is precisely what Congress and the President are trying to do.

So just because national unemployment or declining cities are pressing problems, that doesn’t mean that you can solve it by spending more at the national level to get the aggregate numbers down. You need to ask what are the choices people make – the poor, the unemployed, as well as those who could help or employ them – that create these problems and what are the knowledge and incentives at the individual level that result in that aggregate outcome.

Micro-foundations of Cities

In the case of cities the great urbanist Jane Jacobs relentlessly and effectively attacked the urban-planning orthodoxy of the 1950s for imposing someone’s ideal bird’s-eye, macro-urban vision on the micro-fabric of great cities. Rather than try to understand from the ground up how cities’ spontaneous processes work – the informal neighborhood networks, the diverse knowledge and skills and tastes that both attract people to, and themselves generate the opportunities found in, great cities – the planners sought to directly shape the macro-urban landscape, gardener-like, according to their own ideal, usually rationalistic central plan. It is just like saying, “Wow, these 500-year-old quadrangles at Oxford University are lovely; let’s build some in Las Vegas!”

As Robert Caro documents in The Power Broker, his great book about New York’s city planner, Robert Moses, too often the results were massive highway and urban-renewal projects that tore apart living neighborhoods, disrupting and destroying lives and the economic vitality of once-thriving city districts.

Choosing the right unit of analysis is more than an academic exercise. It’s a matter of poverty and prosperity, even of death and life.

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.

I’m at a social gathering that includes some doctors. One doctor is discussing a prescription drug for a particular ailment. I interrupt with a lengthy discourse on the medication, explaining that the doctor’s understanding is faulty. He has misunderstood the most important applications of the drug. His analysis of the side effects is absurd. I patiently explain to the other bystanders that the doctor is simply wrong.

This scene, of course, has never occurred. And yet in many a social gathering I have heard doctors explain to me that the minimum wage is good for the poor; it raises their wages at no cost in reduced employment. I have had doctors patiently explain to me that my understanding of the energy market is faulty, that there is no competition there, simply the greed of big multinational oil companies that jack up the price of gasoline from time to time and only lower it to mask their sinister ability to exploit us.

So here’s the puzzle. Why do doctors feel competent to contradict economists on economic matters while economists would never contradict doctors on medical matters?

There’s a simple explanation. Doctors are more confident than economists in their ability to understand the world around us. Doctors feel that they hold the power of life and death. This induces a certain measure of self-esteem leading to the occasional intellectual overreach.

There may be something to this theory, but I doubt many doctors would contradict an engineer about the safety of a particular bridge or correct an astronomer’s assertion on the identity of a particular constellation.

We are left with a more depressing conclusion. Doctors (and plenty of other folks) don’t respect economists as credible sources of information on many economic topics. I used to think that this was the inevitable result of being a social scientist rather than a “real” scientist. No doubt the imprecision of economics has something to do with our relatively low standing in the eyes of the public relative to the practitioners of more reliable disciplines, such as physics and chemistry.

But lately I’ve started to wonder if there is a more fundamental misunderstanding at work. That misunderstanding is about the very essence of the field of economics. I’ve come to realize that most people, even intelligent, educated people, have not the faintest clue as to what economists do or what the discipline of economics has to contribute to an understanding of the world around us.

I got an inkling of the problem one time when on an airplane, the woman next to me asked what I did for a living. I mentioned that I wrote books on economics. Too bad my husband isn’t here, she said. He loves books on the stock market. I wanted to reply that I was glad her husband had stayed home, given that I have no interest in books on the stock market. I held my tongue, but I learned a lesson that I have heard confirmed in subsequent conversations with even highly educated strangers—most people think economics has something to do with personal finance or the stock market. At best, non-economists think economics is all macro, dealing with GDP, interest rates, and the money supply. Most non-economists find these topics either intimidating or boring. No wonder that most people are unaware that economics has something to say about what Alfred Marshall called the “ordinary business of life.” That side of economics, the micro side, the side that focuses on human behavior at either the individual level or in groups, has been dwarfed by the emphasis on financial news, interest rates, and the stock market.

You can see part of the problem when you mention the word “markets” to a non-economist. He immediately thinks of the stock market rather than the slightly surreal concept of economics where buyers and sellers are linked by prices.

What Is to Be Done?

So what can we do to give non-economists an idea of what economics is really about? The simple answer, of course, is to teach more people economics. But it’s a Catch-22. If people have a preconception that economics is about financial matters and if people are either intimidated or bored to tears at the prospect of a lecture on finance, then this solution is unlikely to help. It’s a little like the old “Saturday Night Live” skit about Smucker’s jam. How do you market a product with such an unattractive name? With a name like economics, you know it must be fascinating!

A more attractive and practical answer is to pick a different name for the field, a name that gets away from that embedded term “economic,” which reasonably enough, makes people think of financial matters. When strangers ask me what I do for a living, I’ve stopped saying that I teach economics. It’s a conversation stopper unless you’re talking to a fan of the stock market.

