Explorations in Austrian Economics (Advances in Austrian Economics, Vol 11)

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ADVANCES IN AUSTRIAN ECONOMICS VOLUME 11

EXPLORATIONS IN AUSTRIAN ECONOMICS EDITED BY

ROGER KOPPL Fairleigh Dickinson University, Madison, USA

United Kingdom – North America – Japan India – Malaysia – China

ADVANCES IN AUSTRIAN ECONOMICS Series Editor: Roger Koppl Associate Editors: J. Birner and M. Wohlgemuth Recent Volumes: Volume 6:

Austrian Economics and Entrepreneurial Studies – Edited by Roger Koppl

Volume 7:

Evolutionary Psychology and Economic Theory – Edited by Roger Koppl

Volume 8:

The Dynamics of Intervention: Regulation and Redistribution in the Mixed Economy – Edited by P. Kurrild-Klitgaard

Volume 9:

The Cognitive Revolution in Economic Science – Edited by Elisabeth Krecke´, Carine Krecke´ and Roger Koppl

Volume 10:

The Evolution of Consumption: Theories and Policy – Edited by Marina Bianchi

JAI Press is an imprint of Emerald Group Publishing Limited Howard House, Wagon Lane, Bingley BD16 1WA, UK First edition 2008 Copyright r 2008 Emerald Group Publishing Limited Reprints and permission service Contact: [email protected] No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. No responsibility is accepted for the accuracy of information contained in the text, illustrations or advertisements. The opinions expressed in these chapters are not necessarily those of the Editor or the publisher. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-1-84855-330-9 ISSN: 1529-2134 (Series)

Awarded in recognition of Emerald’s production department’s adherence to quality systems and processes when preparing scholarly journals for print

LIST OF CONTRIBUTORS Peter J. Boettke

Department of Economics, George Mason University, Fairfax, VA, USA

Christopher J. Coyne

Department of Economics, West Virginia University, Morgantown, WV, USA

Martin Gregor

Institute of Economic Studies, Charles University, Prague, Czech Republic

Steven Horwitz

Department of Economics, St. Lawrence University, Canton, NY, USA

Hansjo¨rg Klausinger

Department of Economics, Vienna University of Economics and Business Administration, Vienna, Austria

Roger Koppl

Department of Economics and Finance, Fairleigh Dickinson University, Madison, NJ, USA

Peter T. Leeson

Department of Economics, George Mason University, Fairfax, VA, USA

Peter Lewin

University of Texas at Dallas, School of Management, Richardson, TX, USA

Torsten Niechoj

Macroeconomic Policy Institute (IMK) in the Hans Boeckler Foundation, Duesseldorf, Germany

Lawrence H. White

Department of Economics, University of Missouri-St. Louis, St. Louis, MO, USA

Alfred G. Wirth

Wirth Institute for Austrian and Central European Studies, University of Alberta, Edmonton, Alberta, Canada Anthony F. Rotatori Festus E. Obiakor vii

ADVISORY BOARD Don Bellante University of South Florida, USA

Ejan Mackaay University of Montreal, Canada

Stephan Boehm University of Graz, Austria

Uskali Ma¨ki University of Helsinki, Finland

Peter J. Boettke George Mason University, USA

Ferdinando Meacci Universita` degli Studi di Padova, Italy

James Buchanan George Mason University, USA

Warren Samuels Michigan State University, USA

Bruce Caldwell University of North Carolina, USA

Barry Smith State University of New York, USA

Jacques Garello Universite´ d’Aix-Marseille, France

Erich Streissler University of Vienna, Austria

Roger Garrison Auburn University, USA

Martti Vihanto Turku University, Finland

Jack High George Mason University, USA

Richard Wagner George Mason University, USA

Masazumi Ikemoto Senshu University, Japan

Lawrence H. White University of Missouri, USA

Richard N. Langlois The University of Connecticut, USA

Ulrich Witt Max Planck Institute, Germany

Brian Loasby University of Stirling, Scotland, UK ix

OPENING REMARKS BY ALFRED WIRTH Alfred G. Wirth First, let me express my sincere welcome to all of you for what I expect will be two days ﬁlled with the pleasures of exploration, learning, and respectful disagreement. I very much appreciate your attendance at what I hope will become a recurring event. Second, I would like to thank Franz Szabo, and all the others who have worked so hard to organize this symposium. As you know – or will learn from Dr. Szabo – the Wirth Institute’s objective is to study and disseminate important intellectual and cultural works that originated in Austria and the other Central European nations that were part of the Habsburg Empire until 1918. As a student of economics, I particularly wanted the Wirth Institute to sponsor this symposium. This was not easy to do, because the Austrian School is not represented in the University of Alberta’s Economics Department. Furthermore, music, art, psychoanalysis, architecture, but not economics – are what usually come to mind when people think of Austrian/ Central European cultural contributions to our world. The Austrian School of Economics differs from other schools in some signiﬁcant ways. As is the case for most new schools, it began with the publication of a seminal work. In this case, it was Carl Menger’s Grundsa¨tze der Volkswirtschaftslehre, published in 1871. But other aspects are more unique: 1. No other school carries a nation’s name. National names are often offputting and can also be misleading. Therefore it is important to remember Explorations in Austrian Economics Advances in Austrian Economics, Volume 11, 7–9 Copyright r 2008 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11001-8

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that this name was not chosen by the members of the school. The label was applied by its ﬁrst critics, German economists. They considered their historic approach to be appropriately rigorous and much more scientiﬁc. Given Prussian military and political successes over Austria by the 1870s, when Germans called something ‘‘Austrian’’, they meant that it was slipshod or weak. So, originally the name ‘‘Austrian School’’ was a pejorative. Success, and especially general acceptance, often leads to being forgotten. Major parts of the Austrian approach, such as the theory of marginal utility, capital/interest, opportunity cost, monetary policy, business cycle analysis, and value/price, were integrated into other systems of economic analysis. Once these principles were well established, some felt that there was little reason to carry on in the mold of the Austrian School. Its intrinsic diversity sometimes makes Austrian economics difﬁcult to identify. And like any successful parent, it has given rise to many differing offspring, many with new labels. The Austrian School is not as mathematical nor model-centric as is popular today in most, if not all, economic faculties. It encompasses many disciplines – economics, philosophy, and sociology. Thereby its development is in continuous disequilibrium, while constantly searching for equilibrium.

The Austrian School played a signiﬁcant role internationally well into the 1930s, partly because a number of its major contributors taught in England. Friedrich von Hayek, while at the London School of Economics, became a major disseminator of Austrian concepts to the English-speaking world, both directly and through some of his students like John Hicks and Ludwig Lachmann. Via Gottfried von Haberler, Hayek was one of the fathers of the University of Chicago’s monetarism. Ludwig von Mises also played a major role in the English-speaking world, especially after his arrival in the United States. So did Josef Schumpeter and Peter Drucker, both of them moving away from the core of the Austrian School, but not its tradition. Yet, arguably because of the Austrian School’s opposition to the rising popularity of Keynesian pump priming (Hayek’s pupil Nicholas Kaldor subsequently moved over to Keynes), the School became largely forgotten in the 1940s. Austrian economics has enjoyed a resurgence since 1974, largely due to two events: The Institute for Humane Studies conference held in Vermont that summer, and the award of the Nobel Prize to Hayek that fall. Today,

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while work continues in many parts of Europe and even Asia, the USA (early on through Murray Rothbard and Israel Kirzner) is now the biggest academic contributor to Austrian economics. As a competitor outside today’s mainstream, the Austrian School’s inﬂuence may seem somewhat marginal sometimes, but its work is certainly not second rate. And it remains a very important contributor to economic thought. Throughout our symposium I suggest that we reﬂect on, and towards the end, try to address, some of the following questions: 1. What insights into human behavior, actual or normative, does your own work within the Austrian School offer? 2. What is the proper role of government: Active policymaking? Or just to set out the rules and then let the market work its wonders? What is the practical impact of the Austrian School today in Eastern Europe, and in Southeast Asia, where much of its philosophy has been adopted? 3. What is the appropriate role of the economist vis-a`-vis the public or the government? 4. What are the still unique and important insights to be offered by the Austrian School today? 5. How would we like the Austrian School to evolve: (a) Become better known and reach greater acceptance, with more research in the Austrian style? (b) Have more inﬂuence on policy, as happened in years past? (c) Place more graduates into good faculties? (d) Address important questions in social sciences aside from economics? We have a way of looking at the world that is diverse, prefers a liberal/ libertarian approach, thinks that interference from above should be minimized, and believes that each human being’s imperfect search for his own beneﬁt, his personal equilibrium, will get the overall job done best. Each of you has made the effort to be here. For Canadians this has been especially challenging because we inadvertently chose a major holiday weekend, our Thanksgiving. But together we can ensure that it will be worthwhile, and I thank you for coming.

THE RESEARCH PROGRAM OF AUSTRIAN ECONOMICS$ Lawrence H. White THE LINEAGE Austrian economics today is a living research program, pursued by scholars around the globe, associated with an intellectual lineage that began in Vienna with Carl Menger’s 1871 Grundsa¨tze der Volkswirtschaftslehre (Principles of Economics).1 Menger’s ideas were soon advanced by his followers Eugen von Bo¨hm-Bawerk and Friedrich von Wieser. In the mid-20th century Ludwig von Mises and Friedrich Hayek did the most to extend economic research along Mengerian lines. Some of the Mengerian innovations (marginalism, opportunity cost) have been incorporated into mainstream neoclassical economics, and Mises and Hayek viewed their own research program merely as modern economics.2 But as Israel Kirzner (1994, p. xii) has noted, those involved in ‘‘the contemporary post-Misesian revival of Austrian Economics’’ now appreciate ‘‘the distinctiveness of the Austrian tradition’’ stemming from Menger.3 Historians of economic thought often cite methodological commitments that set Menger and his followers apart from other economists. A more

$

Keynote address for conference on ‘‘The Austrian School of Economics’’ sponsored by the Wirth Institute for Austrian and Central European Studies, University of Alberta, 8 October 2005.

Explorations in Austrian Economics Advances in Austrian Economics, Volume 11, 11–24 Copyright r 2008 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11002-X

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fruitful way to distinguish Austrian economics is to note that it asks different questions.4 Its characteristic methods may then be seen as applications of the tools appropriate to its topics of inquiry, rather than as all that remains available after rejecting standard methods.5 Austrian analysis properly uses verbal logic when it develops the theory of entrepreneurship or reconstructs the evolution of an institution, because these topics resist the standard neoclassical method of mathematically solving for an optimum or a market equilibrium. An economist who values the Austrian tradition should not feel restricted to studying such topics as entrepreneurship by a pre-commitment not to use mathematics. Rather than its side constraints, its research goals should set Austrian economics apart: it pursues distinctive conjectures and refutations. I use the phrase ‘‘an economist who values the Austrian tradition’’ rather than simply ‘‘an Austrian economist,’’ because no economist should feel compelled to tackle nothing but uniquely Austrian questions. Standard Marshallian supply-and-demand analysis is not speciﬁcally Austrian, but it is useful for addressing many interesting and important questions about the world. Let me brieﬂy recap what Austrians have contributed to economics. Menger was a pioneer in tracing relative prices to subjective valuations. He pointed to consumer wants as the driving force behind the constellation of market prices and quantities. He distinguished ‘‘lower-order’’ consumer goods from ‘‘higher-order’’ productive inputs, and introduced the principle that the prices of higher-order goods derive from their anticipated contributions to the production of valued consumer goods. Menger (1985, p. 146) framed a key part of the Austrian economics research program when he identiﬁed ‘‘a noteworthy, perhaps the most noteworthy, problem of the social sciences: How can it be that institutions which serve the common welfare and are extremely signiﬁcant for its development come into being without a common will directed toward establishing them?’’ Today we may speak of research along these lines as the search for ‘‘invisible hand’’ explanations, emphasizing its roots in Adam Smith. Smith understood that money (for instance) had emerged through market forces rather than central design. But it was Menger rather than Smith who offered the ﬁrst satisfying explanation of how the institution of money had arisen. Smith had infelicitously said that people are ‘‘led by an invisible hand’’ to promote the wealth of the nation, not that the market operates almost as if guided by an invisible hand. It should be ‘‘as if,’’ because there is no literal guiding hand or common will directing human action.6 And it should be

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‘‘almost’’ because there are important cases when – as James M. Buchanan (1982) once put it – an order is deﬁned only in the process of its emergence. When historical path-dependence matters, it is inaccurate to suggest that the market outcome merely exhibits a unique equilibrium that was implicit in the data.7 Building on Menger, Ludwig von Mises made the greatest contributions to deﬁning by example the research program of Austrian economics. Mises brought microfoundations to the study of the value of money. He examined the effects of ‘‘free banking’’ (the competitive issue ﬁduciary media) on the quantity and purchasing power of money. Combining the insights of the 19th-century Currency and Free Banking Schools with the interest theories of Bo¨hm-Bawerk and Wicksell, he began to develop the monetarymalinvestment theory of the business cycle. He elaborated the monetary approach to the balance of payments. Mises analyzed monetary regimes – the gold standard, central banking – by taking a comparative institutions approach that incorporated the political incentives facing governments. And that’s all in his ﬁrst book! In his pathbreaking work on socialism, Mises began the work of spelling out the critical role of (genuine) markets in capital goods for economic calculation. He pointed to entrepreneurship as the key to the market process. He examined interventionism by asking whether its operation would not bring about results contrary to the ostensible goals of its proponents, and by sketching an ‘‘interventionist dynamic’’ that takes hold when proponents persist. In political economy, in the words of David Hart (1982), Mises sought to illuminate ‘‘the causal interrelationships between private property, the division of labor, free trade, and peace.’’ Friedrich Hayek extended two main areas of the Misesian research program: the problem of economic calculation and the features of the business cycle. In the area of calculation he emphasized the dispersion of economically relevant knowledge in society and the attendant problem of coordinating the plans of people who act on local knowledge about resources and economical production techniques. He urged economists to think about the price system as a coordinating device, and about competition as an irreplaceable procedure for discovering which business plans are appropriate to the resources, technology, and plans of others in a society. In the area of business cycle research Hayek hypothesized that the seeds of the downturn are sewn when a distortion of the interest rate leads to unsustainable changes in the capitalistic structure of production. He pointed to inherent instabilities in the world monetary system created by speciﬁcally national credit superstructures resting on national central banks.

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Late in his career, Hayek raised the question of the consequences of the denationalization of money.

THE REVIVAL OF THE RESEARCH PROGRAM For the ﬁrst 15 years or so of the post-1974 revival, a large percentage of the papers in ‘‘Austrian Economics’’ were exegetical exercises in the history of economic thought, or methodological ruminations on how one ought to do economics.8 One of my own ﬁrst publications (White, 1977) was a historical exegesis of Austrian methodological ruminations, entitled ‘‘Methodology of the Austrian School,’’ so I cannot plead innocence here. During this period, graduate students in the Austrian economics programs at NYU and George Mason were spending time and gray matter studying the hermeneutics of Hans-Georg Gadamer, although they had not yet read much of the economics of Menger or Mises. At a professional society session I was asked to comment on a student paper on hermeneutics. I raised the obvious question of whether, for a student who has read Mises’ defense of subjectivism, the marginal beneﬁt of studying Gadamer’s defense of subjectivism exceeded the opportunity cost of studying actual Austrian economics.9 Too little of the ‘‘Austrian’’ work in this phase actually did economics, that is, used Austrian ideas to offer novel explanations of important features of the world. I say ‘‘too little’’ because the beneﬁts from doctrine-historical and methodological studies decline at the margin. Time spent on them crowds out time spent making substantive contributions where Austrians are well equipped to contribute: to the study of capitalistic production, business cycles, monetary and banking institutions, the ﬁrm, monopoly and antitrust, entrepreneurship and market process, the legal system, socialism, and state intervention. Austrian economics will fail to capture the interest and respect of the economics profession if it is all meta-economic talk and no explanatory action, if it neglects to generate interesting explanatory conjectures and refutations.10 I am not criticizing the work that was done in Austrian methodology or the history of economic thought, only the absence of other more applied work. Some amount of backward-looking and methodologically defensive work was no doubt indispensable to the revival of a consciously Austrian tradition. Here I face a paradox. If I declare that I am against economists spending much time prescribing to other economists how they should conduct their

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research, I’m making a prescription to other economists myself. Let me instead invoke the sage advice of Edgeworth (1891, p. 633): As the producer of wealth will push his investment in the different agents of production up to a certain limit which has been called ‘‘margin of proﬁtableness’’; so, in the manufacture of economic wisdom, each of us should expend his little fund of energy, partly on the ﬁxed capital of the deductive organon and partly on the materials of historical experience. The margin of proﬁtableness in the intellectual as in the external world will differ with the personality of individuals. No general rule is available, except that, like the cultivated Athenian, we should eschew the invidious disparagement of each other’s pursuits.

Austrian economics provides a set of useful ideas for analyzing economic patterns, for doing economic history. It provides a ‘‘set of tools.’’ The best way to demonstrate that these tools are useful is to use them, not to talk about their virtues in the Abstract. But of course we should do research for the sake of better understanding the world, not for the sake of demonstrating the greater virtue of one approach over others. The purpose of choosing the most effective potato masher is to mash potatoes most effectively, not to make a case for that style of masher. In the second half of the revival to date, from 1990 to the present, the absolute volume and percentage of useful Austrian research, going beyond methodology and history of thought, has fortunately increased. Austrian economics has become more applied. For example: Peter Boettke (1993) on perestroika, Emily Chamlee-Wright (1997) on urban female entrepreneurship in Ghana, Roger Garrison (1994) on parallels between the business cycles of the 1920s and 1980s, Steve Horwitz (1990) on the Panic of 1907, Steve Horwitz and Peter Lewin (2001) on changes in family structure, Sandy Ikeda (2004) on urban planning, Peter G. Klein and Sandra K. Klein (2001) on corporate divestitures, Israel Kirzner (1997, pp. 54–63) on advertising and antitrust, Roger Koppl and Leland Yeager (1996) on ‘‘big players’’ in the Russian ruble market, Richard Langlois (1999) on the historical evolution of the factory system, Mike Montgomery (1995) on cyclical persistence in investment, Frederic Sautet (2000) on the entrepreneurial theory of the ﬁrm, George Selgin (2008) on the history of private coinage, Stefan W. Schmitz (2002) on electronic money, Ed Stringham (2003) on the development of securities trading in 17th-century Amsterdam and Esteban Thomsen (1992) on the informational role of prices. What makes these works ‘‘Austrian’’ is their analytical grounding (at least in part) in the theoretical tradition from Menger to Mises and Hayek.11

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What makes them valuable is their explanatory oomph. Deﬁning Austrian economics as an analytical tradition makes it clear, I hope, that a piece of economic research can be Austrian but unimportant or misapplied (the theory may not actually ﬁt the case at hand) or even erroneous. Just as Mises (1981, p. 181) found ﬂaws in Menger, we are free to ﬁnd various ﬂaws in the arguments of Mises and Hayek. Conversely, a different piece of economic research can be non-Austrian but extremely valuable. Useful economics can be found outside the Austrian tradition. Free banking research provides an example of research that is Austrian by its grounding in Mises. Subrick and Beaulier (2004, p. 7), however, write: While the theoretical and empirical ‘‘free banking’’ contributions of Selgin and White marked a signiﬁcant contribution to monetary economics, its [sic] does not follow directly from the Austrian tradition. [Footnote in the original: For example, Hayek did not support free banking. See White (1999)]. Rather, their work has been adopted and accepted by the Austrians. Additional work in monetary economics that ﬂow from Mises and Hayek has not materialized in great substance.

In fact, one of the points I made in White (1999) is that it is surprising that Hayek did not think free banking conducive to economic coordination, because Mises did. Furthermore, Hayek should have ‘‘supported’’ free banking to be consistent with his own thought in other areas. The proposition that free banking promotes economic coordination does ‘‘follow directly from the Austrian tradition.’’

ECONOMIC POLICY What deﬁnes whether a work is ‘‘Austrian in theory’’ is not whether it supports laissez-faire conclusions. As a citizen I am not against laissez-faire conclusions, but as an economist I insist that such conclusions are neither necessary nor sufﬁcient for Austrianness. It is not sufﬁcient because works in the Chicago and Public Choice traditions, and other forms of neoclassical economics, can be and are used to support laissez-faire conclusions. It is not necessary because a useful Austrian work may support no policy conclusions, or even anti-laissez-faire conclusions. Nobody can say that Austrian economics is entirely policy-neutral in practice, because work in Austrian economics more often supports laissezfaire than does work in mainstream economics. Even Israel Kirzner (1992, p. 86), who scrupulously cautions against conﬂating wertfrei economic analysis with policy advocacy, acknowledges that ‘‘the later Austrians

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arrived at even more consistently laissez-faire positions’’ than the founders of the school. Menger’s revolutionary view of how the market is driven by consumer wants did not prevent him from endorsing positive degrees of redistribution, paternalism, and state enterprise (Kirzner, 1992, pp. 94–96). But after Friedrich von Wieser (1927 [1914]), who advocated progressive interventionism bordering on Fabianism, and especially in the post-1974 revival, the set of anti-laissez-faire policies promoted in Austrian works is small (Boettke, 1995). Mises was more pro-laissez-faire than other Austrians of his and earlier generations, and it was above all Mises who has inﬂuenced the post-1974 revival via his students in the United States (especially Kirzner, Rothbard, and Sennholz, of whom Rothbard has been especially inﬂuential and especially libertarian).12 The reason for the laissez-faire connection is that Austrian theories (particularly the Mises-Hayek-Kirzner theory of the entrepreneurial market process) explain how unrestricted markets tend to achieve coordination, and how restrictions on markets hamper coordination. So it is understandable to associate Austrian economics with laissez-faire policy conclusions, as, for example, Mark Skousen (2005) does in his recent book Vienna and Chicago: Friends or Foes?13 But it is nonetheless potentially misleading to differentiate the Austrian School from the Chicago School, as Skousen does, not only by positive theory and methodology but also by a greater degree of ‘‘anti-statism’’ (e.g., greater skepticism of antitrust policy) and greater support for the gold standard.14 Those policy positions are neither necessary nor sufﬁcient to identify an author as an Austrian economist. David Friedman is more anti-statist than Roger Koppl, but Koppl’s economics is more Austrian.15 Austrians have long debated whether Austrian economics is or can be wertfrei. One external observer, the Chicago economist Sherwin Rosen (1997, p. 143), complimented Austrians for not being wertfrei: The analytical precision of neoclassical economics as a logical system in principle is hermetically sealed from philosophical, ethical and moral issues, though of course in practice it is not. Neoclassical welfare economics is greatly constrained by the necessity of respecting known or given preferences and technologies. Austrians are not unwilling to confront questions of what kinds of social institutions and rules of the game make for a good society.

Do Austrians deserve the compliment? Yes and no. Yes, in the sense that Austrian economics (but also public choice) does examine the effects of institutions and ‘‘rules of the game’’ – for example, how stock markets and private property in capital goods enable economic calculation. No, in the

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sense that prescribing the features of ‘‘the good society’’ is outside the realm of Austrian economics as such. Austrian welfare analysis is every bit as constrained as neoclassical analysis by ‘‘the necessity of respecting known or given preferences and technologies.’’ If these are your preferences (e.g., that misdirecting and thereby wasting investment is bad), then these are the appropriate policies (do not have the central bank expand the supply of credit so as to distort the interest rate temporarily). But yes again, in the sense that Mises, Hayek, and many of their followers, as individuals, have often been willing – more often than neoclassical economists – to replace their economist hats with political philosopher hats in order to write normatively about constitutional political economy.16 Some readers simply miss the distinction between two disjoint sets: {an author’s work in Austrian economics} and {that same author’s work in political philosophy or public policy}. Rosen (1997, p. 143) cites Hayek’s The Constitution of Liberty as though it were just as much a work in Austrian economics as Hayek’s earlier economics articles ‘‘Economics and Knowledge’’ and ‘‘The Use of Knowledge in Society.’’ Arnold Kling (2003), citing political commentary on the Mises Institute website, writes: ‘‘The Austrian School thinks that you do not need a government to provide national defense.’’ In case it needs to be said explicitly, let me say it explicitly: Austrian economics encompasses neither Hayek’s Old Whig constitutionalism nor Murray Rothbard’s anarcho-capitalism. Those are separate bodies of thought. It is in our interest as economists to maintain the distinction between our economics and our political philosophy, so that well-meaning observers who do not accept particular political views do not view our economic analysis (theories and their historical applications) as tainted. It is at least partly the fault of self-styled Austrians that the distinction has not been clear to readers like Kling.

THE FORTUNES OF AUSTRIAN ECONOMICS The Nobel Memorial Prize came to Hayek, not coincidentally, as Keynesian macroeconomics was collapsing. Of course it was not Hayekian theory that brought down the Keynesian ediﬁce, but Monetarist empiricism. There were too few working Austrian macroeconomists in 1974 to ﬁeld a baseball team. The views that gained market share at Keynesian expense were Monetarism and then New Classical Macroeconomics (also known as Rational Expectations), which morphed into Real Business Cycle Theory. Austrian

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economists received some nods in the process. Robert Lucas (1977) cited Hayek on the research agenda of squaring business cycle theory with general equilibrium theory. The ﬁrst sentence of Finn Kydland and Edward Prescott’s (1982) famous real business cycle paper cites Bo¨hm-Bawerk’s observation that production takes time. Some Austrian themes could be identiﬁed in both new theories. Lucas shared with Mises and Hayek the proposition that monetary shocks initiate the cycle. But he explicitly rejected on empirical grounds their view that temporary distortion of the interest rate propagated the cycle. Kydland and Prescott rejected even the proposition that monetary shocks initiate the cycle. In retrospect, it seems a shame that no Austrians provided the journals with empirical evidence in favor of the Austrian theory. If we recognize it as a shame, there is a lesson to be learned: it pays to keep on top of the mainstream literature for openings where Austrian insights can be interjected. My own best journal placement came from being alert to peculiar ideas in the work of Fischer Black and Eugene Fama (plus the good luck that the AER sent my paper to Black to referee, and his response convinced the editor that his views were indeed very peculiar and worth criticizing). I kick myself for not having been alert early on to the importance of the Diamond-Dybvig model of bank runs. In 1989, the Berlin Wall fell. Two years later the Soviet Union dissolved. The Austrian position in the debate over socialist calculation gained new academic respect. Not only in comparative economics but also in industrial organization, neoclassical economists gave new attention to Hayek’s insights into the role markets play in coordinating activity in an economy of widely dispersed information. Wrote Rosen (1997, pp. 144–45): In what was perhaps their ﬁnest hour, the Austrians, led by Mises and Hayek, argued that [Lange’s] vision of market socialism was impossible, and that it was based on a fundamentally misguided vision of markets and prices. The failure of planning and central control and market reforms occurring all over the world today is one of the most important economic events of our age. Isn’t it is odd that so few neoclassical economists could use their theory to take much of a stand on such matters? But the logical basis of neoclassical theory is not well-equipped for that task.

The non-Austrian libertarian Bryan Caplan (2004, p. 33), however, is less impressed: ‘‘[H]istorical evidence suggests that poor incentives – not lack of economic calculation – were the main source of the economic defects of ‘really existing socialism.’ ’’ Whether Caplan is right is a question now calling for applied research, not immunizing stratagems.

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WHY HAS NOT AUSTRIAN ECONOMICS RESEARCH FARED BETTER PROFESSIONALLY? Austrians have not published much in the top journals. Subrick and Beaulier (2004, p. 3 n. 1) ﬁnd only ﬁve Austrian articles in the AER and JEL since 1984. Only two authors doing Austrian work appear in Tom Coupe´’s list of the world’s top 1000 economists ranked by 1990–2000 publications in top journals.17 Why have the journals not been more receptive? Peter Boettke (2005) has optimistically claimed that Hayek’s prize had a tremendously positive effect on the profession’s estimation of the scientiﬁc character of Austrian economics: Mises, unfortunately, after the Samuelsonian revolution was dismissed as a non-scientist pretending to be a scientist. After Hayek won, at least the Austrians were considered as part of the scientiﬁc community whereas before they were not.

Frederic Sautet (2005), however, pertinently asks (on a blog where he and Boettke are co-contributors) why Austrians are professionally marginalized (‘‘Why Aren’t Austrians at the Discussion Table?’’). He tentatively answers that – contra Boettke – the mainstream still ﬁnds Austrian economics unscientiﬁc due to its lack of mathematical logic and econometric testing. Given that the mainstream attitude is not going to change soon, Sautet recommends that Austrians get on with doing empirical studies using ‘‘ﬁeld work research, statistical information,’’ and news accounts. It is not clear why he does not also recommend using mathematics and econometrics (non-naively, of course) where they can be judiciously used for what Sautet calls ‘‘illustrating the logic of choice at work in the world.’’ The question of barriers to Austrian success in a mainstream-dominated profession is related to the question of whether Austrian economics is complementary or radically subversive of mainstream economics. I honestly think that the most valuable explanatory parts of Austrian economics are complementary. The view that it is radically subversive, held by Austrians at the Lachmann-Shackle end of the spectrum, seems to be pragmatically selfdefeating in the sense that it hasn’t generated novel explanatory conjectures and refutations.18 Strategically, marketing Austrian economics as radically subversive will not help Austrians get a ‘‘seat at the table.’’

NOTES 1. In English translation: Menger (1981).

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2. Wrote Mises (1969, p. 41) about the success of Menger and his immediate followers: ‘‘But after some years all the essential ideas of the Austrian School were by and large accepted as an integral part of economic theory. About the time of Menger’s demise (1921), one no longer distinguished between an Austrian School and other economics.’’ He noted one exception: the ‘‘Austrian’’ label remained attached to a distinctive theory of the business cycle. 3. Steve Horwitz (2000, ch. 1) elaborates how Menger’s contributions have been extended by Mises, Hayek, and Kirzner. 4. Mario Rizzo (1996, p. xiv) has contrasted Austrians to neoclassicals as follows: ‘‘Austrians ask different kinds of questions and provide different kinds of answers. This is not to say that they may not sometimes ask the same or similar questions or that their vocabulary might not be at least superﬁcially similar to that of the neoclassical mainstream. It is to say, however, that Austrian economics is a fundamentally different enterprise from neoclassical social physics.’’ 5. In 2005 the Wikipedia entry on ‘‘Austrian School’’ (http://en.wikipedia.org/ wiki/Austrian_School; accessed on 5 October 2005) unfortunately began: ‘‘The Austrian School is a school of economic thought that rejects . . . ’’ It has since been revised to the prefereable ‘‘that advocates,’’ but still deﬁnes the school by methodological commitments. 6. The logo of the Association for Private Enterprise Education adds a paradox to the infelicity of taking Smith’s metaphor literally: it pictures an ‘‘invisible hand’’ holding the world. 7. For a different perspective on the contrast between Menger and Smith, see Daniel Klein (1997). 8. For quantitative evidence based on counting articles in the Review of Austrian Economics, see Subrick and Beaulier (2004), Table 1. 9. Peter Boettke later told me that this became known as ‘‘the White critique’’ of hermeneutics. 10. I have made this argument before: White (1992, p. 258). 11. For a summary of this tradition see Kirzner (1992, ch. 3). 12. See Powell and Stringham (forthcoming). 13. I must register my disagreement with Skousen’s statements (2005, p. 3) that Austrian economics defends property as the basis of justice and defends the free market as a means of maximizing happiness. The former view conﬂates Austrian economics with libertarian legal theory. The latter would violate the Austrian tenet that economic theory is about preferences and choices and not about hedonic experiences (see White, 1995). 14. A technical quibble: Skousen (2005, p. 8) writes that ‘‘the Austrians . . . maintain that a given rate of monetary inﬂation is never sustainable, whatever the level.’’ If we assume a gold standard is in place, and is subject to supply and demand shocks, the supposedly maintained position would be true. But nothing in Austrian monetary theory says that a positive rate of monetary expansion is unsustainable under a ﬁat standard. (Some Austrians may have suggested that any ﬁat standard must sooner or later explode, but experience has cast doubt on that view by now). For example, the monetary base could grow at 2% per year for decade after decade. 15. I use Roger Koppl as my example of an Austrian who is not an archlibertarian because he has so identiﬁed himself in public discussions.

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16. Israel Kirzner is a prominent Austrian who has seldom if ever been known to don a political–philosopher hat. 17. See Coupe´’s lists at http://student.ulb.ac.be/Btcoupe/ranking.html 18. I worry that viewing Austrian economics as ‘‘the economics of time and ignorance’’ can devolve into viewing it as ‘‘the economics of questions about which one can only make methodological statements’’.

REFERENCES Boettke, P. (1993). Why perestroika failed: The politics and economics of socialist transformation. New York: Routledge. Boettke, P. (1995). Why are there no Austrian socialists? Ideology, science and the Austrian school. Journal of the History of Economic Thought, 17(Spring), 35–56. Boettke, P. (2005). ‘‘Re: RE: [mises] A Nobel for Kirzner,’’ Message 13724 posted to Mises Yahoo! Group (14 Sept., 2005, 4:25 pm). Available at http://groups.yahoo.com/group/ mises/message/13724 Buchanan, J. M. (1982). Order deﬁned in the process of its emergence. Literature of Liberty, 5(Winter), 5. Available at http://oll.libertyfund.org/Essays/Bibliographical/Barry0312/ ReadersForum.html#xx01 Caplan, B. (2004). Is socialism really ‘‘impossible’’? Critical Review, 16(1), 33–52. Chamlee-Wright, E. (1997). The cultural foundations of economic development. London: Routledge. Edgeworth, F. Y. (1891). An introductory lecture on political economy. Economic Journal, 1, 625–634. Garrison, R. W. (1994). The roaring twenties and the bullish eighties: The role of government in boom and bust. Critical Review, 7, 259–276. Hart, D. (1982). Ludwig von Mises, money, and the fall and rise of classical liberalism in the 20th century. Retitled editorial originally published in Literature of Liberty, 5 (Autumn 1982). Available at http://www.econlib.org/library/Essays/LtrLbrty/msEdBib1.html Horwitz, S., & Lewin, P. (2001). Changes in the family – A market process approach to divorce. Unpublished manuscript. Available at http://www.utdallas.edu/Bplewin/ marketprocessfamily.pdf Horwitz, S. G. (1990). Competitive currencies, legal restrictions, and the origins of the fed: Some evidence from the panic of 1907. Southern Economic Journal, 56, 639–649. Horwitz, S. G. (2000). Microfoundations and macroeconomics: An Austrian perspective. New York: Routledge. Ikeda, S. (2004). Urban interventionism and local knowledge. Review of Austrian Economics, 17(June), 247–264. Kirzner, I. M. (1992). The meaning of market process. London: Routledge. Kirzner, I. M. (1994). Introduction. In: I. M. Kirzner (Ed.), Classics in Austrian economics (Vol. 1). London: Pickering and Chatto. Kirzner, I. M. (1997). How markets work: Disequilibrium, entrepreneurship and discovery. IEA Hobart Paper no. 133. Institute of Economic Affairs, London. Klein, D. B. (1997). Convention, social order, and the two coordinations. Constitutional Political Economy, 8, 319–335.

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Klein, P. G., & Klein, S. K. (2001). Do entrepreneurs make predictable mistakes? Evidence from corporate divestitures. Quarterly Journal of Austrian Economics, 4, 3–25. Kling, A. (2003). The sect of Austrian economics. Tech Central Station, 11/11/2003. Available at http://www.techcentralstation.com/111103C.html Koppl, R., & Yeager, L. (1996). Big players and herding in asset markets: The case of the Russian ruble. Explorations in Economic History, 33, 367–383. Kydland, F., & Prescott, E. C. (1982). Time to build and aggregate ﬂuctuations. Econometrica, 50, 1345–1371. Langlois, R. N. (1999). The coevolution of technology and organization in the transition to the factory system. In: P. L. Robertson (Ed.), Authority and control in modern industry (pp. 45–72). London: Routledge. Lucas, R. (1977). Understanding business cycles. Carnegie-Rochester Conference Series on Public Policy, 5, 7–29. Menger, C. (1981). Principles of economics. (James Dingwall & Bert F. Hoselitz, Trans.). New York: New York University Press. Menger, C. (1985). Investigations into the method of the social sciences with special reference to economics. (Francis J. Nock, Trans.). New York: New York University Press. Montgomery, M. (1995). Capital complementarity, time-to-build, and the persistence of investment starts. Journal of Macroeconomics, 17, 187–205. Powell, B., & Stringham, E. Economics in Defense of Liberty: The Contribution of Murray Rothbard. In: S. Horwitz (ed.), Biographical dictionary of Austrian economists. Cheltenham, UK: Edward Elgar, forthcoming. Rizzo, M. J. (1996). Foreward. In: P. Gerald, F. ODriscoll, Jr. & M. J. Rizzo (Eds), The economics of time and ignorance (2nd ed.). New York: Routledge. Rosen, S. (1997). Austrian and neoclassical economics: Any gains from trade? Journal of Economic Perspectives, 11, 139–152. Sautet, F. (2000). An entrepreneurial theory of the ﬁrm. London: Routledge. Sautet, F. (2005). Why Aren’t Austrians at the Discussion Table. Posted to The Austrian Economists blog (16 September 2005, 01:28 AM). Available at http://austrianeconomists. typepad.com/weblog/2005/09/why_arent_austr.html Schmitz, S. W. (2002). The institutional character of new electronic payments systems: Redeemability and the unit of account. In: L. Michael & S. W. Schmitz (Eds), Carl Menger and the evolution of payments systems: From barter to electronic money (pp. 159–183). Cheltenham: Edward Elgar. Selgin, G. (2008). Good money: Birmingham button makers, the royal mint, and the beginnings of modern coinage, 1775–1821. Ann Arbor: University of Michigan Press. Skousen, M. (2005). Vienna and Chicago: Friends or foes? Chicago: Regnery. Stringham, E. (2003). The extralegal development of securities trading in seventeenth century Amsterdam. Quarterly Review of Economics and Finance, 43, 321–344. Subrick, J. R., & Beaulier, S. (2004). An appeal from new to old (and middle-aged) Austrians. Unpublished manuscript. Available at http://www.scottbeaulier.com/ ANAPPEALFROMNEWTOOLD.doc Thomsen, E. F. (1992). Prices and knowledge: A market-process perspective. London: Routledge. von Mises, L. (1969). The historical setting of the Austrian school of economics. New Rochelle: Arlington House. von Mises, L. (1981). Epistemological problems of economics. New York: New York University Press.

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von Wieser, F. (1927 [1914]). Social Economics. trans. A. F. Hinrichs. New York: Adelphi. White, L. H. (1977). Methodology of the Austrian school. New York: Center for Libertarian Studies. White, L. H. (1992). Afterword: Appraising Austrian economics: Contentions and misdirections. In: B. J. Caldwell & S. Boehm (Eds), Austrian economics: Tensions and new directions (pp. 257–268). Boston: Kluwer. White, L. H. (1995). Is there an economics of interpersonal comparisons? Advances in Austrian Economics, 2a, 135–151. White, L. H. (1999). Why didn’t Hayek favor laissez-faire in banking? History of Political Economy, 31, 753–769.

