The Case for Austrian Economics

Great Debates
1

In this thread, John DiFool asks why we shouldn’t be talking about ‘demand side economics’ as opposed to ‘supply side’ economics. The assumption is that these are really the only two options.

I’d like to make the case for the third option: Austrian Economics.

Austrian economics used to be mainstream. Pre-depression, the economic debate was largely one between the Austrians and the Keynesians. The third major school of economics, Monetarism, didn’t come along until Milton Friedman popularized it some time later.

The Austrians lost the original debate for several reasons. One was that they couldn’t come up with a mathematical model for the economy, and their business cycle theory didn’t fully explain the great depression. The other reason was that the Austrian economic theory did not lend itself well to government ‘fixes’. At least not short-term fixes.

Keynes, on the other hand, had sophisticated models which sort-of explained what was happening, and had relatively easy answers for how to fix it. So Keynes won the day.

Later, Keynesianism had its own problems trying to explain the stagflation of the 1970’s, and Monetarism took over and became the prevailing accepted economic wisdom pretty much until the financial collapse of 2000. At that point, Keynes was the only game in town because the monetarist solution to recession could not be enacted because of the liquidity trap. Monetarists argue that you can improve the economy by loosening the money supply through lower interest rates. But if interest rates are zero, you’ve got nowhere to go. Therefore, Keynesians took the ball and ran with it. But now it looks like they’re out of bullets as well - the appetite for more deficit spending has collapsed around the world, and the stimulus spending so far has not worked as promised.

So what’s the difference between these theories and Austrians, and why do I think the Austrians are (mostly) right?

The key difference is that both Keynesians and Monetarists explicitly split macroeconomic thinking from microeconomic. Microeconomics deals with how individuals and firms respond to incentives and prices. Macroeconomics in the Keynesian and Monetarist schools deals with aggregates - they abstract away all the micro details and produce aggregate quantities like ‘K’ and ‘L’, representing capital and labor. These plug into nice neat formulas. For example, you have aggregate supply/demand curves or IS/LM model, which shows the relationship between interest rates and economic output, treating ‘output’ as a single scalar value.

But K isn’t a single number. In the real economy, capital is spread out in numerous places, according to the judgments of millions of people as to where it can be used best. Labor is not a number - it represents the skills, desires, and allocation of hundreds of millions of people. There’s no single ‘price’ that changes when supply or demand moves - there are millions of prices, all of which are related to each other, and the movement of one causes a shifting of the relationships of all.

As an example, low interest rates don’t stimulate production evenly: they bias the market in favor of projects that are interest-sensitive - capital intensive projects that take a long time to return the investment. This causes capital to flow to these projects at the expense of other uses of the capital.

Now, if low interest rates reflect the true nature of the underlying ‘real’ economy, then the shift to long-term projects is a good thing as the low interest rates indicate that capital is currently cheap due to real economic factors. But if interest rates are artificially held low by a central authority, money flows into these same projects, but the money flow is at odds with the real needs of the economy. This causes misallocations of labor and capital and ultimately hurts economic growth. Austrians would blame the Fed under Bush for doing exactly that.

And all of these things reflect a real economy underneath. The relative prices of goods results in assembly lines being built, people training for specific jobs, products being queued up in inventories, etc. When you change relative prices, all of these things are affected. Change doesn’t happen instantly. And change has cost - inventories are wasted, people lose the advantage of knowledge, assembly lines are dismantled, capital investment is destroyed.

The Austrians would say that aggregating all of this into simple numbers so that models can be applied is to abstract away the things that actually make all the difference. Macroeconomics cannot be understood without studying the microeconomic impact of macro manipulation. And since the real economy is so complex that it cannot be modeled, and the real economy operates on information not available to central planners, any attempts to manipulate it by adjusting the aggregate measures (demand, money supply) will result in destruction of real wealth.

Of course, prices move in economies all the time, and cause this kind of destruction. But when the movements come from real demand representing the true preferences of the people, it’s ‘creative destruction’ - the removal of goods and services that no one wants any more. When governments change demand or money supply by fiat, it causes destruction because prices become misleading. And when the demand stimulus ends, more destruction occurs when the economy re-adjusts itself back to pre-stimulus price conditions.

For example, consider the home ownership tax credit that just expired. It’s explicit purpose was to hold up the prices of homes. But now that it has expired, home sales and starts have plummeted. What it did was create artificial demand, which caused the relative prices of everything related to homes to change. Apartments weren’t built in the kinds of numbers they otherwise would be. Home builders and tradesmen that should have been retraining for a new career stayed in the old, over-supplied career. Home Depot ordered mixes of goods into inventory it might not otherwise have ordered. People who should not be buying homes bought them. Then the subsidy ended, and suddenly all these distortions have to be corrected. This takes time and capital that would otherwise have been spent somewhere else.

The other thing these changes do is create uncertainty. Normally, price rises signal real demand, and cause producers and consumers to change behavior. But when the government starts imposing changes by fiat, it becomes much harder to understand what prices mean. Should Home Depot hire more sales people to meet the demand for home products? Well, that depends if the demand is temporary or not. How do you tell? This raises risk, which impedes investment and employment.

