From the Very Nature of Economic Theory, Averages Can NEVER Form a Link in Its Reasoning

Yet we are doing nothing less than this if we try to establish direct causal connections between the total quantity of money, the general level of all prices and, perhaps, also the total amount of production. For none of these magnitudes as such ever exerts an influence on the decisions of individuals; yet it is on the assumption of a knowledge of the decisions of individuals that the main propositions of non-monetary economic theory are based. It is to this ‘individualistic’ method that we owe whatever under standing of economic phenomena we possess; that the modern ‘subjective’ theory has advanced beyond the classical school in its consistent use is probably its main advantage over their teaching.

If, therefore, monetary theory still attempts to establish causal relations between aggregates or general averages, this means that monetary theory lags behind the development of economics in general. In fact, neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc. I would even go so far as to assert that, from the very nature of economic theory, averages can never form a link in its reasoning.

—Friedrich A. von Hayek, A Tiger by the Tail: The Keynesian Legacy of Inflation, 3rd ed., comp. Sudha R. Shenoy (London: Institute of Economic Affairs, 2009), 16-17.

Hayek on the Meaning of the Well-Known Doctrine Called the “Acceleration Principle of Derived Demand”

The significance of the results so far obtained can perhaps be made clearer if we relate them to a well-known doctrine, the so-called “acceleration principle of derived demand.” This doctrine, into the long history and the detail of which we need not enter here, essentially asserts that, since the production of any given amount of final output usually requires an amount of capital several times larger than the output produced with it during any short period (say a year), any increase in final demand will give rise to an additional demand for capital goods several times larger than that new final demand. The demand for capital goods according to this theory is the result of final demand multiplied by a given coefficient. We shall refer here to the two factors which determine this product as the “multiplicand” and the “multiplier” respectively, the former being final demand and the latter the ratio at which this final demand is transformed into demand for capital goods. (This “multiplier” with which the acceleration principle operates must, of course, not be confused with the Multiplier which plays such an important role in Mr. Keynes’ theories).

—Friedrich A. von Hayek, “Profits, Interest and Investment (1939),” in Profits, Interest and Investment and Other Essays on the Theory of Industrial Fluctuations (1939; repr., Clifton, NJ: Augustus M. Kelley Publishers, 1975), 18-19.

Keynes Tried to Do the Impossible: Reconciling Money and Equilibrium

Multiplier-accelerator models had trouble dealing with money. The analysis of the cycle in terms of multiplier-accelerator interaction could be conducted entirely in real terms. Thus the role of money often came in as an afterthought. In order to accomplish that link the LM-curve had to be accounted for and that could be done by assuming that it was horizontal. As Laidler (1999) stresses, in that way one cut out any feedback from the monetary system that might disturb the smooth operation of whatever linear-difference-equation dynamics were to be analyzed. Thus even with explicit dynamics it appeared that the role of money was not so fundamental as Keynes had claimed it to be.

Kohn (1986) attributes this failure of the Keynesian revolution to a basic error in Keynes’s thinking. In his view, Keynes had tried to do what was undoable, namely to reconcile money and equilibrium. In order to explain the role of money, one needs to introduce uncertainty or specific market failures, assumptions that are incompatible with the conditions of equilibrium, which requires perfect knowledge, plan coordination or market clearing on all markets et cetera. This internal inconsistency of the GT [Keynes's General Theory] was quickly resolved by those who further developed Keynesian economics. They dropped the monetary factor and retained the assumption of equilibrium as the foundation of their work.

—Bert Tieben, The Concept of Equilibrium in Different Economic Traditions: An Historical Investigation (Cheltenham, UK: Edward Elgar Publishing, 2012), 391-392.

To Overthrow General Equilibrium Theory, Hans Mayer Attacked Indifference Curve Analysis

Mayer said mental facts, or self-observation, sufficed to establish two things. First, want satisfactions of different kinds were interdependent and, second, they were linked, not in the simultaneous manner suggested by indifference curves, but in a dynamic, causal, fashion: the relationship between wants and their satisfaction was not one of general, mutual dependence as suggested by indifference mapping, but one in which new wants emerged in time, depending on the degree to which existing desires had been satisfied. It was thus invalid to assume that all wants were present at the beginning of the “problem.” The “postulate of the law of equal marginal utility . . . becomes impossible in the real world of the psyche.” Given that it was the basis on which the theory of general equilibrium depended, if “this fundamental law of the equalization of the level of marginal utility did not hold, the whole theoretical system of equilibrium prices would lose its main support.”

—Robert Leonard, Von Neumann, Morgenstern, and the Creation of Game Theory: From Chess to Social Science, 1900-1960, Historical Perspectives on Modern Economics (New York: Cambridge University Press, 2010), 85.

Hans Mayer, a Neglected Figure in Austrian Economics, Put the Concept of Static Equilibrium on Trial

Because of the disgrace he later brought upon himself, in 1938, Hans Mayer is the neglected figure in the history of Austrian economics in the interwar period. . . .