INTRODUCTION Roger Koppl The chapters collected in this volume were originally given at a memorable 2005 conference in Edmonton, Canada. Our host was the Wirth Institute for Austrian and Central European Studies. The conference organizer, Professor Vivek H. Dehejia of Carleton University assembled an impressive and amiable group of scholars, each of whom has a serious interest in the Austrian school of economics. The Wirth Institute took its current name in recognition of the generous endowment of Dr. Manfred Wirth and his son Dr. Alfred Wirth. Their generosity to the institute reﬂects a commitment to their Austrian heritage that extends beyond present-day Austria to encompass the broad cosmopolitan legacy of central Europe as a whole. Conference participants could not fail to notice the dedication of Wirth Institute staff including its Director, Dr. Franz A. J. Szabo, to the common cultural legacy of central Europe. The conference opened with a talk from Alfred Wirth, which revealed both an unexpectedly deep immersion in the Austrian school of economics and a capacity for brevity rarely seen in such patrons. Dr. Wirth noted that the Austrian school illustrates the fact that ‘‘Success, and especially general acceptance, often leads to being forgotten.’’ Much of what was once unique to the Austrian school has become part of the cognitive DNA of work-a-day economists. Given today’s sad neglect of the history of economic thought, these same economists often wonder quite sincerely what the fuss is about when it comes to the Austrian school. The conference conﬁrmed the unstated premise of Dr. Wirth’s talk: There are more successes ahead for the Austrian school; the riches of the Austrian school have not been Explorations in Austrian Economics Advances in Austrian Economics, Volume 11, 1–6 Copyright r 2008 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11010-9

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exhausted and further inquiry in the Austrian tradition will likely yield much that is new and valuable to offer in trade with other intellectual traditions. Our keynote speaker was Lawrence H. White, the F. A. Hayek Professor of Economic History at the University of Missouri, St. Louis. No stranger to the history of economic thought, Professor White recounts some of the successes Dr. Wirth referred to and chronicles the revival of the Austrian school, which can be dated to about 1974. At ﬁrst, work of ‘‘the post-1974 revival’’ was heavy on methodology and exegesis, and light on economics. Beginning about 1990, however, the new Austrians started to shed the cocoon of methodology and exegesis and sat down to work on economic problems. Professor White points to his own ‘‘methodological ruminations’’ of this period in order to politely pretend that he, too, was wound up in the same cocoon. In truth he was doing important work in money and banking from the start. The rest of us caught up about 1990 and ﬁnally began to produce ‘‘useful Austrian research, going beyond methodology and history of thought.’’ (Larry does not mince words.) The talk ends with a discussion of ‘‘the fortunes of Austrian economics’’ and a plea that Austrians give up the posture of ‘‘radical subversion’’ in favor of the view ‘‘that the most valuable explanatory parts of Austrian Economics are complementary.’’ White seems to ask: ‘‘If you’re so smart, why aren’t you cited?’’ In the short time since White issued his challenge, we have seen the rise of a group of talented young graduates of GMU’s doctoral program, including Ed Stringham, Ben Powell, Scott Beaulier, Bob Subrick, Peter Leeson, Chris Coyne, Anthony Evans, and Dan D’Amico. They have amassed an impressive volume of publications, including many in non-Austrian journals such as Kyklos and Journal of Economic Behavior and Organization. Leeson and Coyne have ‘‘A hits’’ with articles in the Journal of Political Economy, Journal of Law and Economics, and Economic Journal. This same group of authors has succeeded in the popular media with appearances in (or on) CNN, the New York Times, The Economist, and the Boston Globe. More to the point of the White challenge (‘‘If you’re so smart, why aren’t you cited?’’), this group has been cited frequently in the mainstream literature. Mises and the economists of his ‘‘Circle’’ were cited frequently. They were also deeply involved with the mass media of contemporary Austria, as Hansjo¨rg Klausinger chronicles. The episode he covers is important and deserves greater attention. In the inter-war years, Mises and his colleagues were trying to rescue Austrian civilization and fend off collectivist threats to civil peace and the division of labor. They launched a coordinated campaign of newspaper articles, columns, letters, and so on meant to sway public

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opinion toward liberal policies and away from collectivism and nationalism. The liberalism of Mises’ group reﬂected a keen awareness of the disaster that collectivist ideologies threatened to create. Mises (1933, p. 202) warned at the time that we will have ‘‘progress on the road the western civilization has taken for thousands of years, or a rapid plunge into a chaos from which there is no way out, from which no new life as we know it will ever develop’’ depending on whether the voice of the economist is heard. It was not heard. Klausinger notes that in this effort, ‘‘the liberal cause had to rely on shifting coalitions and fragile personal relations, which in the end turned out too weak for sustaining the policies envisioned by the Austrian economists.’’ Austrian economists have not always appreciated the important events Klausinger describes. We have been more conscious of the methodological writings of the period than of these popular writings. For Mises, Machlup, and the others, I think, both types of work were part of the same struggle to save Austrian civilization. This point suggests and addendum to the White challenge: If you must do methodology, be sure the points at issue matter for what happens outside the moldering wall of your university’s perimeter. White’s welcome challenge seems a ﬁtting introduction to Martin Gregor’s chapter comparing the efﬁcacy of private and public institutions at correcting erroneous believes. Adopting the epistemic perspective characteristic of Austrian economics, Gregor takes on Wittman (1995), who argues that democratic markets are efﬁcient. Gregor develops an evolutionary model that lets him compare the likely efﬁciency of collective and decentralized choice in converging on a language of commerce for trading groups. With decentralized choice, agents with a low opportunity cost will more readily undertake the cost of learning a new language in order to trade with persons having a different native tongue. In almost all cases, therefore, the system converges on the more easily learned language. In collective choice, false perceptions of the electorate have a greater chance of producing the wrong collective choice. Gregor’s example reﬂects (consciously, I presume) the ‘‘language problem’’ of the Hapsburg empire (Schorske, 1981, p. 236). Gregor’s chapter includes an astute critique of Bryan Caplan’s ‘‘rational irrationality.’’ Caplan’s emphasis on the value of expertise may be at odds with Hayek’s account of the production and distribution of knowledge in society. This account owes much to Hayek’s role in the ‘‘calculation debate’’ of the 1930s and 1940s. As the chapter of Boettke, Coyne, and Leeson explains, the claim was that ‘‘without private property in the means of production, rational economic calculation is not possible.’’ In The Road to Serfdom, they explain, Hayek drew out the social consequences of ignoring

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this epistemic limit. When governments try to substitute plan for market they must either mitigate the role of plan or turn tyrannical. ‘‘Hayek’s argument,’’ they say, ‘‘is that just as we should expect those with superior skills in any industry to rise to the top, we should also expect those who have superior skills in exercising political power and coercion to advance within the political apparatus of planning.’’ I agree with the claim of Boettke, Coyne, and Leeson that Hayek’s classic book and ‘‘his entire body of thought in the area of political economy, are as relevant today as they were then.’’ To cite just one supporting example, much of the current literature on prediction markets, cascades, and other manifestations of the wisdom (Surowiecki, 2004) and folly (Mackay, 1841) of crowds (Bikhchandani, Hirshleifer, & Welch, 1992 and Hanson, 1999) reﬂect Hayek’s insight from The Road to Serfdom that the ‘‘interaction of individuals, possessing different knowledge and different views, is what constitutes the life of thought’’ (Hayek, 1944, p. 165). Vela Velupillai’s (2007, p. 288) demonstration of ‘‘The Impossibility of an Effective Theory of Policy in a Complex Economy’’ seems to have led him to an appreciation of Hayek’s ‘‘lifelong skepticism on the scope for policy in economies that emerge and form spontaneous orders.’’ Velupillai is an important complexity theorist and several persons have noted the links between Hayek’s theory of complexity and modern complexity theory (Rosser, 1999; Koppl, 2000; Caldwell, 2004; Markose, 2005). Caldwell seems to infer that hermeneutics is ‘‘too literary in orientation’’ and ‘‘too extrascientiﬁc’’ to be a part of Hayek’s ‘‘scientiﬁc subjectivism.’’ My chapter takes on this argument and a similar one from Viktor Vanberg. My argument depends crucially on distinguishing the ‘‘classical hermeneutics’’ of Wilhelm Dilthey, Max Weber, and others from the ‘‘universal hermeneutics’’ that begins with Martin Heidegger. I believe it is a mistake to think that Hayek’s complexity theory or his theory of mind is somehow inconsistent with classical hermeneutics. In other words, peace, love, and understanding should prevail between scientiﬁc and humanistic social science. My chapter may run contrary to the spirit of White’s keynote address because it is exegetical and methodological. I am even forced to admit that is may all be a quibble over words. But if peace and love do not prevail between humanistic and scientiﬁc social science, then each style of social science loses insights and wisdom peculiar to the other style. Promarket economists should lament such lost gains from trade. Torsten Niechoj provides an interesting opportunity for trade across a different border, namely that between supporters and opponents of trade unions. Hayek was clearly in the latter group. He was concerned by his

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perception that many large labor unions in the democratic West had excessive power, including excessive political power. Niechoj thinks Hayek has undervalued the positive functions of unions. He develops a brilliant internal critique of Hayek’s posture toward unions that builds nicely on Hayek’s work on the production and distribution of knowledge in society. For example, unions ‘‘collect the dispersed knowledge of individuals and transform it into public knowledge, which can be used and discussed.’’ Niechoj challenges Austrian economists by pointing deeply Hayekian arguments in unexpected directions. Horwitz and Lewin also challenge Austrian economists by pointing Hayek’s capital theory in unexpected directions. Horwitz gives us a close study of the analogies between Hayek’s theory of capital and his theory of mind. Both are adaptive classifying systems in the sense of McQuade and Butos (2005). Like the mind, the capital structure is a kind of map of the economy that embodies, and thus deﬁnes, ‘‘the contours of the possible.’’ Like the mind, the capital structure is an ‘‘expectational model’’ because it embodies the forward-looking plans of entrepreneurs. Like the mind, ﬁnally, the capital structure is classiﬁcatory because the uses of the different bits and their inner relations undergo adaptive change in response to price changes and other changes in the economy. The analogy has its limits, as Horwitz carefully points out. It is helpful and informative, however, in part because it ‘‘might help us to deepen our understanding of ﬁrms as sites of organized learning.’’ I might add the suggestion that each ﬁrm has malleable and ﬁxed aspects to its theory of the world. The ﬁrm’s structure of human and non-human capital can change over time, but its ‘‘core competency’’ may be ﬁxed in invariable even when the outside world stops valuing that core competency. This ﬁxed part of the ﬁrm’s nature might be compared to the deepest and most invariable parts of our mental apparatus, such as our psychology of vision. I cannot help seeing the stick in the water as bent, even though I know it is not. Just as biological evolution endows us with a kind of Kantian a priori subject to change only in biological time, the founder of a ﬁrm may endow his organization with a core competency that cannot be altered even in the face of bankruptcy. Peter Lewin also takes a capital-based perspective on the ﬁrm, one that emphasizes the importance of disequilibrium, heterogeneity of resources, dispersed knowledge, and, vitally, a characteristically Austrian understanding of rent that recognizes no essential difference between the ‘‘rent’’ of land and the ‘‘rent’’ of a worker’s time. Armed with this Austrian understanding of rent, Lewin concludes that ‘‘heterogeneity of resources would have no strategic signiﬁcance’’ in equilibrium and in the ubiquitous

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disequilibrium of markets, ‘‘rent is not an indication of inefﬁciency or monopoly power.’’ Lewin’s analysis reveals the shallowness of pretending to ﬁnd objectionable monopoly rents in the value-creating strategic choices of creative entrepreneurs. All valuable assets yield a ‘‘rent,’’ properly understood. Those strategic choices could enhance such rents only if the system were in disequilibrium in the ﬁrst place, so that those rent-enhancing decisions serve the desirable end of increased coordination. The contributions to this volume show that the Austrian tradition is rich and full of surprises. They are heterogeneous and innovative, contentious, idiosyncratic, engaging. They suggest a bright future for the Austrian school. For those of us lucky enough to have participated in the Wirth conference that October, they will also serve as a warm reminder of a place where ideas in a central European tradition are valued and explored.

REFERENCES Bikhchandani, S., Hirshleifer, D., & Welch, I. (1992). A theory of fads, fashion, custom, and cultural change as informational cascades. Journal of Political Economy, 100(5), 992–1026. Caldwell, B. (2004). Hayek’s challenge. Chicago: University of Chicago Press. Hanson, R. D. (1999). Decision markets. IEEE Intelligent Systems, 14(3), 16–19. Hayek, F. A. (1944). The road to serfdom. Chicago: The University of Chicago Press. Koppl, R. (2000). Teaching complexity: An Austrian approach. In: D. Colander (Ed.), The complexity vision and the teaching of economics. Cheltenham: Edward Elgar. Mackay, C. (1841). Extraordinary popular delusions and the madness of crowds. The second edition (1852) can be downloaded from http://www.econlib.org/library/Mackay/ macExContents.html Markose, S. M. (2005). Computability and evolutionary complexity: Markets as complex adaptive systems (CAS). The Economic Journal, 115, F159–F192. McQuade, T., & Butos, W. (2005). The sensory order and other adaptive classifying systems. Journal of Bioeconomics, 7, 335–358. Mises, L. v. ([1933b] 1976). Epistemological problems of economics. New York: New York University Press. Rosser, J. B. (1999). On the complexities of complex economic dynamics. Journal of Economic Perspectives, 13(4), 169–192. Schorske, C. E. (1981). Fin-de-Sie`cle Vienna: Politics and culture. New York: Vintage Books. Surowiecki, J. (2004). The wisdom of crowds. New York: Random House. Velupillai, V. (2007). The impossibility of an effective theory of policy in a complex economy. In: M. Salzano & D. Colander (Eds), Complexity hints for economic policy. Milan: Springer. Wittman, D. (1995). The myth of democratic failure. Chicago: University of Chicago Press.

POLICY ADVICE BY AUSTRIAN ECONOMISTS: THE CASE OF AUSTRIA IN THE 1930S$ Hansjo¨rg Klausinger ABSTRACT In Austria the 1930s constituted the ﬁnal period of success and failure of the Austrian school, ending with its emigration to the United States. This chapter focuses on this period, when the Austrian economy was hardest hit by the Great Depression, and it examines the ways and means by which the Austrian economists attempted to inﬂuence economic policy. In particular, from 1932 to 1934 in a concerted effort Austrian economists like Ludwig Mises, Fritz Machlup, and especially Oskar Morgenstern tried to ‘‘educate’’ the Austrian public and policy-makers in the beneﬁts of a liberal approach towards the crisis. This effort included the advocacy of the policies typically associated with the gold standard, that is, stable money, balanced budgets, the absence of exchange restrictions, and free trade. In the actual situation the outcome of these endeavors was futile, if not harmful, insofar as indeed Austrian economic policy slowly converted to the implied deﬂationary stance of monetary and ﬁscal policy. Yet, under the regime of the so-called corporate state the necessary $

Paper presented at the Austrian School Conference organized by the Wirth Institute for Austrian and Central European Studies at the University of Alberta (Edmonton, Canada).

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complement of such policies, namely the ﬂexibility of prices and the furthering of competition, could not be accomplished. This eventual failure of the liberal cause may be ascribed to the fact that it had to rely on shifting coalitions and fragile personal relations, which in the end turned out too weak for sustaining the policies envisioned by the Austrian economists.

1. INTRODUCTION This chapter takes up a discussion ongoing in two largely unconnected communities, that is, that of Austrian contemporary historians and the historians of Austrian economic thought, both contemplating the inﬂuence of the Austrian school of economics on economic policy in the 1930s. From these rather different points of view the policy recommendations of the Austrian economists have been considered, either as harmful and the cause of the Austrian economy’s failure to recover from the depression, or as the last chance for rescue missed due to the incompetence of economic policymakers.1 Here I will turn to a question preliminary to this debate, namely, on the ways and means by which the Austrian economists attempted to inﬂuence economic policy, and consequently on the extent of the success or failure of this attempt.2 To begin with, we have to identify the Austrian economists under investigation and the sources used. At the beginning of the 1930s the hard core of the liberal strand of the Austrian school consisted of Ludwig Mises, widely considered as the leader of the ‘‘Austroliberals,’’ and Fritz Machlup, Friedrich August Hayek, and Gottfried Haberler as members of the next generation. Of these Hayek and Haberler have played only a minor role because of their frequent absence from Austria. Furthermore, we add Oskar Morgenstern to this list, who – although he emphasized his distance to the Mises group and became increasingly critical of the theoretical tenets of the Austrian school – in the realm of economic policy almost completely concurred with the views of the Austroliberals.3 Thus the economists on whom we will mainly focus in the following are Mises, Machlup, and Morgenstern.4 The claim to novelty of this chapter rests on its use of sources hitherto largely neglected in this type of studies. Thus, although the scientiﬁc contributions of the authors in question are given their due weight as a background to the debate, the focus will be, on the one hand, on commentaries

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and columns published in daily newspapers dealing with topical issues of economic policy,5 and on the other hand, on unpublished papers and correspondence. In the latter regard, the documents preserved in the Oskar Morgenstern Papers, in particular Morgenstern’s diary from this period, are invaluable, and much of the following will be based on them.6 Yet, one must be aware from the outset of the limitations and risks of the use of such documents: Not only do such papers all too often convey their author’s rather subjective interpretation of the facts, but the conclusions drawn may also be biased by the arbitrary selection of the documents that survived – for example, the relevant documents from Mises, Machlup, Hayek, and Haberler are regrettably incomplete. The structure of the chapter mirrors a twofold approach, theoretical and historical.7 In the following section we present the main problems faced by Austrian economic policy and the solutions and recipes recommended by the economists. Then, in the next section, we pursue the economists’ activities of policy advice through the 1930s, concentrating on a few crucial episodes. Finally, in conclusion, a judgment is ventured on the extent of the economists’ impact on actual policy, and how this impact can be attributed to the individual economists that made up the group.

2. PROBLEMS, LESSONS, RECIPES: THE ECONOMISTS’ ADVICE In this section we shortly characterize the Austrian economists’ position on a list of topical issues especially relevant before the background of the Austrian experience in the 1930s.8 2.1. The Danger of Inﬂationism In the aftermath of the experience with hyperinﬂation in 1922/1923 and based on the Austrian theory of the business cycle – where inﬂation by fueling the boom is the true cause of crisis and depression – the Austrians considered inﬂation as the prime economic evil. Accordingly, they condemned as misguided the policy of the Austrian National Bank in face of the Creditanstalt crisis in 1931, that is, its coping with the crisis by supplying funds in exchange for Creditanstalt bills, thus increasing its bills’ portfolio and, simultaneously, loosing its exchange reserves due to a currency crisis in the wake of the banking crisis. The Austrians persisted in

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their warnings about inﬂation even when the public switched from banking deposits to currency and thereby more than compensated the increase in high-powered money – still they saw an overhang of money and a danger of inﬂation due to the existence of hoarded banknotes. Consequently, they recommended the return to a ﬁxed gold parity of the Schilling as the best recipe to prevent inﬂation or any other manipulation of the currency.9

2.2. Coping with Ailing Banks The proper reaction to the Creditanstalt crisis, and later on to the crisis of other ailing Austrian banks, would have been to put the protection of the currency above the protection of the banks. Thus, insolvent – possibly in contrast to just illiquid – banks should not be rescued by injections of credit, as in the end this will lead only to inﬂation and a crisis of the currency, as it did in Austria in 1931. From an economic point of view the superior solution was therefore to let such banks go bankrupt and liquidate them, so that monetary stability would not be endangered, as the sound ﬁrms formerly under the control of the failed banks would survive anyway.10

2.3. The Nonsense of Exchange Controls In October 1931 Austria had introduced exchange controls as an emergency measure to cope with the currency crisis and the precipitous loss of exchange reserves. As a consequence the volume of external trade shrank considerably and the free market rate of the Schilling diverged from the ofﬁcial parity by up to a maximum 35 percent; in effect this worked like an additional duty on exports and a premium on imports. Small wonder that the Austrian economists turned their ﬁercest attacks on exchange controls and from the beginning urgently demanded their unconditional abolition. In fact, as we will see, the rejection of the regime of exchange controls was decisive in uniting these economists in their ﬁght against an ill-guided economic policy. They argued consistently that exchange controls could not accomplish their task of defending the ofﬁcial parity – only monetary restriction could have done so – but due to their harmful side effects crippled Austria’s foreign trade. These negative effects were indeed aggravated when in the attempt to make them work exchange controls were supplemented by ever more trade restrictions: tariffs, bans on imports, quotas, clearing arrangements, and a return to bilateralism in general. Besides, the ensuing heavy regulation of

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foreign trade and foreign exchange was regarded as paving the way towards a planned economy, and thus had to be combated also for the sake of saving the liberal market economy (or what then had remained of it in Austria).11

2.4. The Mechanism of the Trade Balance The economists’ approach towards the problem of the trade balance, and thus to Austria’s notorious trade deﬁcit, was that fundamentally the state of the trade balance was the result (and not the cause) of the development of the other items in the balance of payments, in particular of the (desired) increase in foreign indebtedness. For example, they explained the Austrian trade deﬁcit as the consequence of capital consumption due to policies hostile to proﬁts and investment, which gave rise to the need for importing capital. Accordingly, a trade deﬁcit could by no means be remedied by the introduction of trade restrictions – with the other items in the balance of payments ﬁxed such restrictions just reduce exports to the same extent as they do imports and thus affect the volume, but not the balance of trade. Therefore, protectionism was considered the wrong method because instead of curing a trade deﬁcit it harmed the domestic export sector and thus economic activity as a whole. Obviously, this view of the trade balance relied on the swift working of the mechanism of external trade, that is, the effect of changes in exchange reserves on the real exchange rate and, thereby, on the trade balance. Speciﬁcally, in the case of a ﬁxed gold parity the burden of adjustment will thus rest on the ﬂexibility of domestic prices.12

2.5. The Goal of Free Trade The Austrian economists were champions of free trade. Thus, they deplored all the obstacles to foreign trade introduced by so many countries as a protectionist policy response to the problems of the Great Depression. Furthermore, faced with these protectionist regulations, they recommended radical measures: to unilaterally eliminate tariffs and restrictions for foreign imports as the best recipe for the Austrian economy. Consequently, on a global level, the ultimate goal was the re-establishment of universal free trade in contrast to the proliferation of preferential treaties, like those established in the Rome Protocols concluded between Austria, Italy, and Hungary in 1934.13

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2.6. Foreign Debts, Moratoria, and the Transfer Problem Consistent with their conﬁdence in the swift working of the mechanism of international trade the Austrian economists considered the transfer problem (with regard to the repayment of foreign debts) solely as the problem of raising the required sum of money, for example, through taxes. Thus, to them the failure to transfer signiﬁed more a lack of the willingness than of the ability to pay, and a transfer moratorium – like that announced in Austria in June 1932 – could not be justiﬁed along these lines. Just as in the case of domestic debts the refusal to repay foreign debts constituted a serious threat to the rule of law as a crucial base for international trade and ﬁnance in a liberal framework.14

2.7. The Chimera of Public Works The rejection of the idea that public works could be used as a remedy for depression was widespread among Austrian economists, and their arguments based on the quantity equation were quite simple. If not accompanied by inﬂation, that is, by an increase in the quantity (or the velocity) of money, public works, or other attempts at pump priming will be ineffective in the aggregate, just redistributing employment between industries. And if accompanied by inﬂation, they will indeed be effective in creating a sort of prosperity, yet as with all sorts of inﬂation such a prosperity will be shortlived and in the end lead to a still more severe depression. Thus, no longterm beneﬁts, but much harm, were to be expected from such projects.15

2.8. The Remedy of Wage Cuts To the contrary, in a depression the ‘‘natural healing method’’ (Machlup, 1933b, p. 781) to follow is wage cuts. By their effects on production costs these will induce ﬁrms to employ more workers and by a suitable redistribution of purchasing power there will also be sufﬁcient demand for the goods additionally produced, thus the possibility of Keynes-like effective demand failures was ﬁrmly denied. Yet, in these days the existence and power of trade unions, and regulations of the labor market like the provision of unemployment beneﬁts, were seen as interfering with this method. Therefore, to many Austrian economists the depression demonstrated the necessity, and afforded the opportunity, to reshape the

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institutional framework in order to bring it closer to the ideal of classical liberalism.16

2.9. The Quest for Auﬂockerung Regulations of many kinds did not only interfere with the functioning of the labor market but with product markets, too. Greater ﬂexibility of prices and a more competitive environment through lower barriers to entry for domestic and – by a less protectionist trade policy – foreign ﬁrms were propagated under the catching phrase of Auﬂockerung.17 The necessity of such a kind of deregulation as the preferable alternative to devaluation derived from the discrepancy that had developed between the almost stable domestic prices in Austria and the falling prices in the world markets. Furthermore, as a result of Austrian crisis policy – and of the anti-liberal spirit to which the regime of the corporate state (Sta¨ndestaat) professed – the regulations of industry and agriculture were becoming ever more rigid, and thus the need for Auﬂockerung more pressing, in the course of the 1930s.18

3. IMPLEMENTING THE AUSTRIAN RECIPES In this section we discuss the practice of the Austrian economists’ policy advice – ﬁrst we give an overview on the diverse channels of inﬂuence used and then pick out a few characteristic episodes to highlight if and how such inﬂuence was actually exerted. Once more, it should be kept in mind that depending on the available sources the choice of examples is necessarily selective.

3.1. Channels of Inﬂuence The most visible (and as a source accessible) way in which the Austrian economists propagated their policy recommendations was the campaign in the Neues Wiener Tagblatt, already referred to earlier.19 From 1931 to 1934 two types of articles by Austrian economists, most of them published anonymously, appeared: on the one hand, commentaries on topics of economic policy (Beitra¨ge zur wirtschaftlichen Vernunft), and on the other hand, short weekly columns which tried to educate the public in the basics

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of Austrian economic thought (Zwei Minuten Volkswirtschaft). Whereas these more than hundred columns were solely the work of Machlup, the approximately 75 commentaries were authored by various writers, again with Machlup the main contributor, followed by Morgenstern and others. The initiative to these journalistic writings was born at the end of 1931, when the economic situation appeared extremely chaotic and the authors most urgently felt the need for a turnaround in economic policy. Consequently, the aim of the campaign was to re-establish the adherence to liberal ideas as a guideline for policy. Presumably, the campaign itself grew out of a kind of liberal network: Morgenstern, the newly appointed director of the Austrian Institute for Business Cycle Research, Machlup, Victor Gra¨tz, the director of the Steyrermu¨hl Company, which published the Tagblatt, and a close friend of Mises, and the Austrian industrialist Julius Meinl appear to have participated in this initiative. In parallel within the Chamber of Commerce Mises attempted – by and large successfully as long as he remained active in Austria – to unite the organized business interests behind this liberal program, as outlined in a series of papers, memoranda, and speeches.20 When the Tagblatt campaign petered out in 1933/1934, this was for a host of reasons, among them the emigration of most of the authors (except Morgenstern) and the hostility of the newly proclaimed corporate state to lessons in liberalism made effective by the introduction of censorship. In any case, with few exceptions, after 1934 it had become more difﬁcult to further the liberal cause openly in the press. In the background of the campaign there existed some loose circles, which not only served as a place for discussion but also as a link between the economists and representatives from business and politics. One of these circles was that of the Meinl group. Meinl was well known for his support of liberal economic policies, which he, jointly with the director of his company, Kurt Schechner, furthered in numerous pamphlets and articles.21 As pointed out by Machlup (1980, p. 135) often the contributions to the Tagblatt had been discussed before in meetings initiated by Meinl, with Machlup, Morgenstern, Mises, and Gra¨tz as regular participants. Even after the end of the Tagblatt campaign Meinl remained active for the liberal cause within the narrower limits imposed by the corporate state, and in 1934 started publishing a monthly review, the Wirtschaftliche Rundschau, in the ﬁrst year with Morgenstern as the editor and main contributor. Another channel of inﬂuence consisted in the Austrian economists’ personal contacts with those actually involved in policy-making, that is, politicians, ofﬁcials from international organizations, Austrian business leaders and representatives of the Chamber of Commerce. For example,

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from Morgenstern’s diary we see that beginning in 1931 he regularly met with Viktor Kienbo¨ck, the president of the Austrian National Bank, Rost van Tonningen, the representative of the Finance Committee of the League of Nations (LoN), the LoN’s adviser to the National Bank Gijsbert Bruins and his successor Maurice Fre`re, and with Adrian van Hengel, the general director of the reconstructed Creditanstalt, to name but a few. Furthermore, Morgenstern built also the center (or so it appears from his own notes) of another circle, with participants mainly from Austrian industry. Within this circle, in 1932/1933, topical issues of economic policy became the subject of a series of ‘‘conferences,’’ in which Morgenstern appropriately excelled in the role of scientiﬁc expert.22 However, as we will ﬁnd out, after 1934 for those economists that still lived in Austria, most of them centered around Morgenstern and the Institute, the way in which they were able to make their policy advice effective had changed: from the indirect inﬂuence through unofﬁcial circles and press campaigns to a more direct involvement in the bureaucracy of economic policy-making.

3.2. The Economic Education of Viktor Kienbo¨ck, President of the Austrian National Bank At the beginning of the time period considered Austrian economic policy stood at the crossroads: on the one hand, from the Austrian economists’ point of view it had committed a series of blunders by breaking most of the rules of the liberal framework, on the other hand, the replacement of Richard Reisch, the former president of the Austrian central bank, by Kienbo¨ck,23 and a change of government at the same time,24 had opened up the possibility to restore sound policies. Now in order to gauge the inﬂuence of the economists’ policy advice we have to show inasmuch it was at odds with the intentions of the newly appointed economic policy-makers. At a ﬁrst glance, it is obvious that in early 1932 both in the Tagblatt campaign and in personal contacts the radical recommendations of Machlup and Morgenstern were in sharp opposition to the rather pragmatic (and slowly evolving) policies actually entertained. A few illustrations will sufﬁce: Morgenstern (M 3 February 1932) demanded an immediate abolition of exchange controls and criticized the idea of maintaining them provisionally for an interim period, and Machlup (M 18 and 27 February 1932) castigated Kienbo¨ck (and Weidenhoffer, the Austrian Minister of Finance) for substituting appeals to ‘‘economic patriotism’’ for the effective

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policy measures required, like for example, a restriction of the money supply and a more austere ﬁscal policy. Already before, Morgenstern in private conversation had attempted to dissuade Bruins from his toying with the idea of a devaluation of the Schilling and his defense of exchange controls (see D 26 January 1932), and apparently he succeeded in winning over Rost (against Bruins) for a more radical position on credit restriction and the loosening of exchange controls (see D 13 and 27 January 1932). In this regard, he claimed ‘‘a great success’’ when the Finance Committee’s report mirrored his and Rost’s position to a large extent, and he also tried to give the report as much publicity as possible.25 However, Morgenstern (M 10 April 1932) was severely critical of the Committee’s suggestion to sharpen the effectiveness of exchange controls by supplementing them by bans on imports. With regard to Kienbo¨ck, in these times Morgenstern’s esteem for him as an expert was quite low – although easily to be surpassed by his contempt for other representatives of Austrian economic policy. However, when it came to the introduction of a moratorium on foreign payments in June 1932, it appears as if with respect to its technical implementation Morgenstern had lent and Kienbo¨ck had acted on behalf of his advice.26 Typically Machlup, who always had kept a much greater distance to those in charge of policy-making, outright rejected the idea of a moratorium for reasons of principle.27 As a ﬁnal example, when in 1932 problems of two more ailing banks (the Wiener Bankverein and the Niedero¨sterreichische Escompte) became known, Morgenstern (jointly with for example, Mises and van Hengel) pleaded for letting them go bankrupt (D 31 October 1932). Yet, Kienbo¨ck (seconded by Rost) prevailed with his own favored solution, the founding of a trust company for rescuing these banks, ﬁnanced by the central bank and the government.28 The debate on deﬂation versus devaluation as the conﬂicting options for Austria’s exchange rate policy provides another characteristic episode. After the introduction of exchange controls and the depreciation of the Schilling in the free exchange markets (like Zurich), the choice was between deﬂation, that is, a restriction of the money supply, strong enough to enable a return to the old gold parity after the abolishing of the controls, and a devaluation of the Schilling to a new lower parity. Up to mid-1932 the Austrian economists were unanimous in their preference for deﬂation: Morgenstern (M 3 February 1932), Hayek in a speech to the Industrieller Club (M 2 March 1932), and similarly Mises in two speeches before the Vienna Chamber of Commerce in March and July 1932 (Mises 2002, chapters 28 and 29) adhered to this view. In this state of affairs statistical inquiries by the Institute demonstrated that despite the ofﬁcial ﬁxing of the Schilling

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parity a price gap had developed: Domestic prices had already adapted to the actually lower value of the Schilling (or, conversely, to the higher Schilling price of gold in free markets) and stayed roughly constant in contrast to the falling prices in world markets.29 In face of this evidence and taking into account the rigidity of the Austrian price structure, the economists reconsidered their position. Fixing the Schilling at a devalued parity was then accepted, although with some moral indignation, as a mere recognition of the fact of previous and not as a signal of future inﬂation. Yet it was crucial in their view that the new parity could be credibly established.30 Morgenstern (M 1 August 1932) speciﬁcally suggested combining devaluation with some credit restriction so that eventually the new parity could be sustained above the one currently prevailing at free exchange markets. In fact, this came close to the policy actually chosen by the Austrian central bank:31 After a gradual easing of exchange controls the Schilling was ﬁxed (formally in 1934) at a new rate approximately 20 percent below its former parity, where it remained henceforth. It is this period of the easing of exchange controls and the eventual ﬁxing of a new Schilling parity, when the conﬂicting views of Morgenstern and Kienbo¨ck apparently began to accommodate. This was the more important as concomitantly Kienbo¨ck became the person to dominate Austrian economic policy in general, not merely monetary policy.32 On the one hand, this rapprochement resulted from Kienbo¨ck unequivocally committing himself to a hard currency policy and, as far as his political clout permitted, to ﬁscal austerity. On the other hand, Morgenstern moderated his critique, and the more he and the Institute became involved in the business of policy advice the more he inclined to pragmatic views. As a point in case we may note that still in 1932 he had judged the attempts to secure a foreign loan as unnecessary and even harmful (Morgenstern M 10 April 1932). Yet after the raising of the Lausanne loan in 1933, he praised it (and the accompanying policies of the Austrian government) as a proper means for securing monetary stability – that is, under the precondition that the loan was used solely for strengthening central bank reserves instead of misused for ﬁnancing government expenditure (M 12 August 1933).33 Moreover, in this judgment he was not so much out of line with the other economists, even Mises had earlier on (2002, chapter 29 [25 July 1932]) greeted the granting of the loan as providing the ‘‘breathing room’’ needed for the implementation of reforms.34 In any case, now the opportunities became more frequent when Morgenstern found himself in complete agreement with Kienbo¨ck.35 Perhaps not quite incidentally, Morgenstern at about the same time terminated his collaboration with the Tagblatt,

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possibly reﬂecting the incongruity with his newly acquired role as policy adviser. Signiﬁcantly, at the same time the inﬂuence of Gottfried Kunwald, another important ﬁgure in Austrian economic policy, waned. Kunwald had played an important role, in particular during the cabinets of the Chancellor Ignaz Seipel, whom he had advised in 1922/1923 on the stabilization of the Schilling after the Austrian hyperinﬂation. Yet, Kunwald had become an outsider to the political establishment in the 1930s and he sharply criticized Kienbo¨ck’s policy for being deﬂationist putting forward in Kunwald (1934) his own theory of money and credit as an alternative to the liberal position.36

3.3. Morgenstern and Industrial Interests: Pragmatism and Mischief Morgenstern’s determination to occupy, also for the beneﬁt of the Institute and its ﬁnances, a vital role in economic policy advice is vividly demonstrated by the burst of activities to which it gave rise, in particular in the period from 1932 to mid-1933. During this time he initiated a large number of meetings. The most broadly based was a series of ‘‘conferences’’ for discussing the urgent problems of Austrian economic policy in general. The ﬁrst such conference on 11 January 1932 was initiated by Rost (and Morgenstern), and hosted by the banker and economist Karl Schlesinger.37 Moreover, Morgenstern participated also in the meetings of the still more liberal-minded Meinl group, organized by Meinl and later on by Schechner. These were then less frequented by the leaders of industry and politics, but more so by liberal economists (e.g., Mises, Machlup, and Strigl) and ofﬁcials of the Chamber of Commerce. As a sort of spin-off Morgenstern and the Meinl group suggested establishing a committee, on the model of the British ‘‘Royal Commissions,’’ at the Hauptverband der Industrie, an interest group representing Austrian industry.38 A meeting of this committee was organized by Anton Apold39 in May 1932, followed by four more conferences, between November 1932 and April 1933, with an audience slightly different from that of January 1932.40 The themes discussed at these meetings were wide-ranging and indeed encompassed all areas of economic policy. The issues directly impinging on monetary policy, like exchange controls, devaluation and the like, have already been dealt with earlier. Yet, in particular under the auspices of the industrial interests the conferences focused on measures of how to cut production costs in order to restore the proﬁtability and competitiveness of

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industry. The obvious candidates were taxes and social burdens on the one hand, and wages on the other hand. Yet, in these areas the room for maneuver was rather limited: As Morgenstern pointed out, most participants’ (including Rost’s and Kienbo¨ck’s) view of the budget was much too optimistic, and with regard to wage cuts he was doubtful of their effectiveness – in sharp contrast to Mises and Machlup, who considered them the only viable way of overcoming the depression.41 Nevertheless he agreed that the problem faced by Austrian industry was ﬁrst and foremost a problem of excessive production costs.42 With regard to trade policy views and interests were divided: Whereas in this regard Morgenstern associated himself with the Meinl group’s (and the economists’) adherence to the idea of free trade, Apold and others entertained more protectionist views, much to Morgenstern’s disdain.43 Some inﬂuence of all these activities on actual policy-making can be ascertained from the documents. For example, Morgenstern and the industrialists apparently had some say in the speciﬁc regulation of the problem of private debts denominated in foreign currency or covered by a gold clause. In fact, after in principle conﬁrming the validity of the gold (and foreign currency) clauses the actual consequences were mitigated by a government decree (the Goldklauselverordnung).44 In another respect it is also highly revealing that many participants in these conferences shared the conviction that a parliamentary democracy is ill-suited to effectively cope with the problem of crisis and must therefore be replaced by a more authoritarian regime – as indeed happened in Austria after March 1933.45 One more project in which Morgenstern was involved must be dealt with separately, that is, an industrial project of pump priming. In Austria, as in other countries, proposals for public works as a supposed remedy for depression were pouring out relentlessly.46 In 1932/1933 some of those industrialists already active in the above-mentioned circles, with Morgenstern in the role of scientiﬁc adviser, began working on a pumppriming project, too. The committee that in the end was to propose this project was led by Hans Altmann, the director of Elin, an electrical industry company.47 The ‘‘pump primers’’ (or Ankurbler, as Morgenstern somewhat condescendingly used to refer to them) met regularly from September 1932 to January 1933, and as their plan matured it was also submitted to members of the government when a law on produktive Arbeitslosenfu¨rsorge (productive unemployment relief) was under consideration.48 Eventually, on February 10, 1933 the plan (Industrieller Ankurbelungsplan) was presented to the public in a press conference.49 The main proposition of the plan was a wage subsidy for newly employed workers, in an amount double the

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beneﬁts paid to the unemployed. This value was justiﬁed by appealing to a kind of multiplier effect insofar as primary employment in the investment goods industries would generate secondary employment (in a relation of 1:1) in the consumption goods industries.50 Additional conditions appended to the granting of the subsidy were a minimum size of the project (of at least 1,000 workers), the provision that new projects should not compete with existing domestic plants, and that industries protected by import restrictions be excluded – conditions which were tailored to the interests of the companies represented by the plan’s proponents.51 Obviously, taking into account the economists’ prevalent disdain for pump priming, and in particular the rejection of the idea of secondary employment and the multiplier,52 Morgenstern’s role was rather awkward. In the discussion within the Altmann circle he had vehemently opposed the Deutsch plan (see D 24 September 1932), and on another occasion he noted, ‘‘all people know that I consider the idea of the secondarily employed (nachgezogenen) consumption worker as unprovable’’ (D 26 December 1932). Anyway, in spite of his doubts Morgenstern had good reasons, as we will shortly notice, not to visibly distance himself from this project and thus was forced to formulate diplomatically in public. Consequently, although a member of the committee of proponents his public support – in a discussion in the Industrieller Club (see D 12 February 1933) and in an anonymous article in the Tagblatt (M 12 February 1933) – was only lukewarm. Primarily, he defended the plan as being not inﬂationary because it was neutral for the government budget – the saving in unemployment beneﬁts due to the secondary effects just compensating for the expenditures on subsidies – and not coupled with proposals for credit expansion. In contrast, Machlup, who had no reason for hiding his opinion, sharply criticized the plan (like any other instance of pump priming) in a column (M 19 February 1932). Yet, in the end, the fate of the project was largely as Morgenstern had expected, after a meeting with Jakoncig: a ‘‘Pallawatsch’’ (D 19 January 1933).53 Undoubtedly, in these days Morgenstern had acquired an imposing reputation in economic policy advice, and he was rumored as a candidate for many important positions. Yet, besides his successful work within the diverse circles around Altmann, Apold, Meinl, Schechner, and many others, he also experienced harmful failures. An incident most interesting with respect to the above-mentioned activities is the story how Morgenstern did not become the General Secretary of the Hauptverband der Industrie, which is enlightening insofar as this affair climaxed just in the same days when the industrialists presented their pump-priming plan.

