In His 1903 Work Titled “Money” (“Das Geld”), Karl Helfferich Laid Down the “Austrian Circle” Challenge to the Austrian School of Economics

In 1903, the influential monetary economist Karl Helfferich, in his work on Money, laid down a challenge to the Austrian School. He pointed out correctly that the great Austrians, Menger, Böhm-Bawerk, and their followers, despite their prowess in analyzing the market and the value of goods and services (what we would now call “micro-economics”), had not managed to solve the problem of money. Marginal utility theory had not been extended to the value of money, which had continued, as under the English classical economists, to be kept in a “macro” box strictly separate from utility, value, and relative prices. Even the best monetary analysis, as in Ricardo, the Currency School, and Irving Fisher in the United States, had been developed in terms of “price levels,” “velocities,” and other aggregates completely ungrounded in any micro analysis of the actions of individuals.

In particular, the extension of Austrian analysis to money faced a seemingly insuperable obstacle, the “problem of the Austrian circle.”

—Murray N. Rothbard, The Essential von Mises (Auburn, AL: Ludwig von Mises Institute, 2009), 55.

The Austro-Hungarian Bank Saw Mises’s Gold Standard Proposal as a Threat to Its Secret and Illegal Slush Fund

In 1906, his doctorate out of the way, Mises determined to take up the Helfferich challenge, apply marginal utility theory to money, and solve the problem of the Austrian circle. He devoted a great deal of effort to both empirical and theoretical studies of monetary problems. The first fruits of this study were three scholarly articles, two in German journals and one in the English Economic Journal in 1908–09, on foreign exchange controls and the gold standard in Austria-Hungary. In the course of writing these articles, Mises became convinced that, contrary to prevailing opinion, monetary inflation was the cause of balance of payments deficits instead of the other way round, and that bank credit should not be “elastic” to fulfill the alleged needs of trade.

Mises’s article on the gold standard proved highly controversial. He called for a de jure return in Austria-Hungary to gold redemption as a logical conclusion of the existing de facto policy of redeemability. In addition to running up against advocates of inflation, lower interest rates, and lower exchange rates, Mises was surprised to face ferocious opposition by the central bank, the Austro-Hungarian Bank. In fact, the Bank’s vice-president hinted at a bribe to soften Mises’s position. A few years later, Mises was informed by Böhm-Bawerk, then Minister of Finance, of the reason for the vehemence of the Bank’s opposition to his proposal for a legal gold standard. Legal redemption in gold would probably deprive the Bank of the right to invest funds in foreign currencies. But the Bank had long used proceeds from these investments to amass a secret and illegal slush fund, from which to pay subventions to its own officials, as well as to influential journalists and politicians. The Bank was keen on retaining the slush fund, and so it was fitting that Mises’s most militant opponent was the publisher of an economic periodical who was himself a recipient of Bank subsidies.

—Murray N. Rothbard, The Essential von Mises (Auburn, AL: Ludwig von Mises Institute, 2009), 56-57.

Irving Fisher Was the True Founder of Modern Macroeconomics with Its Aggregative Reasoning and Its Politically Managed Fiat Money

This new view culminated in the work of Irving Fisher, who in 1911 formalized the quantity theory in mathematical terms and proposed it as a formula for use by politicians and bureaucrats charged with the task of managing money in the interests of stability of the price level. Indeed, it was Fisher and not Keynes who was the true founder of modern macroeconomics with its aggregative reasoning and its central notion of politically managed fiat money. As the modern monetary theorist and historian of thought, Jürg Niehans wrote:

Fisher’s reformulation of the quantity theory of money … has successfully survived seventy-five years of monetary debate without a need for major revision; its analytical content is accepted today by economists of all persuasions, and in the present world of fiat money it is actually more relevant than it was in Fisher’s gold standard world.

Such was the state of monetary economics when Mises published his seminal work on The Theory of Money and Credit, in 1912. In writing this book, Mises achieved two aims. The first was to reconstruct monetary theory by integrating it with the subjective-value theory of price which had been developed by the early Austrian economists, most notably Carl Menger and Eugen Böhm-Bawerk. By doing this Mises was able to resolve the so-called “Austrian Circle,” according to which the value of money could not be explained in terms of marginal utility because any such explanation involved circular reasoning. It was this misconception that opened the door to Fisher’s analysis of money in terms of aggregative variables such as the national money supply, velocity of circulation of money, the average price level, and so on, eventually leading to the unquestioned predominance of the macroeconomic quantity theory of money.

