austrian economics d. allen dalton econ 325 – radical economics boise state university fall 2012

Austrian Economics

D. Allen DaltonECON 325 – Radical Economics

Boise State UniversityFall 2012

Originsand

Development

Pre-History• Italian Subjectivist Tradition

– Pierre de Jean Olivi (1248-1298)– San Bernardino of Siena (1380-1444)– Ferdinando Galiani (1728-1787)

• School of Salamanca– Martin de Azpilcueta Navarrus

(1493-1586)– Luis de Molina (1535-1601)– Juan de Mariana (1536-1624)

Pre-History• French Tradition

– Richard Cantillon (1680?-1734?)• Essai sur la Nature du Commerce en General (1755)

– A.R.J. Turgot (1727-1781)• Reflections on the Formation and Distribution of

Wealth (1766)

– Etienne Bonnot de Condillac (1714-1780)• Commerce and Government (1776)

– Jean-Baptiste Say (1767-1832)• Treatise on Political Economy (1803)

– Frederic Bastiat (1801-1850)• “A Petition” (Petition of the Candlemakers) (1845)• Economic Sophisms (1845)

The Founders•Carl Menger

– Grundsatze (1871) trans. Principles of Economics• emphasis on causal-genetic

explanations• centrality of subjective utility,

uncertainty, adjustments in disequilibrium, and time

– Investigations on the Method of the Social Sciences (1883)• Methodenstreit

The Founders• Eugen von Bohm-Bawerk

(1851-1914)– Capital and Interest

(1884,1889,1912)• Mixture of productivity and time

preference theories of interest

– Karl Marx and the Close of His System (1896)• Critique of Marx, especially his

failure to solve the “transformation problem”

The Founders• Friedrich von Wieser (1851-

1926)– Natural Value (1889)

• cost is marginal utility foregone from application of unit of input to produce one good rather than another

• imputation problem; expected prices of first-order goods determine the prices of higher order goods

– Social Economics (1914)

20th Century Giants• Ludwig Mises (1881-1973)

– Theory of Money and Credit (1912)

– Socialism (1922)– Human Action (1949)

• Friedrich Hayek (1899-1992)– Prices and Production (1931)– The Pure Theory of Capital

(1941)– Individualism and Economic

Order (1948)

Renaissance• Murray Rothbard (1926-1995)

– Man, Economy and State (1962)– America’s Great Depression (1963)– Power and Market (1970)– An Austrian Perspective on the

History of Economic Thought (1995)

• Israel Kirzner (1930 - )– Competition and Entrepreneurship

(1973)– The Meaning of Market Process

(1992)

Modern Representatives• Roger Garrison

– Time and Money: The Macroeconomics of Capital Structure (2000)

• Steven Horowitz– Microfoundations and Macroeconomics (2000)

• Jesús Huerto de Soto– Money, Bank Credit, and Economic Cycles (2006)

• Roger Koppl– Big Players and the Economic Theory of Expectations

(2002)

• J. Guido Hulsmann– Mises: The Last Knight of Liberalism (2007)

• Walter Block– Labor Economics from a Free Market Perspective (2008)

Methodology

Methodology•Methodological Individualism•“A Priori” Method•Praxeology – science of human

action; logic of relationship between the categories of ends and means

•Critique of Mathematics and Econometrics in theory

Methodology• “..economics is not about things and

tangible material objects; it is about men, their meanings and actions.” – Mises, Human Action, p.92

• “Action is guided by plans, i.e., by thought, and all action has to be interpreted as the outward manifestation of such plans… In fact all phenomena are intelligible only as the oucome of planned action.” – Lachmann, “From Mises to Shackle,” p. 57

Methodology

• Nature of economics is that all economists can do is to attempt to explain the general patterns arising from choice

• Behavior is tied to individual perceptions of means and ends; problem of knowledge and expectations is of fundamental concern

• Economizing, not maximizing, behavior

AustrianMicroeconomics

Market as a Process•Critique of “Perfect Competition”

– “…the perfectly competitive model portrays (as does each and every equilibrium model of a market) a pattern of mutual anticipations and executed decisions which, if somehow attained, would lead no participant to wish that he had acted differently.” – Kirzner, “The Driving Force of the Market,” p. 39

