Steve Keen Interview on Economics, Austrians, and Debt

Steve Keen is interviewed below by Gordon Long of the Financial Repression website. More details here.



Most interesting are Steve Keen’s comments on Austrians and the EU.

Steve Keen also blogs at Forbes now. See his latest post here, where he analyses what might happen if the anti-austerity Greek party Syriza forms a coalition government in Greece in the coming election.

Austrians and the Definition of “Inflation” Again

Updated

The Austrians have an obsession with the definition of the word “inflation”: they want to define it as an increase in the money supply, instead of (as people normally use it) a general increase in prices.

In support of this, they assert that this was the “original” definition of “inflation.”

Some historical research suggests the word “inflation” has always been used to describe a general increase in prices, as well as an expansion of the money supply. This can be clearly seen to anyone who does a few minutes of searching on Google Books for the word “inflation” in the 19th century, or in Google Ngram Viewer.

The following graph (which needs to be opened in a separate window to be read properly) shows the usage of the expressions “inflation of money,” “inflation of currency,” “inflation of prices,” “inflated prices,” “inflation of the currency,” and “inflation of the money” in Google Ngram Viewer.

These expressions appear in the 1830s and 1840s in English writings, but it is extremely difficult to see how either sense was the “original” or formally correct usage.

In fact, the expressions “inflated prices” and “inflated price” seem to appear even in the 18th century and the early decades of the 19th century, so that the word “inflate” and its derived forms were clearly connected with prices from an early date. For example, there are explicit examples of this usage in the English translation of Jean Baptiste Say’s A Treatise on Political Economy (1821):

“We have hitherto regarded the inflated price of grain as the only evil to be apprehended. But England, in 1815, was alarmed by a prospect of an opposite evil; viz, that its price would be reduced too low, by the influx of foreign grain.”
Say, Jean Baptiste. 1821. A Treatise on Political Economy; or, The Production, Distribution, and Consumption of Wealth (vol. 1; trans. by C. R. Prinsep from 4th French edn.). Longman, Hurst, Rees, Orme, and Brown, London. p. 296.

“The experience of English commerce has, however, proved, that a casual inflation of the price of domestic, and depression of that of external products, may be the basis of permanent commerce.”
Say, Jean Baptiste. 1821. A Treatise on Political Economy; or, The Production, Distribution, and Consumption of Wealth (vol. 1; trans. by C. R. Prinsep from 4th French edn.). Longman, Hurst, Rees, Orme, and Brown, London. p. 176.

Moreover, a sample of writing from the 1830s onwards shows how “inflation” was used in the sense of price inflation from the beginning:

(1) 1835:
“It may be that the dumping of stock on the market may serve to check an excessive inflation of prices. When stocks are on the rise I do not believe the operation has material effect. It appears to be done mostly when stocks are on the decline.”
1835. Public Documents of the Legislature of Massachusetts. Volume 2. Russell and Cutler, Boston. p. 27.

(2) 1838:
“Might not the prevalence of a speculating mania the withdrawal of considerable labour from productive employment, and the expansion of bank issues, be particularly included among the causes which contributed to the inflation of prices?”
O’Reilly, Henry. 1838. Settlement in the West: Sketches of Rochester: With Incidental Notices of Western New-York. W. Alling, Rochester. p. 363.

(3) 1839:
“The artificial inflation of prices, from the previous abundance of paper currency, had created a great demand for specie to be exported, in order to purchase commodities abroad at rates which would afford enormous profits under the existing scale of prices here.”
Holly, D. W. and Conrad Swackhamer. 1839. The United States Magazine and Democratic Review. Volume 6. Langtree and O’Sullivan, Washington, D.C. p. 116.

(4) 1839:
“But while we express ourself, as strongly in favor of measures tending to secure to the cotton growing States independence of the Bank of England, (or any like bank any where else) and such, as will place them above fear of any combinations of private capitalists, we do not by any means wish to be understood to advise, or countenance any arrangement on this side the Atlantic, which has for its object an unreasonable inflation of prices.”
Carroll. B. R. 1839. The Southern Agriculturist and Register of Rural Affairs; Adapted to the Sothern Section of the United States. Vol. XII. January 1839. No. 1. A. E. Miller, Charleston, S.C. pp. 424–425.

(5) 1840:
“The question recurs, what were the causes of the unusual mania of speculation — the excessive and long continued inflation of prices, and the confidence that this inflation, after it was known to be excessive, would continue, and the expectation that it would still further increase?”
Hale, Nathan (ed.), Chronicle of Events, Discoveries, and Improvements, for the Popular Diffusion of Useful Knowledge Nathan Hale. S. N. Dickinson, Boston. 1840. p. 11.

(6) 1840:
“The operations of the Government from 1812 to 1815, gave the impulse to the expansion of business and the inflation of prices ...”
1840. An Examination of the Principles of the Independent Treasury Bill, the Objections urged against it, and the Antagonist or Bank System of the Opposition in the Speech of Isaac Parrish of Ohio. Globe Office, Washington. p. 5.

(7) 1843:
“That inflation of circulation and consequent inflation of prices was caused by ‘Democratic policy’, which gave to us the State banks, and stimulated them to extravagant emissions of paper; but. no sooner was the object accomplished. than the popular prejudice which was awakened by the appeals of demagogues against the United States Bank;”
Blair, Francis Preston and ‎John Cook Rives (eds.). 1843. The Congressional Globe Containing Sketches of the Debates and Proceedings of the Third Session of the Twenty Seventh Congress. Volume XII. Globe Office, Washington. p. 170

(8) 1851:
“When the volume of money is enlarged, prices rise; the rise of prices, by producing an apparent general prosperity, engenders a spirit of speculation; speculation produces an augmentation of credits, and since an increase of purchases on credit do not require, until a future period, a corresponding increase of money to pay for them, it follows that the inflation of prices is, by the mischievous influences of credit, often carried far beyond the point at which they would be arrested under a system of cash payments.”
Opdyke, George. 1851. A Treatise on Political Economy. G.P. Putnam, Broadway, New York. p. 325.

BIBLIOGRAPHY
Blair, Francis Preston and ‎John Cook Rives (eds.). 1843. The Congressional Globe Containing Sketches of the Debates and Proceedings of the Third Session of the Twenty Seventh Congress. Volume XII. Globe Office, Washington.

Carroll. B. R. 1839. The Southern Agriculturist and Register of Rural Affairs; Adapted to the Sothern Section of the United States. Vol. XII. January 1839. No. 1. A. E. Miller, Charleston, S.C.

Opdyke, George. 1851. A Treatise on Political Economy. G.P. Putnam, Broadway, New York.

O’Reilly, Henry. 1838. Settlement in the West: Sketches of Rochester: With Incidental Notices of Western New-York. W. Alling, Rochester.

Say, Jean Baptiste. 1821. A Treatise on Political Economy; or, The Production, Distribution, and Consumption of Wealth (trans. by C. R. Prinsep from 4th French edn.). Longman, Hurst, Rees, Orme, and Brown, London.

Why most Austrians do not Understand Modern Mark-up Pricing Theory

The proof is right here in these posts by the Austrian economist Robert Murphy:

Robert P. Murphy, “Problems with the Cost Theory of Value,” Mises Daily, May 23, 2011.

Robert P. Murphy, “Subjective-Value Theory,” Mises Daily, May 30, 2011.

A reading of these posts shows that when many Austrians attack what they call the “cost theory of value” they are attacking a Classical, Marxist or quasi-Marxist theory: they simply do not understand nor do they refute modern Post Keynesian and non-neoclassical Institutionalist mark-up pricing theory (which can also be called the cost-plus/administered price theory).

