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Austrian Economics

[A few disclaimers:  First, this post is very critical of Austrian economics.  For the record there are a lot of things I like about the school but I don’t think those things need to be said as much as these things.  The tone gets a little more hostile than I intended but that should give you some idea of the tension between Austrian and mainstream economics.  Second, these criticisms are motivated mainly by my interactions with the current “pop-Austrian” school that is all over the internet these days (mainly centered around mises.org).  This is the version of Austrian economics that my readers are most likely familiar with but there may be some who claim this is not representative of true Austrian economics.  For a similar argument from someone much closer to the school check out this debate between Caplan and Boettke.  I started you off on part 4 because it basically summarizes my view of Austrian economics (though it’s a little more diplomatic).  I recommend watching the whole thing though, it’s pretty interesting.]

A friend recently asked me “if Austrian economics doesn’t believe in theory or empirics how can they ever win?”  My answer was that they can’t, although that’s not a completely accurate characterization of them.  She asked me this, I think, under the impression that I was an Austrian.  In fact I’ve been getting that a lot lately.  When I was interviewing for my last teaching job they asked me how I felt about UW and I said if I had it to do over again I probably would have gone someplace more fresh water and that I was more of a Milton Friedman-free market-type.  Admittedly, I went about it this way because I didn’t want to highlight my Austrian tendencies.  To my surprise, during my first week on the job one of the professors came into my office and said he had a couple of students that were into Austrian economics and he told them they should come talk to me as the resident Austrian.  I said, a bit flustered, “I’m actually not an Austrian… but that’s cool I’d love to talk to them.”

Then like a week later, another professor passed me in the hall with a brown-bag schedule (that’s where professors give a little talk to other professors about whatever they are working on) and he said “hey Mike, you wanna give one on Austrian economics?”  And again I replied “I’m not an Austrian, but I guess I can do that, although it will be largely about what’s wrong with it.”  For some reason everyone thought I was an Austrian!  But I never claimed any kind of affinity to this school.  What I did claim affinity for was free markets, as well as a general disdain for government meddling in the economy, including in the monetary system.  But then I thought about it: what else could I be?

Here is the Wikipedia page on modern schools of economics.  As you can see, there is mainstream, Austrian, Marxian, and institutional.  Let’s start with mainstream:

It begins with the premise that resources are scarce and that it is necessary to choose between competing alternatives. That is, economics deals with tradeoffs. With scarcity, choosing one alternative implies forgoing another alternative—the opportunity cost. The opportunity cost expresses an implicit relationship between competing alternatives. Such costs, considered as prices in a market economy, are used for analysis of economic efficiency or for predicting responses to disturbances in a market . . . Economists represent incentives and costs as playing a pervasive role in shaping decision making.

OK, that’s great, sign me up!

 . . . Mainstream economics also acknowledges the existence of market failure

OK, no problem, that’s a given.

. . .  and insights from Keynesian economics

Whoa, hold on!  Keynesian economics?  Didn’t I read somewhere that Keynesian economics  is a model with no scarcity and no tradeoffs?  So if I don’t believe in Keynesian economics because it doesn’t “begin with the premise that resources are scarce and that it is necessary to choose between competing alternatives,” am I in or out of the mainstream?  Apparently this makes me out.  If I’m out then what am I?  I’m not an institutionalist and I’m certainly not a Marxist.  I must be an Austrian!  After all I like free markets and they like free markets.  I like free money, they like free money.  I don’t understand why everyone else thinks the previous two statements are not redundant, they don’t…….. well you get the idea.

Unfortunately there are some serious problems with Austrian economics.

Austrians don’t dislike models, they just don’t like math.  I think this is a major plus with a lot of casual economists.  The problem is that math is a really handy modelling tool.  Indeed, in the words of Sir Francis Bacon: “If in other sciences we should arrive at certainty without doubt and truth without error, it behooves us to place the foundations of knowledge in mathematics.”   Austrians come up with philosophical reasons to avoid using complex math but these often only make sense if you don’t know much about math.  And the problem is that avoiding math allows you to be very inconsistent.

