In Theorizing on Capital, Hayek Uses the Wieserian Device of a COMMUNIST SOCIETY (!) Subject to an Omniscient Dictator

But the Mengerian tradition was developed in very different directions by his brilliant followers, Eugen von Böhm-Bawerk and Friedrich von Wieser, and by their own students and followers. Without tracing out this doctrinal development in any detail, suffice it to say that today the term “Austrian economics” is used to designate two very different paradigms. One derives from Wieser and may be termed the “Hayekian” paradigm, because it represents an elaboration and systematization of the views held by F. A. Hayek, a student of Wieser’s at the University of Vienna. Although it is yet to be generally recognized by Austrians, Wieser’s influence on Hayek was considerable and is especially revealed in the latter’s early work on imputation theory, which sought to vindicate the Wieserian (as against the Böhm-Bawerkian-Misesian) position that the imputation problem must be solved within the context of an exchangeless economy subject to the control of a single will yet somehow able to calculate using (subjective) value as the “arithmetic form of utility.”³

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³That there is no possibility of economic calculation and rational or purposeful allocation of resources within an economy based on division of labor where one will alone acts is, of course, the essence of Mises’s critique of socialism. Perceiving the unbridgeable gulf between his own and Wieser’s position on the possibility of directly imputing values to higher-order goods in the absence of monetary exchange, Mises, in his Notes and Recollections wrote that “[Wieser’s] imputation theory is untenable. His ideas on value calculation justify the conclusion that he could not be called a member of the Austrian School, but rather was a member of the Lausanne School.”

Also, Hayek, explicitly following Wieser, conceives the main problem of capital theory to be to explain how it is that the nonpermanent resources constituting the capital stock can yield a permanent net (physical) return. This Wieser-Hayek method of describing the quaesitum [something sought for, end or objective] of capital theory loads the dice in favor of explaining the interest return on capital in terms of productivity (rather than time-preference) considerations and, at the same time, diverts attention from what Böhm-Bawerk brilliantly perceived to be the fundamental question that must be satisfactorily answered by a correct theory of interest and was so answered by Mises’s pure time-preference theory: What is the cause of the difference in value between goods which differ only in their temporal availability? 

In theorizing on capital, moreover, Hayek makes significant use of the Wieserian device of a communist society subject to the control of an omniscient dictator, a device which reflects a paradigmatic lack of concern with problems of monetary appraisement and calculation. 

—Joseph T. Salerno, “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6, no. 2 (1993): 114, 114n. 

De-Homogenizing Mises and Hayek: Hayek Believes that the Banks Are NOT “GUILTY” of Causing Business Cycles

There is another grave problem with Hayek’s 1933 analysis. He believes that the banks are not “guilty” of causing business cycles also because he thinks that in the early stages the “natural rate of interest” or profit on the market increases, and that the banks are not astute enough to realize it, so that they only pull the loan rate of interest below the natural rate, that is, by not raising their loan rates fast enough to match changes in the natural rate. The difficulty with this is that it misconceives the Misesian (1912) insight. The problem is not one of omission, rather it is one of commission; it is not that the banks are too passive and ignorant about finding the right loan rate to match the natural rate. Instead, it is that they actively expand credit beyond the cash in their vaults, thereby pushing the loan rate below the natural rate. In short, the Misesian view is that the banks don’t have to search for the natural rate in order to avoid generating the business cycle; all they have to do is not expand credit beyond their cash holdings. This is surely a much easier task. The banks’ insistence on expanding credit generates the business cycle, and makes them responsible and thus “guilty” as charged.

—Walter Block and Kenneth M. Garschina, “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process,” Review of Austrian Economics 9, no. 1 (1996): 83.