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Due to Morgenstern’s good connections with prominent captains of industry, in October 1932 Ludwig Urban, the president of the Hauptverband, had offered him the post of an economic adviser, combined with the directorship of a small scientiﬁc ofﬁce, possibly alongside his work at the Institute.54 During the process of deliberation within the Hauptverband the idea of a more thorough restructuring of the organization was born, such that Morgenstern should have replaced the present General Secretary, Gustav WeiX-Wellenstein, already in his seventies. As WeiX-Wellenstein belonged to those who Mises (1978a, p. 83) considered his ‘‘dear good friends’’ and fellow combatants for the liberal cause, this idea contributed to make Morgenstern’s always somewhat uneasy relationship with Mises even more delicate. In late 1932 some unexpected stumbling blocks delayed the appointment: First, the press caught word of the reorganization,55 which apparently diminished the momentum of the reformers. Secondly, it coincided with the presentation of the contentious pump-priming plan. And thirdly Morgenstern was asked to present himself to those members who did not yet know him56 by means of a lecture; when it eventually took place on February 22, 1933, apparently it was no great success.57 Since then, it appears, things began to go awry: Morgenstern had already been harmed by ongoing controversies within the Hauptverband that involved both Urban and Apold,58 then in February 1933 his ambitions became known to the press creating once more some unwelcome turbulence,59 furthermore Schechner – another of Morgenstern’s patrons – got embroiled in a tax fraud scandal, which drew blunt anti-Semitic attacks from right-wing newspapers.60 Finally, after ever more delays, probably due to the resistance by WeiX-Wellenstein and the acting Vice President, Robert Ehrhart, Morgenstern refused to wait any longer and declined the offer on March 3, 1933. Possibly, the purpose of this action had been to force a response from the President, who had been absent in the crucial days, yet, the news of Morgenstern’s rejection found its way from the Hauptverband to the press the same day, and thus it became ﬁnal.61 To add insult to injury, Morgenstern above all became the target of an attack by the newspaper of the Austrian Nazis, which accused him of being a Jew, a Manchesterliberal, a disciple of Mises, and a prote´ge´ of Schechner.62 As a result WeiXWellenstein remained in his post until October 1933, when he joined the board of the Hauptverband until in 1934 it was dissolved and transformed into the corporatist Bund der Industrie. Morgenstern reacted to all this mischief by loosening his ties with the Hauptverband and also with Apold, which however surfaced one more time, again in connection with one of Morgenstern’s failed projects. When in 1933

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Morgenstern became involved in a plan to establish a private trust company (Treuhandgesellschaft) in Vienna63 for ﬁnancing and restructuring bankrupt ﬁrms, it ran into heavy criticism from ‘‘patriotic’’ circles within the Austrian conservatives. These accused the Treuhand of forming a pretext for an attempt of the German Nazis to take over parts of the Austrian industry.64 In this regard, Morgenstern was not helped by his former close relationship with Apold, who in summer 1933 came under investigation for supporting the illegal Austrian Nazis and in mid-1934 was temporarily arrested and forced to retire for his alleged involvement in the July putsch.65 Anyway, in consequence the Treuhand project had to be abandoned. Still, in 1938 when Morgenstern already in the United States contemplated the Austrian events after the Anschluss, he wondered about having so many ‘‘personal enemies’’ within the Hauptverband.66 In the end, these two failures illustrate how Morgenstern, in his rise to prominence in Austrian economic policy advice, had become entangled in the net of opposing interest groups and competing political factions that characterized Austrian politics. Signiﬁcantly, he encountered resistance from otherwise sharply opposed camps: from the Mises group and the bureaucracy within the Hauptverband (because of their support for WeiXWellenstein); from Austrian conservatives, who suspected him of covertly acting in favor of the German Nazis in the Treuhand affair; and ﬁnally from the Austrian Nazis, who conversely attacked Morgenstern for his allegedly liberal credentials and his closeness to Mises. So in sum, these attacks must not be attributed to Morgenstern’s idiosyncratic temperament but reveal a typical feature of the constraints under which policy advice had to proceed in Austria these days.

3.4. Hard Currency Policy and Auﬂockerung: Success and Failure of Policy Advice Leaving Morgenstern in 1933 and having a fresh look at him at the end of 1934 – after a one-year-gap in his diary – we ﬁnd that these two troublesome affairs had not interrupted his rise to an inﬂuential position in Austrian economic policy advice, but just redirected it – away from the representatives of Austrian industry and towards a closer cooperation with the corporate state’s bureaucracy. Proof of this is the multiplicity of ofﬁcial positions that he ﬁlled in this period: He was part of the team that negotiated the treaty with the foreign creditors of the Creditanstalt; he eventually entered the Treuhandgesellschaft owned by the Austrian central

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bank; he became adviser to the bank and to the Ministry of Commerce, where he was concerned in particular with the regulation of railroads and freight trafﬁc; ﬁnally – within the mushrooming bureaucracy of the corporate state – he played a major role in a newly formed price commission associated with the Institute and in the corresponding interministerial committee. These developments coincided with Morgenstern’s success in expanding the tasks and securing the ﬁnances of the Institute.67 His rise was also facilitated by other prominent economists’ absence from Austria. Machlup had emigrated to the United States and had rejected an offer by Meinl to involve himself again in Austrian economic policy.68 Hayek also remained distant from Austrian politics although during the crucial phase to be examined below he praised the axis consisting of Kienbo¨ck, Draxler, and van Hengel for their competent ﬁnancial policies.69 And even Mises, now teaching in Geneva, was only occasionally present in Vienna, and moreover within the corporate state the Chamber could no longer provide the channel of inﬂuence for his recommendations as it had done before. These are the preconditions for the Austrian economists’ activities when we look at a last episode, namely the debate on devaluation and Auﬂockerung following the breakdown of the gold bloc. When in 1936 the gold bloc countries (France, Switzerland, and the Netherlands) eventually were forced into abandoning the gold parity, this left Austria in a dilemma. In order to maintain its competitiveness in international trade, it had to close the gap between Austrian and world market prices, in particular the prices in the former gold bloc countries. The available options were then either a devaluation of the Schilling or the attempt, similar to the Bru¨ning campaign in Germany in the early 1930s, to bring down Austrian domestic prices. In accordance with its newly maintained hard currency policy the Austrian government and the National Bank chose not to devalue. Although in the short run – due to exogenous events70 – this decision did not do much harm to the Austrian economy, combined with the inactivity in other respects to most observers (past and present) this constituted the last missed chance for a recovery of the economy up to its pre-depression level of activity. What was then the economists’ advice? Morgenstern’s concern with the ‘‘price gap’’ had been an ever-resonating theme throughout the whole decade. Thus, although he recommended against devaluation, he pointed out that such a hard currency strategy will only be feasible if accompanied by a policy of Auﬂockerung in order to lower prices and ultimately close the price gap. If such a policy could not be implemented, the second-best option would be to devalue. The arguments cited against devaluation were the burden of foreign denominated debt and political reasons, presumably the

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necessity either to accept lower real wages or to accommodate nominal wages, where both strategies would aggravate an already difﬁcult political situation.71 These alternatives of Auﬂockerung and devaluation were clearly spelled out in private communication and in a memorandum (Denkschrift) of November 1936 (Morgenstern, 1936a), parts of which were published (see Morgenstern, 1936b). Crucial to all of Morgenstern’s advice in this regard was his insistence on the urgency with which a policy of Auﬂockerung had to be pursued. In contrast, Haberler, who observed these events from the outside (in Geneva), openly favored devaluation in the form of pegging the Schilling to the devalued French franc. Already earlier he had recommended such a policy for the case that France would leave the gold parity (Haberler, M 4 November 1933), and now he propagated it because he felt that the income reductions required otherwise might turn out as untenable. Devaluation thus constituted an opportunity that should not easily be missed, whereas to stick to the old parity would indeed be ‘‘heroic.’’72 Yet, when he presented his opinion in correspondence to Kienbo¨ck and Draxler, they reacted ungraciously.73 Finally, if we can trust Morgenstern’s notes, Mises played a curious role in this regard: He recommended a hard currency policy but allegedly (in October 1936) suggested to amend it with subsidies to the most vulnerable industries,74 a policy not quite up to Mises’ liberal credentials and which Morgenstern in his memo vehemently opposed. As components of his favored strategy of Auﬂockerung Morgenstern proposed the easing of trade restrictions, in particular abolishing the bans on speciﬁc imports, and the facilitation of the entry of new ﬁrms into domestic trades and industries, thereby furthering a more competitive environment for Austrian production.75 Moreover, in the already highly regulated Austrian economy there existed a multiplicity of measures for directly intervening into the formation of prices (and wages). Accordingly, with the decision not to devalue a new institutional framework for price control had been created with the Institute as an ofﬁce of price observation, reporting to an interministerial committee, which in turn had to work out proposals for lowering prices.76 Now, at the outset Morgenstern was optimistic that this commission could be used as a vehicle for furthering the policies he favored. Yet, he soon had the opportunity to experience the fate of Auﬂockerung in practice through his committee work. Already in the ﬁrst sessions of the committee the efforts to lower speciﬁc prices met ﬁrm resistance of the respective interest groups, and especially so when prices of agricultural products (e.g., sugar, milk) were concerned.77 Already the Denkschrift was written as a desperate attempt to speed up a process that Morgenstern deemed too slow

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and too indecisive to cope with the situation of the Austrian economy, which he described as a ‘‘morass’’ (D 21 October 1936). Yet, the opposition against the lifting of import bans and forced price decreases subsisted. When Morgenstern attacked the persistence of import bans in an article (Morgenstern, 1937b), apparently with the backing of Kienbo¨ck,78 it drew harsh criticism from Austrian industry.79 Finally after a representative of the agrarian interests, Felix Feest, had been appointed to head the price commission, Morgenstern resigned – he ultimately had become convinced that nothing useful would result from these activities.80 In the end, policymakers had chosen to follow only one of the two component parts of Morgenstern’s advice: they stuck to the parity of the Schilling with prices and costs as rigid and high as before. Morgenstern’s last words in this respect were those in a speech in January 1938, held before a section of the Vaterla¨ndische Front (Morgenstern, 1938), on the eve of his departure from Austria for a three-month visit to the United States and at a time when he had mostly withdrawn from policy advice for the sake of his scientiﬁc career.81 On this occasion he warned that Austria’s capability to survive (Lebensfa¨higkeit) did depend on the directions chosen for economic policy, more so than on its endowment with natural resources. Consequently, Austria could only survive economically if it did not drift any longer towards ‘‘autarky’’ and a ‘‘pseudo-planned economy,’’ but instead integrated itself into the world economy by means of freer trade, opened up its industries to more competition, internal and external, and steered a course towards ‘‘rejuvenation.’’ Thus, this speech was a last call for Auﬂockerung, and this time not mitigated in its wording by any propensity to compromise with the politics of the corporate state. Yet, it came too late, not least because similar calls had been ignored for the years before.

4. THE ECONOMISTS’ INFLUENCE ON AUSTRIAN POLICY IN THE 1930S: FACT OR FICTION? The evidence reviewed above suggests some tentative conclusions. This investigation took 1931 as its point of departure, when in the name of ‘‘emergency measures’’ Austrian economic policy discarded its adherence to the liberal framework in many respects. The ensuing situation gave rise to the combined effort of economists to ﬁght this tendency and to restore a liberal economic order. And indeed, in the interim period 1932–1934,

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characterized by economic crisis, the slow demise of the parliamentary system, and the restoration of monetary and ﬁnancial stability, their impact was considerable in ‘‘educating’’ politicians and representatives of international institutions in inﬂuential positions with regard to Austrian economic policy. (As may be concluded from Morgenstern’s experiences with the Hauptverband the education of industrial interests eventually turned out still more difﬁcult). This education resulted in ﬁrmly linking the conservative governments, in particular those of the Sta¨ndestaat era, to a monetary and ﬁscal framework again dominated by the mentality of the gold standard, that is, the quest for sound money and a balanced budget. In any case, in this regard a caveat is in order for it is difﬁcult to judge, if the power exerted by the foreign creditors and the ﬁnancial experts, for example, those of the LoN, had not led to a similar result, even without the interventions of the Austrian economists. The economists’ success in the ﬁeld of ‘‘macroeconomics’’ (allowing for this anachronistic terminology) was, however, offset by their failure with regard to ‘‘microeconomic’’ issues, like the reduction of trade restrictions or the deregulation of industry (and especially agriculture), where an antiliberal spirit prevailed, in particular, under the reign of the corporate state ideology. This failure became the more glaring in the ﬁnal phase of Austria’s existence as an independent state. While the hard currency policy remained almost unchallenged, even in the face of the breakdown of the gold bloc and the devaluation of its currencies, the attempt to implement a policy of Auﬂockerung as its necessary complement came to naught. Here the arguments of the economists, although shared to some extent by members of the Austrian policy establishment, proved powerless when running counter to the combined interests of the ‘‘corporations’’ on which the corporate regime was based. Thus, Morgenstern’s resignation in 1937 symbolized the ﬁnal defeat of liberalism in Austria even before the Anschluss and, in the end, the combination of success and failure, leading to contractionary monetary and ﬁscal policies in the face of rigid prices, produced as an unintended consequence a sure recipe for depression.82 The episodes discussed also show to what an extent the Austrian economists in their pursuit of the goal of a liberal economic order were forced to content themselves with ‘‘second-best’’ solutions. The necessity to compromise was a common experience both for Mises and later on for Morgenstern in their role as policy advisers.83 The examples provided above range from the acceptance of devaluation to Morgenstern’s cooperation with the pump primers, and eventually to his resignation when the ﬁnal campaign for Auﬂockerung had failed. In particular, the position of the

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Austrian economists was aggravated by the fact that in interwar Austria liberalism lacked a political base. Some refuge for liberal thought had been offered within the banking system (including the central bank), the Chamber of Commerce and a few circles of industrialists, but especially after the breakdown of the Creditanstalt even this kind of support began to evaporate. The commitment of the Austrian state (in the form of the Sta¨ndestaat) to the ideals of corporativism was of course detrimental, too. Thus eventually, best exempliﬁed by the fate of Morgenstern, the liberal cause had to rely on shifting coalitions and fragile personal relations, which in the end turned out too weak for sustaining the policies envisioned by the Austrian economists. With regard to the individuals contributing to the successes and failures of the economists’ activities in policy advice, the available yet incomplete evidence supports the thesis that, although starting as a concerted action of all the economists involved, Morgenstern became the central ﬁgure as time went by. For example, there is scant evidence for Mises’ self-conscious statement that it ‘‘was my achievement alone . . . that the inﬂation went no further’’ in 1932 (Mises, 1978a, p. 91); more generally this evidence sheds doubts on a historiography of Austria in the 1930s largely based on the account in Mises’ Recollections. Furthermore, in the course of this development Morgenstern’s role changed from an ‘‘outside observer’’ to that of an ‘‘insider’’ within the bureaucratic structure of economic policy – in contrast to Machlup and, after 1934, also to Mises. One might thus ﬁnd some irony in the fact that it was Morgenstern, a stern critic of liberal economic theory in other respects, who became the last economist to hold out – and fail – in Austria in his ﬁght for the liberal case.

NOTES 1. For examples of these two strands of literature see Stiefel (1988), Mattl (1984) and Senft (2002), and Ebeling (2001, 2002), Leube (2002), and Pallas (2005, Section 5.3), respectively. Both views take for granted that feasible alternatives to the policies actually followed have existed, a thesis famously disputed for Germany by Borchardt (1991); for Austria see Butschek (1984). 2. In this regard, the following draws on, revises, and supplements an earlier paper (Klausinger, 2007). 3. For more biographical information see the entries in Hagemann and Krohn (1999). For a characterization of the conﬂicting positions within Austrian economics from Morgenstern’s point of view see Leonard (2004), on his sometimes strained relationship to the Mises group see also Klausinger (2006).

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4. For sake of brevity we will refer to these authors as ‘‘the (Austrian) economists.’’ Obviously, this group of ‘‘economists’’ does not include those members of the Austrian economics community associated with Austromarxism, universalism, or the tradition of the romantic or historical school. 5. Most of these articles appeared anonymously in the Viennese daily newspaper Neues Wiener Tagblatt between 1931 and 1934. A selection of these articles has been reprinted in Machlup, Morgenstern, Haberler, and Hayek (2005); on the underlying ‘‘campaign’’ see below, Section 3. 6. In the text citations to articles reproduced in Machlup et al. (2005) are by an ‘‘M’’ followed by their date of publication – these are not included in the references; all other contributions to daily, weekly, and monthly papers are referred to as usual. Citations of the Oskar Morgenstern, Gottfried Haberler, and Fritz Machlup Papers are abbreviated by OMP, GHP, and FMP, respectively, followed by the number of the box. Morgenstern’s diary (in OMP 13) is cited by ‘‘D’’ and the date of the entry. If not indicated otherwise, translations from German sources are my own. 7. On the Austrian economic history of the 1930s see also, in addition to the references in note 1, Kernbauer (1991), Sandgruber (1995, pp. 382–402), and in particular on the Creditanstalt crisis Schubert (1991). 8. In this section references will be primarily to sources from the policy debate of the 1930s. For an overview of the arguments typically used in Machlup’s columns see Klausinger (2004). 9. From the contemporary debate see, for example, Morgenstern (M 4 October 1931) for a general perspective; Machlup (M 27 February and 24 April 1932) on the danger of hoarded notes; Machlup (M 4 September 1932 and 24 February 1933) on the superiority of a gold currency; and Machlup (M 4 February 1934) on the priority of a stable parity over a stable price level. On inﬂationism in general see Mises (1924, pp. 203–215, 1981, pp. 251–262). 10. See, for example, Machlup (M 18 February and 22 May 1932), see also Machlup (1933a). 11. See for example, Machlup (M 8 and 9 October 1932), Morgenstern (M 7 May 1932); similarly Mises (2002, chapters 23 [18 February 1932] and 31 [19 October 1932]). 12. Machlup (M 15 May and 2 October 1932), Haberler (M 22 January and 12 April 1933), and Mises (2002, chapters 23 [8 February 1932] and 27 [30 May 1933]). For the persistence of the Austrian critique on the erroneous preoccupation with the trade deﬁcit see also Morgenstern (D 19 October 1935). 13. See for example, Machlup (M 10 April 1932) and Morgenstern (M 13 May 1933) for the rejection of trade preferences and Machlup (M 23 October 1932) for the proposal of unilateral tariff reductions. 14. See Machlup (M n.d. [May 1932?]), an article written for but not published by the Tagblatt, and Morgenstern (M 22 May 1932). 15. See, for example, Machlup (M 17 April 1932, 19 Feb, 4 March, and 7 May 1933) and Mises (1931, Section 4 [1978b, Section III.A]). On Morgenstern’s position see below. 16. See, for example, Mises (1931) and Machlup (M 26 November 1933). 17. The term Auﬂockerung – in its literal meaning: loosening (the ground) – was well known from the German debate, where it had been used among others by

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Ro¨pke and Lautenbach, who propagated it as a complement to (and not as the Austrians: as a substitute for) expansionist policy. 18. For a general perspective see Mises (1931). For the later contributions by Morgenstern and Strigl see below. 19. For more details see Klausinger (2005). From the authors’ perspective see Morgenstern (1937a) and Machlup (1980). 20. See Ebeling (2002) and the papers reprinted in Mises (2002, 2003). Already in 1930 Mises had represented the Chamber in the Wirtschaftskonferenz on the causes of the depression, with participants from business, agriculture and labor; the published ﬁndings of this conference, where no consensus had been reached, mirrored Mises’ views to a large extent. See Grandner and Traxler (1984) and Ebeling (2002, p. xxxi). 21. See, for example, Meinl (1932) and Meinl and Schechner (1932). 22. See more below. 23. For biographical details see Kienbo¨ck (1995). 24. When the Pan-Germans (Grossdeutschen), which propagated a policy of union with the German Reich, had left the government in January 1932, this facilitated a rapprochement towards France and Great Britain, and the LoN, paving the way for a ‘‘liberal solution’’ to the economic crisis. 25. Later on Morgenstern (M 8 May 1932) also agreed with only minor exceptions with Rost’s quarterly report to the LoN. 26. Morgenstern’s article in the Tagblatt (M 22 May 1932) was based on an expose written for Kienbo¨ck (D 22 May 1932), and in fact the fund in question was built along the lines proposed by Morgenstern. Nevertheless, after the encounter with Kienbo¨ck he still described him as ‘‘the greatest ignoramus’’ (D 26 May 1932). 27. See Machlup (M n.d. [May 1932?]). 28. See Berger (2000, pp. 263–275) and Kienbo¨ck (1995, pp. 53–54). 29. See Morgenstern (M 8 May 1932), where he refers to Anon. (1932), an article in the monthly bulletin of the Institute, most probably authored by Morgenstern himself. 30. See, for example, Strigl (M 29 May 1932) and Machlup (M n.d. [July 1932?]), again Machlup’s commentary was not printed by the Tagblatt. Credibility should be furthered, for example, by upholding the validity of the gold clauses. 31. Viktor Brauneis, the General Director of the Austrian National Bank, reacted favorably to the views expressed in Morgenstern’s article (see Brauneis to Morgenstern, 5 August 1932, OMP 4). 32. This was, for example, the judgment of Richard Schu¨ller, a senior government ofﬁcial, see Nautz (1990, pp. 173–174). 33. Still Morgenstern probably shared the opposition to those clauses in the Lausanne Protocol that reconﬁrmed the prohibition of the Anschluss to the German Reich. 34. This became the majority position of the Chamber of Commerce; however, a minority (from Carynthia, Tyrol, and Salzburg) recommended to reject the Lausanne loan (see Neues Wiener Tagblatt, 27 July 1932, pp. 9–10). 35. For example, Morgenstern stated his broad agreement with Kienbo¨ck on the loan and currency question (D 14 October 1933) and later on, even more

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emphatically, exclaimed: ‘‘Now, he can be cited approvingly on so many things’’ (D 13 November 1934; emphasis in the original). 36. On Kunwald see Weissensteiner (2004) and, in contrast, the characterization by Mises (1978a, pp. 80–82). 37. Among the participants in the ﬁrst conference were (besides Schlesinger) Brauneis, Bruins, Rost, Gra¨tz, and the bankers Victor Bloch, Emil Kux, and Alexander Weiner. 38. Besides, there also existed the smaller and more exclusive Industrieller Club. See Haas (1979, p. 110). 39. Apold was general director of the Alpine Montan, an Austrian steel company owned by the German Vereinigte Stahlwerke; see also below. 40. These four conferences were hosted, respectively, by Alexander Hryntschak, a member of parliament who represented the industrial interests within the ruling Christian Social Party, Apold, Schechner, and Alfred Go¨tzl, the director of the Garvenswerke, a machine company; regular participants included among others van Hengel, Kienbo¨ck, and Rost. 41. See Morgenstern (D 25 November and 26 December 1932); see also Apold’s plea for Auﬂockerung and cost cutting in a speech to the Industrieller Club (Apold, 1933). 42. See Morgenstern (1933a). 43. For example, Apold, representing a steel company also involved in coal mining, favored the government’s policy of banning coal imports, whereas Meinl, much of whose business was based on the import of coffee, not only pleaded for freer trade in general, but also for a lowering of the duties on coffee in particular. See Morgenstern (D 3 November 1932) and on the coffee duties Schechner (1932). 44. See Morgenstern (D 12, 15 and 19 March 1933). 45. See Haas (1979, pp. 110–123). On Morgenstern’s position see Klausinger (2006, Section 3). 46. For example, the plan by Deutsch and Verte´s (1932) and another by the Chamber of Labour; see the critiques by Haberler (1932) and Machlup (M 4 March 1933). 47. The other members of the committee were Anton Apold and Eugen Herz (of the Alpine Montan), Bruno Bauer (an architect), Ernst Geiringer (of Jute, Hanf & Textil, a textile company within the Creditanstalt group), Alfred Go¨tzl (of the Garvenswerke), and Martin Kink (of Porr, a construction ﬁrm). 48. Morgenstern reports of meetings, with the Minister of Commerce, Guido Jakoncig (D 9 December 1932), the Minister of Finance, Emanuel Weidenhoffer (D 18 December 1932), and the Minister for Social Affairs, Josef Resch (D 15 February 1933), which all left him rather unimpressed. 49. For a description of the plan see Neues Wiener Tagblatt (‘‘Industrieller Arbeitsbeschaffungsplan,’’ 11 Feb 1933, 11–12); cf. also Weber-Felber (1990, pp. 229–230). 50. In fact, this part of the plan was somewhat unclear so that in a ﬁrst version the subsidy proposed was not double but fourfold the unemployment beneﬁts, apparently arguing that one primary investment worker would employ one secondary investment worker, and both then employ two consumption workers. See the criticism in the O¨sterreichischer Volkswirt 25, 21 (‘‘Neuer Arbeitsbeschaffungsplan,’’ 18 February 1933, pp. 474–475).

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51. See Weber-Felber (1990, p. 229). 52. See above, Section 2. 53. Only insufﬁciently translated by ‘‘chaos.’’ On the public works initiatives of the Austrian government in 1933 see Weber-Felber (1990, chapter 7). 54. See D (30 October and 15 November 1932). 55. See the remarks in the Neue Freie Presse (13, 14, and 16 December 1932); for Morgenstern’s reaction see D (13 December 1932). 56. To the ‘‘Provinzler’’ (people from the provinces, that is, the non-Viennese), as Morgenstern referred to them (D 25 January 1933). 57. See D (26 February 1933). The lecture was published in Die Industrie (Morgenstern, 1933b), the weekly journal of the Hauptverband. 58. This conﬂict was between, on the one hand, those (like Apold) who favored decisive steps towards an authoritarian solution of the economic and political crisis and simultaneously attacked the agrarian course of the acting government and, on the other hand, those (like Urban) who opted for a more detached position. As a consequence, in January 1933 Apold and the Alpine Montan had left the Hauptverband. At the same time, the Hauptverband was also deeply divided between advocates of protectionism and free trade and thus could not agree on an unequivocal position with regard to import restrictions. See Haas (1979, pp. 116–123). 59. See Die Stunde (‘‘GroXe Personalvera¨nderungen beim Hauptverband,’’ 3 February 1933, p. 1, and ‘‘Sinnwidrigkeit der Einfuhrverbote,’’ 11 February 1933, p. 2), where Morgenstern was associated with the free traders within the Hauptverband. See on this D (7 and 27 February 1933). 60. See, for example, articles in the Deutscho¨sterreichische Tageszeitung (5 March 1933) and in Freiheit! (6 and 7 March 1933). 61. See Die Stunde (‘‘Der Hauptverband der Industrie fu¨r Hochschutzzoll,’’ 5 March 1933, p. 2), which points out that Morgenstern’s liberal attitude got in conﬂict with the protectionist position of the majority within the Hauptverband. Morgenstern tells his version of the story in D (4 March 1933). 62. See the Deutscho¨sterreichische Tageszeitung (‘‘Die Kandidatur Dr. Morgensterns,’’ 10 March 1933, p. 12). Already earlier as a reaction to similar rumors and to a request by the Hauptverband, Morgenstern had asked his father for researching into the family’s genealogy in order to prove his Aryan descent. See D (12 February 1933) and W. Morgenstern (1934). 63. Not to be confused with the Treuhand company that had come into existence by the merger of the Wiener Bankverein and the Niedero¨sterreichische Escompte and was partly owned by the Austrian National Bank. 64. See the attacks (e.g., ‘‘Nationalsozialistische Industrieoffensive,’’ 3 September 1933, p. 1; ‘‘Zum Nazieinbruch in die Industrie’’ and ‘‘Wozu ein separates Konjunkturforschungsinstitut?,’’ 10 September 1933, p. 2; ‘‘Der ‘gebesserte’ Morgenstern,’’ 1 Oct 1933, p. 2) in Sturm u¨ber O¨sterreich, the weekly journal of the Ostma¨rkische Sturmscharen, a para-military organisation close to the Christian Socialists and headed by Kurt Schuschnigg, then Minister of Justice (see Morgenstern D 3 September 1933 and passim). Signiﬁcantly, in his attempts to stop these attacks Morgenstern turned to Kunwald for mediating between him and Schuschnigg (see D 12 and 30 September, and 2 October 1933).

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65. Rost in his diary (12 Mar 1934) called Apold an ‘‘Austrian Nazi’’ (see Berger, 2000, p. 529). 66. Morgenstern to Haberler (28 April 1938, GHP 65). 67. Morgenstern’s ofﬁcial positions are referred to in his diary in numerous places. On the Institute’s ﬁnances see, for example, Craver (1986) and Fleck (2000). 68. See the correspondence between Machlup and Meinl in January 1936 (FMP 53). 69. See Hayek to Haberler (3 June 1936, GHP 67). During his term as Minister of Finance 1935/1936 Ludwig Draxler pursued an uncompromising course of ﬁscal austerity. 70. Such exogenous events were the stimulation of Austrian exports due to the demand generated by re-armament and, in particular, due to trade with Italy, as Austria had not joined the LoN boycott after the Abessinyian war. 71. Morgenstern (1936b, p. 169) also warned (somewhat obscurely) that a devaluation would hurt Austria’s small Alpine farmers. 72. See Haberler’s letters to Morgenstern (30 October, 20 November 1936, 9 January 1937 and n.d. [1937], OMP 5). 73. See Haberler to Draxler (18 Dec 1936) and the replies by Kienbo¨ck (to Haberler, 12 December 1936 and 9 February 1937, all in GHP 65). 74. See Morgenstern (D 25 October 1936) and Morgenstern to Haberler (14 March 1937, GHP 65). Here, as in other places, the lack of documents makes it impossible to crosscheck Morgenstern’s contentions. 75. See Morgenstern (1936a); Strigl (1937a, 1937b, 1937c) also contributed to this campaign. 76. See Morgenstern (1936a, p. 4). 77. See Morgenstern (D 31 October 1936). 78. See Morgenstern to Haberler (14 March 1937, GHP 65) 79. See Die Industrie 42, 28 (‘‘Die Einfuhrverbote,’’ 9 July 1937, p. 6). 80. ‘‘Es wird nichts herauskommen.’’ (D 24 July 1937) On Feest and the price commission see also Mattl (1984, pp. 145–146, 149). 81. Morgenstern was ousted from the Institute after the Anschluss in March 1938 and did not return to Austria. 82. In retrospect, Machlup (1980, p. 128) conceded that his policy advice in the 1930s had been shaped by his ‘‘inexperience with deﬂation and [the] downward rigidity of wage rates.’’ 83. Cf. Mises (1978a, p. 75): ‘‘In science, compromises are treason to truth. In politics compromises are unavoidable . . . ’’

ACKNOWLEDGMENT I am grateful to the participants of the conference and to an anonymous referee for their valuable comments. For the permission to quote from the

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Oskar Morgenstern Papers I thank the Rare Books, Manuscript, and Special Collections Library of Duke University (Durham, NC).

REFERENCES Anon. [Morgenstern, O.] (1932). Ru¨ckblick auf das Jahr 1931. Monatsberichte des O¨sterreichischen Instituts fu¨r Konjunkturforschung, 6(2), 17–27. Apold, A. (1933). Selbstkosten und Preise. Mitteilungen des Industriellen Klubs, 357, 1–12. Berger, P. (2000). Im Schatten der Diktatur. Die Finanzdiplomatie des Vertreters des Vo¨lkerbundes in O¨sterreich, Meinoud Marinus Rost van Tonningen, 1931–1936. Vienna: Bo¨hlau. Borchardt, K. (1991). Perspectives on modern German economic history and policy. Cambridge: Cambridge University Press. Butschek, F. (1984). Die wirtschaftspolitischen Alternativen in der Stagnationsperiode 1933 bis 1937. Wirtschaftspolitische Bla¨tter, 31, 234–246. Craver, E. (1986). Patronage and the directions of research in economics: The Rockefeller foundation in Europe, 1924 1938. Minerva, 24, 205–222. Deutsch, O., & Verte´s, A. (1932). Aufbau, nicht Abbau! Vienna: O¨sterreichische Staatsdruckerei. Ebeling, R. M. (2001). The economist as the historian of decline. Ludwig von Mises and Austria between the two world wars. Mimeo. Hillsdale, MI. Ebeling, R.M. (2002). Introduction to Mises (2002), pp. xiii–liii. Fleck, Ch. (2000). Die gescheiterte Gru¨ndung eines Zentrums fu¨r sozialwissenschaftliche Forschung in den 30er-Jahren in Wien. AGSO¨-Newsletter, 20, 15–29. Grandner, M., & Traxler, F. (1984). Sozialpartnerschaft als Option der Zwischenkriegszeit? Liberalkorporatistisches Krisenmanagement am Beispiel der Wirtschaftskonferenz von 1930. In: E. Fro¨schl & H. Zoitl (Eds), Februar 1934. Ursachen, Fakten, Folgen (pp. 75–117). Vienna: Wiener Verlagsbuchhandlung. Haas, K. (1979). Industrielle Interessenpolitik in O¨sterreich zur Zeit der Weltwirtschaftskrise. Jahrbuch fu¨r Zeitgeschichte, 1978, 97–126, Vienna. Haberler, G. (1932). Mit oder ohne Inﬂation. Zu ‘‘Aufbau, nicht Abbau’’. Der O¨sterreichische Volkswirt, 25(6(5 Nov)), 136–137. Haberler, G. Papers. Hoover Institution Archives. Stanford University. Hagemann, H., & Krohn, C.-D. (Eds). (1999). Biographisches Handbuch der deutschsprachigen wirtschaftswissenschaftlichen Emigration nach 1933. Munich: Saur. Kernbauer, H. (1991). Wa¨hrungspolitik in der Zwischenkriegszeit. Geschichte der Oesterreichischen Nationalbank von 1923 bis 1938. Vienna: Oesterreichische Nationalbank. Kienbo¨ck, M. (1995). Viktor Kienbo¨ck. Christliche Demokratie. Zeitschrift des Karl von Vogelsang-Institutes, 12(2), 3–72. Klausinger, H. (2004). ‘‘Two Minutes of Austrian Economics.’’ Fritz Machlup’s journalistic writings, 1932–1934. Research into the History of Economic Thought and Methodology, 22(B), 97–130. Klausinger, H. (2005). Die Austroliberalen und die Kampagne im Neuen Wiener Tagblatt. In Machlup et al., pp. 11–35.

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Klausinger, H. (2006). From Mises to Morgenstern. Austrian economics during the Sta¨ndestaat. Quarterly Journal of Austrian Economics, 9(3), 25–43. Klausinger, H. (2007). Der Austroliberalismus und die o¨sterreichische Wirtschaftspolitik in den 1930er Jahren. In: R. Neck (Ed.), Die O¨sterreichische Schule der Nationalo¨konomie (Schriften der Karl Popper Foundation). Frankfurt: Peter Lang. Kunwald, G. (1934). Das Leben der Erwartungs- und Kreditwirtschaft. Jena: Fischer. Leonard, R. (2004). ‘‘Between worlds,’’ or an imagined reminiscence by Oskar Morgenstern about equilibrium and mathematics in the 1920s. Journal of the History of Economic Thought, 26, 285–310. Leube, K. R. (2002). Preliminary remarks on Mises in interwar Vienna. ICER Working Paper no. 34. Machlup, F. (1933a). Die Wa¨hrungs- und Kreditkrise. Schmollers Jahrbuch, 57, 373–388. Machlup, F. (1933b). Kostensenkung oder Kreditausweitung? Der O¨sterreichische Volkswirt, 25(33(13 May)), 780–782. Machlup, F. (1980). My early work on international monetary problems. Banca Nazionale del Lavoro Quarterly Review, 33(133), 115–146. Machlup, F. Papers. Hoover Institution Archives. Stanford University. Machlup, F., Morgenstern, O., Haberler, G., Hayek, F. A. et al. (2005). Wirtschaftspublizistische Beitra¨ge in kritischer Zeit (1931–1934). H. Klausinger (Ed.). Marburg: Metropolis. Mattl, S. (1984). Die Finanzdiktatur. Wirtschaftspolitik in O¨sterreich 1933–1938. In: E. Talos & W. Neugebauer (Eds), Austrofaschismus. Beitra¨ge u¨ber Politik, O¨konomie und Kultur 1934–1938 (pp. 133–160). Vienna: Verlag fu¨r Gesellschaftskritik. Meinl, J. (1932). Sieg der Vernunft oder Katastrophe (2nd ed.). Vienna: Berger und Fischer. Meinl, J., & Schechner, K. (1932). Sind die geplanten Steuer- und Zollerho¨hungen notwendig? Zum Lausanner Abkommen. Vienna: Published by the authors. Mises, L. (1924). Theorie des Geldes und der Umlaufsmittel (2nd ed.). Munich: Duncker und Humblot. Translated as Mises (1981). Mises, L. (1931). Die Ursachen der Wirtschaftskrise. Tu¨bingen: Mohr. Translated as Mises (1978b). Mises, L. (1978a). Notes and recollections. Spring Mills: Libertarian Press. Mises, L. (1978b). The causes of the economic crisis: An address. In: P. L. Greaves, Jr. (Ed.), On the manipulation of money and credit (pp. 173–203). New York: Free Market Books. Mises, L. (1981). The theory of money and credit. Indianapolis: Liberty Classics. Mises, L. (2002). Between the two world wars: Monetary disorder, interventionism, socialism, and the great depression (Selected Writings of Ludwig von Mises, volume 2). R. M. Ebeling (Ed.). Indianapolis: Liberty Fund. Mises, L. (2003). Der unbekannte Mises. Reden und Aufsa¨tze zur o¨sterreichischen Wirtschaftspolitik der Zwischenkriegszeit. K. R. Leube (Ed.). Frankfurt: FAZ-Buch. Morgenstern, O. (1933a). Industriepolitische Zielsetzung. Zum Problem der o¨sterreichischen Produktionskosten. Die Reichspost, 40(28 Feb), 9. Morgenstern, O. (1933b). Probleme der o¨sterreichischen Industriepolitik. Die Industrie, 38(9), 5–7. Morgenstern, O. (1936a). Bemerkungen zur wirtschaftspolitischen Lage O¨sterreichs im Hinblick auf die internationalen Abwertungen. Typescript (dated 23 Nov). Morgenstern, O. (1936b). Wa¨hrung und Preise. O¨sterreichische Zeitschrift fu¨r Bankwesen, 1, 166–171.

