Archive for the 'Carl Menger' Category

The Rises and Falls of Keynesianism and Monetarism

The following is extracted from a paper on the history of macroeconomics that I’m now writing. I don’t know yet where or when it will be published and there may or may not be further installments, but I would be interested in any comments or suggestions that readers might have. Regular readers, if there are any, will probably recognize some familiar themes that I’ve been writing about in a number of my posts over the past several months. So despite the diminished frequency of my posting, I haven’t been entirely idle.

Recognizing the cognitive dissonance between the vision of the optimal equilibrium of a competitive market economy described by Marshallian economic theory and the massive unemployment of the Great Depression, Keynes offered an alternative, and, in his view, more general, theory, the optimal neoclassical equilibrium being a special case.[1] The explanatory barrier that Keynes struggled, not quite successfully, to overcome in the dire circumstances of the 1930s, was why market-price adjustments do not have the equilibrating tendencies attributed to them by Marshallian theory. The power of Keynes’s analysis, enhanced by his rhetorical gifts, enabled him to persuade much of the economics profession, especially many of the most gifted younger economists at the time, that he was right. But his argument, failing to expose the key weakness in the neoclassical orthodoxy, was incomplete.

The full title of Keynes’s book, The General Theory of Employment, Interest and Money identifies the key elements of his revision of neoclassical theory. First, contrary to a simplistic application of Marshallian theory, the mass unemployment of the Great Depression would not be substantially reduced by cutting wages to “clear” the labor market. The reason, according to Keynes, is that the levels of output and unemployment depend not on money wages, but on planned total spending (aggregate demand). Mass unemployment is the result of too little spending not excessive wages. Reducing wages would simply cause a corresponding decline in total spending, without increasing output or employment.

If wage cuts do not increase output and employment, the ensuing high unemployment, Keynes argued, is involuntary, not the outcome of optimizing choices made by workers and employers. Ever since, the notion that unemployment can be involuntary has remained a contested issue between Keynesians and neoclassicists, a contest requiring resolution in favor of one or the other theory or some reconciliation of the two.

Besides rejecting the neoclassical theory of employment, Keynes also famously disputed the neoclassical theory of interest by arguing that the rate of interest is not, as in the neoclassical theory, a reward for saving, but a reward for sacrificing liquidity. In Keynes’s view, rather than equilibrate savings and investment, interest equilibrates the demand to hold the money issued by the monetary authority with the amount issued by the monetary authority. Under the neoclassical theory, it is the price level that adjusts to equilibrate the demand for money with the quantity issued.

Had Keynes been more attuned to the Walrasian paradigm, he might have recast his argument that cutting wages would not eliminate unemployment by noting the inapplicability of a Marshallian supply-demand analysis of the labor market (accounting for over 50 percent of national income), because wage cuts would shift demand and supply curves in almost every other input and output market, grossly violating the ceteris-paribus assumption underlying Marshallian supply-demand paradigm. When every change in the wage shifts supply and demand curves in all markets for good and services, which in turn causes the labor-demand and labor-supply curves to shift, a supply-demand analysis of aggregate unemployment becomes a futile exercise.

Keynes’s work had two immediate effects on economics and economists. First, it immediately opened up a new field of research – macroeconomics – based on his theory that total output and employment are determined by aggregate demand. Representing only one element of Keynes’s argument, the simplified Keynesian model, on which macroeconomic theory was founded, seemed disconnected from either the Marshallian or Walrasian versions of neoclassical theory.

Second, the apparent disconnect between the simple Keynesian macro-model and neoclassical theory provoked an ongoing debate about the extent to which Keynesian theory could be deduced, or even reconciled, with the premises of neoclassical theory. Initial steps toward a reconciliation were provided when a model incorporating the quantity of money and the interest rate into the Keynesian analysis was introduced, soon becoming the canonical macroeconomic model of undergraduate and graduate textbooks.

Critics of Keynesian theory, usually those opposed to its support for deficit spending as a tool of aggregate demand management, its supposed inflationary bias, and its encouragement or toleration of government intervention in the free-market economy, tried to debunk Keynesianism by pointing out its inconsistencies with the neoclassical doctrine of a self-regulating market economy. But proponents of Keynesian precepts were also trying to reconcile Keynesian analysis with neoclassical theory. Future Nobel Prize winners like J. R. Hicks, J. E. Meade, Paul Samuelson, Franco Modigliani, James Tobin, and Lawrence Klein all derived various Keynesian propositions from neoclassical assumptions, usually by resorting to the un-Keynesian assumption of rigid or sticky prices and wages.

What both Keynesian and neoclassical economists failed to see is that, notwithstanding the optimality of an economy with equilibrium market prices, in either the Walrasian or the Marshallian versions, cannot explain either how that set of equilibrium prices is, or can be, found, or how it results automatically from the routine operation of free markets.

The assumption made implicitly by both Keynesians and neoclassicals was that, in an ideal perfectly competitive free-market economy, prices would adjust, if not instantaneously, at least eventually, to their equilibrium, market-clearing, levels so that the economy would achieve an equilibrium state. Not all Keynesians, of course, agreed that a perfectly competitive economy would reach that outcome, even in the long-run. But, according to neoclassical theory, equilibrium is the state toward which a competitive economy is drawn.

Keynesian policy could therefore be rationalized as an instrument for reversing departures from equilibrium and ensuring that such departures are relatively small and transitory. Notwithstanding Keynes’s explicit argument that wage cuts cannot eliminate involuntary unemployment, the sticky-prices-and-wages story was too convenient not to be adopted as a rationalization of Keynesian policy while also reconciling that policy with the neoclassical orthodoxy associated with the postwar ascendancy of the Walrasian paradigm.

The Walrasian ascendancy in neoclassical theory was the culmination of a silent revolution beginning in the late 1920s when the work of Walras and his successors was taken up by a younger generation of mathematically trained economists. The revolution proceeded along many fronts, of which the most important was proving the existence of a solution of the system of equations describing a general equilibrium for a competitive economy — a proof that Walras himself had not provided. The sophisticated mathematics used to describe the relevant general-equilibrium models and derive mathematically rigorous proofs encouraged the process of rapid development, adoption and application of mathematical techniques by subsequent generations of economists.