Modern mark-up/cost-plus pricing theory has the following important characteristics:

(1) it is not the Marxist or Classical Economics labour theory of value. Virtually all Post Keynesians reject the labour theory of value. Nor is mark-up pricing theory a quasi-Marxist “cost theory of value” where value is equated with price;

(2) following from (1), a fundamental distinction must be made between (i) value and (ii) price. Mark-up/cost-plus pricing theory is explaining price of some commodities, not their value;

(3) following from (2), most Post Keynesians and non-neoclassical Institutionalists can and do accept that value defined as the satisfaction or utility derived from the consumption of a good is subjective. The argument is not about subjective value/utility, which does exist, but about how certain market prices are actually determined, even though the utility derived from a good is subjective;

(4) Mark-up/cost-plus pricing theory does not dispute or deny the existence of flex-price markets in modern economies (such as in stock markets, primary commodities, auction markets for works of art, antiques etc.), and that when these markets involve goods with well-behaved demand curves and prices really are flexible, the prices can be explained, more or less, by conventional supply and demand dynamics. Mark-up/cost-plus pricing theory does not claim to be a universal theory of price formation, but merely an important theory that does explain many prices.

(5) Mark-up/cost-plus pricing theory does, however, dispute the extent and significance of flex-price markets in modern economies.

Empirical evidence in many surveys throughout the developed world and even in developing nations shows us that most prices are set by businesses through their cost accounting conventions in an ex ante manner before transactions take place, on the basis of (1) total average unit costs plus (2) a profit mark-up, at a given, estimated, projected or target quantity of output or level of sales (from which of course the ex post or actual quantity of output produced or sold in a given time period might differ).

Empirical evidence shows us that these mark-up prices are generally inflexible with respect to demand, but tend to change – though it is by no means a necessary or universal process – when total average unit costs change or when the business wants to change its profit mark-up.

In addition, there is a strong bias – or asymmetry – towards upwards rather than downwards price adjustments in modern mark-up price markets.

(6) in many mark-up pricing businesses, when demand changes, there will be no price adjustment, but adjustment in capacity utilisation and changes in buffer stocks/inventories.

When demand slumps, for example, firms will fire workers, cut production, and cut costs, and generally leave prices unchanged. When demand surges, firms will expand production, increase overtime and hire workers, and generally leave prices unchanged too.

That there are exceptions to this general type of firm behaviour, where, for example,

(i) some firms might temporarily cut their mark-up in a recession,
(ii) cut their mark-up for customers who make bulk purchases, or
(iii) where some retail businesses do indeed hold clearance sales of certain items that they have difficulty selling

simply does not refute the evidence that most mark-up pricing businesses do not generally adjust prices in response to demand changes in the way required by conventional supply and demand dynamics.

Now Austrian economics is fundamentally dependent on the idea of flexible prices and wages moving towards their market clearing values in a way that allegedly coordinates markets.

But if the majority of prices are mark-up prices and simply not very responsive to demand, many Austrian theories fall apart or are severely undermined.

There is no strong tendency to Misesian “economic coordination” by price adjustment, because such price adjustment does not happen in most markets. The idea that rapid and smooth recoveries from recessions/depressions happen by price adjustment (and by wage adjustment) is untrue: recovery will happen in most mark-up pricing markets by changes in demand and production, and because of the prevalence of such markets, this means that throughout most of the economy changes in demand cause direct changes in employment, production and output.

Unless Austrians properly understand modern mark-up/cost-plus pricing theory and actually engage with it, they are doomed to be intellectually irrelevant and an embarrassment.

Further Reading
Mark-up Pricing in 20 Nations and the Eurozone: the Empirical Evidence.

Post Keynesian Price Theory 101.

“Kaldor on Economics without Equilibrium,” March 9, 2013.

Did Austrians Never Predict Hyperinflation?

I read libertarian blogs frequently, and one thing I have noticed of late is how some Austrian economists and vulgar Austrians who comment on Austrian/libertarian blogs and are now so embarrassed by the prior predictions of hyperinflation that they deny that Austrians ever made any such predictions.

So is this new denial really true? Did no Austrian economist or Austrian pundit predict hyperinflation?

Of course, when confronted with the evidence that a number of them did indeed predict this, Austrians will quickly slip into the no true Scotsman fallacy, fallacy of equivocation, or the moving the goalposts fallacy.

Often the argument will run like this:

Austrian: No Austrian predicted hyperinflation!

Critic: But person x – an Austrian – predicted hyperinflation.

Austrian: But person x is not a genuine Austrian! [no true Scotsman fallacy].

Critic: But person x supports Austrian economics and uses it in economic analysis and self-identifies as an Austrian.

Austrian: But he is still not a genuine Austrian economist with a degree in Austrian economics! [fallacy of equivocation].

Critic: Well, person y is recognised as an Austrian economist with a degree in that field under another prominent Austrian economist and he predicted hyperinflation too.

Austrian: but person y did not predict hyperinflation as 100% certain, he only said it might happen! [fallacy of equivocation and moving the goalposts fallacy].

Of course, the argument may hinge on the meaning of “predict.” The ordinary dictionary definition of “predict” is to “announce something as an event that will occur in the future” or “say that something will happen”: this could mean either that

(1) the person says the event absolutely will happen with a 100% certainty (in a given time frame), or (more probably)

(2) the prediction that something will happen (in a given time frame) is probable or highly probable and contingent on given conditions (if x and y continue to occur, then z will result).

These are the meaningful senses of the word “predict,” but, as it happens, we have evidence that Austrians predicted hyperinflation in both senses.

We need only look at these examples:

(1) Marc Faber predicted that hyperinflation in the US was 100% certain in 2009



Mark Faber is a Swiss investor, publisher of the Gloom Boom & Doom Report, and director of Marc Faber Ltd (an investment advisor and fund manager).

But it is clear from this that Faber does not dispute that he uses the Austrian School of thought in economics analysis.

But there he is on the record predicting that hyperinflation was 100% certain, and he said the same thing here in this interview published on May 27, 2009.

Of course the absurd thing is that Faber gave no time period for his prediction in the video (was it supposed to be within 1 year? 2? 3? 6? 10? 50? 100?), and one need hardly point to how absurd it is for anyone to claim that he is predicting something, but then spectacularly fail to give a time period to limit the prediction and allow it to be tested.

Nevertheless, the context would suggest that Faber was thinking of a short to medium time frame, perhaps 10 years at the most. As of this day, his prediction has failed.

And we should note that in the same video, Peter Schiff made a conditional, probabilistic prediction of hyperinflation too.

(2) Peter Schiff in 2008
In this interview from April 21, 2008:

“[sc. Interviewer]: What is your long-term, 20 year outlook on the health and durability of the American economy as a whole? Will the combination of new regulations, welfare liabilities and inflationary pressure create a prolonged recession similar to what Japan has undergone since the early ’90s?

Peter [Schiff]: I am not sure. The road ahead will be filled with many potholes and include some important forks. Since I do not for sure which ones we will follow, I prefer to invest abroad until our path is more certain. As it stands now, we are headed to a hyperinflationary depression. I hope we will choose a different path before we actually get there.”
Tim Swanson, “Interview with Peter Schiff,” Mises Economics Blog, April 21, 2008.

In the full interview, Schiff explicitly states that he supports Austrian economics (he says: “Austrian economics is economics, period!”). Although Schiff’s time frame was in the context of a 20 year period, what is interesting here is that this was before the turn to QE in about December 2008: already around April 2008 Schiff was predicting hyperinflation in a probabilistic sense.

