Over the month of June, blogger Lorenzo and Steve Horwitz engaged in a three-post exchange on Austrian economic theory. I think that Lorenzo gets away with some criticisms that do not consider much of the literature. Since the topics are wide-ranging, this post is going to lack structure and instead approach the debate on a point by point basis. I will warn readers that this post is long and likely to be considered one made from Austrian “fundamentalism.

Lorenzo’s First post

I will follow the structure of points made here.

(1) Lorenzo notes the Austrian focus on the heterogeneity of capital, but suggests that they do not focus equally on the heterogeneity of labor. This is actually untrue. In Profits, Interest and Investment (1939), Hayek explicitly assumes a certain level of heterogeneity in labor: it is the major factor considered when explaining the rise in unemployment when the structure of production has to readjust during the recessionary period. Ironically, the debate is set within the context of a paper written by Horwitz on the differences between Austrian and Keynesian theory. It is ironic because it was Keynes who assumed a certain degree of labor homogeneity — it is the basis of his wage-unit (and, contra Horwitz, Keynes agrees with the idea of capital heterogeneity, citing Hayek’s “The Maintenance of Capital”). In fact, in his criticism of The General Theory, Hazlitt attacks Keynes on exactly this point.

(3) I understand the argument that Lorenzo wants to make, but we ought to distinguish between the idea of an “efficient outcome” (that is, the best use of all means of production) and the actual outcome. One should also remember that a “sustainable” structure of production doesn’t require an “efficient” structure of production, where “efficient” takes its Neoclassical definition. The idea of loss, which is extremely important in the Austrian theory of the market process, assumes inefficiency — it assumes an unprofitable allocation of resources. So, to accuse the Austrians of being “perfectionists” doesn’t seem to fit with basic Austrian theory. In fact, the theory of the market process is essentially one that seeks to explain the evolution of “voluntary” (market?) institutions which deal with the problems of allocating resources against the uncertainty of the future. So, if we are even to talk about “efficiency,” it’s a relative efficiency or even growing efficiency, where this means: improvement in the allocation of resources. “Improvement,” in turn, implies that there is some scope for error.

(4) Lorenzo makes a good point on expectation (specifically, expectation of future income). Expectations, prior to the late 1930s, is probably a weak point of the Austrian literature. Lachmann makes this comment in his 1986 The Market as an Economic Process: the Austrians, with their full fledge acceptance of the implications of subjectivism, were in the best position to assume the responsibility of integrating expectations into economic theory, but they did not. But, expectations do not take away from the importance of monetary calculation. An entrepreneur can base his production (or the aggregate supply function, as Keynes called it) on expected future income, but this still requires her to economize her means of production. Economization requires monetary calculation — this is the basis of Ludwig von Mises’ criticism of socialism (defined, at the time, as the communal ownership of the means of production). It should also be mentioned that the concept of profit and loss assumes some degree of integration with expectations. Entrepreneurs want to profit, which assumes that they allot the means of production in a way to do so. Since this all assumes a range of time, the idea of expected income is implicit in how Austrians view basic entrepreneurial action (it is also implicit in the “Austrian” idea that entrepreneurs risk assets against the uncertainty of the future).

(5) The criticism here is that Austrians focus too much on inflation and too little on deflation, and then too often blame deflation on prior inflation. He argues that they are not necessarily causally related, but offers little in defense of this assertion (arguing that they are both monetary phenomena, as if that favors one implication over another). Let’s assume an Austrian boom phase that suddenly reverses due to some decision by the central monetary authority to restrain economic activity or some shock which leads to a credit contraction. Why does the credit contraction take place? The liquidation of investments includes the liquidation of debts, which implies the destruction of credit. There is also an increase in uncertainty, which may cause (and, empirically, has caused) people to hold greater quantities of money. Austrians tend to be more divided on this latter issue, with economists like Horwitz and Selgin arguing in favor of fiduciary injections to equilibrate the supply of money with the demand for it. Others disagree, and I have made an argument to this effect elsewhere. But, the point is that the causal link between deflation and inflation is well thought out, despite the fact that both are monetary phenomena. In more “mainstream” terms: deflation are not “sunspot” phenomenon!

On the other hand, I do back any criticism of Austrians too willing to warn of hyperinflation. But, these predictions should not be confused with the underlying theory. Austrians who predicted hyperinflation ignored the nuances the theory comes with, and therefore made predictions without considering all the relevant empirical factors which made these calls completely unrealistic. In any case, hyperinflation is not a central part of the Austrian theory of business cycles or monetary distortions. It is an extreme case that comes with a complete loss of confidence in the relevant currency.