A theorist in the tradition of Menger and von Wieser, Mayer was interested in the imputation problem. However, amongst the issues regarding which considerable discussion was devoted in his seminar in the late 1920s were those of the incorporation of time into equilibrium theory, the psychological bases of marginalist economics, and the place of mathematics in economic analysis. . . .

Mayer saw himself as an Austrian bulwark against Marginalist orthodoxy. As early as 1911, in a review of Schumpeter's Das Wesen und der Hauptinhalt der theoretischen Nationalökonomie, he criticized the use of the differential calculus in economics. He said that although the possibility of infinitesimal change was plausible in the measurement of time and space, it was inapplicable in the consideration of economic quantities: what sense did it make to speak of the satisfaction yielded by an infinitesimal portion of, say, a shoe? He stated that in the economic realm, reasoning in mathematical terms, made possible through the adoption of methods that had proven themselves in the natural sciences, marked a surrender to pure “form.” By the mid-1920s, the supposed sterility of the use of mathematics and the excessive simplification involved in reducing subjective action in time to a static, mathematical description had become essential motifs in Mayer's work. In his seminar meetings, he took his students through the early work of Cournot, the Lausanne School, and Jevons. One might say he was putting the concept of static equilibrium on trial.

—Robert Leonard, Von Neumann, Morgenstern, and the Creation of Game Theory: From Chess to Social Science, 1900-1960, Historical Perspectives on Modern Economics (New York: Cambridge University Press, 2010), 83-84.

The Schumpeterian Entrepreneur Is Disequilibrating, But the Kirznerian Entrepreneur Is Equilibrating

All this leads me to express a certain dissatisfaction with the role assigned to the entrepreneur in the Schumpeterian system. . . . Here it is enough to observe that Schumpeter's entrepreneur and the one developed here can in many ways be recognized — and, let me add, reassuringly recognized — as the same individual. But there is one important respect — if only in emphasis — in which Schumpeter's treatment differs from my own. Schumpeter's entrepreneur acts to disturb an existing equilibrium situation. Entrepreneurial activity disrupts the continuing circular flow. The entrepreneur is pictured as initiating change and as generating new opportunities. Although each burst of entrepreneurial innovation leads eventually to a new equilibrium situation, the entrepreneur is presented as a disequilibrating, rather than an equilibrating force. Economic development, which Schumpeter of course makes utterly dependent upon entrepreneurship, is “entirely foreign to what may be observed in . . . the tendency towards equilibrium.”

By contrast my own treatment of the entrepreneur emphasizes the equilibrating aspects of his role. I see the situation upon which the entrepreneurial role impinges as one of inherent disequilibrium rather than of equilibrium — as one churning with opportunities for desirable changes rather than as one of placid evenness. Although for me, too, it is only through the entrepreneur that changes can arise, I see these changes as equilibrating changes. For me the changes the entrepreneur initiates are always toward the hypothetical state of equilibrium; they are changes brought about in response to the existing pattern of mistaken decisions, a pattern characterized by missed opportunities. The entrepreneur, in my view, brings into mutual adjustment those discordant elements which resulted from prior market ignorance.

—Israel M. Kirzner, Competition and Entrepreneurship (Chicago: University of Chicago Press, 1973), 72-73.

“Capital Reversal” Creates Serious Difficulties for the Neoclassical Theory of Interest

In the course of the Cambridge debate it was the reswitching and capital reversal paradoxes which cast the deepest shadow upon the mainstream neoclassical theory of distribution. Yet, as we shall see, these paradoxes present no problem at all for the explanation of interest contained in the Misesian theory of capital and interest.

The problem posed for the neoclassical theory by the phenomenon of ‘capital reversal’ is well known. Capital reversal occurs when a change in the rate of interest is associated with a seemingly ‘perverse’ change in adopted production technique — for example, when a reduction in the interest rate implies a switch to ‘the less, not the more, time-consuming, or roundabout or capital-intensive technique’ (Yeager, 1976). The capital reversal is at least theoretically possible was conceded by major exponents of the neoclassical position in the 1960s (Saumelson, 1966; Ferguson, 1969). That this concession implies serious difficulties for the neoclassical view of interest as the supply-and-demand price of a productive service, has been emphasized by many writers.

—Israel M. Kirzner, introduction to Essays on Capital and Interest: An Austrian Perspective (Cheltenham, UK: Edward Elgar Publishing, 1996), 7.

Mises’s Redirection of Capital and Interest Theory Along Mengerian Lines Was Brutally Attacked by Knight

It was thus Mises, in his 1940 Nationalökonomie rediscovery and further development of Fetter’s pure time-preference theory of interest, who was to refine Böhm-Bawerkian theory and redirect it along Mengerian lines. In his slashing review article on Mises’s book, Knight (1941) perceptively recognized this — and saw it as grounds for dismissing Mises’s entire approach to the theory of capital and interest. In other words, Knight was attacking Mises not only because he was, like Böhm-Bawerk and Fisher, emphasizing the role of time in production (whereas for Knight the foundation of wisdom in this area consists in recognizing that ‘in a stationary economy, all production and consumption are strictly simultaneous; the waiting period is zero; there is none’: ibid., p. 420). Rather, he was attacking Mises for his ‘original and naive or absolute “Austrianism”’ (ibid., p. 422) — by which he apparently meant Mises’s Mengerianism. (This reading of Knight's attack is reinforced by his own explicit rejection of Mises’s frequent and favourable references to Menger’s conception of the ‘order’ of goods. On Knight's sweepingly dismissive attitude to this conception of Menger’s, see also his highly critical introduction to the 1950 English edition of Menger’s 1871 Grundsätze (p. 25).) For Knight, Mises’s cardinal sin was not so much is emphasis on the role of time per se, as his denial of primary explanatory significance to the objective productivity of time.

