Misesian Economic Calculation and Coordination in Market Economies: An Overview and Critique

UPDATED

Mises’s notion of economic calculation and coordination in market economies is at the heart of Austrian economics.

I provide an overview below and critique.

Note that I am not discussing the issues of the strict socialist calculation debate, which should be differentiated from Mises’s views on economic calculation in capitalist systems where there are money and money prices for capital goods (unlike the socialist economies Mises imagined).

In market societies, there are money prices, and economic calculation “is calculation in terms of money prices” (Mises 1998: 206). Money prices allow us to compare “input and output on a common basis” (Mises 1998: 209), and money is the “common denominator of economic calculation” (Mises 1998: 215). Economic calculation “in terms of money prices is the calculation of entrepreneurs producing for the consumers of a market society” (Mises 1998: 217), and it deals with the future, though it takes “pasts events and exchange ratios of the past into consideration” (Mises 1998: 211).

The aim that economic calculation achieves is to “establish the outcome of acting by contrasting input with output” (Mises 1998: 211). The prices of the past are starting points in the endeavour to “anticipate future prices” (Mises 1998: 213). Money prices allow the calculation of profit and loss (Mises 1998: 231).

So far so good.

Mises states the monetary factors needed for a reasonable level of economic calculation in a market system:

“The first aim of monetary policy must be to prevent governments from embarking upon inflation and from creating conditions which encourage credit expansion on the part of banks. But this program is very different from the confused and self-contradictory program of stabilizing purchasing power.

For the sake of economic calculation all that is needed is to avoid great and abrupt fluctuations in the supply of money. Gold and, up to the middle of the nineteenth century, silver served very well all the purposes of economic calculation. Changes in the relation between the supply of and the demand for the precious metals and the resulting alterations in purchasing power went on so slowly that the entrepreneur’s economic calculation could disregard them without going too far afield. Precision is unattainable in economic calculation quite apart from the shortcomings emanating from not paying due consideration to monetary changes. The planning businessman cannot help employing data concerning the unknown future; he deals with future prices and future costs of production. Accounting and bookkeeping in their endeavors to establish the result of past action are in the same position as far as they rely upon the estimation of fixed equipment, inventories, and receivables. In spite of all these uncertainties economic calculation can achieve its tasks. For these uncertainties do not stem from deficiencies of the system of calculation. They are inherent in the essence of acting that always deals with the uncertain future.” (Mises 1998: 225).

So according to Mises what is required is as follows:

(1) for the sake of “economic calculation all that is needed is to avoid great and abrupt fluctuations in the supply of money”; and

(2) slow changes in purchasing power of money (as in the 19th century and gold standard eras), so that the “entrepreneur’s economic calculation could disregard them without going too far afield.”

This entails that mild changes in money’s purchasing power – whether inflation or deflation – are, according to Mises, consistent with effective economic calculation. For example, the 19th century had bouts of inflation, such as from 1896–1914, yet presumably Mises thought that economic calculation proceeded during this period without being seriously impaired.

But there is also a clear contradiction here: Mises says that governments have to be prevented “from creating conditions which encourage credit expansion on the part of banks.” Yet the 19th century and gold standard era had significant credit expansion, as I have demonstrated here.

Yet presumably Mises held that the 19th century did have reasonably effective economic calculation. Either Mises must

(1) abandon the idea that 19th century had reasonably effective economic calculation, or

(2) admit that some moderate degree of credit expansion is consistent with economic calculation.

If the latter, then it follows that the post-1945 era with its relatively low inflation and moderate credit expansion must also have had reasonably effective economic calculation.

But how does the price system perform its most fundamental task in economic calculation and coordination? Why, for example, would Austrians complain about excessive money supply expansion “distorting” prices and frustrating or impairing economic calculation?

The reason is that the Austrians see prices revolving around or moving towards their market-clearing values. The market-clearing price is the “right” price in an economic sense, because it is the adjustment of prices by market participants in their trades towards their market-clearing levels that coordinates, or equates, supply and demand.

In particular, the capitalists who produce consumer goods have a crucial role here:

“The driving force of the market process is provided neither by the consumers nor by the owners of the means of production – land, capital goods, and labor – but by the promoting and speculating entrepreneurs. These are people intent upon profiting by taking advantage of differences in prices. Quicker of apprehension and farther-sighted than other men, they look around for sources of profit. They buy where and when they deem prices too low, and they sell where and when they deem prices too high. They approach the owners of the factors of production, and their competition sends the prices of these factors up to the limit corresponding to their anticipation of the future prices of the products. They approach the consumers, and their competition forces prices of consumers’ goods down to the point at which the whole supply can be sold. Profit-seeking speculation is the driving force of the market as it is the driving force of production.” (Mises 1998: 325–326).

