Were Nominal Wages Flexible in 1890s and Early 1900s America?

There is some empirical evidence that they were not.

Sundstrom (1990) looks at industrial wage data from the Ohio State Bureau of Labor Statistics (BLS) during the recessions of 1893 and 1908 and finds considerable wage rigidity even at that time.

In 1893, Cincinnati manufacturing employment contracted by over 16% and factories reduced working days by 9.2% between 1892 and 1893, but Sundstrom found that 77.1% of manufacturing workers experienced no change in nominal wages, and what evidence that exists for 1894 and 1895 also indicates that wage cuts were small in these years too (Sundstrom 1990: 312–313).

Given that deflation occurred in 1893 until 1898, this would suggest that many workers’ real wages probably rose.

In the data for the severe recession of 1908, Sundstrom (1990: 314) finds that, throughout Ohio, 6.37% of industrial workers experienced wage increases, while only 7.36% experienced wage cuts. This suggests that most workers experienced no nominal wage cuts.

Overall, Sundstrom (1990: 314) finds that nominal average hourly earnings only fell by about 1% between 1907 and 1908.

Sundstrom (1990: 310) concludes that as “early as the 1890s, Ohio employers were much more likely to respond to downward demand fluctuations by reducing employment, days worked, and hours than by reducing wage rates.”

To put this into a broader historical context, we can turn to Hanes (1993). Hanes concludes that 19th century American nominal wages had already become relatively inflexible by the 1890s (Hanes 1993: 733–734).

His explanation for this is as follows:

“The years between the … [sc. American Civil War] and World War I saw little or no increase in the fraction of workers belonging to unions. Countercyclical macro policy did not exist; wage contracts were extremely rare, and unenforcible. On the other hand, the period was one of enormous change in the structure of product and labor markets, associated with the spread of large-scale industrial production. Production workers in the new industrial establishments, whether or not they were formally unionized, were likely to strike against nominal wage cuts in downturns. I argue that firms learned to avoid, or at least delay, nominal wage cuts in downturns. I present evidence that firms in industries that had suffered especially large numbers of strikes in the 1880’s were less likely to cut nominal wages in the depression of 1893.” (Hanes 1993: 733–734).

The crucial point here is that this development cannot be blamed on trade unions because they were weak in the late 19th century in terms of numbers and membership, they faced hostility from the courts and government, and even when they existed they could not generally create binding legal employment contracts with employers, because the courts did not recognise them (Hanes 1993: 750–751).

Hanes (1993: 751) contends that strikes were a widespread phenomenon amongst non-unionised workers, and that it was the spread of large-scale manufacturing firms with numerous workers that was itself that main factor that caused labour strife and the increasing wage rigidity accepted by private firms.

What is the lesson? It is that people, generally speaking, have shown a strong propensity to oppose nominal wages cuts since at least the late 19th century, and private businesses themselves – even with the incredible amount of violence against labour in those days – were coming to shun nominal wage cuts to avoid troublesome labour difficulties.

Nor can trade unions or governments be blamed for this phenomenon.

BIBLIOGRAPHY
Sundstrom, William A. 1990. “Was There a Golden Age of Flexible Wages? Evidence from Ohio Manufacturing, 1892–1910,” The Journal of Economic History 50.2: 309–320.

Hanes, Christopher. 1993. “The Development of Nominal Wage Rigidity in the Late 19th Century,” The American Economic Review 83.4: 732–756.

Philip Pilkington on the Myth of Hyperinflation

First, you need only look at the video below to see the kind of hysterical craziness that was unleashed after the crisis of 2008 and the turn in the Western world to that most misunderstood of policies: quantitative easing.



According to the Austrian economics-inspired crank Marc Faber, hyperinflation in the US was “100% certain,” no less!

Well, we are still waiting for that alleged hyperinflation.

Philip Pilkington has an old but wonderful post here that really is one of the best refutations of this nonsense I have ever seen:

Philip Pilkington, 2013. “Hyperinflation! The Libertarian Fantasy That Never Occurs,” Nakedcapitalism.com, March 6.

The answer is, quite simply, that Austrians and hyperinflation cranks do not – and have never – understand real world capitalism.

Their economic models and assumptions are virtually worthless, and they have never understood the role of administered prices/mark-up prices, excess capacity, and stocks/inventories in modern economies.

I advise them to read Nicholas Kaldor’s classic Economics Without Equilibrium (Armonk, N.Y., 1985), simply one of the best short introductions to real world capitalism you will find.

The General Theory, Chapter 19: Changes in Money-Wages

Chapter 19 of The General Theory is a crucial one: it discusses the consequences of nominal wages cuts in modern market economies.

Keynes begins by pointing out that neoclassical economics (which he called the “Classical” theory) assumes that a major reason why market economies are supposed to self-adjust is via flexible wages (and, by implication, prices). When wages are rigid, this is (allegedly) the cause of serious maladjustment in neoclassical theory (Keynes 1964 [1936]: 257).

Keynes accepted that a “reduction in money-wages is quite capable in certain circumstances of affording a stimulus to output, as the classical theory supposes” (Keynes 1964 [1936]: 257), but there were many reasons why it would not generally do so.

Keynes also emphasised the need to distinguish the real wage from the nominal wage (or “money-wage”) (Keynes 1964 [1936]: 259).

Keynes analysed the effects of reductions in nominal wages in the following way:

(1) a reduction in nominal wages may reduce prices, but if the price falls are uneven, it will redistribute real income from wage-earners to other classes of society, such as producers and rentiers (the latter of whom often have fixed incomes) (Keynes 1964 [1936]: 262). But this is likely to reduce the aggregate level of consumption (or propensity to consume), so that the macroeconomic effects will actually be harmful (Keynes 1964 [1936]: 262).

(2) if the reduction in nominal wages affects industries that export products, then a reduction in money wages might stimulate demand for a nation’s exports and hence its domestic investment (Keynes 1964 [1936]: 262–263). Keynes noted that the UK of his day was an export-led economy (as compared with the United States), and that this accounted for the popularity of the belief that cutting money-wages would increase employment in Great Britain (Keynes 1964 [1936]: 263).

(3) but in an open economy, a reduction in money wages may increase the favourable balance of trade but worsen the terms of trade (Keynes 1964 [1936]: 263).

(4) If a reduction in money wages occurs but with expectations of further wage rises in the future, then this might be favourable to consumption and investment (Keynes 1964 [1936]: 263).

But, if a reduction in money wages leads to expectations of further wage cuts in the future, then it may well be counterproductive as it may lead to deferment of both investment and consumption (Keynes 1964 [1936]: 263).

(5) If both a reduction in wages and some fall in prices occur, and lead to a lower liquidity preference, then this will reduce the rate of interest, and prove favourable to investment.

But if, at the same time, there is an expectation of further wage and price increases in the future, then demand for long-term loans may not be as great as demand for short term loans (Keynes 1964 [1936]: 263), and if wage cuts cause loss of confidence and discontent, the increase in liquidity preference might more than offset the original reduction in the latter (Keynes 1964 [1936]: 264).

(6) A reduction of wages simply within one particular industry will be advantageous to the capitalist owners and/or managers of that industry, and a general reduction in wages throughout an economy might produce an optimistic mood amongst entrepreneurs in general, but labour troubles are likely to complicate matters badly:

“On the other hand, if the workers make the same mistake as their employers about the effects of a general reduction, labour troubles may offset this favourable factor; apart from which, since there is, as a rule, no means of securing a simultaneous and equal reduction of money-wages in all industries, it is in the interest of all workers to resist a reduction in their own particular case. In fact, a movement by employers to revise money-wage bargains downward will be much more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices.” (Keynes 1964 [1936]: 264).

(7) And, crucially, Keynes pointed to the disastrous effects of debt deflation:

“On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partly offset any cheerful reactions from the reduction of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those entrepreneurs who are heavily indebted may soon reach the point of insolvency, — with severely adverse effects on investment. Moreover the effect of the lower price-level on the real burden of the National Debt and hence on taxation is likely to prove very adverse to business confidence.” (Keynes 1964 [1936]: 264).

To this Keynes could have added that private household debt will have much the same disastrous effects if wage and price deflation proceeds far enough.

Keynes, then, pointed to the negative distributional and other effects of wage reductions, and contended that only (4) or (5) gave much hope of inducing favourable results from nominal wage cuts.

But, with respect to (4), in order to prevent the expectation of further nominal wage cuts, a wage reduction would have to be deep and wide enough throughout an economy and limited to a single occurrence:

“The contingency, which is favourable to an increase in the marginal efficiency of capital, is that in which money-wages are believed to have touched bottom, so that further changes are expected to be in the upward direction. The most unfavourable contingency is that in which money-wages are slowly sagging downwards and each reduction in wages serves to diminish confidence in the prospective maintenance of wages. When we enter on a period of weakening effective demand, a sudden large reduction of money-wages to a level so low that no one believes in its indefinite continuance would be the event most favourable to a strengthening of effective demand. But this could only be accomplished by administrative decree and is scarcely practical politics under a system of free wage-bargaining.” (Keynes 1964 [1936]: 265).

Next Keynes notes that market equilibration in neoclassical theory depends on effective wage and price adjustment maintaining consumption and smoothing out changes in the demand to hold money:

“It is, therefore, on the effect of a falling wage- and price-level on the demand for money that those who believe in the self-adjusting quality of the economic system must rest the weight of their argument; though I am not aware that they have done so. If the quantity of money is itself a function of the wage- and price-level, there is indeed, nothing to hope in this direction. But if the quantity of money is virtually fixed, it is evident that its quantity in terms of wage-units can be indefinitely increased by a sufficient reduction in money-wages; and that its quantity in proportion to incomes generally can be largely increased, the limit to this increase depending on the proportion of wage-cost to marginal prime cost and on the response of other elements of marginal prime cost to the falling wage-unit.” (Keynes 1964 [1936]: 266).

In effect, Keynes is saying that the neoclassical belief in market equilibration via wage reductions depends on the “real balances” effect (Hayes 2006: 177) (and note how Keynes assumes an exogenous money supply here too).

Keynes continues by noting that, in some respects, a cut in nominal wages is effectively equivalent to expansionary monetary policy (Keynes 1964 [1936]: 266; Hayes 2006: 178). But Keynes argues that the clear advantages of increasing the money supply over reductions in nominal wages make the latter an absurd policy.