—Israel M. Kirzner, introduction to Essays on Capital and Interest: An Austrian Perspective (Cheltenham, UK: Edward Elgar Publishing, 1996), 4.

Heterogeneity of Capital Means Heterogeneity in Use; Heterogeneity in Use Implies Multiple Specificity

All capital resources are heterogeneous. The heterogeneity which matters is here, of course, not physical heterogeneity, but heterogeneity in use. Even if, at some future date, some miraculous substance were invented, a very light metal perhaps, which it was found profitable to substitute for all steel, wood, copper, etc., so that all capital equipment were to be made from it, this would in no way affect our problem. The real economic significance of the heterogeneity of capital lies in the fact that each capital good can only be used for a limited number of purposes. We shall speak of the multiple specificity of capital goods.

—Ludwig M. Lachmann, Capital and Its Structure (Kansas City: Sheed Andrews and McMeel, 1978), 2.

Hayek Is Famous for Having Been a Pioneer in the Idea of Intertemporal Equilibrium

In his famous 1933 Copenhagen lecture, Hayek pronounced “the fundamental problem of all economic theory,” to be “the question of the significance of the concept of equilibrium and its relevance to the explanation of a process which takes place in time” (Hayek, [1933] 1939b, p. 138). There can be no doubt that this “fundamental problem” was never far from Hayek’s concern as an economic theorist (and of course this is true for most economic theorists, of most schools of thought). Even when Hayek was to criticize “modern economists” for their “perhaps excessive preoccupation with the conditions of a hypothetical state of stationary equilibrium” (Hayek, [1935] 1949a, p. 167), the relevance of the equilibrium concept and its centrality for economic understanding was not in question. Hayek is famous for having been a pioneer in the idea of intertemporal equilibrium (Hayek, [1928] 1994), and even after he expressed his impatience with the profession’s preoccupation with the equilibrium concept, he considered  intertemporal equilibrium to be a central building block for his own system of understanding. In regard to the coordination problem, we note that Hayek did not object so much to the professional attention to what is called the state of “competitive equilibrium” (in which “the data for the different individuals are fully adjusted to each other”), as to its failure to explain “the nature of the process by which the data are thus adjusted” (Hayek, 1949a, p. 94). We have already noticed how important for Hayek’s work on coordination, was his pathbreaking reinterpretation of equilibrium in terms of the mutual compatibility of plans. Our purpose in identifying “equilibrium” as an important theme in Hayek’s work is not to throw doubt on the importance for Hayek of the plan-coordination idea; it is simply to take note of the separateness of these ideas. To interpret equilibrium as expressing plan compatibility is not quite the same thing as to replace the role of equilibrium itself in economic understanding, by that of plan-compatibility.

—Israel M. Kirzner, “Hedgehog or Fox? Hayek and the Idea of Plan-Coordination,” in The Driving Force of the Market: Essays in Austrian Economics, Foundations of the Market Economy (London: Routledge, Taylor and Francis e-Library, 2003), 192-193.

In Asset Markets, “Big Players” Induce Herding Since Traders Trade with Other People's Money

The trouble with discretionary market interventions is not that they come from government but rather that government is a Big Player. Bigness does not a Big Player make, but it helps. To be a Big Player it is not enough to be able to influence the market, to be largely immune from competitive pressures, or even to meet both conditions. A Big Player is anyone who habitually exercises discretionary power to influence the market while himself remaining wholly or largely immune from the discipline of profit and loss. Finance ministers and central bankers are paradigmatic Big Players, but only when exercising discretionary power. Private actors, too, may be Big Players. Each seller in oligopoly is one, which is what makes modeling oligopoly so difficult.

Our claim may seem unreasonable. Surely the authorities exercising discretion have an objective function or reaction function. Cannot such a function be set forth with just as much (or little) confidence as the equations describing underlying conditions of demand and supply? No: the concept of objective or reaction function cannot be put to good use.

In exercising discretion, a central bank commits itself to nothing but what it deems best in view of information available at the time of each decision, interpreting and weighing each bit of information as it then chooses. The variables in the bank’s reaction function and the weights given to each, as well as the function’s mathematical form, may thus change from decision to decision. Were changes in the function ruled out, the bank would be following a rule instead of exercising discretion. The econometric problem of identifying a changeable reaction function is necessarily insuperable, and assuming its existence is useless for guiding expectations.