(6) Lorenzo quotes Horwitz, who writes that Austrians assume the “classical” loanable funds theory of interest. Horwitz is wrong. There may be modern Austrians who accept this theory of interest, but early Austrians should not be included within their ranks. The pure time preference theory of interest, as developed by Böhm-Bawerk, but most importantly by Frank Fetter and Mises, is not a loanable funds theory of interest. The “market rate of interest,” which pre-Keynesian theorists might have assumed to be the rate of interest on loanable funds, is a product of entrepreneurship. It, and Mises is explicit here, includes a premium for risk and other considerations that fall outside the realm of time discount between future and present goods. It also includes the price that banks (and whoever else commands these interest rates) have to pay savers for their capital (a lowering of the natural rate of interest implies that society values future goods more relative to present goods [but, according to Mises, never more in absolute terms], and thus need to be paid less to “part with liquidity,” in Keynes’ terms).

This is why, I think, those who compare Keynes’ liquidity preference theory of interest with the Austrian time preference theory largely miss the point: both are actually somewhat compatible (a long-term project of mine is to compare the theories and show how they might compliment each other). Keynes’ main insight, in my opinion, is that there are various forms of savings, and so these are in competition with each other. So, where Mises assumed that the interest on loanable funds might be close to the “natural rate” of interest, the spread between the different forms of interest might not make this true.

(7) We return to inflation. The argument is that we cannot correlate inflation with the bust, because the latter have been historically preceded by low levels of inflation. Lorenzo must define inflation as increases in the “price level” (probably indexed by the consume price level), and if so, this criticism confuses me. The Austrian theory of business cycle actually supposes a stable consumer price level or only a very slightly fluctuating one, since a “healthy” lengthening of the structure of production would “require” a fall in consumer spending — i.e. a fall in the consumer price level (or price deflation amongst consumer goods). The main price change Austrians are “worried” about is the rise in the prices of capital goods relative to consumer goods, and if you check the (inadequate) indexes that exist, you’ll see just this pattern between 2002 and 2007–08. In fact, it was the stable price level which was a major reason why Mises predicted the coming depression during the late 1920s.

(8) This point follows from (7), but is very ambiguous (and disjointed: first it starts with self-correction and it ends with risk and alternative business cycle theories). Lorenzo asks why we can’t assume that the bust is the product of something other than a previous inflationary boom. Well, we could, but we would need an adequate theory of such a bust, and Austrians don’t think an adequate theory has been provided. And, in fact, the empirical evidence seems to validate the Austrian story: low interest rates, increases in circulating credit, investment in capital goods (durable goods), an increase in the cost of capital goods relative to consumer goods, et cetera. Even Post Keynesian Axel Leijonhufvud suggests that the facts seem to fit the Austrian explanation than those of its rivals.

And here is as good a place as any to mention that the risk story is complimentary to the Austrian one (although,one should distinguish between “risk” and “uncertainty,” where the two are not necessarily the same thing — a very “Keynesian” point). Let’s take, for example, the recent financial crisis. Financial assets are weighed against their perceived risk; why did rating agencies get risk so wrong? Risk is not a subject is isolation from monetary calculation. The risk attributed to, say, mortgage backed securities (prior to 2007–08 rated at AAA!) was perceived to be low due to the market “signals” at the time — the housing market was perceived to be “strong.” The revelation of the true nature of risk was, in part, an ex post phenomenon. But, this is implicit in the Austrian story: sustained over-issuance of fiduciary media causes changes in the pricing process, which distorts monetary calculation. This includes the calculation of risk. (This also serves as a response to point (10) of Lorenzo’s post.)

(9) This point contains two criticisms: one is that Austrians focus too much on the over-supply of money and the other is that monopolies — which is what Austrians accuse the Federal Reserve System of being — should under-supply. With regards to the latter, that we live in a monopolized currency system (i.e. one currency) doesn’t mean we live in a monopolized banking system. Our banking system is cartelized under the “leadership” of the Federal Reserve, and what this allows for is an over-issuance of fiduciary media. George Selgin, in The Theory of Free Banking, explains this process quite clearly. Essentially, a cartelized banking system with a single currency removes some of the checks on fiduciary expansion that might otherwise limit individual banks. Regarding the first criticism, my response is the same as that one listed under (5).

