← Autodidact Archive · Original Dissent · OlafLynckner
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The Austrian School of Economics Is "Crank Science" Arguement Against Lew Rockwell, Murray Rothbard and Ludwig Von Mises Commentary -- [url]http://www.huppi.com/kangaroo/L-ausmain.htm[/url] A Critique of the Austrian School of Economics: INTRODUCTION The Austrian School of Economics is an anarchist branch of economics that has attracted a wide libertarian following. Founded in 1871, it is named after four turn-of-the-century Austrian economists who developed its theories: Carl Menger, Eugen von Böhm-Bawerk, Ludwig von Mises and Friedrich von Hayek. Later, as the school migrated to America, non-Austrians like Murray Rothbard and Henry Hazlitt also helped develop and popularize its teachings. Perhaps the first thing to stand out about Austrian economics is its relationship to mainstream economics. The two completely reject each other, and proudly so. Their differences extend even deeper than their diametrically opposite interpretations of the economy; they even use different philosophical approaches. The two could almost be called separate disciplines, if they were not attempting to describe the same phenomena. So, then, how do they view each other? Mainstream economists dismiss the Austrians as cranks. Nobel economist Paul Samuelson wrote that "I tremble for the reputation of my subject" after reading the "exaggerated claims that used to be made in economics for the power of deduction and a priori reasoning [the Austrian methods]." (1) Noted economist Mark Blaug has called Austrian methodologies "so cranky and idiosyncratic that we can only wonder that they have been taken seriously by anyone." (2) Austrians, on the other hand, have their own spin on their differences. Here's Llewellyn Rockwell, Jr., president of the Ludwig von Mises Institute, after listing several different economic schools of thought: "Also part of this mix, but in many ways apart from and above it, is the Austrian School. It is not a field within economics, but an alternative way of looking at the entire science." (3) As we shall see, that the Austrians are "apart" is clear - - "above" is mere bluster. For most of the Austrian School's history, mainstream academia has simply ignored it. Even today, none of its works are on the required reading list at Harvard. Most introductory economics texts don't even mention the school, and its economists are absent from many encyclopedias or indexes of the century's great economists. Several of its founding figures struggled to make ends meet, rejected by universities which did not view their work as sound. Even today, the movement's faculty boasts no more than 75 scholars worldwide. (4) By comparison, there are over 20,000 economists in the American Economics Association alone. Their failure to rise in academia has not been for want of publicity -- on the contrary, their leaders have been publishing books for over 120 years, all the while bumping elbows with famous economists like John Maynard Keynes. And after Hayek shared a Nobel Prize in 1974 for a contribution to monetary theory, the school received a huge burst of academic attention. But it was just as quickly rejected. Their dismal showing in academia stems from the fact that they have simply failed to make their case. In classic crank tradition, Austrians have a conspiracy theory to explain this failure. In an essay subtitled "Ignorance and the Universities," Austrian professor Patrick Gunning writes: "The aim of this essay is to try to explain why positivism [the mainstream approach] has succeeded in professional economics, while subjectivist economics [the Austrian approach] has failed. Itââ¬Â¦ identifies two main reasons for this phenomenon. The first is that ordinary people cannot tell the difference between good and bad economics. The second is that the training ground for professional economics is the university. In modern times, the university is more likely than not to be funded by the government. In a democracy, government funding implies (1) a competition for funds and (2) bureaucracy. Both of these characteristics favor positivism." (5) Today the Austrian tradition is kept alive by the Ludwig von Mises Institute, a think tank financed entirely by wealthy business donors. It is part of a broader phenomenon, the explosion of far-right think tanks in the last 20 years, funded by such conservative and libertarian donors as the Bradley, Coors and Koch family foundations. These foundations have poured hundreds of millions of dollars into the creation of an "alternate academia" of right-wing think tanks, after the failure of mainstream academia to support right-wing dogma. This alternate academia comes complete with extensive media ties to publicize their research, which is why Austrians are so frequently found on conservative talk radio. Austrian economist Israel Kirzner describes the critical role that their primary backer, the Foundation for Economic Education (FEE), has played in the "revival" of Austrian economics: "It was their vision which brought Ludwig von Mises to FEE at a time when he was, to put it mildly, all but ignored on the academic scene. It was through the resources of FEE, its skilled use of the tools of communication and public education, which ensured that Mises' message would survive." (6) This movement has not been completely unsuccessful in making inroads into "liberal" academia. Austrians have self-described "intellectual communities" at three universities, most notably Auburn, where the von Mises Institute is affiliated. The Institute publishes only one journal and one newsletter in English, and holds only one major seminar a year. However, thanks to its well-funded publicity, the movement is starting to generate more academic discussion. The differences between Austrian and mainstream economics The Austrian School is not a monolithic ideology. One of their top professors, Peter Boettke, writes: "ââ¬Â¦It must be admitted that Austrian economics is plagued with many thorny issues of an epistemological, theoretical, empirical, and political nature. Disagreement within the ranks of Austrian economists still persists over [many] issuesââ¬Â¦" (7) Perhaps the largest split is between the "narrow church" of Mises and the "broad church" of Hayek. The Miseans do not consider Hayek a "true" Austrian, and even refer to him privately as a "social democrat," because he did not subscribe to all the tenets of hard-core Austrianism. Factions aside, the general differences between Austrian and mainstream economics can be summarized as follows: Mainstream economists use the scientific method; Austrians reject it, at least for the study of the economy. Instead, they use a pre-scientific method which deduces truths from a priori knowledge. Mainstream economists make heavy use of statistics; Austrians claim statistics have very little value, because of their extreme limitations. Mainstream scientists believe in both objective and subjective truth (that is, absolute truth and personal truth); Austrians believe only in subjective. Mainstream scientists seek to explain human behavior on many different levels: the gene, the individual, the group and the specie. Austrians believe that all explanations of human behavior can be traced back to the individual. Mainstream economists often use models that use perfect starting assumptions; Austrians claim not to. Mainstream economists believe that monopolies can arise from a number of causes; Austrians believe that only government causes monopolies. Mainstream economists believe in fiat money; Austrians believe in the gold standard. Mainstream economists assert that the mystery of the business cycle is deep and poorly understood; Austrians claim the government causes it. THE SCIENTIFIC METHOD Perhaps the defining difference between mainstream and Austrian