We may put the matter in another way. A decisionmaker employing discretion learns over time. ‘‘Real’’ learning implies more than the accretion of information; it implies a change in knowledge and in how news is ‘‘framed,’’ ‘‘filtered,’’ or interpreted. Real people are always somewhat surprising. Just as we would not expect to model our loved ones mathematically, so we should not expect to succeed in modeling central-bank presidents. The behavior of Big Players, to paraphrase Keynes, affords no scientific basis whatever on which to form any calculable reaction function.We simply do not know (Keynes, 1973).

In asset markets, Big Players induce herding. Many of the traders in an asset market are trading with other people’s money (Scharfstein and Stein, 1990). Good and bad trades affect their reputations as hired hands. Reputation typically hinges on relative performance. If most S&Ls are failing, including yours, you are not considered a bad banker, just the unlucky victim of an industry crisis. When you go along with the common wisdom and things go bad, you can share the blame with everyone else and leave your relative performance still looking pretty good. If things go well instead, so much the better. The really dangerous thing is to defy common wisdom and lose; your reputation is shot and you must look for a new line of work (Scharfstein and Stein, 1990).

—Roger Koppl and Leland B. Yeager, “Big Players and Herding in Asset Markets: The Case of the Russian Ruble,” Explorations in Economic History 33, no. 3 (July 1996): 368-369).

Policy Uncertainty Creates a Low Level of Confidence Leading to a Prolonging of the Economic Slump

My ‘Austrian’ explanation of the long slump will be that policy uncertainty has created a low state of confidence and a corresponding slump in investment. The ‘state of confidence’ has a long history in economics, as I will show. Economists today are more likely to speak of ‘animal spirits’ than ‘confidence’ to identify the same supposed dispositions, expectations and emotions of business investors. Whatever the label, it is an important topic. And yet there has been relatively little attention to the theory of the state of confidence. Drawing on Higgs (1997) and Koppl (2002), I will outline a theory of confidence that explains the long slump, a theory that fills in the something that has inhibited economic adjustment after the boom.

In brief, the explanation is as follows. Interventionist policies create uncertainty, raise the costs of financial intermediation and discourage investment. I might almost say that the problem is not that the government has done too little, but that it has done too much. That way of putting it, though, may seem to suggest that I am an ‘austerian’ who wants to heat up the economy by freezing government spending. The problem, however, is not the level of government spending. The problem is changing rules, uncertain regulations, shifting Fed policy. The problem is the variability and unpredictability of government economic policy.

In the theory I lay out below, the state of confidence is more likely to be arbitrary and self-referencing the more precarious our knowledge of the future. Investor expectations are never certain (by their nature) and never a total blank. Where we are between the poles of ignorance and prescience depends on the policy regime affecting investors. I will emphasise two aspects of the policy regime: whether the rules of the game are uncertain and whether there is ‘Big Player’ influence.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 13-14.

The “Lachmann Problem” Is the Problem of Building a Radically Subjectivist Theory of Expectations

What produced this great personal achievement of Lachmann? It was not, I think, his solution to any economic problem, but his identification of one. The problem Lachmann drew our attention to was the need for a theory of expectations in which each person’s actions are animated by the spontaneous activity of a free human mind. I will call the problem of building a radically subjectivist theory of expectations, the ‘Lachmann problem.’

It is not obvious how such a thing is to be done. How can I let the agents of my model be free and still predict anything—even within the model! If we take seriously the ‘subjectivism of active minds,’ we seem to fall into the horrible pit of open possibility with no ladder upon which to get out. This, we have been told, is nihilism.

I think there is a way out. We can combine the radical subjectivist attention to human thoughts with a more ‘objective’ understanding of the evolution of rule-governed action. Doing so may permit us to correlate observable market conditions with certain properties of economic expectations. It may help us learn when economic expectations will be more prescient and when less. It may help us learn when markets are driven mostly by fundamentals and when they are more subject to fads and fashion. To anticipate, my proposal for solving the Lachmann problem puts Schutz and Hayek together. (Alfred Schutz was a sociologist notable for his use of Husserl’s phenomenology. F.A.Hayek, of course, was one of the leading figures of Austrian economics.)

—Roger Koppl, “Lachmann on the Subjectivism of Active Minds,” in Subjectivism and Economic Analysis: Essays in Memory of Ludwig M. Lachmann, ed. Roger Koppl and Gary Mongiovi, Routledge Frontiers of Political Economy (London: Routledge, Taylor and Francis e-Library, 2003), 61-62.

“Complementarity” Is of the Essence of Capital Use; the Entrepreneur Has to Find the “Optimum Combination”

It is hard to imagine any capital resource which by itself, operated by human labour but without the use of other capital resources, could turn out any output at all. For most purposes capital goods have to be used jointly. Complementarity is of the essence of capital use. But the heterogeneous capital resources do not lend themselves to combination in any arbitrary fashion. For any given number of them only certain modes of complementarity are technically possible, and only a few of these are economically significant. It is among the latter that the entrepreneur has to find the ‘optimum combination.’ The ‘best’ mode of complementarity is thus not a ‘datum.’ It is in no way ‘given’ to the entrepreneur who, on the contrary, as a rule has to spend a good deal of time and effort in finding out what it is. Even where he succeeds quickly he will not enjoy his achievement for long, as sooner or later circumstances will begin to change again.