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Morgenstern, O. (1937a). Entstehung und Abbau der o¨sterreichischen Devisenbewirtschaftung. Nationaløkonomisk Tidsskrift, 75, 34–56. Morgenstern, O. (1937b). Strategie der Einfuhrverbote. Der O¨sterreichische Volkswirt, 29(39 (26 June)), 767–769. Morgenstern, O. (1938). Die Bedingungen der wirtschaftlichen Lebensfa¨higkeit O¨sterreichs, Typescript (Jan 1938). In: Oskar Morgenstern Papers, box 22. Morgenstern, O., Papers. Rare Book, Manuscript, and Special Collections Library. Duke University. Morgenstern, W. (1934). Familie Morgenstern. Typescript. In: Oskar Morgenstern Papers, box 74. Nautz, J. (Ed.) (1990). Unterha¨ndler des Vertrauens. Aus den nachgelassenen Schriften von Sektionschef Dr. Richard Schu¨ller. Vienna: Verlag fu¨r Geschichte und Politik. Pallas, C. (2005). Ludwig von Mises als Pionier der modernen Geld- und Konjunkturtheorie. Marburg: Metropolis. Sandgruber, R. (1995). O¨konomie und Politik. O¨sterreichische Wirtschaftsgeschichte vom Mittelalter bis zur Gegenwart. Vienna: U¨berreuter. Schechner, K. (1932). Ein Beitrag zu den ‘‘sachlichen Erwa¨gungen’’, die den Finanzminister veranlassen, neuerlich eine Erho¨hung des Kaffeezolles zu beantragen. Vienna: Steyrermu¨hl. Schubert, A. (1991). The Credit-Anstalt crisis of 1931. Cambridge: Cambridge University Press. Senft, G. (2002). Im Vorfeld der Katastrophe. Die Wirtschaftspolitik des Sta¨ndestaates, O¨sterreich 1934–1938. Vienna: Braumu¨ller. Stiefel, D. (1988). Die groXe Krise in einem kleinen Land. Vienna: Bo¨hlau. Strigl, R. (1937a). Grundsa¨tzliches zur Frage der Preispolitik. Der O¨sterreichische Volkswirt, 29(32(8 May)), 627–628. Strigl, R. (1937b). Clearingspitzen. Der O¨sterreichische Volkswirt, 29(38(5 June)), 707–708. Strigl, R. (1937c). Auﬂockerung der Wirtschaftspolitik. Neue Freie Presse, (21 Nov), 22. Weber-Felber, U. (1990). Wege aus der Krise: Freie Gewerkschaften und Wirtschaftspolitik in der Ersten Republik. Vienna-Zurich: Europa. Weissensteiner, F. (2004). Dr. Gottfried Kunwald: Bundeskanzler Seipels Finanzberater und Freund. O¨sterreich in Geschichte und Literatur, 48, 208–226.

THE CONTINUING RELEVANCE OF F.A. HAYEK’S POLITICAL ECONOMY Peter J. Boettke, Christopher J. Coyne and Peter T. Leeson ABSTRACT This chapter explores the political economy of F.A. Hayek with emphasis on the continued relevance of his work for contemporary scholars. We focus on the theme of coordination throughout Hayek’s research program. This general theme can be traced from Hayek’s technical economics up through his later writings in political philosophy. After considering Hayek’s major works in political and legal theory, we conclude by discussing the contemporary implications of Hayek’s political economy. Speciﬁcally, we discuss eight areas where modern economists should pay close attention to the main lessons and themes in Hayek’s writings.

1. INTRODUCTION Friedrich A. von Hayek was arguably the most important classical liberal political economist of the 20th century. Although trained as a technical economist, Hayek’s body of work extended well beyond the discipline of Explorations in Austrian Economics Advances in Austrian Economics, Volume 11, 79–98 Copyright r 2008 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11005-5

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economics. Indeed, the most productive reading of Hayek’s body of work is as an interconnected research program of ‘‘political economy’’ that overlaps the disciplines of economics, politics, and law (Boettke, 1999). As Gordon (1981, p. 471) notes, Hayek’s ‘‘writings on these matters [the relation of economics to political philosophy] are unequalled in profundity, historical scholarship, and current relevance.’’ Our goal in this chapter is to explore Hayek’s political economy with emphasis on the continued relevance of this work for contemporary scholars. In order to pursue this line of inquiry we ﬁrst provide a discussion of the foundations of Hayek’s political economy. It is our contention that the general theme of ‘‘coordination’’ can be traced from Hayek’s technical economics up through his later writings in political philosophy (see O’Driscoll, 1977). After exploring this foundation we discuss the historical context and main theme of Hayek’s classic work, The Road to Serfdom. The Road to Serfdom is perhaps Hayek’s most well-known work. In addition to being a best seller in England and the United States, it has been translated into nearly 20 languages. Unauthorized copies of the book circulated throughout Eastern Europe before the collapse of the Berlin Wall. There can be little argument that Hayek’s ideas have been inﬂuential throughout the world. Indeed, according to Hayek (1944, p. xvii), the very reason he penned the book was ‘‘due to a peculiar and serious feature of the discussions of problems of future economic policy at the present time.’’ While The Road to Serfdom captures many critical elements of Hayek’s political economy, it cannot be considered a complete explication of his political economy. Hayek’s later works, such as The Constitution of Liberty (1960), and his three-volume Law, Legislation and Liberty (1973, 1976, 1979) can be seen as developing and reﬁning the arguments made in The Road to Serfdom. As such, after providing an overview of Hayek’s classic work, in Section 4 we discuss some of the critical insights in Hayek’s additional writings in political and legal theory. We conclude the chapter by discussing the contemporary implications of Hayek’s political economy. We contend that Hayek’s political economy is as relevant as ever and that modern economists should pay close attention to the main lessons and themes in Hayek’s writings. The speciﬁc areas we consider include:1 1. New institutional economics 2. Institutional change 3. Development economics

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Understanding the scope of spontaneous orders Experimental economics The cognitive turn in economic science Understanding the costs of the growth of government The classical liberal agenda.

In order to demonstrate the continuing relevance of Hayek we discuss the impact his work has had in each of these areas, as well as the implications of this for future research.

2. COORDINATION – THE FOUNDATION OF HAYEK’S POLITICAL ECONOMY At ﬁrst blush, Hayek’s writings appear to be disjointed, as they span a wide variety of disciplines. For instance, Hayek contributed to technical economics, political and legal theory, and psychology, among other areas.2 However, we argue that there are several clear themes that run throughout these inter-disciplinary works: 1. The role of subjective knowledge in individual decision-making. 2. The ‘‘compositive method’’ in which institutions must be explained as the result of ‘‘bottom-up,’’ individual action. 3. A clear recognition that economic phenomena do not exist independent of certain institutional, cultural, and legal structures. Equally important is the fundamental question that Hayek was seeking to answer throughout his body of research. Beginning with his 1928 essay, Hayek established the central problem of economics as one of coordination. Hayek was preoccupied with the same question that puzzled Adam Smith some 150 years earlier: how does order emerge unintendedly from the actions of millions of economic actors? Carl Menger (1883 [1996], p. 124) captured the importance of this issue when he asked: ‘‘How can it be that institutions which serve the common welfare and are extremely signiﬁcant for its development come into being without a common will directed toward establishing them?’’ Menger went on to note that, ‘‘this is the question of importance for our science . . . ’’ (1883, p. 125). Hayek’s earliest writings in economics were focused on tracing out the implications of the coordination of economic activities through time. As his work matured, Hayek started to emphasize the institutions necessary for this dovetailing of plans among different individuals. His early economic

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writings on imputation, capital and interest theory, trade cycle theory, and monetary theory all had a ‘‘coordinationist’’ theme. Hayek’s focus on how individuals possessing dispersed knowledge of ‘‘time and place’’ learn and coordinate their activities, as well as the spontaneous orders that result from these interactions, underlies his entire research program. According to Hayek (1937, pp. 50–51), the central question of all social science is: how the spontaneous interaction of a number of people, each possessing only bits of knowledge, brings about a state of affairs in which 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.

For Hayek, economics is a science that studies coordination problems. It examines the dovetailing of plans by individual actors that must result so that complex social orders can emerge. Moreover, incentives must be aligned between actors. Individuals must come to know not only the best opportunities currently available for mutually beneﬁcial exchange, but must also continually discover new possibilities for mutual gain from exchange with others. Indeed Hayek’s political economy stems directly from the realization that the institutional setting affects individual behavior and what is learned in an economic system. Keeping in mind these fundamental themes is critical in order to fully grasp his political economy.

3. THE HISTORICAL CONTEXT OF THE ROAD TO SERFDOM To better understand The Road to Serfdom, it is important to understand the historical context in which the book was written. The ﬁrst edition of the book was published in Great Britain in March 1944. At the time, Great Britain and the United States were engaged in a World War with Nazi Germany. The Soviet Union was the main ally, while Nazi Germany was the major enemy. Many in Great Britain and the United States viewed the Soviet Union as a model of an ideal socialist society, which would result in widespread equality, and the removal of poverty. In stark contrast, Nazi Germany was viewed as a brutal dictatorship that allowed capitalist elites to maintain their entrenched positions.

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Underlying the favorable view of the Soviet Union was a widespread acceptance of the socialist ideology by both intellectuals and the public. Indeed, the socialist critique of the liberal economic order had effectively shaped the ideological and intellectual terms of the debate by the beginning of the 20th century. Most participants in the intellectual and political debate agreed that laissez-faire liberalism had failed to provide equality and humane social conditions. Instead, progressive legislation was demanded in order to correct for the failings of free competition. Sir William Harcourt captured this sentiment when he noted that ‘‘we are all Socialists now’’ (quoted in Trevelyan, 1942, p. 510). The Great Depression, which by popular interpretation of the time demonstrated that not only was capitalism unjust but that it was also unstable, contributed to the critique of laissez-faire liberalism. The collapse of the United States and United Kingdom economies shook an entire generation’s faith in the capitalist system. It was argued that if the capitalist system was to survive in the world of the 1930s, it had to be subject to democratic political forces of control. Continual government intervention was necessary to tame its operation and protect the populace from unscrupulous business and irresponsible speculation. Rational planning came to be viewed as not only a viable alternative to be debated, but also the only alternative to chaos. In The Road to Serfdom, Hayek’s aim was to demonstrate that Nazi Germany was not a result of inconsistencies in the capitalist system. Rather, the Nazi movement was a result of socialist ideology of the pre-World War I period that had been embraced by many intellectuals in both Great Britain and the United States. Hayek argued that this occurrence was not particular to Germany. Indeed, implementing socialist policies anywhere in the world could potentially lead to political tyranny. It was Hayek’s goal to explain how socialist ideas change the demands on democratic institutions and how these institutions are then transformed into tools of totalitarian rule. This transformation, Hayek argues, is due to the fact that democratic institutions are unable to meet these changing demands in a manner consistent with democratic principles. As Hayek summarizes the argument: ‘‘Is there a greater tragedy imaginable than that, in our endeavor to consciously to shape our future in accordance with high ideals, we should in fact unwittingly produce the very opposite of what we haven been striving for?’’ (1944, p. 5). Keeping in mind both the historical context in which Hayek wrote, as well as his main goals, we now turn to an overview of the main arguments in The Road to Serfdom.

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4. THE ROAD TO SERFDOM: THE CENTRAL ARGUMENTS The Road to Serfdom is broken into 16 concise chapters that combine theory, intellectual history, and historical observation. The main focus of the book was to demonstrate the social consequences of ideas. Hayek envisions ideas as the motive force in history. Bad ideas are undesirable because they permit the rule of privileged interests over the common interest. Ideas provide a social infrastructure within which individuals pursue their own interests. In order to avoid political tyranny and economic servitude, these ideas must constrain the self-seeking behavior of individuals appropriately. To understand the theoretical core of Hayek’s argument, one has to look at the previous work of his teacher and mentor, Ludwig von Mises, regarding the feasibility of socialism as an economic system. In Socialism, Mises (1922 [1981]) argued that ‘‘rational’’ economic calculation was impossible under a socialist system. Economic calculation is ‘‘rational’’ if decision-makers can efﬁciently allocate scarce capital resources among competing uses. Acting people must mentally process the alternatives available to them and to do so they must have some guide for comparing inputs and outputs. Mises’ contribution was to establish that this decisionmaking ability (i.e., rational economic calculation) is dependent on the institutional context of private property. Mises reasoned as follows: 1. Without private production in the means of production, there will be no market for the means of production. 2. Without a market for a means of production, there will be no money prices established for the means of production. 3. Without money prices, reﬂecting the relative scarcity of capital goods, economic decision-makers will be unable to rationally calculate the alternative uses of capital goods. In short, without private property in the means of production, rational economic calculation is not possible. Under institutional regimes that attempt to abolish private ownership in the means of production, decisionmakers will be in the dark with no guide as how to best allocate resources. In the world in which we live, economic decision-makers are confronted with many possible projects and economic calculation provides a guide for selecting the best project from an economic standpoint. In the absence of well-deﬁned property rights in the means of production, decision-makers will have no guide for deciding which projects to pursue.

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In his writings that preceded The Road to Serfdom, Hayek’s contribution to Mises’ argument was to elaborate the precise role that the price system played in providing information required for complex plan coordination. The Mises–Hayek argument demonstrated that the socialist system could not replicate what the private property and price system provided. No one mind or group of minds could possibly possess the knowledge necessary to coordinate a complex industrial economic system. In stark contrast, the private property and price system economizes on the information needed by economic actors to properly allocate resources. Hayek proceeds in The Road to Serfdom under the assumption that this Misesean–Hayekian theoretical argument has been established and accepted in the technical economic literature. Hayek’s aim was not to establish that socialist planning could not achieve the efﬁciency that the capitalist system could. Rather, it was to demonstrate what would emerge from the failure of socialist planning to achieve its desired results. In other words, the Mises– Hayek technical economic calculation argument showed why socialism would fail; in The Road to Serfdom, Hayek showed what would result from that failure. In the intellectual history provided in the ﬁrst three chapters, Hayek’s goal was to demonstrate that despite the Mises–Hayek critique of socialism, the socialist criticism of competition had effectively undermined the legitimacy of liberal institutions among the general public and especially among the intellectual elite. Liberalism, Hayek argued, imparted a ‘‘healthy suspicion’’ of any argument that demanded restrictions on market competition. With its critique of the competitive system, socialist theory had swept away the liberal constraints against special pleading and opened the door for interest groups demanding protection from competition under the ﬂag of socialist planning (Hayek, 1944, p. 40). Hayek not only highlighted the economic issues with socialism, but also the political difﬁculties of planning. Indeed, Hayek’s discussion of the delegitimation of the need for constraints on democratic government and the rule of law are one of the main arguments in The Road to Serfdom (1944, pp. 56–87). In order for planning to be implemented, government ofﬁcials cannot be constrained by formal rules but must be entrusted with discretionary power. Additionally, planning requires widespread agreement, and democracy is only capable of producing a certain level of agreement. Hayek argued: That planning creates a situation in which it is necessary for us to agree on a much larger number of topics than we have been used to, and that in a planned system we cannot

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What is the result of the need for widespread agreement? planning leads to dictatorship because dictatorship is the most effective instrument of coercion and the enforcement of ideals and, as such, essential if central planning on a large scale is to be possible. The clash between planning and democracy arises simply from the fact that the latter is an obstacle to the suppression of freedom which the direction of economic activity requires.

By its very nature, attempts at central planning will tend toward dictatorship because this is the only effective means of making the necessary decisions required by central planning. Yet another key point Hayek makes in The Road to Serfdom is the liberal proposition that economic freedom and political freedom are linked. He argues that economic control does not control merely a sector of human life which can be separated from the rest; it is the control of the means for all ends. And whoever has sole control of the means must also determine which ends are to be served, which values are to be rated higher and which lower – in short, what men should believe and strive for. Central planning means that the economic problem is to be solved by the community instead of by the individual; but this involves that it must be the community, or rather its representatives, who must decide the relative importance of the different needs. (1944, p. 92)

Economic choices cannot be separated from the other choices made by individuals. As such, as planning increases, the freedoms and choices available to individual members of the populace will decrease. When the government decides what products are to be produced, there is little choice left to the individual citizen. The diverse preferences of the populace must be homogenized so that they conform to the central plan. In addition to the highlighting the connection between economic and political freedom, Hayek also pointed out the organizational logic implied in the substitution of central decision-making for the private decisions of the citizenry in the marketplace. His analysis includes both an examination of the incentives faced by representatives creating the central plan, and the evolutionary process engendered by these institutions for the selection of leaders. Recall that Hayek assumed that the Mises–Hayek critique of socialism was widely accepted. Using this assumption as a starting point, he analyzed the organizational logic of central planning and what

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societal/institutional transformation would occur in response to the failure of the socialist system to achieve its stated ends. Hayek took as a given that due to the inability of central planners to engage in rational economic calculation, they would ultimately fail to achieve their desired purpose. When faced with this failure, one potential option would be for government ofﬁcials to reverse course and adopt liberal economic policies. Hayek argued that in a context where liberalism had been undermined by the socialist critique, government ofﬁcials were unlikely to face sufﬁcient incentives that would cause them to reverse course. As such, we should expect more interventions in the attempt to correct these past failures. This is the basis for the ‘‘slippery slope’’ argument whereby some initial intervention leads to an increasing number of future interventions in the attempt to remedy past failures. Hayek’s analysis of organizational planning under socialism is evident in Chapter 10, ‘‘Why the Worst Get on Top.’’ Hayek warns the reader that since the economic knowledge necessary to plan the economy rationally will not be available to planners, these decision-makers will be forced to rely on the forms of information that are readily available. In the context of central planning, this comes in the form of incentives to exercise political power. Hayek’s argument is that just as we should expect those with superior skills in any industry to rise to the top, we should also expect those who have superior skills in exercising political power and coercion to advance within the political apparatus of planning. In pointing this out, Hayek was challenging the claim that experiments in real existing planning were tainted by ‘‘historical accident’’ and/or ‘‘bad’’ people and therefore could not be used to illustrate the difﬁculties associated with central planning. Hayek’s counterargument was that it was not true that if only ‘‘good’’ people controlled the planning bureau, then the results would be harmonious with liberal democratic values. As Hayek wrote: There are strong reasons for believing that what to us appears the worst features of the existing totalitarian systems are not accidental by-products but phenomena which totalitarianism is certain sooner or later to produce. Just as the democratic statesman who sets out to plan economic life will soon be confronted with the alternative of assuming dictorial powers or abandoning his plans, so the totalitarian dictator would soon have to choose between disregard of ordinary morals and failure. It is for this reason that the unscrupulous and uninhibited are likely to be more successful in a society tending toward totalitarianism. (1944, p. 135)

In this context, success requires a skill set including the talent for ‘‘unscrupulous’’ and ‘‘uninhibited’’ moral behavior with respect to humanity. Totalitarianism is neither a consequence of ‘‘corruption’’ not

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‘‘historical accident,’’ but rather a logical consequence of the institutional incentive of the attempt to centrally plan an economy. Throughout The Road to Serfdom, Hayek tells the tragic story of the consequences of central planning. It is not just that a band of thugs takes control of the coercive apparatus of the state and employs it to oppress the mass of citizens for their own beneﬁt. Instead, the arbitrary employment of power is a consequence, and not a cause, of the desire to plan the economy scientiﬁcally. In order ‘‘to achieve their end, collectivists must create power – power over men wielded by other men – of a magnitude never before known, and . . . their success will depend on the extent to which they achieve such power’’ (1944, p. 144). Even liberal socialists, as opposed to collectivists, in their desire to plan the economy, must establish institutions of discretionary planning and grant authority to the planners to exercise their political power in order to accomplish the task entrusted to them. The complexity of the task implied in planning an economic system would require that planners be granted almost unlimited discretion. As a result, we should expect that only those that possess superior talent in exercising discretionary power would survive.

5. HAYEK ON THE STATE, INDIVIDUAL, ECONOMIC FREEDOM, AND THE LAW Hayek’s interest in political and social theory, starting with The Road to Serfdom, continued in his later writings, speciﬁcally The Constitution of Liberty (1960) and the three-volume Law, Legislation and Liberty (1973, 1976, 1979). It is not Hayek’s purpose in The Road to Serfdom to explore what the role of the state should be, but rather to trace the consequences of ideas and speciﬁcally the adoption of socialist ideas and practices. In his later writings, Hayek focused more directly on the role of the state in the context of individual and economic freedom, as well as the legal system. In this section we consider some of the main ideas in these later writings. As will become clear to the reader, much of Hayek’s analysis regarding the role of the state, the legal system and political and economic freedom are outgrowths of the arguments made in The Road to Serfdom and the themes found in his earlier economic writings. According to Hayek (1976, p. 136), ‘‘The possibility of men living together in peace and to their mutual advantage without having to agree on common concrete aims and bound only by abstract rules of conduct was perhaps the greatest discovery

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mankind ever made.’’ Starting with The Road to Serfdom, Hayek’s writings should be read as an analysis of the moral and political signiﬁcance of this discovery as well an examination of the threats to its sustainability (Gordon, 1981, p. 472). As discussed at the outset, an emphasis on dispersed, local knowledge of time and place, understanding how individuals coordinated their activities and the spontaneous orders emerging from these interactions are at the center of Hayek’s research program. In this regard, Hayek sought to understand how individuals can best learn and act on this dispersed knowledge. He concluded that a respect for private property, a wellfunctioning rule of law, and a stable monetary order were crucial for individual experimentation, learning, and widespread coordination. In the Constitution of Liberty, Hayek (1960 [1978], pp. 148–161) argues that these institutions provide a predictable environment within which people can orient their behavior. As Hayek writes: The signiﬁcance for the individual of the knowledge that certain rules will be applied is that, in consequence, the different objects and forms of action acquire for him new properties. He knows of man-made cause-and-effect relations which he make use of for whatever purpose he wishes. The effects of these man-made laws on his actions are of precisely the same kind as of the laws of nature: his knowledge of either enables him to foresee what will be the consequences of his actions, and it helps him to make plans with conﬁdence. (1960, p. 153)

Rules and laws are designed in the absence of perfect foresight. In other words, those developing rules and laws cannot know the particular case where they will be applicable. As such, general rules, which are predictable and known by all, allow unforeseeable situations to be dealt with in the most effective manner. Hayek recognized the need for general rules that allowed individuals with dispersed knowledge to learn and, at the same time, limited the amount of harm that could be done by any one individual. He realized that each individual is imperfect and as such we must develop the rules of the game so that the best of all possible worlds will not be the enemy of the ‘‘good’’ society. Hayek (1948, pp. 11–12) pointed this out, as well as the connection of his research program with that of the Scottish Enlightenment program, when he wrote: [T]he main point about which there can be little doubt is that [Adam] Smith’s chief concern was not so much with what man might occasionally achieve when he was at his best but that he should have as little opportunity as possible to do harm when he was at his worst. It would scarcely be too much to claim that the main merit of the individualism which he and his contemporaries advocated is that it is a system under

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In this sense, Hayek’s political economy can be viewed as ‘‘robust’’ in that his aim is to develop a system that will sustain and remain strong even in the presence of imperfect individuals. Hume (1742 [1987], pp. 40–42) captured the issue of robustness when he noted: Political writers have established it as a maxim, that, in contriving any system of government, and ﬁxing the several checks and controuls of the constitution, every man ought to be supposed a knave, and to have no other end, in all his actions, than private interest. By this interest we must govern him, and, by means of it, make him, notwithstanding his insatiable avarice and ambition, co-operate to public good. Without this, say they, we shall in vain boast of the advantages of any constitution, and shall ﬁnd, in the end, that we have no security for our liberties or possessions, except the good-will of our rulers; that is, we shall have no security at all.

Hayek continued the development of this political economy project in Law, Legislation and Liberty (1973, 1976, 1979). The main theme of this trilogy is that rules must be general, non-arbitrary, and equally applied to all individuals. This pure ‘‘Rule of Law,’’ as Hayek calls it, must serve as the backdrop for imperfect agents. Given a predictable legal code, individuals can learn and adapt their behavior in order to coordinate their activities with those of others. Consistent with the generality principle mentioned earlier, Hayek claims that in a free society only the general welfare can be pursued and not the particular aims of any individual within society. According to Hayek, many contemporary notions of social justice are focused on the particular case of individuals within the general order. But, in Hayek’s system, justice can only be maintained at the level of the general legal framework and rules of the game. Speciﬁc actions designed to remedy certain instances of ‘‘injustice’’ will fail to effectively remedy the situation and will undermine the general system. To understand Hayek’s argument, it must ﬁrst be realized that political decisions are never about particular distributions of resources. Instead, political decisions are decisions that affect the rules of the economic game. These rules create a set of expectations and a resulting pattern of exchange, production, and distribution. The ‘‘mirage of social justice,’’ is the belief that speciﬁc distributional outcomes can be picked independent of the very process through which exchange and production takes place. The rules of just conduct serve to govern the means by which various purposes and

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plans are pursued. As such, these rules serve to reconcile the actions pursued by disparate individuals within the general order governed by these rules. In contrast, a command serves a particular purpose and as such is in direct conﬂict with rules of just conduct. Put simply, discriminatory laws undermine the rules of just conduct and the framework of a just society. After describing and defending the ‘‘rule of law’’ in Volumes 1 and 2 of Law, Legislation and Liberty, Hayek (1979) makes the case for political constraints in the third and ﬁnal volume. Recognizing the role interest groups play in democratic political systems, Hayek argued that the problem with limited democracy is that it becomes ‘‘the playball of all separate interests it has to satisfy to secure majority support’’ (1979, p. 99). As a result, the government becomes unable to accomplish the tasks required for good governance. Thus, constraints are necessary to avoid the devolution into arbitrary, unconstrained, interest-group government. At this point, the reader can hopefully see the interconnectedness between Hayek’s various strands of work. The underlying inquiry that drove all of Hayek’s research was: how do individuals learn to coordinate their economic activities with those of others under varying institutional arrangements? In his earliest work, he focused on this question in the context of economic theory – capital structure, interest rates and monetary theory, etc. Starting with The Road to Serfdom, his concern with these issues became more focused on the implications of various political systems. This focus on political, social, and legal theory continued throughout the rest of his career.

6. CONCLUSION – HAYEK’S RELEVANCE TODAY F.A. Hayek’s political economic insights are as relevant today as when they were ﬁrst written. A number of areas in the contemporary economics landscape reﬂect the continuing importance Hayek’s ideas. These areas include: 1. New institutional economics. New institutional economics (NIE) focuses on the study of institutions and the interplay between institutions and other organizational arrangements (Me´nard & Shirley, 2005, p. 1). Further, NIE assumes that actors have imperfect information and face constant uncertainty. The emphasis on institutions, as well as the abandonment of standard neoclassical assumptions of perfect information

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and rationality can be found throughout Hayek’s work. In his review of the state of NIE, Oliver Williamson (2000) highlights Hayek as a critical precursor to NIE. As such, the NIE research program should be seen as building on Hayek’s political economy. 2. Institutional change. Hayek’s inﬂuence is also evident in the effort to understand institutional quality and institutional change (Boettke, Coyne, Leeson, & Sautet, 2005). For example, Hayek’s inﬂuence can be seen in the work of Olson (2000) and Djankov, Glaeser, La Porta, Lopez-deSilanes, and Shleifer (2003) on institutional quality and the politics of predation. Hayek’s focus on the ‘‘bottom-up’’ emergence of institutions versus the ‘‘top-down’’ imposition of institutions is relevant given ongoing efforts to ‘‘export’’ liberal institutions to countries where they do not currently exist (see, for instance, Coyne, 2007). In general, Hayek forces us to realize that different institutional settings create different economic, social, and political outcomes. Understanding the various outcomes of different institutional settings is an empirical question. In the realm of public policy, arguments about institutions and institutional capacity are more prevalent today than ever before. The idea that we need simple rules for a complex world is no longer considered unthinkable and is much more common than the idea that because of complexity we need detailed interventions.3 It is now a conventional wisdom that rules outperform discretion in the realm of public policy. Policy analysis has moved to the level of the rules of the game that create the institutional environment within which economic activity takes place. This is most evident in the public policy discussion surrounding development economics and the emphasis on creating an institutional environment that cultivates an entrepreneurial environment where individuals are enabled to realize the mutual gains from trade. Cooperation is encouraged, and conﬂict minimized due to the institutional environment that is adopted in any given society (see, for instance, Ostrom, Gibson, Shivakumar, & Andersson, 2002). 3. Development economics. Many underdeveloped countries suffer from the very problems Hayek was analyzing in his writings. In many of these countries corruption is rampant. Property is coercively redistributed rather than protected. A stable rule of law is absent as the legal system is unpredictable and constantly changing. Hayek’s political economy offers insight into these outcomes. For example, Hayek’s work has proven to be extremely prescient and relevant for current debates in growth theory as illustrated by the work of Mahoney (2001) and Glaeser and Shleifer (2002).

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The recognition of the importance of entrepreneurship to understanding growth continues to spur economists to ﬁnd ways to incorporate the elusive concept of entrepreneurship into the understanding of the competitive market process (see Baumol, 2002). Some of this research is amenable to standard empirical work, but there has also been a growing recognition that work that emphasizes institutions and economic change must eschew cross-country data analysis and engage in detailed micro-data analysis of speciﬁc context. This can be accomplished through an analytic narrative approach (see Bates, Greif, Levi, Rosenthal, & Weingast, 1998), ethnographic analysis of underground economies (e.g., de Soto, 1989), or micro-data surveys (e.g., Frye, 2000). Empirical economics is going through a transformation just as drastic as theoretical economics and it is doing this in line with Hayek’s focus on disaggregation and in a manner that is consistent with the subjectivist notion of developing a political economy of everyday life that respects the meaning that individuals construct and place on their activities and the activities of others. 4. Understanding the scope of spontaneous orders. A growing research explores the extent to which spontaneous orders can evolve and operate in the absence of the state (see, for instance, Leeson 2007a, 2007b, 2008; Benson, 1989; Anderson & Hill, 2004). An important aspect of Hayek’s work is the emergence of spontaneous orders that facilitate cooperation versus the need for the state to formally legislate rules to foster cooperation. The central question becomes the extent and robustness of governance mechanisms, their ability to handle problems of social diversity, large populations, and capacity to handle violence. 5. Experimental economics. Vernon Smith (2005) has noted that his work in experimental economics was originally inspired by Austrian economics, and speciﬁcally the work of Hayek. Indeed, Smith sees his research as contributing to key questions asked by Hayek long ago: how do individuals utilize human knowledge that is dispersed and can never be possessed by a single individual? Under what conditions will individuals partake in mutually beneﬁcial exchanges without any inﬂuence from a central planner? Moreover, Smith emphasizes that laboratory experiments allow for the observance of the emergence of spontaneous orders in the form of rules governing the market and market exchanges. In this regard, the ﬁeld of experimental economics should be seen as a direct descendent of Hayek’s political economy. 6. The cognitive turn in economic science. In the realm of economic science, Hayek’s inﬂuence can be seen in the cognitive direction of research

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(see Koppl, 2006) that has been taken by Kuran (1995) and North (2004). Several scholars, including Gilad (1982) and Harper (1996, 1998) have incorporated the psychological concept of ‘‘locus of control’’ into the theory of entrepreneurship.4 Finally, the Hayekian view of cognition can be seen in the works of complexity theorists including Holland (1992) and by Kauffman (1993).5 Hayek’s (1952) The Sensory Order will continue to play a role in the development of this sub-ﬁeld (see Caldwell, 2004, pp. 270–279). 7. Understanding the costs of the growth of government. Even in developed countries such as the United States, one observes a steady increase in the level of government intervention over time. Often, special interests are protected through regulation, and protective measures such as tariffs. There have been frequent calls for nationalized healthcare despite the fact that the Medicare system is bankrupt. One also observes a call for more government involvement in forced savings through interventions in the Social Security system. Government spending has increased dramatically year over year. While the type of central planning employed in the Soviet Union is no longer with us, governments around the world – in both developed and underdeveloped nations – continually implement programs designed to increase the scope of the state. As Hayek demonstrated, following such a course of action runs counter to economic development as well as political and individual freedom. Some scholars, such as Higgs (1987), have empirically explored how the onset of crisis leads to permanent growth in the size government. As Hayek noted in The Road to Serfdom, oftentimes efforts to utilize government to combat tyranny elsewhere actually result in the unintended consequence of movements toward tyranny at home. 8. The classical liberal agenda. In the realm of ideological commitment, a new generation of liberal scholars have emerged who have taken up Hayek’s ideas and run farther with them than even Hayek dared to imagine. Kukathas (2003), for example, argues that the toleration of religious and ethnic minorities provided by liberal institutions must be pursued to its logical conclusion even in the world that we live in today. Also, recent work on decentralized governance and law by Benson (1990) has developed Hayek’s distinction between law and legislation in a consistent manner. Finally, the work by scholars such as Weingast (1995) on market preserving federalism is another example where the argument for decentralized governance and ﬁscal federalism that Hayek made is inspiring new theoretical presentation and empirical investigation.

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We have argued that F.A. Hayek’s political economy is as relevant today as when it was ﬁrst written. Modern scholars of political economy would do well to go back to Hayek for untapped ideas and for a deeper understanding of the issues relevant to this area of study. Much of the current work in political economy can be traced back to Hayek, even if his inﬂuence not explicitly recognized by the authors (see, for instance, Acemoglu & Johnson, 2005; Acemoglu, Robinson & Johnson, 2001; Glaeser & Shleifer, 2002). These writings also demonstrate how Hayek’s political economy can generate fruitful empirical analysis. Hayek’s writings consisted of many empirical claims and these studies have contributed to the testing and analysis of some of Hayek’s hypotheses. This growing empirical literature demonstrates the continued signiﬁcance of Hayek’s political economy. It is our hope that modern scholars will recognize the lasting importance of Hayek’s research program.

NOTES 1. This is not an exhaustive list of all modern areas where Hayek’s work is relevant. For example, Hayek’s work is also important in the areas of complexity theory (see Rosser, 1999; Caldwell, 2004; Koppl, 2000, 2006) and public choice (see Boettke & Lopez, 2004) to name but two. 2. For a discussion of the connections between Hayek’s political theory and his work in economics, see Boettke (1999). Caldwell (2000, 2004, pp. 270–279) and Horwitz (2000) discuss the connections between Hayek’s economic theory and his work in cognitive psychology. Beaulier, Boettke, and Coyne (2004) discuss Hayek’s legal theory. 3. For example, The 2004 Nobel Prize to Kydland and Prescott for, in part, their work on rules versus discretion can be seen as consistent with this basic Hayekian point. 4. Volume 7 of Advances in Austrian Economics addresses ‘‘Evolutionary Psychology and Economic Theory.’’ 5. See also Butos and McQuade (2005). Butos (2003) explores Hayek’s cognitive theory and the implications for the Austrian notion of rationality.

ACKNOWLEDGMENT The authors would like to thank the Mercatus Center for their generous support of this research.

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MARKETS VS. POLITICS: CORRECTING ERRONEOUS BELIEFS DIFFERENTLY Martin Gregor ABSTRACT In the ﬁelds of social choice, public choice, and political economics, the key difference between private and political decision-making is whether preferences have to be aggregated to make a decision. A related, yet much less studied difference is whether also beliefs have to be aggregated. In this chapter, we argue that belief aggregation creates different incentives for individual belief updates in private and political choice. We review contemporary theories of biased beliefs in politics: Bayesian misperceptions, behavioral anomalies, and rational irrationality. We examine assumptions and consequences of all the approaches vis-a`-vis issues of common knowledge, stability, symmetry, and multiplicity of stable states. As a route for further analysis, we construct an evolutionary model including a coordination failure. Differences in learning dynamics make the political play of this baseline game Pareto-inferior to the private play.

Explorations in Austrian Economics Advances in Austrian Economics, Volume 11, 55–78 Copyright r 2008 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11004-3

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1. INTRODUCTION In public choice and political economics, disagreement or conﬂict is traditionally attributed to heterogeneity of values, interests, or goals (Persson & Tabellini, 2000). By assuming conﬂicting objectives, one gets around heterogeneity in beliefs on how the economy works, and political phenomena can be explained without any reference to errors of policymakers or voters. Motivation for this abstraction is expressed relentlessly in Wittman (1989, p. 1421): he rejects to explain government failures by simply postulating ‘extreme voter stupidity.’ A typical example of this approach is incorporation of rational expectations into the political business cycle, whereby Alesina and Roubini (1995) altogether eliminated myopia of voters. Whether this modeling strategy is necessary and sufﬁcient to address the key issues of political economy nevertheless remains an open question. Speciﬁcally regarding political business cycles with rational expectations, Blankart and Koster (2006, p. 179) claim that they ‘remain in competition with the alternative and (at least sometimes) empirically better-performing models of public choice.’ More generally, in some contexts one ﬁnds it puzzling that political economy models do not involve any error or mistake, and that players manage to converge on equilibria with largely sophisticated beliefs and strategies. To completely disregard that false descriptive beliefs exist and are corrected over the course of the play then restricts attention to epiphenomena or leads to certain dubious implications. For instance, models of the Communist economy where apparatchiks possess with the same knowledge on the role of price system as trained economists have (e.g., Shleifer & Vishny, 1992), appear implausible to anyone with more profound experience from the former Communist bloc. An alternative viewpoint is that false descriptive beliefs persist and signiﬁcantly affect policy outcomes, even in the long term. What is even more important, incentives to correct erroneous beliefs in markets may differ from incentives in politics. Traditionally, this problem is understood under the rubric of rational ignorance, where information gathering in politics is suboptimal due to uncompensated positive externalities of informed voting; however, latest advances show that this explanation is unsatisfactory, for voters can easily get reliable estimates at very low costs (Martinelli, 2006). Alternative explanations on the role of false beliefs in politics are proposed and examined. Many prominent economists from different ages have elaborated on the idea that in politics people have erroneous beliefs, e.g., James Stuart Mill

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(Mill, 1861/1972), Ludwig von Mises (Mises, 1979), and James Buchanan (Buchanan & Wagner, 1977). It is no coincidence that the role of false descriptive beliefs on economic policy is approached as a crucial issue in schools or traditions which attempt to derive general conclusions on the role of the government intervention in the economy. Particularly illustrating is the difference between Chicago and Austrian schools of economics, discussed at length in Skousen (2005). Chicago economics leans to the explanation that any market, even political one, sufﬁciently clears. This is spelled out in the idea of efﬁcient democratic political markets, suggested initially in Stigler (1971) and reinvigorated in Wittman (1995). In the latter book, labeled as an ‘amazing hit’ of Chicago school of political economy (Caplan, 2005a), Wittman argues that democratic political markets are efﬁcient; voters are rational, compensations drive redistributive politics to the centrist position, and adjustments between political supply and demand is instantaneous or take place without impediments. It is argued that there is no signiﬁcant difference between correction of beliefs and strategies in markets and in politics. Austrian economists have a distinctly different approach. Firstly, Austrians argue that ideas, ideologies, or beliefs are important and exogenous determinants in the decision-making. According to Mises, ‘[e]verything that happens in the social world in our time is the result of ideas.’ (Mises, 1979, p. 108) Human action, by reﬂecting preferences, reﬂects also ideological and descriptive beliefs. Secondly, the market with political ideas not necessarily features the best ideas available. Ideas are aggregate sets of descriptive beliefs which evolve and are tested; not only by empirical observation (benchmarking and comparing ex ante vs. ex post outcomes), but also by manipulation, indoctrination, and via the media. Biases are sustainable for a very long time, which Austrians casually explain by referring to the history of political ideas. If there is convergence towards elimination of proponents of biases, it is very slow and hard to track; the Communist empire with nowadays apparently mistaken ideology lasted over 70 years, and numerous proponents of the Communist ideology kept their support till the very end. The perspective held by Austrians and others on the systematically erroneous beliefs has been recently resurrected because of advances in public choice and political economics. These recent developments reinvigorated attempts to link classic Austrian insights to contemporary research on political economy, like in Caplan and Stringham (2005). Three major motivations for revived interest in political learning can be identiﬁed: evidence on maintaining (erroneous) political beliefs by laymen, models of

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ideological or principled candidates replacing opportunistic candidates, and the lack of a comprehensive theory of reform resistance. A uniﬁed framework on market and political updates of false beliefs is nevertheless far away from our reach. This chapter proceeds as follows. In Section 2, we highlight recent evidence on systematic biases in policy-relevant beliefs and elaborate on the aforementioned motivation. The section also introduces the reader to core issues related to modeling political learning. Next, we review recent theories of imperfect learning in politics: Bayesian misperceptions in Section 3, behavioral anomalies (especially conﬁrmatory bias) in Section 4, and rational irrationality in Section 5. We examine assumptions and implications of the approaches. Speciﬁcally, we analyze whether they explain if incentives to correct beliefs in politics are weaker than incentives to improve beliefs on markets. In Section 6, we construct an evolutionary model with a coordination failure. We prove that due to different belief updating, the collective play of this baseline game is never Pareto-superior to the private play. In ﬁnal Section 7, we conclude by arguing that original insights of Austrians are useful part of this research, but have to be transformed into formal models with adaptive learning and evolutionary dynamics.

