The Critical Difference between New Classicism and Austrianism Lies in Differing Treatments of the KNOWLEDGE PROBLEM

The New Classicists accept the Monetarist propositions about the long run and argue that the assumption of “rational expectations” allow those propositions to apply to the short run as well. In effect, the New Classicists deny the significance of Hayek’s distinction between two kinds of knowledge. Market participants behave “as if” they actually know the structure of the economy. They react to monetary expansions in ways that compensate for price and interest-rate distortions. So long as expectations about future price and interest-rate movements are not systematically in error, there will be no intertemporal discoordination, and no discoordination of any other kind that can be attributed to the monetary expansion. In this view, a Hayekian trade cycle anticipated is a Hayekian trade cycle avoided. 

The rational-expectations argument is nothing new to Austrian theory. In fact, Mises (1953) recognized the kernel of truth in the argument long before the appearance of John Muth’s (1961) classic article. He warned the advocates of inflationary finance against ignoring Lincoln’s dictum: You can’t fool all the people all the time. In the early 1940s Ludwig Lachmann (1977) called the Austrian theory into question on the basis of what was, in effect, a rational-expectations argument. The rise of the New Classicism in recent years has refocused attention on the role of expectations in trade cycle theory. Without doubt, the course of the trade cycle is influenced in a fundamental way by the expectations of market participants. But the idea of rational expectations is not quite the show stopper that the New Classicists believe it to be. Again, the critical difference between New Classicism and Austrianism lies in differing treatments of the knowledge problem. 

It is peculiar for economists to assume that market participants know, or behave “as if” they know, the structure of the economy. After all, economists have had disagreements among themselves for more than 200 years about how the economic system works. Some believe that the economy works in the manner envisioned by Keynes or by his many interpreters, some believe that the economy is more  accurately depicted by the Classical model, and some believe that the economic relationships identified by the Austrians are essential to the understanding of the economy’s structure. There are important differences even within each of these three theoretical frameworks, and there exist still other, more radical alternatives such as Marxism and modern Institutionalism. 

It would be an amazing feat for market participants either individually or collectively to single out not only the correct theoretical framework but also the parametric values that are currently applicable. And if they actually performed this feat (or behaved “as if” they had performed it), the question of just how they did it would be the most challenging question the economics profession has yet faced.

—Roger W. Garrison, “Hayekian Trade Cycle Theory: A Reappraisal,” Cato Journal 6, no. 2 (Fall 1986): 443-444.

J. S. Mill Warns Us Against the Simplistic Incorporation of Derived Demands into Macroeconomic Theorizing

 John Stuart Mill’s cryptic aphorism, “Demand for commodities is not demand for labor,” warns us against the simplistic incorporation of derived demands into macroeconomic theorizing. Some such notion of derived demand, whereby the demand for final output and the demand for the factors of production always move in the same direction, characterizes virtually all modern macroeconomic theories. The recognition that the two demands can move in opposite directions characterizes the Austrian formulation and constitutes one of the most fundamental differences between the Austrian theory and its rivals. 

In accordance with Mill’s Fourth Proposition, a decrease in the current level of consumption does not necessarily mean a decrease in the demand for labor (and for other factors of production); a decrease in the current level of consumption may mean instead an increase in the level of saving, an increase in the level of future consumption, and a corresponding shift of resource demand away from the production for current-period consumption and toward the production for future-period consumption (Hayek 1941, pp. 433-39). There may even be a net increase in the current demand for capital and labor.

Hayek and other Austrian theorists have heeded Mill’s Fourth Proposition by recognizing that in a given period consumption spending and investment spending can—and, in conditions of full employment, must—move in opposite directions. In fact, it is the shifting of resources between consumption and investment activities—and between the different stages of the production process—in response to changing intertemporal consumption preferences that allows the economy to achieve intertemporal coordination. And it is the similar shifting of resources in response to monetary manipulations that constitutes intertemporal discoordination.

—Roger W. Garrison, “Hayekian Trade Cycle Theory: A Reappraisal,” Cato Journal 6, no. 2 (Fall 1986): 441-442.