economists lies in their opposing philosophies towards learning truth. Mainstream scientists use a well-developed process called the scientific method. This method employs both data and theory. "Data" includes facts, evidence and statistics. "Theory" is the attempt to describe general laws, principles and causes and effects found in the data. Both form a cycle, as data goes into the formulation of theory, whose conclusions then engender more data collection in an attempt to confirm, refute or develop yet more theories. The accuracy of this process is verified by experimentation or prediction. Scientists believe they are on the right path when both theory and data agree; when they disagree, they know something is wrong. It could be the theory is wrong, or the data is badly collected or interpreted. Austrians accept this method in principle, but argue that it is more appropriate for hard sciences like physics or chemistry, not soft sciences like sociology or economics. The problem is that humans, unlike electrons, have freedom of choice. They are therefore vastly more unpredictable, even if placed in the same situation twice. Within economics, Austrians favor a method called "apriorism." A priori knowledge is logic, or knowledge that exists in a person's mind prior to, and independent of, outer world experience. For example, the statement "two plus two equals four" is true whether or not a person goes out into his garden and verifies this by counting two pairs of tomatoes. What this means is that Austrians reject the attempt to learn economic laws through experiment or real world observation. The only true economic laws are those based on first principles, namely, logic. As Hayek wrote, economic theories can "never be verified or falsified by reference to facts. All that we can and must verify is the presence of our assumptions in the particular case." (1) So the mainstream approach is inductive, and the Austrian approach is deductive. The first draws generalizations from the data, the second applies preconceived generalizations to the data. A completely deductive approach is pre-scientific, however, which is why Austrians cannot legitimately claim to use a scientific method. Deduction does occur in science, but the generalizations are primarily based on other data, not a priori assumptions. This is not to say that Austrians do not refer to real-world events and data in their writings. They just don't do it in the usual scientific way. Here is Austrian economist Ken Gaillot, Jr., describing their use of data: "The Austrian economist sees his task as deducing the implications of human choice under conditions observed in the real world. The assumptions of economic theory are the point at which the theory is empirically verifiable. This approach allows qualitative prediction of economic events, explanation of observed patterns, and evaluation of government policy." (2) In other words, Austrians get to critique the real world, but the real world is prevented from informing their theories. Even their predictions are "qualitative," not "quantitative" -- meaning they are free to call the government "bad," without being held down to the statistics that would verify this claim. The Austrian approach to philosophy is a very old one: Rationalism. You have to go back to the 17th and 18th centuries to find when it was last considered a serious philosophical movement. It was widely abandoned after its inadequacies were laid bare by other schools of philosophy: Empiricism, Positivism, and most famously by Immanuel Kant's Critique of Pure Reason. Philosophy has progressed tremendously since Rationalism; the Austrian approach is a relic of history. The problem with rationalism is that it makes the search for truth a game without rules. Rationalists are free to theorize anything they want, without such irritating constrictions as facts, statistics, data, history or experimental confirmation. Their only guide is logic. But this is no different from what religions do when they assert the logical existence of God (or Buddha or Mohammed or Gaia). Theories ungrounded in facts and data are easily spun into any belief a person wants. Starting assumptions and trains of logic may contain inaccuracies so small as to be undetectable, yet will yield entirely different conclusions. In fact, if we accepted all the tenets of the Austrian School, we would have a second reason why it fails to qualify as science. To be a science, a school must produce theories that are falsifiable -- that is, verifiable. If a theory's correctness or falseness cannot be verified, then it is not science. Perhaps it's religion, or metaphysics, or an unsupported claim. Austrian economists make claims about the market (such as markets know better than governments), but then deny us the tools for verifying those claims (such as statistics). One might ask: how do they know? Austrians claim to know these things by logic. But although their literature frequently evokes "a priori" knowledge, this term appears to be misused. Humans are not born knowing that "two plus two equals four." It is something they must learn from their environment, namely, school. Forging this learned knowledge into axioms comes later, and then through a process of trial and error. So in this sense, "a priori" knowledge doesn't even exist, unless one refers to a very basic level of knowledge capability, such as the physical construction of the human brain or animal instincts. Austrians may be using the term "a priori" to mean logical proofs or axioms, such as "If A=B, and B=C, then A=C." But if Austrians were creating economic axioms that were true by logical force, then the Austrian School would become world famous overnight, whether mainstream economists liked it or not. In truth, Austrian journals are not filled with these kinds of axioms. Their arguments are really no more than theories that are guided or tested by logical proofs. Again, that's no different from what religions do. The fact that we have thousands of different religions in the world is remarkable evidence of the fallibility of this method. STATISTICS According to Llewellyn Rockwell, one of the areas "that distinguishes Austrians from the mainstream is economic statistics. Austrians are critical of the substance of most existing statistical measures of the economy. They are also critical of the uses to which they are put." (1) They do not, of course, believe that statistics are completely without their value, only that this value is slight. Mises wrote: "If a statistician determines that a rise of 10 per cent in the supply of potatoes in Atlantis at a definite time was followed by a fall of 8 per cent in price, he does not establish anything about what happened or may happen with a change in the supply of potatoes in another country or at another time. He has not 'measured' the 'elasticity of demand' of potatoes. He has established a unique and individual historical fact." (2) Austrians claim that statistics fail to capture the full dynamism, trends and contradictory forces of the economy. That such a limited statistic might then be used to formulate economic policy is folly. Economic knowledge can only be gained by individuals as they make transactions on the market. But the argument that a statistic is a one-dimensional historical fact is strained, to say the least. Suppose a private eye tells you that your neighbor is stealing your apples. You respond this is not logically possible. So he produces a photograph of your neighbor in your tree, with a smile and a basket full of apples. And you respond that the value of this photograph is slight, because it does not show the full context, movement and soundtrack of a movie recording! Needless to say, even photographs can be used to determine context, movement, trends and other phenomena, if only by adding more photographs. Add enough of them, in