Despite the early success of the Walrasian paradigm, Kenneth Arrow, perhaps the most important Walrasian theorist of the second half of the twentieth century, drew attention to the explanatory gap within the paradigm: how the adjustment of disequilibrium prices is possible in a model of perfect competition in which every transactor takes market price as given. The Walrasian theory shows that a competitive equilibrium ensuring the consistency of agents’ plans to buy and sell results from an equilibrium set of prices for all goods and services. But the theory is silent about how those equilibrium prices are found and communicated to the agents of the model, the Walrasian tâtonnement process being an empirically empty heuristic artifact.

In fact, the explanatory gap identified by Arrow was even wider than he had suggested or realized, for another aspect of the Walrasian revolution of the late 1920s and 1930s was the extension of the equilibrium concept from a single-period equilibrium to an intertemporal equilibrium. Although earlier works by Irving Fisher and Frank Knight laid a foundation for this extension, the explicit articulation of intertemporal-equilibrium analysis was the nearly simultaneous contribution of three young economists, two Swedes (Myrdal and Lindahl) and an Austrian (Hayek) whose significance, despite being partially incorporated into the canonical Arrow-Debreu-McKenzie version of the Walrasian model, remains insufficiently recognized.

These three economists transformed the concept of equilibrium from an unchanging static economic system at rest to a dynamic system changing from period to period. While Walras and Marshall had conceived of a single-period equilibrium with no tendency to change barring an exogenous change in underlying conditions, Myrdal, Lindahl and Hayek conceived of an equilibrium unfolding through time, defined by the mutual consistency of the optimal plans of disparate agents to buy and sell in the present and in the future.

In formulating optimal plans that extend through time, agents consider both the current prices at which they can buy and sell, and the prices at which they will (or expect to) be able to buy and sell in the future. Although it may sometimes be possible to buy or sell forward at a currently quoted price for future delivery, agents planning to buy and sell goods or services rely, for the most part, on their expectations of future prices. Those expectations, of course, need not always turn out to have been accurate.

The dynamic equilibrium described by Myrdal, Lindahl and Hayek is a contingent event in which all agents have correctly anticipated the future prices on which they have based their plans. In the event that some, if not all, agents have incorrectly anticipated future prices, those agents whose plans were based on incorrect expectations may have to revise their plans or be unable to execute them. But unless all agents share the same expectations of future prices, their expectations cannot all be correct, and some of those plans may not be realized.

The impossibility of an intertemporal equilibrium of optimal plans if agents do not share the same expectations of future prices implies that the adjustment of perfectly flexible market prices is not sufficient an optimal equilibrium to be achieved. I shall have more to say about this point below, but for now I want to note that the growing interest in the quiet Walrasian revolution in neoclassical theory that occurred almost simultaneously with the Keynesian revolution made it inevitable that Keynesian models would be recast in explicitly Walrasian terms.

What emerged from the Walrasian reformulation of Keynesian analysis was the neoclassical synthesis that became the textbook version of macroeconomics in the 1960s and 1970s. But the seemingly anomalous conjunction of both inflation and unemployment during the 1970s led to a reconsideration and widespread rejection of the Keynesian proposition that output and employment are directly related to aggregate demand.

Indeed, supporters of the Monetarist views of Milton Friedman argued that the high inflation and unemployment of the 1970s amounted to an empirical refutation of the Keynesian system. But Friedman’s political conservatism, free-market ideology, and his acerbic criticism of Keynesian policies obscured the extent to which his largely atheoretical monetary thinking was influenced by Keynesian and Marshallian concepts that rendered his version of Monetarism an unattractive alternative for younger monetary theorists, schooled in the Walrasian version of neoclassicism, who were seeking a clear theoretical contrast with the Keynesian macro model.

The brief Monetarist ascendancy following 1970s inflation conveniently collapsed in the early 1980s, after Friedman’s Monetarist policy advice for controlling the quantity of money proved unworkable, when central banks, foolishly trying to implement the advice, prolonged a needlessly deep recession while central banks consistently overshot their monetary targets, thereby provoking a long series of embarrassing warnings from Friedman about the imminent return of double-digit inflation.


[1] Hayek, both a friend and a foe of Keynes, would chide Keynes decades after Keynes’s death for calling his theory a general theory when, in Hayek’s view, it was a special theory relevant only in periods of substantially less than full employment when increasing aggregate demand could increase total output. But in making this criticism, Hayek, himself, implicitly assumed that which he had himself admitted in his theory of intertemporal equilibrium that there is no automatic equilibration mechanism that ensures that general equilibrium obtains.

My Paper “Between Walras and Marshall: Menger’s Third Way” Is Now Posted on SSRN

As regular readers of this blog will realize, several of my recent posts (here, here, here, here, and here) have been incorporated in my new paper, which I have been writing for the upcoming Carl Menger 2021 Conference next week in Nice, France. The paper is now available on SSRN.

Here is the abstract to the paper:

Neoclassical economics is bifurcated between Marshall’s partial-equilibrium and Walras’s general-equilibrium analyses. Given the failure of neoclassical theory to explain the Great Depression, Keynes proposed an explanation of involuntary unemployment. Keynes’s contribution was later subsumed under the neoclassical synthesis of the Keynesian and Walrasian theories. Lacking microfoundations consistent with Walrasian theory, the neoclassical synthesis collapsed. But Walrasian GE theory provides no plausible account of how GE is achieved. Whatever plausibility is attributed to the assumption that price flexibility leads to equilibrium derives from Marshallian PE analysis, with prices equilibrating supply and demand. But Marshallian PE analysis presumes that all markets, but the small one being analyzed, are at equilibrium, so that price adjustments in the analyzed market neither affect nor are affected by other markets. The demand and cost (curves) of PE analysis are drawn on the assumption that all other prices reflect Walrasian GE values. While based on Walrasian assumptions, modern macroeconomics relies on the Marshallian intuition that agents know or anticipate the prices consistent with GE. Menger’s third way offers an alternative to this conceptual impasse by recognizing that nearly all economic activity is subjective and guided by expectations of the future. Current prices are set based on expectations of future prices, so equilibrium is possible only if agents share the same expectations of future prices. If current prices are set based on differing expectations, arbitrage opportunities are created, causing prices and expectations to change, leading to further arbitrage, expectational change, and so on, but not necessarily to equilibrium.