Keynes sketches his argument for this view in the following way:

(1) It is paradoxically only in a fully socialist economy that wage policy can be done uniformly and effectively by administrative decree. In a market economy, it is unrealistic to think that there could be “uniform wage reductions for every class of labour” (Keynes 1964 [1936]: 267):

“The result [sc. uniform wage reductions] can only be brought about by a series of gradual, irregular changes, justifiable on no criterion of social justice or economic expediency, and probably completed only after wasteful and disastrous struggles, where those in the weakest bargaining position will suffer relatively to the rest. A change in the quantity of money, on the other hand, is already within the power of most governments by open-market policy or analogous measures. Having regard to human nature and our institutions, it can only be a foolish person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter. Moreover, other things being equal, a method which it is comparatively easy to apply should be deemed preferable to a method which is probably so difficult as to be impracticable.” (Keynes 1964 [1936]: 267–268).

(2) Since certain classes of people such as rentiers have fixed incomes, a relatively rigid wage system is fairer:

“Thus the greatest practicable fairness will be maintained between labour and the factors whose remuneration is contractually fixed in terms of money, in particular the rentier class and persons with fixed salaries on the permanent establishment of a firm, an institution or the State. If important classes are to have their remuneration fixed in terms of money in any case, social justice and social expediency are best served if the remunerations of all factors are somewhat inflexible in terms of money. Having regard to the large groups of incomes which are comparatively inflexible in terms of money, it can only be an unjust person who would prefer a flexible wage policy to a flexible money policy, unless he can point to advantages from the former which are not obtainable from the latter.” (Keynes 1964 [1936]: 268).

(3) Above all, money supply growth rather than wage cuts will overcome the dangers of debt deflation:

“The method of increasing the quantity of money in terms of wage-units by decreasing the wage-unit increases proportionately the burden of debt; whereas the method of producing the same result by increasing the quantity of money whilst leaving the wage unit unchanged has the opposite effect. Having regard to the excessive burden of many types of debt, it can only be an inexperienced person who would prefer the former.” (Keynes 1964 [1936]: 268).

(4) Finally, if a fall in interest rates is brought about by falling nominal wages, this can, as Keynes already noted, cause deferment of investment (Keynes 1964 [1936]: 269).

Furthermore, Keynes argued, gradual reductions in nominal money wages might have the perverse effect of actually increasing real wages (Keynes 1964 [1936]: 269).

Keynes’s conclusion, then, was as follows:

“In the light of these considerations I am now of the opinion that the maintenance of a stable general level of money-wages is, on a balance of considerations, the most advisable policy for a closed system; whilst the same conclusion will hold good for an open system, provided that equilibrium with the rest of the world can be secured by means of fluctuating exchanges. There are advantages in some degree of flexibility in the wages of particular industries so as to expedite transfers from those which are relatively declining to those which are relatively expanding. But the money-wage level as a whole should be maintained as stable as possible, at any rate in the short period.

This policy will result in a fair degree of stability in the price-level; — greater stability, at least, than with a flexible wage policy. Apart from ‘administered’ or monopoly prices, the price-level will only change in the short period in response to the extent that changes in the volume of employment affect marginal prime costs; whilst in the long period they will only change in response to changes in the cost of production due to new technique and new or increased equipment.” (Keynes 1964 [1936]: 270–271).

As an aside, I note here how Keynes seems to have assumed that “administered or monopoly prices” were not very significant. And that leads me into my last point.

What is especially interesting about Keynes’s analysis is this: it concedes points to neoclassical economics – such as the idea of exogenous money, prices determined by marginal cost, and relatively flexible but uneven price movements – that Keynes did not need to concede, but still Keynes shows that the neoclassical theory is deficient.

BIBLIOGRAPHY
Hayes, Mark. 2006. The Economics of Keynes: A New Guide to The General Theory. Edward Elgar, Cheltenham.

Keynes, J. M. 1964 [1936]. The General Theory of Employment, Interest, and Money. Harvest/HBJ Book, New York and London.

Kalecki, Keynes, Wages and Capacity Utilisation

In this fascinating interview of heterodox economist Bob Rowthorn, he makes a very interesting point about the importance of capacity utilisation and fixprices in Keynesian economics, in terms of the differences between the views of Keynes in the General Theory and Kalecki (N.B. the video may start at an earlier point than I set it at in Mozilla Firefox!).



Now I have not looked carefully into this, but does anyone know any good literature about this subject, and specific references in Kalecki’s work?

The crucial point is that Keynes was opposed to nominal wage cuts (for reasons explained in Chapter 19 of the General Theory), and his analysis there seems to assume a flexprice world (Hayes 2006: 178: “The General Theory itself is a ‘flex-price’ system, but not of Hick’s Walrasian type”) as a concession to the neoclassical theory of Keynes’s day, in order to show that even flexible prices and wages do not necessarily cure unemployment.

But, once we have a mark-up pricing world with adjustments in capacity utilisation where prices are generally relatively inflexible, then expansion of aggregate demand does not simply cause inflation as it would if prices were generally flexprice.

And once we move to the real world of fixprices (the world of mark-up prices and capacity utilisation as in Kalecki’s models), Keynesian economics simply becomes an even stronger and more robust theory of modern market economies.


BIBLIOGRAPHY
Hayes, Mark. 2006. The Economics of Keynes: A New Guide to The General Theory. Edward Elgar, Cheltenham.

Murphy on Sticky Wages

Robert P. Murphy in his recent response to Krugman on Mises and the Great Depression refers us to the following post to refute the idea that “sticky wages” really are a problem for free market economics:

Murphy, Robert P. 2010. “Do Sticky Wages Weaken the Case for Markets?,” Mises Daily, June 7
http://mises.org/daily/4353/Do-Sticky-Wages-Weaken-the-Case-for-Markets

This post deserves to be read by everyone who wants to see how far Austrian economists (and, incidentally, even mainstream New Keynesians like Mankiw) are from understanding real-world capitalism.

Keynes was clear that even if wages and prices were perfectly flexible this would still be no reliable and automatic cure for involuntary unemployment, and that there could still be failures of aggregate demand (Davidson 1992). Keynes, then, would not have been a New Keynesian like Mankiw.

But the issue here is wage stickiness.

First, Murphy does not even dispute that wage stickiness is a real phenomenon in modern market economies (what is now called a “stylised fact”), but instead wishes to put the blame for it mostly on modern governments.

I will return below to why this is wrong, but Murphy makes an astonishing claim that is utterly untrue:

“Now we have to ask, why do workers hold out for so long without jobs, insisting on wages that no one is willing to pay? After all, the other goods and services in the economy see their prices fall in a speedy fashion even though the sellers of these items depend on them for their livelihood. So if a street vendor knows enough to slash his hot dog prices when demand collapses, why don’t hairdressers accept pay cuts when the same happens to their industry?

What was that? Murphy is saying that real world “prices fall in a speedy fashion”?

Has Murphy ever noticed that in virtually all recessions since the late 1930s throughout the developed world, even recessions tend to be inflationary? Deflation has virtually disappeared.

Relative price rigidity is a fact of life. Even in the terrible disaster that was the Great Depression it was a clear phenomenon.

The reason has been known since the work of Gardiner Means: most prices in modern capitalist economies are relatively inflexible mark-up/administered prices (for the empirical evidence, see Appendix 2 below).

Flexible price setting as required in standard economics textbooks – where prices are set by supply and demand dynamics – is largely shunned by the private sector itself.

A great part of the economy of each modern capitalist nation consists of mark-up pricing sectors, but even though (of course) flexprice markets do exist they are a considerably smaller part of the economy than most people think (perhaps less than 30% in many nations).

And, even though many nations saw price deflation in the Great Depression, even in the 1930s mark-up prices were significant and relatively inflexible as compared with other markets: Gardiner Means, for example, discovered that the administered pricing sector of the US economy had seen price declines of only about 10% during the depression, whereas the more competitive or flexprice sectors had seen price falls of about 40 to 60% (Means 1975).

So even Robert Murphy’s initial assumption that we live in a world of highly flexible prices cannot be taken seriously, and utterly collapses.

But to return to the issue of sticky wages. The main cause of sticky wages is not government intervention.

The empirical evidence that has accumulated over the years shows that people in general object to having their nominal wages cut. But even managers and capitalists often dislike pay cuts. Recent studies suggest that employers avoid pay cuts because they diminish workers’ morale, and then falling morale reduces productivity, amongst many other reasons (Bewley 1999). The evidence of Bewley shows that even employers are often averse to wage cuts during recessions. A nice summary of Bewley’s work on wages is available here.

But moving on, even Murphy’s explanation of wage rigidity during the depression in the US is flawed:

“…why don’t hairdressers accept pay cuts when the same happens to their industry? In the case of the Great Depression, the answer is simple enough: the federal government didn’t allow wages to fall. After the 1929 crash, Herbert Hoover gathered the nation's leading businessmen for a conference in Washington and urged them to allow profits and dividends to take the hit, but to spare workers’ paychecks. Rather than cut wages, businesses were supposed to implement spread-the-work schemes where workers would cut back their hours.”

First, Hoover’s “high wage” policy was not an alien, evil government intervention imposed on unwilling and hostile business people: it was a policy that many largely agreed with, as I note here. Already in the 1920s and 1930s many employers had grown averse to wage cuts.

Secondly, Rose (2010) presents some (admittedly ambiguous) evidence that Hoover’s “high wage” policy actually did not have much effect on the timing of US wage cuts during the depression.

Of course, that rigid wages in the face of falling prices squeezed profits and induced business pessimism and bankruptcy is undoubtedly true, but the solution was not wage cuts.

Why? Keynes showed why in Chapter 19 of the General Theory (Keynes 1964 [1936]: 257–271), and one important reason is that, even when nominal wages fall, this induces debt deflationary effects (especially when levels of private debt are very high), just as Irving Fisher had argued (Fisher 1933; see also Dimand 1997 and Dimand 2011).

Above all, if price deflation is quite uneven across sectors and product markets (as in many countries during the depression), the burden of fixed nominal debt will soar, inducing difficulty in servicing debt to many debtors and actual bankruptcy to others.

A further means by which demand for final goods and services is contracted is that a greater transfer of wealth from debtors to creditors occurs and creditors often have a lower marginal propensity to consume.