Market as a Process• Critique of “Perfect Competition”

– “the model cannot be used to ‘explain’ market prices; the model presumes that everyone has, somehow, correctly and self-fulfillingly guessed what the market price is going to be. …the model treats each market participant as a price-taker…”

– Kirzner, “The Driving Force of the Market,” p. 39

Market as a Process•Hayek’s Foundational Articles

– “Economics and Knowledge”– “The Use of Knowledge in Society”– “The Meaning of Competition” (all in Individualism and Economic

Order)•Kirzner’s Competition and

Entrepreneurship

Market as a Process•“Equilibrium…exists if the

actions of all members of the society over a period are all executions of their respective individual plans on which each decided at the beginning of the period.” – Hayek, “Economics and Knowledge” p. 37

Market as a Process• “The problem which we pretend to solve

is how the spontaneous interaction of a number of people, each possessing only bits of knowledge, brings about a state of affairs in which product prices correspond to costs, etc., and which could be brought about by deliberate direction only by somebody who possessed the combined knowledge of all those individuals. But in our analysis…

Market as a Process• …instead of showing what bits of

information the different persons must posess in order to bring about that result, we fall in effect back on the assumption that everybody knows everything and so evade any real solution of the problem.”– Hayek, “The Use of Knowledge in

Society”

Market as a Process• “The overambitious plans of one

period will be replaced by more realistic ones; market opportunities overlooked in one period of time generate systematic alterations in the corresponding decisions for the succeeding period. Taken over time, this series of systematic changes in the interconnected network of market decisions constitutes the market process.” – Kirzner, C&E, p.10

Market as a Process• “As the market process unfold, with

one period of market ignorance followed by another in which ignorance has been somewhat reduced, each buyer or seller revises his bids and offers in the light of his newly acquired knowledge of the alternative opportunities…In this sense the market process is inherently competitive.” – Kirzner, C&E, , p. 12

Market as a Process• “Into… a world of men unable to learn…

introduce a group of outsiders who are able to perceive opportunities …where a good can be sold at a price higher than that at which it can be brought. This group of entrepreneurs…notice profit opportunities that exist because of the initial ignorance of the original market participants and that have persisted because of their inability to learn…” – Kirzner, C&E, , p. 14

Market as a Process• Revision of plans by disappointed

individuals constitutes the market process.

• Entrepreneurs, alert to unperceived opportunities, help in this revision of plans.

• As plans are revised, the subjective data on which individuals base their plans comes closer into correspondence with the objective data – reducing market ignorance.

Analytical Tools• Supply and Demand – distinction

between supply and production (supply curves are not based on production)

• Market period and reactions to disequilibrium

• Ordinal marginal analysis rather than indifference curve analysis

• Verbal rather than graphical analysis

AustrianMacroeconomics

Time and Money• Time is the medium of action in all

markets.• Money is the medium of exchange

in all markets• In “macroeconomics,” focus is upon

growth and deviations in production.

• Production takes time – as capital goods are turned into consumer goods.

Time and Money•Macroeconomics has to concern

itself with capital structure.•Money is a “loose joint” that

binds the supply of capital goods and the subsequent demand for the corresponding consumer goods.– Monetarist tight joint– Keynesian broken joint

Capital-Based MacroeconomicsBased on the Business Cycle Theory of Ludwig von Mises and F. A. Hayek

With acknowledgment to Professor Roger W. Garrison, Auburn University

Friedrich A. Hayek

1899 - 1992

Prices and Production (1931, 1935)

Nobel Prize in Economics

1974

--for pioneering work in the theory of money and economic fluctuations and for penetrating analysis of the interdependence of economic, social, and institutional phenomena.

Ludwig von Mises

1881 - 1973

“The period of production must be of such a length that exactly the whole available subsistence fund is necessary on the one hand and sufficient on the other for paying the wages of the labourers throughout the duration of the productive process.”

The Theory of Money and Credit

(1912)

The Elements of Capital-Based Macroeconomics

“Loanable funds” is the generic term that refers both to lending (which constitutes the supply side of the market) and to borrowing (which constitutes the demand side).