2. PRELIMINARIES 2.1. Motivation Anecdotic evidence from sciences and history reads that people not only tend to repeat wrong decisions, but also keep false descriptive beliefs for a long time. In terms of politics and speciﬁcally economic policy, a host of studies recognized systematic differences of beliefs between laymen and experts: voters underestimate the economic beneﬁts of free trade, overestimate the percentage of the budget spent on welfare, and misinterpret low economic growth as absolute economic decline (Caplan, 2001b, 2002; National Survey of Public Knowledge of Welfare Reform and the Federal Budget, 1995; Survey of Americans and Economists on the Economy, 1996). Rubin (2003) identiﬁes ‘folk economics’ as economics of wealth allocation, not production. Quoting surveys on popular beliefs, experimental economics on exchange, monitoring, and shirking, and studies on how children learn economics, Rubin ﬁnds that folk economics by and large disregards phenomena of specialization, division of labor, capital investment, and economic growth.

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Closely related is the literature on determinants of descriptive beliefs, especially ideological ones. In a trading experiment where subjects assessed to what extent price will reﬂect supply and demand, Austin and Cox (2007) illustrate that ideological differences inﬂuence descriptive beliefs about economic institutions. Blinder and Krueger (2004) also ﬁnd that economic knowledge is determined by ideology, not the use of information. They obtain evidence for idealism (or sociotropic motivation), namely when it comes to national economic policy, people are often more interested in what they perceive to be the common good than what is in their narrow self-interest. Public choice and political economics have undergone a related development in the revival of interest in partisan (ideological or principled) candidates, replacing Down’s opportunistic candidates (Besley, 2006). Beliefs of politicians have a role, for which evidence can be drawn from quasi-experiments with lack of policy convergence after a common popularity shock (Lee, Moretti, & Butler, 2004). Certainly, this complex issue is affected by the way the party system works, but the inability of candidates to commit to a policy concessions implies that they or their organizations indeed follow stable objectives, and possess with stable (and not necessarily identical) descriptive beliefs. In addition, public choice and political economics are far from a conclusive theory of reforms of the public sector, sufﬁcient to explain numerous delays and deadlocks. For economists, it is notoriously difﬁcult to explain why there is such a striking difference between outcomes of current political markets and policy recommendations, if efﬁciency-enhancing measures can be complemented with compensatory mechanisms. Established political-economy explanations resort to very speciﬁc assumptions. Alesina and Drazen (1991) presume a non-intuitive tax system with information asymmetry resulting in the production of costly signals, and receive a version of the war of attritions. Howitt and Windtrobe (1995) postulate that with a reform initiative, the policy issue fully discloses in public and the reform initiator risks a loss with some probability. Thus, unwillingness to accept a lottery prevents from submitting a reform initiative. The model however requires passive media and passive voters, impossibility to bargain as well as a particular distribution of preferences. On empirical side, the idea that reform resistance can be associated simply with ignorance has been tested in Heinemann (2004). A working hypothesis is that there should be a negative function of the population’s level of economic education. Unfortunately, since there is no internationally consistent data set on economic education, Heinemann uses variables

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describing the general state of education such as school enrollment ratios, the availability of media information, and the development of the ﬁnancial sector such as credit aggregates. He gets a signiﬁcant effect of these variables upon the reform realization, hence tentative evidence on the importance of the lack of knowledge in policy-making.

2.2. Modeling Several frameworks capture the intuition that homo economicus may learn differently than homo politicus. We investigate in details hypotheses of Bayesian learning from biased signals (misconceptions), behavioral anomalies, especially conﬁrmatory bias or overconﬁdence, and metarational irrationality. Before proceeding to each theory, we recognize a couple of issues that any theory of learning, Bayesian or non-Bayesian, has to address. (a) Deviation from the best response. Does inability to derive a correct belief necessarily imply deviation from the best response strategy? If there is a deviation, the incorrect beliefs are not serving one’s own interests and deserve to be called false consciousness (Boudreaux & Crampton, 2003). The problem is that strong evolutionary pressure will be exerted on corrections towards the best response, with associated updates in beliefs; one has to explain why deviations towards the best response, for example, via random experimentation, are impossible or costly. (b) The best response with false beliefs. We may have a case when the beliefs are self-serving rationalizations of material interests (‘where you stand depends on where you sit’) and are upheld since an update toward a more correct belief could lead to a deviation from the best response. This explanation is plausible, but needs very detailed assumptions on the underlying game where this ‘equilibrium with illusions’ occurs. One attempt is coordination failure in Section 6. Empirically, this poses a problem for regressions that attempt to explain descriptive beliefs via ideology; the positive relationship between beliefs and ideology is spurious. Austin and Cox (2007) claim that their results are inconsistent with the idea that ideology and belief are mere self-serving rationalizations of interest. Yet, they also think that over shorter time periods, ideology is a relatively stable and exogenous determinant of descriptive beliefs about the workings of the economy.

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(c) Symmetry on the supply versus demand side. If people are prone to have false descriptive beliefs, the biases must be present both on the supply and demand side of political markets. This is, among others, a problem for conﬁrmatory bias applied in the principal–agent framework. It also poses a challenge for self-selection of individuals with certain beliefs into political supply. (d) If information is acquired up to the point where the marginal cost equals the marginal beneﬁt (Stigler, 1971), there is no rationale to assume zero cost of information on the beneﬁts and costs of acquiring the information. Unless one purchases or seeks information on the basis of correct priors on the cost and beneﬁts of the search, we have – for any item of practical information – an inﬁnite number of beneﬁt and cost schedules: the cost of acquiring the practical information, the cost of information on the cost of the information, and so on. (e) Common knowledge. If possibility of an erroneous belief is common knowledge, we need to know what gives credibility to statements; otherwise, massive cheap talk occurs. For example, if receivers believe that ideology partly reﬂects interests, then the question of what to believe depends less on the receiver’s ideology than it does on the receiver’s perception of the difference between his or her own ideology and that of the sender. If something is not common knowledge, we run into the danger of arbitrary modeling. Recall also an important consequence of Bayesian learning, namely that people cannot ‘agree to disagree’: if all important aspects are common knowledge, exchange of opinions and common priors must lead to agreement (Aumann, 1976). (f) Multiple stable states. Technically speaking, it is not so difﬁcult to create a model with coordination failure where a population converges to an inefﬁcient stable state in pure strategies. A far more complicated is to get a situation where the population is mixed and stable, i.e., only a part of population holds false beliefs for endogenous, not exogenous reason. There must be either a very special dynamics or those with good beliefs must have some beneﬁt from individuals having false beliefs and vice versa. (g) Comparative statics. Does the model imply that if an error gets costlier, the size of error declines? This is in general a message of simple heuristics approach (Gigenrenzer & Selten, 2001), expressive voting (Brennan & Hamlin, 1998) as well as rational irrationality (Caplan, 2001a, 2001b). Cowen (2005) however claims that for pride goods, this relationship need not hold.

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3. BAYESIAN LEARNING Even if individuals create rational expectations, Romer (2003) posits that the mean belief in a large population is biased whenever errors in individual beliefs are correlated. This idea is modeled in a setup with two policies. Identical voters have priors on their relative advantage. At a known cost, they can get a signal on the relative advantage and can also observe signals of other voters. Each individual selects the number of her costly observations. The problem for inference is that the signal consists of true value and two types of errors – common and idiosyncratic. The common part is identical to all voters (hence is correlated), whereas the idiosyncratic part is speciﬁc for each individual. This means that an individual observing signals can eliminate the idiosyncratic part, but not the common part. The shortcomings of this approach are as follows: (a) Distribution of signals can be obtained only at a cost. This requires careful interpretation of the cost of observing the distribution of signals. In politics, opinion polls (and summaries of expert judgments) are virtually costless, hence even an individual who does not observe any signal (e.g., does not watch TV) should be able to get the aggregate information. This echoes recent theories on the collective aggregation of information, where the electorate with rational ignorance may have asymptotically perfect knowledge (Martinelli, 2006). (b) Common part of error. If the signal realizes with a political debate, or a political event, the common part of error can be explained by argumentation skills, spin, popularity, or attractiveness of one candidate over another. This is fully in spirit of probabilistic voting literature. However, such signals are not randomly drawn from distributions independent over time, but are persistent. Persistence obviously precludes Bayesian elimination of the error unless mean of the distribution of the common error is known. (c) Discounting bias. If variance of the common error is low comparing with variance of the idiosyncratic error, then people make almost unbiased estimates. Other than zero expected value is not a complication either: if individuals know that, for example, Candidate A is always much nicer than Candidate B, they would discount attractiveness of his or her talk. This is similar to Austen-Smith (1991) who claims that under asymmetric information on impact of transfers and tax incidence, voters insure by buying less transfers and lower taxes; only those programs that credibly signal their merit will win elections. Moreover, that the

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improved information on common error is individually speciﬁc and cannot be transmitted contrasts with the probabilistic-voting literature (Persson & Tabellini, 2000), where a popularity shock realizes only once, and demand side cannot tackle it; its anticipated effect is mitigated rather by the supply side, i.e., the competition of politicians. (d) Individual decision on acquiring signal. The number of signals acquired is independent on the values of the acquired data. Romer (2003) assumes individual-speciﬁc beneﬁt and cost functions from acquiring information, solely motivated by civic engagement or expressive motives. This goes against Stigler (1971), where acquiring information depends on the expected beneﬁt of the correction. Although this can be handled formally (distributions of both common and idiosyncratic parts are known, so an individual can compute expected improvement of obtaining a signal in the next period), the problem is that we may get a very complicated dynamics of adjustments, depending on the realization of shocks in different periods. (e) Application to private choice. Superiority of private over public choice could be related to the fact that prior private consumption, one observes consumption of the good by others. With exception of yardstick competition, that is in politics impossible. Unfortunately not much is to be inferred from this difference, since the superiority is related to assumption that political choice involves a lower number of consumption decisions; by introducing sequential private choice, we create extra opportunities for obtaining true information, which makes comparison of politics and markets worthless. What would happen for identical timing – when both the political and private choices were sequential – is ambiguous; in Romer’s model, there would probably be no differences. In other words, this type of correlated error seems not to be helpful in addressing the difference between market learning and political learning.

4. BEHAVIORAL ANOMALIES 4.1. Innate Biases Evolutionary psychology suggests that the explanation of a large number of biases lies in the persistent traits of human psyche, and that systematically wrong descriptive beliefs can be related to behavioral traits gained in the

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very past. Rubin (2003) refers to anthropological division of civilization into mobile and sedentary societies; the former being egalitarian, based on hunter-gatherers, with little food storage, little division of labor, and occupational specialization given only by age. As a result, ‘instinctive economics’ (economics rooted in human instincts) disregards capital investments and division of labor. This simple but ambitious explanation is very difﬁcult to challenge since economic education that aims to deprive people of folk or instinctive economics is not very well measured, and also because descriptive beliefs depend on the ideology, which is exogenous in the short term, but arguably endogenous in the long term (Austin & Cox, 2007).

4.2. Status Quo and Loss Aversion Heinemann (2004) argues that many psychological anomalies such as status quo bias and loss aversion have a substantial explanatory potential particularly in the context of reform resistance. First, the status quo bias describes a situation where people have a preference for one option among many others only because the option happens to be the status quo. If a change occurs, this speciﬁc option immediately loses extra attraction. Loss aversion denotes the fact that the absolute change in utility associated with a loss is larger than the absolute change in utility associated with a gain. With loss aversion, the utility function is dependent on the reference point which tends to be the status quo. All these anomalies work against reforms aiming to change the status quo. The behavioral explanations nevertheless encounter severe problems if taken literally on markets with behaviorally unbiased trading partners. The loss aversion combined with S-shaped utility curve would lead to the emergence of a special insurance, not observed in reality (Wittman, 1995). Even if valid, the anomalies are of little use for our purpose because they make no difference between private and collective choice. In addition, for any anomaly to exist, there is no need for biased descriptive beliefs; preferences are inconsistent with choice because of the psychologically predetermined structure of choice, not because of false beliefs.

4.3. Conﬁrmatory Bias Conﬁrmatory bias can be understood by a phrase that ‘ﬁrst impression matters,’ namely that one is overconﬁdent about validity of an initially held

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hypothesis. Experiments and psychologists conﬁrm that the way people search for, process, and remember information is indeed guided by the priors (Camerer, 1995). Rabin and Schrag (1999) were the ﬁrst to model the conﬁrmatory bias as overconﬁdence in the currently held hypothesis. Speciﬁcally, an agent initially believes that each of two possible states of the world is equally likely. The agent then receives a series of independent and identically distributed signals that are correlated with the true state. When the agent gets a signal that is counter to the hypothesis he currently believes is more likely, there is a positive probability that he or she misreads that signal as supporting his current hypothesis. Importantly, the agent is unaware that he is misreading evidence in this way and engages in Bayesian updating that would be fully rational provided he were not misreading evidence. The problem with application of conﬁrmatory bias in politics is arbitrariness of common knowledge. Rabin and Schrag (1999) in Section 5 model principal–agent relationship when the principal is aware of agent’s bias. Thereby they introduce a fundamental asymmetry in knowledge, because the principal is aware of the bias, but the agent is not. However, at least in citizen-candidate models, a politician must be behaviorally identical to the voter, hence asymmetry is unfounded. If both are unaware of any bias, we can have a very rich structure of updates ending in a pseudoBayesian equilibrium based on incorrect updates. If both are aware, then it depends on whether the bias is common knowledge – if so, then it is irrelevant for choice, since any agent can reconstruct her updates using the knowledge of the bias. Yet, if the bias is not common knowledge but is symmetric, then we again have a very speciﬁc problem of coordination on incorrect updates. In any case, either coordination is nearly by chance (nobody is aware of any bias), or coordination is an extremely deep informational problem involving many levels of knowledge (what the individual 1 thinks that the individual 2 thinks about what the individual 1 thinks about the individual 2 etc.). Simply, the lack of common knowledge makes the problem immensely complex. Indeed, even the authors honestly admit that ‘usefully incorporating conﬁrmatory bias into economic analysis will depend upon the extent to which people believe that others suffer from conﬁrmatory bias’ (Rabin & Schrag, 1999, p. 71). The most recent attempt to apply conﬁrmatory bias into politics is Cowen (2005). He deﬁnes ‘self-deception’ as tendency to welcome conﬁrming evidence for a prior but throw out disconﬁrming evidence. The problem is that he explains the phenomenon by two, mutually exclusive hypotheses. One is that ‘the quest for pride causes individuals to throw away

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information that reﬂects badly on their values and their afﬁliation’ (Cowen, 2005, p. 439). Values or afﬁliations are therefore consumption goods (pride goods), and one considers trade-off between pride and material consumption. Another explanation is evolutionarily psychological. Self-deception is a second-best heuristics for individuals who need to boost motivation, command the loyalty of others, avoid depression, and protect themselves against a tendency towards distraction (Cowen, 2005, p. 440). Nevertheless, none is, in fact, conﬁrmatory bias or overconﬁdence as deﬁned in the behavioral literature, e.g., Rabin and Schrag (1999). At last, Cowen (2005) inclines to the pride-goods explanation of selfdeception. The novelty is that any choice has both materially instrumental component and value (or emotional) component. This is exactly what expressive voting literature (Brennan & Hamlin, 1998) captures under ‘instrumental voting’ (to affect what happens in the world) versus ‘expressive voting’ (to make a statement on values). This approach implies that efﬁciency is affected only if the consumption of pride goods produces externalities. Removal of self-deception is a classic collective action problem, identical information-gathering, and incentives for rational ignorance. In this respect, it adds nothing extra to the concept of rational ignorance.

5. RATIONAL IRRATIONALITY One of the most systematic and the most ambitious attempts to rationalize biased beliefs is ‘rational irrationality’ concept by Caplan (2000, 2001a, 2001b, 2003), related to the cognitive dissonance by Akerlof and Dickens (1982). An individual faces a trade-off between the amounts of rationality and irrationality consumed. Rationality brings beneﬁts in terms of identifying the best instruments to achieve personal goals, while irrationality delivers emotional beneﬁts. Each individual has rational expectations on the costs and beneﬁts of rationality, hence consumes a privately optimal amount of rationality. Caplan (2001a, 2001b) argues that the opportunity costs of irrationality in market exceed opportunity costs of irrationality in politics, which he considers to be the key difference between the markets and politics. To illustrate different equilibria amounts of rationality in politics and private life, Caplan (2003, p. 221) uses the way people interpret autarky: ‘[T]he belief that protectionism is a wealth enhancing national policy makes little difference for the individual adherent, who still enjoys the beneﬁts of

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international trade. But holding that household self-sufﬁciency is the path to prosperity has large private costs.’ In other words, collective learning is less efﬁcient than private learning due to positive externalities involved in improving an erroneous belief. Private costs of irrational bias in politics are negligible, so people tend to be biased, and politicians who win competition for the favor of voters with irrational biases tend to share those biases. This has interesting and profound implications not only for politics, but also for academic social criticism and other ﬁelds (Boudreaux & Crampton, 2003). One may further speculate about the difference between imperfect rationality and imperfect information. Caplan (2003, p. 222) notes: ‘Intuitively, a person with ample free information might still choose to irrationally disregard it; conversely, a person with virtually no information could still take full advantage of the little that he does know.’ This suggests that the optimal level of rationality does not signiﬁcantly change when media, interest groups, and politicians bring virtually free information. If processing of information is too costly for a layman, additional items of information remain out of scope of his or her interest. The idea of rational irrationality can be addressed empirically, or rejected in theory. For the issue of laboratory tests, see discourse between Caplan (2005a, 2005b) and Wittman (2005a, 2005b); in this text, we focus exclusively on the theoretical part, and identify several caveats: (a) Costless thinking on meta-level. Caplan divides rationality into two levels: meta-rationality, allocating rationality into activities, and rationality within the realm of each speciﬁc activity. As to the latter, we simply behave rationally only to extent chosen on the meta-level; we dispose with meta-rational expectations. If errors were due to lack of thinking, we could conjecture that on meta-level, thinking is costless, but on lower levels, thinking is costly. This fundamental asymmetry is unfounded; why should one know the price of thinking, and not in the price of information, and vice versa. No justiﬁcation for this asymmetry, or for any dualism of meta-level and normal levels, has been offered. (b) Anyway, suppose we dispose with an unbiased estimate of costs of thinking. How could we arrive at the ﬁgure? It could be on the basis of the long-term experience. The psychic cost cannot be measured exactly before you start thinking, but can be approximated by the amount of time spent by thinking. An individual might summarize previous experiences into a vector of costs and a vector of beneﬁts. A regression of non-linear cost function on beneﬁts might provide estimates of the

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beneﬁt-cost parameters. If a rational individual had no reason to believe that the problem he is facing statistically signiﬁcantly differs from the previous problems, he or she would use the predicted estimates for optimization. However, Caplan’s idea is not in the direction that cognitive capacity is allocated, but that emotions are consumed. (c) Experience as a capital good. The allocation of rationality could be determined by an individual whose thinking on meta-level is costly. However, in such a model we implicitly introduce a dynamic setting without considering other factors. Experience (the result of thinking) might be a stock variable (human capital), and enters the decisionmaking process along with pure thinking. For such decision-making production, an individual gets an optimal amount of rationality when she optimizes evolution of capital over time, given the knowledge of depreciation rate, the expectation of dynamics of future problems, and the possible changes to her thinking costs. Now the problem becomes genuinely complex, and meta-rational expectation assumption loses part of its appeal. The chance that a boundedly rational individual selects an optimal path of thinking investments turns to be very low. (d) Compensations for learning. A very unclear yet important issue is how opportunities to learn are evaluated and compensated. Consider the following problem exposed by Caplan (2003, p. 231): ‘Suppose free trade provides $600 in beneﬁts to each voter, but 60% are willing to pay up to $2 for the irrational belief that free trade costs them $1000. A simple vote for free trade will clearly fail.’ Ordinary logrolling, according to Caplan, cannot utilize forgone gains to trade, because agents still retain their false beliefs. Even if the minority of 40% gave all net beneﬁts to the irrational majority (i.e. $400 each), members of the irrational majority would consider that to be a loss of $600 ($1000400), and would vote for protectionism (status quo). The obvious problem is that in such a case, voters are not rational on the meta-level. If they really had rational expectations, they would know that by investing $2 of $400 transfer into learning, they would realize net gain $398. Another possibility is that the minority is able to condition the transfer on learning, which is a much more plausible option that to condition the transfer on vote with the secret ballot, as Caplan (2003) notes in footnote 11. (e) Why false beliefs as empirical shortcuts come into being? One explanation is via the cost of thinking. Strictly positive cost of thinking and more generally costs of investments into human capital are obvious. Caplan’s intuition is however in the direction of pride goods mentioned

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in subsection 4.3. ‘[Y]ou may be willing to forego some wealth in order to retain cherished – though irrational – beliefs.’ (Caplan, 2003, p. 223) That invites an idea that changes in beliefs are avoided, because one pays special adjustment cost for leaving wrong beliefs and approximating true beliefs. To explain where this cost comes from, and why it is constant, needs very speciﬁc behavioral or evolutionarily psychological assumptions. Little is known on how these (probably emotional) costs affect consumer behavior, and inﬂuence efﬁciency properties of market and political allocations. (f) Expertise and voters’ activity. In all areas where thinking costs matter, meta-rational individuals should behave as perfectly rational individuals. First of all, they should respond to credible signals of rationality or ability. If experts were able to produce credible (costly) signals of incurring thinking costs (such as PhD in Economics), the meta-rational individuals would follow their advice, thereby economizing on thinking costs. But laymen do not follow experts views on many policy issues, which Caplan (2002) himself demonstrated in a survey comparing views of American economists and Americans on the economy. (g) Meta-rational individuals would be able to perfectly deduce that irrationality regarding speciﬁc issues is ruling the world. Any consequences related to the allocation of rationally would be known. For example, the meta-rational voters could not accuse political supply of inefﬁciency, for they could easily conjecture that the main problem lies in the under-supply of reasonable political demand. These strange consequences lead us astray from the meta-rational individuals.

6. POLITICAL VS. INDIVIDUAL ADJUSTMENT The attempts to theorize on error in political economy among Austrian economists have to date led to urgent claims to model learning and dynamics of the mixed economy at the micro- and macro-levels (Ikeda, 2003). Evolutionary economics offers such a toolkit, comprising ingredients such as strategies, populations of players, well-speciﬁed interactions, and ﬁtness functions. Evolutionary reasoning can be divided into two branches, stability and dynamic concepts. For stability, we seek for stable states which cannot evolve, so mutants cannot outperform normal population. Such states frequently overlap with competitive equilibria in standard microeconomics and with plausible reﬁnements of Nash equilibria in game theory.

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For dynamic concepts, we have a colorful picture with differential equations and simulations. Although externalities and collective action in evolutionary framework often produce interesting results, very little formal research has been conducted with regard to evolution on political markets where collectiveaction problem and the possibility to impose own will upon the others are constantly present. An interesting exception is Caveiro (2005) who applies neural networks to the adaptation of voters to political business cycle. This section attempts to contribute to this literature and show that it may address modeling issues raised in Section 2.2. We introduce an evolutionary model of coordination of market exchanges in a heterogeneous population; the setup is a very straightforward application of elementary evolutionary game theory. The model identiﬁes one way why political (centralized) decision-making is more likely to produce a coordination failure than individual (decentralized) decision-making. Unlike rational irrationality and other previously discussed explanations, the model abstracts from different marginal beneﬁts from learning in private and collective choice. The thrust of the explanation lies exclusively in the different mechanics of adjustment of strategies on markets and in politics. In markets, individuals can verify both their strategies and their beliefs. In politics, choice is imposed by the majority, and individuals only verify their beliefs. A population that could have converged to a superior equilibrium if markets are let free may be forced to an inferior equilibrium by a majority will. Accordingly, remaining individuals verify their beliefs into pessimistic ones. At last, everyone, including dissenters, is satisﬁed with the inferior equilibrium, since it perfectly corresponds to the pessimistic beliefs. We show that in this model, politics can work as a pessimistic ‘self-fulﬁlling prophecy,’ which markets cannot.

6.1. Core Assumptions The setup assumes two groups normalized to a unit-size, A and B, differing in the mother tongues, a and b. In each of an inﬁnite number of periods, a randomly selected pair iAA and jAB has an opportunity to trade, but the trade occurs only if both i and j can use the same language; gains from trade are 3 for each. Using the other language is costly, but let language a be simpler to master than b; the costs of using a translator are 1 for i and 2 for j. These costs have to be expended in each and every period. As a result, trading in language a is Pareto-efﬁcient, yielding in each period payoffs (3, 2),

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Table 1. IAA/jAB Language a costless Language b costly

Payoff Matrix.

Language a costly

Language b costless

3, 2 1, 2

0, 0 1, 3

whereas trading in the more cumbersome language b is less efﬁcient, yielding payoffs (1, 3). Such a game is an asymmetric modiﬁcation of Battle of Sexes. The use of a native or foreign language can be organized individually or politically. By political choice, we mean that the majority elects a citizencandidate who decides on the mandatory business language. Thereby we assume that the politician can forbid members of her group to use the other language privately. The native language is costless, but risky (trade may not happen), whereas the foreign language is risk-less, but costly. The two strategies can also be interpreted as a nationalistic versus cosmopolitan strategy. Payoffs in interactions between randomly drawn iAA and jAB are in Table 1. Each individual has a private belief that the trade partner is able to use the other language, si or s j. In order to work with a polymorphic interpretation of the population, we assume only pure beliefs, si, s j A{a, b}. This has expositional advantages in terms of conveying the message of the model in a very simple, albeit simpliﬁed way. Pure beliefs implies that the populations are represented by a realization of two binomial distributions BA( ) and BB( ) over {a, b}, where we denote a BA(a), 1 a ¼ BA(b), b BB(b), and 1 b ¼ BB(a). Hence, aA[0, 1] denotes the share of group A that believes that members of group B are willing to use a, and bA[0, 1] is the share of group B that believes that members of group A are willing to use b. (In other than stable states, we always add subscript t denoting period t). Below we will see that anyone with belief si ¼ a or s j ¼ b plays only nationalistic strategy, so each variable also represents the share of those who are nationalistic, namely are unwilling to pay the cost of using the other language.

6.2. Individual Adjustment For individual decision-making, each individual selects the language on the basis of her private belief, observes the payoffs and may update the belief, if

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incorrect. Then, the random draw of trading pairs (i, j) is repeated. Since each individual has a pure belief, we have only strict best responses, a or b (e.g., for player i, si ¼ a implies strategy a, and si ¼ b implies strategy b). Therefore, one can check whether the belief about the trading partner was correct, or not, simply by observing her payoffs and the corresponding strategy proﬁle. By examination of Table 1, we can observe correct (equilibrium) beliefs in two strategy proﬁles (those with payoffs (3, 2) and (1, 3)) and incorrect (out-of-equilibrium) beliefs in two strategy proﬁles (those with payoffs (0, 0) and (1, 2)). What happens if the beliefs are incorrect? We have to specify the rate of adjustment of an individual strategy. Here, it is plausible to assume that the rate is linear in opportunity cost associated with the best response. In proﬁle [a, b] with payoffs (0, 0), the opportunity costs are 1 – 0 ¼ 1 for player i and 2 0 ¼ 2 for player j (See Table 1). We know that this proﬁle occurs with probability atbt. In proﬁle [b, a] with payoffs (1, 2), the opportunity costs are 3 – 1 ¼ 2 for player i and 3 – 2 ¼ 1 for player j. This proﬁle occurs with probability (1 at)(1 bt). Assuming rate of adjustment linear in opportunity cost with constant 0oPr1, we have two difference equations a_ ¼ 2pð1 at Þð1 bt Þ pat bt ¼ pð2 2at 2bt þ at bt Þ

(1)

b_ ¼ pð1 at Þð1 bt Þ 2pat bt ¼ pð1 at bt at bt Þ

(2)

Interpretation of p is straightforward: it is the share of people who, having observed an incorrect belief, make a correct adjustment. It is now useful to derive situations when shares a and b are constant; these are also depicted on Fig. 1 2 2a 2a

(3)

1a b_ ¼ 0 : b ¼ 1þa

(4)

a_ ¼ 0 : b ¼

The system converges to a stable state when a_ ¼ b_ ¼ 0. This is equivalent to a þ b þ ab ¼ 1 ¼ a þ b ab/2, which holds as long as a ¼ 0 or b ¼ 0. By plugging into equation (3), we have two stable states, inefﬁcient one, (a, b) ¼ (0, 1), and efﬁcient one, (a, b) ¼ (1, 0). What is more interesting is to identify the basin of attraction for each stable state. This appears difﬁcult

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inefficient 0, 1

bt

. a=0

. b=0 0, 0

Fig. 1.

at

efficient 1, 0

Dynamics of Individual Adjustment.

analytically, yet we can use Fig. 1 with arrows indicating the signs of attraction. Although we have two evolutionarily stable states, the basin of attraction for the inefﬁcient one is a singleton. With exception of (a0, b0) ¼ (0, 1), there is no trajectory that would end up in the inefﬁcient stable point, (a, b) ¼ (0, 1). In other words, the adjustment dynamics described in equations (1) and (2) drives any population to the efﬁcient stable state, with only one extreme exception, if all start using language b. 6.3. Political Adjustment Suppose that two citizen candidates, each with a different belief, enter elections and manifest their beliefs. Voting is costless, and we concentrate on the equilibrium with sincere voting, namely when each individual votes for the language on the basis of her belief. This reﬁnement is legitimate as long as individuals do not play weakly dominant strategies. Identity of the politicians depends on which type of private belief dominates in each group in period t ¼ 0. In period t ¼ 0, each of elected citizen candidates adopts a mandatory language on the basis of his belief. Strategy set of each trader reduces to a singleton, and all trading pairs end up in an identical strategy proﬁle. The proﬁle is either an inefﬁcient equilibrium, as in [b, b] with payoffs (1, 3), or an efﬁcient equilibrium, as in [a, a] with payoffs (3, 2). In addition, there

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Table 2. a0, b0 a0Z1/2 a0o1/2

The Strategy Proﬁle in Political Adjustment for t ¼ 0. b0o1/2

b0Z1/2

a, a efﬁcient b, a out of equation

a, b out of equation b, b inefﬁcient

are two out-of-equilibrium proﬁles, [a, b] with payoffs (0, 0) and [b, a] with payoffs (1, 2). Table 2 summarizes. Equilibrium. If the proﬁle is equilibrium, none of politicians has any incentive to change her belief. The citizens update beliefs like in individual choice. The only difference is that in a purely individual adjustment, they selected a strategy corresponding to their beliefs, and thereby veriﬁed both belief and strategy; here, the strategy is mandatory, so they only verify the belief. Regardless of assumptions on the rate of adjustment, for a0Z1/2 and b0r1/2 (inefﬁcient [b, b] proﬁle), we have a_ 0 and b_ 0. For a0o1/2 and b0Z1/2 (efﬁcient [a, a] proﬁle), we have a_ 0 and b_ 0. Citizens’ beliefs converge to the beliefs of the politicians, reﬂecting initial distribution (a0, b0); any initial disagreement or heterogeneity in beliefs disappears throughout the process of political learning. Out of equilibrium. Here, we have to determine how the politicians change their beliefs (and accordingly the mandatory language). We have at least two options, optimistic and realistic: (i) they are able to coordinate on efﬁcient, risk-dominant equilibrium, or (ii) they adjust exactly like citizens. It also depends on the number of periods in-between consecutive elections. Regardless of these nuances, we will see that the main result, namely that political learning is less efﬁcient than individual learning, preserves. Start with proﬁle [a, b] with payoff (0, 0), corresponding to a0Z1/2 and b0Z1/2. In case (i), when politicians immediately coordinate on the efﬁcient equilibrium [a, a], we have that all players j are forced to use a. _ This implies adjustment a_ 0 and bo0. If elections come early, we may have at the time of elections bto1/2 (sufﬁcient adjustment) or btZ1/2 (insufﬁcient adjustment). If adjustment is sufﬁcient, a-politicians are elected and we have an efﬁcient equilibrium. Otherwise, we have again [a, b] proﬁle, but since btob0, repeated elections gradually push citizens’ beliefs to the efﬁcient equilibrium. In case (ii), when politicians adjust exactly like citizens, we have to specify the rate of adjustment. This should reﬂect opportunity costs. The opportunity cost for politician 1 is 1, and the opportunity cost for politician 2 is 2. Both opportunity costs are exerted with probability one. The dynamics is a_ ¼ pat and b_ ¼ 2pbt . It is again irrelevant whether elections

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arrive sooner or later because beliefs of repeatedly elected politicians will only reﬂect gradual adjustments of citizen beliefs. Adjustment for proﬁle [b, a] is analogous. For risk-dominant politicians (case (i)), the economy operates under efﬁcient [a, a] regime. For realistic politicians (case (ii)), politicians update by a_ ¼ 2pat and b_ ¼ pbt . Fig. 2 illustrates the dynamics. For any initial distribution of beliefs, (a0, b0), it shows the point of convergence, i.e., of political stability. If politicians out of equilibrium can coordinate on the risk-dominant equilibrium (which is an optimistic assumption), then we have an inefﬁcient stable state only for (a0, b0)AS0. If politicians adjust like citizens, then we have an inefﬁcient stable state for an even larger set, ða0 ; b0 Þ 2 S 0 [ S1 [ S 2 . S1 is formally deﬁned as the set of all (a0, b0), for which there exists t, where atW1/2 and btr1/2. S2 is formally deﬁned as the set of all (a0, b0), for which there exists t, where atr1/2 and btW1/2. Notice that in the end, regardless of which state is achieved, both populations are completely satisﬁed with their politicians because they share identical beliefs with the citizens and thereby promote language policies that are equilibrium policies from the perspective of all citizens. To conclude, Fig. 2 shows that in politics, initial majorities matter for learning; if population B is initially strongly self-conﬁdent and population A is weakly self-conﬁdent, a politically stable state induces trades in the inefﬁcient language b. For markets, this occurs only in a degenerate case, (a0, b0) ¼ (0, 1); learning in markets drives nearly all populations to the inefficient 0, 1 S2

S0

b0 S1

efficient 0, 0

Fig. 2.

a0

1, 0

Dynamics of Political Adjustment.

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efﬁcient stable state. By restricting individual experimentation in strategies, politics is signiﬁcantly more likely to deliver an inefﬁcient outcome.

7. CONCLUSION Although the dominant interest of Austrian School of Economics in markets with well-deﬁned and well-protected property rights sways main interests away from political economy, many Austrian scholars dispose with a distinctive and common idea on how politics operates. One political economy insight frequently mentioned in Austrian writings is that voters systematically keep false beliefs. We regard this hypothesis plausible, and review contemporary literature so as to identify ﬁrm theoretical foundations for the hypothesis. In Sections 3–5, we analyzed three types of explanations and pointed to their caveats: Bayesian misperceptions are unlikely to sustain over time, behavioral anomalies make no difference between private and political choice, rational irrationality struggles with operational deﬁnition of meta-rationality, and the implications of the consumption of pride goods or emotions do not differ from implications of classic rational ignorance. We have offered an evolutionary model as an alternative avenue. The objective of the model is to prove that politics may be more prone to coordination failures; collective play of an identical baseline game leads to a Pareto-inferior outcome than private play. The model addressed all modeling issues analyzed in Section 2.2: (i) deviations toward best responses are on the basis of opportunity costs, (ii) false beliefs play the crucial role throughout adjustment but disappear in stable states, (iii) citizen candidates are behaviorally identical to voters, (iv) information on updated aggregate beliefs is not available, so one tends to update private beliefs only on the basis of private experience, and lastly (iv) comparative statics depends only on the initial distribution of population. This model shows that dispersed insights by Austrian economists can be further extended if one engages in formal modeling of simultaneous evolution of beliefs and strategies.

ACKNOWLEDGMENT Roger Koppl and Mark Skousen deserve thanks for valuable comments to a very preliminary version of the paper. Support by the Ministry of Education (MSM0021620841) is gratefully acknowledged.

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SCIENTIFIC HERMENEUTICS: A TALE OF TWO HAYEKS Roger Koppl ABSTRACT Hayek favored both classical hermeneutics and science. His scientiﬁc reasoning shows the logical necessity of methodological dualism. Bruce Caldwell and Viktor Vanberg oppose hermeneutics and methodological dualism in favor of science. Their arguments depend on inappropriate interpretations of the doctrine of methodological dualism and an impoverished understanding of hermeneutics that fails to distinguish classical hermeneutics from universal hermeneutics. Hayek showed that ‘‘scientiﬁc’’ and ‘‘humanistic’’ approaches to social science can and should be compatible and complementary. Opposing (classical) hermeneutics in favor of science may cause a loss of knowledge by tending to deprive ‘‘scientiﬁc’’ social science of insights arising from more ‘‘humanistic’’ traditions.