Deficit spending brings the specter of future tax increases or higher interest rates, which impedes certain kinds of investment. The promise of new future regulations makes it harder for businesses to plan. A lot of business leaders are saying right now that the Obama administration has created so much uncertainty through its policies that it is impeding the recovery.

Austrian economics is on the rise again. Hayek’s “The Road to Serfdom” has been a major seller at Amazon for the past two years, and briefly hit #1 in all books a while ago and remained in the top 10 until the publisher ran out of books. Last year’s Nobel Prize in economics went to Elinor Ostrom, who did a very Austrian-influenced study of how people organize in the absence of government. Several world leaders such has Vaclav Klaus are explicitly Austrian in their outlook. Furthermore, advances in mathematics, especially in information theory, complexity theory, and chaos theory, are shedding more light on the insights of the Austrians and opening the door to study of Austrian theories.

Neither Republicans nor Democrats really like the Austrians (although Republicans often pay lip service to Hayek). Both sides desire economic theories that give them the rationale for government intervention. Hayek would not be a ‘supply sider’, because he would have seen artificial inducements of business to be just as destructive as Keynesian inducements of demand.

A true Austrian leader would respond to many economic ‘problems’ by saying, “Hey, government doesn’t have the tools to fix that. Government will provide stability, ensure the proper functioning of markets, provide some social programs, and that’s about it. You figure out the rest.” That’s not what people want to hear, so politicians instead promise to fix their problems through stimulus, or through business subsidies, or by lowering interest rates or adding/removing regulations. In short, top-down imposed change. Austrians would disagree with most of it, unless they could be convinced that the need was so dire that the cost of change to the underlying real economy was worth it.

Finally, I’d like to point out that Austrians are not anarchists or even Libertarians. Hayek believed in a wide swath of government programs and regulation. Not as much as we have today, but certainly more than most libertarians would like.

If you’re interested in reading more about the Austrians, I recommend Econlib.org, the library of economics and Liberty at George Mason University. This is probably the largest collection of Austrian economists in the world. I also highly recommend the EconTalk series of podcasts, which are very fair discussions of economic theory from a mostly Austrian perspective, but where they are willing to criticize Austrian theory where appropriate and give due to other schools of economics as well. There are also some great discussion there with non-Austrians such as Paul Romer, and non-economists such as Mark Helperin, and nobel prize winning economists like Vernon Smith and Gary Becker. All presented in a very layman-friendly way.

Any questions? Would anyone like to debate this?

2

First, I don’t know much about economics.

Now, it interests me how you show the last century or so to be a competition among different schools of economic thought. Austrian solutions became obsolete after the Great Depression. Stagflation led to the loss of credibility of Keynes in favor of Monetarism. Monetarism fell before the liquidity trap. Now, the the Austrian school is resurging once again, in response to the last decade’s economic problems that are not being solved with Keynesian methods.

So my question(s) is, if there is adoption of Austrian principles to the extent that Keynes is embraced today, what is preventing this cycle from continuing? What is preventing another crisis like the Great Depression that makes everyone abandon Austrian economics again? You mentioned a “dire need” that could convince Austrian proponents to enact top-down solutions, could you expand on that a little?

Thanks

3

Starting with the last question first.

No.

But it has to be done anyway, like when people show up who think gold is magic. It’s a harmful belief, just as it would be harmful if doctors prescribed poison instead of medicine.

Austrian Business Cycle Theory still, to this day, doesn’t explain the Depression. You need at least a partially Keynesian answer to explain 1933 and 1937 and the situation after the war, whereas ABCT hasn’t really changed in its essentials in 70+ years. The Austrians created the first theory of the business cycle, then almost immediately stopped producing any macro-theory that was of any use at all.

And why? Precisely because Hayek and the others refused to follow their own thoughts to their logical conclusion. I mean, hell, von Mises himself talked about the costs of high real wages. This means, directly, that there is a cost to sticky nominal wages in a time of deflation like the Depression (sticky wages + deflation = higher real wages). This little logical deduction should be simplicity itself for any economist. The pain of sticky wages should lead directly to old school monetarism, at the very minimum, for people brave enough to follow their own ideas wherever they may lead. But no, their fanaticism meant that they refused to consider the clear deductions from their first principles. It took braver souls to follow the road to its logical end.

Beginning to end, this is all a huge oversimplification to the point of error. I’m not going to write a history of 20th century macro, so I’m just going to focus briefly on the money.

Monetarism, in the Friedman sense, has not yet been tried for the current crisis. The M3 has been dropping, just as the money supply dropped in the Depression. You can’t say something has failed when no one is actually following Friedman’s advice of constant money supply growth. That’s why some people, even some libertarians, are getting so upset with the Fed and the ECB.

This is just wrong. New Keynesianism, for one, is explicitly built right on top of microeconomic foundations. You can do the same for Monetarism, which is partly Keynesian in underlying structure (as it has to be, in order to explain the Depression).