For instance, Austrian economists supposedly don’t believe in cardinal utility.  Mainstream economists also supposedly don’t believe in cardinal utility.  The Austrian approach to the matter is to say that you can’t perform any mathematical operation on an ordinal value therefore you can’t do anything with a utility function so everything mainstream economics does with utility functions is inappropriate.  This seems very plausible if you don’t really understand what mainstream economists are doing with utility functions.  On the other hand here is an excerpt from my graduate micro text:

Toward the end of the nineteenth century, perhaps initially from introspection, the concept of utility as a cardinal measure of some inner level of satisfaction was discarded.  More importantly, though, economists, particularly Pareto, became aware that no refutable implications of cardinality were derivable that were not also derivable from the concept of utility as a strictly ordinal index of preferences.  As we shall see presently, all of the known implications of the utility maximization hypothesis are derivable from the assumption that consumers are merely able to rank all commodity bundles, without regard to the intensity of satisfaction gained by consuming a particular commodity bundle . . .

. . . To say that utility is an ordinal concept is therefore to say that the utility function is arbitrary up to any monotonic (i.e., monotonically increasing) transformation.

In other words, when mainstream economists say they are only using cardinal utility, they mean that all of their implications are robust to any monotonic transformation of the utility function.  This is quite reasonable if you are concerned about the philosophical implications of cardinal utility.  But if someone doesn’t know what “monotonic transformation” means, then they don’t realize that this is reasonable, and it is very difficult to explain it to them.  I don’t want to beat up on the guy I was talking to in that post, he’s not an economist.  But the reason that began was a post in which an Austrian unwittingly built a theory on cardinal utility and nobody noticed.  In fact, I was looking for that article just now (I thought the link was in my post but apparently not) and I couldn’t find it but I found this one.

In the above post, the author explains the diamond water paradox which is a famous economic problem that has been solved for hundreds of years.  But the explanation has a glaring error.  There is no law of diminishing marginal utility.  There is a law of diminishing marginal value.  If you substitute value for utility, then everything he says is correct.  But you can easily get diminishing marginal value–and therefore the diamond water paradox–with increasing marginal utility.  But Austrians don’t get the difference between value and utility because they don’t even think about it because they refuse to consider a model with a mathematical utility function.  This prevents them from realizing that they are actually using cardinal utility all over the place!

If this is over you head, I’m not surprised, this is complicated stuff and requires careful attention.  But that’s exactly the problem with this amathematical (if I may) approach.  It prevents you from focusing on it in a way that is really beneficial to understanding what is going on.  As a case in point take this guy.

Why do individuals pay much higher prices for some goods versus other goods? The common reply to this is the law of supply and demand. But what is behind this law? To provide an answer to this question economists refer to the law of diminishing marginal utility.

At that point, most people stop listening. Too technical for me! But in fact, it is not. The concept of marginal utility is the essential building block of a sound theory of human action as it applies in the science of economics. But too often, the mainstream theory is misleading. So I offer this Austrian attempt to demystify the idea.

The problem is, it sort of is rocket science.  Or at least it’s pretty difficult.  And he is making it seem simple because he doesn’t really get it.  And he is completely mischaracterizing the mainstream view.

Mainstream economics explains the law of diminishing marginal utility in terms of the satisfaction that one derives from consuming a particular good. For instance, an individual derives vast satisfaction from consuming one cone of ice cream. The satisfaction he will derive from consuming a second cone might also be vast but not as vast as the satisfaction derived from the first cone. The satisfaction from the consumption of a third cone is likely to diminish further, and so on.

Mainstream economics doesn’t have a law of diminishing marginal utility.

In the mainstream way of thinking it is not individuals but a given hard-wired valuation scale in their minds that decides what is good for them. The prices of goods in the mainstream way of thinking are established by mechanical shifts in supply and demand curves. This framework depicts human robots rather than human beings.