(12) I think I agree with the accusation that many “internet” Austrians downplay the role of empiricism, and I also think this is true of some academic Austrians. I have noted before that historical studies of the recent recession have been scant and inadequate. The main problem, I think, is that few people want to do the econometric work (including compiling aggregates that don’t exist yet). But, an attack on “internet” Austrian is not an attack on the underlying body of academic Austrian theory. The reader should refer to Mises’ Human Action and Theory and History. Much of the focus of Mises’ “disciples” is on the idea that theory cannot be extracted out of the data, rather the latter must be interpreted through the former. But, this isn’t a rejection of empiricism. The only way we can apply a theory to the data is by looking at the data, which gives an important role to the historian (or empiricist). So, Mises’ a priorism should not be confused with anti-empiricisms, because this is not an accurate interpretation of Mises’ epistemological and methodological beliefs.

(13) In this final post, Lorenzo confuses malinvestment with failure. Yes, businesses do fail all the time — again, this is implicit in the Austrian concept of “loss.” Malinvestment is a specific phenomenon, though, which occurs when there is sustained intertemporal discoordination caused by fiduciary over-expansion: in the bust, it manifests as a “cluster of failure.” As such, what Austrian business cycle theory seeks to explain is not just “failure,” but why so many businesses fail at once. In Lorenzo’s terminology, we could also say that ABCT seeks to explain why there is a sudden fall in nominal income (income in terms of money). It is also true that the recent housing crisis was “caused” by perverse incentive, but there’s no reason to assume that this didn’t work in conjunction with distortions in the pricing process. Namely, these incentives shaped the structure of production, while fiduciary over-expansion provided the means to cause these changes in shape.

In short, Lorenzo (and Horwitz) attribute to Austrians some beliefs which simply aren’t applicable. It shows some unfamiliarity with the “basic” (that is, “main” or “essential”) literature. Other than that, it’s also important to realize that sometimes economic phenomena and concepts can’t be treated in isolation of each other. The market is a process that occurs over time through the action of individuals, and so causal relationship between certain events is implied. This, for example, has become increasingly clear with regards to monetary deflation: they are not sunspot events — they need to be triggered, and this implies causality.

Horwitz’ Response

Contrary to what my above comments about his response may imply, many parts of it are great. For instance, in response to Lorenzo’s (2), Horwitz writes that Austrians don’t believe in “price flexibility.” This should be interpreted, though, within the Austrian theory of prices. “Austrian” prices are not Neoclassical equilibrium prices; the Austrians seek to explain real world price formation, which are in disequilibrium. As such, this world of disequilibrium implies some degree of “inflexibility,” because price formation is imperfect. What helps avoid utter chaos is a process of entrepreneurial “trial and error,” guided by profit and loss. As such, Austrians do not believe in “full employment,” or that the labor market can clear just by simply readjusting wage levels (even if many “internet” Austrians might believe so). Nevertheless, this doesn’t mean that Austrians can’t point at legislation that makes price adjustments even more inflexible (like minimum wages, wage sharing policies, et cetera).

I also agree with Horwitz that Austrians focus on inflation largely because it is more empirically relevant. But, again, I’d like to emphasize the causal relationship between inflation and deflation that Lorenzo decides to leave largely unaddressed, instead simply asserting that there needs not be causality. Horwitz doesn’t really address this either. For instance, when considering the Federal Reserve’s response to the deflation of the early 1930s, Horwitz simply suggests that we consider both as relevant. But, the deflation which the Fed should have supposedly assuaged was a product of the “bad debt,” caused by the misallocation of resources during the preceding boom. And, again, one cannot ignore the uncertainty this chaos causes, and the role uncertainty plays in inducing a rise in the demand for money.

My response above should be considered in conjunction with Horwitz’. I do have my differences with him: as aforementioned, I think he does not do justice to the pure time preference theory of interest. Nor do I agree with his views on deflation caused by a rise in the demand for money (see that aforementioned link to my Cobden Center article). But, he does underscore the Austrian disequilibrium approach to the market process, and the idea that market activity is largely a product of emergent order. That is, it is an evolutionary process, which implies a level of imperfection. But, as Horwitz states, this does not mean that government has a role in helping to solve these imperfections. I actually try to address this within the context of monetary calculation here: “Government Spending is Bad Economics” (see also my recent lecture on banking regulation and my article on monetary calculation).

Lorenzo’s Rejoinder

Here, Lorenzo reformulates some of his objections in light of Horwitz’ response and then adds some new ones. Allow me to address them subject by subject.