This urge for microeconomic roots, a Grand Unified Theory of economics, is actually one of my chief criticisms of modern macroeconomic theory. They ought to let the micro stuff go for now and get the macro picture better worked out.

Ah yes. It’s like Cambridge Capital Controversy all over again. This is the key problem. This is the heart of the controversy. This the meat of your objection.

This objection is utter and complete nonsense.

We can understand a lot about chemistry without knowing about quarks. We can understand the theory of evolution even without DNA. Darwin didn’t know genetics, and Gregor Mendel didn’t know the underlying causes of dominant and recessive traits. That did not cast their work out into the void of the imponderable. Evolution was well accepted before Crick and Watson, by people who were willing to look at the evidence dispassionately without the bias of their religion.

Some core ideas of macroeconomics are extremely well established. The effect of a dramatic increase of the money supply in order to pay government bills isn’t in dispute at all among the Austrians. They know what hyperinflation is, and what causes it. They understand the big macro equations just fine whenever they wish to, whenever the conclusion is favorable to them. This is the source of their stunning hypocrisy. It’s not that the Austrians claim that we’re ignorant of macro effects in general. Rather, they claim we’re ignorant of the macro effects of anything that runs counter to their ideology.

Well, piss on that.

All of this “boo-hoo-hoo, we don’t know anything so let’s follow my preferred form of government” is just empty posturing, engaged in solely when their normal arguments fail. It happens like this every time, but the line of our knowledge is emphatically not where the Austrians like to say it is. We have some holes in our theories, sure, but we still know an awful lot. You could call this a New Monetarist graph, and it makes the point a thousand times over. This is the correlation between industrial production and real wages (inverted) during the Depression. This is a macroeconomic correlation. All of those different individuals, all of those different machines, all doing their own thing, and yet their behavior matches up so damn well it’s astonishing. To deny this is not any kind of bold epistemological statement. It is, rather, a vote for willful ignorance, of ignoring clear evidence in favor of believing whatever you wanted to believe in the first place. It is completely intellectually vacuous.

To understand the micro behavior better, to fully discover the economic DNA that makes the big theories work, would be nice. We should research it further. But it’s ultimately not necessary to do that in order to understand the macro essentials. We understand gravity well enough to get ourselves to the moon, even without a Grand Unified Theory of physics. We understand macroeconomics with significantly less precision, but still well enough to shorten the length of the average recession (that is, excluding supply shocks) with the right economic policy.

This is what Paul Krugman calls the confidence fairy argument. It is based on utterly nothing.

We can actually measure confidence in many ways. And there was an awful lot of certainty, not uncertainty, when the economy went sour. It was a certainty that nominal GDP was about to make its biggest drop since the Great Depression. And guess what happened? The economy went into the shitter in the biggest drop since the Great Depression. That’s certainty, right there. It’s a certainty that things are going to hell.

Right now, we can look at bond yields dropping again. That’s more certainty. It’s certainty on the part of investors that the economy sucks, so they might as well buy the safest thing they can. Well, this whole thing can be turned completely around. Put out more money, increase its velocity, provide a touch higher inflation, and people will know for certain that there are dollars bouncing around out there. Businesses will know for certain that new opportunities are coming. Increase nominal GDP expectations, and there will be certainty in the markets that recovery is coming.

And that will itself lead to recovery. Certainly. No magical confidence fairies required.

Great book.

Irrelevant book with respect to macro theory.

As I recall, Road to Serfdom has no defense at all of Austrian Business Cycle Theory in it. It’s not even really a critique of a European-style mixed economy. It is, instead, a killer critique of a totally socialized economy, like the Soviet Union, or more generally, of any economy that is deliberately heading in that direction. Great at what it does, but it does not offer any real grounds for comparison to any established macro theory. Its recent surge in popularity nice and all, but it still isn’t going to provide its readers with a perspective on today’s big policy questions.

And while we’re talking about George Mason, let’s link GMU professor Bryan Caplan’s essay “Why I am not an Austrian”. Caplan is an extreme libertarian, an anarcho-capitalist. He is, thus, somewhat out of touch with reality. Still, he has a certain sort of clever going for him and he gives ABCT the right wholloping that it deserves.

The Austrians did their good work getting business cycle investigation started. Then their work got outdated, largely because they refused to learn more when the investigation was leading to places they didn’t want to go. Willful ignorance, always and forever. There should really nothing more to discuss. Goldbuggery, Austrian econ, “full-reserve” banking. They’re all zombies, dead and yet still walking around. They should be put out of their misery, instead of being continually reanimated by naifs and zealots and ideologues.

4

In your long note, this sentence is the worst one. Adjusting the “nominal” terms of wealth doesn’t affect “real” wealth. True wealth and progress is dependent on real land, real ideas, real innovation, real productivity increases. Adjusting the monetary base only appears to work because it depends on fooling people psychologically to chase after “profits” that don’t really exist (e.g. housing bubble).