And eventually severe debt deflation will cause distress and bankruptcy to creditors and the financial system. So the smooth and rapid market clearing as postulated by Austrians and other mainstream neoclassicals as the cure for high involuntary unemployment simply could not and did not happen.

Murphy cites the recession of 1920–1921 as an example of how (alleged) wage and price flexibility cleared markets and led to a (supposedly) quick recovery. But the recession of 1920–1921 is highly anomalous, as I have shown elsewhere (see Appendix 1 below), and a demand-side explanation is more convincing as an explanation of recovery in 1921. There was no financial crisis, no banking failures, the deflation was probably expected, some actual positive supply shocks, and private debt levels were considerably lower than in 1929.

Murphy is also wrong that the Federal Reserve “jacked rates up to record high levels,” if he is talking about the recovery in 1921:

Discount Rate of the Federal Reserve Bank of New York
Date | Rate
1920
May | 6%
June | 7%
Dec. | 7%
1921
Jan. | 7%
Apr. | 7%
May. | 6.5%
Jun. | 6%
Jul. | 5.5%
Sep. | 5%
Nov. | 4.5%

1922
Jan. | 4.5%
Jun. | 4%.
http://fraser.stlouisfed.org/download-page/page.pdf?pid=38&id=1477

As we can see, the Fed lowered interest rates from May 1921, and a recovery began in August 1921, after looser monetary policy had been adopted.

Then from November 1921 to June 1922, the Fed engaged in unprecedented open market operations to aid the recovery process.

The Austrian obsession with the recession of 1920–1921 is strange, given its anomalous nature. Why don’t they look at the US recessions of the 1870s and 1890s, for example?

The US had no central bank in these years, small government, a gold standard, either no or very limited unemployment relief at best, and (presumably) a greater degree of price and wage flexibility (although even in this period wage stickiness existed: see Sundstrom 1990; Sundstrom 1992; Hanes 1992; Hanes 1993). Yet serious economic problems occurred in both the 1870s and 1890s.

Take the 1890s. The graph below shows US unemployment in the 1890s according to three estimates. For various reasons, Lebergott’s estimates may be the better ones for unemployment rates in this period.

High unemployment continued for years after the shock of 1892–1893.

So what is the Austrian explanation for this? If wages and prices were not sticky, then there was still no rapid recovery and quickly self-adjusting labour market.

If wages were sticky, then not even late Gold Standard capitalism escaped the “stylised fact” of relatively rigid wages.

Either way the Austrian view is damned.

Appendix 1: The Recession of 1920–1921
“The US Recession of 1920–1921: Some Austrian Myths,” October 23, 2010.

“There was no US Recovery in 1921 under Austrian Trade Cycle Theory!,” June 25, 2011.

“The Depression of 1920–1921: An Austrian Myth,” December 9, 2011.

“A Video on the US Recession of 1920-1921: Debunking the Libertarian Narrative,” February 5, 2012.

“The Recovery from the US Recession of 1920–1921 and Open Market Operations,” October 4, 2012.

“Rothbard on the Recession of 1920–1921,” October 6, 2012.

Appendix 2: Empirical Evidence on Administered Prices
“Downward’s Pricing Theory in Post-Keynesian Economics: Chapter 8,” January 23, 2014.

“Mark-up Pricing in South Africa,” January 20, 2014.

“Mark-up Pricing in Sweden,” January 9, 2014.

“Mark-up Pricing in Canada,” January 7, 2014.

“Some More Empirical Evidence on Full Cost Pricing,” December 10, 2013.

“Mark-up Pricing in New Zealand,” November 30, 2013.

“Mark-up Pricing in Australia,” November 30, 2013.

“Mark-up Pricing in Japan,” November 29, 2013.

“Mark-up Prices in Iceland,” November 25, 2013.

“Mark-up Pricing in Norway,” November 23, 2013.

“Mark-up Pricing in Ireland,” November 22, 2013.

“Two Marketing Studies on US Administered Prices,” November 16, 2013.

“Hall and Hitch on Marginal Cost and Price,” November 4, 2013.

“Administered Pricing in the United Kingdom,” October 19, 2013.

“Administered Prices in the Eurozone: Some Empirical Data,” October 16, 2013.

“Gardiner Means on Administered Prices,” June 20, 2013.

“Early Literature on Administered Pricing,” May 8, 2013.

BIBLIOGRAPHY
Bewley, T. F. 1999. Why Wages Don’t Fall During a Recession. Harvard University Press, Cambridge, MA.

Davidson, P. 1992. “Would Keynes be a New Keynesian?,” Eastern Economic Journal 18.4: 449–463.

Dimand, Robert W. 1997. “Debt-Deflation Theory,” in D. Glasner and T. F. Cooley (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York. 140–141.

Dimand, Robert W. 2011. “Lessons from the 1929 Crash and the 1930s Debt Deflation: What Bernanke and King Learned, and what they could have learned,” in Claude Gnos and Louis-Philippe Rochon (eds.), Credit, Money and Macroeconomic Policy: A Post-Keynesian Approach. Edward Elgar, Cheltenham. 33–44.

Fisher, Irving. 1933. “The Debt-Deflation Theory of Great Depressions,” Econometrica 1.4: 337–357.

Keynes, J. M. 1964 [1936]. The General Theory of Employment, Interest, and Money. Harvest/HBJ Book, New York and London.

Means, Gardiner C. 1975. “Simultaneous Inflation and Unemployment: A Challenge to Theory and Policy,” in Gardiner C. Means et al., The Roots of Inflation: The International Crisis. Wilton House Publications, London.

Sundstrom, William A. 1990. “Was There a Golden Age of Flexible Wages? Evidence from Ohio Manufacturing, 1892–1910,” The Journal of Economic History 50.2: 309–320.

Sundstrom, William A. 1992. “Rigid Wages or Small Equilibrium Adjustments? Evidence from the Contraction of 1893,” Explorations in Economic History 29.4: 430–455.

Salerno’s Response to Krugman on Mises and the Great Depression

Salerno’s recent response to Krugman is here:

Joseph Salerno, “Paul Krugman Attacks Ludwig von Mises: Another Win for Austrian Economics!,” Mises Economics Blog, January 28th, 2014
http://bastiat.mises.org/2014/01/paul-krugman-attacks-ludwig-von-mises-another-win-for-austrian-economics/

Salerno’s post is unintentionally hilarious, given the quotation that opens his post (comparing the righteous and poor persecuted Austrians with Gandhi!):

“First they ignore you, then they laugh at you, then they fight you, then you win.”

(Mahatma Gandhi).

Funny you use that quote, Salerno, because it would appear to be a perfect description of how you (and other Austrians) treatment me and my blog.

First of all, arguments stand and fall on their own merits, not on the obscurity or identity of the author. But it appears Salerno doesn’t agree with that and resorts to exactly the tactics described above.

Salerno says the following of my post here:

“Actually, our jaded scribe [sc., Krugman] could not be bothered to train his sites on Mises’s actual views but rather rests content to attack a caricature of Mises’s position as presented in a pseudonymous post by an individual calling himself ‘Lord Keynes’ on the blog Social Democracy for the 21st Century: A Post Keynesian Perspective. Blithely accepting ‘Lord Keynes’s’ claims at face value, Krugman declares ‘von Mises, faced with the reality of depression, basically dropped Austrian business cycle theory.’”
Joseph Salerno, “Paul Krugman Attacks Ludwig von Mises: Another Win for Austrian Economics!,” Mises Economics Blog, January 28th, 2014
http://bastiat.mises.org/2014/01/paul-krugman-attacks-ludwig-von-mises-another-win-for-austrian-economics/

No, Salerno, I did not say that “von Mises, faced with the reality of depression, basically dropped Austrian business cycle theory.”
Here is what I said (with my quotation from Mises following):

“However, it is interesting that Mises thought that his Austrian monetary theory of the cycle could not adequately explain the severity and length of the Great Depression (as also noted by Hülsmann 2007: 617–618):

“The crisis from which we are now suffering is also the outcome of a credit expansion. The present crisis is the unavoidable sequel to a boom. Such a crisis necessarily follows every boom generated by the attempt to reduce the ‘natural rate of interest’ through increasing the fiduciary media. However, the present crisis differs in some essential points from earlier crises, just as the preceding boom differed from earlier economic upswings. The most recent boom period did not run its course completely, at least not in Europe. Some countries and some branches of production were not generally or very seriously affected by the upswing which, in many lands, was quite turbulent. A bit of the previous depression continued, even into the upswing. On that account—in line with our theory and on the basis of past experience—one would assume that this time the crisis will be milder. However, it is certainly much more severe than earlier crises and it does not appear likely that business conditions will soon improve.

The unprofitability of many branches of production and the unemployment of a sizable portion of the workers can obviously not be due to the slowdown in business alone. Both the unprofitability and the unemployment are being intensified right now by the general depression. However, in this postwar period, they have become lasting phenomena which do not disappear entirely even in the upswing. We are confronted here with a new problem, one that cannot be answered by the theory of cyclical changes alone.” (Mises 2006 [1931]: 163–164).

So it appears that Salerno either (1) did not read the post or (2) did not read it properly or ignored what I actually said. Since Salerno later repeats one of my quotations from Mises, it would appear to be (2).

But if Salerno did not read the post properly or “ignored” what I said, then Salerno appears to have fulfilled the first of these failings of his quotation (“First they ignore you, then they laugh at you, then they fight you, then you win”).

It also follows that Salerno’s charge that my post was “a caricature of Mises’s position” is a straw man, though perhaps unintentionally.

This is reinforced when Salerno borrows a quotation of mine from Mises and uses it to prove that “Mises did not deny that the Great Depression was initiated by credit expansion.” That is correct, but then I did not assert that Mises abandoned his business cycle theory.

Salerno’s following charge that Krugman is unable “to grasp a multi-causal explanation of a complex and multifaceted historical episode” that was the Great Depression is so stupid, it’s laughable, and is actually more appropriate for the grossly oversimplistic explanation of Mises himself, who ignored the complex factors in the 1930s that thwarted any strong inducement to hire labour and clear the labour market via lower wages, such as the level of demand for output, the degree of uncertainty of capitalists about the future, business expectations, the general state of expectations, and the state of the financial system and credit markets, and so on.