—Joseph T. Salerno, introduction to Money: Sound and Unsound (Auburn, AL: Ludwig von Mises Institute, 2010), xv-xvi.

The Bimetallistic Refinement of the Quantity Theory after 1870 Contributed to the Destruction of the Gold Standard

The proponents of the bimetallic standard argued for remonetization of silver on the grounds that this measure would increase the money supply and thus arrest the decline in prices under the monometallic gold standard that had begun in the late 1870s. The quantity theory of money was the foundation of the arguments put forward by the bimetallists. The theoretical counter-arguments of the advocates of the monometallic gold standard were completely inadequate to meet the challenge posed by the quantity theorists. They were based on the view that the costs of production of mining gold directly determined the price level, a distortion of classical monetary theory developed by Ricardo and the currency school. Paradoxically, although the gold standard remained intact, at least for the short run, the seeds for its eventual abolition had been sown because the classical sound money doctrine had been discredited among economists.

As David Laidler, a modern proponent of the quantity theory, commented:

[T]he refinement of the quantity theory after 1870 did not strengthen the intellectual foundations of the Gold Standard. On the contrary, it was an important element in bringing about its eventual destruction. . . . [T]he notion of a managed money, available to be deployed in the cause of macroeconomic stability and capable of producing a better economic environment than one tied to gold, was not an intellectual response to the monetary instability of the post-war period. The idea appeared in a variety of guises in the pre-war literature as a corollary of the quantity theory there expounded.

Thus by the end of the nineteenth century the view that money should ideally be “stable” in value had fully displaced the classical ideal of “sound” money, meaning a commodity chosen by the market whose value was strictly governed by market forces and immune to manipulation by governments.

—Joseph T. Salerno, introduction to Money: Sound and Unsound (Auburn, AL: Ludwig von Mises Institute, 2010), xiv-xv.

Bimetallist Regimes Functioned As Alternating Monometallic Standards Due to Differences Between the Legal and Market Bimetallic Ratios

The bimetallist regimes that were legally in force in France, Belgium, Switzerland, Italy, and the U.S. actually ended up functioning as alternating monometallic standards. In the face of fixed legal bimetallic ratios (i.e., the official mint values at which silver could be exchanged for gold) in these nations, developments in the market for precious metals that caused the international market bimetallic ratio (i.e., the price at which silver bullion exchanged for gold bullion on the open market) to change also caused one of the metals to drive the other out of circulation.

In the U.S., for instance, the period before 1834 was a de facto silver standard owing to the fact that the market bimetallic ratio was consistently greater than the legal ratio (15-to-1) that prevailed in the U.S. Reacting to a shortage of circulating gold, Congress raised the legal ratio to 16-to-1 in 1834. This now placed the legal ratio above the market ratio, which meant that it would now be profitable for individuals to take silver out of circulation (which was now the undervalued rather than overvalued metal at the mint) and bring their gold (which was now the overvalued metal) to the mints. Quite expectedly, gold now displaced silver in circulation. In 1853, the revision of the coinage laws did not alter the legal ratio so as to bring silver back into circulation. Hence, the U.S. was actually practicing a gold standard de facto from the 1830s.

—Giulio M. Gallarotti, The Anatomy of an International Monetary Regime: The Classical Gold Standard, 1880-1914 (New York: Oxford University Press, 1995), 21.