We could increase the “nominal” measure of a company’s stock such as doing a 2-for-1 stock split. Does that numerical slight-of-hand magically mean the company is financially stronger? Does that nominal adjustment mean their employees that own stock have suddenly become smarter or more competitive in their industry?

You mock people who think “gold is magic” and yet this same analysis doesn’t apply to currency manipulation?

Have you run a business?

5

Wait, how is that a “third option”? Supply-side economics is a version of Austrian School economics.

6

No.

It is, rather, the most counter-intuitive sentence to people who don’t understand the effects of sticky wages combined with deflationary conditions. The thing to keep in mind is that a sick economy works differently than a healthy economy, and they require different approaches. You don’t treat a patient with hypothermia the same way you treat a patient with severe burns.

Normally not. Except when it does. That is, during periods of insufficient aggregate demand due to people hoarding currency instead of making purchases and investing.

You are repeating fallacies from the Great Depression era. You are making mistakes that are more than 70 years old. The single most effective thing that FDR ever did during the New Deal wasn’t his works projects, but instead the decision to drop the gold peg, which increased both nominal and (as a result) real GDP. This is not a point of contention–it is a matter of economic consensus. I can cite people from the entire spectrum on this one, from libertarians like Milton Friedman to Keynesian liberals like Christina Romer, chair of Obama’s council of economic advisors. They speak with one voice on this matter about dropping the gold peg, increasing the money supply, causing a bit of inflation, increasing nominal GDP: this decision was the single most important factor in recovery from the Depression.

This is Scott Sumner’s FAQ on the issue. He’s what you might call a New Monetarist. In his words, “The real problem is a nominal problem.” The FAQ is concise and might be too technical, but I can answer questions.

This is my own thread on the subject. Long, and also technical. I don’t want to repeat myself, but I can clarify anything that is unclear.

7

I already read that when you first posted it. That whole post hinges on the belief that money (in nominal terms) drives the economy.

Ah yes… this concept of “hoarding” and other related fanciful phrases such as “liquidity trap.”

People (and businesses, and banks) don’t hoard their currency because the want to sew dollar bills together as blankets to keep themselves warm or glue them on walls as wallpaper. They hoard dollar bills because they don’t see real investments or real wealth opportunities.

Dropping the gold peg has several benefits but it’s wrong to say it is the single most important reason for economic recovery. What makes the analysis confusing is that we don’t have (and didn’t have) the technology to concretely measure the additive ideas and innovation of the people. (Measure continuous brain scans? Measure average thermodynamic output of a large group of humans?) We can’t reliably put direct quantifiable numbers on the disparity between Europe innovation and productivity and America’s. As a crutch, we use GDP as measures and therefore, we mistakenly believe money (the money amount is baked into GDP calculation) solves the problem.

8

Love the thread. Please keep it going. All of my favorite posters are here and contributing. A rarity on the SDMB. If Measure For Measure would chime in, we’ve have a full house.

I enjoy Hellestal’s posts a great deal. Smart guy, lots of data at hand. Good debater. I’ve learned a lot from him.

But he definitely falls into the

“Let’s put a dozen-or-so really smart guys in charge of dialing up, or dialing down, the fiat money supply and fiscal policy. People putting their own capital and resources at risk, along with a private market for money can’t be trusted to avoid booms and busts. Only enlightened technocrats can do that.”

“We didn’t know everything we needed to know before the Great Depression, or even just after the Great Depression, or maybe even after WWII, or maybe even up until the pre-Volcker era. But now we’ve got it figured out.”

Definitely comes across as an ivory-tower type. Not as if that’s a bad thing. Some of my best friends are ivory-tower academics.

I like the debates because I’m still noodling through an optimal transition off a fiat-money supply and fractional-reserve banking system and I’m not there yet. I don’t agree with Rothbard’s proposal at the end of “What Has the Government Done With Our Money?” That is, a proposed transition that wouldn’t cause enormous social upheaval and result in a President and Congress that is worse for economic and job growth than we have now. Which would take some doing.

9

I’m not sure that you’ve really made a case for the Austrians, Sam. About the best thing the Austrians seem to do is say why nothing else is going to work – and of course anytime something doesn’t work, that certainly makes them look good,. But really that’s sort of the same thing as psychics drumming up their hits; it doesn’t really prove that they knew what was upcoming, and certainly isn’t evidence that if you buy their Magic Rock that good things will happen in your future.

Ultimately, economics has to serve as a tool for humanity. If you can’t make any practical suggestions, then your school of thought it useless regardless of whether you bat 50% or 100% at shooting down every other school’s suggestions. So far as I can tell, the only proposed model for anything that’s come out of the Austrian territory is the business cycle theory, which hasn’t shown any relationship to reality. Unless they have something to offer beyond critique, there simply isn’t any there there. A case against everyone else isn’t a case for Austrian.

10

I specifically left business-cycle theory out of the discussion, choosing instead to focus on more core insights of Austrian theory - the inadvisability of abstracting away the complexity of the real economy in particular.

