Austrian Economics

‘in any issue of any journal there’s a lot of crap ..’ (Robert Lucas, 1984) Austrian Economics ‘there is no Austrian economics - only good economics and bad economics’ (Milton Friedman, 1976) ‘I could verify the existence of witches if you give me the chance every other year to tack on some variables in the regression’ (Robert Solow, 1984)

Congratulations on your profile The profession has been criticised for its adherence to models of a free market that claim to show demand and supply continually rebalancing over relatively short periods of time – in contrast to the decade-long mismatches that came ahead of the banking crash in key markets such as housing and exotic derivatives, where asset bubbles ballooned. Members of the Post-Crash Economics Society said their course was dominated by models and equations that trained undergraduates for City jobs without a broader understanding of the way economies and businesses work. (The Guardian, 11 November 2013)

Congratulations on your profile The profession has been criticised for its adherence to models of a free market that claim to show demand and supply continually rebalancing over relatively short periods of time – in contrast to the decade-long mismatches that came ahead of the banking crash in key markets such as housing and exotic derivatives, where asset bubbles ballooned. (The Guardian, 11 November 2013) ‘For forty years I have preached that the time to prevent a depression is during the preceding boom; and that, once a depression has started, there is little one can do about it. My advice was completely disregarded as long as the boom lasted. Now suddenly, when my prediction has come true and we have reached the stage where ... little can be done about the inevitable reaction which has set in, people suddenly turn to me and ask for my opinion.’ (Friedrich Hayek, 1975)

Krugmanism

Plus ça change? Albert Einstein 1842 - 1924 Carl Menger 1840 - 1921 ‘A researcher who … takes his departure from arbitrary axioms … falls necessarily into error, even if he makes superior use of mathematics’ ‘Not everything that can be counted counts, and not everything that counts can be counted.’ Pick up a test paper, and remove the words ….

Plus ça change? Though a skilled mathematician, he used mathematics sparingly. He saw that excessive reliance on this instrument might lead us astray in pursuit of intellectual toys, imaginary problems not conforming to the conditions of real life: and further, might distort our sense of proportion by causing us to neglect factors that could not easily be worked up in the mathematical machine Marshall followed the rule that • one should use mathematics as a shorthand and not as an engine of inquiry; • one should keep to the mathematics until it is done; • then translate the mathematics into English; • then provide an illustration of the point with an important real world example; • then burn the mathematics; and • if you cannot succeed at (4) then burn (3) (A C Pigou on Alfred Marshall, 1925 ) Alfred Marshall 1842 - 1924

REF-2014 research evaluation framework ‘Internal preparations for REF-2014 reward disciplinary orthodoxy by resting upon the evaluations of a single reader per Unit of Assessment and by expecting each member of staff to fit within the narrative of that Unit’ ‘if you know economics and nothing else, you will be a bane to mankind, good, perhaps, for writing articles for other economists to read, but for nothing else’ (Friedrich Hayek, 1944)

Austrian School Carl Menger (1840-1921) Friedrich von Wieser (1851-1926) Eugene Böhm-Bawerk (1851-1914). Ludwig von Mises (1881-1973) Friedrich Hayek (1899-1992) Contrast with classical labour theory of value: David Ricardo (1772-1823) John Stuart Mill (1806-1873) Karl Marx (1818-1883) http://library.mises.org/books/J246rg%20Guido%20H252lsmann/Mises%20The%20Last%20Knight%20of%20Liberalism.pdf 107 ff

Austrian School Austrian approach: (dynamic adjustment to shifting equilibria) marginal subjective evaluations (variable with circumstances) Anglo-Saxon approach: (static equilibria) marginal utility (inherent in the commodity) inter-personal comparisons optimality based on known knowns Pareto optimality

Historical School vs Austrian School Concerns how might the state promote welfare wary of laissez-faire lessons from history rather than theory Gustav Schmoller 1938 - 1917 Concerns analytical science: general propositions human action drives market phenomena subjective values drive choices Carl Menger 1840 - 1921

Historical School vs Austrian School Concerns how might the state promote welfare wary of laissez-faire lessons from history rather than theory J M Keynes 1883 - 1946 Concerns analytical science: general propositions human action drives market phenomena subjective values drive choices F A Hayek 1899 - 1992