Once You Admit the Existence of a State, then All Private Property Has Been Effectively Abolished; Therefore, State, Any State, MEANS Socialism

What Murray realized and I still had to learn was that the most vociferous and ferocious rejection and opposition to Austro-libertarianism would not come from the traditional socialist Left, but rather from these very self-proclaimed “anti-socialist,” “limited government,” “minimal state,” “pro-private enterprise,” and “pro-freedom” outfits and their intellectual mouthpieces, and above all from what has become known as the Beltway Libertarians. They simply could not stomach the fact that Murray had demonstrated with plain logic that their doctrines were nothing but inconsistent intellectual clap-trap, and that they were all, to use Mises’s verdict vis-a-vis Milton Friedman and his company, a “bunch of socialists,” too, notwithstanding their vehement protestations to the contrary. For, as Murray argued, once you admitted the existence of a State, any State, defined as a territorial monopolist of ultimate decision-making in every case of conflict, including conflicts involving the State itself, then all private property had been effectively abolished, even if it remained provisionally, qua State-grant, nominally private, and had been replaced instead by a system of “collective” or rather State-property. State, any State, means socialism, defined as “the collective ownership of factors of production.” The institution of a State is praxeologically incompatible with private property and private property based enterprise. It is the very anti-thesis of private property, and any proponent of private property and private enterprise then must, as a matter of logic, be an anarchist. In this regard (as in many others) Murray was unwilling to compromise, or “intransigent,” as his detractors would say. Because in theory, in thinking, compromise is impermissible. In everyday life, compromise is a permanent, and ubiquitous feature, of course. But in theory, compromise is the ultimate sin, a strict and absolute ‘no no.’ It is not permissible, for instance, to compromise between the two incompatible propositions that 1+1=2 or that 1+1=3 and accept that it is 2.5. Either some proposition is true or it is false. There can be no “meeting in the middle” of truth and falsehood.

—Hans-Hermann Hoppe, Getting Libertarianism Right (Auburn, AL: Mises Institute, 2018), 109-111.

Any Explanation of the Business Cycle Must Necessarily Be a Praxeological (As Opposed to a Psychological) One

Business cycles—so the central message of chapter 22 of Keynes’s General Theory, the “Notes on the Trade Cycle”—are psychologically determined phenomena. This is surely incorrect. A psychological explanation of the business cycle is strictly impossible, and to think of it as an explanation involves a category mistake: Business cycles are obviously real events, experienced by individuals, but experienced by them as occurring outside of them in the world of real goods and real wealth. Beliefs, sentiments, expectations, optimism, and pessimism on the other side are psychological phenomena. One can think of one psychological phenomenon as affecting or influencing another one, but it is impossible to conceive of a psychological phenomenon as having any direct impact on outcomes in the outside world of real things and goods. Only through actions can the course of real events be influenced; and any explanation of the business cycle then must necessarily be a praxeological (as opposed to a psychological) one.

—Hans-Hermann Hoppe, “Theory of Employment, Money, Interest, and the Capitalist Process: The Misesian Case Against Keynes,” in The Economics and Ethics of Private Property: Studies in Political Economy and Philosophy, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2006), 167-168.

The Socialist Society Will Always Decide for the Shorter Production Period, Preferring to Produce Consumer Goods Instead of Capital Goods

In the individualistic society the individual, not society, accumulates. Capital accumulation takes place by saving; the saver has the incentive of receiving income from the saved capital as the reward of saving. In the communist society, society as such will receive the income that today flows to the capitalists alone; it will then distribute this income equally to all members or otherwise use it for the good of the whole. Will that alone be a sufficient incentive for saving? To be able to answer this question, one must imagine that the society of the socialist state will be faced every day with the choice whether it should devote itself more to the production of consumer goods or more to that of capital goods, whether it should choose productive processes that do indeed take a shorter time but correspondingly yield less output or choose ones that take more time but then also bring greater output. The liberal thinks that the socialist society will always decide for the shorter production period, that it will prefer to produce consumer goods instead of capital goods, that it will consume the means of production it will have taken over as heir of the liberal society or at best maintain them but in no case increase them. That, however, would mean that socialism will bring stagnation, if not the decline of our whole economic civilization, and misery and need for all. That the state and the cities have already pursued investment policy on a large scale is no disproof of this assertion, since they pursued this activity entirely with the means of the liberal system. The means were raised by loans, that is, they were provided by private parties who expected from them an increase in their capital incomes. If in the future, however, the socialist society should face the question whether it will feed, clothe, and house its members better or whether it will save on all these things in order to build railroads and canals, to open mines, to undertake agricultural improvements for the coming generations, then it will decide for the former, even on psychological and political grounds alone.