After this Salerno links to a paper by Ohanian (2009) arguing that Hoover’s “high wage” policy was a major cause of the US depression, which is rather strange because Mises was talking about the Great Depression in Europe, not the United States.

Be that as it may, it is clear that, firstly, Hoover’s “high wage” policy was not some alien, evil government intervention imposed on unwilling and hostile business people and industrialists: it was a policy they largely agreed with. But secondly and more importantly, Jonathan D. Rose (2010) presents some evidence that Hoover’s “high wage” policy actually did not have much effect on the timing of US wage cuts during the depression.

Thirdly, even when wages fell, this induced severe debt deflationary effects, because price deflation was quite uneven, and the burden of fixed nominal debt soared. So the smooth and rapid market clearing as postulated by Mises as the cure for high involuntary unemployment simply could not and did not happen.

Next, Salerno admonishes Krugman to “stop trawling obscure blogs for biased material” on Austrians – referring to my blog.

This seems like a rather good example of the second part of Salerno’s opening quote (“First they ignore you, then they laugh at you, then they fight you, then you win.”).

Even the charge that my blog is “obscure” (though irrelevant) is, I think, wrong. I’ve made it into the Onalytica Influence Index’s “Top 200 Influential Economics Blogs” (August 2013). Even though I am at no. 178 (at the moment), there are thousands of economics blogs all over the internet, so I’m not quite so “obscure” as Salerno thinks.

And, in point of fact, Robert Murphy seems to have already moved onto the third stage (“fighting” me): he promised here to respond in greater detail to me later this week. I look forward to that.

Finally, Salerno’s links to his paper “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” in his attempts to provide Krugman with “an honest and accurate account of the Austrian theory.”

That is priceless, because a “reformulation” implies that there was something inadequate about the original theory, which does not say much for the ABCT if it needs to be regularly reformulated.

I would go so far as to say that the Austrian business cycle theory is a sad history of “reformulations” as Austrians encountered severe and cutting criticisms of their theory.

For example, Hayek’s first version of the ABCT in Prices and Production (London, 1931) encountered devastating criticisms from Sraffa (1932a, 1932b) and others and he was forced to “reformulate” the theory in Profits, Interest and Investment (London, 1939).

If we turn to Salerno’s new ABCT, one of the main purposes of his paper is to address the criticism that the ABCT “cannot explain the positive correlation of consumption and investment that occurs over the course of the business cycle” (Salerno 2012: 5). But such a charge against the ABCT is only one of the minor problems with the theory.

The main problem with the classic ABCT was always its use of the Wicksellian natural rate of interest: an irrelevant and non-existent concept, as Sraffa showed a long time ago (Sraffa 1932a and 1932b). Outside of an equilibrium state, there could be as many natural rates of interest as there are factor inputs. So what natural rate should banks target when setting interest rates?

I will leave a more detailed critique of Salerno’s paper for another post, but for the moment it is sufficient to note that Salerno (2012: 6, 37–38) invokes and indeed needs the non-existent natural rate of interest for his “new” ABCT to work, just like most of the other versions of the theory.

On this point alone, Salerno’s “reformulation” of the ABCT is as worthless as any other of the pathetic “reformulations” over the years.

Further Reading
“Hoover’s High Wage Policy and the Great Depression,” July 30, 2013.

“Austrian Business Cycle Theory: The Various Versions and a Critique,” June 21, 2011.

BIBLIOGRAPHY
Mises, Ludwig von. 2006 [1931]. “The Causes of the Economic Crisis,” in Percy L. Greaves (ed.). The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala. 155–181.

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.
https://files.nyu.edu/rpm213/public/files/Dissertation.pdf

Murphy, Robert P. “Multiple Interest Rates and Austrian Business Cycle Theory.”
http://consultingbyrpm.com/uploads/Multiple%20Interest%20Rates%20and%20ABCT.pdf

Ohanian, Lee E. 2009. “What – or Who – Started the Great Depression?,” NBER Working Paper Series, 15258
http://www.nber.org/papers/w15258

Salerno, Joseph. 2012. “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15.1: 3–44.
http://mises.org/journals/qjae/pdf/qjae15_1_1.pdf

Sraffa, P. 1932a. “Dr. Hayek on Money and Capital,” Economic Journal 42: 42–53.

Sraffa, P. 1932b. “A Rejoinder,” Economic Journal 42 (June): 249–251.

Rose, J. D. 2010. “Hoover’s Truce: Wage Rigidity in the Onset of the Great Depression,” Journal of Economic History 70: 843–870.

Austrians Rush to Defend Mises

Just as I predicted, various Austrians have rushed to defend their hero Ludwig von Mises after reading Krugman’s recent post that linked to my own:

Robert P. Murphy, “Krugman on Mises on the Great Depression,” Mises Institute of Canada, January 28th, 2014
http://mises.ca/posts/blog/krugman-on-mises-on-the-great-depression/

Joseph Salerno, “Paul Krugman Attacks Ludwig von Mises: Another Win for Austrian Economics!,” Mises Economics Blog, January 28th, 2014
http://bastiat.mises.org/2014/01/paul-krugman-attacks-ludwig-von-mises-another-win-for-austrian-economics/

I will deal with Joseph Salerno’s post elsewhere, and only focus on Murphy’s below.

Murphy’s first substantive point is to claim that Krugman is wrong to assert that “von Mises, faced with the reality of depression, basically dropped Austrian business cycle theory.”

First, I did not say that Mises totally dropped his business cycle theory, and it is quite possible Krugman did not mean to imply this either (since he linked to my post), and Murphy has misinterpreted him.

In point of fact, I said that “it is interesting that Mises thought that his Austrian monetary theory of the cycle could not adequately explain the severity and length of the Great Depression” (and people can read my original post and verify that for themselves). That is, Mises was forced to look for other explanations, rather like Hayek when the latter suddenly discovered the evils of “secondary deflation” as an additional cause of the length of the Great Depression.

At any rate, Murphy then selectively quotes this passage from Mises:

“The crisis from which we are now suffering is also the outcome of a credit expansion. The present crisis is the unavoidable sequel to a boom. Such a crisis necessarily follows every boom generated by the attempt to reduce the ‘natural rate of interest’ through increasing the fiduciary media. However, the present crisis differs in some essential points from earlier crises, just as the preceding boom differed from earlier economic upswings. The most recent boom period did not run its course completely, at least not in Europe. Some countries and some branches of production were not generally or very seriously affected by the upswing which, in many lands, was quite turbulent. A bit of the previous depression continued, even into the upswing. On that account—in line with our theory and on the basis of past experience—one would assume that this time the crisis will be milder. However, it is certainly much more severe than earlier crises and it does not appear likely that business conditions will soon improve.

The unprofitability of many branches of production and the unemployment of a sizable portion of the workers can obviously not be due to the slowdown in business alone. Both the unprofitability and the unemployment are being intensified right now by the general depression. However, in this postwar period, they have become lasting phenomena which do not disappear entirely even in the upswing. We are confronted here with a new problem, one that cannot be answered by the theory of cyclical changes alone.” (Mises 2006 [1931]: 163–164).

Yes, Mises desperately tried to say that his ABCT still applied as an explanation of the boom and cause of the initial downturn, but look at how feeble Mises’s attempt is:

(1) Mises admits that Europe did not experience a strong boom, and that on the basis of his own theory “one would assume that this time the crisis will be milder. However, it is certainly much more severe than earlier crises and it does not appear likely that business conditions will soon improve.” That is, his theory lacked predictive power about the course of the bust after 1929.

(2) Secondly, Mises said that his theory could not explain the depth and length of depression in terms of the “unprofitability of many branches of production” and the high unemployment.

So my original statement is right. But ultimately this point is not that important, because the ABCT is wrong for many reasons I have explained here.

And Daniel Kuehn does a wonderful job here discrediting the Hayekian version of the Austrian business cycle theory, and most of his criticisms apply also to Mises’s original ABCT.

But next we come to Murphy’s hypocrisy. Murphy likes to present himself as great defender of Austrian economics, and rushes to defend the Austrian business cycle theory (ABCT) in his post, giving his devoted Austrian fans the impression that the beloved ABCT is safe and sound from the criticisms of that nasty ogre Krugman.

I, however, have actually read a great deal of Murphy’s work.

I direct readers to these fascinating writings by Murphy:

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.
https://files.nyu.edu/rpm213/public/files/Dissertation.pdf

Murphy, Robert P. “Multiple Interest Rates and Austrian Business Cycle Theory.”
http://consultingbyrpm.com/uploads/Multiple%20Interest%20Rates%20and%20ABCT.pdf

Now what, you may ask, is the significance of this?

A substantial part of Murphy’s PhD (Murphy 2003: 58–177) is devoted to rejecting that theory generally accepted by Austrians called the “pure time preference theory of interest” and defending a monetary theory of the interest rate.

Murphy, like John Maynard Keynes and modern Keynesians, thinks that interest rates are a monetary phenomenon, and in this post even hails Keynes’ analysis in Chapter 13 of the General Theory as “brilliant”:

Robert P. Murphy, “Is Keynes from Heaven or Hell,” Free advice, 7 July 2011
http://consultingbyrpm.com/blog/2011/07/is-keynes-from-heaven-or-hell.html

But the really important point is that Murphy’s paper “Multiple Interest Rates and Austrian Business Cycle Theory” is about as damning a critique of the classical Austrian business cycle theory (dependent on Wicksell’s natural rate of interest) as you will find.

Murphy accepts that the Austrian business cycle when it is based on Wicksell’s unique natural rate of interest is a flawed theory and cannot work in that form.

This is quite clear when Murphy comments on Hayek’s debate with Piero Sraffa:

“In his brief remarks, Hayek certainly did not fully reconcile his analysis of the trade cycle with the possibility of multiple own-rates of interest. Moreover, Hayek never did so later in his career. His Pure Theory of Capital (1975 [1941]) explicitly avoided monetary complications, and he never returned to the matter. Unfortunately, Hayek’s successors have made no progress on this issue, and in fact, have muddled the discussion. As I will show in the case of Ludwig Lachmann—the most prolific Austrian writer on the Sraffa-Hayek dispute over own-rates of interest—modern Austrians not only have failed to resolve the problem raised by Sraffa, but in fact no longer even recognize it.