Here is a link to the paper: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3964127

The current draft if preliminary, and any comments, suggestions or criticisms from readers would be greatly appreciated.

The Explanatory Gap and Mengerian Subjectivism

My last several posts have been focused on Marshall and Walras and the relationships and differences between the partial equilibrium approach of Marshall and the general-equilibrium approach of Walras and how that current state of neoclassical economics is divided between the more practical applied approach of Marshallian partial-equilibrium analysis and the more theoretical general-equilibrium approach of Walras. The divide is particularly important for the history of macroeconomics, because many of the macroeconomic controversies in the decades since Keynes have also involved differences between Marshallians and Walrasians. I’m not happy with either the Marshallian or Walrasian approach, and I have been trying to articulate my unhappiness with both branches of current neoclassical thinking by going back to the work of the forgotten marginal revolutionary, Carl Menger. I’ve been writing a paper for a conference later this month celebrating the 150th anniversary of Menger’s great work which draws on some of my recent musings, because I think it offers at least some hints at how to go about developing an improved neoclassical theory. Here’s a further sampling of my thinking which is drawn from one of the sections of my work in progress.

Both the Marshallian and the Walrasian versions of equilibrium analysis have failed to bridge an explanatory gap between the equilibrium state, whose existence is crucial for such empirical content as can be claimed on behalf of those versions of neoclassical theory, and such an equilibrium state could ever be attained. The gap was identified by one of the chief architects of modern neoclassical theory, Kenneth Arrow, in his 1958 paper “Toward a Theory of Price Adjustment.”

The equilibrium is defined in terms of a set of prices. In the Marshallian version, the equilibrium prices are assumed to have already been determined in all but a single market (or perhaps a subset of closely related markets), so that the Marshallian equilibrium simply represents how, in a single small or isolated market, an equilibrium price in that market is determined, under suitable ceteris-paribus conditions thereby leaving the equilibrium prices determined in other markets unaffected.

In the Walrasian version, all prices in all markets are determined simultaneously, but the method for determining those prices simultaneously was not spelled out by Walras other than by reference to the admittedly fictitious and purely heuristic tâtonnement process.

Both the Marshallian and Walrasian versions can show that equilibrium has optimal properties, but neither version can explain how the equilibrium is reached or how it can be discovered in practice. This is true even in the single-period context in which the Walrasian and Marshallian equilibrium analyses were originally carried out.

The single-period equilibrium has been extended, at least in a formal way, in the standard Arrow-Debreu-McKenzie (ADM) version of the Walrasian equilibrium, but this version is in important respects just an enhanced version of a single-period model inasmuch as all trades take place at time zero in a complete array of future state-contingent markets. So it is something of a stretch to consider the ADM model a truly intertemporal model in which the future can unfold in potentially surprising ways as opposed to just playing out a script already written in which agents go through the motions of executing a set of consistent plans to produce, purchase and sell in a sequence of predetermined actions.

Under less extreme assumptions than those of the ADM model, an intertemporal equilibrium involves both equilibrium current prices and equilibrium expected prices, and just as the equilibrium current prices are the same for all agents, equilibrium expected future prices must be equal for all agents. In his 1937 exposition of the concept of intertemporal equilibrium, Hayek explained the difference between what agents are assumed to know in a state of intertemporal equilibrium and what they are assumed to know in a single-period equilibrium.

If all agents share common knowledge, it may be plausible to assume that they will rationally arrive at similar expectations of the future prices. But if their stock of knowledge consists of both common knowledge and private knowledge, then it seems implausible to assume that the price expectations of different agents will always be in accord. Nevertheless, it is not necessarily inconceivable, though perhaps improbable, that agents will all arrive at the same expectations of future prices.

In the single-period equilibrium, all agents share common knowledge of equilibrium prices of all commodities. But in intertemporal equilibrium, agents lack knowledge of the future, but can only form expectations of future prices derived from their own, more or less accurate, stock of private knowledge. However, an equilibrium may still come about if, based on their private knowledge, they arrive at sufficiently similar expectations of future prices for their plans for their current and future purchases and sales to be mutually compatible.

Thus, just twenty years after Arrow called attention to the explanatory gap in neoclassical theory by observing that there is no neoclassical theory of how competitive prices can change, Milgrom and Stokey turned Arrow’s argument on its head by arguing that, under rational expectations, no trading would ever occur at prices other than equilibrium prices, so that it would be impossible for a trader with private information to take advantage of that information. This argument seems to suffer from a widely shared misunderstanding of what rational expectations signify.

Thus, in the Mengerian view articulated by Hayek, intertemporal equilibrium, given the diversity of private knowledge and expectations, is an unlikely, but not inconceivable, state of affairs, a view that stands in sharp contrast to the argument of Paul Milgrom and Nancy Stokey (1982), in which they argue that under a rational-expectations equilibrium there is no private knowledge, only common knowledge, and that it would be impossible for any trader to trade on private knowledge, because no other trader with rational expectations would be willing to trade with anyone at a price other than the equilibrium price.

Rational expectations is not a property of individual agents making rational and efficient use of the information from whatever source it is acquired. As I have previously explained here (and a revised version here) rational expectations is a property of intertemporal equilibrium; it is not an intrinsic property that agents have by virtue of being rational, just as the fact that the three angles in a triangle sum to 180 degrees is not a property of the angles qua angles, but a property of the triangle. When the expectations that agents hold about future prices are identical, their expectations are equilibrium expectations and they are rational. That the agents hold rational expectations in equilibrium, does not mean that the agents are possessed of the power to calculate equilibrium prices or even to know if their expectations of future prices are equilibrium expectations. Equilibrium is the cause of rational expectations; rational expectations do not exist if the conditions for equilibrium aren’t satisfied. See Blume, Curry and Easley (2006).

The assumption, now routinely regarded as axiomatic, that rational expectations is sufficient to ensure that equilibrium is automatic achieved, and that agents’ price expectations necessarily correspond to equilibrium price expectations is a form of question begging disguised as a methodological imperative that requires all macroeconomic models to be properly microfounded. The newly published volume edited by Arnon, Young and van der Beek Expectations: Theory and Applications from Historical Perspectives contains a wonderful essay by Duncan Foley that elucidates these issues.