—Ludwig von Mises, Nation, State, and Economy: Contributions to the Politics and History of Our Time, trans. Leland B. Yeager, ed. Bettina Bien Greaves (Indianapolis: Liberty Fund, 2006), 157-158.

In “Hydraulic Keynesianism,” the Models Resembled the Mathematical Description of a Plumbing System

The difficulty in understanding the General Theory may have contributed to its success as the founding text of macroeconomics. The book is open to alternative interpretations. In the post-war years, if you wanted to propose interventionist policies to ‘stabilise the economy’ or otherwise improve economic performance, you might well cite the General Theory as the source or context for your proposed policies. Thus, a variety of interventionist systems of thought were labelled ‘Keynesian’.

After the war, one version of economics, described as Keynesian, came to dominate macroeconomics. This breed of Keynesianism would estimate a consumption function, an investment function and other functions intended to represent stable relationships determining the overall levels of output, employment and prices. Changing policy variables such as the government deficit could, it was thought, shift these functions about and give us a better combination of output, employment and prices. Increasing money growth, for example, would inevitably cause some price inflation, but it would also reduce unemployment. This supposed inverse relationship between inflation and unemployment (Samuelson and Solow 1960) is known as the ‘Phillips curve’. Assuming a stable Phillips curve, any event that might increase unemployment could be met with a bit of inflation as a reliable offset.

This sort of macroeconomics is sometimes called ‘hydraulic Keynesianism’. Keynes was claimed as an important source and it was ‘hydraulic’ because the models resembled the mathematical description of a plumbing system. The flow of spending in an economy looked like the flow of water in a system of pipes. And just as we can regulate the flow of water with a few valves, we can regulate the economy with a few relatively simple policy instruments – or so it was thought.

—Roger Koppl, From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 41-43.

For John Law, Money Is an “Instrument” That Is Deliberately Designed to Achieve the “Policy Goals” of Government Planners

In 1705, Law published his principal work on money, entitled Money and Trade Considered: With a Proposal for Supplying the Nation with Money. Law’s “proposal” was intended to provide his native Scotland with a plentiful supply of money endowed with a long-run stability of value. The institutional centerpiece envisioned in Law’s scheme resembles a modern central bank, empowered to supply paper fiat money via the purchases and sales of securities and other assets on the open market. Also strikingly modern are the theoretical propositions with which Law supports his policy goals and prescriptions.

Law initiates his monetary theorizing with two fundamental assumptions about the nature and function of money. The first is that if money is not exactly an original creation of political authority, it ideally functions as a tool to be molded and wielded by government. Law believes that the State, as incarnated in the King, is the de facto “owner” of the money supply and that it therefore possesses the right and the power to determine the composition and quantity of money in light of the “public interest.” Writes Law:

All the coin of the Kingdom belongs to the State, represented in France by the King: it belongs to him in precisely the same way as the high roads do, not that he may appropriate them as his own property, but in order to prevent others doing so; and as it is one of the rights of the King, and of the King alone, to make changes in the highways for the benefit of the public, of which he (or his officers) is the sole judge, so it is also one of his rights to change the gold or silver coin into other exchange tokens, of greater benefit to the public. . . .

Translating Law’s statement into modern terms, money is an “instrument” that is or should be deliberately designed to achieve the “policy goals” considered desirable by political money managers and other government planners.

—Joseph T. Salerno, “Two Traditions in Modern Monetary Theory: John Law and A. R. J. Turgot,” in Money: Sound and Unsound (Auburn, AL: Ludwig von Mises Institute, 2010), 3-4. 

Although the Demand for Money Can Be Defined as a FLOW or as a STOCK, We Will Use the Stock or Cash Balances Definition

The demand for money can be defined either as the demand for monetary payments (flow), or as the demand for cash balances (stock). As far as the determination of the price level is concerned, both definitions lead to the same result. We will work with the second definition (money demand concerns cash balances) because it highlights the crucial fact that money renders its services not only at the moment when it is used in spending, but also during the entire period when it is being held or “hoarded.” Money is the most marketable commodity. Thus cash balances, even while they are not being spent, provide liquidity services to their owners.