fact, and the result is a movie. Austrians also argue that aggregate statistics are worthless because they don't show what's going on in the individual parts. For example, in 1996 the Gross Domestic Product was about $7 trillion. But this included the production of cancer-causing cigarettes as well as cancer-curing medicines, and the productive efforts of the market as well as the destructive efforts of government. Rockwell argues: "It is not possible to collapse the complexity of market arrangements into enormous aggregates. We cannot, for example, say the economy's capital stock is one big blob summarized by the letter K and put that into an equation and expect it to yield useful information. The capital stock is heterogeneous. Some capital may be intended to create goods for sale tomorrow and others for sale in ten years." (3) With so many counter-forces and trends, why should these statistics be accepted as meaningful? A good analogy is the study of gases. They are composed of countless individual molecules, each with different positions, directions, energy levels, etc. Yet early scientists did not study them individually; they studied them collectively. And this approach proved quite useful for producing valuable information, statistics and general laws. There is an underlying reason why Austrians seek to deny the validity of statistics: if they accepted them, their positions would prove untenable. An example is the fastest period of growth in U.S. history: the New Deal era, from 1933 to 1973. This was also a time of unprecedented government growth, when the top tax rate reached 91 percent. Obviously, these numbers have to be denied. The only numbers that Austrians trust to any great extent are prices. Other than that, the Austrian school is to be characterized for its innumeracy. One could ask how they even know a business cycle exists, or whether the economic events they are critiquing are even happening. The paradox is that if they can critique accurately, then government can calculate accurately. Even the Austrian's allies in business would not want to live in a world without statistics. Entrepreneurs have a huge demand for numbers other than prices: for example, Neilson ratings, consumer surveys, price trends, etc. It is the only way they can make enlightened investment decisions. As Libertarian critic Mike Huben points out: "Business employs two kinds of economists: those who can create and use statistics, and those who can create and apply corporatist propaganda. Guess which the Austrians are..." METHODOLOGICAL SUBJECTIVISM How, then, do Austrians understand anything that goes on in the economy? Through an approach called methodological subjectivism. Kirzner defines this as the recognition "that the actions of individuals are to be understood only by reference to the knowledge, beliefs, perception and expectations of these individuals." (1) Austrians claim that attempting to understand individual actions through statistics or other group generalizations is mistaken, for all the reasons outlined in the previous section. By comparison, mainstream economists find it useful to know that unemployment has risen from 6 to 12 percent, because that means more workers will be competing for fewer jobs, and they will be reducing their wage demands to get them. It doesn't matter what the individual wants, plans or believes -- his decision to accept a lower wage is being determined by a market force larger than himself. And one can accept the mainstream view while acknowledging there may be exceptions to the generalization. The undeniable existence of market forces is something that subjectivists have had to grapple with. Gunning explains the history of their effort: "In classical economics, the behavior of subjects was thought to be governed by the forces of nature. The classical economists searched for laws of economic interaction -- inevitable outcomes of economic interaction that were beyond the control of the actors. "The old subjectivist economists did not deny that there were outcomes of interaction that were beyond the control of any particular actorââ¬Â¦ It is true that no specific individual plans the totality of economic interaction. However, this does not mean that interaction should be attributed to the forces of nature. Instead, the outcome must be regarded as a somewhat unpredictable, yet logical, outcome of the choices of the individuals involved in the interaction." (2) A good way to see this viewpoint is to return to the unemployment example given above. If unemployment rises from 6 to 12 percent, that's because countless individuals acting on their own knowledge made it happen. If market forces exist, it's not for impersonal reasons, but because subjective individuals interact on the market. The realization that humans act on their knowledge gave rise to what Gunning calls the "new subjectivism." He continues: "Mises discovered the new subjectivism by trying to understand the method of the old subjectivistsââ¬Â¦ The old subjectivists sought to explain economic interaction in terms of their assumptions about subjects' characteristics: wants, abilities, expectations, knowledge and plans of subjects. But they did not explain why it was appropriate to assume the subjects have these characteristics. "Thinking, to be meaningful, must be connected with some goal. It is therefore a part of choosingââ¬Â¦ [But] thinking and choosing are not two separate activities. They are intimately related. In view of this, the phrase 'thinking and choosing' is cumbersome. A simpler term is acting. When Mises wanted to refer to thinking and choosing, he used the term action. When the economist studies subjects, said Mises, she is studying human actions." (3) Mises classified the idea that "humans act" as a priori knowledge, since it is something that humans instinctively know and accept. (Its opposite would be "humans involuntary react.") Mises held this idea to be as true as any mathematical form of a priori knowledge, such as "two plus two equals four." And just as math helps scientists understand physical behavior, the knowledge that "humans act" helps economists understand economic behavior. All economic logic flows from this axiom. Mises used it to build his own logical theory of human economic action, called praxeology. (Hayek did not subscribe to praxeology, hence the current rift in the Austrian School.) There are several problems with subjectivism, both new and old. Even granting the premise that humans are endowed with free will, there is no denying that even impersonal forces affect human actions to a very large degree. Both mainstream and Austrian economists agree that economics is "primarily concerned with the efficient allocation of scarce resources among competing uses." (4) But resources are often discovered by accident -- for example, the well-driller who strikes oil, the sailor who discovers an island, or the coal miner who finds gold. Technology is also often discovered or invented by accident as well, as in the invention of plastics. These accidents of history ripple through the economy, sometimes radically altering its supply and demand, and creating the market forces to which people must respond. Even natural disasters throw entire economies into new directions. For example, the steam engine was considered equal to or even superior than the gasoline engine from 1890 to 1914. But then a national epidemic of hoof-and- mouth disease led to the withdrawal of horse troughs, which is where steam cars refilled with water. The disappearance of a market for steam engines brought their thriving research and development to a halt, whereas gasoline engines profited from another 80 years of research and development. (5) Thus, an accident of history is responsible for the big oil companies of today, and the direction of an entire global economy (not to mention the attendant