There is no method of reasoning more common, and yet none more blameable, than, in philosophical disputes, to endeavour the refutation of any hypothesis, by a pretence of its dangerous consequences to religion and morality. When any opinion leads to absurdities, it is certainly false; but it is not certain that an opinion is false, because it is of dangerous consequence. Such topics, therefore, ought entirely to be forborne; as serving nothing to the discovery of truth, but only to make the person of an antagonist odious. David Hume Explorations in Austrian Economics Advances in Austrian Economics, Volume 11, 99–122 Copyright r 2008 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11006-7

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HAYEK AS SCIENTIST AND HERMENEUT Bruce Caldwell (2004) argues that F.A. Hayek abandoned methodological dualism in the wake of his discovery of complexity theory in 1952. Complexity saved Hayek from a slow slide into the dark waters of hermeneutics. Caldwell thinks there are ‘‘dangers of association’’ with hermeneutics. Hayek is ‘‘scientiﬁc,’’ hermeneutics is not, and we had better stick with science. Hayek’s methodology was not hermeneutics, according to Caldwell, it was ‘‘scientiﬁc subjectivism.’’ Viktor Vanberg (2004) makes a similar argument. Hayek was not a methodological dualist, at least not after 1952. Vanberg, too, sees Hayek as ‘‘scientiﬁc’’ in contrast with much of the rest of the modern Austrian school including Ludwig von Mises, Ludwig Lachmann, and Don Lavoie. Vanberg speaks of Hayek’s ‘‘naturalistic subjectivism.’’ For both Caldwell and Vanberg the main offense of hermeneutics seems to be the doctrine of methodological dualism. There is much that I agree with in the perspectives of both Caldwell and Vanberg. In particular, I agree that Hayek’s subjectivism was both ‘‘scientiﬁc’’ and ‘‘naturalistic.’’ But I believe it was also hermeneutic. We might as justly describe Hayek’s methodology as ‘‘scientiﬁc hermeneutics’’ or as ‘‘naturalistic hermeneutics.’’ The source of my disagreement with Caldwell and Vanberg does not seem to be with their understandings of Hayek’s ‘‘scientiﬁc’’ or ‘‘naturalistic’’ subjectivism, but with their understandings of what hermeneutics and methodological dualism are all about. I will discuss the meaning of ‘‘hermeneutics’’ and methodological dualism only later, but some brief comments now are in order. Hermeneutics ‘‘attempts to understand human actions by interpreting them in more or less the way we interpret a written text, hermeneutics being the theory and method of such interpretations’’ (Koppl & Whitman, 2004, p. 295). Wilhelm Dilthey deﬁned ‘‘hermeneutics’’ as ‘‘the methodology of the interpretation of written records’’ (Dilthey, 1900, p. 249). Hans Albert (1985) distinguishes ‘‘classical hermeneutics’’ from ‘‘universal hermeneutics.’’ Classical hermeneutics is more modest, claiming only that human actions can be understood in much the same way we understand a poem or the instructions on a tube of toothpaste: we attempt to understand the purpose of the act (whether written or otherwise) in terms of the internal perceptions and beliefs of the person who performed it. Universal hermeneutics is an encompassing philosophy deriving in large part from the work of Martin Heidegger. It includes perplexing claims such as ‘‘the movement of human existence . . . issue[s] in a relentless inner tension between illumination and concealment’’ and ‘‘interpretation is always on the way’’ (Gadamer, 1981, pp. 104 and 105).

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Caldwell and Vanberg fail to distinguish the two types of hermeneutics. Hayek was hermeneutic only in the more modest classical sense, which is perfectly consistent with modern science, including cognitive science and neuroscience. Methodological dualism is a central doctrine of both classical and universal hermeneutics. It is the doctrine that the methods of the social sciences differ from those of the natural sciences. The essential point here is that matter does not talk (Machlup, 1978). A psychologist might interview a subject, but a botanist would not. The physicist does not need to know what dust motes think they are doing as they bounce randomly in solution. The natural scientist studies phenomena that are interpreted only by observers. The social scientist studies phenomena that are being interpreted by his objects of inquiry. If I am going to study a race riot, I had better understand the rioters’ theory of race. I might reject their theory altogether, but the theory helps explain the riot. I must understand the theory and refer to it. The social scientist must understand the people he studies. To do his job, he must ‘‘interpret’’ human meanings. This ‘‘method of interpretation’’ is present in the social sciences, but not in the natural sciences. (Later I will brieﬂy consider whether biology, especially ethology is an exception.) The standard statement of methodological dualism does not tell us where the methods of the two branches of science are the same and where different. This point matters, I think. Citing Albert (1988), Vanberg (2004) stipulates a meaning for ‘‘methodological dualism’’ that makes it inconsistent with Hayek’s naturalism. This stipulated meaning supports his thesis nicely, but may not be the most appropriate one to apply. The conﬂict between the hermeneutical and anti-hermeneutical Austrians is fueled in part by the existence of good textual evidence on both sides. I will look at some evidence that Hayek was a hermeneut before moving on to the evidence that he was a scientist who took a stance incompatible with hermeneutics. After discussing the term ‘‘hermeneutics’’ I will argue my case that Hayek was a scientiﬁc hermeneut. In the conclusion I discuss why the whole business might matter.

HAYEK THE HERMENEUT Hayek the hermeneut lives in some interpretations of The CounterRevolution of Science (Hayek, 1952a). Caldwell reviews works, including some not discussed here, in which The Counter-Revolution is viewed as hermeneutical at least in part (2004, pp. 430–438). Theodore Burczak (1994)

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argues that there are ‘‘postmodern’’ and thus hermeneutic ‘‘moments’’ in Hayek’s work and gives several examples from The Counter-Revolution. Caldwell describes G.B. Madison as an ‘‘inﬂuential early proponent’’ of the view that The Counter-Revolution ‘‘represents an ‘interpretive turn,’ or a turn toward hermeneutics’’ (2004, p. 430). He cites Madison (1989). In a somewhat more recent paper Madison (1994) says that Hayek asks ‘‘genuinely hermeneutic questions.’’ He claims that Hayek ‘‘argued for an alternative approach’’ to economics in The Counter-Revolution, ‘‘one which today would be labelled interpretive or hermeneutical.’’ In his defense of ‘‘interpretive reasoning’’ in social science, Boettke makes several references to The Counter-Revolution (1990, pp. 40–41). Boettke explicitly links ‘‘interpretive reasoning’’ with ‘‘the continental philosophies of hermeneutics and phenomenology’’ (1990, p. 35). He quotes Hayek from The Counter-Revolution saying that the social sciences start with ‘‘what men think and mean to do’’ (Hayek, 1952a, p. 57 as cited in Boettke, 1990, p. 40). Boettke goes on to quote Hayek saying, ‘‘The data of the human sciences, in fact, ‘are what the acting people think they are’ ’’ (Hayek, 1952a, p. 44 as quoted in Boettke, 1990, p. 40). As we have seen with the quotes Boettke selected, there are good textual grounds for interpreting The Counter-Revolution as hermeneutics. Hayek speaks of ‘‘the peculiar object and methods of the social studies’’ (p. 41). He says famously, ‘‘it is probably no exaggeration to say that every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism’’ (p. 53). He cites favorably the famous phenomenologist Felix Kaufmann (p. 98, n. 51) and, of course Ludwig von Mises.

HAYEK THE SCIENTIST Hayek’s other book from 1952, The Sensory Order, is clearly a fully ‘‘scientiﬁc’’ effort. The general tone and argument may easily seem somehow inconsistent with hermeneutics. Beyond this rather vague consideration, is the fact that Hayek (1952b, p. 122) presents a theory of mind in which all the elements creating mind operate in a ‘‘mechanistic’’ fashion. ‘‘The principles by which the transmission of the individual impulses in the central nervous system is determined are of a kind which might well be described as ‘mechanical.’ ’’ Hayek allows ‘‘the logical possibility’’ that we might ‘‘build a machine fully reproducing the action of the brain and capable of predicting how the brain will act in different circumstances’’ (1952b, p. 189). In a

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lengthy discussion of ‘‘mechanical and purposive behavior’’ Hayek says ‘‘machines could be produced . . . which show all the characteristics of purposive behavior’’ (1952b, p. 126). Indeed, ‘‘some, such as the predictor for anti-aircraft guns, or the automatic pilots for aircraft, have actually been produced’’ (p. 126). Caldwell (2004) thinks The Sensory Order is inconsistent with hermeneutics. Hayek never took the ‘‘interpretive turn,’’ Caldwell argues, because he wanted ‘‘a scientiﬁc rebuttal of scientism. Hermeneutics, with its origins in the exegesis of sacred texts, was too literary in orientation, to extrascientiﬁc, to serve his purposes’’ (p. 437). The Sensory Order ‘‘would bring him [Hayek] closer to Popper but distance him from the hermeneutical critique of naturalism’’ (2004, p. 346). Vanberg (2004) also uses The Sensory Order against claims for a hermeneutic social science. ‘‘By contrast to the versions of Austrian subjectivism discussed above,’’ says Vanberg, ‘‘F. A. Hayek advocates what one may describe as ‘naturalistic subjectivism’’’ (p. 180). Hayek’s ‘‘empiricist subjectivist research agenda’’ (p. 182) is an ‘‘alternative’’ (p. 180) to earlier ‘‘versions of Austrian subjectivism,’’ (p. 180) including hermeneutics and the Verstehen tradition. The Sensory Order is ‘‘of particular interest in [that] context,’’ Vanberg argues (p. 183). Apparently, the point (in part at least) is that Hayek eschews hermeneutics in favor of a ‘‘naturalistic, explanatory account of mental phenomena’’ (p. 185). If The Sensory Order is scientiﬁc while The Counter-Revolution hermeneutic, and if science and hermeneutics are somehow at odds, then it may cause perplexity to note that The Counter-Revolution is the only work of his own that Hayek cites in The Sensory Order.1 I discuss the relationship between these two books in Koppl (2002, pp. 57–59). ‘‘Logically,’’ I say, ‘‘The Sensory Order is volume 1; The Counter-Revolution of Science is volume 2’’ (p. 57).

WHAT IS HERMENEUTICS? Like more or less any other important term in the social sciences and humanities, ‘‘hermeneutics’’ has been given many different meanings. For this essay I will stipulate a deﬁnition that I think is useful: Hermeneutics is the theory and practice of interpreting human actions and their products. This deﬁnition is close to that of the Oxford English Dictionary. ‘‘The art or science of interpretation, esp. of Scripture. Commonly distinguished from exegesis or practical exposition.’’ Hermeneutics as used here emerged

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originally from the ‘‘art or science’’ of Scriptural interpretation. It now applies, however, more broadly. We may attempt to interpret any text or human action.2 The key to hermeneutics is Verstehen, which is simply the German word for ‘‘understanding.’’ As a technical term in the social sciences, the word identiﬁes the human ability to grasp human meanings. This ability is remarkable because the data for any inference about human meanings never single out only one interpretation. For example, ‘‘Can you open the window?’’ may mean, ‘‘Please open the window,’’ or ‘‘Are you able to open the window?’’ or something else, depending on context. While our guesses about such things are fallible, we have a remarkable ability to hone in on the intended meaning. Utterances are not the only meanings we can guess. Any purposeful human action has a meaning to the actor. It has a ‘‘meant meaning.’’ Observers can guess the meaning. A certain gesture may be meant as a threat, as a greeting, or as a mock-threat. A given act may be a theft or a purchase depending on the intentions of the actors. When we understand a human meaning, we interpret an act or utterance. The interpretation refers to the thoughts of others, which cannot be observed. Only the external signs can be observed. The interpretation is a guess. On the one hand, the evidence for any guess is always inadequate to logically isolate one interpretation. On the other hand, we consistently hit upon the right interpretation, or something close to it. Mistakes are common. But they are not as common as they should be given the inadequacy of the evidence supporting most interpretations. Verstehen uses intuition. Etymologically, ‘‘intuition’’ means ‘‘looking in.’’ It is direct perception or immediate apprehension. Intuition contrasts with deliberation and logical reasoning. An intuition is not thought through; it is just seen. When observing human action, we often ‘‘just see’’ the intended meaning. We use our intuition. Sometimes, we deliberate. We weigh evidence and compare competing hypotheses. But even in these cases, we use our intuition. There is a gap between the evidence and our guess. Intuition closes the gap. We cannot fully reveal the inferential processes that lie behind the intuitive understanding of others. To do so, one would have to identify the physical signals that are interpreted as meaningful acts. If the signals were not described in purely physical terms, some of the processes of inference would remain hidden. Second, one would have to identify all the particular inferential mechanisms applied to those signals. Either step is

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probably too much for current science. Hayek claimed that it is logically impossible to eliminate reference to mental states in our descriptions of human action (1952b, pp. 188–190). In any event, the method of Verstehen seems to be a practical necessity for us. This claim is the doctrine of methodological dualism. The word ‘‘hermeneutics’’ is usually applied only to the more theoretical side of things. First, as with Dilthey (1900, p. 249) and Schleiermacher (Forster, 2002), ‘‘hermeneutics’’ may refer to the theory of interpretation. For example, the notion of the ‘‘hermeneutic circle’’ is a theoretical claim about how to interpret a text. We cannot understand the whole except by understanding the parts, but we understand the parts only in their relation to the whole (Dilthey, 1910, p. 127). We need to see the overall meaning of Hume’s History of England if we are to understand his criticism of Cromwell, but it is only through knowing particulars such as his criticism of Cromwell that we understand the overall meaning of his History. There is a ‘‘hermeneutic circle’’ whereby we pass from the whole to the parts and from the parts to the whole until we feel satisﬁed in our overall interpretation. The term ‘‘hermeneutics’’ is also used, however, to refer to the many interpretations made by scholars in the different branches of human studies. Don Lavoie said hermeneutics ‘‘refers essentially to the way in which, in the sciences, the arts, history, and everyday life, we manage to come to an understanding of other people’s actions and words’’ (1994, p. 55). The word ‘‘interpretation’’ is used to refer to individual cases in which one person understands another, or attempts to. But ‘‘hermeneutics,’’ may be used when we refer to relatively broad classes of such cases, especially when the interpreting persons are trained scholars and the persons being interpreted are not. A ﬁnal note on the word ‘‘interpret.’’ In the context of a discussion of hermeneutics, the word refers not to any act of interpretation, but to the attempt to understand human meanings. Copernicus gave us a new ‘‘interpretation’’ of the movements of the planets, but it was not an ‘‘interpretation’’ that drew out human meanings at work in those movements. Therefore, it was not an ‘‘interpretation’’ in the hermeneutical sense.

HISTORICAL NOTES One might trace the history of hermeneutics to ancient times, since there are many ancient texts that discuss how to interpret texts. Plato’s ‘‘Euthyphro,’’

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for example, might be viewed as a lesson in the difﬁculties of interpreting any religious tradition. Abelard and Luther are two other reasonable beginnings, since they were involved in controversies over the meaning of the Bible. A reasonably continuous hermeneutical tradition, however, probably does not precede the late 18th century. (This claim seems implicit in Forster, 2002). I will pick up the history of hermeneutics, however, with Friedrich Daniel Ernst Schleiermacher (1768–1834). Wilhelm Dilthey (1833–1911) built on Schleiermacher. The tradition that begins with Schleiermacher and Dilthey runs in a more or less continuous line through Weber, Husserl, Schutz, Heidegger, and Gadamer. As far as I can tell, the hermeneutics tradition descends from Dilthey and not directly from Schleiermacher. We might have begun with Dilthey, therefore. It was Schleiermacher, however, who separated hermeneutics from scriptural interpretation, and this act of separation may make him a more proper starting point. According to Forster (2002), Schleiermacher made two original contributions to hermeneutics. First, he made hermeneutics ‘‘universal’’ in the sense that it applies to all subjects, times, and places and to both the spoken and written word. Second, he introduced the hermeneutic circle discussed earlier, apparently under the label ‘‘semantic holism’’ (Forster, 2002). Dilthey, as we have seen, deﬁned ‘‘hermeneutics’’ as ‘‘the methodology of the interpretation of written records’’ (Dilthey, 1900, p. 249). He emphasized the claim that understanding moves ‘‘from the external to the internal’’ (1910, p. 69) and placed great weight on the notion of ‘‘meaning’’ (p. 73). ‘‘Actions and their permanent, outward results constantly help us to reconstruct the mental content from which they arose’’ (p. 76). Dilthey was an advocate of methodological dualism. Indeed, he seems to be its originator, although I do not think he used the term. The usual statement of the doctrine is that the methods of the social sciences differ from the methods of the natural sciences. The statement may be anachronistic when applied to Dilthey, however, because he did not use the term ‘‘social science’’ (as far as I know) and seemed to absorb all of the social sciences into history. Mises praises Dilthey highly, but notes that he ‘‘failed entirely to recognize the unique epistemological character of economics’’ (1957, p. 308). Decoded, Mises remark means that Dilthey did not recognize the existence of theoretical laws of social science; he viewed all ‘‘the human studies’’ as history. For Mises, Dilthey’s ‘‘chief contribution’’ was that the understanding of human meanings ‘‘was epistemologically and methodologically different from the natural sciences’’ (1957, p. 312).3

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Dilthey distinguishes the causal relations articulated in natural science from the human meanings articulated in the human studies. If I see a scorched and broken tree I conclude that it was hit by lightning. I reason from effect to cause. If I see a man throw his hands in front of his face and turn away, I conclude that he is afraid of something hitting him. I reason from outward sign to inward meaning. It is not an inference from effect to cause because ‘‘the gesture and the terror are not two separate things but a unity’’ (p. 120). Cause and effect (the bolt and its aftermath) are two separate things, as Hume emphasized in his critique of induction (Hume, 1748 [1910], pp. 346–350). Thus, for Dilthey, ‘‘Elementary understanding is not an inference from an effect to a cause’’ (p. 119). Dilthey distinguished the ‘‘human studies’’ from ‘‘the natural sciences’’ (p. 79). Natural science produces results ‘‘which are esoteric,’’ that is, far from our common experience (p. 79). The human studies do not become ‘‘detached’’ in this way from ‘‘our practical contact with the external world’’ (p. 79). Dilthey says ‘‘the human studies . . . rest on experience, understanding, and knowledge of life’’ (p. 80). They do not give us curved space, relativity of time, or action at a distance, all rather mysterious notions. They give us a world of human meanings such as love, fear, means, end, action, and plan, all of which are familiar and sensible precisely because they are human meanings. The ‘‘system of interactions’’ of the human studies ‘‘is distinguished from the causal order of nature by the fact that, in accordance with the structure of mental life, it creates values and realizes purposes; and this, not occasionally, not here and there’’ but always and everywhere (p. 129).

CLASSICAL HERMENEUTICS IS NOT UNIVERSAL HERMENEUTICS Universal hermeneutics is more radical than classical hermeneutics. The key to universal hermeneutics is Heidegger’s ‘‘ontological turn’’ (Gadamer, 1975, p. 434). ‘‘Heidegger’s hermeneutical phenomenology,’’ Gadamer explains, ‘‘and the analysis of the historicalness of There-being had as their aim a general renewal of the question of being and not a theory of the human sciences’’ (p. 229). Ontology can be difﬁcult in any event. Its treatment in universal hermeneutics is perplexing. Gadamer does not say that our understanding of anything, whether a human meaning or not, is mediated by language. For him instead, that which is understood is

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language. ‘‘Being that can be understood is language’’ and ‘‘the nature of what is understood’’ is ‘‘interprentation’’ (p. 432). Such a view might seem to leave out lots of extra-linguistic phenomena such as the warmth of the Sun or the structure of the atom. But for Gadamer, ‘‘we may not only speak of a language of art, but also of a language of nature, in short, of any language that things have’’ (p. 432). These supposed insights into language and interpretation allow Gadamer to say, ‘‘the speculative nature of language shows its universal ontological signiﬁcance’’ (p. 432). It is in this sense that universal hermeneutics is universal.4 Don Lavoie reports that ‘‘the older hermeneutics tradition’’ of Dilthey, Max Weber, and others was confronted ‘‘with Edmund Husserl’s phenomenology, resulting in a transformation of both schools of philosophy’’ (1994, p. 54). The leading ﬁgures of the new ‘‘phenomenological hermeneutics’’ were ‘‘Alfred Schu¨tz, Martin Heidegger, HansGeorg Gadamer, and Paul Ricoeur’’ (1994, p. 54). Only the ﬁrst two members of this list were not followers of Heidegger, which is to say that Schutz is the odd man out. Phenomenological hermeneutics contains a part that follows Heidegger and a part that does not. Though a phenomenologist, Schutz was a classical hermeneut in Albert’s sense, whereas Gadamer and the others espouse universal hermeneutics. Lavoie is explicit about the differences between Schutzian and ‘‘postHeideggerian’’ (Lavoie, 1994, p. 59) hermeneutics. Following Heidegger (apparently), Lavoie rejects the idea of ‘‘an objective science of subjective phenomena’’ (p. 59). The phrase alludes to Schutz’s claim that ‘‘All social sciences are objective meaning-contexts of subjective meaning-contexts’’ (Schutz, 1932, p. 241). Lavoie’s repudiation of ‘‘objectivism’’ is consistent with Gadamer’s claim that the ‘‘illusions of reﬂective self-consciousness’’ had been burst by Nietzsche’s ‘‘demand that we doubt more profoundly and fundamentally than Descartes,’’ so that ‘‘the purely theoretical validity of scientiﬁc objectivity to which the sciences laid claim’’ was now in question (Gadamer, 1981, p. 100). Nor is Lavoie satisﬁed with Schutz’s theory of meaning. For, ‘‘according to post-Heideggerian hermeneutics, meaning turns out to not really be strictly about the recovery of original intentions at all’’ (Lavoie, 1994, p. 59). To the reader’s unspoken question of what, then, meaning is ‘‘about,’’ Lavoie replies ‘‘Understanding is itself rendered as a dynamic process’’ (p. 59). This remark is consistent with Gadamer’s claim that ‘‘Selfunderstanding is always on-the-way’’ (Gadamer, 1981, p. 103). The reader must not object that ‘‘understanding’’ and ‘‘self-understanding’’ are different things, for we are dealing here with ‘‘a totally new concept of

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understanding and self-understanding’’ (p. 102), whereby ‘‘it becomes more important to trace the interests guiding us with respect to a given subject matter than simply to interpret the evident content of a statement’’ (pp. 105–106). Thus, Lavoie is on solid post-Heideggerian ground when he says, ‘‘understanding is not a merely reproductive, but rather a creative productive process’’ (Lavoie, 1994, p. 59). Universal hermeneutics rejects ‘‘atomism,’’ which ‘‘locates the domain of meaning in isolated individual minds’’ (Lavoie, p. 57). Meaning is ‘‘intersubjective’’ and ‘‘publicly available in all sorts of readable texts’’ (p. 59). Lavoie attributes this view to Schutz. But Schutz never abandoned the notion of subjective meanings. Schutz says quite clearly, ‘‘every interpretation of subjective meaning involves a reference to a particular person’’ (1932, p. 135). I think Vanberg is fundamentally right to say, ‘‘Lavoie sees the distinguishing characteristic of the hermeneutical approach that he endorses in the fact that it is not about ‘seeing things from the agent’s point of view’ . . . but is concerned with a kind of ‘meaning’ that is separable from the intentions of the acting person’’ (Vanberg, 2004, p. 162). As a referee has pointed out to me, meaning in Gadamer is emergent from processes that involve human intentions and is not, in this sense, ‘‘separable’’ from them. But this link to intentions is rather indirect and does not equal ‘‘seeing things from the agent’s point of view.’’

IS HERMENEUTICS ANTI-SCIENCE? Caldwell and Vanberg are both concerned that hermeneutics might be antiscientiﬁc. This fear is clearly inapplicable to classical hermeneutics. It does not apply to Schutz. The situation is cloudier with regard to universal hermeneutics. I take up each point in turn. As far as I am aware, there is no serious question of whether classical hermeneutics is anti-scientiﬁc. Certainly, the phenomenological hermeneutics of Schutz contains no ‘‘critique of science’’ of the sort worrisome to ﬁgures such as Vanberg and Caldwell. Dilthey’s doctrine of methodological dualism entails no rebuke to natural science. I think it is true, as Mises argued, that Dilthey did not recognize the existence of an ahistorical, theoretical science of society. It was all history to him. But as the same example of Mises shows abundantly, there is no contradiction or particular difﬁculty in retaining a hermeneutical view of ‘‘the human studies’’ while recognizing that they include disciplines that are ‘‘scientiﬁc’’ in the today’s Anglo-American sense.

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Similarly, there is no negative ‘‘critique of science’’ in Schutz. On the contrary, Schutz recognized not only the value and legitimacy of natural science, but the value and legitimacy of social science as well. Schutz’s most important work (Schutz, 1932) was largely a defense of an Austrian version of economic theory against historicism (Prendergast, 1986; Koppl, 2002). In various works Schutz defends the scientiﬁc ‘‘attitude of the ‘disinterested observer’ ’’ who must ‘‘suspend his subjective point of view’’ (Schutz, 1945, pp. 247 and 248). The scientist seeks theories that are valid ‘‘at any place, and at any time, wherever and whenever certain conditions, from the assumption of which he starts, prevail’’ (p. 248). (This language closely parallels language to be found in Mises’ work). Schutz’s defense of the objectivity of science directly contradicts universal hermeneutics, for which reason we saw Lavoie criticize him. Thus, it is hardly to be feared that a Schutzian hermeneutics is anti-scientiﬁc or ‘‘too extrascientiﬁc’’ (Caldwell, 2004, p. 437) for the purposes of Hayek or Austrian economics. It is more difﬁcult to say whether the universal hermeneutics defended by Lavoie and some other hermeneutic Austrians is anti-scientiﬁc. PostHeideggerian philosophy in general includes some strongly anti-rationalist and anti-science elements as the Sokal hoax helped to reveal. But we cannot attribute such views to Austrian hermeneuts, who reject the fuzzy thinking and collectivism present in some postmodern writings. Lavoie and other Austrian defenders of universal hermeneutics tend to follow Gadamer rather closely. Remarks in Gadamer’s work seem ambiguous. Some remarks suggest that hermeneutics leaves science alone. Referring to Heidegger’s supposed insight that ‘‘scientiﬁc objectivity may be understood ontologically’’ (Gadamer, 1981, p. 162), Gadamer says, ‘‘Only fools could see in such an ontological derivation a diminishment of the signiﬁcance or legitimacy of science’’ (1981, p. 162). Other remarks seem to oppose science in some degree. ‘‘Only by the de-mythologization of science (which controls what is proper to it but cannot know the one whom it serves) can the mastery of knowledge and ability become self-mastery’’ (Gadamer, 1981, p. 150). Gadamer’s critique of technology seems to reveal some resistance to science (Gadamer, 1981, pp. 69–87). (Presumably, Gadamer derived this critique mostly from Heidegger’s critique of technology.) ‘‘Science,’’ we are told, ‘‘is no longer the quintessence of knowledge and of what is worth knowing, but a way’’ (pp. 69–70). Science is responsible for ‘‘the civilizational pattern of modernity’’ (p. 70). While such modernity might seem to be a good thing, Gadamer is not happy. He broods darkly, ‘‘the scientiﬁc concept of mechanics has become an arm prolonged to monstrous

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proportions’’ (pp. 70–71). The technology science permits attacks our very ability to think. ‘‘It is inevitable, then, that the modern technology of communication leads to a more powerful manipulation of our minds’’ (p. 73). We feel ‘‘dependent and helpless in the face of’’ the ‘‘technically mediated life forms’’ of modernity (p. 73). We descend into ‘‘society of functionaries’’ who must adapt to circumstances, but whose creative capacities are frustrated (pp. 72 and 73). These last comments seem to say we are emasculated by technology. Is Gadamer asking us to choose between science and virility? I do not know whether Gadamer should be viewed as anti-science, and I do not know whether we should attribute any anti-science attitudes Gadamer might have to his Austrian followers. I am content if we recognize the whole question is moot when it comes to the phenomenological hermeneutics of Alfred Schutz, which stay within the bounds of ‘‘classical hermeneutics’’ as deﬁned by Albert.

CALDWELL AND VANBERG ON METHODOLOGICAL DUALISM For both Caldwell and Vanberg, the biggest problem with hermeneutics is methodological dualism. ‘‘A fundamental claim of the hermeneutics approach,’’ Caldwell says, ‘‘is that interpretation is unavoidable in the human sciences, speciﬁcally because their subject matter is different from that of the natural sciences’’ (Caldwell, 2004, pp. 434–435). Vanberg criticizes the Austrian view, attributed to both Mises and Lavoie, that social science should ‘‘adopt a methodology fundamentally different from that of the natural sciences’’ (Vanberg, 2004, p. 164). I believe Caldwell and Vanberg are both mistaken in their repudiation of methodological dualism. Their arguments are not quite the same. In both cases, however, it seems to me that views they accept and, indeed, assert, contain the essential idea of methodological dualism. Caldwell is vague about the meaning of doctrine, perhaps because of his odd implicit assumption that there is, somehow, but one ‘‘split’’ or ‘‘divide’’ among the sciences to which one might adhere. Vanberg, by contrast, makes it very clear just what he understands the doctrine to say. I do not believe, however, that his statement of the doctrine is the correct one, at least in the context of Austrian economics. Let me take up each point in more detail.

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Caldwell Caldwell, I have said, is never very clear about what methodological dualism is supposed to be. He is against it, but I cannot quite understand what it is that he opposes. Indeed, it seems that the term ‘‘methodological dualism’’ never appears in his 2004 book. (In addition to the index and my own reading, I searched his book for the phrase through amazon.com). Caldwell does, however, refer repeatedly to the question of whether Hayek’s ‘‘dividing line’’ (p. 255) between sciences separated the natural sciences from the social sciences or studies of complex phenomena from studies of simple phenomena (p. 255). This odd notion of ‘‘the dividing line’’ (my emphasis) crops up again on page 301. Hayek would ‘‘replace’’ the one distinction with the other (p. 305). Later, Caldwell claims the one dividing line was ‘‘viewed by Hayek as a more scientiﬁc way to make the distinction’’ (p. 346 my emphasis). Somehow we must choose whether ‘‘the’’ dividing line, ‘‘the’’ distinction, shall be ‘‘natural vs. social’’ or ‘‘simple vs. complex.’’ I cannot understand this idea and do not know why Caldwell would make such an assumption. Caldwell also says, ‘‘Hayek proclaimed that the natural science-social science split is less important than that between simple and complex phenomena’’ (Caldwell, 2004, p. 435). Caldwell does not tell us, however, where this supposed proclamation was made. With it, he says, Hayek was ‘‘downplaying, perhaps even dismissing’’ hermeneutics. Those wishing to see Hayek as a hermeneut ‘‘must deal with this fact’’ (Caldwell, 2004, p. 435). Caldwell, however, has given no evidence of the fact (Hayek’s ‘‘proclamation’’) with which we are supposed to deal. [In spite of this strange and serious ﬂaw in Caldwell’s 2004 book, it is probably the best overall treatment of Hayek yet published, as I argued in my review of it Koppl (2006)].

Vanberg Vanberg, happily, is clear as a bell. He deﬁnes the methodological dualism of ‘‘Austrian subjectivism’’ by two claims. First, ‘‘because human action is based on subjective intentions and expectations, understanding these intentions and expectations rather than causal analysis is the appropriate method of inquiry,’’ and second, ‘‘because human action is purposeful and goal-directed, it must be explained in teleological rather than in causal terms’’ (Vanberg, 2004, p. 167). I think Vanberg’s deﬁnition of methodological dualism may be put this way: ‘‘Be interpretive, but don’t use the concepts of cause and effect.’’

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METHODOLOGICAL DUALISM IN DILTHEY To address Vanberg’s view of methodological dualism, I will consider what Dilthey and Mises said about it. Mises’ view of the doctrine is the one that really matters, in the context of Austrian economics. Mises seems to be the one who imported the doctrine to Austrian economics and is celebrated for it by, I believe, all the hermeneutical Austrians, classical and universal. It may be worth considering Dilthey’s views, however. Dilthey seems to be the progenitor of the doctrine and Mises praises him highly for it. As we saw earlier, Dilthey sees three differences between the natural science and ‘‘the human studies.’’ First, natural science infers causes from effects, whereas the human studies infer inner meanings for outward indications. Second, natural science produces concepts alien to common sense, whereas the human studies do not. Finally, unlike the natural sciences, the human studies refer to values and purposes in their objects of inquiry. Dilthey’s ﬁrst point of distinction might seem subject to criticism. Causality is present in the natural and social sciences alike, one might argue. Such an argument, however, would use an anachronistic notion of causality. In today’s language we might say that John’s anger ‘‘caused’’ him to yell. We are not troubled by the objection that John’s yelling was a chosen action. Saying the anger ‘‘caused’’ him to yell is saying that he yelled ‘‘because’’ he was angry. The anger was a motive and explanatory factor. It does not mean that John had no choice about whether to yell. To Dilthey, however, causality meant a kind of ‘‘mechanistic’’ linkage that operates independently of human choices. If, therefore, we are appealing to intentions, desires, and beliefs in our explanation of something, we are not applying ‘‘causal’’ reasoning in Dilthey’s sense. Vanberg relies on precisely the sort present-day notion of causality I have been discussing. He says ‘‘cognitive factors such as intentions, desires, and beliefs play a causal role in human action’’ (2004, p. 169). While I fully agree with that statement, it would have seemed absurd and contradictory to Dilthey, who relied on a notion of causality that excluded any reference to ‘‘cognitive factors.’’ The difference between Vanberg and Dilthey on this point is the meaning of the word ‘‘cause.’’ Dilthey’s second point of distinction was that natural science produces concepts alien to common sense, whereas the human studies do not. Dilthey seems to have adumbrated an insight later found in Hayek. In natural science we infer cause from effect. We see stars and imagine atoms. We infer atoms from the observable effects of their action. In the social sciences we work in the opposite direction. We see factories and imagine a time structure

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of production. We are directly familiar with the ‘‘atoms’’ of our analysis, people, and reason our way to larger social patterns from our understanding of people. Thus, in natural science the elements of the theoretical system are strange things such as quarks and strings that produce familiar things such as rocks and stars. In the social sciences, instead, the elements are familiar things such as thoughts and emotions that produce strange things such as price vectors and autocorrelated conditional heteroscedasticity in ﬁnancial time series. Hayek refers to the second kind of reasoning as ‘‘Menger’s compositive method’’ (Hayek, 1952a, pp. 61–76; Hayek, 1935, p. 11). Finally, we noted, the human studies refer to values and purposes and natural science does not. This point seems to be accepted by all (Caldwell, 2004, p. 122; Vanberg, 2004, pp. 167–168). Dilthey says that we can ‘‘understand’’ others because they are like us. ‘‘He understands history because he himself is a historical being’’ (Dilthey, 1910, p. 126). ‘‘Every word, every sentence, every gesture or polite formula, every work of art and every historical deed is intelligible because the people who express themselves through them and those who understand them have something in common’’ (Dilthey, 1910, p. 123). Hayek makes the same point we have just seen Dilthey make. He cites Empedocles’ ‘‘Knowledge is of like by like’’ and notes that he got the quote from Mises (Hayek, 1967, pp. 58 and 59; Mises, 1930 [1981], p. 134).5 It seems to me that biology, a natural science, refers to the values and purposes of animals. We understand humans best and ﬁnd it unproblematic to apply the categories of human mental life to other people. We understand other animals less fully, although we say the lion is ‘‘hunting’’ and the bird is ‘‘building a nest’’ or ‘‘seeking prey.’’ Methodological dualists have generally compared social science or ‘‘the human studies’’ to physics and chemistry and thus not faced the question of biology. I think we should recognize that the methodological differences between social science and natural science are matter of degree, while retaining the ancient label ‘‘methodological dualism.’’ The difference between day and night is a matter of degree, but we still have a ‘‘dualism’’ of night and day.

METHODOLOGICAL DUALISM IN MISES Mises gives a complete statement of methodological dualism in Theory and History. Methodological dualism refrains form any proposition concerning essences and metaphysical constructs. It merely takes into account the fact that we do not know

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how external events – physical, chemical, and physiological – affect human thoughts, ideas, and judgments of value. This ignorance splits the realm of knowledge into two separate ﬁelds, the realm of exterior events, commonly called nature, and the realm of human thought and action (Mises, 1957, p. 1).

Methodological dualism as represented by Mises does not deny that the social sciences are sciences. It does not imply that empirical testing is impossible or forbidden. [Vanberg (2004) acknowledges this point on page 161]. It does not even deny that cause and effect operate in the social sphere, although our earlier remarks about anachronistic meanings of causality apply here as well. Mises says that natural science and social science are distinguished by ‘‘the categorical system resorted to in each in interpreting phenomena and constructing theories’’ (1957, p. 240). The natural sciences ‘‘are entirely guided by the category of causality,’’ whereas the social sciences refers to ‘‘purpose and of conscious aiming at ends’’ (1957, p. 240). The social sciences are ‘‘teleological’’ (Mises, 1957, p. 240). Such ‘‘teleological’’ reasoning, however, is perfectly ‘‘causal’’ in the sense most common today, which is the sense employed in Vanberg (2004, p. 169). With Mises, methodological dualism is an argument against the sort of reductionism that would replace references to mental phenomena with statements using the language of physics, chemistry, and physiology. It is an argument against ‘‘positivism,’’ which Mises describes as ‘‘a materialistic metaphysical doctrine’’ (1957, p. 241). In recent times, Mises argued in 1957, the two most important living variants of the hated positivist doctrine were ‘‘panphysicalism’’ and ‘‘behaviorism.’’ Panphysicalism says, in Mises interpretation, ‘‘What cannot be rendered in the language of physics is metaphysical nonsense’’ (1957, p. 244). Behaviorism ‘‘is in some respects different’’ from panphysicalism. It is a similar doctrine, however, ‘‘in its hopeless attempt to deal with human action without reference to consciousness and aiming at ends’’ (1957, p. 245). Both doctrines required elimination of all reference to cognitive factors. Methodological dualism as deﬁned by Mises aims at establishing precisely the point that Vanberg claims is not at issue between methodological dualist and their critics. Vanberg says ‘‘Opponents of methodological dualism’’ do not deny the ‘‘cognitive factors’’ such as ‘‘intentions, desires, and beliefs play a causal role in human action.’’ They ‘‘can easily agree’’ that social science is ‘‘teleological’’ in the sense that they must ‘‘account for the role of cognitive factors.’’ Opponents of methodological dualism ‘‘will, however, insist that causation by such factors is still causation in the standard sense’’ (Vanberg, 2004, p. 169).

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According to Vanberg, then, disputes over methodological dualism are solely disputes about how we should use the word ‘‘causation.’’ This point of view neglects the fact that the historical opposition to the doctrine of methodological dualism came from scholars who denied that Vanberg’s ‘‘cognitive factors’’ should have any place at all in social science. The point he esteems beyond dispute was precisely the point being disputed when Mises articulated the doctrine and used it to defend the autonomy of the social sciences against the scientism of positivists such at Otto Neurath. Having defeated all opposition, the doctrine of methodological dualism is declared false and absurd!

HAYEK THE SCIENTIFIC HERMENEUT I do not know if Hayek was a methodological dualist in Caldwell’s sense, because I do not know what meaning Caldwell gives to the term. I think Hayek was not a methodological dualist in Vanberg’s sense, but Vanberg gives us an inappropriate deﬁnition of it. In the sense of the term appropriate for any discussion of Austrian economics and economists, namely Mises’ sense of the term, Hayek was indeed a methodological dualist. As both Caldwell and Vanberg note, Hayek argued against behaviorism and positivism. He recognized and emphasized the ‘‘subjective’’ nature of social phenomena. Caldwell correctly notes that in The Sensory Order, Hayek ‘‘insisted that, as a practical matter, we will always have to refer to beliefs, desires, and intentions (what he [Hayek] calls mental terms) when we interpret hum actions’’ (Caldwell, 2004, p. 437). Mises too defends methodological dualism as, in Caldwell’s words, ‘‘a practical matter.’’ It is for Mises a contingent fact that ‘‘up to now at least’’ we have been unable to ‘‘bridge the gulf . . . between mind and matter’’ (1957, p. 1). Thus, ‘‘at least for the time being,’’ Mises infers, we ‘‘must adopt a dualistic approach, less as a philosophical explanation than as a methodological device’’ (Mises, 1957, p. 1). Is this not a defense of dualism ‘‘as a practical matter?’’ Some parallelism of language shows just how closely Hayek adhered, in The Sensory Order, to Mises’ version of methodological dualism. In Theory and History, Mises defends methodological dualism by noting that, ‘‘Identical external events result sometimes in different human responses, and different external events produce sometimes the same human response. We don’t know why’’ (1957, p. 18). This same language appears also in The Sensory Order. ‘‘[P]sychology must start from stimuli deﬁned in physical

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terms and proceed to show why and how the senses classify similar physical stimuli sometimes as alike and sometimes as different, and why different physical stimuli will sometimes appear as similar and sometimes as different’’ (1952a, pp. 7–8). Hayek was a methodological dualist and a hermeneut, but not antiscience. He was a scientiﬁc hermeneut.