“Austrian expositions of their trade cycle theory never incorporated the points raised during the Sraffa-Hayek debate. Despite several editions, Mises’ magnum opus (1998 [1949]) continued to talk of ‘the’ originary rate of interest, corresponding to the uniform premium placed on present versus future goods. The other definitive Austrian treatise, Murray Rothbard’s (2004 [1962]) Man, Economy, and State, also treats the possibility of different commodity rates of interest as a disequilibrium phenomenon that would be eliminated through entrepreneurship. To my knowledge, the only Austrian to specifically elaborate on Hayekian cycle theory vis-à-vis Sraffa’s challenge is Ludwig Lachmann.”
(Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory,” pp. 11–12).

Murphy then discusses Lachmann’s (1994: 154) solution to Sraffa’s critique, but finds it wanting:

“Lachmann’s demonstration—that once we pick a numéraire, entrepreneurship will tend to ensure that the rate of return must be equal no matter the commodity in which we invest—does not establish what Lachmann thinks it does. The rate of return (in intertemporal equilibrium) on all commodities must indeed be equal once we define a numéraire, but there is no reason to suppose that those rates will be equal regardless of the numéraire. As such, there is still no way to examine a barter economy, even one in intertemporal equilibrium, and point to ‘the’ real rate of interest.”
(Murphy, “Multiple Interest Rates and Austrian Business Cycle Theory,” pp. 14).

So there you have it.

Wicksell’s natural rate does not exist, yet Hayek’s ABCT and Mises’s original ABCT in the form he held it in the 1930s uses the natural rate, as can be seen in Mises’s original 1931 paper that I originally quoted:

“According to the circulation credit theory (monetary theory of the trade cycle), cyclical changes in business conditions stem from attempts to reduce artificially the interest rates on loans through measures of banking policy—expansion of bank credit by the issue or creation of additional fiduciary media (that is banknotes and/or checking deposits not covered 100 percent by gold). On a market, which is not disturbed by the interference of such an ‘inflationist’ banking policy, interest rates develop at which the means are available to carry out all the plans and enterprises that are initiated. Such unhampered market interest rates are known as ‘natural’ or ‘static’ interest rates. If these interest rates were adhered to, then economic development would proceed without interruption—except for the influence of natural cataclysms or political acts such as war, revolution, and the like. The fact that economic development follows a wavy pattern must be attributed to the intervention of the banks through their interest rate policy. ….

At the interest rates which developed on the market, before any interference by the banks through the creation of additional circulation credit, only those enterprises and businesses appeared profitable for which the needed factors of production were available in the economy. The interest rates are reduced through the expansion of credit, and then some businesses, which did not previously seem profitable, appear to be profitable.” (Mises 2006 [1931]: 161).

It follows that if Murphy were intellectually honest and not an evasive shill for his fellow Austrian economists, he would graciously concede that his own published work entails that he himself appears to accept that the classical Austrian business cycle theory per se (using the natural rate) cannot explain recessions or depressions.

Krugman is right in rejecting the classical Austrian business cycle theory, even if not for the reasons that Murphy does.

BIBLIOGRAPHY
Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. by D. Lavoie), Routledge, London.

Mises, Ludwig von. 2006 [1931]. “The Causes of the Economic Crisis,” in Percy L. Greaves (ed.). The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala. 155–181.

Murphy, Robert P. 2003. Unanticipated Intertemporal Change in Theories of Interest, PhD dissert., Department of Economics, New York University.
https://files.nyu.edu/rpm213/public/files/Dissertation.pdf

Murphy, Robert P. “Multiple Interest Rates and Austrian Business Cycle Theory.”
http://consultingbyrpm.com/uploads/Multiple%20Interest%20Rates%20and%20ABCT.pdf

Paul Krugman cites Yours Truly

That is, Krugman cites my critique of Mises’s explanation of the Great Depression here in his New York Times blog:

Paul Krugman, “Soup Kitchens Caused the Great Depression, AFF Edition. That’s AFF for “Austrian Founding Fathers,” Conscience of a Liberal, January 27, 2014.

That was nice of him!

I suppose frenzied Austrian counter-reponses will appear in due course.

Keynesians, Austrians, Demand, and Production

Keynesians think that demand and, above all, aggregate demand drive production and employment.

Austrians also think demand drives production but in a different way.

This passage by Mises shows how and why Keynesians and Austrians differ on how demand drives production:

“In allocating labor and capital goods, the entrepreneurs and the capitalists are bound, by forces they are unable to escape, to satisfy the needs of consumers as fully as possible, given the state of economic wealth and technology. Thus, the contrast drawn between the capitalistic method of production, as production for profit, and the socialistic method, as production for use, is completely misleading. In the capitalistic economy, it is consumer demand that determines the pattern and direction of production, precisely because entrepreneurs and capitalists must consider the profitability of their enterprises.

An economy based on private ownership of the factors of production becomes meaningful through the market. The market operates by shifting the height of prices so that again and again demand and supply will tend to coincide. If demand for a good goes up, then its price rises, and this price rise leads to an increase in supply. Entrepreneurs try to produce those goods the sale of which offers them the highest possible gain. They expand production of any particular item up to the point at which it ceases to be profitable. If the entrepreneur produces only those goods whose sale gives promise of yielding a profit, this means that they are producing no commodities for the manufacture of which labor and capital goods must be used which are needed for the manufacture of other commodities more urgently desired by consumers.

In the final analysis, it is the consumers who decide what shall be produced, and how. The law of the market compels entrepreneurs and capitalists to obey the orders of consumers and to fulfill their wishes with the least expenditure of time, labor and capital goods. Competition on the market sees to it that entrepreneurs and capitalists, who are not up to this task, will lose their position of control over the production process. If they cannot survive in competition, that is, in satisfying the wishes of consumers cheaper and better, then they suffer losses which diminish their importance in the economic process. If they do not soon correct the shortcomings in the management of their enterprise and capital investment, they are eliminated completely through the loss of their capital and entrepreneurial position. Henceforth, they must be content as employees with a more modest role and reduced income.” (Mises 2006 [1931]: 156–157).

The Austrian view of how demand drives production is as follows:

(1) Consumers purchase what they desire and value, and businesses produce these products by following the wishes of consumers. This idea is strongly related to what Mises means by “consumer sovereignty” (a phrase apparently coined by W. H. Hutt [Benton 1999: 911]), which, he thinks, is a fundamental characteristic of markets:

“The consumers patronize those shops in which they can buy what they want at the cheapest price. Their buying and their abstention from buying decides who should own and run the plants and the farms. They make poor people rich and rich people poor. They determine precisely what should be produced, in what quality, and in what quantities. They are merciless bosses, full of whims and fancies, changeable and unpredictable. For them nothing counts other than their own satisfaction. They do not care a whit for past merit and vested interests. If something is offered to them that they like better or that is cheaper, they desert their old purveyors. In their capacity as buyers and consumers they are hard-hearted and callous, without consideration for other people.” (Mises 2008: 270);

(2) but for Austrians it is primarily “price signals” and free competition that drive production: demand for a product may emerge or increase, and the price of that product will rise because of the increased demand.

The higher “price signal” and higher profits available in that product line, as compared with other markets with lower profits, zero profits or losses, will cause businesses to move into the more profitable market and produce more of that good.

When new firms have entered that market, the resulting increase in the quantity of goods produced will drive prices down, and thereby bring a tendency towards supply and demand equilibrium;

(3) eventually the increased production will tend to drive prices down towards marginal cost, and, when the price reaches this point, businesses will cease to increase production, and look for better profit opportunities elsewhere.

To the extent that (1) a market really does have flexible prices caused by dynamics of supply and demand, (2) the good can be produced in a reasonably elastic way, and (3) freedom of entry is not difficult, the Austrian story, more or less, applies to a minority of markets, except for point (3) above, since marginal cost is usually irrelevant for most firms.

But, apart from point (1) (which itself requires qualification), the Austrian view is, generally speaking, wrong, because it fails to consider the role of mark-up pricing/administered price industries and businesses.

In reality, it is the Keynesian view of how demand drives production that describes most markets. That view is as follows:

(1) Consumers purchase what they desire and value, and businesses generally produce these products by following the wishes of consumers. However, advertising and sales promotion have a great role in creating demand in modern economies, over and above the effects caused by price reductions. In the modern world, many businesses will be heavily involved in actively creating and increasing demand for their products (Galbraith 1985: 215; Benton 1999: 912);

(2) in reality, it is not “price signals” but “quantity signals” – in the sense of the quantity of a good demanded – that drive a great deal of production and employment (Kaldor 1985: 25). This is because very many firms use mark-up pricing and generally shun flexible prices. Businesses will mostly keep the price of their products unchanged when demand changes, and instead will employ the following means (not necessarily in this order): (1) use inventories to meet changes in demand, (2) increase excess capacity utilisation, and (3) increase worker overtime and/or increase employment.

Even when stocks or inventories cannot be drawn upon, (2) or (3) are the normal responses. Some empirical evidence confirms this. In a survey of 654 UK businesses, the firms were asked: what does the business do when there is a boom in demand which cannot be met from stocks or inventories?

Most UK firms said they simply increase overtime of workers (as reported by 62% of firms), hire more workers (12%), or increase capacity (8%) to produce more output, rather than increase the price of their product (Hall et al. 2000: 442).

Only 12% said they would increase the price of their product (Hall et al. 2000: 442).

(3) So, first of all, a significant increase in demand will not generally cause a price increase, and so the Austrian view of how firms seek profit is grossly unrealistic in many markets.

Secondly, the widespread use of inventories, overtime, and excess capacity utilisation in many established markets means that severe barriers to entry exist. Existing firms will often meet increased demand without any need for new firms to enter the market, and very high demand can simply mean existing firms will build new plants and production facilities, rather than see new businesses enter their markets.

Nor will increased production drive market prices to marginal cost, because mark-up pricing firms will maintain their administered price based on total average unit costs plus a profit mark-up: marginal cost is irrelevant for most firms.

It follows from all this that most output and employment changes in modern market economies are liable to be driven by demand but by means of “quantity signals,” not price signals.

The Keynesian policy of stimulating an economy by increasing demand will then generally increase output and employment, and not simply prices. Although booms do indeed tend to be inflationary in modern economies, nevertheless the process of inflation in a mark-up pricing world is uneven, much less intense and quite different from any crude economic theory that holds that all or most prices are flexible and simply a function of supply and demand dynamics.