pollution problems). Is this economic activity primarily traceable to the beliefs, plans or expectations of subjective individuals? Of course not. An Austrian might argue that individuals are nonetheless responsible for searching out resources and inventions. But even eliminating the luck involved with finding them, the fact remains that entire market forces are unleashed by the discoveries of a relatively few people. The subjective effect that Austrians evoke is actually slight; the vast majority of people are not subjectively interacting with each other on the market, but are responding to market trends created by a small group of discoverers. Even if it were possible for everyone on the market to contribute a discovery, theirs would be only a tiny fraction of the total; they would still be inundated by the market forces unleashed by everyone else's. METHODOLOGICAL INDIVIDUALISM A closely related Austrian philosophy is methodological individualism. This means that all economic phenomena can be traced back to, and explained by, the actions of individuals. Even when individuals act on behalf of a group, or as part of a group, they are acting as individuals. Thus, "group behavior" is a false concept. As political scientist Jon Elster argues: "A family may, after some discussion, decide on a way of spending its income, but the decision is not based on 'its' goals and 'its' beliefs, since there are no such things." (1) Even if the final budget is a compromise that does not correspond to the wish of any single family member, then members have nonetheless agreed to the compromise, since compromising is somehow more rewarding than not compromising. The opposite of this is methodological holism, which holds that groups have traits, behaviors and outcomes that cannot be understood by reducing them to their individual parts. That is, groups consist not only of individuals, but also relationships between individuals. It is not enough to say that "the functions and traits of my car can be reduced to, and explained by, the atoms that make it." This overlooks an equally important point -- that these atoms need to be shaped into a car. The fact that atoms are fundamental units that exhibit certain properties actually explains very little. The economic equivalent here would be a factory. A car factory may have thousands of employees, but none of them possess the complete knowledge to build an entire car. Each worker's knowledge and responsibility are specialized and limited, and can only build part of a car. Only the interdependent efforts of the entire group can roll a car off the assembly line. An individualist might object that human beings are unlike atoms, in that people have the ability to create their own relationships and therefore such interdependent groups as company workforces. But this occurs neither spontaneously nor at an individual level. Suppose a car factory has no central organization, and workers just began building a car, communicating with no one except the workers whose parts were immediately connected to their own. It could turn out that the engine workers thought they were building a Mercedes Benz, while the trunk workers thought they were building a Yugo. Obviously, there needs to be centralized organization. Austrians seek to get around this problem by establishing the entrepreneur - - the firm's central organizer -- as the "isolated actor" of their analysis. Here are some Austrian assertions to this effect: "The entrepreneurââ¬Â¦ is the driving force of the market processââ¬Â¦" (2) "Thus the role of the entrepreneur emerged as the agency that causes the (prospective) means of production to be used to produce goods for the consumer role." (3) "In economics, the distinctly human element involved in causing, by means of choice, the economic functions to be performed is assigned to a particular role, that of the entrepreneur." (4) These quotes evoke the delightful image of entrepreneurs running their companies all by themselves. Indeed, Gunning asserts without irony: "To help us identify the characteristics of entrepreneurship, we begin by showing how an isolated actor would come to perform the functions of producing, consuming, saving, and supplying factors." (5) We should not, of course, interpret this to mean that Austrians are so gullible as to believe that entrepreneurs run their companies single-handedly. But these are the conceptual games they must play to protect the fiction that "isolated actors" and "primary agents" exist in an economy that is overwhelmingly interdependent. Even in their primary role as organizers, entrepreneurs depend on the group. A company president can only issue general guidelines to his managers, who must inevitably organize and direct much of their departments on their own. The larger a company gets, the less personal and direct control an entrepreneur has over it. He must delegate out an increasing share of authority and responsibility, and is more dependent than ever on others to help him run things, investigate conditions, inform policy, and make recommendations. Furthermore, individual employees who are acting on delegated authority are attempting to act in the interest of their employer (usually a corporation, not an entrepreneur), which depends on their model of that abstract entity. The firm's lack of individualism can be seen from the other direction as well. Individual firms are rarely the basic unit of the economy; almost all products run through several firms before completion. Information brokers, for example, often do not know where their information comes from or how it was derived, or where it goes or for what purposes. Stores like Sears do not produce all their own goods; they merely serve as part of a larger network of firms cooperating to sell their products. Ultimately, there is a continual network of interdependence running from the individual worker to the global economy. Picking out the "entrepreneur" as the primary level of analysis is like singling out the quarterback as the "isolated actor" of a football team. Another objection to methodological individualism is that it fails to adequately account for culture, tradition, rules and other social habits. (6) Much of human behavior is to be explained on these grounds, not individual knowledge or choice. Hayek attempted to explain habits and other rules of social behavior on the grounds that they promoted order and efficiency within the group. Over time, they promoted group success. (7) But what Hayek failed to do was describe how these rules and customs were passed on, and why they weren't replaced by other rules. The answer is group selection. Imagine two farms, one more efficiently organized than the other. Over time, the less efficient farm and its methods may disappear, and the more efficient farm will pass on its customs and rules to future generations (of both farms and people). Individuals who join these farms will learn by teaching or imitation. Much of their future activity will be based on these social norms, not their own individual choices. To the extent that individual choice is present, it is to follow these social norms, or attempt to create new ones. In debates between methodological individualism and holism, the winner that usually emerges is a compromise position: we are both individuals and members of the group. Those who seek to explain everything on a purely individual level are just as doomed to fail as those who seek to explain everything on a purely group level. Different branches of science actually seek to explain human behavior at many different levels: the gene, the individual, the group, and the specie. Being open to different types of methodologies is characteristic of mainstream science. Insisting on only one methodology at all times is a feature of crank science. The problem with insisting on only one level of analysis is that