If the selection of goods is set mechanically, how in the world can one talk about utilities and choices? Without conscious, purposeful conduct, the use of the word “utility” is a contradiction in terms. After all, the benefit that a good provides must be in relation to individuals’ particular ends and their particular set-up.

Contrary to mainstream thinking, the Austrian framework shows that it is the importance of various ends that determine the selection of goods by individuals. The means-end framework also shows that the prices of goods are not set mechanically by some kind of supply-demand curves but by the goal-seeking choices of individuals.

Supply and demand curves are determined by the goal-seeking choices of individuals!  These choices are necessarily dependent on a “given hard-wired valuation scale in their minds that decide what is good for them.”  There’s no difference between these two approaches.  OK I’m getting heated reading this and it’s turning into a rant so I will resist the temptation to critique every line in the post.

For the record, I should say that mainstream economics frequently invokes diminishing marginal utility as well.  And admittedly they probably don’t realize it a lot of the time.  But if I went to one of them and pointed it out, I’m pretty sure that in fairly short order we would come to the understanding that they were in fact doing it and they would shrug and say “ok but it still makes my point, and I could do it with ordinal utility it would just be more complicated.”  And most of the time I would agree.  But you can’t even have this conversation with Austrians.

The Austrian refusal to consider any model containing any but the simplest math has two serious consequences.  First is that they make mistakes.  Second is that they don’t really understand what mainstream economists are doing.  So when a mainstream economist reads a critique from an Austrian he gets a paragraph in and decides that the Austrian doesn’t really know what he’s talking about and there’s no point in arguing with him or paying attention to him.  So there’s basically no communication possible between these schools.  Their critiques are not targeted at mainstream economists.  Thy are targeted at non-economits.  This brings me to my next big criticism.

Austrian economics is not a science it’s a religion.  What I mean by this is that it is not attempting to discover how the world works.  It thinks it knows how the world works and all of its energies are focused on gaining converts to their ideology.  This is not meant as a backhanded swipe at religion, but religions should stay in their place and sciences should stay in theirs.  There are definitely valuable insights in Austrian economics.  Many of these are incorporated into mainstream economics.  Some of them are undeserving overlooked.  But Austrian economists don’t spend any effort questioning them so it is impossible for them to come to the conclusion that Carl Menger might have been mistaken about something.  Doing this would be like a Christian saying “I agree with most of what Jesus taught but I think he was wrong about _________.”  This is not allowed.  That meme works alright if the person/entity in which you put your faith is right about everything but unfortunately Carl Menger is fallible.

As an illustration of this phenomenon check out this correspondence between myself and mises.org reproduced word for word:

Me: Regarding your post looking for people to write for the Mises blog, are you interested in things that are not entirely “steeped in Austrian tradition?”  I’m very friendly to the basic tenants of Austrian economics but I would like to challenge some of the finer points.  I think I could generate some good discussion.

Them: I’m sure you can find libertarian venues for such pieces, but that is not what Mises Daily is looking for.

The consequences of this are twofold.  First, the discipline does not evolve.  And indeed I suspect that Christian theology has advanced more in the last 50 years than Austrian economics.  To see what I mean just go to mises.org and ask a question about anything and I can almost guarantee you that their response will be to tell you to read a 50-year-old book.  Second, if you only listen to Austrians you are listening to the same arguments people were having a hundred years ago (sometimes more).  This would be fine if the other side were still making the same arguments that the other side was making a hundred years ago but this is not the case.  So an Austrian will hear Paul Krugman claim that more government spending is needed to save the economy and launch into a lesson on the broken window fallacy [follow up] [follow up 2].