—Ludwig M. Lachmann, Capital and Its Structure (Kansas City: Sheed Andrews and McMeel, 1978), 3.

There Are at Least 7 Different Approaches to “Equilibrium” with Additional Dimensions to Consider

A term which has so many meanings that we never know what its users are talking about should be either dropped from the vocabulary of the scholar or “purified” of confusing connotations. (Machlup 1958)

The continuing use of the word “equilibrium” by different people to mean different things justifies yet another brief examination. No pretense, however, is made at completeness.

I can think of at least seven different approaches to equilibrium. These are not mutually exclusive and are, indeed, related in important ways:

1. equilibrium as a balance of forces
2. equilibrium as a state of rest (a stationary state)
3. equilibrium as a state of uniform movement (a steady state — of which 2 is a special case)
4. equilibrium as a constrained maximum
5. equilibrium as an optimum
6. equilibrium as rational action
7. equilibrium as a situation of consistent plans.

In each case at least two dimensions can be identified. Equilibrium can relate to the entire economy (general equilibrium) or to a subset of the economy (partial equilibrium) or to the individual. Equilibrium can be considered for a single all-encompassing period (static equilibrium), or for a succession of self-contained periods (temporary equilibrium) or for a succession of related sub-periods (intertemporal equilibrium).

—Peter Lewin, Capital in Disequilibrium: The Role of Capital in a Changing World, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2011), 15-16.

Human Action Implies a Rejection of the Notion of Economic Equilibrium as an End-State

There is a close relationship between the Austrian conception of economic equilibrium and the key methodological aspect of this school. This is the notion that economics is a science of human action.

Mises (1949) defined human action as ‘conscious or purposeful behaviour’. He rejected the notion that economic individuals are ‘automatons’ who passively react to given means and given ends. Take the example of a rational agent who maximizes utility subject to constraints. The outcome of this maximization process is completely determinate given that one knows the objective function and the constraining conditions. The Austrians do not consider this type of choice-making meaningful, purposeful behaviour because it lacks a distinctive human element. Anyone facing the same objective function and constraints would make the same decision, a rare condition for people of flesh and blood. The notion of human action gives a much richer portrait of human existence. It assumes that people select their own ends and choose means to attain those ends. For an individual to act is a personal affair and touches the heart of being human. In the words of Mises: ‘Action is the essence of his nature and existence, his means of preserving his life and raising himself above the level of animals and plants’ (ibid., 18). What makes action human is the fact that it is goal-oriented or purposeful behaviour. People are conscious beings and they use their brain to imagine a future in which life is better. Their actions are directed at making that dream become reality and although they know that disappointments are a fact of life, they will not stop trying. Man ‘is not only homo sapiens, but no less homo agens’ (ibid., 14) which is governed by the lifelong quest to improve his living conditions, whatever disappointments and setbacks he may find on his path.

One of the key tenets of the Austrian tradition is that human action implies a rejection of the notion of economic equilibrium as an end-state. When equilibrium means that every participant in a market realizes his plans, or in neoclassical terminology ‘maximizes utility’, no one has an incentive to change his or her behaviour. This is the end of economic activity and the negation of human action. ‘A man perfectly content with the state of affairs would have no incentive to change things. He would have neither wishes nor desires; he would be perfectly happy. He would not act; he would simple live free from care’ (Mises 1949, 13).

—Bert Tieben, The Concept of Equilibrium in Different Economic Traditions: An Historical Investigation (Cheltenham, UK: Edward Elgar Publishing, 2012), 302-303.

“Genetic-Causal Economics” Is the Method of Reducing Aggregates to Statements about Individual Choices

As is often true, Lachmann's real economic education — his detailed inquiry into the problems of the discipline — began after he met the requirements for his doctorate. In addition to the study of Pareto he and Kauder began work on Hayek's Monetary Theory and the Trade Cycle (1933) and Prices and Production (1931). During these sessions Kauder stressed the importance of subjectivism, especially subjective opportunity cost as the key concept in economic analysis. Lachmann also returned to the study of genetic-causal economics, the term of Werner Sombart and Hans Mayer for the Austrian method of reducing aggregates to statements about individual choices.

By this time, Lachmann's basic theoretical formulation, with the possible exception of the role of changing expectations in economic life, had been worked out. The foundations of Lachmann's theoretical structure were (1) a firm belief in the subjective theory of value and the related concept that the economic cost of an action always refers to a forgone opportunity; (2) a preference for the genetic-causal method of inquiry in contrast to the mathematical-functional approach of the Lausanne school; (3) a familiarity with the verstehende methode as espoused by Max Weber (an aspect of Lachmann's work that lay dormant for the next twenty years); and (4) an acceptance of the Mises-Hayek theory as a cogent explanation of the trade cycle.

—Walter E. Grinder, introduction to Capital, Expectations, and the Market Process: Essays on the Theory of the Market Process, by Ludwig M. Lachmann (Kansas City: Sheed Andrews and McMeel, 1977), 8-9.