As someone who works in industrial engineering, I have a deep appreciation for this kind of complexity, which draws me towards the Austrian theory. I know what it takes to build up an enterprise to the point where it has found a market and structured itself to provide goods to that market, and it drives me a little mad when I hear politicians and academic economists talk about manipulating the economy through the money supply while totally ignoring how that affects the extremely complex structures that depend on the information that comes from prices.

I’m not sure why you brought up the gold standard. Hayek didn’t support the gold standard, and neither do I. Hayek called it “an irrational superstition”. He WAS in favor of stability of the money supply, and felt that intentionally manipulating the money supply to manage the economy led to bad decision making and ultimately a weaker economy. I think he was a little more favorable to monetarism, because the goal of monetarism was price stability. He was skeptical that monetarists could know enough about the economy to know what a stable price was, but in theory both had the same goal of making sure prices reflected the underlying reality of the real economy. Both Keynes and Friedman wanted to take control of the money supply away from the whim of regulators. Friedman’s idea was to make it calculable using a formula so there would be no personal judgment involved. Hayek didn’t really have a great plan for this, so far as I can tell. He waffled between various mechanisms.

Hayek felt that one of the problem with Keynesianism and wages was that in an explicitly Keynesian world, labor unions would figure out that they could push for hgher wages, and the Keynesians would make that work for them by increasing the money supply to prevent loss of demand. But this was in an era of high rates of unionization, when the unions were very powerful. I don’t know if he’d modify his thinking today.

And yet both base their theories on statistical analysis of aggregate measures which explicitly abstract away the complexity of the underlying economy.

Actually, I would say that Hayek and the Austrians would probably scoff at the idea of a ‘grand unified theory’ of the economy in the same way that they’d scoff at a grand unified theory of exactly how the world ecosystem works. It’s a complex, chaotic system that cannot be modeled and predicted.

An economy is a hell of a lot more complex than a chemical reaction.

And yet, if your knowledge of evolution caused you to decide to manage the evolution of an ecosystem by mucking about with the ratio of species and trying to manipulate the environment to make the ecology ‘better’, how do you think you’d do?

It’s one thing to observe that the output of a complex system can be measured, or that when aggregated certain relationships can be determined. It’s quite another to go from there to assuming that you can manipulate those measures and effectively control that system in meaningful, efficient ways.

It’s not hypocrisy because they aren’t claiming that these relationships don’t exist, or even that they can’t be manipulated. Their argument is that there are unseen costs to that manipulation, and by abstracting away the details of the real economy, Keynesian economists ignore that.

Let me ask you something - let’s say we did an experiment whereby we took an economy and inflated the money supply by X. Then some time later, we deflate the money supply to return it to its previous level. Will you get the same economy back? Will the level of overall production return to what it was before? Will GDP go back roughly to where it was? Will prices return to the level they were at?

I’d like to know how you’d answer that.

Again, you confuse being able to aggregate and see relationships with being able to control the underlying, complex system that produces those relationships.

Again, you are using inappropriate analogies. Gravity is a very simple thing compared to an economy. I think this is the mistake modern economists make - they want to believe they are scientists who can use the same tools scientists and engineers use, and they can control the levers of an economy as if it were a machine that can be manipulated with a few variables.

No one disputes that you can increase prices by inflating the money supply, or that you can stimulate aggregate demand or constrain it in the same way. Of course dumping a bunch of money on people will increase temporary demand. What’s lost, though, is what this manipulation is actually doing to the underlying structure of the economy, to the billions of connections firms have to each other through prices, to the distribution networks and supply chains, the competitive relationships between companies, to the ability to use prices to accurately determine the relative supply and demand of goods to each other.

At what cost? So you shorten the recession, but at the end you have twisted the economic relationships of thousands of companies and made it harder for people to plan. You’ve injected moral hazards through bailouts, injected additional planning risk by making it impossible to know what future interest rates will be, you’ve caused good firms to go out of business and bad firms to ‘win’ because stimulus money didn’t flow evenly throughout the economy, you’ve caused some sectors to build up more capacity than they really need because they mistook stimulus-driven demand for real demand. How much economic growth does this cost? At what point does it become self-defeating?

You know, for someone who is supposed to understand the nuances of economics, you sure make a lot of very angry, very certain statements. As does Paul Krugman.

What they won’t know ‘for certain’ is whether those dollars now tell them that the economy is healthy, or whether they represent an adrenaline shot to a fundamentally unhealthy heart. So what do they do with all that money? They sit on it. Businesses are sitting on 2 trillion dollars in capital right now. They’ve got money. They don’t know where to spend it, because they don’t know the rules any more.