counter- examples crop up which are nearly impossible to explain. Methodological individualists claim that individuals seek to maximize their personal rewards. But if this were true, then soldiers would become conscientious objectors instead of risking death in war. Charity, favors, volunteer work, loans and other forms of altruism would never happen. Parents would not sacrifice for their children. True believers would not sacrifice their resources or their lives for a cause. Yet these things happen. One of the most famous failures of methodological individualism is why people vote. According to public choice theorists, who base their science on this method, there is no logical reason for individuals to vote. The costs and inconvenience of voting (getting off work, driving to the polling site, getting picked for jury duty) far outweigh its rewards (which would only occur on the extremely rare occasion that someone cast the deciding vote). A rational actor would simply take a "free ride" and allow others to decide the election for him. "Unfortunately for theory," laments political scientist Carole Uhlaner, "people do vote." (8) Voting strongly suggests that people are not pure individualists, but are endowed with a degree of civic-mindedness. The following wry comment from economist Laurence Moss sums it all up nicely: "American institutionalists have long benefitted from the existence of the Austrian school of economics... The Austrian writers have served as whipping boys for the institutionalist critique against atomistic individualism and extreme rational calculation." (9) STARTING ASSUMPTIONS Austrians and mainstream economists also differ completely on what starting assumptions to use. When mainstream economists build a theoretical model to understand an economic activity, they often -- but hardly always -- make assumptions of perfect conditions. For example, they will assume that consumers have perfect information about the market, that market competition is perfect, that all products are perfectly homogenous, or that there are zero costs to firms entering the market. Austrians point out, however, that these conditions do not exist in the real world, so the results of these models' calculations are worthless. It is even more short-sighted to use these unrealistic results to guide national economic policy. There is a mainstream rebuttal to this argument, but for the moment, let's continue. Austrians call for economic assumptions to reflect the real world -- warts and all. True, this would make the market imperfect as well, but Austrians argue that human economic activity is continually striving to overcome these imperfections, and the market is far better suited than the government to do so. The model that Austrians actually use is the theory of market process. It starts by assuming that individuals have limited and imperfect information. But probably the most important information that a person can learn is the supply and demand for any given product, which is encoded in its price. Through trading on the market, individuals learn new information, and revise and improve their goals and methods accordingly. New ways of competing for customers are found, and this competition results in steadily falling prices. This constant market process results in an ever-more efficient allocation of limited resources. All this sounds admirably realistic -- until you get to the fine print. Austrians commit the very same sin they accuse mainstream economists of doing, by calling for utopian starting conditions before their model will work as advertised. Here is Gaillot describing their own model: "Market process theory assumes that there is no force and fraud. Force includes force by individuals in the form of theft and so forth, and force by the government in the form of taxation, regulation, and so forth. Austrians recognize that force by both individuals and governments exists, and that market theory does not completely explain reality. Instead, market theory allow economists to understand the processes at work in a market society and to isolate the effects of force. Attempts to analyze real-world markets must account for government and individual force. Austrian analysis of government policies thus includes not only the direct effects of the policies, but also the effect of the policy on the functioning of the market process." (1) This remarkable paragraph essentially calls for the utopian perfection of the human race before the Austrian model can be applied or even criticized! All market failures today can be blamed on the fact that we have a government, regardless of the actual level of government involvement in the failure. But what if the U.S. decided to become libertarian, and adopt an Austrian economic policy? Then they would still be protected from accusations of failure, because they can always blame criminals for wrecking the market process. This theory therefore serves to justify a heightened War on Crime. Considering the economic and demographic groups popularly associated with crime, one can easily see the possibilities for demagoguery and scapegoating in the event the new economic system turned out to be inherently flawed. Liberals can point out an even more basic flaw in the "absence of force" requirement. And that is that all property rights are maintained and defended by force, or the credible threat of force. All property is protected by police and military forces, and violations of property rights result in the appropriate forceful response. Therefore, the idea that a land of perfect property rights can exist force-free is either a giant self-contradiction or hopelessly utopian. Austrian hypocrisy aside, why do mainstream economists themselves use perfect starting assumptions? First, we should note that economists are primarily concerned with how the real world can be modeled, and the accuracy of their models is continually improving. Studying how assumptions are violated is a major part of economics. For example, William Vickrey and James Mirrlees won the 1996 Nobel Prize for their theories of asymmetric information (unequal information between buyers and sellers). The rise of New Keynesianism in the last 10 years has been based on George Akerlof's fundamental point that human beings are not perfectly rational, but nearly rational. Another liberal school of economics, institutionalism, doesn't even subscribe to static equilibrium models at all, but agree (ironically) with Austrians that the economy is one of constant change. It is really the neoclassical (conservative) economists who rely so heavily on perfect starting assumptions. If Austrians want to criticize their allies, then liberal economists are perfectly happy to let them. A neoclassical defense for using perfect assumptions is that countless factors affect activities taking place in the real world, so economists must simplify their starting assumptions if they are to quantify the economy at all. Even so, economists have numerous tools to get around this problem, tools that have been improving with time. They can start by isolating the most important factors. They can also focus the model on a highly specific industry, product or individual, which greatly reduces the complicating factors. Another method is to establish broad groupings or taxonomies with similar characteristics that yield variables that can be applied to smaller categories. The claim that these models do not have applications for the real world betrays the Austrian's own unfamiliarity with statistics. THE MARKET PROCESS According to Austrians, only individuals "on the scene" know what's going on in the market, and any attempt to manage it centrally is bound to fail. Perhaps the best way to highlight the error of market process theory is by analogy. Suppose you are the chief of a tribe of wandering nomads, and you wander into a region that is