Still more interesting evidence is that Peter Schiff’s Euro Pacific Capital newsletter in its April 2009 issue contained an article by James Turk who predicted that hyperinflation in the US was “imminent.” Did Schiff agree with this article? If so, we have evidence that Schiff thought hyperinflation was highly probable in the short term, not just in a 20 year time frame.

And we have already noted that Peter Schiff made a conditional, probabilistic prediction of hyperinflation too in 2009 in the video above.

(3) Doug French in 2009
In this Mises Daily article:

“So instead of allowing the market to provide a healthy cleansing deflation, the Fed, the Treasury, and bank regulators are fighting valiantly to keep the fractional-reserve-bubble machine operating, with the ultimate result likely to be inflation and possibly hyperinflation.
http://mises.org/daily/3653
Doug French, “Store ’em If You Got ’em,” Mises Daily, August 17, 2009.

Doug French is clearly an Austrian economist (he received a master’s degree under Murray N. Rothbard at the University of Nevada).

Even though his statement about hyperinflation is far less strident and only a possibility, one must question how he could have mentioned it as a serious possibility without at the same time thinking it was at least probable.

(4) Gary North in 2012
Gary North raises hyperinflation as one of two possibilities, presumably both of which he thought were probable:

“The Federal Reserve and its allies — virtually the entire intellectual class — use this fear to maintain its position as the quasi-public bureaucracy in charge of America’s money. It lured the nation into the lobster trap of debt — debt undergirded by Federal Reserve fiat money and congressional deficits — and the country cannot see a way to get out on a pain-free basis. There is no pain-free escape, as we will find over the next two decades: hyperinflation or the Great Deflationary Default or both.

The government’s debt and the monetary inflation cannot go on indefinitely. Either the dollar dies or else the debt is repudiated. Maybe both.”
Gary North, “How to End the Fed, and How Not To,” Mises Daily, September 10, 2012.

North is clearly a strong supporter of Austrian economics.

(5) Ron Paul in 2011
Details in this article here. In an interview from 2011, Paul predicts the collapse of the US dollar and hyperinflation, presumably in a probabilistic sense.

Nobody can doubt Paul’s credentials as a supporter and advocate of Austrian economics:

“Paul is a proponent of Austrian School economics; he has authored six books on the subject, and displays pictures of Austrian School economists Friedrich Hayek, Murray Rothbard, and Ludwig von Mises (as well as of Grover Cleveland) on his office wall.”
http://en.wikipedia.org/wiki/Ron_Paul#Political_positions

So from (1) to (5) above we have predictions of hyperinflation as a 100% certainty (Faber in no. 1), to hyperinflation (apparently) as a serious probability (no. 2, no. 4 and no. 5) to hyperinflation at least a serious possibility (3).

The idea that Austrians never predicted hyperinflation in any sense is outrageous, mendacious and contemptible rewriting of history.

Austrians and their Incoherent Views on Administered Prices

Of the very few writings by Austrian economists or those heavily influenced by Austrian economics that mention (or supposedly mention) the concept of administered prices/mark-up prices, one can list the following:

(1) Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala. pp. 163–164.

(2) Rothbard, Murray N. 1959. “The Bogey of ‘Administered Prices,’” The Freeman 39–41.
http://www.fee.org/the_freeman/detail/the-bogey-of-administered-prices#axzz2s3nbZRZX

Rothbard, M. N. 2009 [1962]. Man, Economy, and State, The Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala. 662–664.

(3) Hazlitt, Henry. 1965. What You Should Know About Inflation (2nd edn.). D. Van Nostrand Company Inc. London and New York. 88–90.

(4) Howard, Irving E. 1966. “Will the Real Price Administrator Please Stand Up!,” The Freeman April 1: 46–50.
http://www.fee.org/the_freeman/detail/will-the-real-price-administrator-please-stand-up#axzz2s3nbZRZX

(5) Poirot, Paul L. 1971. “Cost-Plus Pricing,” The Freeman, January 1: 48–50.
http://www.fee.org/the_freeman/detail/cost-plus-pricing#axzz2s3nbZRZX

(6) Greaves, Bettina B. 1984. Free Market Economics: A Syllabus. Foundation for Economic Education, Irvington-on-Hudson, NY.

(7) Shapiro, Milton M. 1985. Foundations of the Market Price System. University Press of America, Inc. Lanham, MD and London. 365–366.

(8) Lachmann, Ludwig M. 1977. Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy (ed. Walter E. Grinder). Sheed Andrews and McMeel, Kansas City. 238–239.

Lachmann, L. M. 1986. The Market as an Economic Process. Basil Blackwell. Oxford. 134.

Lachmann, L. M. 1994. “The Salvage of Ideas: Problems of the Revival of Austrian Economic Thought,” in D. Lavoie (ed.), Expectations and the Meaning of Institutions: Essays in Economics. Routledge, London. 159–178, at 165–166.

(9) Reisman, George. 1996. Capitalism: A Treatise on Economics. Jameson Books, Ottawa, Ill. and Chicago. 167–169, 200–201, 414–417.

For reasons explained here, Mises (2009 [1953]: 163–164) is neither a description of mark-up pricing nor a refutation of it.

Rothbard (1959: 39–41; 2009 [1962]: 662–664), Hazlitt (1965: 88–90), Howard (1966), Poirot (1971), Greaves (1984), and Shapiro (1985: 365–366) simply constitute unconvincing denials that any such thing as “administered pricing” even exist, and even worse do not even show basic understanding of the doctrine.

But, by the time we come to Lachmann (1977: 238–239; 1986: 134; 1994: 165–166) and Reisman (1996: 167–169, 200–201, 414–417) suddenly there is an embarrassing volte face: now administered pricing and cost-plus pricing is acknowledged as a reality and not only that but also a significant part of the price systems of modern market economies.

So which is it?

It is absurd for any Austrian to say that “Austrians have refuted the existence of administered pricing,” because two major Austrian economists have frankly admitted their existence and economic significance.

Yet another confusion about what Austrians think about administered prices stems from George Reisman’s Capitalism: A Treatise on Economics (1996), where administered prices are mentioned on p. 417 in a context that suggests that Böhm-Bawerk somehow anticipated the doctrine, when he did not.

Further Reading
“Lachmann and Post Keynesianism on Prices,” August 1, 2012.

“Caldwell on Lachmann on Equilibrium Prices,” November 6, 2012.

“Mises versus Lachmann on Equilibrium Prices,” December 17, 2012.

“Do Modern Austrians ever Read Lachmann?,” October 13, 2013.

“Böhm-Bawerk had No Theory of Administered Prices,” November 10, 2013.

“Does this Passage show that Mises understood Mark-up Pricing?,” February 1, 2014.

“Rothbard’s Non-Refutation of Administered Prices,” February 1, 2014.


BIBLIOGRAPHY
Greaves, Bettina B. 1984. Free Market Economics: A Syllabus. Foundation for Economic Education, Irvington-on-Hudson, NY.

Howard, Irving E. 1966. “Will the Real Price Administrator Please Stand Up!,” The Freeman April 1: 46–50.
http://www.fee.org/the_freeman/detail/will-the-real-price-administrator-please-stand-up#axzz2s3nbZRZX

Lachmann, Ludwig M. 1977. Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy (ed. Walter E. Grinder). Sheed Andrews and McMeel, Kansas City.

Lachmann, L. M. 1986. The Market as an Economic Process. Basil Blackwell. Oxford.

