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Saturday, January 14, 2012

Peter Boettke on Austrian Economics

The professor of economics discusses the contributions made by the Austrian School. He introduces recent books by Austrians, explains what we can learn from Mises and Hayek, and argues that economics is the sexiest subject

What is Austrian economics? How does it differ from standard economics?

Like a lot of things in economics, it’s the opponents that give the labels to people. The people who were practising economics at the University of Vienna thought they were just doing economics. It’s the critics who said, “Oh! That’s those Austrian economists.” It’s a label that gets to be associated with a set of propositions, both analytical – about the way you study economics, its methodology – and about the policy conclusions of economics. Representatives of that tradition came out of Vienna in the late 19th and early part of the 20th century. They then migrated to the London School of Economics, and to Switzerland, and eventually to the United States, where they held positions at places like Harvard, Princeton and Chicago. They coalesced around New York University, which became a hub of teaching Austrian economics.

So where are most Austrian economists now? Are they in the US?

It’s a worldwide movement, but I would say the place that has the strongest concentration of Austrian economists in the US is George Mason University. Outside the US, it’s probably Madrid, at King Juan Carlos University, and there is also Universidad Francisco Marroquin in Guatemala. Then there are a lot of people sprinkled here and there. It’s not necessarily full-blown Austrian economics. Here at George Mason as well, it becomes a mix and match of different ideas in economics that people find interesting.

Analytically, the biggest difference between the Austrians and their mainstream brethren is a focus on processes of adjustment and changing conditions, as opposed to static or equilibrium states of affairs. In a supply and demand curve, a standard economist would focus on the price and quantity vector that would clear the market. The Austrians want to talk about all the exchanges and activity that take place that results in that vector being discovered and the market being cleared.

Can you give an example?

Imagine if refrigeration wasn’t an option and you had some fish to sell. You start selling them at $10 a fish, and this many people buy the fish. After a while it slows down and you still have some fish remaining. As the day wears on you’re trying to get rid of the fish because they’re going to spoil. So you adjust your price down, you sell it at $8 a fish, or $6 a fish or $5 a fish. Eventually the market clears and all the fish find a buyer. In standard economics, we talk about the price and quantity vector that would clear that market, and the formal techniques of economics – a series of simultaneous equations – would get us to that vector. The Austrians don’t disagree with that price and quantity vector. But they want to talk about all the activity, a lot of which is what we call entrepreneurship – people adjusting the price, arbitrage opportunities and so on. Eventually you get to that vector, but your focus isn’t on the vector, it’s on all the stuff that goes on before it’s discovered.

From this example, and also from the books you’ve recommended, I get the sense that it’s a lot broader than regular economics?

Yes, because Austrians want to talk about the institutional environment within which economic activity takes place. They want to talk about cultural frames of reference that form the priors that rational actors have. They want to talk about the fact that we each have different priors, because we’re diverse individuals who have different perspectives on the world. Somehow, we have to reconcile these differences through the exchange processes in the market. So, the books series that I edit at Cambridge with Timur Kuran – it’s not an Austrian series, it’s just a straight-up economics series, but its title is “Cambridge Studies in Economics, Cognition and Society”. It’s a very broad notion of social science, of which economics is a part, rather than the idea that economics is somehow separated from all the social sciences.

Is Austrian economics considered “heterodox” by the mainstream establishment?

This is complicated because on the one hand it is. If you go to the official classifications in economics, and look up Austrian economics, it will be listed under modern heterodox economics. But in most cases, when people think of heterodox economics, it’s economics that challenges the basic presumptions of economists. So if you follow the debate that has been going on at Harvard, they had the walkout on Greg Mankiw’s class [Ec10, the basic economics class that Harvard offers as part of its core curriculum for undergraduates]. What the students object to is that Greg Mankiw teaches the invisible hand, ie how through the exchange process individual interests can be reconciled in the overall public interest. People think that’s too ideological. Then Steve Marglin [who teaches a course called Economics: A Critical Approach] did his talk on heterodox economics. He talks about the fact that markets are exploitative, there’s injustice, there’s irrationalities. For heterodox economists, markets don’t satisfy, they exploit. They deny the invisible hand. The Austrians don’t.

Imagine a two-by-two matrix, in which the rows are defined by whether you are dealing with a simple problem situation, or a complex problem situation. The columns are social order or social disorder. Then you look at the individuals pursuing their individual self-interest. What’s going to result? In simple problem situations – where agents are perfectly informed, they live in large number situations and are dealing with homogeneous products – you can get social order, because no one individual can influence the effect on any other individual. But once you introduce complexities into the system, the system no longer generates the invisible hand, and you can get disorder. So in a simple problem situation with free markets everything is popcorn and candy canes, and then we move to a complicated problem situation and we get unemployment and irrational exuberance etc. This is Keynesian economics and market failure theory – all very mainstream.

What Marxists believe is that even under simple problem situations, the market can’t do its job – you get monopolies, you get exploitation. Classical economists, Austrian economists, and New Institutional economists reside in the box that starts with a complex problem situation but nevertheless gets you social order. The way you do that is not based on the behavioural assumptions of the actors, but on the institutional assumptions underlying them, ie things like the political, legal and cultural context within which individuals engage and exchange. If that context is the right context, then even in the most difficult of situations, individuals can generate social order. They can cope with their ignorance, they can take care of uncertainty. When the market goes astray, it’s not because there is something wrong with the market mechanism, it’s because the rules under which the market mechanism operates have got distorted.

Are you saying mainstream economics can’t handle the complexities of the real world?

This is why methodology of the social sciences matters. It defines not only what we consider to be good questions, but probably more importantly what we consider acceptable answers. A lot of people within mainstream economics would like to handle complexity, and we see them constantly striving to do it, but they constrain their efforts by certain methodological straitjackets. They claim they have to fit things into formalistic models, otherwise it’s not a good answer. One of my favourite books is by Richard Nelson, who teaches at Columbia, about evolutionary economics. In that, he makes a distinction between what he calls “appreciative” theory and “formal” theory. What he means is that there is a theory that all economists agree to when they talk to one another about what goes on in markets, about entrepreneurship, about innovation.

Schumpeter uses the phrase “creative destruction”. For example, you have Tower Records, it does very well, then innovation comes in and eventually Tower Records goes out. We can tell the story about how markets operate in that way, and we can develop an appreciation for it. What we can’t do is put it in a model, and our formal, official theory is the modelling exercise. So there is this disjoint between the appreciative theory we can talk about, and the formal theory which limits what we can talk about to only those things that we can formally prove in a deductive model. Austrians aren’t challenging the appreciative theory of neo-classical economics. In fact they’re very much part of the neoclassical tradition. It’s just that the Austrians want to talk about things like dispersed knowledge, heterogeneity, uncertainty – not just risk, but real uncertainty – and institutions, how institutions arise to allow us to cope with our ignorance and our uncertainty and to ameliorate the frictions that exist in the world. Rather than seeing the frictions as the thing that destroys the model we have, or prima facie evidence that the market is not very efficient, they play a positive role.

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