unfamiliar to everyone. Soon the tribe becomes thirsty, and everyone agrees to start searching for water. In the first version of this example, suppose you are an "anarchist" chief, and allow the tribe to conduct its own search without organization, coordination or planning. A lot of effort will be wasted and duplicated in the chaos that follows. Next, suppose you are a "mixed economy" chief -- that is, you believe that individual effort should be balanced by group effort. You therefore organize the search for water, by sending everyone out in different directions. When they all return, one announces the discovery of a lake, and the tribe proceeds to the lake together. (Another possible result is that two scouts come back with different pieces of information, and putting them together results in the discovery of the lake.) Next, imagine that you are a "central-planning" chief -- that is, you insist on controlling every action of every individual in the entire search. As they radiate from your central location, you shout out after each one of them to look under that rock, behind that bush, around that tree. As they get out of shouting range, you communicate with each other by smoke signal. One scout may signal that he has found a rock: may he look under it? You signal back: yes. Of course, this will slow down the search considerably, because you'll be overwhelmed by messages from the field. And this is terribly inefficient as well, because you don't know their local situation as well as they do, and they are much better placed to make these tactical decisions. Austrian economists love to criticize socialism and other forms of big government on the basis of the last example. They argue that a central planner does not have the fantastic knowledge needed to control individual members to such a degree, and the members should be free to act on their own knowledge. This is undoubtedly true. But is the solution to this problem the first approach? Of course not. In the second approach, the chief did not need to know the Absolute Truth of the land to organize an effective search. And individuals were free to search as they needed on their individual jaunts. When they returned with their reports from the field, the chief did not need to know exactly what each one of them had learned or experienced in order to choose the correct policy: send the entire tribe to the lake. The idea that the chief could not form an effective strategy because he did not personally see everything for himself is absurd. One might then ask whether this example applies to both the public and private sectors. Austrians would probably see no problem using the tribe analogy to describe private organizations, but would object to using it to describe public ones. But why? That is an enormously difficult question for Austrians. One of their most common ploys is to appeal to the strawman of the "socialist" tribe, by pointing out that overly centralized government is inefficient. But when denied that strawman, Austrians have no obvious answer. All the subjectivism, individualism and market process that exists in the private sector should exist in the public sector as well. Both companies and governments provide goods and services in exchange for money. Customers vote with their dollars; voters vote with their ballots. Both customers and voters are self-interested, seeking the best goods and services for the least money. Companies and politicians that do not perform well go bankrupt or are voted out of office. And if society should reduce government that has grown too centralized and inefficient, then it should do no less for monopolies, which share the same shortcomings. MONOPOLIES Austrians believe that the government destroys the market process for several reasons. Rockwell writes: "One obvious exampleââ¬Â¦ takes place at the Justice Department's antitrust division. There the bureaucrats pretend to know the proper structure of industry, what kind of mergers and acquisitions harm the economy, who has too much market share or too little, and what the relevant market is. This represents what Hayek called the pretense of knowledge. "The correct relationship between competitors can only be worked out through buying and selling, not bureaucratic fiat. Austrian economists, in particular Rothbard, argue that the only real monopolies are created by government. Markets are too competitive to allow any monopolies to be sustained." (1) The claim that governments cause monopolies defies the historical evidence. History actually shows the opposite: the more unregulated the market is, the worse the problem of monopolies. However, the Austrian claim is not wholly without merit. Utilities are examples of monopolies run or regulated by the government (although they are natural monopolies, and privatizing them doesn't work, as Britain found out in the 80s). Often companies persuade governments to erect barriers of market entry to potential competitors. Sometimes government subsidies allow one company to overpower its competitors. But such cases are usually the result of money-based lobbying, which is a corruption of the system. Corruption in the public sector no more "refutes" its central principle than does corruption in the private sector. The solution to corruption is to eliminate it by enforcing better laws. European democracies offer broad practical evidence that this sort of corruption can be greatly reduced. But this Austrian critique completely ignores another, more common type of monopoly: that which forms naturally on the unregulated market. There are many reasons for this tendency, ranging from "it takes money to make money" to the greater efficiency of large corporations. Without antitrust laws or some other countervailing market force, growing companies will not stop until they become monopolies or oligopolies. The height of monopoly growth and abuse in the U.S. coincided with its greatest period of laissez-faire, or government nonintervention in the market. Known as the Gilded Age (the period between the Civil War and World War I), this period saw the phenomenal rise of the Robber Barons and their great trusts (monopolies). John D. Rockefeller monopolized oil under his Standard Oil Company; J.P. Morgan dominated finance; Andrew Carnegie, steel; James Hill, railroads. Historians have well chronicled the ruthlessness of these men -- Morgan once remarked that "I don't know as I want a lawyer to tell me what I cannot do. I hire him to tell me how to do what I want to do." Rockefeller's father once boasted that "I cheat my boys every chance I get, I want to make 'em sharp." These men lived for market conquest, and plotted takeovers like military strategy. In the late 19th century, trusts formed also in wheat, fruit, meat, salt, sugar refining, lumber, electrical power, rubber, nickel, paper, lead, gypsum, iron, cottonseed oil, linseed oil, whiskey distilling, cord manufacture -- and many others. Once a trust emerged, it would raise its prices and drop its quality of service, as well as engage in unfair trading practices that drove other firms out of business. The abuses of these monopolies became so great that they became a national scandal. So deep was antitrust sentiment that when both houses of Congress passed the Sherman Antitrust Act in 1890, there was only a single dissenting vote! (2) But U.S. presidents did not bother to enforce it, and the monopoly problem continued to worsen. The worst period of monopoly formation was between 1898 and 1902. Prior to this, there was an average of 46 major industrial mergers a year. But after 1898, this soared to 531 a year. (3) By 1904, the top 4 percent of American businesses produced 57 percent of America's total industrial production, and a single firm would dominate at least 60 percent of production in 50 different industries. (4) The power of these monopolies easily dwarfed the