Lachmann, L. M. 1994. “The Salvage of Ideas: Problems of the Revival of Austrian Economic Thought,” in D. Lavoie (ed.), Expectations and the Meaning of Institutions: Essays in Economics. Routledge, London. 159–178.

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala.

Poirot, Paul L. 1971. “Cost-Plus Pricing,” The Freeman, January 1: 48–50.
http://www.fee.org/the_freeman/detail/cost-plus-pricing#axzz2s3nbZRZX

Rothbard, Murray N. 1959. “The Bogey of ‘Administered Prices,’” The Freeman 39–41.
http://www.fee.org/the_freeman/detail/the-bogey-of-administered-prices#axzz2s3nbZRZX

Rothbard, M. N. 2009 [1962]. Man, Economy, and State, The Scholar’s Edition. Ludwig von Mises Institute, Auburn, Ala.

Shapiro, Milton M. 1985. Foundations of the Market Price System. University Press of America, Inc. Lanham, MD and London.

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.

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

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.

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.

Do Modern Austrians ever Read Lachmann?

For example, this passage:

“In neoclassical equilibrium theory the relationship between value and price becomes problematical in a way it was not for classical economists. The difference is one of the knowledge we may attribute to market participants. In the classical world it was reasonable to assume that every trader in a market knew the long-run cost of production of the product traded and was able to make use of this knowledge in dealing with day-to-day price fluctuations. But neoclassical equilibrium rests on a complex interplay of demand and supply in thousands of markets. In the absence of ‘The Auctioneer’ nobody can ‘know’ an equilibrium price until the system as a whole has attained this position. Traders are unable to compare current prices with a ‘long-run normal price’ as they do not know the latter. The problem of price formation arises in a new form. The day-to-day conduct of traders requires a new form of explanation.

It is therefore not surprising that a fairly straight line links Mayer’s position to contemporary discussions of fixprice and flexprice markets, two terms we owe to Sir John Hicks. Once we realise that in our world all prices are disequilibrium prices, the problem mentioned above arises on many levels. It was to be expected that post-Keynesians would seek guidance in the writings of Keynes who, in any case, distrusted neoclassical theory. Chapter 29 of the Treatise on Money may be said to contain a rudimentary theory of price formation in conditions of disequilibrium. A few years ago Professor Davidson made a notable attempt to take Keynes’s thought on price formation in different markets a little further by distinguishing between ‘produce-to-market’ and ‘produce-to-contract’ entrepreneurs (Harcourt (ed.) 1977:313–17).

In different markets prices are formed in different ways. Not all pricefixing agents have the same interests. Here historical change plays its part. The decline of the wholesale merchant, whose dominating role Marshall took for granted, for instance in textile markets, and who naturally aimed at setting such prices as would permit him to maximize his turnover (a short-run consideration), reduced the range of markets with flexible prices. The rise of the industrial cost accountant as a pricefixer, with his interest in ‘orderly marketing’ (a long-run consideration) and his aversion to frequent price changes, has made most prices of industrial goods in our world Hicksian fixprices. In all markets dominated by speculation of course prices must be flexible. On the other hand, all bureaucracies, including those concerned with production planning in large industrial enterprises, naturally abhor flexible prices. ... .” (Lachmann 1994: 165–166; originally published in Lachmann 1982).

And a further observation:

“Hence, while Marshall’s was a world of flexible prices, even though not of ‘perfect competition,’ ours is a ‘fixprice world’ with prices set on a ‘cost plus’ basis and wage rates as ultimate price determinants.

The analytical significance of this historical change lies, on the one hand, in the fact that the ‘Temporary Equilibrium Method’ which Hicks himself, following Lindahl, used in Value and Capital in 1939, has lost much of its validity. ‘The fundamental weakness of the Temporary Equilibrium method is the assumption, which it is obliged to make, that the market is in equilibrium—actual demand equals desired demand, actual supply equals desired supply—even in the very short period.’ (76) Hence we have to look for another method of dynamic analysis. To find it we must move nearer to Keynes and his successors who are here given credit for having understood, earlier than others, that a fixprice world requires a fixprice method of analysis.” (Lachmann 1977: 238–239).

One will look in vain for a discussion of these issues in other Austrian literature, apart from a scant discussion in Reisman (1996: 414–417).

But none of the modern Austrians – not even Lachmann – bothered to properly think through the implications of administered prices.

If they had, they would have seen that the central plank of the Misesian theory of economic coordination – that the market, even an “unhampered” market, has a strong tendency to market clearing and full use of resources – must be abandoned.

BIBLIOGRAPHY
Lachmann, Ludwig M. 1977. Capital, Expectations, and the Market Process: Essays on the Theory of the Market Economy (ed. Walter E. Grinder). Sheed Andrews and McMeel, Kansas City.

Lachmann, L. M. 1982. “The Salvage of Ideas: Problems of the Revival of Austrian Economic Thought,” Journal of Institutional and Theoretical Economics 138.4: 629–645.

Lachmann, L. M. 1994. “The Salvage of Ideas: Problems of the Revival of Austrian Economic Thought,” in D. Lavoie (ed.), Expectations and the Meaning of Institutions: Essays in Economics. Routledge, London. 159–178.

Reisman, George. 1996. Capitalism: A Treatise on Economics. Jameson Books, Ottawa, Ill. and Chicago.

When Austrians Throw Reality to the Wind

I am sternly lectured here by an internet Austrian commenting on my last post that my empirical evidence supporting the statement that many businesses use administered prices is all for naught, because, well, empirical reality does not matter:

“First, there is the role of empirical evidence in economic theorising. A chronicler like you will never get that part. Second, there is the important point that what people say is irrelevant to an economic theorist. It may be to an accountant (which you seem to be) but not to a person dabbling in Economics.”
http://socialdemocracy21stcentury.blogspot.com/2013/10/lavoie-on-administered-prices.html?showComment=1381482208666#c8603208885956595634

The words highlighted in yellow say it all: vulgar Austrians do not care about empirical reality. If an Austrian economic theory is contradicted by reality, then reality is irrelevant.

For example, if one wants to create a theory about how prices are actually set in the real world, then obviously surveys of how business people actually do set prices must be “irrelevant to an economic theorist.”

Thus the findings of the Oxford Economists’ Research Group (OERG) in the 1930s, on real world price setting, confirmed by numerous studies since then (Andrews 1964; Means 1972; Okun 1981; Blinder et al. 1998, with Downward and Lee 2001; Fabiani et al. 2006), must be totally irrelevant to how prices are set:

“For several years a group of economists in Oxford have been studying problems connected with the trade cycle. Among the methods adopted is that of discussion with business men, a number of whom have been kind enough to submit to questioning on their procedure in various circumstances: and among other matters in the questionnaire were inquiries about the policy adopted in fixing the prices and the output of products.” (Hall and Hitch 1939: 12).

“The most striking feature of the answers was the number of firms which apparently do not aim, in their pricing policy, at what appeared to us to be the maximization of profits by the equation of marginal revenue and marginal cost. In a few cases this can be explained by the fact that the entrepreneurs are thinking of long-run profits, and in terms of long-run demand and cost curves, even in the short run, rather than of immediate profits. This is expressed to some extent by the phrase commonly used in describing their policy – ‘taking goodwill into account’. But the larger part of the explanation, we think, is that they are thinking in altogether different terms; that in pricing they try to apply a rule of thumb which we shall call ‘full cost’, and that maximum profits, if they result at all from the application of this rule, do so as an accidental (or possibly evolutionary) by-product.