Yeah? And how are the predictions for that recovery working out so far? We have one Keynesian, Christina Romer, who stuck her neck out and actually made real predictions based on what we were told were very good models of the economy . She was wildly wrong. Can you explain what went wrong with her models? She promised unemployment below 8% with the stimulus. Why didn’t that happen? If these aggregate measures are so easy to manipulate, and the multiplier predictable with such precision (two decimal point!), how come the result was so far off? And what happened to the Keynesian’s prediction of a ‘V’ shaped recovery? Given low interest rates, Quantitative Easing, the stimulus, and 1.6 trillion dollars in deficit spending, home come the economy didn’t come roaring back like a freight train? Oh yeah, because Saint Krugman said the stimulus should have been even larger. Because an extra trillion on top of all this would have made all the difference.
The effect of uncertainty is unappreciated by some economists, possibly because they’ve spent their entire lives in academia and have no appreciation for what it takes to actually run a business, or the thought process that goes into making decisions about investment.

Economists are quick to jump on people who have opinions about economic policy without degrees in economics. But when business leaders try to tell them what they are doing is wrong or that they are creating conditions that make it hard for them to do their jobs, they are quick to dismiss them as irrelevant.

Yes, even Keynes liked it. In fact, Keynes told Hayek that not only did he agree with the book, but that he was “profoundly, morally in agreement with it.” I have to wonder what Keynes would think of the way his theories are being used today to grow the size of government.

I agree that it’s not a macro theory book. I brought it up as an example of the resurgence of Hayek in particular, which is also causing Austrian economic theory to make a resurgence of sorts. I predict we’ll hear even more about it as the latest round of Keynesian policy shows its limitations.

There’s a lot more to Austrian economics than business cycle theory.

No. It’s a description of how a mixed economy can be driven towards a completely socialist economy through pressures caused by its own interventions, which inexorably lead to more interventions. If it was about purely socialist economies, it would have been called “Serfdom”.

Oh yes it does, because it highlights the unintended consequences that occur when you muck about with the economy.

I just listened to an interview with Caplan the other day, and he said he was starting to think that perhaps he dismissed the Austrians a little too cavalierly.

Nice for you to lump Austrian economics with those other theories as if they were related. Nice smear tactic.

11

The Austrians would say that the fact that there are no easy answers is not an excuse to pretend there are.

Economics does not have to serve as a tool for humanity in the sense that it must be prescriptivist and tell you how to do things. It’s perfectly acceptable to study economics in an attempt to understand the economy and even make predictions about it, and quite another to say that now that you know a little bit about it, you should start intervening in it willy-nilly to make it ‘better’.

An an analogy - we have some pretty good weather models that help us predict storms and temperature trends. But we have the good sense to not use that model to try to control the weather, because we understand that while the outputs of weather systems can be measured and are even somewhat predictable, the outputs are chaotic in terms of inputs. We might be able to get a bit of local control through cloud seeding and whatnot, but we wouldn’t dream of doing something like choosing to minimize hurricanes by removing moisture from the air because our models show that hurricanes are more likely when there is a high relative humidity. We understand that we really don’t know the consequences to world weather patterns when inputs are changed, even though we can measure the outputs and observe patterns and relationships between aggregate values.

12

Unless there is a course of action to follow based on those forecasts, it’s meaningless. If I forecast a storm, then people know to stay inside or take an umbrella. If I forecast a recession…well great, so what are people expected to do?

13

Well, one answer is not to do the equivalent of praying to the weather gods. Taking wrong action because you don’t know the right action is not going to solve your problem, and will likely make it worse.

I’m not suggesting that modern economics is a religion or devoid of insight or anything like that. I’m not even saying that interventions in a real crisis are not warranted. I suspect even Hayek would have supported efforts to fix the fiscal meltdown, at least to the point where the economy was functioning again and grain barges weren’t sitting in docks because money wasn’t moving.

Maybe the best insight the Austrians can give us is to have a little more humility about what we do and don’t know about an economy, and to act accordingly - something Paul Krugman could use a little more of.

14

That mindset is fundamentally at odds with the incentive and reward system in academia and government.

But business leaders, who must be held accountable on a real-time basis for their decisions, admit it all the time.

15

I think this is one of the fundamental problems with Austrian economics; their theory doesn’t explain why the price mechanism is supposed to be optimal or even moderately effective in all markets. How do we know prices reflect underlying preferences and technology well? For example they may simply reflect monopoly power. For example suppose we have an industry with a dozen competitors competing fiercely with each other keeping prices roughly at marginal cost. Then suppose these companies merge and (in a world without competition policy) there is only one firm which dominates the industry and uses its monopoly power to ramp up prices. The underlying technology and preferences haven’t changed; prices have increased because of an increase in monopoly power and there is no efficiency-enhancing signal conveyed by the new price compared to the old.

Or you could have a scenario where prices, perhaps in asset markets, are being driven by a speculative fad rather than fundamentals. Historically this has happened many times in history from the South Sea bubble to the recent sub-prime bubble. Again it’s not clear why the price mechanism is doing a good job of efficiently allocating resources. Was the Nasdaq allocating resources efficiently to startup firms in 1999? Were the bond markets doing a good job of allocating resources to the housing sector in 2006?

In the real world there are all sorts of reasons why markets might fail: increasing returns, monopoly power, asymmetric information, asset-price bubbles all of which can arise from the “spontaneous processes” of the market. If these market failures are sufficiently large it makes sense for the government to intervene. Austrian economics doesn’t provide a guide about when the government should intervene and when it shouldn’t.