Hayek Chides Schumpeter on the Assumption of “Imputation” Outside the Market

The breathtaking naivete of the Orthodox Line should have been evident even in the 1940s. As Hayek later chided Schumpeter on the assumption of “imputation” outside the market, this formulation “presumably means . . . that the valuation of the factors of production is implied in, or follows necessarily from the valuation of consumers’ goods. But . . . implication is a logical relationship which can be meaningfully asserted only of propositions simultaneously present to one and the same mind.”

Economists were convinced of the Lange solution because they had already come under the sway of the Walrasian general equilibrium model; Schumpeter, for example, was an ardent Walrasian. In this model, the economy is always in static general equilibrium, a changeless world in which all “data” — tastes or value scales, alternative technologies, and lists of resources — are known to everyone, and where costs are known and always equal to price. The Walrasian world is also one of “perfect” competition, where prices are given to all managers. Indeed, both Taylor and Lange make the point that the Socialist Planning Board will be better able to calculate than capitalist markets, since the socialist planners can ensure “perfect competition,” whereas the real world of capitalism is shot through with various sorts of  “monopolies”! The socialist planners can act like the absurdly fictional Walrasian “auctioneer,” bringing about equilibrium rapidly by trial and error.

—Murray N. Rothbard, “The End of Socialism and the Calculation Debate Revisited,” Review of Austrian Economics 5, no. 2 (1991): 55-56.

According to Marget, Keynes Misrepresents the History of Monetary Theory; Therefore, Progress Involves Escaping the Keynesian “Blind Alley”

Arthur William Marget (1899-1962) was a respected American monetary theorist and scholar who received his doctorate from Harvard in 1926 and taught for the next fifteen years at the University of Minnesota. His best known work, The Theory of Prices (2 vols: 1938, 1942), had three goals. Marget sought to demonstrate that Keynes misrepresented the history of monetary theory, to reveal the shortcomings of Keynes’s own approach, and to show that progress required an escape from the Keynesian “blind alley” and a return to the “high road” of earlier tradition.

The book was either behind its time, ahead of it, or (as I suspect) both. The doctrinal revolution that Marget opposed swept The Theory of Prices aside. Perhaps it was imprudent of him to pursue three ambitious goals at once, for even the book’s supporters found it long and arduous. Nicholas Kaldor, a non-supporter whose review managed to misstate the book’s subtitle, called Prices I “mid-Victorian,” with its “leisurely repetitiousness, elaborate style, pompous exactitude, and . . . exhaustive scholarship,” reminding him “of the bourgeois solidity and spaciousness of that bygone age” (1939, pp. 495-6).²

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²Marget’s response (1942, p. vii): “I, on the contrary, rest my case on the proposition that if the qualities of ‘exactitude,’ ‘solidity,’ and ‘exhaustive scholarship’ are indeed characteristic only of a ‘bygone age,’ that fact constitutes a condemnation of our own age and a commentary on our current needs.”

—John B. Egger, “Arthur Marget in the Austrian Tradition of the Theory of Money,” Review of Austrian Economics 8, no. 2 (1995): 3-4, 4n.

Caballero (2010) Describes the “Dynamic Stochastic General Equilibrium” Model Class as “an Irresistible Snake-Charmer”

The Great Recession seems to be creating a change in the trend of macroeconomic thinking. Prior to the financial crisis of 2008, dynamic stochastic general equilibrium (DSGE) models dominated the macroeconomics literature without any apparent challengers on the horizon. Since then, however, we have seen an increasing interest in macroeconomic models that address the state of confidence (“animal spirits”), complexity, cognition, and radical uncertainty. . . .

Most of the renewed interest in animal spirits, complexity, cognition, and radical uncertainty has come from a more or less “Keynesian” perspective and might alternatively be described as the “return of interventionism.” We note that rejecting the stale theoretical approach of the last few decades could just as well coincide with a greater appreciation of capitalism in general and the market process in particular. Caballero (2010) illustrates the potential to emphasize animal spirits, complexity, cognition, and radical uncertainty from a more “Hayekian” perspective. Indeed, we believe that we may be seeing the revival of old disputes between Keynesian and Hayekian perspectives in macroeconomics. Whether (and to what extent) self-consciously “Austrian” economists will contribute, should these disputes reemerge, may depend on whether they prove themselves able to enter the conversation in a constructive and understandable way. . . . 