Garrison Recommends Putting Capital Theory with Expectations Back into Macroeconomics

In a letter of August 1989, Lachmann posed to me a direct question about Mises’s and Hayek’s neglect of expectations (a neglect he referred to in a subsequent letter as “a simple matter of historical fact”). “Do you agree with me that in the 1930s Hayek and Mises made a great mistake in neglecting expectations, in failing to extend Austrian subjectivism from preferences to expectations?” His particular phrasing of this question links it directly to his 1976 article, in which he traced the development of subjectivism “From Mises to Shackle.” Also, Lachmann’s question was a leading question, followed immediately with “What, in your view, are the most urgent tasks Austrians must now address?” Lachmann himself had spent several decades grappling with expectations. He recognized in an early article ([1943] 1977) that expectations in economic theorizing present us with a unique challenge. They cannot be regarded as exogenous variables. We must be able to give some account of “why they are what they are.”

But neither can expectations be regarded as endogenous variables. To do so would be to deny their inherent subjectivist quality. This challenge always emphasized but never actually met by Lachmann has been dubbed the “Lachmann problem” by Roger Koppl (1998: 61).

My response to Lachmann did not deal head-on with the Lachmann problem but focused instead on Hayek and Keynes and derived from considerations of strategy. Hayek was trying to counterbalance Keynes, whose theory featured expectations but neglected capital structure. Without an adequate theory of capital, expectations became the wild card in Keynes’s arguments. Guided by his “vision” of economic reality, a vision that was set in his mind at an early age, he played this wild card selectively — ignoring expectations when the theory fit his vision, relying heavily on expectations when he had to make it fit. Hayek’s countering strategy is made clear in his Pure Theory of Capital (1941: 407ff.): “[Our] task has been to bring out the importance of the real factors [as opposed to the psychological factors], which in contemporary discussion are increasingly disregarded.” But in countering Keynes’s “expectations without capital theory,” Hayek produced — or so it could be argued — a “capital theory without expectations.” In response to Lachmann’s question about the most urgent tasks, I suggested that we need to put capital theory (with expectations) back into macroeconomics and that my inspiration for working in this direction was Lachmann’s own writings.

—Roger W. Garrison, Time and Money: The Macroeconomics of Capital Structure, Foundations of the Market Economy (London: Routledge, 2002), 16.

Mises’ Great Achievement Was to Apply the Austrian Method to the Broad “Macro” Areas

Ludwig von Mises was a “third-generation” Austrian, a brilliant student in Böhm-Bawerk's famous graduate seminar at the University of Vienna in the first decade of the twentieth century. Mises’ great achievement in The Theory of Money and Credit (published in 1912) was to take the Austrian method and apply it to the one glaring and vital lacuna in Austrian theory: the broad “macro” area of money and general prices.

For monetary theory was still languishing in the Ricardian mold. Whereas general “micro” theory was founded in analysis of individual action, and constructed market phenomena from these building blocks of individual choice, monetary theory was still “holistic,” dealing in aggregates far removed from real choice. Hence, the total separation of the micro and macro spheres. While all other economic phenomena were explained as emerging from individual action, the supply of money was taken as a given external to the market, and supply was thought to impinge mechanistically on an abstraction called “the price level.” Gone was the analysis of individual choice that illuminated the “micro” area. The two spheres were analyzed totally separately, and on very different foundations. This book performed the mighty feat of integrating monetary with micro theory, of building monetary theory upon the individualistic foundations of general economic analysis.

—Murray N. Rothbard, foreword to The Theory of Money and Credit, by Ludwig von Mises (Indianapolis: Liberty Fund, 1981), 14.

The Money Commodity Is Demanded and Held Only Because It Is More Marketable than Other Commodities

To return to the concept of the evenly rotating economy, the error of the mathematical economists is to treat it as a real and even ideal state of affairs, whereas it is simply a mental concept enabling us to analyze the market and human activities on the market. It is indispensable because it is the goal, though ever-shifting, of action and exchange; on the other hand, the data can never remain unchanged long enough for it to be brought into being. We cannot conceive in all consistency of a state of affairs without change or uncertainty, and therefore without action. The evenly rotating state, for example, would be incompatible with the existence of money, the very medium at the center of the entire exchange structure. For the money commodity is demanded and held only because it is more marketable than other commodities, i.e., because the holder is more sure of being able to exchange it. In a world where prices and demands remain perpetually the same, such demand for money would be unnecessary. Money is demanded and held only because it gives greater assurance of finding a market and because of the uncertainties of the person’s demands in the near future. If everyone, for example, knew his spending precisely over his entire future—and this would be known under the evenly rotating system—there would be no point in his keeping a cash balance of money. It would be invested so that money would be returned in precisely the needed amounts on the day of expenditure. But if no one wishes to hold money, there will be no money and no system of money prices. The entire monetary market would break down. Thus, the evenly rotating economy is unrealistic, for it cannot actually be established and we cannot even conceive consistently of its establishment. But the idea of the evenly rotating economy is indispensable in analyzing the real economy; through hypothesizing a world where all change has worked itself out, we can analyze the directions of actual change.