Furthermore I am not terribly impressed by the Austrian arguments about the “complexity of markets”. Again complexity doesn’t mean effectiveness. And neither do we need perfect insight into a complex entity to intervene. The human body is complex beyond our understanding but this doesn’t mean modern medicine can’t intervene effectively when necessary. The earth’s environment is extremely complex and yet pretty much all of human civilization from farming to industry to cities involves shaping the environment to our benefit.

16

Yeah, not from my experience. You’ll notice that you don’t find error bars in quarterly reports.

17

I agree with most of what you say but most of this is STILL mainstream economics.

Just as all politics is local, all economics is micro.

Doesn’t mean that you can’t use macro analysis.

It brings more than a spectre of one of these things.

So is anti-semitism, what’s your point

and do you prefer the lip service over honest disagreement?

Too often the Austrian response is “do nothing” the market will sort itself out, heck the great depression would have sorted itself out in the long run. And Keyne’s response was “in the long run we are all dead”.

He was a non-interventionist which is not that much different.

To be fair I haven’t taken a good look at this stuff since college. I should read this stuff again.

18

BTW I think one point that is important to remember is that “Austrian economics” isn’t a serious part of economic research today. It used to be until around the 1930’s but after the war it re-emerged more as an extension of libertarian ideology than a serious school of economics.

One clear sign of this is the high degree of ideological uniformity among people who call themselves Austrians. I don’t know a single Austrian who is not a libertarian or conservative. By contrast mainstream neoclassical economists come from a wide range of political perspectives ranging from near-libertarians to near-socialists.

Secondly there is very little empirical work done in Austrian economics. Mainstream economic research produces an enormous number of empirical papers which try to test competing theories using real-world data. Austrian economics consists almost entirely of verbal theorizing without subjecting the theories to any kind of systematic empirical testing.

Finally there is not a whole lot of new ideas coming from Austrians. Most of their big ideas come from people like Hayek and Mises who wrote 60 or more years ago. There is just not a lot of serious university research done by Austrians. They have a much bigger presence in libertarian think-tanks than in the best research universities. For the most part they are just re-hashing the same ideas again and again without persuading anyone who doesn’t already share their ideology.

19

Austrians don’t assume the economy is perfect. They don’t assume that prices are always exactly efficient. Hayek himself was in favor of government intervention to correct market failures. But these are micro decisions. If you can show that a market has failed because information asymmetries or because of monopoly power, he would advocate regulation to correct that market. He was in favor of social programs for the poor as well. Ayn Rand hated Hayek. She thought he was dangerous because he was still willing to intervene in the economy when necessary.

But aside from specific failures, Austrians see the economy as being a problem of coordination. How do you connect producers and sellers together? How do you allow people with disparate pieces of information to find each other and work together? How does capital find the most efficient uses? The Austrians say that it’s the price system that does this. Prices transmit information. The process of bidding creates information. The number of bits of information contained in the price system of an economy is staggering. But more importantly, prices cannot be examined to determine the why of things. All you need to know as a producer is what someone will pay for your product. You don’t need to know why they need it. This is actually what makes the price system efficient as an information transmission device - it tells you everything you need to know to allocate your own resources, but no more.

So the relative prices of all the goods and services in an economy are what allow us to coordinate and direct resources in optimal fashion. Not perfect fashion, but in the best way we know how.

And yes, prices get distorted. Part of the reason for the bubble last time around wasn’t just low interest rates from the fed, but a glut of capital available from China. Irrational exuberance can happen. Manias can happen. Natural disasters can happen. Lots of things can shock the price system in temporary fashion. The point is that these shocks cause damage. They destroy information, they cause coordination to be more difficult. It doesn’t have to be just government action.

These are specific areas of inefficiency, no doubt. But the economy is a hell of a lot more than that. The fact that you can walk into a grocer any time you want and be assured that there is food on the shelves, of the general variety you like, at prices that represent close to the marginal cost of making and delivering those goods, is evidence that the price system works very well. The fact that people from many countries can coordinate their activities to create a car or a television without even knowing of the existence of each other is evidence that prices work very well.

We tend to talk about high finance and big failures and aggregate measures because they are big and draw the attention of us all. We look at the big trees in the forest, and forget that 90% of the ecology is managed by the things scuttling around at the bottom. Even in recessions, we generally have access to the things we need, in the quantity and variety that we need them, at prices that represent the most cost-effective way of getting them to us. We don’t over-produce much. Many businesses operate on just-in-time inventories.

The more you dig into this stuff, the more you appreciate the complexity and beauty of what’s going on. Even within a single company, the amount of information that is collected and analyzed to optimize production can be staggering. Business plans can carry hundreds or thousands of pages of supporting analysis of markets and supply factors.