BIBLIOGRAPHY
Benton, Raymond. 1999. “Producer and Consumer Sovereignty,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z. Routledge, London and New York. 911–914.

Galbraith, J. K. 1985. The New Industrial State (4th edn.). Houghton Mifflin, Boston.

Hall, S., Walsh, M. and A. Yates. 2000. “Are UK Companies’ Prices Sticky?,” Oxford Economic Papers 52.3: 425–446.

Kaldor, Nicholas. 1985. Economics Without Equilibrium. M.E. Sharpe, Armonk, N.Y.

Mises, Ludwig von. 2006 [1931]. “The Causes of the Economic Crisis,” in Percy L. Greaves (ed.). The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala. 155–181.

Mises, Ludwig von. 2008. Human Action: A Treatise on Economics. The Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Mises’s Explanation of the Great Depression: A Critique

Ludwig von Mises lived through the Great Depression as Keynes did, and produced his own explanation of it. I present a critique of Mises’s explanation of the Great Depression below.

First, some background. Around 1930 Mises joined an Austrian government economic commission to study the causes of the depression in Austria, along with (interestingly enough) the future Austro-fascist leader Engelbert Dollfuss (Hülsmann 2007: 614), to whom Mises was later to give economic advice (see below on this). The report of the committee blamed (1) inflationary expectations in Austria and (2) rises in taxation and government spending and increased wage rates (which had all squeezed business profits) for the inability of Austria to attract foreign capital needed to facilitate quicker adjustment and recovery from the depression (Hülsmann 2007: 614–615).

But Mises was not satisfied with the report (Hülsmann 2007: 615), and formed his own explanations for the depression, which were published as various articles and papers (see Mises 2006 [1931]; Mises 2002a [1931]; Mises 2002b [1932]).

On February 28, 1931, Mises gave a lecture called “The Causes of the World Economic Crisis” in Czechoslovakia (Mises 2006 [1931]).

In the published version of that lecture, Mises expounded his Austrian business cycle theory (ABCT) (Mises 2006 [1931]): 160–162), with its belief in monetary expansion driving the market rate of interest below its Wicksellian natural level, causing malinvestment which is physically unsustainable. This theory is, of course, false and untenable, for reasons explained here (in the links in section 32). Amongst the many reasons why the theory is wrong is that there is no such thing as a Wicksellian natural rate of interest, and neither the Great Depression nor booms and busts in general are explained by the ABCT because banks cannot push interest rates below a non-existent natural rate.

However, it is interesting that Mises thought that his Austrian monetary theory of the cycle could not adequately explain the severity and length of the Great Depression (as also noted by Hülsmann 2007: 617–618):

“The crisis from which we are now suffering is also the outcome of a credit expansion. The present crisis is the unavoidable sequel to a boom. Such a crisis necessarily follows every boom generated by the attempt to reduce the ‘natural rate of interest’ through increasing the fiduciary media. However, the present crisis differs in some essential points from earlier crises, just as the preceding boom differed from earlier economic upswings. The most recent boom period did not run its course completely, at least not in Europe. Some countries and some branches of production were not generally or very seriously affected by the upswing which, in many lands, was quite turbulent. A bit of the previous depression continued, even into the upswing. On that account—in line with our theory and on the basis of past experience—one would assume that this time the crisis will be milder. However, it is certainly much more severe than earlier crises and it does not appear likely that business conditions will soon improve.

The unprofitability of many branches of production and the unemployment of a sizable portion of the workers can obviously not be due to the slowdown in business alone. Both the unprofitability and the unemployment are being intensified right now by the general depression. However, in this postwar period, they have become lasting phenomena which do not disappear entirely even in the upswing. We are confronted here with a new problem, one that cannot be answered by the theory of cyclical changes alone.” (Mises 2006 [1931]: 163–164).

Mises saw the answer in his belief that (1) the high unemployment of the depression was caused by trade unions forcing wages up above market clearing levels (confirmed in Hülsmann 2007: 620), (2) governments had allegedly “capitulated to the labor unions,” and (3) the state provision of unemployment relief had allowed wage rates to remain high:

“The unions now have the power to raise wage rates above what they would be on the unhampered market. However, interventions of this type evoke a reaction. At market wage rates, everyone looking for work can find work. Precisely this is the essence of market wages—they are established at the point at which demand and supply tend to coincide. If the wage rates are higher than this, the number of employed workers goes down. Unemployment then develops as a lasting phenomenon. At the wage rates established by the unions, a substantial portion of the workers cannot find any work at all. Wage increases for a portion of the workers are at the expense of an ever more sharply rising number of unemployed.

Those without work would probably tolerate this situation for a limited time only. Eventually they would say: ‘Better a lower wage, than no wage at all.’ Even the labor unions could not withstand an assault by hundreds of thousands, or millions of would-be workers. The labor union policy of holding off those willing to work would collapse. Market wage rates would prevail once again. It is here that unemployment relief is brought into play and its role [in keeping workers from competing on the labor market] needs no further explanation.

Thus, we see that unemployment, as a long-term mass phenomenon, is the consequence of the labor union policy of driving wage rates up. Without unemployment relief, this policy would have collapsed long ago. Thus, unemployment relief is not a means for alleviating the want caused by unemployment, as is link in the chain of causes which actually makes unemployment a long-term mass phenomenon.” (Mises 2006 [1931]: 167–168).

The solution, then, for Mises was eliminating unemployment relief (presumably forcing the unemployed to starve and accept lower wages), cutting government spending and taxes (Mises 2006 [1931]: 175), and not only to cut wages but also to make wage determination free from labour unions (Mises 2006 [1931]: 169).

How suppression of trade unions was to be achieved and their freedom of association restricted was left understated, and Mises’s feeble hope that the “formation of wage rates should be hampered neither by the clubs of striking pickets nor by government’s apparatus of force” (Mises 2006 [1931]: 169) rings hollow.

How else could such suppression of trade unions be realistically achieved except by government coercion?

Mises hints at the solution in a passage where unions are themselves blamed as perpetrators of all sorts of evil:

“If the government were to proceed against those who molest persons willing to work and those who destroy machines and industrial equipment in enterprises that want to hire strikebreakers, as it normally does against the other perpetrators of violence, the situation would be very different. However, the characteristic feature of modern governments is that they have capitulated to the labor unions.” (Mises 2006 [1931]: 167).

This is the point in the essay where Mises may as well have been winking at his audience to indicate what his words imply: that governments should break up and repress unions and restore labour market freedom.

It comes as no surprise that Mises had praised Mussolini’s fascism in 1927 because it had (according to Mises) “saved European civilization.” Mises also contended that the “merit that Fascism … [had] thereby won for itself will live on eternally in history.” Part of the reason for this sickening praise was no doubt that Italian fascism had smashed independent trade unions. And, if that wasn’t enough, Mises was himself in the 1930s to become an economic adviser to the Austro-fascist Engelbert Dollfuss (Chancellor of Austria from 1932), who did indeed smash independent trade unions in Austria.

But to return to the point at hand. Why was Mises’s wage rate explanation wrong?

The reason is that capitalist investment and demand for labour is not a simple function of the wage rate or interest rate, as naïve, ignorant and incompetent Austrian ideologues like Mises thought, and many still think.

The propensity to invest is a complex phenomenon involving many factors, not just interest rates and the wage rate, but fundamentally the level of demand for output, the degree of uncertainty of capitalists about the future, the expectations of business people, the general state of expectations, and the state of the financial system and credit markets, and so on. Above all, the first three factors – demand for output, uncertainty and expectations – must be considered fundamental causes of the inducement to invest for many businesses, especially those that are mark-up price enterprises with excess capacity and inventories.

In the Great Depression, business expectations were shattered in an unprecedented way, as was demand for output. Simply reducing wages was no reliable or effective cure for unemployment in the 1930s (or indeed during recessions in general) when business expectations were deeply pessimistic, demand was stagnant and uncertainty about the future deep. If we also add to this the fact that many nations had banking crises and lending practices would have become deeply conservative, Mises’s focus on wages as the main cause of 1930s unemployment can be seen as the folly it was.

Whatever lowering of demand for labour that might have been caused by higher wage rates during the depression could have been overcome and rendered irrelevant by effective expansion of aggregate demand.

Furthermore, Mises’s economic analysis was just as flawed when he came to analyse prices:

“The demand that a reduction in prices be tied in with the reduction in wage rates ignores the fact that wage rates appear too high precisely because wage reductions have not accompanied the practically universal reduction in prices. Granted, the prices of many articles could not join the drop in prices as they would on an unhampered market, either because they were protected by special governmental interventions (tariffs, for instance) or because they contained substantial costs in the form of taxes and higher than unhampered market wage rates. The decline in the price of coal was held up in Germany because of the rigidity of wage rates which, in the mining of hard coal, come to 56 percent of the value of production. The domestic price of iron in Germany can remain above the world market price only because tariff policy permits the creation of a national iron cartel and international agreements among national cartels. Here too, one need ask only that those interferences which thwart the free market formation of prices be abolished. There is no need to call for a price reduction to be dictated by government, labor unions, public opinion or anyone else.” (Mises 2006 [1931]: 169–170).

Mises was blissfully unaware of what many economists were to discover in the 1930s and what Gardiner Means had already discovered: that real world price rigidities are mainly caused by the private sector itself, because most businesses adopt relatively inflexible mark-up/administered prices.

The type of price setting required by Mises’s economic theory is largely shunned by the private sector itself, so that the price flexibility Mises thought would clear markets cannot be attained.

Even though many nations saw price deflation in the Great Depression, even in the 1930s mark-up prices were significant and relatively inflexible as compared with other markets: Gardiner Means, for example, discovered that the administered pricing sector of the US economy had seen price declines of only about 10% during the depression, whereas the more competitive or flexprice sectors had seen price falls of about 40 to 60% (Means 1975) – a very clear disparity.

Finally, there is not a shred of evidence that Mises ever understood that even if wages and price were highly flexible, the existence of fixed nominal debt impedes and thwarts his imagined type of market clearing dynamics. For if debts remain fixed and wages and prices fall (or even more disastrously if wages fall but prices are less flexible), then it is likely that debtors will face severe problems as their burden of debt soars, and most probably deflation will induce bankruptcy of debtors and then bankruptcy of creditors and banks.