In his centenary retrospective on Menger’s contribution, Hayek (1970), commenting on the inexactness of Menger’s account of economic theory, focused on Menger’s reluctance to embrace mathematics as an expository medium with which to articulate economic-theoretical concepts. While this may have been an aspect of Menger’s skepticism about mathematical reasoning, his recognition that expectations of the future are inherently inexact and conjectural and more akin to a range of potential outcomes of different probability may have been an even more significant factor in how Menger chose to articulate his theoretical vision.

But it is noteworthy that Hayek (1937) explicitly recognized that there is no theoretical explanation that accounts for any tendency toward intertemporal equilibrium, and instead merely (and in 1937!) relied an empirical tendency of economies to move in the direction of equilibrium as a justification for considering economic theory to have any practical relevance.

The Walras-Marshall Divide in Neoclassical Theory, Part II

In my previous post, which itself followed up an earlier post “General Equilibrium, Partial Equilibrium and Costs,” I laid out the serious difficulties with neoclassical theory in either its Walrasian or Marshallian versions: its exclusive focus on equilibrium states with no plausible explanation of any economic process that leads from disequilibrium to equilibrium.

The Walrasian approach treats general equilibrium as the primary equilibrium concept, because no equilibrium solution in a single market can be isolated from the equilibrium solutions for all other markets. Marshall understood that no single market could be in isolated equilibrium independent of all other markets, but the practical difficulty of framing an analysis of the simultaneous equilibration of all markets made focusing on general equilibrium unappealing to Marshall, who wanted economic analysis to be relevant to the concerns of the public, i.e., policy makers and men of affairs whom he regarded as his primary audience.

Nevertheless, in doing partial-equilibrium analysis, Marshall conceded that it had to be embedded within a general-equilibrium context, so he was careful to specify the ceteris-paribus conditions under which partial-equilibrium analysis could be undertaken. In particular, any market under analysis had to be sufficiently small, or the disturbance to which that market was subject had to be sufficiently small, for the repercussions of the disturbance in that market to have only minimal effect on other markets, or, if substantial, those effects had to concentrated on a specific market (e.g., the market for a substitute, or complementary, good).

By focusing on equilibrium in a single market, Marshall believed he was making the analysis of equilibrium more tractable than the Walrasian alternative of focusing on the analysis of simultaneous equilibrium in all markets. Walras chose to make his approach to general equilibrium, if not tractable, at least intuitive by appealing to the fiction of tatonnement conducted by an imaginary auctioneer adjusting prices in all markets in response to any inconsistencies in the plans of transactors preventing them from executing their plans at the announced prices.

But it eventually became clear, to Walras and to others, that tatonnement could not be considered a realistic representation of actual market behavior, because the tatonnement fiction disallows trading at disequilibrium prices by pausing all transactions while a complete set of equilibrium prices for all desired transactions is sought by a process of trial and error. Not only is all economic activity and the passage of time suspended during the tatonnement process, there is not even a price-adjustment algorithm that can be relied on to find a complete set of equilibrium prices in a finite number of iterations.

Despite its seeming realism, the Marshallian approach, piecemeal market-by-market equilibration of each distinct market, is no more tenable theoretically than tatonnement, the partial-equilibrium method being premised on a ceteris-paribus assumption in which all prices and all other endogenous variables determined in markets other than the one under analysis are held constant. That assumption can be maintained only on the condition that all markets are in equilibrium. So the implicit assumption of partial-equilibrium analysis is no less theoretically extreme than Walras’s tatonnement fiction.

In my previous post, I quoted Michel De Vroey’s dismissal of Keynes’s rationale for the existence of involuntary unemployment, a violation in De Vroey’s estimation, of Marshallian partial-equilibrium premises. Let me quote De Vroey again.

When the strict Marshallian viewpoint is adopted, everything is simple: it is assumed that the aggregate supply price function incorporates wages at their market-clearing magnitude. Instead, when taking Keynes’s line, it must be assumed that the wage rate that firms consider when constructing their supply price function is a “false” (i.e., non-market-clearing) wage. Now, if we want to keep firms’ perfect foresight assumption (and, let me repeat, we need to lest we fall into a theoretical wilderness), it must be concluded that firms’ incorporation of a false wage into their supply function follows from their correct expectation that this is indeed what will happen in the labor market. That is, firms’ managers are aware that in this market something impairs market clearing. No other explanation than the wage floor assumption is available as long as one remains in the canonical Marshallian framework. Therefore, all Keynes’s claims to the contrary notwithstanding, it is difficult to escape the conclusion that his effective demand reasoning is based on the fixed-wage hypothesis. The reason for unemployment lies in the labor market, and no fuss should be made about effective demand being [the reason rather] than the other way around.

A History of Macroeconomics from Keynes to Lucas and Beyond, pp. 22-23

My interpretation of De Vroey’s argument is that the strict Marshallian viewpoint requires that firms correctly anticipate the wages that they will have to pay in making their hiring and production decisions, while presumably also correctly anticipating the future demand for their products. I am unable to make sense of this argument unless it means that firms — and why should firm owners or managers be the only agents endowed with perfect or correct foresight? – correctly foresee the prices of the products that they sell and of the inputs that they purchase or hire. In other words, the strict Marshallian viewpoint invoked by De Vroey assumes that each transactor foresees, without the intervention of a timeless tatonnement process guided by a fictional auctioneer, the equilibrium price vector. In other words, when the strict Marshallian viewpoint is adopted, everything is simple; every transactor is a Walrasian auctioneer.

My interpretation of Keynes – and perhaps I’m just reading my own criticism of partial-equilibrium analysis into Keynes – is that he understood that the aggregate labor market can’t be analyzed in a partial-equilibrium setting, because Marshall’s ceteris-paribus proviso can’t be maintained for a market that accounts for roughly half the earnings of the economy. When conditions change in the labor market, everything else also changes. So the equilibrium conditions of the labor market must be governed by aggregate equilibrium conditions that can’t be captured in, or accounted for by, a Marshallian partial-equilibrium framework. Because something other than supply and demand in the labor market determines the equilibrium, what happens in the labor market can’t, by itself, restore an equilibrium.