Salerno summarises Mises’s views on flexible prices moving towards their market-clearing values in the Misesian view of economic coordination:

“Mises conceives the market process as coordinative, ‘the essence of coordination of all elements of supply and demand.’ This means that the structure of realized (disequilibrium) prices, which continually emerges in the course of the market process and whose elements are employed for monetary calculation, performs the indispensable function of clearing all markets and, in the process, coordinating the productive employments and combinations of all resources with one another and with the anticipated preferences of consumers.” (Salerno 1993: 124).

“prices that are generated by the market process and serve as the data for economic calculation. These are realized prices; or, in other words, they are the actual outcome of the historical market process at each moment in time and are determined by the value scales of the marginal pairs in each market. They are, therefore, also market-clearing prices the establishment of which coincides with a momentary situation, what Mises calls the ‘plain state of rest’ (PSR), in which no market participant, given his existing marginal-utility rankings of goods and money and knowledge of prevailing prices, can enhance his welfare by participating in further exchange. However, despite their character as market-clearing prices, these are also disequilibrium prices. Thus as a consequence of the unavoidable errors of entrepreneurial forecasting and price appraisement under uncertainty, most goods are sold at prices that do not conform to their monetary costs of production, thereby generating realized profits and losses for producers.” (Salerno 1990: 121).

“Despite the economy’s disequilibrium character, however, the market-clearing process has an important function to perform in the pricing and allocation of scarce resources, a function that Hutt felicitously described as ‘the dynamic coordinative consequences of price adjustment.’ According to Mises, the coordinative social appraisement process of the market insures that the current price of every scarce resource is equal to its expected marginal revenue product (discounted by the interest rate), and thus that all existing productive resources are always fully employed in those uses that entrepreneurs consider to be most valuable in light of their knowledge of the technological possibilities and their forecasts of future market conditions, including their appraisements of prospective output prices.

As I have argued elsewhere, a Misesian conceives the market’s coordinative process as extremely hardy and no more liable to be disrupted by market-produced changes in the money-spending stream, such as hoarding, dishoarding, and changes in the production costs of mining gold, than by changes in the ‘real’ data of the economic system. As Mises argued, however, the process can be hampered and distorted by external intervention that undermines or nullifies its market-clearing property in resource markets, a property that may be crudely and temporarily restored by an episode of unanticipated inflation which lowers the real prices of labor and other resources toward equilibrium levels. Thus Mises’s analysis explains the observed effect of inflation on employment and output in a way that is fully consistent with the microfoundations of Austrian monetary theory and does not invoke ad hoc and unrealistic assumptions about the behavior of market participants.” (Salerno 2010: 210–211).

The crucial point is that it is flexible prices that are supposed to coordinate demand with supply, as noted by Rothbard:

“There is no reason why prices cannot fall low enough, in a free market, to clear the market and sell all the goods available. If businessmen choose to keep prices up, they are simply speculating on an imminent rise in market prices; they are, in short, voluntarily investing in inventory. If they wish to sell their ‘surplus’ stock, they need only cut their prices low enough to sell all of their product. But won’t they then suffer losses? Of course, but now the discussion has shifted to a different plane. We find no overproduction, we find now that the selling prices of products are below their cost of production. But since costs are determined by expected future selling prices, this means that costs were previously bid too high by entrepreneurs. The problem, then, is not one of ‘aggregate demand’ or ‘overproduction,’ but one of cost-price differentials. Why did entrepreneurs make the mistake of bidding costs higher than the selling prices turned out to warrant? The Austrian theory explains this cluster of error and the excessive bidding up of costs; the ‘overproduction’ theory does not. In fact, there was overproduction of specific, not general, goods. The malinvestment caused by credit expansion diverted production into lines that turned out to be unprofitable (i.e., where selling prices were lower than costs) and away from lines where it would have been profitable. So there was overproduction of specific goods relative to consumer desires, and underproduction of other specific goods.” (Rothbard 2008: 56-57; emphasis in original text).

So in the Austrian theory businesses must lower prices to clear their product market, even if the price falls below the cost of production. If they suffer losses, this is only because they overproduced goods in specific industries, and they must make supply adjustments in those specific industries only, to allow prices to be adjusted upwards to restore profits.

Finally, the role of flexible wages is also described by Salerno:

“Now, unlike the Chicago price theorists, Mises and the Misesian wing of the modern Austrian school, do not believe that the market economy is ever at or even within sight of long-run general equilibrium. Rather, the structure of realized market-clearing prices is seen by Austrians as functioning, despite its non-general equilibrium character, to continuously coordinate the uses and technical combinations of available resources in light of entrepreneurial forecasts of constantly shifting future market conditions, including consumer preferences. Hence, for Mises, in direct contrast to Friedman, it is the decline in real wage rates toward their market-clearing levels brought about by unforeseen inflation that is equilibrating – albeit crudely and temporarily; the ensuing restoration of the former level of real wage rates by renewed union restrictionism, on the other hand, marks a reversion to a pervasive and chronic disequilibrium situation in which the labor market is precluded from establishing even a coordinative, momentary equilibrium of supply and demand, while the market’s long-run tendency to generate a structure of final equilibrium wage rates and optimal allocation of labor is permanently stifled.” (Salerno 2010: 210–211).