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Caballero (2010)—who warns against “the pretense of knowledge”—provides support for our claim that macroeconomic thinking is moving in a direction more favorable to Austrian insights. He describes the DSGE model class as “an irresistible snake-charmer” and calls for a radical change in macroeconomics (p. 86). “The root cause of the poor state of affairs in the field of macroeconomics,” according to Caballero (2010, p. 100), “lies in a fundamental tension in academic macroeconomics between the enormous complexity of its subject and the micro-theory-like precision to which we aspire.”

—Roger Koppl and William J. Luther, “Hayek, Keynes, and Modern Macroeconomics,” Review of Austrian Economics 25, no. 3 (September 2012): 224, 235.

The Efficient-Markets Hypothesis Is a Good Example of the Neglect of the Entrepreneur in Economic Theory

The entrepreneur is a key figure in the market economy. In a dynamic economy, ideas, products, and services are constantly changing. Entrepreneurship, broadly defined, refers to actions of individuals as they strive to cope with constantly changing market conditions. When viewed in this way, all market participants—consumers, producers, and investors—engage in entrepreneurial activity.

Despite the crucial role of entrepreneurship in the market process, the entrepreneur is often neglected in economic theory. A good example of this neglect is the efficient-markets hypothesis (EMH) of financial investments. This theory holds that the individual investor cannot outwit the market because all available information is already incorporated in stock prices. The efficient-markets approach taken to its logical extreme “means that a blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the expert.” The implication is that a buy-and-hold strategy is as good as any other and that there is no scope for entrepreneurial activity in financial markets.

Insights from the Austrian theory of the competitive market process are used in this article to show that the role of the entrepreneur in investment decisions is similar to that in other spheres of economic activity. Entrepreneurial opportunities exist whenever markets are not perfectly coordinated. Hence, it is argued, there is scope for entrepreneurial activity in financial markets just as there is in other markets. In a world of uncertainty and costly information, the pinpointing of economic inefficiencies is found to be just as difficult in financial markets as it is in all other markets. Since the EMH is a version of the zero-profit theorem of competitive equilibrium in the conventional theory of the firm, it is argued that shortcomings of the EMH are similar to those of other long-run competitive theories that focus exclusively on equilibrium outcomes while ignoring the entrepreneurial market process that generated those outcomes. The conclusion is that neither the dart-throwing monkey nor any other automaton is a good substitute for the entrepreneur in investment markets where relative prospects for different assets are constantly changing. Before specifically considering the role of entrepreneurship in financial markets, the reason for the neglect of the entrepreneur in conventional economic analysis is briefly analyzed.

—E. C. Pasour Jr., “The Efficient-Markets Hypothesis and Entrepreneurship,” Review of Austrian Economics 3, no. 1 (December 1989): 95-96.

A Major Problem with the Efficient Market Hypothesis Is It Assumes Everyone Arrives at a Rational Expectations Forecast

The efficiency of the market means that the individual investor cannot outwit the market by trading on the basis of the available information. The implication of the EMH [efficient market hypothesis] is destructive for fundamental analysis, for this means that analysis of past data is of little help since whatever information this analysis will reveal is already contained in asset prices. Proponents of the EMH argue that if past data contains no information for the prediction of future prices, then it follows that there is no point in paying attention to fundamental analysis. A simple policy of random buying and holding will do the trick. One of the pioneers of the EMH who has popularized this framework is Burton G. Malkiel.

The theory holds that the market appears to adjust so quickly to information about individual stocks and the economy as a whole that no technique of selecting a portfolio — neither technical nor fundamental analysis — can consistently outperform a strategy of simply buying and holding a diversified group of securities. 