That, I think, was Keynes’s intuition. But while identifying a serious defect in the Marshallian viewpoint, that intuition did not provide an adequate theory of adjustment. But the inadequacy of Keynes’s critique doesn’t rehabilitate the Marshallian viewpoint, certainly not in the form in which De Vroey represents it.

But there’s a deeper problem with the Marshallian viewpoint than just the interdependence of all markets. Although Marshall accepted marginal-utility theory in principle and used it to explain consumer demand, he tried to limit its application to demand while retaining the classical theory of the cost of production as a coordinate factor explaining the relative prices of goods and services. Marginal utility determines demand while cost determines supply, so that the interaction of supply and demand (cost and utility) jointly determine price just as the two blades of a scissor jointly cut a piece of cloth or paper.

This view of the role of cost could be maintained only in the context of the typical Marshallian partial-equilibrium exercise in which all prices — including input prices — except the price of a single output are held fixed at their general-equilibrium values. But the equilibrium prices of inputs are not determined independently of the values of the outputs they produce, so their equilibrium market values are derived exclusively from the value of whatever outputs they produce.

This was a point that Marshall, desiring to minimize the extent to which the Marginal Revolution overturned the classical theory of value, either failed to grasp, or obscured: that both prices and costs are simultaneously determined. By focusing on partial-equilibrium analysis, in which input prices are treated as exogenous variables rather than, as in general-equilibrium analysis, endogenously determined variables, Marshall was able to argue as if the classical theory that the cost incurred to produce something determines its value or its market price, had not been overturned.

The absolute dependence of input prices on the value of the outputs that they are being used to produce was grasped more clearly by Carl Menger than by Walras and certainly more clearly than by Marshall. What’s more, unlike either Walras or Marshall, Menger explicitly recognized the time lapse between the purchasing and hiring of inputs by a firm and the sale of the final output, inputs having been purchased or hired in expectation of the future sale of the output. But expected future sales are at prices anticipated, but not known, in advance, making the valuation of inputs equally conjectural and forcing producers to make commitments without knowing either their costs or their revenues before undertaking those commitments.

It is precisely this contingent relationship between the expectation of future sales at unknown, but anticipated, prices and the valuations that firms attach to the inputs they purchase or hire that provides an alternative to the problematic Marshallian and Walrasian accounts of how equilibrium market prices are actually reached.

The critical role of expected future prices in determining equilibrium prices was missing from both the Marshallian and the Walrasian theories of price determination. In the Walrasian theory, price determination was attributed to a fictional tatonnement process that Walras originally thought might serve as a kind of oversimplified and idealized version of actual market behavior. But Walras seems eventually to have recognized and acknowledged how far removed from reality his tatonnement invention actually was.

The seemingly more realistic Marshallian account of price determination avoided the unrealism of the Walrasian auctioneer, but only by attributing equally, if not more, unrealistic powers of foreknowledge to the transactors than Walras had attributed to his auctioneer. Only Menger, who realistically avoided attributing extraordinary knowledge either to transactors or to an imaginary auctioneer, instead attributing to transactors only an imperfect and fallible ability to anticipate future prices, provided a realistic account, or at least a conceptual approach toward a realistic account, of how prices are actually formed.

In a future post, I will try spell out in greater detail my version of a Mengerian account of price formation and how this account might tell us about the process by which a set of equilibrium prices might be realized.

An Austrian Tragedy

It was hardly predictable that the New York Review of Books would take notice of Marginal Revolutionaries by Janek Wasserman, marking the susquicentenial of the publication of Carl Menger’s Grundsätze (Principles of Economics) which, along with Jevons’s Principles of Political Economy and Walras’s Elements of Pure Economics ushered in the marginal revolution upon which all of modern economics, for better or for worse, is based. The differences among the three founding fathers of modern economic theory were not insubstantial, and the Jevonian version was largely superseded by the work of his younger contemporary Alfred Marshall, so that modern neoclassical economics is built on the work of only one of the original founders, Leon Walras, Jevons’s work having left little impression on the future course of economics.

Menger’s work, however, though largely, but not totally, eclipsed by that of Marshall and Walras, did leave a more enduring imprint and a more complicated legacy than Jevons’s — not only for economics, but for political theory and philosophy, more generally. Judging from Edward Chancellor’s largely favorable review of Wasserman’s volume, one might even hope that a start might be made in reassessing that legacy, a process that could provide an opportunity for mutually beneficial interaction between long-estranged schools of thought — one dominant and one marginal — that are struggling to overcome various conceptual, analytical and philosophical problems for which no obvious solutions seem available.

In view of the failure of modern economists to anticipate the Great Recession of 2008, the worst financial shock since the 1930s, it was perhaps inevitable that the Austrian School, a once favored branch of economics that had made a specialty of booms and busts, would enjoy a revival of public interest.

The theme of Austrians as outsiders runs through Janek Wasserman’s The Marginal Revolutionaries: How Austrian Economists Fought the War of Ideas, a general history of the Austrian School from its beginnings to the present day. The title refers both to the later marginalization of the Austrian economists and to the original insight of its founding father, Carl Menger, who introduced the notion of marginal utility—namely, that economic value does not derive from the cost of inputs such as raw material or labor, as David Ricardo and later Karl Marx suggested, but from the utility an individual derives from consuming an additional amount of any good or service. Water, for instance, may be indispensable to humans, but when it is abundant, the marginal value of an extra glass of the stuff is close to zero. Diamonds are less useful than water, but a great deal rarer, and hence command a high market price. If diamonds were as common as dewdrops, however, they would be worthless.

Menger was not the first economist to ponder . . . the “paradox of value” (why useless things are worth more than essentials)—the Italian Ferdinando Galiani had gotten there more than a century earlier. His central idea of marginal utility was simultaneously developed in England by W. S. Jevons and on the Continent by Léon Walras. Menger’s originality lay in applying his theory to the entire production process, showing how the value of capital goods like factory equipment derived from the marginal value of the goods they produced. As a result, Austrian economics developed a keen interest in the allocation of capital. Furthermore, Menger and his disciples emphasized that value was inherently subjective, since it depends on what consumers are willing to pay for something; this imbued the Austrian school from the outset with a fiercely individualistic and anti-statist aspect.