Cash balances are demanded for the liquidity services they provide. They are demanded for their purchasing power. The only exception is the merely nominal demand for money by collectors. The latter are not interested in the purchasing power of the bank notes and coins they collect. They are only interested in the notes and coins per se—that is why we call them collectors. But true money users do not demand mere nominal cash balances, but real cash balances. They demand a certain purchasing power.

—Jörg Guido Hülsmann, “The Demand for Money and the Time-Structure of Production,” in Property, Freedom, and Society: Essays in Honor of Hans-Herman Hoppe, ed. Jörg Guido Hülsmann and Stephan Kinsella (Auburn, AL: Ludwig von Mises Institute, 2009), 311.

The Static State Can Dispense with Economic Calculation But a Static State Is Impossible in Real Life

The static state can dispense with economic calculation. For here the same events in economic life are ever recurring; and if we assume that the first disposition of the static socialist economy follows on the basis of the final state of the competitive economy, we might at all events conceive of a socialist production system which is rationally controlled from an economic point of view. But this is only conceptually possible. For the moment, we leave aside the fact that a static state is impossible in real life, as our economic data are forever changing, so that the static nature of economic activity is only a theoretical assumption corresponding to no real state of affairs, however necessary it may be for our thinking and for the perfection of our knowledge of economics. Even so, we must assume that the transition to socialism must, as a consequence of the levelling out of the differences in income and the resultant readjustments in consumption, and therefore production, change all economic data in such a way that a connecting link with the final state of affairs in the previously existing competitive economy becomes impossible. But then we have the spectacle of a socialist economic order floundering in the ocean of possible and conceivable economic combinations without the compass of economic calculation.

—Ludwig von Mises, Economic Calculation in the Socialist Commonwealth, trans. S. Adler (1990; repr., Auburn, AL: Ludwig von Mises Institute, 2012), 22-23.

Calculation “In Natura,” In an Economy Without Exchange, Can Embrace Consumption Goods Only and Completely Fails with Goods of a Higher Order

It is an illusion to imagine that in a socialist state calculation in natura can take the place of monetary calculation. Calculation in natura, in an economy without exchange, can embrace consumption goods only; it completely fails when it comes to dealing with goods of a higher order. And as soon as one gives up the conception of a freely established monetary price for goods of a higher order, rational production becomes completely impossible. Every step that takes us away from private ownership of the means of production and from the use of money also takes us away from rational economics.

It is easy to overlook this fact, considering that the extent to which socialism is in evidence among us constitutes only a socialistic oasis in a society with monetary exchange, which is still a free society to a certain degree. In one sense we may agree with the socialists’ assertion which is otherwise entirely untenable and advanced only as a demagogic point, to the effect that the nationalization and municipalization of enterprise is not really socialism, since these concerns in their business organizations are so much dependent upon the environing economic system with its free commerce that they cannot be said to partake today of the really essential nature of a socialist economy. In state and municipal undertakings technical improvements are introduced because their effect in similar private enterprises, domestic or foreign, can be noticed, and because those private industries which produce the materials for these improvements give the impulse for their introduction. In these concerns the advantages of reorganization can be established, because they operate within the sphere of a society based upon private ownership of the means of production and upon the system of monetary exchange, being thus capable of computation and account. This state of affairs, however, could not obtain in the case of socialist concerns operating in a purely socialistic environment.

—Ludwig von Mises, Economic Calculation in the Socialist Commonwealth, trans. S. Adler (1990; repr., Auburn, AL: Ludwig von Mises Institute, 2012), 17-18.

A Consistent Macroeconomic Approach Would Have to Shun Any Reference to Prices and to Money

The macroeconomist deceives himself if in his reasoning he employs money prices determined on the market by individual buyers and sellers. A consistent macroeconomic approach would have to shun any reference to prices and to money. The market economy is a social system in which individuals are acting. The valuations of individuals as manifested in the market prices determine the course of all production activities. If one wants to oppose to the reality of the market economy the image of a holistic system, one must abstain from any use of prices.

—Ludwig von Mises, The Ultimate Foundation of Economic Science: An Essay on Method (Princeton, NJ: D. Van Nostrand Company, 1962), 84.