Follow a supply chain from one business through one or two more levels of supplier and you’ll find it spiderwebs throughout the world and involves hundreds of thousands of people. When you consider the interrelations between all these companies and the then between all the other companies that have their own networks of supply, the complexity gets staggering - it’s well beyond anything any government planner could ever hope to manage. Reducing all this complexity down to a single aggregate causes you to lose much of what really matters in an economy.

Maybe so. The problem is that government lacks the tools to intervene in efficient ways. I’m not saying, and the Austrians didn’t say, that government should never intervene. But you need to understand the limits of government control, and understand that interventions cause damage. In the best case, you might cause less damage than would otherwise be caused without intervention. I believe that’s the case with the original TARP program and some of the other emergency monetary measures Bernanke took to keep credit markets from seizing up.

But it’s a long jump from there to the point we’re at now, where government leaders think that low growth by itself is justification to start selectively injecting trillions of dollars into the economy at the whim of politicians beholden to special interests. And it’s sheer arrogance to think that you can predict how an economy will respond to that with such accuracy that you can model a ‘multiplier’ to two decimal places.

Neither does any other economic model. That becomes a political decision. Keynes himself was not in favor of demand-side counter-cyclical policy, which is what the politicians want to do now. We’ve gone a long way from pure economics here - the debate is now between political forces who use simplified versions of economic theories to justify whatever the hell they want to do, and they manage to find enough partisan economists to back them up.

So you’d be okay with, say, manipulating genes and stem cells willy-nilly and injecting them into people? That’s more akin to what we’re talking about - trying to control an extremely complex, poorly-understood system from the top down. Modern medicine is slowly getting there, but we’re still not at the point where we’re comfortable tweaking our DNA to eradicate problems or injecting engineered stem cells into the body. There are too many unknown interactions. Even drug therapy, which happens at a much higher level, doesn’t get approved until there have been decades of trials. And even then, 90% of drugs are rejected, often because they created side effects that weren’t intended and weren’t predictable.

How successful do you think our drug research would be if we had to just guess whether a drug would work based on a model, then release it into the wild with no controls, no trials, no experiments? That’s what we do with the economy. We have no control economies to measure against. We have no way to experiment with policies in a scientific fashion. All we can do is build a model, devise an intervention, and unleash it. And afterwards we can’t even evaluate the result to determine if it was the right thing to do, because we don’t know what the system would have done in the absence of the policy. There’s no control economy to measure against.

If we had to deploy drugs that way, we wouldn’t do it. We wouldn’t have made much progress in drugs at all.

Again, we shape it at a small level, but environmentalists will tell you there are all kinds of unintended consequences. I assume you’ve heard of the precautionary principle? It says that you shouldn’t muck about with the environment because you can’t predict the outcome. Global Warming’s big risk is that we don’t know what a rapid rise in temperature will do to the ecology, because it’s too complex for us to understand all the feedback mechanisms. Global Warming modelers try to predict what will happen, but their predictions are given within a range of some pretty big error bars. And the weather system at the level they’re trying to model is nowhere near as complex as a modern economy.

20

For a non-serious school of economic thought, there sure are quite a few Ph.D Austrian economists around. Some of them with Nobel prizes.

And while I don’t think Austrian economics is going to come back in its totality, and that there are in fact some serious flaws in aspects of it, I think what is happening is that a lot more economists are realizing that the Austrians had some core insights that were valuable and dismissed too readily in the frantic days of the Great Depression, and that certain aspects of Austrian theory will inform other branches of economics.

Also, one of the reasons Austrian economics was dismissed was because it wasn’t amenable to the math of the day. Austrians couldn’t produce nice neat models like the Keynesians and Monetarists could, and that caused them to be disparaged as non-scientific back in the day. But modern mathematical tools may be brought to bear on Austrian ideas, and we’re gaining a lot of new appreciation of complexity and information through chaos theory, complexity theory, network theory, information theory, and the like. We still may not be able to build complete models of an economy, but we can gain an appreciation for how a stable system can have chaotic responses to inputs and still remain stable, and how difficult problems of information management can be.

That’s not fair. Saying that ideological uniformity in favor of free markets is a sign of ‘flakiness’ of Austrian economics is like saying modern medicine is a cult because modern doctors uniformly don’t believe in illness being caused by bodily humours or evil spirits. In other words, if the philosophy or science indicates that there is a preferable path, you’ll find most people who believe in it to be on that path. I don’t see that as a failing at all.

I’m not sure your statement is correct anyway. Do you know any libertarian Keynesians?

Again, part of the reason is that Austrian economics by its nature doesn’t lend itself to simple models and statistical analysis of those models. But I do have to point out that last year’s Nobel Prize went to a person who is a very famous empiricist who came to some very Austrian-friendly conclusions in her work.

How familiar are you with the work of current Austrians? What evidence do you have for that statement? Again, I would suggest that Elinor Ostrom’s work that won the Nobel last year could reasonably fit into the category of research that expands Austrian theory, even if she herself isn’t explicitly an Austrian economist. I also think that much of the work that could ultimately used to expand Austrian ideas is being carried out in other fields like computer science and chaos theory.