—Murray N. Rothbard, Man, Economy, and State with Power and Market, 2nd ed. of the Scholar's ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 328-329.

Capitalists Perform a Time Function and Their Income Represents an “Agio” (Premium in Intertemporal Exchanges)

Capitalists advance present goods to owners of factors in return for future goods; then, later, they sell the goods which have matured to become present or less distantly future goods in exchange for present goods (money). They have advanced present goods to owners of factors and, in return, wait while these factors, which are future goods, are transformed into goods that are more nearly present than before. The capitalists’ function is thus a time function, and their income is precisely an income representing the agio of present as compared to future goods. This interest income, then, is not derived from the concrete, heterogeneous capital goods, but from the generalized investment of time. It comes from a willingness to sacrifice present goods for the purchase of future goods (the factor services). As a result of the purchases, the owners of factors obtain their money in the present for a product that matures only in the future.

Thus, capitalists restrict their present consumption and use these savings of money to supply money (present goods) to factor owners who are producing only future goods. This is the service—an advance of time—that the capitalists supply to the owners of factors, and for which the latter voluntarily pay in the form of the interest rate.

—Murray N. Rothbard, Man, Economy, and State with Power and Market, 2nd ed. of the Scholar's ed. (Auburn, AL: Ludwig von Mises Institute, 2009), 374.

Clower and Howitt (1998): Our Candid Opinion Is that Much of Keynes's Argument Was “Consciously Disingenuous”

In his 1934 “manifesto” Keynes not only queries the self-adjustment capabilities of “the existing economic system” but contumaciously declares “The system is not self-adjusting, and, without purposive direction, is incapable of translating our actual poverty into our potential plenty.” When Keynes wrote those words, the General Theory was substantially finished, so we find it natural to ask, On the basis of what ideas in the General Theory did Keynes consider it reasonable to flout “. . . almost the whole body of organized economic thinking and doctrine of the last hundred years”? Our candid opinion is, first, that much of Keynes's argument was consciously disingenuous and, second, that the analysis set fourth in the General Theory provides no reasonable grounds to reject the CSP [Classical Stability Presumption].

—Robert Clower and Peter Howitt, “Keynes and the Classics: An End of Century View,” in Keynes and the Classics Reconsidered, ed. James C. W. Ahiakpor (Boston: Kluwer Academic Publishers, 1998), 6, forthcoming.

The Keynesian Multiplier Story Is More of a Myth Than an Accurate Description of the Economic Process

Keynes (1933, 1936), by his elaboration of Richard Kahn’s earlier (1931) argument, thus exalts consumption spending to a magical significance in macroeconomic analysis, contrary to the classical emphasis on production and saving for investment in order to promote the growth of output and employment (Ahiakpor 1995). Such popular claims as “the current U.S. economic expansion is being driven by consumer spending” also reflects the Keynesian multiplier view.

The Keynesian multiplier analysis has become a staple in macroeconomic education at the introductory and higher levels, without students being warned of the concept’s fundamental misrepresentation of how an economy works. . . .

Some previous analysts have cast doubts on the validity or meaningfulness of Keynes’s argument, such as Pigou (1933, 1941), Robertson (1936), Hawtrey (1950, 1952), Hazlitt (1959), Haberler (1960), Rothbard (1962), and Hutt (1974), but with hardly any success in limiting its widespread acceptance and teaching in macroeconomics. . . .

In this article, I argue that the earlier criticisms have not been effective mainly because they miss pointing out the real illusion of the Keynesian multiplier story. If one asked some fundamental questions, such as “From where does the initial spender get the income to spend?” or “What is saving other than the purchase of financial assets and not the hoarding of cash?” (the classical definition of saving) we find that the Keynesian multiplier story is more of a myth than an accurate description of the economic process.

—James C. W. Ahiakpor, “On the Mythology of the Keynesian Multiplier: Unmasking the Myth and the Inadequacies of Some Earlier Criticisms,” American Journal of Economics and Sociology 60, no. 4 (October 2001): 746-747.

Herbert Hoover Started the Great Depression Because His Industrial Program Kept Nominal Wages Fixed

Herbert Hoover. I develop a theory of labor market failure for the Depression based on Hoover’s industrial labor program that provided industry with protection from unions in return for keeping nominal wages fixed. I find that the theory accounts for much of the depth of the Depression and for the asymmetry of the depression across sectors. The theory also can reconcile why deflation/low nominal spending apparently had such large real effects during the 1930s, but not during other periods of significant deflation.

—Lee E. Ohanian, “What — Or Who — Started the Great Depression?” abstract, Journal of Economic Theory 144, no. 6 (November 2009): 2310.

The 5 Principal Pillars Upon Which Keynes Founded His “New Economics” Are ALL Badly Flawed

Keynes founded his New Economics on five principal pillars, all of which are faulty:

1. Saving is nonspending, and does not provide the funds for investment spending as the classical economists had explained;
2. Consumption spending sustains and drives economic expansion through a multiplier process;
3. The rate of interest is determined by the supply and demand for money (cash) or liquidity, not by the supply and demand for “capital” or savings;
4. There are no equilibrating tendencies in a monetary economy to restore it to full employment once involuntary unemployment emerges; and
5. The classical theories of interest, the price level, inflation, and the law of markets (or Say's law) are all founded on the premise that full employment always exists.