governments that oversaw them. As early as 1888, a Boston railroad company had gross receipts of $40 million, whereas the entire Commonwealth of Massachusetts had receipts of only $7 million. (5) And when Rockefeller, Carnegie and Morgan united in 1901 to create U.S. Steel, the result was an international sensation. Cosmopolitan magazine wrote: "The world, on the 3rd day of March, 1901, ceased to be ruled byââ¬Â¦ so-called statesmen. True, there were marionettes still figuring in Congress and as kings. But they were in place simply to carry out the orders of the world's real rulers -- those who controlled the concentrated portion of the money supply." (6) The role of government in all this was to stand back and let this market process happen. It wasn't until Teddy Roosevelt launched his great "trust- busting" campaign in 1902 that this process was reversed. Actual enforcement of the Sherman Act reduced monopolies until the Roaring 20s, when laissez- faire policies again returned to Washington. Over that decade, about 1,200 mergers swallowed up more than 6,000 previously independent companies; by 1929, only 200 corporations controlled over half of all American industry. (7) The New Deal era ushered in yet another era of antitrust policy, again reducing the percentage of monopolies. This was followed by the Reagan era, a period which saw both massive deregulation and another frenzy of mergers and takeovers. In 1988, Federal Trade Commissioner Andrew Strenio remarked: "Since Fiscal Year 1980, there has been a drop of more than 40 percent in the work years allocated to antitrust enforcement. In the same period, merger filings skyrocketed to more than 320 percent of their Fiscal Year 1980 level." (8) Two objections are possible here. The first is that these growing corporations may have captured government and then used it as a tool to capture the market. Those familiar with the Golden Age and Roaring 20s know, however, that governments were basically bribed to stand back and do nothing. They passed very little legislation that actively prevented any firms from entering the market and competing. The Reagan era was different, in that corporate lobbyists began using government as a proactive agent to discourage competition. Nonetheless, the periods of government trust-busting show the proper role of government, and its effectiveness in restoring market competition. The second objection is that a wave of mergers may result in a more natural and efficient equilibrium of larger players, and this could be beneficial for the economy. The result doesn't have to be a monopoly -- perhaps just an oligopoly. The problem is that at the top end, mergers become increasingly harmful to the economy, with monopolies merely representing the worst result. Even oligopolies engage in price-gouging and collaboration. A natural equilibrium hardly represents the best equilibrium -- as recessions and depressions show. How do Austrians deal with the historical correlation between laissez-faire and monopolies? By denying it, of course. The presence of any government at all proves that their conditions of a free market were not met, so the entire correlation is rejected. This is like someone attempting to argue that not watering a plant will result in the fastest growth. And when you point out to him that there is a correlation between the amount of water given to a plant and its rate of growth, he dismisses these experiments on the basis that they all used water. THE GOLD STANDARD AND BUSINESS CYCLE Gold Standard Austrians believe in the gold standard, whereas mainstream economists favor the current system of fiat money. Before exploring why, we should note that virtually all economists agree that the total amount or value of money in a system should closely match its level of economic activity. If there is too much money, then inflation rises. If there is too little money, then unemployment rises. Under the current system, the government fights inflation by contracting the money supply, and fights unemployment by expanding it. This achieves the optimum level of money, and minimizes our economic problems. Austrians call for a 100-percent gold standard (that is, without even fractional reserve banking) because it would get the government out of the business of controlling the money supply. Under a gold standard, the total amount or value of money would be fixed, determined only by the size of the nation's gold reserves. Sure, unemployment and inflation may rise, but eventually prices will readjust themselves through natural inflation or deflation and solve the problem. Austrians believe that this readjustment, painful or prolonged though it may be, is a self-cleansing exercise that rids the economy of malinvestment. That is, it eliminates weak firms that shouldn't have been created in the first place. Another essay on this site rebuts the gold standard in detail. But the following quick review highlights the most important of the gold standard's many weaknesses: First, it would make nearly inflexible the total amount of the nation's money supply. Gold bugs claim the value of that money would adjust itself to the level of market activity through inflation or deflation. But although money inflates easily, it suffers from "price stickiness" when trying to deflate. Often, deflation barely occurs, and the result is high unemployment, recession or even depression instead. In other words, money doesn't adjust itself to the level of economic activity; the level of economic activity adjusts itself to the money. History bears this out: the U.S. suffered eight depressions while on commodity money; in the 60s years since, it has suffered none. Second, gold standards based on a fractional reserve allow the phenomenon of bank panics or bank runs, which leave depositors holding worthless money. This only exacerbates recessions and depressions. The solution to this would be to adopt a pure gold standard. But there is not enough gold in the world to cover the phenomenal amount of economic activity currently in it, without an equally phenomenal revaluation of gold. Furthermore, industry is making increasing demands on gold; a change in dentistry or electronics could deflate an entire economy. Business Cycle The Austrian's beliefs on the gold standard set up the argument that government is the cause of the business cycle (the economy's recurring pattern of recession and recovery). When the government expands the money supply -- usually by easing credit restrictions and lending rates -- this artificially increases investment. Much of this is malinvestment, on projects that wouldn't have been started otherwise. When the malinvestment reaches sufficient proportions, the result is a recession. Should the government do anything to ease the pain? Austrians say no. Weak firms must be allowed to go bankrupt, unjustified jobs must be eliminated, artificially high wages must fall. Only then can the economy start anew on a healthier course of growth. The theory that the Fed's monetary expansion and easing of credit restrictions results in "malinvestment" is an unsupported claim. It is backed up only by the Austrian's faith and deductive "logic" that such malinvestment occurs. It is true that the Fed's actions allow investments to occur that were otherwise waiting to happen. But the real question is: should they? In a depression, a lot of good investment is undoubtedly being held back by lack of money. Whether it proceeds through expanding the money supply or allowing the currency to deflate is irrelevant. What the Austrians are really doing is moving the goal posts. The sound investment waiting to happen in a recession gets branded as "malinvestment" when the Fed takes steps to let it proceed. Whether or not you believe this investment would have been sounder under a deflating currency depends on whether or not you wish to believe a