Menger’s unique contribution is indeed worthy of special emphasis. He was more explicit than Jevons or Walras, and certainly more than Marshall, in explaining that the value of factors of production is derived entirely from the value of the incremental output that could be attributed (or imputed) to their services. This insight implies that cost is not an independent determinant of value, as Marshall, despite accepting the principle of marginal utility, continued to insist – famously referring to demand and supply as the two blades of the analytical scissors that determine value. The cost of production therefore turns out to be nothing but the value the output foregone when factors are used to produce one output instead of the next most highly valued alternative. Cost therefore does not determine, but is determined by, equilibrium price, which means that, in practice, costs are always subjective and conjectural. (I have made this point in an earlier post in a different context.) I will have more to say below about the importance of Menger’s specific contribution and its lasting imprint on the Austrian school.

Menger’s Principles of Economics, published in 1871, established the study of economics in Vienna—before then, no economic journals were published in Austria, and courses in economics were taught in law schools. . . .

The Austrian School was also bound together through family and social ties: [his two leading disciples, [Eugen von] Böhm-Bawerk and Friedrich von Wieser [were brothers-in-law]. [Wieser was] a close friend of the statistician Franz von Juraschek, Friedrich Hayek’s maternal grandfather. Young Austrian economists bonded on Alpine excursions and met in Böhm-Bawerk’s famous seminars (also attended by the Bolshevik Nikolai Bukharin and the German Marxist Rudolf Hilferding). Ludwig von Mises continued this tradition, holding private seminars in Vienna in the 1920s and later in New York. As Wasserman notes, the Austrian School was “a social network first and last.”

After World War I, the Habsburg Empire was dismantled by the victorious Allies. The Austrian bureaucracy shrank, and university placements became scarce. Menger, the last surviving member of the first generation of Austrian economists, died in 1921. The economic school he founded, with its emphasis on individualism and free markets, might have disappeared under the socialism of “Red Vienna.” Instead, a new generation of brilliant young economists emerged: Schumpeter, Hayek, and Mises—all of whom published best-selling works in English and remain familiar names today—along with a number of less well known but influential economists, including Oskar Morgenstern, Fritz Machlup, Alexander Gerschenkron, and Gottfried Haberler.

Two factual corrections are in order. Menger outlived Böhm-Bawerk, but not his other chief disciple von Wieser, who died in 1926, not long after supervising Hayek’s doctoral dissertation, later published in 1927, and, in 1933, translated into English and published as Monetary Theory and the Trade Cycle. Moreover, a 16-year gap separated Mises and Schumpeter, who were exact contemporaries, from Hayek (born in 1899) who was a few years older than Gerschenkron, Haberler, Machlup and Morgenstern.

All the surviving members or associates of the Austrian school wound up either in the US or Britain after World War II, and Hayek, who had taken a position in London in 1931, moved to the US in 1950, taking a position in the Committee on Social Thought at the University of Chicago after having been refused a position in the economics department. Through the intervention of wealthy sponsors, Mises obtained an academic appointment of sorts at the NYU economics department, where he succeeded in training two noteworthy disciples who wrote dissertations under his tutelage, Murray Rothbard and Israel Kirzner. (Kirzner wrote his dissertation under Mises at NYU, but Rothbard did his graduate work at Colulmbia.) Schumpeter, Haberler and Gerschenkron eventually took positions at Harvard, while Machlup (with some stops along the way) and Morgenstern made their way to Princeton. However, Hayek’s interests shifted from pure economic theory to deep philosophical questions. While Machlup and Haberler continued to work on economic theory, the Austrian influence on their work after World War II was barely recognizable. Morgenstern and Schumpeter made major contributions to economics, but did not hide their alienation from the doctrines of the Austrian School.

So there was little reason to expect that the Austrian School would survive its dispersal when the Nazis marched unopposed into Vienna in 1938. That it did survive is in no small measure due to its ideological usefulness to anti-socialist supporters who provided financial support to Hayek, enabling his appointment to the Committee on Social Thought at the University of Chicago, and Mises’s appointment at NYU, and other forms of research support to Hayek, Mises and other like-minded scholars, as well as funding the Mont Pelerin Society, an early venture in globalist networking, started by Hayek in 1947. Such support does not discredit the research to which it gave rise. That the survival of the Austrian School would probably not have been possible without the support of wealthy benefactors who anticipated that the Austrians would advance their political and economic interests does not invalidate the research thereby enabled. (In the interest of transparency, I acknowledge that I received support from such sources for two books that I wrote.)

Because Austrian School survivors other than Mises and Hayek either adapted themselves to mainstream thinking without renouncing their earlier beliefs (Haberler and Machlup) or took an entirely different direction (Morgenstern), and because the economic mainstream shifted in two directions that were most uncongenial to the Austrians: Walrasian general-equilibrium theory and Keynesian macroeconomics, the Austrian remnant, initially centered on Mises at NYU, adopted a sharply adversarial attitude toward mainstream economic doctrines.

Despite its minute numbers, the lonely remnant became a house divided against itself, Mises’s two outstanding NYU disciples, Murray Rothbard and Israel Kirzner, holding radically different conceptions of how to carry on the Austrian tradition. An extroverted radical activist, Rothbard was not content just to lead a school of economic thought, he aspired to become the leader of a fantastical anarchistic revolutionary movement to replace all established governments under a reign of private-enterprise anarcho-capitalism. Rothbard’s political radicalism, which, despite his Jewish ancestry, even included dabbling in Holocaust denialism, so alienated his mentor, that Mises terminated all contact with Rothbard for many years before his death. Kirzner, self-effacing, personally conservative, with no political or personal agenda other than the advancement of his own and his students’ scholarship, published hundreds of articles and several books filling 10 thick volumes of his collected works published by the Liberty Fund, while establishing a robust Austrian program at NYU, training many excellent scholars who found positions in respected academic and research institutions. Similar Austrian programs, established under the guidance of Kirzner’s students, were started at other institutions, most notably at George Mason University.

One of the founders of the Cato Institute, which for nearly half a century has been the leading avowedly libertarian think tank in the US, Rothbard was eventually ousted by Cato, and proceeded to set up a rival think tank, the Ludwig von Mises Institute, at Auburn University, which has turned into a focal point for extreme libertarians and white nationalists to congregate, get acquainted, and strategize together.