I’d prefer to say that I study human behavior. But most people assume that means psychology. So I now tell people I teach spontaneous order. Instead of ending the conversation, I usually get a follow-up question asking about spontaneous order. That gives me a chance to talk about the insights of Adam Smith’s invisible hand and Hayek’s discussion of how markets make use of information.

My idea of talking about spontaneous order is just one way to improve the reputation of what George Stigler called the queen of the social sciences. Many of you understand that economics is about more than just the stock market or interest rates. I’d like to hear from you about how you think economics might improve its image problem. E-mail me your suggestions (or send them to me c/o FEE). If any of them appeal to me I’ll use them at cocktail parties and highlight them in a future column.

Since its inception, the Foundation for Economic Education has been associated with two free-market schools, the Austrian school of Ludwig von Mises and, to a lesser extent, the Chicago school of Milton Friedman. Mises, after leaving Vienna for New York City, was closely involved with Leonard Read, FEE’s founder. He spoke frequently at FEE’s headquarters in Irvington-on-Hudson, and wrote regularly for The Freeman.

Read also developed a relationship with Friedman, who along with University of Chicago colleague George Stigler, wrote one of FEE’s earliest publications. “Roofs or Ceilings?,” published in September 1946, contended that postwar rent controls were counterproductive and should be removed. The FEE pamphlet was highly controversial at the time and was attacked on both sides of the political spectrum. Ayn Rand labeled the pamphlet “collectivist propaganda” and “the most pernicious thing ever issued by an avowedly conservative organization” because the economists favored lifting rent controls on practical, humanitarian grounds, not in defense of “the inalienable right of landlords and property owners.”^[2]

In a highly negative review in the American Economic Review, Robert Bangs assailed Friedman and Stigler, declaring, “Removal of rent controls now would not solve the housing problem, but it could easily contribute to a worsening inequality.”^[3]

Both the Austrian and Chicago schools of free-market economics were decidedly unpopular at the beginning of the postwar period, but now, a generation later, their views are represented in almost all textbooks and economics departments.

Why Has the Chicago School Gained So Much Influence?

The Chicago school, led by Milton Friedman, has especially gained recognition among professional economists. Followers of the Chicago school have won a dozen Nobel Prizes in economics since the award’s inception in 1969.

Why has the Chicago school been more successful than the Austrian school? Both favor private enterprise, low taxes, minimal government, free markets, and sound money. Although differing on methodology and occasionally on policy (e.g., the Austrians support either free banking or a gold standard while the Chicago monetarists advocate a controlled fiat money policy), they have more in common than not. Both Mises and Friedman were founding members of the Mont Pelerin Society. It is too bad that the Misesians and the Friedmanites usually see one another’s philosophies as competitive rather than complementary.

The Advantages of Empirical Work

Historically, Friedman and his followers have taken a different road from the Austrians. They stress quantitative empirical work to test their theories. They also published more of their findings in the professional journals and with well-known university presses. They see themselves as inside the profession. The results were so remarkable that they gradually caught the attention of the rest of the discipline. Take, for example, Milton Friedman’s (coauthored with Anna J. Schwartz) monumental Monetary History of the United States, 1867-1960, a study sponsored by the National Bureau of Economic Research and published by Princeton University Press in 1963. With meticulous research, he demonstrated how the Federal Reserve allowed the money supply to contract by a third during 1929-33. His statistical work gave powerful credence to the idea that it was government, not free-enterprise capitalism, that caused the Great Depression. Friedman’s quantitative study did more to restore faith in free enterprise than a thousand sermons on the virtues of economic liberty. His applied approach was far more effective in destroying the basic tenets of Keynesianism than philosophical tomes. For these contributions to economics, Friedman was awarded the Nobel Prize in 1976.

Friedman’s empirical application of his free-market views has had a wide influence on think tanks and practical politics. The Chilean economic miracle (controlling inflation, cutting taxes, privatizing Social Security) is largely a result of the policy recommendations of the Chicago Boys, economists who studied under Friedman. The Cato Institute’s (and other free-market think tanks) focus on case studies is an outgrowth of Friedman’s research methods.

The Austrians Take Another Path

The Austrians, on the other hand, do not believe theory can be derived or tested empirically. Mises’s method, praxeology, deduced economic principles logically from the axiom that human beings act—that is, attempt to improve their circumstances. Austrian economists prefer to state their theories verbally rather than mathematically. (Mises declined to use even graphs on methodological grounds.) Hayek, despite differences over method with Mises, warned that economics should not mimic physics. He designed a graphic presentation of the Austrian theory of the business cycle, but offered no statistical evidence. Henry Hazlitt dissected Keynes’s General Theory with deft and substantive arguments, but without quantitative analysis, his Failure of the “New Economics” (D. Van Nostrand, 1959) fell on deaf ears. Israel Kirzner established an Austrian center at New York University, but has limited his analysis to high theory. Murray Rothbard used historical data to illustrate the Austrian theory of the business cycle as applied to America’s Great Depression (D. Van Nostrand, 1963). But the skepticism about mathematics, econometrics, and regression analysis harmed the standing of the Austrian school in the eyes of other economists.