Austrian School ‘In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again’ J M Keynes 1883 - 1946 ‘Are we not told that ‘since in the long run we are all dead’, policy should be guided entirely by short-run considerations? I fear that these believers in the principle of après nous le deluge may get what they have bargained for sooner than they wish’ F A Hayek 1899 - 1992

J M Keynes vs F A Hayek ‘It is an extraordinary example of how, starting with a mistake, a remorseless logician can end up in Bedlam.’ J M Keynes 1883 - 1946 ‘‘Mr Keynes aggregations conceal the most fundamental mechanisms of change’ F A Hayek 1899 - 1992

Austrian School Hayek: ‘Economics and knowledge’, Economica (1937) Hayek: ‘The Pretence of Knowledge’, (1975) Henry Plotkin: The Nature of Knowledge (1994) Paul Ormerod: Why Most Things Fail (2005)

Austrian School aversion to the pretence of knowledge (what and to whom?) the insistence upon mathematical precision decision-making cannot be reduced to differential calculus choice is a costly experiment entrepreneurship achieves greater economic coherence prices: a telecommunication system prices: determined by subjective wants ideas about opportunities

Austrian School dynamic process of multi-plan entrepreneurial co-ordination: arbitrage opportunities trading at disequilibrium prices moving markets towards ‘equilibrium’ institutional structures owing their existence to transactions costs: money, banks, law, accountancy, insurance, salesmen, firms

Austrian School dynamic coordination: though market processes catallaxy: spontaneous order achieved by free exchange; participants’ objectives are irrelevant market: non-teleological institution no judgement about the end-states it fosters Neoclassical microeconomics static problem: allocating given means among known ends economy: an administered organisation resources directed to serve given objectives no social/historical/institutional context theory of consumer behaviour/the firm/income distribution

Neoclassical Microeconomics, where mathematicians play …. beer U = f (beer, cigarettes) cigarettes

Neoclassical Microeconomics, where mathematicians play …. marginal analysis neo-classical economics microeconomics constrained optimisation capital output = f (capital, labour) labour

Neoclassical Microeconomics, where mathematicians play …. marginal analysis neo-classical economics microeconomics constrained optimisation vulgar economics x1 q = f (x1, x2) x2

Neoclassical Microeconomics, where mathematicians play …. Entrepreneurship ?

Austrian School Entrepreneurship William Baumol • channelled into activities that • produce wealth • expropriate wealth • government • rent-seeking • organized crime • policy focus: • property rights: well-defined and enforced incentives: taxation, regulation, moral hazard • sound legal and monetary systems

Austrian School Entrepreneurs Paul Ormerod • not few and very clever • but • many and (mostly) failures Biological species - 99.9% are extinct US companies - 10% fail each year

Austrian School Entrepreneurs Paul Ormerod • economic efficiency stems • not from ex ante rational planning • but from ex post elimination of ill-adapted forms • not from smart people within simple worlds • but from dull people within complex worlds

Austrian School ‘We allow the individual share to be determined partly by luck in order to make the total to be shared as large as possible’ (Hayek, 1978) Entrepreneurial Profits ephemeral a reward to being first in applying a new idea a reward for taking a chance rarely persist attract emulation (and envy) protected primarily by state licensing

Austrian School Hayek: ‘Economics and knowledge’ (1937) Markets: Adam Smith: division of labour Friedrich Hayek: division of knowledge markets utilise local expertise ‘particular knowledge of time and place’ entrepreneurship: a process of discovery co-ordination of individuals’ actions, based on imperfect, incomplete, dispersed knowledge

Austrian School The Apostle of Laissez-faire? ‘While the presumption must favour the free market, laissez-faire is not the ultimate and only conclusion’ (1933) ‘Probably nothing has done so much harm to the liberal cause as the wooden insistence of some liberals on certain rules of thumb, above all the principle of laissez-faire’ (1944)

Austrian School The Apostle of Laissez-faire? ‘Our main problems begin when we ask what ought to be the contents of property rights, what contracts should be enforceable, and how contracts should be interpreted or, rather, what standard forms of contract should be read into the informal agreements of everyday transactions’ (1949) ‘Laissez-faire was never more than rule of thumb. It indeed expressed protest against abuses of governmental power, but never provided a criterion by which one could decide what were the proper functions of government’ (1973)