Each side of the market for loanable funds is governed by the rate of interest.

Saving, broadly conceived, underlies the supply of loanable funds.

The Market for Loanable Funds

Consumer borrowing is netted out on the supply side. That is, the focus is on the funds lent collectively by income-earners/savers to the business community. The demand for loanable funds represents demand by businesses for investment.

Capital-based macro features consumption and investment as alternative ways to use resources.

The alternative uses are depicted as a Production Possibilities Frontier (PPF).

Production Possibilities Frontier


The PPF shows the maximum sustainable level of output as a locus of points representing all possible combinations of consumption and investment for a fully employed economy.

Capital-based macro features consumption and investment as alternative ways to use resources.

The alternative uses are depicted as a Production Possibilities Frontier (PPF).


Consider a particular point on the frontier.

This point represents an economy that is fully employed (with the unemployment rate in the 5%-6% range). Hence, output is being produced at a sustainable rate.


Now consider a disequilibrium point inside the PPF.This point represents an economy in recession, producing fewer consumption goods and/or fewer investment goods than it could.

The distance below the frontier reflects the idleness of labor and other resources. The unemployment rate is higher than 6%, suggesting significant cyclical unemployment.

Consider a particular point on the frontier.

This point represents an economy that is fully employed (with the unemployment rate in the 5%-6% range). Hence, output is being produced at a sustainable rate.


This point represents an overheated economy. The unemployment rate is below 5%. The level of output is unsustainable. (Points very far beyond the PPF are, of course, literally impossible.)

Now consider a disequilibrium point beyond the PPF.

Increased saving moves the economy along the PPF in the direction of more investment; decreased saving moves the economy along the PPF in the direction of consumption.

As long as gross investment is greater than depreciation, the economy will grow, as will be represented by an outward shift in the PPF itself.

Investment in this framework is measured in gross terms. Suppose an investment of $600 billion is needed just to offset depreciation.

DEPRECIATION = $600

Beyond the two-way division of resource usage captured by the PPF, capital-based macro tracks the intertemporal allocation of investable resources.

Production time is measured along the horizontal axis.The vertical axis tracks the value dimension—with value at the end of the production process representing consumable output.

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At a given point in time, an ongoing production process is characterized by activities in all the separate stages.

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STAGES OF PRODUCTION Identifying the stages as

“mining” through “retailing” is only suggestive. The actual intertemporal structure of capital, of course, entails a complexity of interconnected production activities.

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For analytical purposes, the economy’s production process is conceived as a continuum of stages and is represented as goods in the making that gain value as they near completion.

The resulting figure is known as the Hayekian triangle.

First, it depicts the production process that plays itself out over time.

Second, it depicts the full complement of stages that exist at a given point in time; the second interpretation suggests that resources can be reallocated in either direction from one stage to another.

Integrating the Elements

The market for loanable-funds—a.k.a. investable resources—shows that the market-clearing rate of interest is 5%, at which saving and investment are in equilibrium at $800 billion.

The PPF shows that with $800 billion committed to investment activities, $2200 billion are available for current consumption.

The market for loanable-funds—a.k.a. investable resources—shows that the market-clearing rate of interest is 5%, at which saving and investment are in equilibrium at $800 billion.

The Hayekian triangle depicts current consumption as the output of the economy’s multi-stage production process. The rate of interest governs the allocation of resources among the stages.

The slope of the hypotenuse of the Hayekian triangle reflects a rate of interest consistent with the rate that prevails in the loanable- funds market.

An initial full-employment equilibrium is defined by:

the Loanable-Funds Market,the PPF,

the Hayekian Triangle,...

…plus the representative stage-specific labor markets.

If gross investment needed to offset capital depreciation is $600 billion, the economy is experiencing net investment of $200 billion.

$600

This additional capital is distributed among the stages of production in accordance with an unchanged rate of interest.

$600

The increase in productive capacity and hence in output is depicted by a shifting outward of the PPF and by a corresponding shifting of the supply and demand for loanable funds.

Watch the economy grow!