Plans: The notion of “plans,” I think, is very Lachmannian. It is an attempt to marry expectations to the Misesian notion of “action;” that is, it explains the role of information and knowledge in deciding action. Plans should not be interpreted in the strict definitional sense of “strategy,” or a paper plan to invest. Instead, it should be understood in a “looser sense:” plans are ideas that individuals turn into actions, based on knowledge acquired by interpreting information available to them. So, it doesn’t necessarily involve the drawing of complex plans of investment (although, I suppose it could — it is, after all, a subjective idea), but just envelops the notion of processing (interpreting) information into knowledge, and acting on this knowledge. To a large extent, it reduces the role of “mechanics” in the market process (which is not “mechanical,” at all — ideal types designed to explain it, however, may give that impression).

“Austeria:” First, I’d like to echo Lorenzo in his criticism of those Austrians who blame their intellectual rivals of purposefully lying or of being stupid. I’ve tried to press the fact that people hold competing ideas out of genuine belief, and oftentimes it comes from looking at the same topic from a separate angle. Some people — including Austrians — can simply hold beliefs in error. But, this doesn’t mean that Austrians should be less strict in their responses; in other words, it doesn’t mean that Austrians should more lenient. The same thing is true for others: Lorenzo shouldn’t be lenient when he genuinely believes the other side to be in error. In this sense, I hope this post doesn’t imply that I think anybody is stupid; it just means I think they are wrong — there is a difference.

But, accusing someone of being impervious to the evidence or unable to cope with reality is almost as bad as calling them liars or stupid. And, this is basically what Lorenzo accuses some Austrians of. Just because they disagree with your interpretation of the facts, doesn’t mean that they’re holding on to some absurd belief, justifying it on the basis of a priorism. This is an extremely unfair interpretation of Austrianism, and one that isn’t even consistent with the most “radical” of Austrians: Ludwig von Mises (as above explained). For example, the “failure to acknowledge” that Mises and Hayek “got the Great Depression wrong” is nothing of the sort; it’s a disagreement with that assertion. (As an aside, Hayek never admitted he was wrong about the Great Depression. He never repudiated his business cycle theory. What he “admitted” is that the Federal Reserve should have stabilized the supply of money in circulation. But, he “admitted” this as early as 1931, so anybody who thinks that Hayek was a deflationist hasn’t read the literature. And, I’m not saying I agree with Hayek; I just don’t want people to put words in Hayek’s mouth.)

Central banks and inflation: Lorenzo disputes that central banks have overseen important inflationary periods. Again, he is too focused on the “price level,” usually measured by tracing the movement of prices of some consumer-oriented basket of goods. But, this isn’t very adequate. You also have to look at the supply of money and the price of non-consumer items (as I have previously noted). Lorenzo also talks about central banks as being born to manage debt. But, the Bank of England (which he brings up) was gradually given more and more privileges because they provided the English government with funds to pay for their spending — for instance, to pay for wars (e.g. the Napoleonic Wars). In the United States, the Federal Reserve was largely founded as a lender of last resort, to protect banks which were over-issuing debt (fiduciary media) and suffering consequent information and bank runs. So, I don’t think Lorenzo here adequately addresses Horwitz’ point on central banks and “inflation” (more accurately, money supply growth).

Business Cycles Again: Lorenzo repeats the oft-made claim,

Especially with the apparent implication that inflationary central banks are required for the business cycle to occur.

I don’t know where that implication follows from, because no Austrian has ever made this claim and in fact there have been plenty of historical case studies made in applying ABCT with pre-central bank panics and industrial cycles (oh, I thought Austrians didn’t like looking at the data?). If you look at my June lecture on banking regulation (linked to above), you see that the American Federal Reserve was largely a response to some of the problems of already existing bank regulations: restrictions on competitive note issuance, Greenback inflation, and “debt-based” inflation (banks, at one point, were induced to issue notes backed by U.S. Treasuries).

Regarding the housing market crisis, I don’t understand Lorenzo’s emphasis on “supply constraints.” Does he wish to accuse the Austrians of assuming an abundance of supply of capital (or durable) goods? No, in the Austrian story it is these prices (not consumer good prices) which are run up, exactly because they are scarce. In fact, this bidding up of capital good prices is a symptom of the problem of changes in the rate of profit. So, the rise in the price of housing (and related capital goods) goes very well with the Austrian story. And yes, when all of this malinvestment is revealed, the entire economy will experience a shock (in many ways a monetary one, which has real consequences). For a good theoretical and empirical (historical) exposition of ABCT and its application to the Great Recession, see Salerno’s “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis” (Quarterly Journal of Austrian Economics 15, 1 [2012]).