This Is Not Science — It Is Witchcraft! Seeing How Bad Econometric Forecasting Is

As for forecasting, a look at the literature on exchange rate economics gives us an idea of how bad econometric forecasting is. We can predict precisely when a falling object will hit the ground and where a projectile will land, but we cannot predict with a reasonable level of confidence whether a currency will appreciate or depreciate on the announcement of unemployment data — that is, we cannot even predict the direction of change, let alone the magnitude of change. I must admit, however, that economists (or applied econometricians) are good at finding explanations for currency appreciation or depreciation in response to the announcement of unemployment data — only after the fact, of course. It all depends on what the researcher wants to prove and if that turns out not to be the case, an explanation is found for why it did not turn out to be the case, sometimes blaming the unwanted results on econometrics itself (such as the low power of the test). This is not science — it is witchcraft.

—Imad A. Moosa, Econometrics as a Con Art: Exposing the Limitations and Abuses of Econometrics (Cheltenham, UK: Edward Elgar Publishing, 2017), 52.

Econometrics Has Been a Success Only in the Limited Sense That It Can Be Used to Prove Almost Anything

Econometrics has been a success only in the limited sense that it can be used to prove almost anything. I have always challenged seminar presenters, saying that if they let me have their data I could turn their results upside down and come up with a different conclusion. Econometrics is very useful for those wanting to prove a pre-conceived belief or find results that support an ideologically driven hypothesis. Take, for example, Brexit, which had proponents and opponents. The empirical results produced by the opponents on the effect of Brexit on the British economy of leaving the EU are all over the place but ideological bias is conspicuous. For example, the Confederation of British Industry (2013), which is against Brexit, estimated the net benefit to Britain of EU membership to be in the region of 4 per cent to 5 per cent of GDP — that is, between £62 billion and £78 billion per year. Conversely, Congdon (2014) puts the cost of Britain’s membership of the EU at 10 per cent, attributing this cost to regulation and resource misallocation. Congdon’s estimates were prepared for the United Kingdom Independence Party (UKIP), which has a strong anti-Europe stance.

—Imad A. Moosa, Econometrics as a Con Art: Exposing the Limitations and Abuses of Econometrics (Cheltenham, UK: Edward Elgar Publishing, 2017), 18.

Anglo-American Economists Are Living in Their Dream World and Are Ignorant of the History of Economic Thought

To one outside the magic circle of the Keynesians the reason seems to be what can be called the isolationism of Anglo-American economics. It is this isolationism that prevents economists from seeing the merits and weaknesses of their work in a detached and objective way and in the right perspective. It prevents them from being aware that most economists in Germany, France and Italy strongly oppose the Keynesian doctrines. For example, to Professor Adolf Weber, the well-known economist of the University of Munich, the idea that full employment is mainly threatened by a lag of investment behind saving, sounds merely like a bad joke. But the isolationism of Anglo-American economists is also historical. They believe earnestly that their ideas are fundamentally new, unique, and a definite answer to the problems of a competitive economy. Insufficiently educated in the history of economic thought, they do not realize that Keynesianism — down to the most technical details, like the concept of the foreign exchange multiplier — is mercantilism or, more precisely, John Lawism pure and simple. Thus they do not recognize that the objections of the classical economists to mercantilism are valid also in respect to their own teachings. Nor do they see that many concepts of the modern planners — fair prices, fair wages, fair profits, and so on — are nothing else than a new edition of the medieval scholastic concepts of justum pretium and justum salarium [just price and just salary], which proved so detrimental to economic progress.

Reading, quoting, praising and promoting each other, and only each other, will not liberate these economists from their voluntary isolationism. They will remain in their dream world. They will continue to predict the unpredictable.

—L. Albert Hahn, “Predicting the Unpredictable,” The Freeman: A Fortnightly for Individualists 3, no. 1 (October 6, 1952): 24.