Keynes successfully persuaded most of his audience, including many economists, of the above claims about classical economics mainly by changing the meaning of some key economic terms, although none of his claims is valid. Neither does a monetary economy work the way Keynes claims, nor are the classical principles founded on the assumption of full employment.

—James C. W. Ahiakpor, “On the Future of Keynesian Economics: Struggling to Sustain a Dimming Light,” American Journal of Economics and Sociology 63, no. 3 (July 2004): 585-586.

There Is NO Such Thing as a “Paradox of Thrift” and Keynes Misrepresented the Classical Concept of Saving

In this article, I restate the classical savings theory of growth to provide a basis for demonstrating that Keynes misrepresented the classical concept of saving to include the hoarding of cash, a mistake which led to his erroneous conclusions about the classical theory of growth. I use Keynes's arguments mainly in the General Theory to restate the paradox of thrift proposition, and I rely on direct quotations from the classics and Marshall to establish Keynes's misrepresentation of their argument. I conclude that there is no such thing as a paradox of thrift other than Keynes's incorrect substitution of “hoarding” for “saving” in the classical theory of income determination. This recognition may help end the annual ritual of teaching students a fundamental confusion from which they later struggle to escape in courses such as development economics or finance. The discussion also shows that there is much of significance yet to be gained by paying careful attention to what the classics said, especially in assessing Keynes's claims against them. Even among the classics, as Samuelson has observed, “their quarrels lasted because often they were quarrels over misunderstandings and definitions.”

The classical theory of growth against which Keynes proposed his paradox of thrift argument simply states that economic growth is determined by the rate of saving or capital accumulation. The greater the amount saved out of income, the more capital goods, land, and labour services can be bought or hired for production.

—James C. W. Ahiakpor, “A Paradox of Thrift or Keynes's Misrepresentation of Saving in the Classical Theory of Growth?” Southern Economic Journal 62, no. 1 (July 1995): 17-18.

Employment Afforded to Labour Does NOT Depend on the Purchasers, But on the Capital

[Demand for commodities is not demand for labour]. We now pass to a fourth fundamental theorem respecting Capital, which is, perhaps, oftener overlooked or misconceived than even any of the foregoing. What supports and employs productive labour, is the capital expended in setting it to work, and not the demand of purchasers for the produce of the labour when completed. Demand for commodities is not demand for labour. The demand for commodities determines in what particular branch of production the labour and capital shall be employed; it determines the direction of the labour; but not the more or less of the labour itself, or of the maintenance or payment of the labour. These depend on the amount of the capital, or other funds directly devoted to the sustenance and remuneration of labour.

—John Stuart Mill, Collected Works of John Stuart Mill, vol. 2, bk. 1, Principles of Political Economy with Some of Their Applications to Social Philosophy, ed. J. M. Robson (Toronto: University of Toronto Press, 1965), 78.

The Austrian School Rejects the Fundamental Assumptions of Modern Macroeconomics

In neoclassical analyses capital is normally treated as a homogeneous aggregate; it is ‘K’ in various models. This is a crucial error from an Austrian perspective. Because capital is, for the Austrians, always embodied in specific goods, it cannot be treated as an undifferentiated mass. Entrepreneurs purchase inputs or build machines that are designed for specific purposes. They cannot be costlessly redeployed to an infinite number of other uses the way the homogeneous conception of capital might suggest. Austrians see capital as heterogeneous and having a limited number of specific uses (Lachmann, 1978 [1956]; Kirzner, 1966). The same is true of labor. The skills and knowledge workers have are not appropriate for all potential production processes, thus their human capital can be conceived of as heterogeneous and specific to a limited number of uses.

Capital is not only heterogeneous in this sense, it also might embody error. Given an uncertain future, producers are always making their best guess as to what to produce and how, so the range of capital goods in existence at any moment is likely to embody a variety of entrepreneurial errors. For example, if two producers buy up the inputs to produce a particular kind of running shoe, but the demand is sufficient only for one to be profitable, then the capital of the other has been misallocated. Of course, we cannot know that until the market process unfolds and the one firm’s losses indicate that the value of their final product was not sufficient to cover costs including interest. This point is important because it implies that we cannot just add up the value of existing capital to get some aggregate measure of ‘total capital’. That procedure would be valid only in equilibrium, where we knew that each higher-order good was deployed correctly. We cannot add up existing stocks of capital to get some aggregate. In thinking about capital we must pay attention to both where the capital (and labor) sit in the structure of production and factors that might distort price signals in ways that make it more difficult for firms to synchronize their production with the public’s preferences about consumption.

—Steven Horwitz, “The Microeconomic Foundations of Macroeconomic Disorder: An Austrian Perspective on the Great Recession of 2008,” in Macroeconomic Theory and its Failings: Alternative Perspectives on the Global Financial Crisis, ed. Steven Kates (Cheltenham, UK: Edward Elgar Publishing, 2010), 98-99.