TWO DICHOTOMIES ARE BETTER THAN ONE As we have seen, Caldwell imagines that Hayek will tolerate only one dichotomous classiﬁcation of the sciences at a time. How ironic for a scholar whose theory of mind emphasizes the role of multiple classiﬁcations! The dichotomy between the social sciences and the natural sciences classiﬁes the sciences according to whether ‘‘understanding’’ is an applicable method. In the social sciences we are engaging a pre-interpreted reality. In the words of Georg Simmel’s (1908 [1971], p. 7) Kantian analysis, ‘‘the unity of society needs no observer.’’ Thus, we must ‘‘understand’’ action in ways we do not ‘‘understand’’ the orbits of the planets. The dichotomy between sciences studying complex phenomena and sciences studying simple phenomena relates to a different set of issues, namely prediction, explanation, and falsiﬁcation. In ‘‘The Theory of Complex Phenomena,’’ Hayek (1964 [1967], pp. 29–31) identiﬁes several differences between simple and complex phenomena. Statistics are of limited value with complex phenomena, general ‘‘laws’’ of the sort found in physics may be absent (pp. 40–42), and we must often content ourselves with ‘‘pattern prediction’’ rather than more precise predictions (pp. 27–29). These differences may exist even when the complex phenomena in question have nothing to do with interpretation of human meanings. The distinction between complex and simple phenomena helps explain the difference between the natural and the social sciences. It helps explain methodological dualism. It is impossible to ‘‘reduce’’ mental phenomena to physical phenomena in any sense other than explaining the principle; this impossibility is a consequence of the complexity of mental phenomena. Mental phenomena are complex in comparison to our apparatus for classifying and ordering them, namely the human mind. We could attempt to describe human action ‘‘in purely physical terms,’’ says Hayek. ‘‘But if we tried to do so for the purposes of explaining human action, we would conﬁne ourselves to less than we know about the situation’’ (p. 43). Without hermeneutics and interpretation we lose information about human action.

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Table 1.

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The Table Gives Examples of Sciences Classiﬁed in Each of Four Categories. Complex Phenomena

Social science Natural science

Economics, sociology, anthropology, psychology Biology, meteorology, parts of physics and chemistry

Simple Phenomena Demography, epidemiology Much of physics and chemistry

If we consider both dichotomies together, we have four types of science. Table 1 illustrates. In the Table 1, I have classed demography, epidemiology, and actuarial science as social sciences dealing with simple phenomena. This classiﬁcation is consistent with Hayek’s view that ‘‘Not all disciplines . . . concerned with the life of men in groups . . . raise problems which differ in any important respect from those of the natural sciences’’ (1952a, p. 41). He gives epidemiology as an example. Social sciences dealing with complex phenomena are what Hayek calls ‘‘social sciences in the narrower sense of the term’’ (1952a, p. 41). They require the interpretation of human meanings. The doctrine of methodological dualism distinguishes the methods appropriate to this group of sciences from the methods of the natural sciences, which do not require the interpretation of human meanings (Table 1).

WHY IT MATTERS It seems that Caldwell and Vanberg wish to rescue Hayek from the dark waters of hermeneutics and land him on the high ground of science. I think they are right to see Hayek as a man of science. They diminish his achievement, however, by attempting to distance Hayek from hermeneutics. Viennese positivism construed social science as ‘‘atoms all the way down.’’ Post-Heidegger hermeneutics construes natural science as ‘‘interpretation all the way down.’’6 Either construal is false. One of Hayek’s great achievements was to ‘‘bring atoms and interpretation together.’’ Hayek used a set of very carefully developed scientiﬁc arguments about complexity and neuroscience to show that logically necessary limits to our knowledge of minds like our own require us to rely on classical hermeneutics. In his words from The Sensory Order, we must rely on ‘‘verstehende psychology’’ (1952b, p. 192). This great achievement is scarcely appreciated or understood today.

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With its scientiﬁc style and purpose, The Sensory Order hardly seems the place for a defense of hermeneutics. But the book’s ﬁnal chapter on ‘‘philosophical consequences’’ contains a ringing endorsement of classical hermeneutics. ‘‘In the study of human action,’’ Hayek says, ‘‘our starting point will always have to be the direct knowledge’’ of ‘‘mental events’’ (p. 191). We ‘‘use our direct (‘introspective’) knowledge of mental events in order to ‘understand,’ and in some measure even to predict, the results to which mental processes will lead in certain conditions’’ (p. 192). By using the terms ‘‘understand’’ and ‘‘verstehende psychology’’ Hayek points directly to the Dilthey tradition Albert calls ‘‘classical hermeneutics.’’ Hayek praised classical hermeneutics as late as 1973. In ‘‘The place of Menger’s Grudsa¨tze in the History of Economic Thought,’’ Hayek attributes to Menger the view that ‘‘in observing the actions of other persons we are assisted by a capacity of understanding the meaning of such actions in a manner in which we cannot understand physical events’’ (1978, p. 277). Observation for Menger, Hayek says, ‘‘implies Verstehen (‘understanding’) in the sense in which Max Weber later developed the concept’’ (p. 277). By citing Weber, Hayek makes an explicit reference to classical hermeneutics. ‘‘It seems to me,’’ Hayek continues, ‘‘that there is still much that could be said in defense of the original position of Menger (and of the Austrians generally) on this issue’’ (p. 277). Hayek chooses to ‘‘pass over this important point,’’ however, on the grounds that revealed-preference theory has shown ‘‘at least in principle’’ that we can dispense with ‘‘these ‘psychological’ assumptions’’ for purposes of ‘‘micro-economic theory’’ (p. 277). Hayek’s hedged concession to revealed-preference theory is no abandonment of hermeneutics. He went out of his way to introduce the word Verstehen favorably and link it to Weber, thus pointing explicitly to the hermeneutics tradition. His concession is, as I have noted, hedged and it applies only to pure theory. The signiﬁcant point here is not the grudging concession, but the strong detour taken in order to speciﬁcally praise the ‘‘underdstanding’’ tradition, not of the subject of his talk, Carl Menger, but of Max Weber, who came later and learned about Verstehen from others. If my argument is about right, it may strengthen our appreciation of Alfred Schutz. As far as I can tell, Hayek made few if any explicit references to Schutz’s work. Although it is an open question whether Schutz had any signiﬁcant inﬂuence on Hayek, a negative conclusion would not be surprising. I have argued elsewhere, however, that Schutz and Hayek are both Misesian methodologists (Koppl, 2002, pp. 25–70). Schutz and Hayek both attempted to improve upon Mises’ methodology. Schutz took a phenomenological approach; Hayek took a naturalistic approach. Because

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Hayek’s naturalism explicitly leaves room for hermeneutics, it is a relatively straightforward matter to integrate the two systems within the context of Mises work. I have attempted to demonstrate the value of such an integration in my work in expectations (Koppl, 2002) and entrepreneurship (Koppl, 2002, pp. 96–106), which I have applied to problems in ﬁnancial markets (Koppl, 2002, pp. 141–194). It might be tempting to regard the main argument of this chapter as a quibble over words. I suppose it has been. But I think it matters even if it is a ‘‘merely verbal dispute.’’ If I am right, then we must not see Hayek as a scientist who turned his back on the unscientiﬁc tradition of hermeneutics. We must see Hayek a scientist who brought the ‘‘understanding’’ tradition of classical hermeneutics under the umbrella of science. In so doing, Hayek has made the rich heritage of the hermeneutics literature available to the scientiﬁc community. If we should, for ‘‘merely verbal’’ reasons, fail to recognize this achievement, we will needlessly cut ourselves off from an important source of wisdom and understanding in the social sciences. We are not so clever, however, that we can afford such a loss.

NOTES 1. In The Sensory Order, Hayek cites ‘‘Scientism and the Study of Society,’’ which was ﬁrst published in Economica and later reprinted as ‘‘Part One’’ of CounterRevolution. He notes both the original publication and the reprint. The evidence for Hayek-as-hermeneut comes from Part I of Counter-Revolution. 2. The next six paragraphs come almost word-for-word from Appendix 1 of Koppl (2002). 3. Mises refers to Dilthey’s ‘‘psychology,’’ which is not obviously ‘‘the understanding of human meanings.’’ But from page 265 of Mises (1957) we learn that the psychology in question is ‘‘the speciﬁc understanding of the historical disciplines,’’ which is to say the understanding of human meanings. 4. I thank an anonymous referee for emphasizing the importance of the ontological turn. 5. I thank Sudha Shenoy and Richard Ebeling for help with the Empedocles quote which appears only in Greek in both Hayek and Mises. See the archives of the Hayek-L list for March 2004, http://maelstrom.stjohns.edu/archives/hayek-l.html 6. I thank my referee for the helpful phrases ‘‘atoms all the way down’’ and ‘‘interpretation all the way down.’’

ACKNOWLEDGMENT I thank Steven Horwitz for managing the review of this chapter and I thank an anonymous referee for helpful comments.

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REFERENCES Albert, H. (1985). Treatise on critical reason. Princeton: Princeton University Press. Albert, H. (1988). Hermeneutics and economics – A criticism of hermeneutical thinking in the social sciences. Kyklos, 41, 573–602. Boettke, P. (1990). Interpretive reasoning and the study of social life. Methodus, 2(2), 35–45. Burczak, T. (1994). The postmodern moments of F.A. Hayek’s economics. Economics and Philosophy, 10, 31–58. Caldwell, B. (2004). Hayek’s challenge. Chicago: University of Chicago Press. Dilthey, W. (1900 [1962]). The development of hermeneutics. In: H. P. Rickman (Ed.), W. Dilthey: Selected writings (pp. 246–263). London: Cambridge University Press. Dilthey, W. (1910 [1962]). ‘‘The construction of the historical world in the human studies,’’ extracts translated and published in Dilthey, W. 1962. In: H. P. Rickman (Ed.), Pattern and meaning in history: Thoughts on history and society. New York: Harper & Row, Publishers. Forster, M. (2002). Friedrich Daniel Ernst Schleiermacher. In: E. N. Zalta (ed.), The Stanford Encyclopedia of Philosophy (Winter 2002 ed.). Available at http://plato.stanford.edu/ archives/win2002/entries/schleiermacher/> Gadamer, H. (1975). Truth and method. New York: The Seabury Press. Gadamer, H. (1981). Reason in the age of Science. Translated by F. G. Lawrence. Cambridge, MA: The MIT Press. Hayek, F. A. (1935). The nature and history of the problem. In: F. A. Hayek (Ed.), Collectivist economic planning: Critical studies on the possibilities of socialism (pp. 1–40). London: George Routledge & Sons, Ltd. Hayek, F. A. (1952a). The counter revolution of science: Studies in the abuse of reason. Chicago: University of Chicago Press. Hayek, F. A. (1952b). The sensory order. Chicago: University of Chicago Press. Hayek, F. A. (1964 [1967]). The theory of complex phenomena. In: F. A. Hayek (Ed.), Studies in philosophy, politics and economics. Chicago: The University of Chicago Press. Hume, D. (1748 [1910]). An enquiry concerning human understanding. New York: P.F. Collier & Son Company. Koppl, R. (2002). Big players and the economic theory of expectations. New York: Palgrave Macmillan. Koppl, R. (2006). Review of Bruce Caldwell, Hayek’s challenge: An intellectual biography of F. A. Hayek. Journal of Economic Behavior and Organization, 59(2), 287–291. Koppl, R., & Whitman, D. G. (2004). Rational-choice hermeneutics. Journal of Economic Behavior and Organization, 55, 295–317. Lavoie, D. (1994). The interpretive turn. In: P. Boettke (Ed.), The Elgar companion to Austrian economics (pp. 54–62). Aldershot, UK: Edward Elgar. Machlup, F. (1978). If matter could talk. In: Methodology of economics and other social sciences (pp. 309–332). New York: Academic Press. Madison, G. B. (1994). The primacy of action and its scientiﬁc consequences for the hermeneutics of the human sciences. In: S. Vincent, R. Knowles & T. van Doan (ed.), Psychology, phenomenology and Chinese philosophy, Chinese philosophical studies (Vol. VI). Council for Research in Values and Philosophy. Available at http://www. crvp.org/book/Series03/III-6/contents.htm Madison, G. B. (1989). Hayek and the interpretive turn. Critical Review, 3(2), 169–185.

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Mises, L. (1957 [1969]). Theory and history: An interpretation of social and economic evolution. Westport, CT: Arlington House Publishers. Mises, L. von (1930 [1981]). ‘‘Conception and understanding,’’ in epistemological problems of economics. New York and London: New York University Press. Prendergast, C. (1986). Alfred Schutz and the Austrian school of economics. American Journal of Sociology, 92, 1–26. Schutz, A. (1932 [1967]). The phenomenology of the social world. Translated by George Walsh and Frederick Lehnert. Evanston, IL: Northwestern University Press. Schutz, A. (1945 [1962]). On multiple realities. In: Collected papers I: The problem of social reality (pp. 207–259). The Hague: Martinus Nijhoff. Simmel, G. (1908 [1971]). How is society possible? In: D. N. Levine (Ed.), Georg Simmel on individuality and social forms. Chicago: The University of Chicago Press. Vanberg, V. (2004). Austrian economics, evolutionary psychology and methodological dualism: Subjectivism reconsidered. In: R. Koppl (ed.), Evolutionary psychology and economic theory of Advances in Austrian Economics (Vol. 7). Amsterdam: Elsevier.

HAYEK VS. HAYEK: A DEFENCE OF MODERATE TRADE UNION ACTIVITY Torsten Niechoj ABSTRACT According to Friedrich A. von Hayek, trade unions are the primary problem of our times. They coerce employers into raising the wages, and they seek privileges in the political sphere. This harsh judgement is, however, not fully justiﬁed by Hayek’s own theory of action and order. In addition to some terminological difﬁculties, he undervalues his insights – developed and applied elsewhere – of competition as a discovery process and of locally available knowledge when it comes to unions. Following this lead, further functions of trade unions apart from their monopoly face appear: trade unions channel information and develop rules for conﬂict resolution; they are part of a process of preference formulation and opinion formation.

1. INTRODUCTION It is not overly surprising that Friedrich August von Hayek as an unequivocal defender of individual freedom and spontaneous order dislikes

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trade unions. What is surprising is the verve with which Hayek holds the trade unions responsible for nearly everything that goes wrong in economics and politics. From the beginning of his writing to his late works this pervades all of his texts. In a speech addressed to the Mont Pelerin Society, in 1947 shortly after the end of World War II, he writes: [I]f there is to be any hope of a return to a free economy, the question of how the powers of trade unions can be appropriately delimited in law as well as in fact is one of the most important of all the questions to which we must give our attention. (von Hayek, 1980a, p. 117)

In his major work, the ‘‘Constitution of Liberty’’, Hayek goes a step further in stating that: [t]here can be no question [ . . . ] that the basic principles of the rule of law have nowhere in recent times been so generally violated and with such serious consequences as in the case of the labor unions. Policy with respect to them will therefore be the ﬁrst major problem that we shall consider. (von Hayek, 1960, p. 266)

According to Hayek nothing less than the market system itself is at stake: While a functioning market and trade unions with coercive powers cannot co-exist, yet it is only in the free system of the market that the unions can survive. Yet the unions are destroying the free market through their legalised use of coercion. (von Hayek, 1980b, p. 55)

These are just a few examples of Hayek’s thinking with respect to trade unions, but even these short statements contain far-reaching accusations and far-reaching implications for economic policy and political theory. For Hayek trade unions are most inﬂuential and simultaneously extremely harmful. In other words, diminishing the power of trade unions would increase economic activity and reduce the waste of resources. Consequently, trade unions are crucial for economic policy. Taking up this lead and investigating the role of trade unions in society from Hayek’s point of view seems promising. Unions are actors playing on two levels – the economic as well as the political – and it is Hayek as an author in the Austrian tradition whose theory brings together both spheres of activity in one research framework. He always treated economics as a social science, not only focusing on exchange under given conditions but combining the analysis of economic and political order.1 Starting from a spontaneous order of individuals, Hayek reconstructs the development of order and the formation and behaviour of collective actors such as trade unions. Then, the key question is: Why and to what extent become trade unions a threat to economy and society?

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The chapter is structured as follows: Initially Hayek’s distinction between spontaneous order and organisations is used to investigate the interaction of individual and collective action. Against this background, the role of trade unions as monopolising economic actors and as rent-seeking political actors is analysed in Sections 3 and 4. It becomes apparent – summarised in Section 5 – that Hayek’s assessment of trade unions is not fully grounded in his theory and that he undervalues his own insights – developed and applied elsewhere – when it comes to unions. Based on these insights, the function of collective actors for knowledge formation and rule enforcement is described.

2. HAYEK ON ACTION AND ORDER For Hayek order is a framework that coordinates the interaction of actors by forming expectations on the actions of others. He differentiates two types of order: a constructed and hierarchical order coordinated by concrete commands to achieve a common goal, called organisation, and a spontaneous order where all individuals achieve their goals under endogenously grown abstract rules (von Hayek, 1963; von Hayek, 1973, Chapter 2). An organisation is deﬁned as an order which is created to fulﬁl the aim (or a set of aims) of its creator, who coordinates the people acting under this order on the basis of commands, not rules. Although a spontaneous order coordinates the individuals’ actions too, it leaves much more freedom for manoeuvre for the actors. An order of this type can adapt to changing situations by individual actions without having to rely on one creator and leader, while still stabilising expectations because the abstract rules guarantee that all actions are within a certain range of accepted behaviour (von Hayek, 1945, 1967); the rules transport implicit knowledge on what can and cannot be done and on the potential reactions and interactions of others. While such an order is itself complex, it needs no complex coordination centre but coordinates itself quasi-automatically (von Hayek, 1973, pp. 36–52). The most prominent example of a spontaneous order – and the only one Hayek investigates in depth – is the catallaxy, or in common terminology: a market economy which is ideally free of state interventionism (von Hayek, 1976, Chapter 10). In the catallaxy it is especially the price system which signals information and leads to a mutual adjustment of the individuals’ plans through positive and not least ‘‘negative feedback’’ (von Hayek, 1968, p. 10, my translation). Between both types of order there is a complementary relationship. Besides individuals, organisations are also part of a spontaneous order.

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von Hayek (1973, p. 46) mentions families, ﬁrms, and associations which are all part of a spontaneous order but not themselves spontaneous in their structure; the government as well is a special kind of organisation. Therefore, we can conclude that spontaneous order is a superior solution for complex coordination problems, as in the case of a market economy, but not a universal principle for all coordination situations, according to Hayek. Organisations, although restricted to low-complex situations, have a right to exist, too. Despite their superiority in principle, in reality complex coordination problems, such as in an economy as a whole, are only more or less spontaneously structured. Hayek – far from propagating a minimal state – recognises the necessity of the state to provide (some) public goods ﬁnanced by taxes and to serve as a third party to enforce the rules of the order (von Hayek, 1960, pp. 257–260, 1979, Chapter 14). Moreover, jurisdiction is essential for the interpretation and enhancement of rules (von Hayek, 1973, Chapter 5). In some cases a spontaneous order is dependent on some organisational elements, especially in as much as the state enters the picture. It has to be noted, however, that organisations, such as ﬁrms, trade unions, or other associations, do not play a role in rule building or enforcement for Hayek. Collective action as intentional action concerning the rules of the order is always bound to state action and not related to civil collective actors (von Hayek, 1960, pp. 142–147). Additionally, the current existence of a spontaneous order does not necessarily imply its future viability. The durability of an order cannot be taken for granted. A spontaneous order is not natural in the sense that it develops under any circumstances and maintains itself in spite of all adverseness. Interventionism caused by collective actors can disturb or even destroy the order (von Hayek, 1976, p. 142f.). Individuals do not have the power to endanger a spontaneous order, whereas groups do have this power, and they may have reasons for interventionist activities. By combining the power of many individuals they gain a status of power that may be sufﬁcient to enforce privileges or the redistribution of goods in their favour (von Hayek, 1979, pp. 99–103). Against this background, intentional collective action and collective actors themselves are suspected to inhibit the functioning of spontaneous order; collective actors may harm or even destroy it. Why Hayek mistrusts trade unions as expressed in the introductory quotations now becomes clearer. Trade unions as collective actors are suspected of using the combined power of individuals to enforce the interests of a limited group. Acting at two levels – the economic and the political one – they inﬂuence

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both the catallaxy (or more speciﬁc: the labour market) and the political process, thus dually hazarding the order. Nevertheless, there has to be more than that to make the trade unions the most extreme example of harmful collective action. Acting at two levels and combining individual power is nothing especially inherent to trade unions; this is characteristic for nearly all organisations. For Hayek the use of coercion by the unions is crucial to explain the differentia speciﬁca between organisations which are beneﬁcial or neutral to the order, and those which are destructive. Collective action is a latent threat to spontaneous order, but not in general harmful.

3. TRADE UNIONS AS ECONOMIC ACTORS As economic actors the trade unions organise the employees in order to promote their common interests. If trade unions acted solely as an association offering service and advice to their members and giving their members a voice, and if they respected rules and the rights of others, they would in Hayek’s view be a helpful part of the catallaxy. The problem with the trade unions, according to Hayek, is their use of coercion to reach their aims (von Hayek, 1960, pp. 267–284). Coercion as deﬁned by von Hayek (1960, p. 133f.) means to force the enforcer’s will onto someone else by threatening with harm: Coercion occurs when one man’s action are made to serve another man’s will, not for his own but for the other’s purpose. [ . . . ] Coercion implies both the threat of inﬂicting harm and the intention thereby to bring about certain conduct.

This deﬁnition includes two essential elements: the intentionality of someone to force and second, the threat of violence. Consequently, a market exchange is not coercion because no one is intentionally inﬂuenced by someone else to trade or not to trade. If someone has little bargaining power due to low skills or unfortunate conditions, but no one is intentionally forcing this person into a particular situation, it is not coercion (von Hayek, 1960, p. 135f.). If someone is capable of restricting the scope of options of someone else, he or she coerces, and there are different degrees of coercion depending on the enforcer’s ability to limit the scope of options (von Hayek, 1960, p. 136f.). What does this mean when applied to the topic discussed here – the labour market and the trade unions? Employees are not coerced by an employer cutting wages in face of shrinking demand or lowered market prices. It is not the will of the employer which creates a situation that allows

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someone to press someone else to work for a low wage, it is the current situation that makes low wages possible. Coercion is involved, however, if trade unions enforce their members’ interests by picketing and by closed shop because the unions try intentionally to raise their bargaining power (von Hayek, 1960, p. 274f.; von Hayek, 1980b, pp. 51–53). Picketing is a means to force non-unionised employees to join or to behave in line with the union’s actions, and closed shop aims at forcing them as well. If the trade unions control a ﬁrm in this way, they can exercise almost unlimited pressure on the employer and [ . . . ], particularly where a great amount of capital has been invested in specialised equipment, such a union can practically expropriate the owner and command nearly the whole return of his enterprise. (von Hayek, 1960, p. 270)

By forcing other non-unionised employees to behave in line with the union’s aims and by forcing them to withhold labour power, i.e., to strike, the trade unions control the labour supply by coercion and thus the price of labour. Consequently, coercion leads to monopoly in the labour market and thereby to non-spontaneous price setting which diminishes the ability of the order to discover or disseminate information (von Hayek, 1980b, pp. 53–55). This usage of coercion, however, is a tricky thing. Picketing does not necessarily take on forms of violence or threatening with violence where the enforcement of someone’s will on others is obvious. In the past, both sides, employers and trade unions, used force, and picketing then took really violent forms. Nowadays, however, picketing is normally a case of moral persuasion. It is a metaphorical, but not real, ‘‘running the gauntlet’’. The closed shop is also not an illegal act of violence but a legalised support of organising trade unions. This is even more true for the highly regulated wage bargaining in continental Europe where there is a set of traditionally emerged rules that intend to – and in reality do quite well – exclude violence from the conﬂict over wages and lead to a low strike intensity (Aidt & Tzannatos, 2002, pp. 115–118). In continental Europe there is no closed shop, and employees voluntarily join unions and participate in strikes. If for this reason we accept that – nowadays and for most industrialised countries – (the threat of) violence is not essential to picketing and closed shop and thus cannot constitute the differentia speciﬁca of the term coercion, then the intentionality of person A to artiﬁcially create a situation which allows the enforcing of A’s will onto person B is the relevant element of Hayek’s deﬁnition of coercion.

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Unfortunately, difﬁculties still remain. In contrast to other Austrians, for example, William H. Hutt (1975, 1988), for Hayek strikes are in principle permissible and should not be declared illegal.2 Consequently, we have to conclude that the strike does not constitute a case of coercion. In the given framework, this seems odd. In every strike there is an intentional moment to enforce a claim by an artiﬁcially created situation, the withdrawal of labour power, i.e., the capacity to work. Therefore, the strike is in this sense analogous to picketing and closed shop. Certainly, nearly all countries recognise a right to strike, but from a Hayekian point of view the existence of the right to strike may be seen as an illegitimate outcome of the coercive action of trade unions in the political sphere (which will be discussed in the next section more extensively). We could then conclude that a consequent development of the Hayekian point of view should include strike as a means of coercion to solve the described difﬁculty of deﬁnition. There is another case, however, that cannot be solved that easily: the case of monopolies. Hayek mentions that when a monopolist offers an essential service, buyers are coerced to buy (von Hayek, 1960, p. 136f.): someone dying of thirst who is willing to give everything he or she has in a Swiss bank account in exchange for a glass of water is forced to agree to such a bargain made by a trader owning the only spring in the desert. This case of a monopoly, however, does not fulﬁl the initial deﬁnition because no one intended to create this situation and no one threatened to use violence. Here, Hayek introduces a completely new deﬁnition of coercion based alone on the scope of options someone has which could in the Hayekian framework better be understood as a case of (extreme bad) conditions but not as coercion because the element of intent is lacking. Elsewhere, he states that if monopolies cannot, at that point of time, be reproduced by others they do not give rise to the existence of coercion (von Hayek, 1960, pp. 264–266). These monopolies are unavoidable, and there is no reason here to blame ﬁrms for constituting such a monopoly. In this situation, however, elements of Hayek’s deﬁnition of coercion appear: A person or ﬁrm initiates a product innovation that constitutes a monopoly for a while, or a process innovation whose cost-reducing effects are not completely reﬂected in lower prices. The intention is to make money that others are willing to pay because of the artiﬁcially created scarcity of the product in the case of the product innovation and a price – artiﬁcially kept high – in the case of the process innovation. So, where is the difference to the labour market case? In both cases the monopolies – innovators and trade unions, respectively – receive a rent and restrict others. The difference is that some rent activities are favourable for

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the economy – the temporary monopolies – but others are not – the trade union behaviour. The line between being favourable or not is, however, thin. Following transaction cost arguments in the tradition of Williamson (1985), collective agreements negotiated by the trade unions guarantee not only rents, i.e., higher nominal wages, but also save transaction costs, i.e., costs of negotiating and enforcing contracts, which otherwise arise for every single contract. Dynamic effects should also be included. Employers may adapt to rising wages by introducing more machinery or different production processes (Madsen & Damania, 2001). So, collective agreements may set incentives for more innovations. Acknowledging this, a differentiation between positive and negative functions for the economy is still possible but it introduces an element of normativeness, or to be more precise: an element of external judgment which cannot be derived from the concept of coercion – understood as intentional rent seeking – itself.3 Having said that, it does not mean that all coercive actions, especially trade unions’ actions, are functional from the point of view of the order. But it implies that trade unions cannot be blamed only because of the fact that they try to raise their bargaining power. To what extent trade unions’ activities are functional or not, needs further investigation and cannot be derived from the existence of coercion, as deﬁned by Hayek, alone. Furthermore, a prerequisite for (negative or positive) functionality is that the trade unions are actually able to monopolise. This hinges on their bargaining power which is not ﬁxed and depends on different factors: the relevance of skills the unions organise determines the effectiveness of their threat to withdraw labour power in a strike; the ability of trade unions to avoid free riding on the side of employees and to organise as many employees as possible raises their bargaining power and vice versa. Existing exit options of employers – due to high unemployment, substitution of labour by capital, or the possibility to relocate production – raises employers’ bargaining power. The institutional and political context of an economy deﬁnes whether conﬂict regulation between employers and employees will follow a cooperative or conﬂicting path. All these factors together determine how successful trade unions are in strengthening the negotiation position of employees. In particular, in times of globalised production and decreasing union density the power of trade unions to monopolise seems to be limited. The monopoly aspect of the trade unions, however, does not give a complete picture of what unions do in the view of Hayek. Clearly, his main focus is on wage increases the unions cause if they succeed in establishing a monopoly position. Nevertheless, there is more in Hayek’s writings, but it is

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more or less hidden. The role the unions play within the ﬁrm and for the discovery of information is mentioned by Hayek, albeit not really elaborated. He only touches on the participation of unions in the creation of rules and of conditions of work as well as in a just structure of remunerations and promotions within ﬁrms (von Hayek, 1960, p. 276f.). In Hirschman’s terminology, in addition to exit, when an employer (or employee) signals that the offer (or work) is no longer satisfying by quitting, there is voice, which signals dissatisfaction via linguistic communication (Hirschman, 1970). Trade unions mediate between management and employees, they are the voice of their members vis-a`-vis management. Unions can signal potential and latent conﬂicts to the management and can help ﬁnding common solutions before such conﬂicts actually break out. Analogously, the management can communicate their problems to the unions. The trade unions also participate in the development of intra-ﬁrm rules which establish fairness norms – as an essential source of productive working conditions – and prevent conﬂicts. If the relationship between management and trade unions is a successful one, the result is low strike intensity and motivated employees. That Hayek was not very interested in the role of trade unions within ﬁrms is probably due to the fact that his main focus was on spontaneous order, not on organisations. Therefore, intra-ﬁrm relationships did not concern him much. He treats ﬁrms as homogenous actors where conﬂicts show up only in wage bargaining but have no further effect on the internal organisation. Not all Austrians share this view. As Foss (1999) demonstrates, the ﬁrm also incorporates elements of a spontaneous order which is essential for the ﬁrm to use knowledge, to interpret the world, and to learn from mistakes. Nevertheless, a ﬁrm is different from a market: the management plans and decides in the end, but it also gives leeway for local decisions and governs by rules as well as by concrete commands. Foss stresses that the members of the ﬁrm are people without perfect knowledge, notes the incomplete contracts in a ﬁrm, and concludes that a ﬁrm, although it is an organisation, is a complex body too, facing complex coordination problems and unintended consequences of their members’ actions. What follows from this rearranged perspective on ﬁrms? A ﬁrm is an organisation but not one where the will of a single person controls everything the ﬁrm is doing directly and without resistance (Foss, 2002). Running a ﬁrm is not like programming a computer, it is a fragile coordination of micro-actors that day after day constitutes itself newly as a collective actor, i.e., the ﬁrm (Coleman, 1990, chapter 16). The growing literature on interest conﬂicts and coordination difﬁculties between

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management on the one hand and shareholders on the other, starting with the seminal paper of Jensen and Meckling (1976), may serve as an illustration that this insight is spreading. For the question under examination here, it is the relationship between management and employees which has to be discussed in more detail. As an organisation, a ﬁrm cannot rely on the market price system for its internal relationships. Hierarchy, i.e., governance by commands, and intra-ﬁrm rules mainly coordinate the work, based on the labour contract deﬁning in which way labour power can be used for the purposes of the ﬁrm. And here the fragility of this coordination has its source. Employees do not work in a ﬁrm in order to fulﬁl the aims of the ﬁrm (efﬁcient use of resources, growth, and in the end proﬁt). Their incentive to work is the wage plus good working conditions. The management and the shareholders have their own, different aims. The collective actor, the ﬁrm, is not held together by a common aim which is shared and promoted by all its members. James S. Coleman (1990, chapter 4) calls this a disjunctive control system, a collective actor where a good is commonly produced and someone (or a body) governs and commands the organisation, whereas, however, the interests of the producers are diverse. This is different from a conjunctive control system where the members of the collective actor follow the same vision and cooperate to make it real. In the case of the disjunctive control system ﬁrm, the employees’ control over their resources, over their labour power, is transferred to the management only because of a reciprocal transfer of money: labour power usage for wage, which is regulated by the labour contract. However these contracts cannot specify and concretise what employees should and should not do in advance; they are incomplete contracts. The management must have the possibility to change the production process, to reallocate the resources, and to deploy the labour power adjusted to changing conditions. Consequently, a labour contract codiﬁes the exchange of the wage against the command over labour power, but not speciﬁed tasks describable in advance. This is a gateway for shirking and disagreement on what is and is not covered by the contract. While some working conditions, methods or tasks might not fall under the agreement from the employees’ perspective, they might do so for the management. As it is impossible to know exactly which ones these might be, because of the incompleteness of the contract, rules, and procedures for solving such conﬂicts are needed. Here, besides ﬁnancial incentives set by the employers (Akerlof, 1982), the task of the trade unions is to formulate the interests of the employees vis-a`-vis the management and to establish norms and procedures which control shirking in the interest of the ﬁrm as well as in the

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interest of the employees. Since the ﬁrm is not a spontaneous order, these rules cannot emerge spontaneously and information is not transported by a price system substitute. An alternative way of creating and adapting rules as well as institutionalised forms of signalling is necessary and is provided (not only, but to some extent) by trade unions. Therefore, if we do not focus on the monopoly aspect of the unions only, but also on their rule-establishing and conﬂict solving capacities as mentioned by Hayek as well, it would be appropriate to take some blame off the unions. But this is only half of the answer to the question of what function trade unions do have in a Hayekian spontaneous order. They also act as political actors, which has to be included in the discussion. It is there, according to Hayek, that the unions try to reallocate resources and to change the rules of the game.

4. TRADE UNIONS AS POLITICAL ACTORS Hayek’s conﬁdence in the success of the political process of a democracy varies over time. In ‘‘Constitution of Liberty’’ he names the three main advantages of a democracy: it is a peaceful method of problem solving; a safeguard of individual liberty; and above all an opinion forming process. (von Hayek, 1960, pp. 107–109; see also Peacock, 2004). It is not a kind of static efﬁciency or permanent superiority that Hayek appreciates in a democracy. It is rather the steady increase in the quality of opinions that the political process generates in the long run. In his later work, however, he stresses the elements within a democracy that lower its problem-solving capacity, endanger liberty, and interfere with the process of opinion formation. Here, organisations are the key. Collective actors try to change the order, which until then had been successful and convenient for everybody, in order to gain advantages for themselves. While as a rough approximation it can legitimately be said that individual selﬁshness will in most instances lead the individual to act in a manner conducive to the preservation of the spontaneous order of society, the selﬁshness of a closed group, or the desire of its members to become a closed group, will always be in opposition to the true common interest of the members of a Great Society. (von Hayek, 1979, p. 90; cf. also von Hayek, 1976, pp. 137–139)

Intentionally or as an unintended side effect, collective actors impair the order. Hayek gives the following rationale (von Hayek, 1979, pp. 143–145). It starts with rent-seeking behaviour of collective actors, not least of trade

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unions. Due to the combined power of a lot of individuals they are actors the government cannot ignore. Collective actors inﬂuence the government to change the order and grant privileges to them. This situation is worsened when the government tries to undo the negative consequences of the privileges by more and more state interventions. Following von Mises (1929), Hayek forecasts cumulative interventionism and the destruction of the catallaxy by increasing inﬂation and price interventions (von Hayek, 1980b, pp. 53–57).4 Therefore, we have to conclude that in principle – or idealiter – the political process in a democracy can produce collective goods (which are good), while nowadays – or realiter – it produces in most cases only ﬁghts for rents and causes cumulative interventionism (which is bad). From this point of view, democracy is degenerated into ‘‘bargaining’’ (von Hayek, 1979, p. 99) for rents. Whether the political process leads to pure rent seeking only or to advancement in opinion formation, the creation of desired public goods, or the solving of conﬂicts depends – according to the citation given earlier – on the existing inﬂuence of collective actors. The criterion for rent seeking seems to be for Hayek already and alone the participation of collective actors in the political process. But this would mean that media corporations, parties, ﬁrms, employers’ associations, trade unions, associations for the protection of the environment or for human rights, and so on, are all and ever rent seekers. If a business association threatens to relocate production when there is no cut in ﬁrm taxes, is that rent seeking? If Greenpeace is hindering whalers doing their job, is that haggling for privileges? If groups try to organise a boycott of Shell or McDonald’s, is that gaining advantages for a special group? All these actors clearly try to reach political aims, but it is not that clear if all of this is harmful. Therefore, a closer look at what collective actors do is necessary. As chief witness, Hayek (1979, p. 90, footnote 12) refers to Mancur Olson’s arguments of the logic of collective action (Olson, 1971). The core of the argument is that collective actors – small or large does not matter – seek advantages for an exclusive group only. Thus the principle of equal treatment is violated. Olson in his 1982 book, however, differentiates more than Hayek. Not all collective action is a seeking for exclusive rents, and not all interests are equally organisable. While small collective actors try to seek outcomes mostly favourable only for themselves, comprehensive collective actors representing a broad range of people’s interests cannot help reaching results that favour a broad range of people. But normally, large groups face severe free-riding problems hindering them to organise as effective as

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small groups. Olson’s arguments leads to the conclusion that some actors, normally small collectives, exploit comprehensive collectives, but not all collective actors do exploit. Trade unions, by the way, are one of Olson’s examples of comprehensive collective actors (Olson, 1982, pp. 47–53). Nevertheless, the situation is not as bad as Olson predicts. Interests are organisable to a different degree and are thereby represented differently in the political process, but there are remedies to overcome organisational problems, also for interests that are difﬁcult to organise: even a few actors can start the production of a collective good, and when a critical mass is reached production grows and is stabilised; networks, trustees, or political entrepreneurs help to reach this critical mass; furthermore, the state can give support for organising interests (Oliver, Marwell, & Teixeira, 1985; Oliver & Marwell, 1988; Marwell, Oliver, & Prahl, 1988). Although this does not necessarily lead to a well-balanced system of interests, it is a more balanced system than the works of Hayek and Olson suggest. A broad range of interests is represented, and rent-seeking actors have to face resistance by other organised interests. But Hayek’s main point is still valid: is there not too much rent seeking in the political process, which could be avoided? To answer this, we have to shed some light on the special attributes of the political process in democracies. In a catallaxy, relations between the actors are characterised by a situation in which goods can be individually owned and consumed. In the political sphere it is not possible for an individual to choose his or her own society. A political choice is always a collective choice whose effects are not restricted to one person. Moreover, competition between parties is restricted. Only a few parties compete and offer only bundles of goods where not all components might suit an individual. Doing politics in such a system leads to the necessity of establishing coalitions and paying compensations to get to a majority-based solution. It also implies that the outcomes necessarily deviate from individual preferences due to bundling and choice as collective choice. All of this can be described as rent seeking. However, this is due to the way a democratic political process works and cannot be revised comprehensively without turning a democracy into something which is no longer a democracy, possibly something undemocratic. Von Hayek (1979, pp. 133–152) – and in a similar way Buchanan and others (Brennan & Buchanan, 1985; Buchanan & Congleton, 1998) – suggest a constitutional forum to reduce rent seeking. This forum still uses majority voting but aims at excluding all rent-seeking activities due to the obligation to decide on abstract rules only and not on concrete measures. Abstractness

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guarantees rules that do not privilege and do not discriminate against anyone. In a way, it means having all members of the society in mind. In contrast to an ideal catallaxy where we can imagine that the right rules are in existence because the order emerged unintentionally and over a longer period of time through the daily actions and interactions of the people themselves, a constitutional forum nowadays faces a different situation. Regardless of who is elected or appointed to formulate the rules in such a forum, the members have to ﬁnd adequate rules for the existing order ﬁrst. Or in other words: it is not known what the ‘‘true common interest’’ (von Hayek, 1979, p. 90) is, besides the fact that it is rule-based. The criterion of abstractness alone does not help much. It can serve as a touchstone for non-discriminating treatment but it does not tell the forum members the content of a rule. To ﬁnd the right rules, the members need knowledge about what people want, they need knowledge whether the rules serve these wants, and how they interact or interfere with each other; this knowledge is locally available but not automatically at hand in the forum. Furthermore, democracy is not only about the right rules. Every rule has to be followed to establish a sustainable order. The pure existence of a constitutional body does not guaranteed that everybody follows the rules, as people want to be convinced that these rules are the right rules, that they are legitimate. Why not use democracy to ﬁnd that knowledge and legitimacy? For Hayek the catallaxy is a discovery process for knowledge; it might also work for the political sphere (diZerega, 1989). A public debate is a necessary prerequisite to discover the right rules and to generate legitimacy. It is this debate which formulates people’s preferences. In the debate the consequences of rules can be discussed. New ideas and new rules can be developed in an open debate. Beliefs have to be justiﬁed and can be refuted. Last but not least, the debate is essential to convince people and thereby ﬁnd support for the rules. In doing this – developing ideas of rules, forming preferences, justifying and disapproving beliefs, and building legitimacy – it proves that politics is not only the re-allocation of goods produced in the economy, i.e., rent seeking, it is also not only the act of choosing a solution by majority voting. Democracy is a productive discovery process to determine urgent societal problems and to ﬁnd out how to solve them (Slembeck, 1997; Wohlgemuth, 2002a; Wohlgemuth, 2002b). This discovery process is obviously not a market-type process: it is voice-driven, not exit-driven. Unfortunately, this democratic discovery process is vulnerable to rent seeking. Individuals have an incentive not to participate in debate and

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discovery. They would have to invest a lot of time but would probably gain only a minimal inﬂuence within the debate. One person – one vote – is also the principle in decisions. In this dilemmatic situation, collective actors function as mediators. Parties, business organisations, trade unions and so on can fulﬁl ﬁve functions for the debate: – First, they give preferences a voice that otherwise would not be expressed because of the free-riding problem. They collect information on people’s wishes, formulate them and bring them to the public. – Second, they combine resources to develop concepts and belief systems to interpret the world for their members, which is necessary to decide which rules are adequate. – Third, they collect the dispersed knowledge of individuals and transform it into public knowledge, which can be used and discussed. – Forth, they convince their clientele that the chosen rules are the right ones and should be followed. – Fifth, they participate in the implementation, enforcement and actualisation of rules. Collective actors in the political process are therefore producers of the political goods: preference discovery, information acquiring, rule proposing, and legitimacy creation. They are also interest groups, but as such they ﬁght for political aims, which is not necessarily the same as rent seeking. Switching exclusively to a constitutional body and restricting the activity of collective actors to zero, requires ﬁnding substitutes for the functions collective actors hold. Maybe this is not necessary, and maybe it is enough to sensitise the political process towards what is needed for a successful establishment of a catallaxy. This would also imply that economists and the economy have to take into consideration that the political process has its own logic and that people’s preferences might be – not as a deﬁcit but as an essential element – such as could lead to consequences not favourable for a catallaxy. Even an ideally functioning political process, solely producing abstract rules, might not lead to a catallaxy-friendly set of rules for the economy. If the majority prefers for example a stable environment, an equal ex post distribution, precautions to guard against misfortune, or if it favours risk-averseness, then the degree of competition in the market will be diminished, consistent with people’s preference order and will. From the point of view of a liberal democracy we have to accept that.