negative. Austrians often repeat that since the Federal Reserve System was created in 1913, our currency has devalued 98 percent, due to the printing of money. But this is a meaningless statistic. Suppose you need $2,000 a month to buy the necessities of life, but you earn $2,000 a month as well. You're making ends meet. Now suppose that your bills climb to $10,000 a month -- but so does your income. Has anything real changed? Of course not. At low levels, inflation under fiat money is relatively harmless. However, the deflation caused by the gold standard is truly destructive. If dollars have inflated to 2 percent of their original value, and the price of gold has risen 20 times, then maintaining the gold standard would have deflated the dollar to 2.5 times its original value. That's a lot of unemployment. No, the real question is not how much money has inflated, but whether or not your absolute standard of living has risen. And in this regard, the current system of fiat money has been a clear success. Between the end of World War II and the early 70s, the U.S. standard of living (adjusted for inflation) doubled -- the fastest rate of prolonged growth in U.S. history. The U.S. became a middle class nation for the first time, with the share of families owning their own homes climbing from 44 to 63 percent. Families owning their own cars rose even more dramatically, from 54 to almost 100 percent. (1) Poverty, which had been 56 percent in 1900, fell to an all-time low of 11 percent in 1973. (2) And, of course, there has not been a single depression since World War II, not in this or any other country following Keynesian monetary policies. Those who would claim that fiat money has been a disaster for our economy are simply indulging in scare-mongering and demagoguery HISTORY OF THE AUSTRIAN SCHOOL A frequent Austrian boast is that Hayek accurately predicted the Great Depression. Given the Austrian's usual disdain for empirical verification, however, it is difficult to know what to make of this claim. Actually, this prediction was a no-brainer, since the U.S. had experienced at least five depressions before the Great One, and the recurring pattern of the business cycle had long ago been recognized. It therefore took no acumen whatsoever to predict an economic downturn. What is more striking is what Hayek didn't predict: that depressions would disappear worldwide in all countries that adopted Keynesian monetary policies. Now that might have been slightly more impressive. Another Austrian boast is that in the 1920s, their economists were involved in some famous debates with the world's top economists, during which they tore down the intellectual pillars of both socialism and Keynesianism. Of course, this boast is always accompanied by the rueful admission that Mises and Hayek didn't convince anybody in academia, and, in fact, were subject to widespread ridicule. Mises couldn't even find a university job afterwards, and Hayek abandoned his work in technical economics, turning his attention to other political and philosophical pursuits instead. These debates began in 1920, when Mises published a ground-breaking article called "Economic Calculation in the Socialist Commonwealth," followed by his book, Socialism. In these works, Mises argued that socialism had to fail, because it had no way of knowing whether it was allocating resources efficiently or not. In market economies, prices help people make economic calculations; profits and losses allow them to know whether they are pursuing the right economic plan. In a centrally planned economy, there is no way for the planners to know. And if they attempted to know, they would become overwhelmed by all the prices, profits and loss statements required to know. Mises and Hayek also argued that any central planning committees entrusted to run the economy would become corrupt. This is the economic version of an old argument, that dictatorships deal in corruption and insufficient information. This argument, without doubt, is true. That the Soviet Union was a dictatorship is also true. What is false is the assertion (made by the Soviet Union itself) that the country was socialist. Socialism means that workers own the means of production, not private individuals or an elite group. Socialism has been proposed in many forms, ranging from social democracy to anarcho-socialism. In the latter, workers would own companies that would compete on the free market, absent any government at all. As you can see, socialism is hardly synonymous with a central planning committee. But one thing socialism cannot be is a dictatorship -- worker's do not own anything if a totalitarian government tells them what to do. Mises and Hayek may have refuted the principle of economic totalitarianism, but they didn't come close to refuting socialism. This is one reason why academia didn't view their arguments against socialism as conclusive. About the same time, Hayek became involved in a famous dispute with John Maynard Keynes. Austrian economist Peter Boettke provides the following account: "The Hayek-Keynes debate was perhaps the most fundamental debate in monetary economics in the 20th century. Beginning with his essay, "The End of Laissez Faire" (1926), Keynes presented his interventionist pleas in the language of pragmatic classical liberalism. As a result, Keynes was heralded as the "savior of capitalism," rather than being recognized as the advocate of inflation and government intervention that he was. "Hayek pinpointed the fundamental problem with Keynes's economics -- his failure to understand the role that interest rates and capital structure play in a market economy. Because of Keynes's unfortunate habit of using aggregate (collective) concepts, he failed to address these issues adequately in A Treatise on Money (1930). Hayek pointed out that Keynes's aggregation tended to redirect the analytical focus of the economist away from examining how the industrial structure of the economy emerged from the economic choices of individuals. "Keynes did not take kindly to Hayek's criticism. He responded at first by attacking Hayek's Prices and Production. Then Keynes claimed that he no longer believed what he had written in A Treatise on Money, and turned his attention to writing another book, The General Theory of Employment, Interest, and Money (1936), which in time became the most influential book on economic policy in the 20th century. "Rather than attempting to criticize directly what Keynes presented in his General Theory, Hayek turned his considerable talents to refining capital theory. Hayek was convinced that the essential point to convey to Keynes and the rest of the economics profession concerning monetary policy lay in capital theory. Thus Hayek proceeded to set forth his thesis in The Pure Theory of Capital (1941). However correct his assessment may have been, this book, Hayek's most technical, was his least influential. By the end of the 1930s, Keynes's brand of economics was on the rise. In the eyes of the public Keynes had defeated Hayek. Hayek lost standing in the profession and with students." (1) This rather accurate account bears only a few additional comments. Blaming the failure of Hayek's book on the fact that it was his "most technical" doesn't wash in economics, where technicality is seen as a strength, not a weakness. One could hardly imagine a more technical and confusing book than Keynes' General Theory. Nobel economist Paul Samuelson would describe Keynes' book thus: "It is a badly written book, poorly organizedââ¬Â¦ it is arrogant, bad- tempered, polemicalââ¬Â¦ it abounds in mare's nests and confusions: involuntary unemployment, wage units, the equality of savings and investments, the timing of the multiplier, interactions of marginal efficiency upon the rate of interest and many othersââ¬Â¦ flashes of insight and intuition intersperse tedious algebra.