Consequently, Malkiel argues that,

A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by the expert. 

The major problem with the EMH is that it assumes that all market participants arrive at a rational expectations forecast. This, however, means that all market participants have the same expectations about future securities returns. Yet, if participants are alike in the sense of having homogeneous expectations, then why should there be trade? After all, trade implies the existence of heterogeneous expectations. This is what bulls and bears are all about. A buyer expects a rise in the asset price while the seller expects a fall in the price.

—Frank Shostak, “In Defense of Fundamental Analysis: A Critique of the Efficient Market Hypothesis,” Review of Austrian Economics 10, no. 2 (1997): 28-29.

The Uniqueness of Mises’s Calculation Challenge to Socialism Is that It Is Totally Unrelated to the Incentive Problem

But the uniqueness and the crucial importance of Mises’s challenge to socialism is that it was totally unrelated to the well-known incentive problem. Mises in effect said: All right, suppose that the socialists have been able to create a mighty army of citizens all eager to do the bidding of their masters, the socialist planners. What exactly would those planners tell this army to do? How would they know what products to order their eager slaves to produce, at what stage of production, how much of the product at each stage, what techniques or raw materials to use in that production and how much of each, and where specifically to locate all this production? How would they know their costs, or what process of production is or is not efficient?

Mises demonstrated that, in any economy more complex than the Crusoe or primitive family level, the socialist planning board would simply not know what to do, or how to answer any of these vital questions. Developing the momentous concept of calculation, Mises pointed out that the planning board could not answer these questions because socialism would lack the indispensable tool that private entrepreneurs use to appraise and calculate: the existence of a market in the means of production, a market that brings about money prices based on genuine profit-seeking exchanges by private owners of these means of production. Since the very essence of socialism is collective ownership of the means of production, the planning board would not be able to plan, or to make any sort of rational economic decisions. Its decisions would necessarily be completely arbitrary and chaotic, and therefore the existence of a socialist planned economy is literally “impossible” (to use a term long ridiculed by Mises’s critics).

—Murray N. Rothbard, “The End of Socialism and the Calculation Debate Revisited,” Review of Austrian Economics 5, no. 2 (1991): 52-53.

The Socialist Commonwealth Is Incapable of Measuring the Needs of Its Citizens and Is Unable to Give Directives to the Producing Units

He [Mises] next disposes of O. Neurath’s new proposal for calculation in physical terms, on account of its inability to add up different goods. There follows a discussion of a book by the exiled Russian economist Boris Brutzkus, who extensively treats the problem of economic calculation under Soviet socialism. Brutzkus concurs with von Mises that without economic calculation, rational economic action under whatever kind of economic system is impossible. He also is of the opinion that the fact that production requires the combination of three factors (land, labor, and capital) retains its validity and importance under socialism. Therefore, a calculation solely in terms of labor values is incapable of providing an indication of the greater or lesser profitability of enterprises. With that the drafting of a uniform plan, the essence of Marxism, becomes impossible. Von Mises quotes Brutzkus to the effect that:

With this the socialist commonwealth, even with the entire instrumentarium of scientific theory and a gigantic statistical apparatus, is incapable of measuring the needs of its citizens and of evaluating them and is therefore not in a position to give the necessary directives to the producing units (N.S., p. 189).

Von Mises finds Brutzkus’s book the first one that deals with the problem of the Soviet Union in a scientific way. All other works are of a descriptive nature and the presentation of the facts either suffers from an uncritical hatred of the Soviet Union (from which he therefore obviously wished to dissociate himself) or from its uncritical adulation.

—William Keizer, “Two Forgotten Articles by Ludwig von Mises on the Rationality of Socialist Economic Calculation,” Review of Austrian Economics 1, no. 1 (1987): 118-119.