Saving as a Basis for Sustainable Economic Growth

The supply of loanable funds registers people’s current saving preferences.

Changes in saving behavior for the economy as a whole can stem from a change in demographics or from a change in attitudes toward saving.

Suppose that, for whatever reason, people decide to save more.

The supply of loanable funds registers people’s current saving preferences.

Changes in saving behavior for the economy as a whole can stem from a change in demographics or from a change in attitudes toward saving.

Suppose that, for whatever reason, people decide to save more.

The loanable funds market strikes a new equilibrium.

Both saving and investment increase to $1,000 billion.

The PPF shows how the increased saving affects the mix of consumption and investment.

For a given income, saving more means consuming less.

The economy moves along the frontier, as current consumption is reduced from $2,200 billion to $1,780 billion.

Resources are shifted away from production activities aimed at the present and near-future and toward production activities aimed at the more remote future.

The PPF shows how the increased saving affects the mix of consumption and investment.

For a given income, saving more means consuming less.

A reshaping of the Hayekian triangle mirrors the move-ment along the PPF in the direction of investment and depicts the change in the time dimension in the production process.

With reduced consumption demand, the derived demand for labor and other factors of production in the late stages is reduced as well.

In the early stages, demand for labor and other factors of production is increased, as the interest-rate effect more-than-offsets the derived-demand effect .

A wage-rate differential during the capital restructuring encourages workers to move from late stages to early stages.

Watch the economy respond to an increase in saving.

A saving-induced reallocation of resources among the stages of production skews the pattern of consumable output toward the future.

People don’t just save; they save-up-for-something. Consumption is down only temporarily—during the transition to new growth path.

Early-stage investments during this transition allow the increased future demands for consumption goods to be accommodated. The economy grows more rapidly than before.

Now watch the economy grow!

Now watch the economy grow!

Legislating Low Interest Rates

Accelerated growth driven by an increase in saving entails a market process in which the interest rate falls and investment increases.

Policymakers may misunderstand the nature of the process and believe that low interest rates (rather than increased saving) is the cause of the increased growth rate.With this understanding in mind, Congress might enact an interest-rate ceiling, prohibiting a yield of more than, say, 2.3% on financial assets.

The result would be a credit shortage, which would be apparent as soon as the legislation went into effect.


Policymakers may misunderstand the nature of the process and believe that low interest rates (rather than increased saving) is the cause of the increased growth rate.With this understanding in mind, Congress might enact an interest-rate ceiling, prohibiting a yield of more than, say, 2.3% on financial assets.


Policymakers may misunderstand the nature of the process and believe that low interest rates (rather than increased saving) is the cause of the increased growth rate.With this understanding in mind, Congress might enact an interest-rate ceiling, prohibiting a yield of more than, say, 2.3% on financial assets. The result would be a credit shortage, which would be apparent as soon as the legislation went into effect.


Policymakers may misunderstand the nature of the process and believe that low interest rates (rather than increased saving) is the cause of the increased growth rate.

With the yield on financial assets held to 2.3%, the yield on real assets would rise to 7.7%, as indicated by the demand price.

With this understanding in mind, Congress might enact an interest-rate ceiling, prohibiting a yield of more than, say, 2.3% on financial assets.


Policymakers may misunderstand the nature of the process and believe that low interest rates (rather than increased saving) is the cause of the increased growth rate.With this understanding in mind, Congress might enact an interest-rate ceiling, prohibiting a yield of more than, say, 2.3% on financial assets. With the yield on financial assets held to 2.3%, the yield on real assets would rise to 7.7%, as indicated by the demand price.

In the face of diminished incentives to save, people begin consuming more.

Foiled by the interest-rate ceiling, people increase their consumption to $2,480 billion, moving the economy counterclockwise along the PPF.

There is now a premium on producing for the present. Labor and other resources are bid away from early stages of production and into late stages. The value added at each stage reflects the yield on real assets of 7.7%.

The market-clearing wage rate for late-stage labor will be higher than the market-clearing wage rate for early-stage labor during the period that the intertemporal capital structure is adjusting to the credit ceiling.

Now, watch the economy react to a credit ceiling.