The broken window fallacy is a perfectly good lesson and it is worth everyone learning.  But it’s not the end of the story here.  This is because the other side has spent a century building a system that doesn’t function like a natural economy.  In the early stages of this, Austrians objected based on well-founded notions of how a natural economy works.  But the boat left without them and it turned into a religion.  So it is stuck in that place.  It is a strange combination of reasonable (though not flawless) analysis of natural economic systems and warnings about the danger of erecting a system that was erected a hundred years ago.  But these things are not adequate for analyzing the short-term workings of that machine.   And because of this they are not adequate for combating that machine.  In order to do this the theory would have to evolve.

When Paul Krugman calls for more government spending, it’s not the same argument that Bastiat was facing.  But Austrians just hear “government spending” and assume it is.  They are right about the big things but they are wrong about the details.  They are right that government spending doesn’t create wealth and that the monetary system is destructive but they refuse to put the two together and admit that it’s possible that government spending could mitigate the destruction.  I’m not saying that is a good justification for it, but once you see it that way it is a good justification for escaping the whole system.  Unfortunately Austrian economics cannot communicate this to mainstream economists because they don’t speak the same language and they can’t communicate it to the masses because most people will see that they are wrong about the details and assume they are wrong in general.

If you reread the excerpt from my economic text above, you will see that the issue of cardinal vs. ordinal utility was settled a century ago and Austrians won!  But they are still fighting that battle because they don’t realize that they won because they don’t get what mainstream economists are doing with utility because they refuse to do any real math.

Finally, as a result of the two above shortcomings: aversion to math and inability to evolve, Austrians, while correct that the system is doomed to failure, are wrong about the way in which it will fail.  In fact they have it exactly backward.  I have written about the details of this so I won’t go into it here.  And I even tried pretty hard to explain it to Austrians.  I even read the 50 year old book they told me to, and carefully critiqued it.  And I know that some of them looked at it because after I posted that on Mises.org I had the most hits in the history of this blog.  But nobody (at least no Austrians) bothered to either refute or agree with what I said.  And if you spend much time on their site, you know that this is an unusual occurrence.  They were more than happy to argue with me when they thought I was making the typical Keynesian argument that they have been combating for 100 years.  But once it becomes clear that I actually know what I’m talking about they get suspiciously silent.

So how can they win?  This really depends on what you mean by win.  If winning involves the advancement of economic though they are simply not built for this.  There are two kinds of people in the world: people who want to be good and people who want to get better.  As a school the Austrians are the former.  They wake up each day thinking about how they can convince people that they are right.  They don’t wake up and think about how they might be wrong.

If winning means gaining a lot of followers, they can’t win because their details are wrong.  [Haha I tricked you it doesn’t depend on what you man by win at all!]  They are gaining support recently largely because they predicted a financial crash.  But they’re pretty much always predicting a crash.  If the economy comes back their support will disappear.  I don’t think that’s going to happen any time soon but it’s not impossible.  Furthermore, a lot of the things they advocate for would cause another crash.  This means that they are incredibly vulnerable to economic events.  For instance, if the government cut spending or the Fed stopped printing money like crazy, holding all other things equal, it actually would crash the economy.  When this happens the other side will say “see look, we tried it your way and it was a catastrophe, now we have to do the Keynesian thing and expand the government and monetary authority.”  And what will the masses do then?

Ultimately, in order to win in either of the above ways, a school of though, like a person, must be both consistent and correct.  The Austrian school, alas, is neither of these and, in my opinion, is incapable of becoming them.  And I say this as someone who genuinely wants all the things that Austrians want.  So what is a freedom-loving economist to do?

For the casual economist, I’m not saying you shouldn’t study Austrian economics but don’t get sucked into it.  Make sure you keep an open mind and look at other points of view.  There isn’t much else out there if you are into things like liberty, and free markets unfortunately.  For my part I will try to provide such an alternative.  Stay tuned for more on that front.

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  1. December 20, 2011 at 3:09 am

    Very interesting. I’ve noticed that Austrians, although they predicted the housing bubble and financial crisis, have incorrectly predicted hyperinflation. They have rejected so much of mainstream economics that they are able to predict the final outcome, but not the details leading up to the final conclusion.