An overwhelming majority of the entrepreneurs thought that a price based on full average cost (including a conventional allowance for profit) was the ‘right’ price, the one which ‘ought’ to be charged. In some cases this meant computing the full cost of a ‘given’ commodity, and charging a price equal to cost. In others it meant working from some traditional or convenient price, which had been proved acceptable to consumers, and adjusting the quality of the article until its full cost equalled the ‘given’ price. A large majority of the entrepreneurs explained that they did actually charge the ‘full cost’ price, a few admitting that they might charge more in periods of exceptionally high demand, and a greater number that they might charge less in periods of exceptionally depressed demand. What, then, was the effect of ‘competition’? In the main it seemed to be to induce firms to modify the margin for profits which could be added to direct costs and overheads so that approximately the same prices for similar products would rule within the ‘group’ of competing producers. One common procedure was the setting of a price by a strong firm at its own full cost level, and the acceptance of this price by other firms in the ‘group’; another was the reaching of a price by what was in effect an agreement, though an unconscious one, in which all the firms in the group, acting on the same principle of ‘full cost’, sought independently to reach a similar result.” (Hall and Hitch 1939: 18–19).

However, for those of us not blinded by Mises’s crazy methodology, empirical reality must ground all economic theories.


BIBLIOGRAPHY
Andrews, P. W. S. 1964. On Competition in Economic Theory. Macmillan, London.

Blinder, A. S. et al. 1998. Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage foundation, New York.

Downward, Paul and Frederic Lee. 2001. “Post Keynesian Pricing Theory ‘Reconfirmed’? A Critical Review of Asking about Prices,” Journal of Post Keynesian Economics 23.3: 465–483.

Fabiani, S., M. Druant, I. Hernando, C. Kwapil, B. Landau, C. Loupias, F. Martins, T. Mathä, R. Sabbatini, H. Stahl and A. Stokman. 2006. “What Firms’ Surveys tell us about Price-Setting Behavior in the Euro Area,” International Journal of Central Banking 2.3: 3–47.

Hall, R. L. and C. J. Hitch. 1939. “Price Theory and Business Behaviour,” Oxford Economic Papers 2 (May): 12–45.

Means, G. C. 1972. “The Administered Price Thesis Reconfirmed,” American Economic Review 62: 292–306.

Okun, A. 1981. Prices and Quantities: A Macroeconomic Analysis. Blackwell. Oxford.

Wicksell’s Natural Rate and Homogenous Capital

Colin Rogers points out an interesting assumption of Wicksell’s natural rate.

The concept of capital can be divided into two ideas:

(1) real capital, or the physical goods themselves, e.g., machines, tools, or raw materials, or
(2) capital defined in terms of a sum of exchange value (or in monetary terms). (Rogers 1989: 27).

Real capital in sense (1) can be measured in technical units, but that would mean that there would be as many technical units as there are types of capital goods (Rogers 1989: 28).

But in order to calculate the rate of interest (the return on capital), capital has to be measured in monetary terms.

Rogers continues:

“Apart from pointing out the technical necessity of defining capital in value terms, Wicksell also suggests that it is necessary for theoretical reasons; namely, that in equilibrium the rate of interest must be the same on all capital. This condition is, of course, the classical condition of long-period equilibrium defined in terms of a uniform rate of return on all assets. It is the notion of equilibrium employed by Wicksell to define the natural rate of interest. To define such an equilibrium, however, capital must be treated as a mobile homogeneous entity so that it may move between sectors to equalize the rate of interest/profit. Capital defined as value capital (financial capital) can fulfil this role but capital defined in technical or quantity terms cannot.” (Rogers 1989: 28).

It well known that Wicksell’s unique “natural rate of interest” was taken over by Mises and Hayek in their early formulations of the Austrian business cycle theory. In essence, the classic Austrian business cycle theory borrowed the “real” natural rate idea from Wicksell that required an assumption of homogeneous capital: something that modern Austrians are at pains to deny, since they accept (as Post Keynesians do) that capital is heterogeneous.

This is serious problem for Austrians. Austrians use a concept – the Wicksellian natural rate of interest – that is incompatible with their heterogeneous capital theory.

BIBLIOGRAPHY
Rogers, C. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.

Austrians and the Definition of “Inflation”

Certain Austrians are running to defend their idiosyncratic definition of “inflation” as an increase in the money supply, instead of (as people normally use it) a general increase in prices.

The fact is that the word “inflation” has always been used to describe a general increase in prices, as well as an expansion of the money supply. This can be clearly seen to anyone who does a few minutes of searching on Google Books for the word “inflation” in the 19th century.

Even in the 19th century, people frequently spoke of an “inflation of the currency” or “inflation in (the) currency” and “inflation of prices” or “inflation in prices.” These expressions appear in the English language from about 1834. When referring to monetary expansions, people in the 1800s also often used the phrases “expansion of credit,” “over-issue of credit,” or “over-issue of (the) currency,” and so on.

Just looking at this graph of usage (better viewed in a separate window) from a search on Google Ngram Viewer, the expression “inflation of prices” is very common in the 19th century, and in some years more common than the expression “inflation of the currency.” As already noted, both appear around 1834.

Furthermore, as we can see in this next graph, the expression “inflated prices” appeared in the late 1790s at the time of the French Revolutionary wars, and so the use of the cognate word “inflated” in an economic sense referring to prices preceded the phrases above.

Even single uses of the word “inflation” in sources from the 1800s can have either meaning, depending on the context.

Examples of “inflation” in the sense of “price inflation” are easy to find:

“The question recurs, what were the causes of the unusual mania of speculation — the excessive and long continued inflation of prices, and the confidence that this inflation, after it was known to be excessive, would continue, and the expectation that it would still further increase?”
Nathan Hale (ed.), Chronicle of Events, Discoveries, and Improvements, for the Popular Diffusion of Useful Knowledge Nathan Hale. S. N. Dickinson, Boston. 1840. p. 11.

“Now, however, without any inflation, and in some important articles under a contraction of prices, the excess of exports is not only more than was ever known before, but quite threefold greater, ...”
William Hanby Crump, The World in a Pocket Book: Or, Universal Popular Statistics. J. Dobson, Philadelphia, 1841. pp. 118–119.

“The expression ‘war prices,’ so commonly used in the past, implied the inflation in values of all kinds of property rated in such representative money, the volume of money largely controlling the degree of inflation in values, but not absolutely, ... ”
John Smith, Hard Times: A Few Suggestions to the Workers and a Broad Hint to the Rich. 1885. p. 45.

“But such a currency so handled cannot cause inflation. Prices remain, as before, at the gold level.”
Littell’s Living Age, Volume 186, T.H. Carter & Company, 1890. p. 648.

“Taking inflation to mean a rise in prices, unaccompanied by a corresponding rise in values, inflation can never be brought about by a mere increase in the volume of gold employed in commerce.”
Blackwood’s Edinburgh Magazine, Volume 149, 1891. p. 401.

“This increase in prices we call inflation, and I do not understand how such an inflation can be repudiated, as has been done to day, while the entire remedy proposed, imaginary or real, evidently is intended to produce a notable increase of prices called forth by inflation.”
Berlin Silver Commission, 1894: Proposals Submitted and Debate on the Proposals. Report of the Proceedings, to which is Appended the Report of the Proceedings of the International Bimetallic Conference at London May 2 and 3, 1894, Volume 2, U.S. Government Printing Office, 1895. p. 775.