Forecasting Mania Is an Integral Part of “Functional Finance,” the “Multiplier Effect” and the “Acceleration Principle”

The forecasting mania of our time is a natural concomitant of what is called Keynesian economics. It constitutes an integral part of the world of “functional' finance,” of the “multiplier effect” of the “acceleration principle” and similar concepts. If one really believes, as the “inventors” of functional finance do, that a depression can be prevented and a boom prolonged ad libitum [as much or as often as necessary or desired] by government deficit spending, if one fails to see that the elimination of the maladjustments in the price-cost relationship created during the previous boom are necessary conditions of revival, then indeed the economic future appears no longer too uncertain. And if one really believes in the working of the multiplier and the acceleration principle, then the more remote future also appears predictable. For according to the multiplier theory a given amount of spending on investment leads in time to an immediately ascertainable stable amount of spending on consumption; whereas a given amount of spending on consumption leads in time to an immediately ascertainable amount of spending on investment.

—L. Albert Hahn, “Predicting the Unpredictable,” The Freeman: A Fortnightly for Individualists 3, no. 1 (October 6, 1952): 23.

After Seeing Numerous Forecasting Failures in the 1940s and 1950s, Dr. Hahn Proposed a “Law of the Necessity of Errors in Forecasting”

All forecasts of postwar deflation turned out to be entirely wrong, as was to be expected. Almost immediately after the end of hostilities a postwar boom began. But the forecasters, in no way discouraged by their errors, stayed on the job. Now they predicted the continuation of inflation. Just when their forecasts became most articulate, in the spring of 1949, the recession of that year set in. Then deflation was considered here to stay; government intervention was advocated. The second postwar boom, not caused, I think, but accentuated by the outbreak of the Korean war in 1950, led again to predictions of continued and even of runaway inflation. But 1951 was basically a year of deflation, and of inflation only in the areas where it was governmentally fostered.

Clearly the regularity of these errors in forecasting can not be pure chance. Something like a Law of the Necessity of Errors in Forecasting must be at work.

It is seldom realized that belief in the possibility of “scientific” business forecasts, and the forecasting mania of our time, are comparatively new phenomena. Until about 1930 serious economists were not so bold — or so naive — as to pretend to be able to calculate the coming of booms and depressions in advance. It would not have fitted into their general view on the working of a free economy. They considered the economic future as basically dependent on unpredictable price-cost relationships and on the equally unpredictable psychological reactions of entrepreneurs. Predictions of future business conditions would have seemed to them mere charlatanry, just as predictions, say, regarding the resolutions of Congress two years from now.

—L. Albert Hahn, “Predicting the Unpredictable,” The Freeman: A Fortnightly for Individualists 3, no. 1 (October 6, 1952): 23.

To Apply to Economics Methods of Analysis Drawn from Physics Was Itself an Unscientific Procedure

Not all economists were carried away by the tide of equilibrium theory which swept through the profession in the second half of the twentieth century. A tiny handful of dissenters, known as Austrians because they followed the teachings of the late nineteenth-century Austrian economist Carl Menger, refused to accept equilibrium theory. One of their leading members, Friedrich von Hayek, wrote a series of articles during the Second World War which questioned the foundations of equilibrium theory. He pointed out that to apply unthinkingly to a social science like economics, which dealt with the behaviour of human beings, methods of analysis drawn from physics, which dealt with inanimate objects, was itself an unscientific procedure. He warned that it was particularly foolish to suppose that future economic events could be predicted as if the economic system behaved like a machine.

—David Simpson, Rethinking Economic Behaviour: How the Economy Really Works (Houndmills, UK: Macmillan Press, 2000), 23-24.

 

The Method of Reasoning Employed by the Neoclassical School Is Essentially the Same As That Followed by Ricardo

The method of reasoning employed by the neoclassical school is essentially the same as the procedure followed by Ricardo as described by Schumpeter:

This is the method of analysis which proceeds by excluding as many variables as possible. Then, for the rest, piling one simplifying assumption upon another until, having really settled everything by these assumptions, he [Ricardo] was left with only a few aggregative variables between which, given these assumptions, he set up simple one-way relations so that in the end, the desired results emerged almost as tautologies.⁴

Nevertheless, it was hailed by almost all professional economists as being a triumph for economic theory when in 1964 it was shown that, given specified endowments of resources, technology and consumer preferences, a system of competitive markets could in a logical sense be proved to exist. This triumph was only slightly marred by the fact that its proponents themselves were divided on its interpretation. Since it was recognised that the result had been achieved by making such drastic simplifications and such sweeping exclusions as were not remotely attainable in practice, did it mean that a real world market economy could work, or did it mean that it could not work?