LTV Is Useless for Economic Calculation Because of the “Reduction Problem” and Because It Ignores Natural Factors of Production

Von Mises finally discusses Leichter, who rigorously adheres to the labor theory of value. Von Mises repeats the arguments he made against this theory in his 1922 book Die Gemeinwirtschaft. The labor theory of value is useless for economic calculation because it is incapable of converting labor of different qualities to a single standard (the so-called “reduction problem”) and because it does not take into account the natural factors of production. Leichter believes that the importance of the various labor tasks can be compared with each other. Von Mises says that such comparisons can of course be made, but that they will lead to different results, depending on the subjective valuations of the person who made them. And what does “importance” mean in this context? Does it refer to the importance of being on the job, of producing better work, or the arduousness of the work, and so forth? Each of these comparisons yields a different result, but only one can be the basis of the reduction factor. Leichter’s contention that practice daily solves this problem by establishing wages (which was also Marx’s solution to this problem) is wholly erroneous. Wage rates are established in market exchange on the basis of subjective valuations, and the problem is precisely whether it is possible to reduce the various kinds of labor to a single standard in a society without market exchange. Leichter attempts his way out of this circular reasoning by stressing that modern wage negotiations have “nearly” nothing to do with “market haggling” in the normal sense of the word—supply and demand play “nearly” no role in determining the wage differentials. Von Mises notes that the double insertion of the word “nearly” robs these arguments of their basis.

The origin of Leichter’s (and Marx’s) error lies in an inadequate and unclear comprehension of the nature of the market mechanism and market price creation. To Leichter, the essence of the market seems to be “haggling” and reference to supply and demand. Von Mises states, however, that “haggling” may even be absent altogether. Even where “fixed” prices that “allow of no reduction” exist, the market mechanism acts in its usual way, except that the state of the market does not so much influence the price through the actual negotiations of the market parties, but through their behavior, such as the absence or queuing of buyers and the corresponding behavior of the sellers.

Von Mises’s other argument against the labor theory of value is that economic calculation should not only comprise labor, but also the material means of production, such as those provided by Nature. Leichter does not demonstrate how the problem of socialist economic calculation can be solved regarding these scarce goods, on which no labor has been spent. He does remark that “society” will set higher prices for these scarce goods. Von Mises argues that the problem is not whether society sets higher or lower prices, but whether it will be able to do so on the basis of the results of economic calculation. “It was never doubted that society can dispose: I maintain that it cannot do so rationally, i.e. on the basis of a calculation” (N.B., p. 500). Orthodox Marxists have been as incapable as others in finding a useful system of economic calculation for a socialist society.

—William Keizer, “Two Forgotten Articles by Ludwig von Mises on the Rationality of Socialist Economic Calculation,” Review of Austrian Economics 1, no. 1 (1987): 117-118.

The True Function of a Positive Rate of Interest Is to Act As an Intertemporal Brake

³Larry Moss has directed my attention to a passage in Mark Blaug’s Economic Theory in Retrospect (1985 [1962]) in which Blaug sets out Böhm-Bawerk’s theory of capital and interest using the “brake” metaphor: “The true function of a positive rate of interest then is to act as a brake on the tendency to neglect present wants by overextending the period of production” (p. 505). The Austrian interest rate as an intertemporal brake stands in sharp contrast to the neoclassical interest rate as a reflection of capital’s productivity. What the interest rate actually reflects, according to the Austrians, is people’s reluctance to forgo enough current consumption to take the fullest advantage of time-consuming production processes.

—Roger W. Garrison, “From Keynes to Hayek: The Marvel of Thriving Macroeconomies,” Review of Austrian Economics 19, no. 1 (March 2006): 11n.