Austrians Should Read their Mises

I suggest they read this passage in Interventionism: An Economic Analysis:

“Thus the market in the capitalist economy is the process regulating production and consumption. It is the nerve-center of the capitalist system. Through it the orders of the consumers are transmitted to the producers, and the smooth functioning of the economic system is secured thereby. The market prices establish themselves at the level which equates demand and supply. When, other things being equal, more goods are brought to the market, prices fall; when, other things being equal, demand increases, prices rise.

One thing more must be noted. If within a society based on private ownership of the means of production some of these means are publicly owned and operated, this still does not make for a mixed system which would combine socialism and private property. As long as only certain individual enterprises are publicly owned, the remaining being privately owned, the characteristics of the market economy which determine economic activity remain essentially unimpaired. The publicly owned enterprises, too, as buyers of raw materials, semi-finished goods, and labor, and as sellers of goods and services, must fit into the mechanism of the market economy; they are subject to the same laws of the market. In order to maintain their position they, too, have to strive after profits or at least to avoid losses.” (Mises 1998: 5)

It is quite surprising how much Mises was prepared to concede: an economy with some limited nationalised industry (although run on the principle of profit and loss) where the majority of capital goods are private owned is still a “market economy” with its fundamental characteristics “essentially unimpaired.”

That is a view far from ravings of many internet Austrians.

BIBLIOGRAPHY

Mises, L. von. 1998 [1940]. Interventionism: An Economic Analysis (trans. Thomas Francis McManus and Heinrich Bund). Foundation for Economic Education, Inc., Irvington-on-Hudson, NY.

Austrians Rewrite the History of the Socialist Calculation Debate

Consider this statement from Gary North over at Mises.org:

“The Soviet Union was based on socialism, and socialist economic calculation is irrational. Ludwig von Mises in 1920 described why in his article, “Economic Calculation in the Socialist Commonwealth.” He showed in theory exactly what is wrong with all socialist planning. He made it clear why socialism could never compete with the free market. It has no capital goods markets, and therefore economic planners cannot allocate capital according to capital’s most important and most desired needs among by the public.

Mises’s argument was not taken seriously by the academic community. Socialism was so popular by 1920 among academics that they did not respond to Mises for over 15 years. When finally one major economist, who really was not a major economist but was simply a Polish Communist, wrote a response to Mises, it got a great deal of publicity. His name was Oscar Lange. He was a hack. He taught at the University of Chicago. He had no theory of economics. ….

So, the only major supposed academic refutation of Mises was made by a hack who switched sides to Communism when he got a better offer. Yet he was heralded as a brilliant economist because he had supposedly refuted Mises.”

Gary North, “Dancing on the Grave of Keynesianism,” Mises Daily, October 01, 2012.

And Austrians might wonder why nobody takes them very seriously.

The “only major supposed academic refutation of Mises” was the work of Oscar Lange? Is this man serious?

I guess all these replies to, and critiques of, Mises in the 1920s and 1930s went down the Austrian memory hole:

Cohn, Arthur Wolfgang. 1920. “Kann das Geld abgeschaft werden?” (“Can Money be Abolished?”), Dissert., University of Jena.

Polanyi K. 1922. “Sozialistische Rechnungslegung,” Archiv für Sozialwissenschaft und Sozialpolitik 49.2: 377–420.

Kautsky, Karl. 1922. Die proletarische Revolution und ihr Programm. Dietz, Stuttgart and Berlin.

Leichter, O. 1923. Die Wirtschaftsrechnung in der socialistische Gesellschaft. Verlag der Wiener Volksbuchhandlung, Vienna.

Polanyi, K. 1924. “Die funktionelle Theorie der Gesellschaft und das Problem der sozialistischen Rechnungslegung,” Archiv für Sozialwissenschaft und Sozialpolitik 52: 218–228.

Neurath, Otto. 1925. Wirtschaftsplan und Naturalrechnung. Laub, Berlin.

Taylor, F. M. 1929. “The Guidance of Production in a Socialist State,” American Economic Review 19 (March): 1–8.

Roper, W. C. 1929. The Problem of Pricing in a Socialist State. Harvard University Press, Cambridge, Mass.

Dickinson, H. D. 1933. “Price Formation in a Socialist Community,” Economic Journal 43 (June): 237–250.

Dickinson, H. D. 1939. Economics of Socialism. Oxford University Press, Oxford.

Lerner, A. 1937. “Statics and Dynamics in Socialist Economics,” Economic Journal 47: 251–270.

Lerner, A. 1938. “Theory and Practice in Socialist Economics,” Review of Economic Studies 6 (October): 71–75.

And this is only a selection of the literature.

My purpose here is not to defend the socialist critics of Mises: whatever you think of the merits of their responses to Mises, the fact is that it is absurd to assert to that nobody responded to Mises “for over 15 years,” and that Lange provided the “only major supposed academic refutation” of him.

How could anyone familiar with the history of economics write such rubbish?

In fact, even Hayek said explicitly that soon after 1920 Mises’s socialist critics began to reply to him:

“In the years immediately succeeding its publication [viz. Mises’s “Economic Calculation in the Socialist Commonwealth – LK] a number of attempts were made to meet his challenge directly and to show that he was wrong in his main thesis, and that even in a strictly centrally directed economic system values could be exactly determined without any serious difficulties.” (Hayek 1935: 36).

One can consult Appendix B of Hayek (1935: 291–293) for a detailed list of the literature.

Furthermore, Mises’s critique of command economy socialism was hardly unique. Hayek (1935: 34) tells us that Max Weber independently came to much the same conclusions as Mises over the difficulty of a planned socialist economy in his posthumous work Wirtschaft und Gesellschaft (Tübingen, 1921), and a Russian economist Boris Brutzkus (who was actually living in Russia) wrote a critique of Soviet economics published in 1921–1922 in the Russian journal Ekonomist, later reprinted in an English translation called “Problems of Social Economy under Socialism” (Hayek 1935: 35). Brutzkus had also criticised war communism along similar lines to Mises.

It is rather curious that Mises’s original article of 1920 was mainly a critique of the marketless, planned, and moneyless economy imagined by Otto Neurath, but the socialist critics of Mises quickly accepted Mises’s view that such a moneyless planned economy would not work (Hayek 1997: 9). Moreover, Mises had never denied that a syndicalist system of production was possible: he admitted that rational economic calculation was possible under syndicalism since he argued that there was a group-collective private ownership of capital goods in such a system (Keizer 1987: 114).

The major responses to Mises and Hayek came from so-called “market socialists,” such Abba Lerner, H. D. Dickinson, and Oscar Lange. These socialists used Walrasian general equilibrium theory, and argued that a decentralized socialist economy would allow the choices of consumers and workers to be free, and that state firms engaged in production competitively would choose cost-minimizing techniques and then expand production until their marginal costs equalled prices. This, they thought, would overcome the difficulties foreseen by Mises.

The foundation was laid by H. D. Dickinson in his article “Price Formation in a Socialist Community” (Economic Journal 43 [1933]: 237–250), where Dickinson argued that the system of equations by which an economy can be represented in a Walrasian economic model would be solved in the socialist economy by planning authorities (Hayek 1997: 13). If the prices were wrong, Dickinson and other socialists argued that, by trial and error, the right prices would be found.

Even Lange accepted Mises’s view the prices are necessary for rational economic calculation (Hayek 1997: 20). By the time Hayek entered the debate he, in essence, conceded that rational economic calculation under socialism might be a theoretical possibility (something which Mises denied), but Hayek thought that in practical terms it was impossible.

The real paradox here is that in his criticisms of market socialists Hayek was driven to question the usefulness of Walrasian general equilibrium theory in understanding real world capitalist economies (Donzelli 1993).