__________

⁴Schumpeter continued: ‘The habit of applying results of this character to the solution of practical problems we shall call “The Ricardian Vice”’.

—David Simpson, Rethinking Economic Behaviour: How the Economy Really Works (Houndmills, UK: Macmillan Press, 2000), 16-17, 213n4.

It Is “In Principle” Impossible to Use Economic Theory and Statistics to Make Economic Forecasts

Morgenstern set out to show the impossibility of making any complete forecast of the state of the economy given the complexity of the mechanisms that shape economic events. He came against economic prediction from several angles, even contradicting himself in the process.

Thus was it “in principle” impossible to use economic theory and statistics to make economic forecasts. He based this claim on arguments concerning economic data, processes, and actors. The lack of homogeneity and the small size of samples made data wholly inadequate for statistical induction. Contrary to in the natural sciences, the data problems of economics were so significant as to render futile any attempt to apply probability methods. As for economic processes, Morgenstern held that attempts to understand the business cycle based on statistical considerations alone could never facilitate economic forecasting. For that, one needed to look to the underlying processes, of which prices were the surface phenomena. These mechanisms, however, lacked the regularity necessary to make them useful for any kind of prediction: only loose and inexact laws could be discovered. Finally, even when predictions were made, their effect was to create anticipations on the part of consumers, the reactions of whom would only serve to make the original forecast false. Unlike astronomy or medicine, the social sciences had the peculiarity of being able to affect their object of study. The prediction of the astronomer could have no effect on the movement of the stars, but that of the economist could change economic events. Morgenstern’s criticism of static theory is thoroughly Misesian: “In the static economy, nobody acts economically any more, and that means that they no longer ascribe value, and that no more acts of choice are made, and no decisions are made, because everything stands still.”

—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), 101.

Equilibrium Theory Might Be Appropriate for a Planned or a Primitive Economy, But Is Not Appropriate for a Modern Market Economy

Equilibrium theory might well be appropriate for a planned economy, or perhaps for a very primitive subsistence economy, where little changes, and one year is much like the next. But it is quite unhelpful in understanding how a modern market economy works. Some of the most important elements of the contemporary economy, such as institutions, entrepreneurship and profits, are missing, while some extreme assumptions which contradict experience, such as perfect knowledge, optimising behaviour and constant returns to scale, have been introduced into the theory in order to achieve predictability. The justification of equilibrium theory therefore rests not on its explanatory power but on its predictive ability. On this point the evidence is overwhelming. All surveys of forecasting accuracy come to the same conclusion: economic forecasts based on equilibrium theory perform no better than naive forecasts which assume that next year’s values will be the same as this year’s.

—David Simpson, introduction to Rethinking Economic Behaviour: How the Economy Really Works (Houndmills, UK: Macmillan Press, 2000), 3. 

The Austrian Aversion to Macroeconomic Aggregates Pertains to Laws Devoid of Reference to Individual Choice

The last 30 years saw the ascent of macroeconomics and a temporary eclipse of Austrian thought. What attitude should Austrian economists adopt today towards macroeconomic aggregates? We spoke above of skepticism engendered by a distrust of all formalizations of economic experience which do not have an identifiable source in the mind of an economic actor. But a more positive attitude is called for. Austrian economists must attempt, wherever possible, to impart a measure of subjectivism to the products of macroeconomic thought.

We may note that Austrian aversion does not pertain to these aggregates as such. Austrian economists, after all, did discuss the balance of payments of the Habsburg Empire. It pertains to the construction of an economic model in which these aggregates move, undergo change, and influence each other in accordance with laws which are devoid of any visible reference to individual choice. Like the bodies of a planetary system, each aggregate is affected by changes in other aggregates, but never, it appears, by changes taking place within itself. It is this conception of the mode of relationships among aggregates, rather than the existence of the aggregates themselves, which defies subjectivism.

—Ludwig M. Lachmann, “An Austrian Stocktaking: Unsettled Questions and Tentative Answers,” in New Directions in Austrian Economics, ed. Louis M. Spadaro (Kansas City: Sheed Andrews and McMeel, 1978), 8-9.

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.