The Next Half Century Belongs to . . .

As we enter a new millennium, where do we go from here? Management guru Peter Drucker has correctly predicted that the “next economics” must emphasize “microeconomics” and in particular productivity and capital formation. “Capital is the future,” he declares.^[4] In my judgment, the Austrian school is ideally suited to play this role. With its concentration on entrepreneurship, capital theory, and subjectivism—the foundations of microeconomics—Austrian economics has a bright future and may even eclipse the Chicago school, especially if the Chicago school (as embodied in the New Classical and Rational Expectations theories) focuses too heavily on tedious mathematical modeling.

Recently Austrian economists have engaged in applied science and case studies, applying their theories to organizational behavior, marketing, finance, trade, and government policies. Granted, statistical analysis has its limitations, as Hayek pointed out in his Nobel-Prize lecture, “The Pretence of Knowledge,” but that does not validate the radical subjectivist view (of Lachmann and others) that nothing is verifiable.

Examples of Applied Economics by Austrians

Recent examples of quantitative and case studies by economists sympathetic to Austrian economics include the privatization efforts by Madsen Pirie and Eamonn Butler of the Adam Smith Institute, the currency reform measures of economist Steve Hanke, and the empirical work of historian Robert Higgs and economists Richard K. Vedder and Lowell Gallaway.^[5] George Selgin and Lawrence White have done extensive historical work on free banking, both in the United States and foreign countries.^[6]

I applaud the recent breakthrough empirical work, Economic Freedom of the World, 1975-1995 (Cato Institute, 1996), by James D. Gwartney, Robert A. Lawson, and Walter E. Block. The authors, representing both major schools of free-market economics, have demonstrated statistically and graphically a strong correlation between economic freedom and the rate of economic growth. Milton Friedman, in the introduction, echoes Mises when he states, “It did not require the construction of an index of economic freedom for it to be widely believed that there is a close relation between economic freedom and the level and rate of economic growth.” But Friedman, ever the consummate quantitative economist, contends that a picture is worth a thousand words. “No qualitative verbal description can match the power of that graph,” he concludes.^[7]

As more and more graduate students with an Austrian bent acquire skills in econometrics, I expect to see advances in applied Austrian business cycle theory. Charles Wainhouse’s doctoral dissertation at NYU was the first to test the Austrian business-cycle theory using time series, and others are following in his footsteps.^[8]

If Austrians devote most of their energy debating abstractions, I’m afraid they will remain an obscure school preaching only to the choir. As University of Georgia professor Peter G. Klein states, “If Austrians focus on metaeconomics, and try to force mainstreamers to rethink abstract issues of epistemology, we’ll go nowhere.”^[9]

Notes

1. Sherwin Rosen, “Austrian and Neoclassical Economics: Any Gains From Trade?,” Journal of Economic Perspectives (Fall, 1997), p. 139. See also Leland Yeager’s perceptive response, “Austrian Economics, Neoclassicism, and the Market Test,” pp. 153–165.
2. Letters of Ayn Rand, edited by Michael S. Berliner (Dutton, 1995), p. 326. In these revealing letters, Rand offered to serve as “unofficial editor” for Read’s publications, but she was turned down. (p. 335).
3. Robert Bangs, review of “Roofs or Ceilings?,” American Economic Review, June, 1947, pp. 482-3.
4. Peter Drucker, Toward the Next Economics and Other Essays (Harper & Row, 1981), p. 10.
5. Robert Higgs, “Wartime Prosperity? A Reassessment of the U.S. Economy in the 1940s,” The Journal of Economic History (March 1992), pp. 41–60; Richard K. Vedder and Lowell Gallaway, Out of Work (Holmes & Meier, 1993). Also see their article, “The Great Depression of 1946,” Review of Austrian Economics 5:2 (1991), pp. 3–31.
6. See, for example, Lawrence H. White, Free Banking in Britain (Cambridge University Press, 1984); George A. Selgin, The Theory of Free Banking (Rowman & Littlefield, 1988) and Selgin, Banking Deregulation and Monetary Order (Routledge, 1996).
7. Milton Friedman, “Foreword,” Economic Freedom of the World, 1975–1995, by James D. Gwartney, Robert A. Lawson, and Walter E. Block (Cato Institute, 1996), pp. vii–viii.
8. Charles E. Wainhouse, Hayek’s Theory of the Trade Cycle: The Evidence from the Time Series, Ph.D. dissertation, New York University, 1984. See also William A. Butos, “The Recession and Austrian Business Cycle Theory: An Empirical Perspective,” Critical Review 7:2–3 (1993), pp. 277–306, and Mark Skousen, The Structure of Production (New York University Press, 1990).
9. Interview in Austrian Economics Newsletter (Mises Institute, Winter, 1995), p. 7.