Austrian School evolutionary thesis applied to knowledge ‘universal adaptation-ism’ (no connotation of progress) adaptationsolves problems knowledge is end-directed adaptive action specie-specific The Nature of Knowledge (1994) Darwin Machines and the Nature of Knowledge (1997) Henry Plotkin

Austrian School Plotkin’s terminology primary heuristic (genetic/instinct) shaped by ‘slow’ moving events (‘generational deadtime’) secondary heuristic (intelligence) shaped by fast moving events problems of an unfamiliar future tertiary heuristic (cultural knowledge) Hayek The Fatal Conceit …. ‘Between Instinct and Reason’ Henry Plotkin

Keynes had ‘a common sense understanding’ Hayek’s was ‘intellectual rather than practical’ Keynes saw economics as ‘a means of improving the lives of others’ Hayek ‘consumed by economic theory for its own sake’ Keynes confronted ‘real-life dilemmas’ Hayek indulged in ‘pure theory’ Nicholas Wapshott

Investment projects are abandoned because there is no demand ‘for ice cream’ by the time ‘ice trays for commercial refrigerators’ are complete. The exact opposite holds Hayek’s business cycle theory: ‘higher order’ capital projects are halted because the demand for final goods becomes too urgent. Nicholas Wapshott

Austrian Business Cycle Theory 1974 Nobel Prize for Economics citation: ‘one of the few economists who warned about the possibility of the major crisis before the great crash came in the autumn of 1929’ • a warning that derived from Hayek’s early monetary theory • cheap credit cannot remedy inappropriately structured investments

Austrian Business Cycle Theory saving falls consumption rises investment rises

Austrian Business Cycle Theory 1975 ‘For forty years I have preached that the time to prevent a depression is during the preceding boom; and that, once a depression has started, there is little one can do about it. My advice was completely disregarded as long as the boom lasted. Now suddenly, when my prediction has come true and we have reached the stage where ... little can be done about the inevitable reaction which has set in, people suddenly turn to me and ask for my opinion.’

Austrian Business Cycle Theory 1933 ‘the general disinclination to explain the past boom by monetary factors has been quickly replaced by an even greater readiness to hold the present working of our monetary organization exclusively responsible for our present plight. And the same stabilizers who believed that nothing was wrong withthe boom and that it might last indefinitely because prices did not rise, now believe that everything could be set right again if only we would use the weapons of monetary policy to prevent prices from falling.’

Austrian Business Cycle Theory Mark Twain (1835 - 1910) ‘History doesn’t repeat itself, but sometimes it rhymes’

Austrian Business Cycle Theory 1920s Mild recession would have followed growth to 1927, but ... .... easy-money held back by two years ‘the normal process of liquidation’ (Hayek, 1935) The Wall Street bubble bursts

Austrian Business Cycle Theory 1970s Stagflation monetary distortions examined in the context of the labour market, trade unions and unemployment shifting Phillips curve misallocations of labour rising inflation rising unemployment ‘Stagflation’

Austrian Business Cycle Theory 1990s Information Communication Technology Share prices rose when ‘e-‘ prefix and/or a ‘.com’ was added to the company name The dot.com bubble bursts

Austrian Business Cycle Theory 2000s Domestic Property the primary feature of unsustainable long-term investments that become viable during a bank credit upswing The housing bubble bursts

Austrian Business Cycle Theory No panaceas … No avoiding the pain of liquidating bad investments ... No atheists in trenches ... No Hayekians in recessions ...

Capitalised Values V = c[1 – (1 + r)-n]/ r n V n> n c< c n r

Capitalised Values V = c[1 – (1 + r)-n]/ r n20 V £100.00 20>5 c< c n5 r 0.07 Structural equilibrium (r = 0.07)

Interest Rate Effect Capitalised Values n20 V £106.80 £102.80 £100.00 n5 r 0.06 0.07

Interest Rate Effect Capitalised Values n20 V capital deepening (resource constraints) £106.80 £102.80 £100.00 n5 r 0.06 0.07

Relative Price Effect Capitalised Values V = c[1 – (1 + r)-n]/ r n20 V £105.00 £100.00 n5 r 0.07 0.079 0.089

Relative Price Effect Capitalised Values n20 V capital shallowing (resource constraints) £100.00 n5 r 0.07 0.079 0.089

Austrian Economics