Right Reason

The Austrians and the New Classicals: One Strand of Thought?

 

 

 

"Normal science" means research firmly based upon one or more past scientific achievements, achievements that some particular scientific community acknowledges for a time as supplying the foundation for its further practice. 

-Thomas Kuhn, The Structure of Scientific Revolutions

 

Comparisons between the Austrians and the New Classicals are nothing new. The New Classicals often thought of themselves as continuing the Austrian project of theorizing by embracing equilibrium-theories of the business cycle inspired by Hayek’s work in the twenties. Alex Tabarrok wrote that has argued that Robert Lucas is the greatest Austrian economist of the 20^th century. The controversy now continues. 

In his blog, “Noahopinion”, Noah Smith argues that the New Classicals drank the Austrians' milkshake. They took what was worthwhile within the Austrian research program, and advanced it further than any Austrian has been able to. The problem with Smith’s argument is that even though there is much that the Austrians and New Classicals agree on, the disagreements between the two are far too many for the New Classicals and Austrians to be continued a single strand of thought. Those differences are brought to light when we consider that the New Classicals, who could very much be considered heirs to the techniques of the Market Socialist Oskar Lange, cannot make sense of the Austrian critique of socialism within their way of doing economics. 

  

The most major difference between the paradigm of Mises and Hayek, and that of Prescott and Lucas is not what they think about issues that Smith brings up like mathematics or disagreements about the nature of the business cycle. The most important differences, which informs the two paradigms’ very outlook is that that the two are contradictory in their answers to what economics is largely about. Whereas the Austrians focus on questions of how the order of the market order emerges, the New Classical assumes that order in their difference equations. 

The most succinct expression of the outlook of the Austrian school comes from Hayek in The Fatal Conceit when he wrote that “The most curious task of economics is to demonstrate to men just how little they really know about what they imagine they can design” (Hayek 1988, 76). On the other hand, in “Methods and Problems in Business Cycle Theory”, Lucas asserted: “One of the functions of theoretical economies is to provide fully articulated, artificial economic systems that can serve as laboratories in which policies that would be prohibitively expensive to experiment with in actual economies can be tested out at much lower cost.” Hayek’s vision of economics is to warn against the very intentions of Lucas: that no human being can have sufficient knowledge to design an economic order, it can only emerge from market process. There is an extreme tension here which betrays the radical difference between the two paradigms, and it is all made manifest by thinking about the Socialist Calculation Debate.

 

We must keep in mind that the Austrian economists' crowning achievement to this day is their proof of the impossibility of socialism during the Socialist Calculation Debate. Within that debate, Mises and Hayek argued that the socialist vision that an economic order could be created by the planning of one or many human minds was impossible, and that the only way for an economic order to come about was through the use of prices. Their legacy is in part built upon their work against socialist in the ‘20s, ‘30s, and 40’s. Anyone who wants to lay claim to improving upon the Mises-Hayek paradigm has to be able to capture the lessons of the Mises’ seminal article “Economic Calculation in the Socialist Commonwealth.” The New Classicals, with their emphasis on the important of analgoue economies. simply cannot do that. 

Even though Lucas emphasizes that we must be mindful of the difference between real and toy economies, the notion that economists could even sufficiently approximate the nature of the economy  in theory would be absurd to both Mises and Hayek. Neither Austrian would have anything to do with statements like:

On this general view of the nature of economic theory then, a ‘theory’ is not a collection of assertions about the behavior of the actual economy but rather an explicit set of instructions for building a parallel or analogue system - a mechanical imitation economy. A ‘good’ model from, this point of view, will not exactly be more ‘real’ than a poor one, but will provide better imitations (Lucas, 1980).

If Mises and Hayek were to read that quote, I bet they would be reminded of Oskar Lange’s argument that socialism could work because the central planning board could serve the function of the Walrasian auctioneer, and direct the use of factors of production with knowledge of their marginal costs. The Austrians disagreed, and Mises shot the first shot in 1920 with “Economic Calculation in the Socialist Commonwealth.” 

 

They argued that Lange greatly overestimated the potential of the human mind to comprehend the economic order, so does Lucas, and that overestimation separates his work work from the tradition of the Austrians because the Austrian tradition constantly emphasized that the market order was simply too complex to be adequately summed up in a system of stochastically disturbed difference equations.     

So much of Austrian scholarship has been inspired by the problems of the emergence of a social order from decentralized cooperation which the Lucas-Prescott paradigm cannot capture. The Mises-Hayek paradigm is concerned first and foremost with the study of spontaneous order, and with the the emergent properties caused by the connectedness between market participants. (Arnold Kling, in his own response to Noah Smith got at the importance of the issue of connectedness when he wrote:  The bottom line: Austrian economics ought to resemble PSST, not New Classical.) The New Classical toy economy cannot capture those aspects of the market order, and so role of spontaneous order in the hat the Austrian School has to do with complexity, and the interconnectedness of human beings within society is manifest in Human Action when Ludwig von Mises wrote:

The (socialist) director does not simply have to deal with coal as such, but with thousands and thousands of pits already in operation in various places, and with the possibilities for digging new pits, with the various methods of mining in each of them, with the different qualities of coal in various deposits, with the various methods for utilizing the coal for the production of power, and a great number of derivatives (Mises 1998, 695).