All in all, Mises’s analysis of the Great Depression was wrong, and he was ignorant of economics and economic reality. Austrians who still adhere to Mises’s ideas are just as ignorant and mistaken.

BIBLIOGRAPHY
Hülsmann, J. G. 2007. Mises: The Last Knight of Liberalism. Ludwig von Mises Institute, Auburn, Ala.

Means, Gardiner C. 1975. “Simultaneous Inflation and Unemployment: A Challenge to Theory and Policy,” in Gardiner C. Means et al., The Roots of Inflation: The International Crisis. Wilton House Publications, London.

Mises, Ludwig von. 2006 [1931]. “The Causes of the Economic Crisis,” in Percy L. Greaves (ed.). The Causes of the Economic Crisis, and Other Essays Before and After the Great Depression. Ludwig von Mises Institute, Auburn, Ala. 155–181.

Mises, L. von. 2002a [1931]. “The Economic Crisis and Capitalism,” in Richard M. Ebeling (ed.). 2002. Selected Writings of Ludwig von Mises: Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression (vol. 2). Liberty Fund, Indianapolis, Ind.

Mises, L. von. 2002b [1932]. “The Myth of the Failure of Capitalism,” in Richard M. Ebeling (ed.), Selected Writings of Ludwig von Mises: Between the Two World Wars: Monetary Disorder, Interventionism, Socialism, and the Great Depression (vol. 2). Liberty Fund, Indianapolis, Ind. 182–191.

A Gulf Separates Milton Friedman and most Austrians

And this video shows why.



Milton Friedman understood perfectly well that central banks are vital in modern market economies to stabilise fractional reserve banking, and he rightly blamed the Federal Reserve for not intervening properly from 1929 to 1933 to stop the financial collapse.

But, of course, for most Austrians – with the exception of the GMU Austrians and (probably) the radical subjectivists – central banks are an unmitigated “evil” and should not even exist.

The “liquidationism” of such Austrians actually entails not only that central banks should do nothing during recessions, but also that they abolish themselves.

In light of this, it is indeed no surprise that Rothbardian Austrians loathe Friedman.

Why is this of interest? Because over at Free Advice Robert Murphy posts a video of Arnold Schwarzenegger singing a paean to Milton Friedman in an attempt to show that all the “non-interventionist stuff in Friedman … is inconsistent with his fine-tuning monetary policy ideas.”

But it is no such thing. Milton Friedman had (from his own perspective) a coherent economic theory that accepted fractional reserve banking as part and parcel of capitalism (unlike Rothbardians), and that such a system needed a central bank to stabilise it.

There is no contradiction involved in followers of Friedman praising his Free to Choose (1980) book and television series and ideas on personal liberty, but accepting the need for a central bank and even some type of monetary policy, as Friedman did.

Kirzner on the Law of Supply and Demand in Austrian Economics

Israel M. Kirzner’s Austrian analysis of the law of supply and demand and prices can be found in these short articles:

Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand#axzz2rJCWXRKy

Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

Kirzner, Israel M. 2000. “The Irresistible Force of Market Competition,” March 1, 2000 http://www.fee.org/the_freeman/detail/the-irresistible-force-of-market-competition#axzz2rJCWXRKy

Kirzner, Israel M. 2000. “Toward an Austrian Critique of Governmental Economic Policy,” April 1
http://www.fee.org/the_freeman/detail/toward-an-austrian-critique-of-governmental-economic-policy#axzz2rJCWXRKy

First Kirzner notes,

“The basic insight underlying the law of supply and demand is that at any given moment a price that is ‘too high’ will leave disappointed would-be sellers with unsold goods, while a price that is ‘too low’ will leave disappointed would-be buyers without the goods they wish to buy. There exists a ‘right’ price, at which all those who wish to buy can find sellers willing to sell and all those who wish to sell can find buyers willing to buy. This ‘right’ price is therefore often called the ‘market-clearing price.’

Supply-and-demand theory revolves around the proposition that a free, competitive market does in fact successfully generate a powerful tendency toward the market-clearing price. This proposition is often seen as the most important implication of (and premise for) Adam Smith’s famed invisible hand. Without any conscious managing control, a market spontaneously generates a tendency toward the dovetailing of independently made decisions of buyers and sellers to ensure that each of their decisions fits with the decisions made by the other market participants. Were this tendency to be carried to the limit, no buyer (seller) would be misled so as to waste time attempting to buy (sell) at a price below (above) the market-clearing price. No buyer (seller) would in fact pay (receive) a price higher (lower) than necessary to elicit the agreement of his trading partner. To the extent that this proposition is valid, free competitive markets achieve what F. A. Hayek has justifiably called a ‘marvel.’ But it is in regard to the validity of this proposition (and in particular to our reasons for being convinced that this proposition is both valid and relevant) that Austrians differ sharply with mainstream textbook economics.”

Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand#axzz2rJCWXRKy

So how does Austrian economics differ from mainstream neoclassical economics on this point?

As Kirzner points out, it differs in the following ways:

(1) Kirzner contends that neoclassical economics holds that market agents have “perfect knowledge,” while Austrians reject this and accept that agents have “imperfections in knowledge”:

“This conclusion is that in any free market, the market-clearing price is instantaneously (or, at least, very rapidly) established. If every market participant knows what every other market participant is prepared to do (including, especially, the quantity he is prepared to buy or sell at any given price), it follows that any price higher than the market-clearing price cannot emerge (since prospective sellers would realize that they would be left with unsold goods). It follows, similarly, that any price lower than the market-clearing price cannot emerge (since prospective buyers would realize that they will be left without the goods they wish to buy and for which they are in fact prepared to pay a higher price if necessary). The proposition that free-market prices are thus inevitably market-clearing prices proceeds inexorably from the belief that market prices are, in effect, instantaneously known to all potential market participants.

The assumption that all market participants are always fully aware of market opportunities in which they might be interested is often presented, in mainstream textbook expositions, as part of the assumption of so-called ‘perfect competition.’ Perfect competition explicitly presumes universal market omniscience. One way of expressing the Austrian unhappiness with the mainstream textbook treatment is to point out that to start supply-and-demand analysis by assuming that competition is ‘perfect’ (in the textbook sense) is not only to be wildly (and therefore unhelpfully) unrealistic.”

Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand#axzz2rJCWXRKy

So Austrians reject the neoclassical unrealistic vision of “perfect knowledge” and “perfect competition.”

(2) But, for Austrians, while most prices are not market-clearing prices nor equilibrium prices (in the sense of being equal to marginal cost), nevertheless there exists a tendency for prices to move towards market clearing values (as also argued in Kirzner 1985: 205), and these movements towards the market clearing point are what supply and demand curves show:

“The core of the classroom analysis generally consists of discussion showing, first, that any market price higher than that indicated by the intersection of the two curves (that is, a price higher than the market-clearing price) must tend to produce competitive pressure toward a decrease in price (since the high price will generate a surplus of unsold merchandise); and second, that any market price lower than that indicated by the point of intersection must produce competitive pressure toward an increase in price (since the low price will generate a shortage of goods offered for sale, as compared with the quantities prospective buyers wish to buy).

Austrians do not have serious disagreement with such discussions in themselves; they simply point out that those discussions are utterly inconsistent with the assumption of perfect competition (which textbook analysis takes as its operative assumption). A little careful analysis of the perfect-competition assumption (which analysis can, however, unfortunately not be fitted into this space) suffices to show that under perfect competition there cannot in fact exist two curves (the demand curve intersecting with the supply curve). Under perfect competition the supply-and-demand diagram shrivels instantly to a single point—the point where the two curves would have intersected (had the curves themselves existed!). This is so because any point on a market supply curve or on a market demand curve that is not that intersection point can have analytical existence only by suspending some or all of the conditions that define the state of perfect competition. The diagram (valuable though it certainly is!) is simply not consistent with the assumed conditions under which it is supposed to be operating.”
Kirzner, Israel M. 2000. “The Law of Supply and Demand,” The Freeman, January 1
http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand#axzz2rJCWXRKy

So Austrians reject the Walrasian “perfect competition” model. This is confirmed by Kirzner in his other writings:

“the term ‘market-clearing price’ (a term not used by Mises) is used in standard economics to refer to the exhaustion of all mutually gainful exchange opportunities under the hypothetical conditions of (relevant) omniscience. Standard economics indeed notoriously proceeds, in applying supply and demand theory to the real world, to operate as if conditions of relevant omniscience can be taken as given. Mises is certainly not making any such assumption of omniscience. His market prices are certainly not ‘market clearing prices’ (in the usual sense of that term). There is, one is able to reassure the puzzled reader, therefore no contradiction in his exposition. Real world market prices are not the equilibrium prices of standard economic theory. (Real world prices relate to equilibrium only in a very narrow sense, a sense to which no attention at all is given in standard theory.) Real world prices are indeed likely to be ‘false’ prices, setting off entrepreneurial-competitive activity modifying the pattern of resource allocation. The real world pattern of resource allocation at any given moment can be described as optimal only relative to existing information in fact possessed by entrepreneurial market participants. The tension in Mises is quite imaginary; it is perceived—quite understandably and reasonably perceived—only as a result of reading Mises through the spectacles acquired in studying mainstream economics.” (Kirzner 2000: 168).

(3) Human beings as economic agents have imperfect knowledge and are imperfect themselves, given that they face uncertainty:

“For Mises, each human being is, in a very important sense, an entrepreneur. … And it is the entrepreneurial element in those decisions that is responsible, in the Austrian view, for that crucially important tendency toward market-clearing that (for Austrians as well as for non-Austrians) constitutes the heart of the law of supply and demand.

The Misesian notion of human action is significantly richer than the mainstream-economics notion of the economizing decision. An economizing decision is seen as the selection of the most desirable option out of an array of given alternatives with a given ranking of what is more desirable and less desirable. Since both the alternatives available and the ranking are already identified prior to the act of decision, such decision-making consists essentially of the solution to a mathematical maximization exercise; the outcome is predetermined: it is implicit in the given context within which the decision is to be made.

