[Note: The original version of this blog post didn’t include the brief paragraph on Hayek’s Ricardo Effect. Inspired in part by Daniel Kuehn’s response, I feel that adding it in better gets across what I’m trying to say with regards to differences in perception of how a market economy works. These divergences become more prominent as economists further develop their beliefs on these varying perceptions.]

The policy world is dominated by a single policy prescription, which falls into two forms taken up by economists who consider themselves in deep opposition: stimulus. Its two forms are monetary and fiscal, which in turn can also be broken up into individual camps. Moreover, some economists may favor both fiscal and monetary stimulus, while others prefer one or the other — some may even oppose one form. As I will argue below, however, all these economists, whether they recognize it or not, share similar traits with regards to how they understand the economy to work. There is a second “policy” category, although it contains policies that seek to dismantle policies, that we may refer to as “regime uncertainty” (see Robert Higgs, “Regime Uncertainty,” Independent Review 1, 4(1997), pp. 561–590). Some of the economists in this second category see the fundamental difference between them and the “stimulus” camp as the latter’s inability to consider the role policy-induced uncertainty has on entrepreneurial action. This is not entirely true; I think the fundamental differences run much deeper than this.

“Keynesian uncertainty,” or that of the kind we see in the writing of John M. Keynes, takes a different form than the “Austrian” regime uncertainty. The former type, though, finds its roots amongst a broad camp of neoclassical economists; the decades prior to the Keynesian revolution saw important changes in the economist’s perception of the working economy, and this becomes doubly true with the introduction of expectations. What begins to matter are the expectations of income streams — this plays a fairly important role in The General Theory, and I suspect that Keynes in this respect was influenced by some of his peers (Rogério Arthmar and Michael E. Brady, “Keynes and the Classics: The Simplest Approach,” Working Paper [2011]) —, and as industrial fluctuations are characterized by falling profitability, leading some to argue that depressed expectations about the future state of profits tends to reinforce episodes of low productivity.

Expectations alone can’t explain the shift, but it helps reinforce it. Contrary to what some economists — such as Ludwig Lachmann — claim, expectations also began to be introduced into Austrian literature during the 1930s. For instance, Hayek considers entrepreneurial expectations in many of his capital theory essays (for instance, “The Maintenance of Capital,” “Price Expectations, Monetary Disturbances and Malinvestments,” and “Profits, Interest and Investment;” see also Ludwig von Mises’ seemingly forgotten 1943 response to Lachmann). It’s true that perhaps Hayek was incorporating expectations as a response to the “second subjectivist revolution” (as Lachmann put it in The Market as an Economic Process), but what we see is that the relevance of expectations is decided by Hayek’s vision of the market economy. The same can be said of others who incorporated expectations into their already established paradigm — In Lachmann’s above cited 1986 book, he accuses Keynes of being a subjectivist only when it suits the purposes of promoting the notion of effective demand. It helped accentuate the fundamental differences between two diverging strands in economic science.

A great illustration and, perhaps, byproduct of this divergence is the fundamentally different way of perceiving the relationship between savings and investment. Classically, investment is made possible by capital accumulation; it is the latter which provides the means to accomplish the former. In The General Theory, the causality seems to be the reverse (I have in mind pp. 117–118 [chapter 10, section II], of the BN Publishing edition): an increase in net investment will cause a rise in income, where this income will be divided into consumption and savings — the increase in the latter should be sufficient to equalize investment and savings, but not too much as to cause a fall in aggregate demand. Since the volume of investment is not decided by the volume of savings, it is directed by the amount of consumption. This is the role played by the “investment” and “employment multipliers” of J.M. Keynes and R.F. Kahn (1931), who in turn were possibly influenced by others (Hawtrey and Robinson, argue Arthmar and Brady, had stressed to Keynes the role of reducing output in the face of a contraction in consumption).

By way of contrast, Hayek was influenced by economists such as Ludwig von Mises, amongst others, who had stressed the validity of the classical approach to savings and investment. While we see evidence of the Ricardo Effect in Hayek’s early writing, you can note that his emphasis on its centrality to the theory of capital begins to accentuate after 1936. What drives the lengthening of the structure of production? A fall in consumption, which induces later stage entrepreneurs to maintain a stream of income by replacing now expensive (in real terms; i.e. the fall in the price of consumer goods, because of a fall in nominal demand) labor with labor-saving machinery. It’s not the emphasis on expectations that marks the difference, but fundamental dissimilarity in the understanding of causation between separate events.

Uncertainty influences expectations, which is why it plays such a large role in the economics of Keynes. But, it is accorded a role that fits a particular set of beliefs. This is sensible, because it’s very difficult to build a scientific theory of expectations alone — they are subjective, unmeasurable, and unpredictable. You use expectations to mend your theories to consider how changes in an individual’s state of knowledge may influence the ultimate action. What this means is that it makes even the short-term future difficult to predict, because expectations can break causality in the sense that the outcome you expect is frustrated by a change in the plans of the individual market agents.

In any case, what needs to be debated is not whether one side accepts uncertainty or not, because everyone considers uncertainty — whether explicitly or implicitly. In the comments section to a “wtf” post by Daniel Kuehn, in response to an above-linked essay by Chidem Kurdas, Bob Murphy asks for evidence of any Keynesian policy advocate discussing the role of uncertainty. Whether or not these economists are talking about uncertainty in their blogs and op-eds is irrelevant, because uncertainty is implicit in their models. Consider, for instance, Paul Krugman’s work on Japan (“It’s Baaack,” Brookings Papers on Economic Activity 1998, 2 [1998]): expectations, and thus uncertainty, is a major factor behind the advocacy for high inflation targeting. That they target different causal factors doesn’t make it any less of a use of uncertainty.

So, when discussing on what causes the differences in policy advocacy between Austrians and the rest, the real answer ought to target the decades (almost a century now) of divergence in understanding of the market process. Uncertainty, long assumed by almost all schools of thought, is the least of it. What matters is that uncertainty was integrated into existing structures, and its these structures which provide the causes of the divergences in beliefs.