The New Classical paradigm cannot even sense of problems of connectedness because of their adherence to general equilibrium as the way of doing economics. 

 

The very nature of how general-equilibrium theory is constructed glosses over the facts that there are particular paths of interaction within a market order. Jason Potts, a fellow heterodox to the Austrians, addressed this concern in The New Evolutionary Microeconomics:

The quality of space being integral derives from the assumption that a single (mathematical) operation links any point in economic space with any other point. Interactions, knowledge, and structure specific connections between points in space and therefore the very existence of these concepts is excluded by the assumption that all points relate, a priori, to all other points directly; that is, with a single mathematical operation (Potts 2000, 17).

Robert Lucas had profuse praise for Gerard Debreu’s Theory of Value, a work which sought to prove that a Pareto optimal distribution of a set resources could be created consistent with profit and utility maximization? On the back of the book Lucas praises The Thgeory of Value as an “immortal classic in twentieth-century economics.” The central role which the New Classicals think that such equilibrium frameworks, especially competitive equilibrium, played in the normal science of economics is a major point of divergence between them and the Austrians. 

 

Competitive equilibrium assumes away the questions of conceitedness which the Austrians are most concerned with, and have given rise to Kirzner’s writings about the entrepreneur, and even Hayek’s ideas about the business cycle. If we are to think about an intellectual’s theorizing as a means of him satisfying the uneasiness certain problems weigh on his mind, we could say that competitive equilibrium assumes away the problems which the Austrians are most troubled by. Mises, for instance, critiqued the use of mathematics in economics for looking over all the questions which should make economists wonder about the possibility of a socialist economy:  

The result is that from the writings of the mathematical economists the imaginary construction of a socialist commonwealth emerges as a realizable system of cooperation under the division of labor, as a fully-fledged alternative to the economic system based on private control of the means of production. The director of the socialist community will be in a position to allocate the various factors of production in a rational way, i.e., on the grounds of calculation (Mises 1998, 698).

For Mises, competitive-equilibrium frameworks glossed over the problems of coordination and price emergence which doomed the hopes of would-be socialists, and as a result that framework did not capture enough of the economy’s essence to be that useful to the study of that phenomenon.  

Lucas’ assertion that economics could create toy economies sufficiently realistic to provide a preliminary testing ground for regulations is of the type which Mises is arguing against here. Even though Prescott, Lucas, and other New Classicals would have recourse to other arguments for why a socialist director would not be able to construct an economic order from on high, they cannot make sense of Mises’ and Hayek’s theses about how cooperation conditioned by prices are able to conquer, to quote Keynes, the dark forces of time and ignorance everyone faces in economic life. As a result, the New Classicals could even be considered a decay, rather than a refinement, of the Austrian insights into the nature of the market order, and of society at large.

 

In the end, there is not a lot of room for the Austrian insights about human competition within a model of an analogue. By asserting that the New Classicals have adopted and advanced the Austrian research program, Noah Smith has  Two features really make the paradigm of Mises and Hayek special: that the two look at purposeful action within the context of radical uncertainty, and the interconnectedness between human beings which results from such behavior. Whereas Prescott and Lucas theorize about a world of linearity and smoothness, Mises and Hayek theorized about a world of complexity and uncertainty. 

So no, the Austrians and New Classicals are not one strand of through. Rather than the New Classicals drinking the Austrians milkshake, stealing their ideas while giving them no credit (in the comments: Noah Smith notes: “I would say someone else picked up a lot of their ideas, ran with them, and won, but didn't give the Austrians any credit... ;-)”), the New Classicals represent the fruition of the economic approach of the Market Socialists. Indeed, it wouldn’t be an understatement to say that Ludwig von Mises and Friedrich Hayek share more in common with John Maynard Keynes and Hyman Minsky than they do either Prescott or Lucas. 

 

 

 

Bibliography  

Debreu, Gerard. Theory of Value. Newhaven and London: Yale University Press, 1987.

Hayek, Friedrich von. The Fatal Conceit. Chicago: Chicago University Press, 1988.

Lucas, Robert. “Methods and Problems in Business Cycle Theory.” Journal of Money, Credit, and Banking 12.4 (1980): 696-715.

Mises, Ludwig von. Human Action. Auburn: Ludwig von Mises, 1998.

Potts, Jason. The New Evolutionary Microeconomics. Northhampton, Edward Elgar Publishing, Inc., 2000. 

The Invisible Hand and Platonic Capitalism

The ancient stoics were of opinion, that as the world was governed by the all-ruling providence of a wise, powerful, and good God, every single event ought to be regarded as making a necessary plan of the universe, and as tending to promote the general order and happiness of the whole: that the vices and follies of mankind, therefore, made as necessary a part of this plan as their wisdom or their virtue; and by that eternal art which educes good from ill, were made to tend equally to the prosperity and perfection of the great system of nature.