Endogenous Expectations Present a Compelling Alternative to Exogenous Theories of Expectations

There would be no business cycle without government artificially expanding credit. Although it may be true that distorted signals were created through government involvement, the critics say, to pin everything on government intervention implies a type of perfect markets theory where there are never any bubbles or systemically inaccurate expectations. But what about the hundreds of bubbles across countries and throughout history (Kindleberger and Aliber 2011)? Surely government intervention did not cause all of them. And if some bubbles occur without government intervention, why not all of them? These critics claim that business cycles are driven by market excesses, not by government intervention (Keynes 2006 [1936], Krugman 2000; Shiller 2006; Minsky and Kaufman 2008; Akerlof and Shiller 2010; Kindleberger and Aliber 2011).

Incorporating endogenous expectations into ABCT [Austrian Business Cycle Theory] answers these critics. By recognizing why people engage in speculation, make seemingly foolish, unrealizable plans, and how markets usually restrain this behavior, Austrian theorists can better explain exactly how government policies contribute to naturally occurring asset bubbles. Understanding how people form expectations highlights how governments often replace limited self-correcting asset bubbles with large bubbles by distorting entrepreneurs’ and consumers’ expectations. We need to understand how people interpret relative price changes, particularly with respect to their expectations of future prices. Unfortunately the mechanisms for how and why expectations change are largely ignored.

This paper sketches a theory, in the tradition of Menger, Mises, and Hayek, that expectations are endogenous to market processes and institutions. Endogenous expectations present a compelling alternative to exogenous theories of expectations, particularly rational expectations. It also forms the basis for an Austrian response to the “irrational exuberance” and “animal spirits” theories advanced by Shiller (2006) and Akerlof and Shiller (2010). Although many Austrians understand the importance of expectations (Mises 2009 [1912], 1949; Lachmann 1943; Wagner 1999; Garrison 2001; Carilli and Dempster 2001; Evans and Baxendale 2008), an analytical theory of expectations remains largely absent from their theorizing. Surveying recent Austrian treatments of the 2008 financial crisis reveals little interest or awareness of the role played by individuals’ interpretive frameworks or expectations.

—Paul D. Mueller, “An Austrian View of Expectations and Business Cycles,” Review of Austrian Economics 27, no. 2 (June 2014): 200.

Friendly Approaches to the Rational Expectations Challenge to the Austrian Business Cycle Theory

According to the rational expectations critique, for instance, as found in Caplan (1997) and Tullock (1988, 1989), the theory needs to explain how otherwise rational entrepreneurs are so easily deceived by a publicly known monetary policy. . . . If entrepreneurs had rational expectations, they would not produce systematic errors. . . .

Broadly speaking, the answers to the rational expectations challenge to the ABCT can be divided into two groups: (1) A friendly approach to the rational expectations critique that acknowledges a need for revision but concludes that the theory still holds and (2) a less friendly approach that maintains that the problem does not lie with the theory but with the initial rational expectations assumption.

The first group can be represented by Carilli and Dempster (2001) and Evans and Baxendale (2008), who treat the rational expectation critique as a “valid challenge and accept the fundamental claim that in its present form the Austrian theory requires revision.”

Carilli and Dempster’s (2001) argument is that the expansive monetary policy of the monetary authority places the entrepreneurs and banks in a prisoner’s dilemma. In short, seizing capital gains during a boom by investing in long-term and capital intensive projects and selling them to other investors before the boom ends is rational behavior. Because this exposition falls within the framework of the prisoner’s dilemma, the rational behavior is implicitly embedded in the exposition.

Evans and Baxendale (2008) accept the rational expectations challenge but argue that because entrepreneurs are heterogeneous, the cluster of errors is driven not by a representative entrepreneur but by entrepreneurs on the margin. For Evans and Baxendale (2008), the critic still must offer a convincing explanation why entrepreneurs can be assumed to be homogeneous. Even if the entrepreneurial heterogeneity argument may put Evans and Baxendale (2008) between the two groups, they still offer a friendly reception to the rational expectations challenge.

—Nicolas Cachanosky, “Expectation in Austrian Business Cycle Theory: Market Share Matters,” Review of Austrian Economics 28, no. 2 (June 2015): 153.