The crucial reason why many perceived that Lange had adequately answered Mises and Hayek was that the mainstream economics profession was taken over by neoclassical theory after 1945.

But it is obvious that the Walrasian basis of the market socialists’ argument for a planned economy is badly mistaken, for Walrasian theory is wrong.

Where that leaves the arguments for planned economies is another question, of course. I will address this in the next post.

BIBLIOGRAPHY

Barone, Enrico. 1908. “Il ministro della produzione nello stato collettivista,” Giornale degli economisti 37: 267-293, 391-414.

Barone, Enrico. 1935. “The Ministry of Production in the Collectivist State,” in F. A. von Hayek (ed.), Collectivist Economic Planning: Critical Studies on the Possibilities of Socialism. G. Routledge & Sons, London.

Chaloupek, Günther. 1990. “The Austrian Debate on Economic Calculation in a Socialist Society,” History of Political Economy 22.4: 659–675.

Christainsen, Gregory B. 1993. “What Keynes really Said to Hayek about Planning,”
Challenge 36.4 (July/August): 50–53.

Cohn, Arthur Wolfgang. 1920. “Kann das Geld abgeschaft werden?” (“Can Money be Abolished?”), Dissert., University of Jena.

Dickinson, H. D. 1933. “Price Formation in a Socialist Community,” Economic Journal 43 (June): 237–250.

Dickinson, H. D. 1939. Economics of Socialism. Oxford University Press, Oxford.

Donzelli, F. 1993. “The Influence of the Socialist Calculation Debate on Hayek’s view of General Equilibrium Theory,” Revue européenne des sciences sociales 31.96.3: 47–83.

Halm, Georg. 1935. “Further Considerations on the Possibility of Adequate Calculation in a Socialist Community,” in F. A. von Hayek (ed.), Collectivist Economic Planning: Critical Studies on the Possibilities of Socialism. G. Routledge & Sons, London. 131–201.

Hayek, Friedrich A. von. 1935. Collectivist Economic Planning: Critical Studies on the Possibilities of Socialism. G. Routledge & Sons, London.

Hayek, Friedrich A. von. 1997. Socialism and War: Essays, Documents, Reviews (ed. Bruce Caldwell). Routledge, London.

Heimann, Eduard. 1922. Mehrwert und Gemeinwirtschaft. Kritische und positive Beiträge zur Theorie des Sozialismus. Engelmann, Berlin.

Kautsky, Karl. 1922. Die proletarische Revolution und ihr Programm. Dietz, Stuttgart and Berlin.

Keizer, W. 1987. “Two Forgotten Articles by Ludwig von Mises on the Rationality of Socialist Economic Calculation,” Review of Austrian Economics 1.1: 109–122.

Keizer, W. 1989. “Recent Reinterpretations of the Socialist Calculation Debate,” The Journal of Economic Studies 16.2: 63-83.

Keizer, W. 1997. “Schumpeter’s Walrasian Stand in the Socialist Calculation Debate,” in W. Keizer, B. Tieben and R. van Zijp (eds.), Austrian Economics in Debate. Routledge, London and New York. 75–94.

Lange, O. 1936. “On the Economic Theory of Socialism (Part I),” Review of Economic Studies 4: 53–71.

Lange, O. 1937. “On the Economic Theory of Socialism (Part II),” Review of Economic Studies 5: 123–142.

Leichter, O. 1923. Die Wirtschaftsrechnung in der socialistische Gesellschaft. Verlag der Wiener Volksbuchhandlung, Vienna.

Lerner, A. 1937. “Statics and Dynamics in Socialist Economics,” Economic Journal 47: 251–270.

Lerner, A. 1938. “Theory and Practice in Socialist Economics,” Review of Economic Studies 6 (October): 71–75.

Mises, L. von. 1920. “Die Wirtschaftsrechnung im sozialistischen Gemeinwesen,” Archiv fur Sozialwissenschaften 47: 86–121.

Mises, L. von. 1935. “Economic Calculation in the Socialist Commonwealth,” in F. A. von Hayek (ed.), Collectivist Economic Planning: Critical Studies on the Possibilities of Socialism. G. Routledge & Sons, London. 87–131.

Neurath, Otto. 1925. Wirtschaftsplan und Naturalrechnung. Laub, Berlin.

Pierson, N. 1935. “The Problem of Value in the Socialist Society,” in F. A. von Hayek (ed.), Collectivist Economic Planning: Critical Studies on the Possibilities of Socialism. Geonze Routledee & Sons, London. 41–86.

Polanyi, K. 1922. “Sozialistische Rechnungslegung,” Archiv für Sozialwissenschaft und Sozialpolitik 49.2: 377–420.

Polanyi, K. 1924. “Die funktionelle Theorie der Gesellschaft und das Problem der sozialistischen Rechnungslegung,” Archiv für Sozialwissenschaft und Sozialpolitik 52: 218–228.

Rothbard, Murray N. 2006 [1991]. “The End of Socialism and the Calculation Debate Revisited,” Mises Daily, 8 December
http://mises.org/daily/2401

Roper, W. C. 1929. The Problem of Pricing in a Socialist State. Harvard University Press, Cambridge, Mass.

Taylor, F. M. 1929. “The Guidance of Production in a Socialist State,” American Economic Review 19 (March): 1–8.

Weber, Max. 1921. Wirtschaft und Gesellschaft. J.C.B. Mohr, Tübingen.

A Simple Question for Opponents of Fractional Reserve Banking

Yes, the person who left this comment on my blog, I am thinking of you and people like you.

Let us imagine two farmers: Bill and Steve.

They freely make and both agree to the following contract:

(1) Bill lends Steve a chicken as a loan for consumption (or, in legal language, a mutuum loan). Both parties agree that Steve becomes owner of the chicken. Steve can “consume” the chicken by eating it, or can even resell it to someone else.

(2) Bill says to Steve: “Steve, I know you keep a reserve stock of chickens – since you are a farmer – so I want to call back this ‘chicken debt’ (that is, make you repay the debt by another chicken, a tantundem chicken of the same quality and age) on demand at some time this year, but I don't know precisely when. Is that alright?”

Steve says: “Bill, that is perfectly alright, I accept these terms completely and freely. I will repay on demand the ‘chicken debt’ I owe you.”

So what is wrong with this contract?

If the opponents of fractional reserve banking can find nothing wrong with it legally, economically or morally, then all we have to do now is substitute money for chickens to see how a mutuum loan of money, callable on demand, must also be acceptable.

It is only a few further steps to see that there can be nothing wrong with fractional reserve banking (FRB) either (assuming for the sake of argument that all parties understand the terms of the contract), for FRB operates on the very same principles.

One might object that many holders of demand deposits or FR transactions accounts these days do not understand that the bank becomes owner of their money, but this is a very different objection from the usual ignorant arguments offered by anti-FRB Austrians (and I have addressed the issue of public ignorance of FRB here).

Normally, the main arguments against FRB put forward by the big name Austrians (e.g., Mises, Rothbard, Hoppe) consistent of the following:

(1) ignorant inability to understand that banknotes (or fiduciary notes) are debt instruments, not property titles.

(2) similar ignorant inability to understand that the “demand deposit” is also nothing but a debt instrument on the bank’s books, not a depositum or bailment. A demand deposit is never a bailment. Thus it is not the case that two property titles to the money exist: the bank becomes the owner of the money, and the FR client is simply a lender, with a debt owed to him by the bank.

Austrians Mangle Business Uncertainty

I recommend this post at the ThinkMarkets blog for the Austrian view of uncertainty:

Chidem Kurdas, “Uncertainty and the Keynesians,” ThinkMarkets, July 20, 2012.