Manipulating Interest Rates with Money

A lower interest rate imposed on the market by direct legislation has a negative effect—and one that becomes apparent almost immediately.

A seemingly positive effect—though only a temporary one—can be achieved if the interest rate is lowered not by an act of Congress but rather by an act of the central bank.

The Federal Reserve can increase the money supply by lending into existence an additional quantity of money.

Injecting money so as to drive the interest rate down to 2.3% is equivalent—at least in its initial effects—to imposing an interest-rate ceiling of 2.3% and then “papering over the credit shortage” with newly created money.

Padding the supply of loanable funds with new money drives a wedge between saving and investment.

The easy-money policy obscures the resulting reduction in saving while it spurs on investment activities with a ready supply of credit at a low rate of interest.

Whereas the problems of an interest-rate ceiling are immediately apparent, the problems of a credit expansion are pushed into the future—and are allowed to fester until they eventually do become apparent.

The conflicting market forces pit consumers against investors in a tug-of-war.

The conflicting market forces pit consumers against investors in a tug-of-war.With less saving and more spending, the behavior of consumers is consistent with a counterclockwise movement along the PPF. But with production decisions governed by a low interest rate, the behavior of investors is consistent with a clockwise movement along the PPF.

Together, consumers and investors push the economy beyond its PPF.

The conflicting market forces pit consumers against investors in a tug-of-war.

The policy-induced combination of consumption and investment is unsustainable….

…but politically popular,

The conflicting market forces pit consumers against investors in a tug-of-war.Together, consumers and investors push the economy beyond its PPF.



The policy-induced combination of consumption and investment is unsustainable….…but politically popular,

…regardless of party.

Excessively long-term projects are initiated at the same time that consumer demand is unusually high.

The “wedge” and “tug-of-war” translate into a distortion of the structure of production.

The Hayekian triangle is being pulled at both ends against the middle. The market process is set against itself as investors and consumers respond in their own way to a low rate of interest.

The resources committed to the early stages of production constitute “malinvestment.”

At the same time, other resources are allocated to the late stages in response to the “overconsumption.”

The specific course of the boom-bust cycle beyond the initial mal-investment and overconsumption is not wholly determinate. Changes in the structure of pro-duction reflect capital durability, specificity and the particular pattern of complementarity and substitutability.

For a time, increased consumption and increased investment have their separate effects. The economy moves beyond the PPF, producing an unsustainable level of output.

There is an investment bias in the allocation of resources, however—as the business community tries to take advantage of the artificially low rate of interest and at the same time satisfy increased consumer demand.

The tug-of-war between consumption and investment is partially won by the investment, if only because it has more “pull”—the new money being lent predominantly to businesses.

The lacking of capital and other resources complementary to those already committed to the production process eventually brings the boom to an end and returns the economy to its PPF.

The initial movement of the economy beyond the PPF constitutes overconsumption (the upward movement) and overinvestment (the rightward movement).

The discoordination of the economy characteristic of a policy-induced boom-bust cycle sets the stage for a secondary contraction—a spiraling of the economy to some point inside the PPF.

In this phase of the cycle, a collapse of the money supply can give leverage to the contraction, making the depression much deeper than can be accounted for solely in terms of the prior misallocation of resources.

Watch the economy respond to an injection of money through credit markets!

Roger Garrison, Time and Money: The Macroeconomics of Capital Structure, London: Routledge, 2001.

F. A. HAYEK

Excerpts from the book plus some supplementary material can be found at http://www. auburn.edu/~garriro

Time and Money develops and defends this capital-based macroeconomic framework and compares it to the alternative frameworks associated with Keynesianism and Monetarism.

Going beyond the issues of growth and cyclical variation, the book also deals with deficit spending, credit controls, tax reform, and more.

AustrianPolitical Economy

Normative Criteria and Policy Espousal

•Success at plan coordination rather than success at resource allocation

•“Free Market”•Generally critical of price and

incomes policies•Market liberal to individualist

anarchist

austrian economics d. allen dalton econ 325 – radical economics boise state university fall 2012

Documents

economic order

economic cycles

economic sophisms

history of economic

oucome of planned action

theory of money

methodologynature of

pure theory of capital