Isolation and marginalization tend to cause a subspecies either to degenerate toward extinction, to somehow blend in with the members of the larger species, thereby losing its distinctive characteristics, or to accentuate its unique traits, enabling it to find some niche within which to survive as a distinct sub-species. Insofar as they have engaged in economic analysis rather than in various forms of political agitation and propaganda, the Rothbardian Austrians have focused on anarcho-capitalist theory and the uniquely perverse evils of fractional-reserve banking.

Rejecting the political extremism of the Rothbardians, Kirznerian Austrians differentiate themselves by analyzing what they call market processes and emphasizing the limitations on the knowledge and information possessed by actual decision-makers. They attribute this misplaced focus on equilibrium to the extravagantly unrealistic and patently false assumptions of mainstream models on the knowledge possessed by economic agents, which effectively make equilibrium the inevitable — and trivial — conclusion entailed by those extreme assumptions. In their view, the focus of mainstream models on equilibrium states with unrealistic assumptions results from a preoccupation with mathematical formalism in which mathematical tractability rather than sound economics dictates the choice of modeling assumptions.

Skepticism of the extreme assumptions about the informational endowments of agents covers a range of now routine assumptions in mainstream models, e.g., the ability of agents to form precise mathematical estimates of the probability distributions of future states of the world, implying that agents never confront decisions about which they are genuinely uncertain. Austrians also object to the routine assumption that all the information needed to determine the solution of a model is the common knowledge of the agents in the model, so that an existing equilibrium cannot be disrupted unless new information randomly and unpredictably arrives. Each agent in the model having been endowed with the capacity of a semi-omniscient central planner, solving the model for its equilibrium state becomes a trivial exercise in which the optimal choices of a single agent are taken as representative of the choices made by all of the model’s other, semi-omnicient, agents.

Although shreds of subjectivism — i.e., agents make choices based own preference orderings — are shared by all neoclassical economists, Austrian criticisms of mainstream neoclassical models are aimed at what Austrians consider to be their insufficient subjectivism. It is this fierce commitment to a robust conception of subjectivism, in which an equilibrium state of shared expectations by economic agents must be explained, not just assumed, that Chancellor properly identifies as a distinguishing feature of the Austrian School.

Menger’s original idea of marginal utility was posited on the subjective preferences of consumers. This subjectivist position was retained by subsequent generations of the school. It inspired a tradition of radical individualism, which in time made the Austrians the favorite economists of American libertarians. Subjectivism was at the heart of the Austrians’ polemical rejection of Marxism. Not only did they dismiss Marx’s labor theory of value, they argued that socialism couldn’t possibly work since it would lack the means to allocate resources efficiently.

The problem with central planning, according to Hayek, is that so much of the knowledge that people act upon is specific knowledge that individuals acquire in the course of their daily activities and life experience, knowledge that is often difficult to articulate – mere intuition and guesswork, yet more reliable than not when acted upon by people whose livelihoods depend on being able to do the right thing at the right time – much less communicate to a central planner.

Chancellor attributes Austrian mistrust of statistical aggregates or indices, like GDP and price levels, to Austrian subjectivism, which regards such magnitudes as abstractions irrelevant to the decisions of private decision-makers, except perhaps in forming expectations about the actions of government policy makers. (Of course, this exception potentially provides full subjectivist license and legitimacy for macroeconomic theorizing despite Austrian misgivings.) Observed statistical correlations between aggregate variables identified by macroeconomists are dismissed as irrelevant unless grounded in, and implied by, the purposeful choices of economic agents.

But such scruples about the use of macroeconomic aggregates and inferring causal relationships from observed correlations are hardly unique to the Austrian school. One of the most important contributions of the 20th century to the methodology of economics was an article by T. C. Koopmans, “Measurement Without Theory,” which argued that measured correlations between macroeconomic variables provide a reliable basis for business-cycle research and policy advice only if the correlations can be explained in terms of deeper theoretical or structural relationships. The Nobel Prize Committee, in awarding the 1975 Prize to Koopmans, specifically mentioned this paper in describing Koopmans’s contributions. Austrians may be more fastidious than their mainstream counterparts in rejecting macroeconomic relationships not based on microeconomic principles, but they aren’t the only ones mistrustful of mere correlations.

Chancellor cites mistrust about the use of statistical aggregates and price indices as a factor in Hayek’s disastrous policy advice warning against anti-deflationary or reflationary measures during the Great Depression.

Their distrust of price indexes brought Austrian economists into conflict with mainstream economic opinion during the 1920s. At the time, there was a general consensus among leading economists, ranging from Irving Fisher at Yale to Keynes at Cambridge, that monetary policy should aim at delivering a stable price level, and in particular seek to prevent any decline in prices (deflation). Hayek, who earlier in the decade had spent time at New York University studying monetary policy and in 1927 became the first director of the Austrian Institute for Business Cycle Research, argued that the policy of price stabilization was misguided. It was only natural, Hayek wrote, that improvements in productivity should lead to lower prices and that any resistance to this movement (sometimes described as “good deflation”) would have damaging economic consequences.

The argument that deflation stemming from economic expansion and increasing productivity is normal and desirable isn’t what led Hayek and the Austrians astray in the Great Depression; it was their failure to realize the deflation that triggered the Great Depression was a monetary phenomenon caused by a malfunctioning international gold standard. Moreover, Hayek’s own business-cycle theory explicitly stated that a neutral (stable) monetary policy ought to aim at keeping the flow of total spending and income constant in nominal terms while his policy advice of welcoming deflation meant a rapidly falling rate of total spending. Hayek’s policy advice was an inexcusable error of judgment, which, to his credit, he did acknowledge after the fact, though many, perhaps most, Austrians have refused to follow him even that far.

Considered from the vantage point of almost a century, the collapse of the Austrian School seems to have been inevitable. Hayek’s long-shot bid to establish his business-cycle theory as the dominant explanation of the Great Depression was doomed from the start by the inadequacies of the very specific version of his basic model and his disregard of the obvious implication of that model: prevent total spending from contracting. The promising young students and colleagues who had briefly gathered round him upon his arrival in England, mostly attached themselves to other mentors, leaving Hayek with only one or two immediate disciples to carry on his research program. The collapse of his research program, which he himself abandoned after completing his final work in economic theory, marked a research hiatus of almost a quarter century, with the notable exception of publications by his student, Ludwig Lachmann who, having decamped in far-away South Africa, labored in relative obscurity for most of his career.