-Adam Smith, The Theory of Moral Sentiments

 

The Arrow-Debreu model of general equilibrium as characterized by Gerard Debreu's Theory of Value is the basic organon for the study of society at large within most of modern economics. After all, equilibrium is the means by which most economists rigorously think about economic phenomena: If a shock divorces the actual price on the markets from the equilibrium, or natural price, then what are the mechanisms within the economy that will bring back the actual price on the market into identity with the equilibrium price? The Arrow-Debreu model, in turn, provides a logical proof for the existence of an equilibrium given certain assumptions about the state of the market, and thus is able to provide a means of mathematically thinking about equilibrium

The model, though, is a Walrasian box which traps the economy into an assumed state of equilibrium without any source of internal change. It is a frozen phantasmal state without even a narrative of how that state is attained. As a foil, general equilibrium models may be very useful in pointing out what we should pay attention to within the ever-changing economy before our eyes. There is nothing to be objected to as long as we keep in mind that a model is not a theoretical explanation of the world, but rather an interesting Gedankenexperiment that holds no necessary correspondence to the world. However, where we fall into error is when we assume that correspondence and that therefore a failure of this Gedankenexperiment requires a failure of the social mechanisms we are thinking about.

 

For the Arrow-Debreu model, one sin in particular is the inference that because there are no mechanisms bringing the Arrow-Debreu model to equilibrium and providing negative feedback to keep it there, that the real economy displays such behavior. Just because the Arrow-Debreu model is only in equilibrium by accident, design, or assumption does not mean that this is true for the world in general.

A clear example of this failure comes from a post on “The HBR Blog Network” by Jonathan Schelfer titled “There is No Invisible Hand.” Within that post, Schelfer argues that the unsuccessful search for invisible-hand mechanisms within general-equilibrium models points to the lack of such a force in the real economy:

Leon Walras, of the University of Lausanne in Switzerland, thought he had succeeded in 1874 with his Elements of Pure Economics, but economists concluded that he had fallen far short. Finally, in 1954, Kenneth Arrow, at Stanford, and Gerard Debreu, at the Cowles Commission at Yale,developed the canonical “general-equilibrium” model, for which they later won the Nobel Prize. Making assumptions to characterize competitive markets, they proved that there exists some set of prices that would balance supply and demand for all goods. However, no one ever showed that some invisible hand would actually move markets toward that level. It is just a situation that might balance supply and demand if by happenstance it occurred.

In 1960 Herbert Scarf of Yale showed that an Arrow-Debreu economy can cycle unstably. The picture steadily darkened. Seminal papers in the 1970s, one authored by Debreu, eliminated “any last forlorn hope,” as the MIT theorist Franklin Fisher says, of proving that markets would move an economy toward equilibrium. Frank Hahn, a prominent Cambridge University theorist, sums up the matter: “We have no good reason to suppose that there are forces which lead the economy to equilibrium.” 

In sum, the lack of any mechanisms leading the economy towards a state of order within the Arrow-Debreu model, as the argument goes, is evidence for believing that there are no such mechanisms within the world.

 

This is unsound reasoning, though. Just because the toy economies constructed by Arrow, Debreu, and similar theorists fail to show any asymptotic behavior towards any steady state does not mean there are actually no such mechanisms. What it really means is that there exist no such mechanisms in systems constructed along the lines of The Theory of Value. Many commentators on this subject including Samuel Bowles call these Walrasian models “Utopian Capitalism” in his Microeconomics which “like utopian socialism, illuminates ideal aspects of a system unrealizable in practice.” (Princeton University Press 2004, pg. 208)

I, however, prefer the term “Platonic Capitalism” since the interesting feature of these models are not that they are simply utopian, but that there are forms of human cooperation removed from reference to change much like the forms of the Platonic heavens. When an economy approximates the Arrow-Debreu model, it does so in a like manner as a triangle in nature approximates the form of a triangle forever removed from the world in those heavens.

To find fault in a triangle in nature because it does not look like a triangle outside of Euclid's Elements is as ridiculous as criticizing an economy because it cannot be identified with the general-equilibrium model in Debreu's Theory of Value. They are both limited to the black board, but from there they can provide both a foil and inspiration for thinking about the real instances of what they've modeled in the world.

 

Overall, that the Arrow-Debreu model of general equilibrium lacks an invisible hand to bring the economy towards equilibrium and a state of order does not mean that we should despair about the lack of such a mechanism within the actual economy. For one thing, despite its brilliance, the Arrow-Debreu model is just a model, and therein lies its brilliance; therefore there is no reason why the world must conform to it. It is a Gedankenexperiment. Nothing is necessarily within it said about the economy that we see before our eyes and thus the belief that because there are not endogenous mechanisms within that model for reaching equilibrium is not reason for despair.