Lorenzo also repeats a very old argument against ABCT: entrepreneurs aren’t stupid. It is an extension of the “rational expectations” argument. But, ABCT doesn’t assume stupidity amongst entrepreneurs. In fact, many entrepreneurs profit from the bubble (and many did, in the real world). I thought I had addressed this in a separate post already, but I can’t find it. Given that I’m almost at 3,700 words, I’ll keep this short: low interest rates don’t say anything useful with regards to expectations of future income. Do you imagine all entrepreneurial action suddenly ceasing because interest rates have fallen? There are some other signals that entrepreneurs can look at, and have looked at, to fear a bubble, but to assume entrepreneurs as omniscient market agents is equally as unrealistic to assume them as totally ignorant. In fact, it is commonplace for the sole major acknowledged contribution of the Austrian school to be their theory of entrepreneurship. In other words, the “rational expectations” criticism doesn’t hold much water.

Related, Lorenzo draws a distinction between Hayekian “uncertainty” and Keynes-Knight-Schumpeter uncertainty, basing his definitions on a paper by Michael E. Brady. Brady misunderstands Hayek’s point in his work on the dispersion of knowledge. This isn’t about uncertainty, but on the nature of knowledge and how it relates to the coordination of resources. It is an addition to the literature on the socialist calculation debate and attempt to distance himself from the equilibrium economics of the Neoclassical school. This being said, one might as well add Mises and Lachmann to the list of those adopted a definition of uncertainty similar to that of Keynes and Knight. But, this definition reinforces ABCT, not undermines it; no less, ABCT is a story of instability.

A final word on business cycles, Lorenzo writes that the observation that capital good industries are usually the most affected by booms and bust is “unremarkable.” He explains this phenomenon on the basis that it is these goods that have “expectations-based value.” What is remarkable is that he fails to ask himself an incredibly pertinent question: why is there this correlation between increases in the quantity of money in circulation and an increase in the value (and price) of capital goods? By claiming that this relationship is “unremarkable,” Lorenzo shows to have missed the essence of the business cycle theory he is criticizing. In turn, he basically purports to explain these changes in “expectation value” as sunspot, or random, events.

Complexity: Lorenzo argues that we can’t really say that government has no purpose, and that doing so is an exercise is “market fundamentalism.” Well, it’s only fundamentalism if you disregard the decades of literature that have been written to explain the workings of the market process, and why government is not part of this process. True, there is always room for disagreement, but unfortunately Lorenzo’s superficial analysis of Austrian theory does not add to the body of positive dissonance.

Ironically, in his analysis of the Austrian prescription to the boom and consequent bust, he avoids the complexities of the recovery period that marred the market response. For instance, during the 1930s the American government put in place a large number of interventionisms, including the NRA. This cartelized the market and limited productivity — even Keynes criticized the NRA! Here, while Lorenzo is adept to fall back on Friedman and Schwartz’ explanation of the causes of the Great Depression (the monetary contraction), he ignores their work on why it continued for so long (work presented in the very same book!). This disregard for complexity is also apparent in the dichotomy drawn between inflation and unemployment, as if these two aggregates are completely unrelated. In the process, he ignores the broad range of Austrian literature — on both sides of the “deflation” divide — on this very topic.

In passing, Lorenzo also attacks the Austrian criticism of calculation in a Socialist society. He claims that that Mises and Hayek overstated the calculation problem. Socialists like Oskar Lange didn’t think there was an overstatement! Lorenzo then claims that prior to the invention of money, humans produced. This very well may be true, but the depth of that production is incomparable to that of modern societies, which use money calculation to allocate resources throughout a deep and wide structure of production. Lorenzo’s problem is that when he accuses Mises and Hayek of overstating monetary calculation, he completely ignores the role that money prices play in the allocation of resources. A role that most serious economists came to accept after Mises’ 1920 and 1922 books on the subject.

There may be room for criticism of the Austrian School, but Lorenzo’s attempt is merely a manifestation of the fact that most critics have opted not to go to the primary sources. Instead, they rely on “internet” explanations; more often than not, these “internet” sources aren’t Austrian, but are provided by the school’s detractors who more often than not also have a substandard understanding of what they’re criticizing. But, this is the natural order of things, because the same problem occurs when Austrians try to critique Keynesian or Monetarist economics: they prefer not to spend the same amount of time studying what they disagree with as they do when they study what they agree with.