The early clash between Keynes and Hayek, so important in the eyes of Chancellor and others, is actually overrated. Chancellor, quoting Lachmann and Nicholas Wapshott, describes it as a clash of two irreconcilable views of the economic world, and the clash that defined modern economics. In later years, Lachmann actually sought to effect a kind of reconciliation between their views. It was not a conflict of visions that undid Hayek in 1931-32, it was his misapplication of a narrowly constructed model to a problem for which it was irrelevant.

Although the marginalization of the Austrian School, after its misguided policy advice in the Great Depression and its dispersal during and after World War II, is hardly surprising, the unwillingness of mainstream economists to sort out what was useful and relevant in the teachings of the Austrian School from what is not was unfortunate not only for the Austrians. Modern economics was itself impoverished by its disregard for the complexity and interconnectedness of economic phenomena. It’s precisely the Austrian attentiveness to the complexity of economic activity — the necessity for complementary goods and factors of production to be deployed over time to satisfy individual wants – that is missing from standard economic models.

That Austrian attentiveness, pioneered by Menger himself, to the complementarity of inputs applied over the course of time undoubtedly informed Hayek’s seminal contribution to economic thought: his articulation of the idea of intertemporal equilibrium that comprehends the interdependence of the plans of independent agents and the need for them to all fit together over the course of time for equilibrium to obtain. Hayek’s articulation represented a conceptual advance over earlier versions of equilibrium analysis stemming from Walras and Pareto, and even from Irving Fisher who did pay explicit attention to intertemporal equilibrium. But in Fisher’s articulation, intertemporal consistency was described in terms of aggregate production and income, leaving unexplained the mechanisms whereby the individual plans to produce and consume particular goods over time are reconciled. Hayek’s granular exposition enabled him to attend to, and articulate, necessary but previously unspecified relationships between the current prices and expected future prices.

Moreover, neither mainstream nor Austrian economists have ever explained how prices are adjust in non-equilibrium settings. The focus of mainstream analysis has always been the determination of equilibrium prices, with the implicit understanding that “market forces” move the price toward its equilibrium value. The explanatory gap has been filled by the mainstream New Classical School which simply posits the existence of an equilibrium price vector, and, to replace an empirically untenable tâtonnement process for determining prices, posits an equally untenable rational-expectations postulate to assert that market economies typically perform as if they are in, or near the neighborhood of, equilibrium, so that apparent fluctuations in real output are viewed as optimal adjustments to unexplained random productivity shocks.

Alternatively, in New Keynesian mainstream versions, constraints on price changes prevent immediate adjustments to rationally expected equilibrium prices, leading instead to persistent reductions in output and employment following demand or supply shocks. (I note parenthetically that the assumption of rational expectations is not, as often suggested, an assumption distinct from market-clearing, because the rational expectation of all agents of a market-clearing price vector necessarily implies that the markets clear unless one posits a constraint, e.g., a binding price floor or ceiling, that prevents all mutually beneficial trades from being executed.)

Similarly, the Austrian school offers no explanation of how unconstrained price adjustments by market participants is a sufficient basis for a systemic tendency toward equilibrium. Without such an explanation, their belief that market economies have strong self-correcting properties is unfounded, because, as Hayek demonstrated in his 1937 paper, “Economics and Knowledge,” price adjustments in current markets don’t, by themselves, ensure a systemic tendency toward equilibrium values that coordinate the plans of independent economic agents unless agents’ expectations of future prices are sufficiently coincident. To take only one passage of many discussing the difficulty of explaining or accounting for a process that leads individuals toward a state of equilibrium, I offer the following as an example:

All that this condition amounts to, then, is that there must be some discernible regularity in the world which makes it possible to predict events correctly. But, while this is clearly not sufficient to prove that people will learn to foresee events correctly, the same is true to a hardly less degree even about constancy of data in an absolute sense. For any one individual, constancy of the data does in no way mean constancy of all the facts independent of himself, since, of course, only the tastes and not the actions of the other people can in this sense be assumed to be constant. As all those other people will change their decisions as they gain experience about the external facts and about other people’s actions, there is no reason why these processes of successive changes should ever come to an end. These difficulties are well known, and I mention them here only to remind you how little we actually know about the conditions under which an equilibrium will ever be reached.

In this theoretical muddle, Keynesian economics and the neoclassical synthesis were abandoned, because the key proposition of Keynesian economics was supposedly the tendency of a modern economy toward an equilibrium with involuntary unemployment while the neoclassical synthesis rejected that proposition, so that the supposed synthesis was no more than an agreement to disagree. That divided house could not stand. The inability of Keynesian economists such as Hicks, Modigliani, Samuelson and Patinkin to find a satisfactory (at least in terms of a preferred Walrasian general-equilibrium model) rationalization for Keynes’s conclusion that an economy would likely become stuck in an equilibrium with involuntary unemployment led to the breakdown of the neoclassical synthesis and the displacement of Keynesianism as the dominant macroeconomic paradigm.

But perhaps the way out of the muddle is to abandon the idea that a systemic tendency toward equilibrium is a property of an economic system, and, instead, to recognize that equilibrium is, as Hayek suggested, a contingent, not a necessary, property of a complex economy. Ludwig Lachmann, cited by Chancellor for his remark that the early theoretical clash between Hayek and Keynes was a conflict of visions, eventually realized that in an important sense both Hayek and Keynes shared a similar subjectivist conception of the crucial role of individual expectations of the future in explaining the stability or instability of market economies. And despite the efforts of New Classical economists to establish rational expectations as an axiomatic equilibrating property of market economies, that notion rests on nothing more than arbitrary methodological fiat.

Chancellor concludes by suggesting that Wasserman’s characterization of the Austrians as marginalized is not entirely accurate inasmuch as “the Austrians’ view of the economy as a complex, evolving system continues to inspire new research.” Indeed, if economics is ever to find a way out of its current state of confusion, following Lachmann in his quest for a synthesis of sorts between Keynes and Hayek might just be a good place to start from.


About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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