So what is wrong with this fundamental Austrian theory? Why is it flawed?

It is wrong for the following reasons:

(1) we have already seen above that Mises’s views on whether economic calculation can still occur properly when there is a credit expansion on the part of banks is confused and inconsistent.

Mises’s assertions on the 19th century entail either (a) that a modern market economy even with moderate money supply and credit expansion and low inflation can presumably have effective economic calculation, or (b) that Mises must abandon the idea that 19th century had reasonably effective economic calculation.

The consequences of (b) entail that modern capitalism has never had any effective economic calculation! If any Austrians want to take this option, then they must explain how real output has expanded at all over the past 200 years and how stunning growth in real output and investment as in, for example, 1945 to 1973 were able to occur.

I take it that few sensible Austrians will opt for (b), and (a) will be their chosen response. But option (a) entails that modern market economies, even with mild to moderate credit expansion, can still achieve economic calculation.

(2) the role of the price system in Mises’s vision of economic calculation is deeply flawed. Mises sees the price system as having flexible prices that move towards their market-clearing values: this is how supply and demand are equated.

But that is most certainly not the reality in vast swathes of modern market economies where fixprices and administered prices are the norm. Many prices in consumer goods, capital goods, retail trade, and service industries are administered prices. They are not adjusted towards their market-clearing values by businesses.

Administered prices are generally not changed in response to demand, and so most of the private sector itself does not behave in the way posited and required by Austrian theory. Money supply growth and credit expansion do not generally “distort” fixprices away from their market-clearing values, because fixprices are not even set to attain those market-clearing values at all.

Yet supply and demand are coordinated in modern capitalist economies, but by businesses making direct adjustments in their output and employment in response to demand.

It is direct changes to supply that equate supply and demand, not flexible prices.

(3) the whole notion that there exists a universal set of market-clearing values for prices and wages just waiting to be discovered by adjusting prices or Walrasian tâtonnement is itself little more than a quasi-theological superstition of modern neoclassical and Austrian economics, because no economist can prove that the law of demand is universally true.

It is not just that the law of demand, with its ceteris paribus (or “[all] other things being equal”) assumption, is defined at a level of abstraction so high that in practice it is unrealistic, but that even in an abstract sense it cannot be proven. Steve Keen demonstrates that the law of demand can be proven only in the case of a single consumer (Keen 2011: 51).

Nor can we generalise the law of demand and prove that it necessarily applies to a whole market either (Keen 2011: 51). A market demand curve “can take any shape at all – except one that doubles back on itself” (Keen 2011: 52).

Note that even if you do not accept this radical critique of the law of demand, factor (2) above – the existence of fixprice markets – is sufficient to refute the Austrian theory of economic coordination.

(4) the employment of labour by business is a much more complicated process than just the demand for labour as predicted by labour supply and demand curves.

Expectations of businesses are subjective, and liable to cycles of pessimism and optimism. Lowering the interest rate or lowering the real wage does not induce the necessary investment when business expectations are shattered or weak. So many businesses depend on demand, sales orders or sale volume (or what can be called “quantity signals”) as the factors that induce them to employ labour.

This means that it is aggregate demand that is the major factor in inducing additional employment in modern economies, not necessarily wage cuts.

All in all, there is not much left of the Austrian vision of economic calculation: it is based on a deeply unrealistic theory of prices, does not consider the reality of fixprices, and fails to even accurately understand how supply and demand are equated in the real world.

The real world, with its extensive fixprices and direct output adjustments, is better modelled and understood by Keynesian economics.

BIBLIOGRAPHY
Keen, S. 2011. Debunking Economics: The Naked Emperor Dethroned? (rev. and expanded edn). Zed Books, London and New York.

Mises, Ludwig von. 1990. Money, Method, and the Market Process: Essays. Kluwer Academic Publishers, Norwell, Mass.

Mises, L. 1998. Human Action: A Treatise on Economics. The Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Rothbard, Murray Newton. 2008. America’s Great Depression (5th edn.). Ludwig von Mises Institute, Auburn, Ala.

Salerno, Joseph T. 1990. “Ludwig von Mises as Social Rationalist,” Review of Austrian Economics 4: 26–54.

Salerno, Joseph T. 1993. “Mises and Hayek Dehomogenized,” Review of Austrian Economics 6.2: 113–146.

Salerno, Joseph T. 2010. Money, Sound and Unsound. Ludwig von Mises Institute, Auburn, Ala.