    Also, the Austrians should really do some research on “shock therapy” in the Soviet Union. I don’t know how much research you’ve done on this topic, but when the former countries of the Soviet Union transitioned from a planned economy to a (mostly) market economy there were huge problems. Their economies recovered and had dramatic improvement thereafter, but there were some huge short-run consequences.

    This makes me worry about the effectiveness of Ron Paul’s plan to cut $1 trillion of government spending in year one if he were to be elected. It would be great in the long-run, but the short-term consequences of such a plan are unpredictable (at least to me right now). There could be adverse effects, which could be bad for libertarianism in the long-run. What do you think?

  2. Free Radical
    December 20, 2011 at 5:52 am

    They don’t even have the details of the final outcome correct. Hyperinflation will never happen in this country (unless we completely change the rules anyway). Deflation is the thing that will likely bring it down.

    I don’t know that about the former Soviet republics but I feel like a lot of them (like Russia) didn’t really become that free. Nonetheless it would be very disruptve to turn the ship around at this point. It’s almost unthinkable that we could do it deliberately with our current culture. You could cut government spending and be fine as long as the monetary situation was ok. The real problem would be unraveling the Fed. Actually, though I have a pretty good solution to this. I haven’t bothered writing it down because the will isn’t really there but it would probably something people would like to read so I’ll probably do it just for fun.

    • February 4, 2013 at 6:22 am

      whean you have to buy a gift for your friend or faimly member why not get them a book or a gift from this web site and e mail sean hannity and ask him to have ron paul on his show also ask greta van sustren to have ron paul on her show and e mail fox and friends and askron paul to be on their show

  3. Free Radical
    December 20, 2011 at 6:30 am

    Oh BTW, Thomas! Please tell me you get the difference between utility and value….Please!

  4. December 27, 2011 at 9:56 am

    You should definitely write up your solution to the monetary problem. I would love to read it.

    I’m a little confused about the nuances between utility and value, or is it more than a nuance? I understand diminishing marginal value but isn’t utility just the value I derive from consuming some good? You should try to explain this to me.

  5. Free Radical
    December 27, 2011 at 7:55 pm

    Value is what you are willing to give up for a good, it’s not measured in utiles it’s measured in other goods (or in money representing other goods) which you could get instead. Utility is a function representing you ordinal preferences between different bundles of goods. Since utility is ordinal, any monotonic transformation of a given utility function is just as good (gives the same conclusions) as another which means you can easily use a utility function with increasing marginal utility to derive all the standard results of consumer theory.

    What you need to get an interior solution is convex indifference curves. This means that the marginal rate of substitution (MRS) must be decreasing as you get more of the good. MRS, you may recall is the amount of the other good you must give up to remain on the same indifference curve when you get more of one good. In other words it is the amount of the other good you are willing to give up for more of one good. In other other words it is marginal value. But, as I said, you can get diminishing marginal value (convex indifference curves) with increasing marginal utility. For instance try deriving demand curves for X and Y from this utility function:

    U=XY

    You will find that they look just like normal demand curves. Then you can plug these into the utility function and get utility as a function of income and you will see that it is increasing at an increasing rate as income increases.

    Then for extra credit try doing the same for this one.

    U=(XY)^2

    You will find that you get exactly the same demand curves because this is a monotonic transformation of the utility function above, which means it preservs the ordinal rankings. Now utility will be increasing even faster when income increases. The point of ordinal utility is basically that we don’t care how much utility increases when income increases because this isn’t the point of a utility function. The point is to generate marginal values (basically) and these two functions generate the same MRS which means the same demand curves (since the height of demand is MV).

    Once you get this read those posts on Mises.org and you will never be an Austrian. Also I will be very gratified. (=

  1. December 29, 2011 at 8:26 am
  2. February 24, 2013 at 8:42 am

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