For Misesian human action, on the other hand, the action is, most importantly, seen as including the determination of both what the available alternatives are and what ranking of relative desirability is to be adopted. Determining these elements inevitably exposes the agent to the uncertainties of an open-ended future (in a sense absent in the context of the standard ‘economizing decision’): action is the present choice between future alternatives that must, in the face of the foggy uncertainty of the future, now be identified in the very act of choice. It is this aspect of human action that renders it, for Mises, essentially entrepreneurial. Mathematical expertise in solving maximization problems is of very limited help in choosing among courses of action when the very alternatives must be ‘created,’ as it were, by the agent’s entrepreneurial imagination and creativity, by his daring and boldness.”
Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

(4) For Austrians, arbitrage and alert entrepreneurs and their desire for profit create a tendency towards market clearing prices, even though real world prices will mostly be non-market clearing prices:

“For Austrians, the law of supply and demand is simply an insight into one particular (but central) element in this more comprehensive, dynamic, entrepreneur-driven market process. For any particular commodity, the market forces acting on the prices at which it will be bought and sold (and thus the market forces acting on the decisions made to produce and to buy it) tend to identify and exploit the opportunities (structured by the technology and the economics of its production on the one hand, and by the urgency with which potential consumers wish to consume it, on the other hand) and thus to ensure that the quantities which are simultaneously worthwhile for producers to produce and for consumers to buy will in fact tend to be produced, offered for sale, and purchased.

If, for example, current production of this commodity is ‘too low,’ this means that opportunities exist for additional units to be produced at an outlay below the highest price potential consumers would be prepared to pay; it is ‘worthwhile’ to produce these additional units. Entrepreneurial producers will tend to discover and act on such opportunities. If, on the other hand, current production is ‘too high,’ this means that the production outlay for at least some units exceeds the highest price potential consumers are prepared to pay for them; these units were produced as a result of entrepreneurial error. Entrepreneurial producers will tend to discover these (marginal) losses and cut back on production.

The entrepreneurial forces acting on the market for any one commodity are thus continually pushing that market toward the market-clearing point—that is, to where (a) the quantity produced is such that (only) all units ‘worth producing’ are indeed produced, and (b) the market price for this commodity is just high enough to make it, as a practical matter, worthwhile for producers to produce this quantity, and is just low enough to make it worthwhile for consumers to buy it.

Clearly, these forces would, were all other dynamic changes in market conditions to be suspended, tend to achieve exactly those outcomes identified, in more conventional mainstream formulations of the law of supply and demand, by the intersection of the supply curve and the demand curve. It is for this reason that we have described Austrian economics as basically in agreement with mainstream economics in its emphasis on the centrality of the law of supply and demand. It is worthwhile, however, briefly to ponder the sense in which the Austrian version of the ‘law’ avoids reliance on any presumption of universal perfect market knowledge (a presumption that, as seen in the preceding article, pervades much standard economics).”
Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

(5) Kirzner takes up Hayek’s theories and sees the movement towards supply and demand equilibrium via flexible prices as a “learning” process:

“As Austrian economist F. A. Hayek emphasized, the market process we have been describing in entrepreneurial terms can also usefully be understood in terms of learning. The process through which the market tends to generate the ‘right’ quantity of a commodity, and the ‘right’ price for it, can be seen as a series of steps during which market participants gradually tend to discover the gaps or errors in the information on which they had previously been basing their erroneous production and/or buying decisions. Buyers who had overestimated the willingness of producers to produce and sell the commodity had been ‘incorrectly’ refusing to offer higher prices (that they would indeed have been prepared to pay); those who had underestimated that willingness were ‘incorrectly’ offering higher prices than were in fact needed to inspire sellers to produce. Sellers who had overestimated the willingness of buyers to buy were ‘incorrectly’ asking higher prices (and were producing more units of the commodity than it was ‘really worthwhile’ to produce), and so on. The market process is one in which, driven by the entrepreneurial sense for grasping at pure profit opportunities (and for avoiding entrepreneurial losses), market participants, learning more accurate assessments of the attitudes of other market participants, tend toward the market-clearing price-quantity combination.”
Kirzner, Israel M. 2000. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

(6) And Austrians also have a different understanding of “competition”:

“Following a long tradition in economics going back at least to Adam Smith, Austrians define a competitive market not as a situation where no participant or potential participant has the power to make any difference, but as a market where no potential participant faces nonmarket obstacles to entry. (The adjective ‘nonmarket’ refers, primarily, to government obstacles to entry; it is used to differentiate such obstacles from, for example, high production costs that might discourage entry. These latter do not constitute noncompetitive elements in a market; to be able to enter means to be able to enter a market if one judges such entry to be economically promising-it does not mean to be able to enter without having to bear the relevant costs of production.) That is, a situation is competitive if no incumbent participant possesses privileges that protect him against the possible entry of new competitors.

The achievements that free markets are able to attain depend, in the Austrian view, on freedom of entry, that is, on the absence of privilege. It is because the law of supply and demand (as understood by Austrians) depends crucially on freedom of entry that this meaning of the term ‘competition’ is so important.”
Kirzner, Israel M. 2000. “The Irresistible Force of Market Competition,” March 1, 2000 http://www.fee.org/the_freeman/detail/the-irresistible-force-of-market-competition#axzz2rJCWXRKy

So what is the problem with this Austrian theory?

First, the simple and plain fact – despite the claims of Austrians that their price theory and view of supply and demand is more realistic than neoclassical economics – is that the Austrian vision is still grossly unrealistic. It assumes most firms are price takers and really do adjust prices in response to demand and supply dynamics.

The Austrian theory is utterly refuted by the widespread existence of administered prices/mark-up prices in most capitalist economies: prices that are set on total average cost of production plus a profit mark-up, and that are generally and normally left unchanged when demand changes. The empirical evidence suggests that such mark-up prices account for somewhere between 54% to 70% of prices in modern market economies (see Appendix 1 below). That is the majority of prices and the percentages found in many surveys are so high that the Austrian story about prices can be taken seriously.

Secondly, the glaring problem with the Austrian view of competition – with its emphasis on opposing alleged government obstacles to competition – is that mark-up pricing industries themselves, not only through the mark-up price but also through effective use of excess capacity and inventories, create severe market barriers to entry, a state of affairs which destroys the Austrian view of market “freedom of entry” in most product markets. For, if a mark-up price remains generally fixed in relation to demand changes, and does not even rise when demand rises, how can there even exist any effective market signals to businesses to enter a new market with high prices when those high prices do not even appear in the first place?

The answer is obviously that these “market signals” do not appear, and that the Austrian theory has already collapsed because most markets (which are mark-up/administered pricing markets) do not set prices in the way required by the theory.

Furthermore, even though the Austrians want to argue that “non-market” barriers to entry refer mostly or wholly to government intervention and that “market” barriers present no problem, they have failed to consider very serious real world “market” barriers that originate from the private sector itself.

Many modern markets are dominated by corporate enterprises, which have long been concerned with creating barriers to entry and which are not motivated by the idea of long-period maximisation of profits (in the neoclassical or Austrian sense). Instead, many corporations are more concerned with not inducing new entries into their markets (Lee 1998: 54–55).

As noted above, many modern firms have excess capacity available to deal with unexpected increases in demand, along with inventories (Lavoie 1992: 124). The effective use of excess capacity is a powerful method by which modern firms deter other firms from entering a market, and such a practice functions as a strong barrier to entry (Lavoie 1992: 124, citing Sylos Labini 1971: 247).

But Austrians like Kirzner remain mired in an economic theory divorced from reality, and are blissfully unaware of the empirical evidence that refutes their theories.

Appendix 1: Empirical Evidence on Administered Prices
“Downward’s Pricing Theory in Post-Keynesian Economics: Chapter 8,” January 23, 2014.

“Mark-up Pricing in South Africa,” January 20, 2014.

“Mark-up Pricing in Sweden,” January 9, 2014.

“Mark-up Pricing in Canada,” January 7, 2014.

“Some More Empirical Evidence on Full Cost Pricing,” December 10, 2013.

“Mark-up Pricing in New Zealand,” November 30, 2013.

“Mark-up Pricing in Australia,” November 30, 2013.

“Mark-up Pricing in Japan,” November 29, 2013.

“Mark-up Prices in Iceland,” November 25, 2013.

“Mark-up Pricing in Norway,” November 23, 2013.

“Mark-up Pricing in Ireland,” November 22, 2013.

“Two Marketing Studies on US Administered Prices,” November 16, 2013.

“Hall and Hitch on Marginal Cost and Price,” November 4, 2013.

“Administered Pricing in the United Kingdom,” October 19, 2013.

“Administered Prices in the Eurozone: Some Empirical Data,” October 16, 2013.

“Gardiner Means on Administered Prices,” June 20, 2013.

“Early Literature on Administered Pricing,” May 8, 2013.

BIBLIOGRAPHY
Kirzner, Israel M. 1985. “Prices, the Communication of Knowledge, and the Discovery Process,” in Kurt R. Leube and Albert H. Zlabinger (eds.), The Political Economy of Freedom: Essays in Honor of F. A. Hayek. Philosophia Verlag, Munich. 193–206.

Kirzner, Israel M. 2000. The Driving Force of the Market: Essays in Austrian Economics. Routledge, London and New York.

Kirzner, Israel M. 2000a. “The Law of Supply and Demand,” The Freeman, January 1
http://www.fee.org/the_freeman/detail/the-law-of-supply-and-demand#axzz2rJCWXRKy

Kirzner, Israel M. 2000b. “Entrepreneurial Discovery and the Law of Supply and Demand,” February 1, 2000
http://www.fee.org/the_freeman/detail/entrepreneurial-discovery-and-the-law-of-supply-and-demand#axzz2rJCWXRKy

Kirzner, Israel M. 2000c. “The Irresistible Force of Market Competition,” March 1, 2000 http://www.fee.org/the_freeman/detail/the-irresistible-force-of-market-competition#axzz2rJCWXRKy

Kirzner, Israel M. 2000d. “Toward an Austrian Critique of Governmental Economic Policy,” April 1
http://www.fee.org/the_freeman/detail/toward-an-austrian-critique-of-governmental-economic-policy#axzz2rJCWXRKy

Lavoie, Marc. 1992. Foundations of Post-Keynesian Economic Analysis. Edward Elgar Publishing, Aldershot, UK.

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Sylos Labini, P. 1971. “La théorie des prix en régime d’oligopole et la théorie du développement,” Revue d’Economie Politique 81.2: 244–272.