The argument of this post is flawed for the following reasons:

(1) Keynesians do not ignore uncertainty, and the heterodox Keynesians, above all, have developed Keynes’s ideas on uncertainty to a very great extent (e.g., G. L. S. Shackle and Paul Davidson).

(2) The implied Austrian belief that having the government “do nothing” would decrease uncertainty, and restore business confidence, is both ridiculous and risible. A “do nothing” policy in 2008 would have collapsed the financial system, caused millions to lose their savings, induced a depression, and shocked business expectations to an extent far greater than any “regime uncertainty” caused by the Obama administration.

(3) Whatever uncertainty is caused by the factors Kurdas lists (Obamacare, regulatory explosion, giant budget deficits, anti-business rhetoric and threats of increasing taxes) – and no doubt to some business people these things are a matter of concern – would be overcome by sufficient aggregate demand and a surge in demand for the products of business.

Paul Davidson has recently addressed this very issue:

“Recently I went to a well-known restaurant in Evanston, Illinois. ... But the night I was there, it was less than half full. I asked the manager if he would he hire more waiters and chefs if his taxes were reduced and/or government removed the existing regulations controlling the way his restaurant could operate. His answer was that even if his taxes were reduced and regulations eliminated, he would only hire more staff if more customers came in for dinner. On the other hand, if there were twice as many customers for dinners than there were on this night (and there were many more customers before the recession began in 2007) he would gladly double the number of workers he employed even if his taxes were not reduced or regulations changed.

That’s how things work in the Real World. This simple case illustrates clearly that entrepreneurs will have confidence to expand and hire more workers only if they find the market demand for their products and services strong and growing.”

Paul Davidson, “Restoring Trust in the American Economy: The Real World v. The Confidence Fairy,” Alternet.org, July 11, 2012.

This is the reality of business confidence – Austrian fairy tales of “evil” government notwithstanding.

Léon Walras and General Equilibrium

Léon Walras, whose photo appears below, was the founder of the neoclassical Walrasian economics tradition.



There are obviously differences between what Alfred Marshall meant by equilibrium and what neoclassicals like Walras meant by it, but general equilibrium can be defined as a situation where all markets, including the labour market, clear at the same time. It can also be called a “full employment equilibrium.”

A question that immediately occurs is this: did Walras think general equilibrium is ever attained in the real world?

Apparently not:

“Equilibrium in production, like equilibrium in exchange, is an ideal and not a real state. It never happens in the real world that the selling price of any given product is absolutely equal to the cost of the productive services that enter into that product, or that the effective demand and supply of services or products are absolutely equal. Yet equilibrium is the normal state, in the sense that it is the state towards which things spontaneously tend under a régime of free competition in exchange and in production.” (Walras 1954: 224–225).

“Such is the continuous market, which is perpetually tending towards equilibrium without ever actually attaining it, because the market has no other way of approaching equilibrium except by groping, and, before the goal is reached, it has to renew its efforts and start over again, all the basic data of the problem, e.g. the initial quantities possessed, the utilities of goods and services, the technical coefficients, the excess of income over consumption, the working capital requirements, etc., having changed in the meantime. Viewed in this way, the market is like a lake agitated by the wind, where the water is incessantly seeking its level without ever reaching it. But whereas there are days when the surface of a lake is almost smooth, there never is a day when the effective demand for products and services equals their effective supply and when the selling price of products equals the cost of the productive services used in making them. The diversion of productive services from enterprises that are losing money to profitable enterprises takes place in various ways, the most important being through credit operations, but at best these ways are slow. It can happen and frequently does happen in the real world, that under some circumstances a selling price will remain for long periods of time above the cost of production and continue to rise in spite of increases in output, while under other circumstances, a fall in price, following upon this rise, will suddenly bring the selling price below cost of production and force entrepreneurs to reverse their production policies. For, just as a lake is, at times, stirred to its very depths by a storm, so also the market is sometimes thrown into violent confusion by crises, which are sudden and general disturbances of equilibrium. The more we know of the ideal conditions of equilibrium, the better we shall be able to control or prevent these crises.” (Walras 1954: 380–381).

A point that emerges is this: the differences between those Austrian economists who adhere to the view of a strong tendency to general equilibrium in the real world (even if it is never attained) and neoclassicals are greatly exaggerated, for even Walras himself believed the same thing: the state of general equilibrium is an ideal, not “a real state.”

I think important conceptual distinctions should be made between the following:

(1) the state of general equilibrium (which never exists in the real world);

(2) a strong tendency to general equilibrium in the real world. This means market processes are moving in that direction normally and consistently as a natural condition. These processes are “equilibrating mechanisms,” and it is their combined effective operation that creates a strong tendency to general equilibrium;

(3) The “equilibrating mechanisms” or “coordinating mechanisms” should not simply be identified with the actual tendency to general equilibrium in the real world. The latter is a distinct phenomenon, whose existence Post Keynesians would deny.

The “equilibrating mechanisms” for Austrians and neoclassicals are regarded as things such as an equilibrium rate of interest clearing the loanable funds market, equilibrium prices, Say’s law, the tendency of the rate of profit to become uniform, entrepreneurship seeking profit, speculative arbitrage, significantly and quickly flexible wages and prices, and so on.

It can be seen that some of these alleged “equilibrating mechanisms” do not even exist: the equilibrium rate of interest and Say’s law, for example. Others do not actually happen in the real world, such as rapidly adjusting wages and prices.

Of course, even Post Keynesians would not deny that there do exist certain coordinating mechanisms. But the issue is whether the ones that do exist really work in the way imagined by neoclassicals and Austrians.

The alleged combined effective operation of these “equilibrating mechanisms” is really a myth, and so is the strong tendency to general equilibrium.

The fundamental insight of Keynes was that, even if we had perfectly flexible wages and prices, market economies would still not necessarily converge to full employment equilibrium. Significant unemployment could still exist even with perfectly flexible wages and prices.

The insight of Irving Fisher and Hyman Minsky was that price deflation in an environment of high private debt causes debt deflation.

Post Keynesians argue that there is nothing in market systems that ensure that the economy will converge automatically to full employment equilibrium (Davidson 1993: 436). This does not mean that free market economies are inherently disequilibrating, however (Davidson 1993: 436). For Keynes, the most serious flaws in capitalism were as follows:

“The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.” (Keynes 1936: 372).

No doubt there are more radical criticisms that could be made of capitalism, but it is important to make clear what Keynes thought.

Keynes regarded the “unemployment equilibrium” (which is better called an “unemployment disequilibrium”) as capitalism’s natural state:

“our actual experience … [sc. is] that we oscillate, avoiding the gravest extremes of fluctuation in employment and in prices in both directions, round an intermediate position appreciably below full employment and appreciably above the minimum employment a decline below which would endanger life.” (Keynes 1936: 254).

Keynes’s view was that real-world capitalist systems have a tendency to fluctuate around a state well below full employment: this is a major and serious problem of market economies.


BIBLIOGRAPHY

Davidson, P. 1993. “Austrians and Post Keynesians on Economic Reality: Rejoinder to Critics,” Critical Review 7.2–3: 423–444.

Keynes, J. M. 1936. The General Theory of Employment, Interest, and Money, Macmillan, London.

Vienneau, Robert. “One Generation Passes and Another comes, but the World Forever Stays,” Thoughts on Economics Blog, August 12, 2007.

Walras, Léon. 1954. Elements of Pure Economics, or, The Theory of Social Wealth (trans. W. Jaffé), Allen & Unwin, London.