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5. TWO RESULTS OR TOO TRADITIONAL RESULTS? Hayek’s hypothesis that trade unions are the ﬁrst major problem of our times is not fully grounded even in his own assumptions. Trade unions have a monopolistic element in their role as economic actors but also have positive functions for their members and the economy as a whole. The main reason is that ﬁrms are organisations (and only partly spontaneous orders) in the form of disjunctive control systems where the relationship between employer and employee is based on a mixture of a speciﬁc exchange in combination with command, and not on a common goal. Consequently, latent conﬂicts exist. In this situation, trade unions channel information and develop rules for conﬂict resolution. Hayek’s insights on rule emergence and information discovery, developed in the ﬁeld of spontaneous order, can also be usefully applied to describing how ﬁrms work. The same holds for the political sphere. Beside rent-seeking activities, trade unions and other collective actors can be conceived as being part of a process of preference formulation and opinion formation. By overcoming the dilemma facing individuals – that they have only low incentives to engage themselves in the public debate – collective actors ﬁll this gap and produce knowledge and legitimacy necessary for well-grounded decisions on rules and their successful implementation. Hayek’s ideas of competition as a discovery process and the importance of knowledge again offer fruitful insights for a theoretical reasoning of the democratic process as a spontaneous order. What has to be included is the role of collective actors such as mediators and discussants within this process. It might appear that these results, which describe trade unions (or generally: collective actors) as helpful parts both of a democratic order and the catallaxy, are too traditional, too much oriented towards a corporatist view of society. Especially for economists, trade unions might be quite an extreme example to demonstrate that collective actors can also support spontaneous order. But if in the case of trade unions it could be reinforced that collective action is an essential part of the economic and political sphere, then this applies for less problematic collective actors all the more. If the power of collective actors should still be curtailed because of their negative effects, substitutes would have to be found for their positive functions.

NOTES 1. See other Austrian authors dealing with economics in this broader sense – for example, Schumpeter’s famous book on the economic and political perspectives of

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capitalism (Schumpeter, 1942), or Mises’s book on interventionism (von Mises, 1929). 2. Hayek reserves some exceptions from this rule. ‘‘There are good reasons why in certain employments it should be part of the terms of employment that the worker should renounce this right; i.e., such employments should involve long-term obligations on the part of the workers, and any concerted attempts to break such contracts should be illegal’’ (von Hayek, 1960, p. 269). 3. Interestingly, the distinction between rent-seeking and proﬁt-seeking activities in a similar context, given by Buchanan (1980), leads to the same problem: the seeking activity itself cannot offer the criterion whether this activity is desirable or not. 4. This view was recently challenged by Wegner (1997) who demonstrates on a Hayekian basis that the spontaneity of the order is not necessarily endangered by non-spontaneous actions. Or in other words: competition is a very robust institution. Re- and devaluations of actors’ options are part of every day life, be they caused by state action, by trade unions’ action, or by competitors’ actions. The actors can adapt to these changes and thereby prevent cumulative destruction.

ACKNOWLEDGMENT I would like to thank the participants of the Edmonton conference ‘‘The Austrian School of Economics’’, 7–8 October 2005, especially Roger Koppl and John Prpic, for valuable comments. The chapter has also beneﬁted from comments by Eckhard Hein, Christoph Sauer, Margit Schratzenstaller, and Jens Weiss on an earlier version and from helpful suggestions by an anonymous referee.

REFERENCES Aidt, T., & Tzannatos, Z. (2002). Unions and collective bargaining. Economic effects in a global environment. Washington, DC: World Bank. Akerlof, G. A. (1982). Labor contracts as partial gift exchange. Quarterly Journal of Economics, 97(4), 543–569. Brennan, G., & Buchanan, J. M. (1985). The reason of rules. Constitutional political economy. Cambridge: Cambridge University Press. Buchanan, J. M. (1980). Rent seeking and proﬁt seeking. In: J. M. Buchanan, R. D. Tollison & G. Tullock (Eds), Toward a theory of the rent-seeking society (pp. 3–15). Collage Station: Texas A&M University Press. Buchanan, J. M., & Congleton, R. D. (1998). Politics by principle, not interest. Toward nondiscriminatory democracy. Cambridge: Cambridge University Press. Coleman, J. S. (1990). Foundations of social theory. Cambridge: Harvard University Press. diZerega, G. (1989). Democracy as a spontaneous order. Critical Review, 3(2), 206–240. Foss, N. J. (1999). The use of knowledge in ﬁrms. Journal of Institutional and Theoretical Economics, 155(3), 458–486.

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Foss, N. J. (2002). ‘Coase vs Hayek’: Economic organization and the knowledge economy. Journal of the Economics of Business, 9(1), 9–35. Hirschman, A. O. (1970). Exit, voice, and loyalty. Responses to decline in ﬁrms, organizations and states. Cambridge: Harvard University Press. Hutt, W. H. (1975). The theory of collective bargaining 1930–1975. London: Institute of Economic Affairs. Hutt, W. H. (1988). Trade unions: The private use of coercive power. Review of Austrian Economics, 3, 109–120. Jensen, M. C., & Meckling, W. H. (1976). Theory of the ﬁrm. Managerial behaviour, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305–360. Madsen, J. B., & Damania, R. (2001). Labour demand and wage-induced innovations: Evidence from the OECD countries. International Review of Applied Economics, 15(3), 323–334. Marwell, G., Oliver, P. E., & Prahl, R. (1988). Social networks and collective action: A theory of the critical mass III. American Journal of Sociology, 94, 502–534. Oliver, P. E., & Marwell, G. (1988). The paradox of group size in collective action: A theory of the critical mass II. American Sociological Review, 53, 1–8. Oliver, P. E., Marwell, G., & Teixeira, R. (1985). A theory of the critical mass: I. Interdependence, group heterogenity, and the production of collective action. American Journal of Sociology, 91(3), 522–556. Olson, M. (1971). The logic of collective action. Public goods and the theory of groups. Cambridge: Harvard University Press. Olson, M. (1982). The rise and decline of nations. Economic growth, stagﬂation, and social rigidities. New Haven: Yale University Press. Peacock, M. S. (2004). On political competition: Democracy, opinion and responsibility. Constitutional Political Economy, 15(2), 187–204. Schumpeter, J. A. (1942). Capitalism, socialism, and democracy. London: Unwin. Slembeck, T. (1997). The formation of economic policy: A cognitive-evolutionary approach to policy-making. Constitutional Political Economy, 8(3), 225–254. von Hayek, F. A. (1945). The use of knowledge in society. American Economic Review, 35(4), 519–530. von Hayek, F. A. (1960). The constitution of liberty. Chicago: University of Chicago Press. von Hayek, F. A. (1963). Arten der Ordnung. ORDO, 14, 1–20. Reprinted in: von Hayek, F. A. (1969). Freiburger Studien. Gesammelte Aufsaetze. Tuebingen: Mohr Siebeck, pp. 32–46. Also translated and reprinted as von Hayek, F. A. (1964). Kinds of order in society. New Individualist Review, 3(2), 3–12. von Hayek, F. A. (1967). Rechtsordnung und Handelnsordnung. In: E. Streissler (Ed.), Freiburger Rechts- und Staatswissenschaftliche Abhandlungen (Vol. 27, pp. 195–230). Karlsruhe: Mueller. Reprinted in von Hayek, F. A. (1969). Freiburger Studien. Gesammelte Aufsaetze. Tuebingen: Mohr Siebeck, pp. 161–198. von Hayek, F. A. (1968). Der Wettbewerb als Entdeckungsverfahren. Series: Kieler Vortraege, No. 56, Kiel: University of Kiel. Also translated and reprinted as von Hayek, F. A. (2002). Competition as a disccovery prrocedure. Quarterly Journal of Austrian Economics, 5(3), 9–23. von Hayek, F. A. (1973). Law, legislation and liberty. Volume 1: Rules and order. Chicago: University of Chicago Press. von Hayek, F. A. (1976). Law, legislation and liberty. Volume 2: The mirage of social justice. Chicago: University of Chicago Press.

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von Hayek, F. A. (1979). Law, Legislation and Liberty. Volume 3: The political order of a free people. Chicago: University of Chicago Press. von Hayek, F. A. (1980a). ‘Free’ enterprise and competitive order. In: F. A. Hayek (Ed.), Individualism and economic order (pp. 107–118). Chicago: University of Chicago Press. von Hayek, F. A. (1980b). 1980s unemployment and the unions. The distortion of relative prices by monopoly in the labour market. Series: Hobart Paper, No. 87, Lancing: Institute of Economic Affairs. von Mises, L. (1929). Kritik des Interventionismus. Untersuchungen zur Wirtschaftspolitik und Wirtschaftsideologie der Gegenwart. Jena: Fischer. Also translated and reprinted as von Mises, L. (1996). A critique of interventionism. Irvington-on-Hudson: Foundation for Economic Education. Wegner, G. (1997). Economic policy from an evolutionary perspective: A new approach. Journal of Institutional and Theoretical Economics, 153, 485–509. Williamson, O. E. (1985). The economic institutions of capitalism. New York: Free Press. Wohlgemuth, M. (2002a). Democracy and opinion falsiﬁcation: Towards a new Austrian political economy. Constitutional Political Economy, 13, 223–246. Wohlgemuth, M. (2002b). Evolutionary approaches to politics. Kyklos, 55(2), 223–246.

ANALOGOUS MODELS OF COMPLEXITY: THE AUSTRIAN THEORY OF CAPITAL AND HAYEK’S THEORY OF COGNITION AS ADAPTIVE CLASSIFYING SYSTEMS Steven Horwitz ABSTRACT By the 1950s, F. A. Hayek’s contributions to a variety of disciplines seemed to be more clearly center around the concept of spontaneous order, or in more contemporary and more general language, ‘‘adaptive classifying systems.’’ In this chapter, I compare two such systems present in Hayek’s thought: his contributions to the Austrian theory of capital and his work on the theory of cognition. This comparison reveals a number of very strong analogies between the two theories, which is not surprising as Hayek himself acknowledged that his work on capital inﬂuenced his thinking when he returned to theoretical psychology after completing The Pure Theory of Capital. Speciﬁcally, I argue that both capital and the mind are adaptive classifying systems characterized by: multiple classiﬁcation/speciﬁcity, the centrality of structure, and a Explorations in Austrian Economics Advances in Austrian Economics, Volume 11, 143–166 Copyright r 2008 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11008-0

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relational concept of order. The chapter concludes with some brief thoughts on the implications of the argument for the theory of the ﬁrm and for the place of methodological dualism in Hayek’s thinking more generally.

The last decade has seen a number of books looking at F. A. Hayek’s contributions to economics and social theory and attempting to draw both connections between them and large lessons from them. In the most recent, and best, of these books, Bruce Caldwell (2004) argues that one central moment in the development of Hayek’s thought is a shift in his methodological perspective from one that emphasized the dualism of the social and natural sciences to one that explored the distinction between ‘‘simple’’ phenomena and ‘‘complex’’ phenomena.1 Caldwell points to the period of the 1940s as the time when Hayek began to undergo this shift. Hayek’s decision to revisit theoretical psychology and publish The Sensory Order (1952) brings together both this emphasis on complex phenomena and Hayek’s attempts to provide a scientiﬁc underpinning for traditional Austrian subjectivism. At the most general level, Hayek was seeing this new framework of emergence, complexity, evolution, and spontaneous order in a variety of places. After quoting a passage from Hayek’s ‘‘Notes on the Evolution of Rules of Conduct’’ from 1967 that reﬂects Hayek’s move toward these other explanatory strategies, Caldwell (2004, p. 285) captures the breadth of this change in Hayek’s thought: Hayek included a note in the article containing the passage just cited that summarizes the point well: ‘‘We shall occasionally use the pair of concepts ‘order and its elements’ and ‘groups and individuals’ interchangeably, although the former is of course the more general term of which the relation between group and individual is a particular instance’’ (Hayek, 1967, p. 66, n. 1). This is just what one should expect from someone who was identifying analogous explanations in a variety of ﬁelds.

To the extent that Hayek began to see, in the 1940s, a new framework for conceptualizing the relationship between the natural and social world, and to offer explanations for phenomena in each area, it is not surprising that there would be analogous explanatory strategies at work in diverse areas of his thought. McQuade and Butos (2005) argue that this shift in Hayek’s thought can best be understood as his having implicitly laid out in The Sensory Order the fundamentals of a class of phenomena that they christen ‘‘adaptive classifying systems.’’ They offer an abstract discussion of how

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such systems operate and then offer several examples of such systems, focusing on the market and the scientiﬁc process. However one chooses to characterize it, the question of what might have prompted Hayek’s shift to these ideas remains an interesting one. A number of hypotheses have been advanced, but what I wish to argue here is that one possible source of Hayek’s thinking about complexity and adaptive systems, particularly as it appears in The Sensory Order and then later in a series of essays in the 1960s, was his work on capital theory in the late 1930s that culminated in 1941s The Pure Theory of Capital, along with the similar contributions and extensions by Ludwig Lachmann in the 1940s and 1950s. It is striking how similar the Austrian theory of capital is to Hayek’s work on cognition. Many of the same underlying ideas of function, complementarity, and structure are present in both. They are, I will argue, analogous models of complexity and capital can fruitfully be understood as an example of the ‘‘adaptive classifying systems’’ identiﬁed by McQuade and Butos. And there is, in fact, one piece of evidence in the secondary literature that Hayek saw a direct connection between the two areas, and it is certainly possible that additional evidence exists in correspondence and other places that conﬁrms that his work on capital got him thinking about ideas and approaches that led to his later work on the mind and complexity more generally. After exploring both Austrian capital theory and Hayek’s theory of mind, I discuss the ways in which capital is an instance of an adaptive classifying system and how capital and mind are analogous models of complexity. I conclude with brief discussions of some theoretical and methodological implications.

THE AUSTRIAN THEORY OF CAPITAL Austrian capital theory begins where so much of Austrian economics begins, with Menger’s (1981 [1871]) Principles of Economics. Speciﬁcally, it is Menger who delineated the difference between goods of the ‘‘ﬁrst order’’ and goods of the ‘‘higher orders.’’ First-order goods are those devoted to the direct satisfaction of consumer wants. Goods of the higher orders are those that contribute to the making of ﬁrst-order goods. The piece of bread I eat for breakfast is a ﬁrst-order good, while the ﬂour, eggs, milk, etc. that went into making it are second-order goods. The inputs that went into making the ﬂour or the milk (e.g., the milking machines at the dairy where the milk was produced) are third-order goods, and so on. For Austrians, capital can be understood generally as any input that contributes to the production of a

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ﬁrst-order good, either directly or indirectly. That is, capital is all of the goods of higher orders. Implicit in this deﬁnition is the idea that capital is ‘‘forward-looking.’’ What makes something capital is not where it came from but what it is doing in forwarding the production plans of its owner. Older deﬁnitions, such as Bohm-Bawerk’s, that referred to capital as ‘‘produced means of production’’ or the like were focused on the origins of a good rather than its function in determining whether or not it was capital. Even Hayek was somewhat guilty of this as he deﬁned capital as ‘‘the total stock of the nonpermanent factors of production’’ (Hayek 1941, p. 9). As Lachmann (1956, p. 12) rightly responds, ‘‘we cannot adopt this deﬁnition as we cannot ignore the uses to which permanent resources are put.’’ More generally, Lachmann (1956, p. 11, emphasis added) deﬁnes capital as ‘‘the stock of material resources’’ and adds, in response to Bohm-Bawerk, that ‘‘the question which matters is not which resources are man-made but which are man-used.’’ Lachmann focuses attention more sharply than Hayek on the uses to which resources are put rather than their physical nature or origin. But even Lachmann does not quite go far enough. Where his deﬁnition falls short is its focus on the ‘‘material’’ nature of capital resources. We can generalize Lachmann’s emphasis on capital being ‘‘man-used’’ by arguing that capital resources need not be material. To see this, we can look at Kirzner’s extension of Lachmann’s emphasis on ‘‘the plan’’ as central to his theory of capital. In addressing the question of how we are to understand how capital gets used and what explains the ‘‘structure’’ that emerges economy-wide, Lachmann (1956, p. 8) argues that ‘‘Capital uses must ‘ﬁt into each other.’ Each capital good has a function which forms part of a plan.’’ Kirzner (1966) picks up on this idea by deﬁning capital more generally as ‘‘unﬁnished plans.’’ Seen this way, capital is any input into a plan. If I wish to produce running shoes, all of the elements that must be combined to execute that plan are thus capital. Seen in the context of my overall plan, each input and each intermediate good produced along the way is an ‘‘unﬁnished plan.’’ Under this Kirznerian view, the materiality of resources is not relevant to their capital status; any good that is part of the plan is capital. For example, human capital or things such as reputation and goodwill should be counted as capital because they are aspects of the production plan need to create the ﬁnal good in question. In their role in the context of that larger plan, they themselves are ‘‘unﬁnished plans.’’ Another way of viewing the question of what makes something capital is to see it as a matter of function. Capital is what capital does: contribute to the plans of entrepreneurs. This observation’s importance is that the same

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good can be capital in one situation and not another. The identical ham sandwich would be a consumer good and not capital if I have prepared it at home for the purpose of direct consumption. However, if I had taken that exact same sandwich and put it in a picnic basket and then sold it in my store, it is now a capital good as it is an ‘‘unﬁnished’’ element of my plan to sell complete picnic lunches. What makes the sandwich capital or not is its relationship to other goods and services and the plans of actors. It is context or, better yet, the place a good sits in the structure or network of production that determines its capital quality. The Austrian theory of capital denies that one can look at a good or service, or even a non-material asset, standing alone and determine whether or it is capital. It is not the physical qualities of the good that make that determination but where it sits in the network of plans of actors. This is why Lachmann (1956, p. 4) continually refers to the structure of capital: It will be our main task in this book to study the changes which this network of capital relationships, within ﬁrms and between ﬁrms, undergoes as the result of unexpected change. To this end we must regard the ‘stock of capital’ not as a homogenous aggregate but as a structural pattern. The Theory of Capital is, in the last resort, the morphology of the forms which this pattern assumes in a changing world.

This emphasis on relationships and unexpected change also highlights the dynamic nature of the theory. Because being capital depends upon a good’s location within a plan, it is possible, and quite likely, that the same good can serve as capital in more than one imaginable plan. Any single good has what Lachmann (1956, p. 2) calls ‘‘multiple speciﬁcity,’’ which is the quality of being used for more than one, but yet a still limited, number of purposes. What is central for the Austrian theory is that capital is not homogenous; capital goods are not perfect substitutes for one another. Any given good can only serve in a limited number of production plans, and it is not possible to create any given production plan out of any capital goods. Goods are not inﬁnitely substitutable, and not all goods have the requisite complementarity necessary to be part of any particular production plan. This emphasis on the ‘‘heterogeneity’’ of capital distinguishes Austrian capital theory from many of its predecessors, especially those, most obviously Knight’s ‘‘Crusonia plant’’ or Solow’s ‘‘shmoo,’’ that viewed capital as a homogenous fund of resources from which equally useful ‘‘ladles’’ could be applied to any production process. Recognizing that capital is heterogenous in this way suggests the importance of the complementarity and substitutability of capital.

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When viewed as part of a production plan, the various capital inputs must ‘‘ﬁt together’’ in order for that plan to be executed. How well various capital inputs can be ﬁt together in this fashion is their degree of complementarity. What entrepreneurs do in constructing their plans is to integrate complementary capital inputs. In the mind of the entrepreneur at the moment the plan is put in motion, the various capital inputs are all in a complementary relationship to one another. Substitution, by contrast, is a feature of capital goods when we consider dynamic change. The plans of entrepreneurs are always constructed in a world of uncertainty and may fail to play out as intended. When plans fail to one degree or another, entrepreneurs may choose to reshufﬂe their capital inputs and formulate a new plan. At this point, the central question is the degree to which one capital good can substitute for another in the plan. The substitutability of capital is what matters when change is necessary. The process of entrepreneurship and monetary calculation is one of constant plan creation, execution, and revision, with the corresponding consideration of the complementarity and substitutability of the capital inputs into those plans. The result of this ongoing process is the production of a capital structure that is an unintended consequence of the various decisions being made by entrepreneurs. Although each individual entrepreneur is consciously and intentionally ﬁtting together complementary capital items into production plans, the degree of integration and complementarity in the capital structure of the economy as a whole is an emergent outcome of the interplay between intra-plan complementarity and inter-plan substitution. One ﬁnal aspect of Austrian capital theory that should be noted is that capital is understood in a ‘‘forward-looking’’ manner. As noted earlier, capital is deﬁned not by how it was produced but by how it contributes to the production of future output in the plans of entrepreneurs. Capital’s value is derived from the value of the output it helps to produce. In this way, capital is a good with a potential to contribute to the creation of further value. That potential, like economic value in general, is due to the expectations and perceptions of entrepreneurs about its contributions to the production process and nothing inherent in the good itself. When we consider the importance of complementarity in the production process, it also becomes clear that the value-potential of any particular item of capital is bound up with context in which it is placed at any point in time. Capital’s value depends on its place in a production plan and the perceptions of its contributions to the ﬁnal good that plan will produce. Capital value is both forward-looking and contextual.

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HAYEK’S THEORY OF MIND Hayek’s theory of mind and cognition is largely laid out in his 1952 book The Sensory Order. The task he sets for himself in that book is to explain how it can be that the world we understand to exist through the methods of science presents itself to us in the mind as a different sort of world. For example, we may know that what we see is but a jumble of waves, particles and the like, but our minds somehow translate those raw physical inputs into the orderly picture of the world we associate with mind and consciousness. Hayek (1952, p. 7) wants ‘‘to know the kind of process by which a given physical situation is transformed into a certain phenomenal picture.’’ Hayek frames his investigation in terms of the ‘‘physical’’ and ‘‘mental’’ orders. He (p. 14) wants to understand the relationship between the two and how mind renders the world orderly in a way that is different from the order we know exists in the physical world: There exists, therefore, no one-to-one correspondence between the kinds (or the physical properties) of the different physical stimuli and the dimensions in which they can vary, on the one hand, and the different kinds of sensory qualities which they produce and their various dimensions on the other. The manner in which the different physical stimuli can vary and the different physical dimensions in which they can be arranged have no exact counterpart in the manner in which the sensory qualities caused by them will differ from each other, or in the dimensions in which these sensory qualities can be arranged. This is the central fact to which we have referred when we insisted that the two orders, the physical order of the stimuli and the phenomenal or mental order of the sensory qualities, are different.

Mind is ‘‘thus a particular order of a set of events taking place in some organism and in some manner related to but not identical with, the physical order of events in the environment’’ (Hayek, 1952, p. 16). More speciﬁcally, Hayek argues that mind is a ‘‘relational’’ order. What makes any given situation ‘‘orderly’’ is not just that there is a certain set of events occuring together, but that there are ‘‘certain relations between them’’ (Hayek, 1952, p. 47). It is in this sense that the whole (the order) is greater than the sum of its parts. One has to understand the relationships among the various elements in order to understand how their arrangement in particular ways can leads to an order that is something distinct from the sum of the elements. It is not just the presence of certain elements that generates an order, but how those elements are arranged. In the case of the mind, it is certain relationships among physical stimuli that produce the orderliness in the world that we associate with consciousness.

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Furthermore, because we know that there are times when physically different stimuli present themselves identically to our senses and other times when physically identical stimuli can appear different, we know that the mental order depends on the context in which particular stimuli appear. There is no simple one-to-one correspondence between physical stimuli and the mental order. The role that a particular physical stimulus plays in producing the mental order (what Hayek calls the sensory qualities of that stimulus) will depend on the relational context in which it appears. These relationships and the order they facilitate is made possible because mind is, in the core of Hayek’s theory, a classiﬁcation system. The mental order is the result of the mind classifying physical stimuli as they arrive. Hayek is careful to argue that the mind does not just take ‘‘pre-sorted’’ stimuli and then ‘‘put’’ them in the right place. Rather, the mind is the way in which stimuli are classiﬁed in the ﬁrst place. The world presents itself to us as orderly because the mind ‘‘pre-classiﬁes’’ stimuli based on networks of neural connections that have been built up through our history of interaction with the external world. The complex part of this process is that what is normally happening is a process of ‘‘multiple classiﬁcation.’’ The category to which particular inputs get assigned may differ depending on the other inputs that accompany it. Hayek (1952, p. 50) explains another sense of ‘‘multiple:’’ The classiﬁcation may thus be ‘‘multiple’’ in more than one respect. Not only may each individual event belong to more than one class, but it may also contribute to produce different responses . . . if and only if it occurs in combination with certain other events.

An example of the ﬁrst sort of multiple classiﬁcation would be the fact that an orange can be classiﬁed as ‘‘round,’’ ‘‘orange,’’ and/or ‘‘fruit.’’ The particular response we have to an orange in front of us might well depend on what else it appears with. For example, on a tray with a strawberry and a watermelon, it would likely evoke ‘‘fruit,’’ but with a carrot and a basketball, it would evoke the color orange (Feser, 1999). Futhermore, it is possible that it could generate a unique response if it occurs with a particular combination of other objects. Individual events often have multiple ways in which they could be classiﬁed and the particular response they generate will often depend upon the other events with which they present themselves. As organisms learn through time, these connections and systems of multiple classiﬁcation become progressively more sophisticated. Hayek (1952, p. 109ff ) uses the metaphors of ‘‘map’’ and ‘‘model’’ to explore the way in which the mental order is structured. The map and the model generally reﬂect the more static and more dynamic aspects of cognition.

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The map refers to the relationship between the ‘‘network of connections’’ among stimuli acting upon the organism and the ‘‘structure of external events which it can be said to reproduce’’ (Hayek, 1952, p. 109). These are the established connections that have been built up in the mind over the lifetime of learning. They reﬂect the ‘‘lay of the land’’ in terms of the learned associations that the mind has made through time. They are neural and physical phenomena. Hayek is careful to say that this is a ‘‘very imperfect map, but also a map which is subject to continuous although very gradual change’’ (p. 110). It is a record of past relationships. He continues: The model, by contrast, refers to the pattern of impulses which is traced at any moment within the given network of semi-permanent channels [and] may be regarded as a kind of model of the particular environment in which the organism ﬁnds itself at the moment and which will enable it to take account of that environment in all its movements. (Hayek, 1952, pp. 114–15)

The map is a reﬂection of the past, but the model is what the organism uses to ‘‘represent’’ the present. The semi-permanent nature of the map restricts the kinds of things that the organism can model at any point in time; we understand our present environment on the basis of the experiences we have accumulated through time. However, the model is dynamic in the sense that it guides behavior in the particular context the organism ﬁnds itself. It reﬂects the set of current impulses that are taking place in the brain, as opposed to the channels for directing those impulses that are captured by the ‘‘map.’’ How the behavior resulting from that set of current impulses plays out in particular instances may feed back over time to gradually adjust the map by restructuring the underlying physical relationships, but in the short run, the model is bounded by the map. This dynamic feedback process is the ‘‘adaptive’’ part of the ‘‘adaptive classifying system’’ framework of McQuade and Butos. More interestingly, Hayek (1952, p. 120) argues that the model ‘‘will thus continually tend to run ahead of the actual situation.’’ Because the model frames the current situation in which the organism ﬁnds itself, based on the historical relationships embedded in the map, the model is essentially ‘‘predictive’’ in that it can be used to anticipate the result of various actions the organism might take.2 The classiﬁcation process that is the mind is largely one that classiﬁes by function in the sense that it classiﬁes by the likely consequences that any set of stimuli will jointly produce. As a result, mental processes are very much processes of expectation: The representation of the existing situation in fact cannot be separated from, and has no signiﬁcance apart from, the representation of the consequences to which it is likely to

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lead. Even on a pre-conscious level the organism must live as much in a world of expectation as in a world of ‘‘fact,’’ and most responses to a given stimulus are probably determined only via fairly complex processes of ‘‘trying out’’ on the model the effects to be expected from alternative courses of action. The reaction to a stimulus thus frequently implies an anticipation of the consequences to be expected from it. (Hayek, 1952, p. 121)

In summary, Hayek’s theory of mind suggests two important implications for our analogy to capital. First, mind is a structure where the importance of any element of that structure can only be understood in terms of its relationships to other elements of the structure, and where the said structure can only emerge if the said elements have particular sorts of relationships. The mind is a network of such connections. Second, those more or less static networks of neural relationships enable the organism to create a more dynamic model of its environment, where that model is constrained by the semi-permanent network (what Hayek calls the map) but is essentially expectational in that its representation of the current environment is the result of having ‘‘tried out’’ various possible action-consequence combinations. Consciousness of the moment, for Hayek, is therefore a world of expectations not a world of ‘‘experienced facts.’’ This brief summary of Hayek’s theory cannot do it real justice. The purpose was to highlight those parts that seem most relevant to the analogy to capital theory.

IS CAPITAL AN ADAPTIVE CLASSIFYING SYSTEM? McQuade and Butos (2005, pp. 338–340) identify three elements necessary to be able to identify a phenomenon as an ‘‘adaptive classifying system.’’ These elements are generalizations of features of Hayek’s description of the mind found in The Sensory Order. After summarizing these, I will identify their analogues in the capital structure and then explore some further analogies between mind and capital. The ﬁrst element McQuade and Butos identify is that the structured of any adaptive classifying system ‘‘must implement an adaptive map.’’ The generalized conception of the map is as a semi-permanent set of features that provide the system with ‘‘general integrity’’ and order as well as ‘‘conforming it to the external environment.’’ At the same time, it must also be ‘‘adaptive’’ in the sense of having ‘‘reactive components’’ that accept external stimuli and are connected to other components of the map such that the map can change as a result of this in-system activity: ‘‘The structure

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of the system is, therefore, mutable, and is conditioned by its experience’’ (McQuade & Butos, 2005, p. 339). Secondly, the activity deﬁned by the map ‘‘must implement an expectational model.’’ In abstract terms, the model must derive from the way in which ongoing stimuli affect the map and must also be ‘‘capable of inducing responses on the environment consistent with the current map, responses which may, in some cases, anticipate events’’ (McQuade & Butos, 2005, p. 339). The model is the ‘‘forward-looking’’ component of the adaptive classifying system in that the model, at any point in time, might lead the system to react to current stimuli by anticipating further stimuli based on a past connection between the current stimuli and the anticipated ones. The model is the way in which the semi-permanent features of the map enable the system to interact with the external world. Finally, McQuade and Butos (2005) posit that ‘‘the reactive components of the system must be sufﬁciently interconnected to support the ability of the system as a whole to classify stimuli’’ (2005, p. 339). How any given external stimulus changes the patterns of transmission across the system is both ‘‘what is being classiﬁed and the results of the classiﬁcation process’’ (p. 339). Changes in the external environment that impact the system at any point can only be classiﬁed if the point of impact is ‘‘sufﬁciently interconnected’’ with the rest of the system such that system-wide classiﬁcatory processes can be invoked. Classiﬁcation is a property of the system as a whole, thus the system must be sufﬁciently ‘‘tight’’ in order for external stimuli that impact it at any point to be classiﬁed effectively. They also note that the very interconnectedness of the system ensures that if one part of the system is damaged, it will lead to the system relearning in ways that enable it to continue classifying but ‘‘that work around the injury’’ (p. 340). The capital structure, as described by Hayek and the Austrians, has the necessary elements to be seen as an adaptive classifying system. The ‘‘map’’ aspect of the capital structure can be seen as actual capital goods and the physical production possibilities frontier they represent. In the easier case of machinery, this would be the physical, engineering capabilities of a particular machine. For human capital, it would be the capabilities represented by the skills, experience, and knowledge of the person in question. For more abstract notions of capital, other notions of the ‘‘limits of its capabilities’’ could be articulated. Clearly the array of ‘‘physical possibilities’’ of capital represent a kind of ‘‘semi-permanent’’ set of features that both relate to the external environment of the capital structure and provide it with general integrity. These possibilities represent the contours of the possible. They are also, however, mutable in response to changes from

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incoming stimuli. A historical inventory of the capital structure of the US economy would illustrate the slow but steady changes that have occurred. Those changes result from the impact of external stimuli, in the form of market signals such as prices, proﬁts, and losses, that feed back to enterpreneurs who then make decisions about what sorts of items will comprise their own capital stock, and, through emergent processes, that of the economy as a whole. Again, the analogy to the map here is set of things we call capital as understood as a set of physical, biological, or mental capacities with objective limits. Changes in the physical stock of capital represent changes in the ‘‘map.’’ The analogue to the model is the current array of uses to which those capital goods are being put, i.e., from among all the possible things the stock of capital could be producing, to what uses are capital goods being put at the moment? As noted above, the plans of entrepreneurs are ‘‘forwardloooking’’ in that the combinations of complementary capital that they construct are based on their expectation that the particular combination will be the most proﬁtable from among those that are objectively possible based on the capabilities of the capital items. The value of capital goods is derived from expectations about the value of the output they will produce. In this way, the capital stock at any point in time is an ‘‘expectational model’’ that is based on ‘‘the effects of current stimuli on the map.’’ As market signals impinge on the current plans of entrepreneurs, they are led to reshufﬂe their capital combinations in response to those ‘‘stimuli.’’ Like the generalized notion of model outlined above, current stimuli may lead to anticipatory reactions based on past connections between those stimuli and the anticipated ones. Owners of capital make use of historical and time-slice information to assist in their adjustments. Routinized behavior has become part and parcel of recent work on the ﬁrm.3 McQuade and Butos (2005, p. 339) also note that the ‘‘overall pattern induced by a particular and concurrent stimuli is characteristic not only of itself, but of what else is sensed by the system at the same time.’’ This is true of the current uses to which capital is being put. If the owner of a capital combination is suffering losses, it will suggest the need for reshufﬂing the combination. In deciding what new combination to make use of (and will thus determine the ‘‘overall pattern’’), the owner must pay attention not only to the signals directly affecting his capital goods but those affecting others as well (‘‘what is sensed by the system at the same time’’). The eventual pattern of capital uses that emerges from this decision-making process will reﬂect the owner having scanned the whole system for the effects of other stimuli. Thus the pattern of capital uses at any moment is the result

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of the way in which speciﬁc stimuli (price changes) are related to other similar stimuli being sensed by the system at the same time. The model/ pattern of capital uses at any one point in time is a consequence of decisions that are based on the ability of the capital stock as a whole to register and classify the effects of stimuli at any point in the structure in a way that is usable system-wide. Entrepreneurial reshufﬂing, and the ‘‘substitutability’’ of capital, represent the ‘‘activity within the system’’ that lead to a new set of capital combinations, which is the ‘‘model’’ of the adaptive classifying system known as the capital structure. It should be clear from this discussion that the third element of an adaptive classifying system is present here as well. The ‘‘reactive components’’ of the capital structure are tightly interconnected in ways that allow ‘‘the system as a whole to classify stimuli.’’ The reactive components in the case of the capital structure are the owners of capital and the interconnections among them are the price signals provided by the external context of ‘‘the market.’’ Movements in prices induce reshufﬂing of the current uses of capital in the short run (the model) and in the long run those changes will affect the kinds of items that comprise the capital stock (the map). As noted in the previous paragraph, movements in price at any one part of the capital structure will be transmitted system-wide, which allows the system as a whole to classify those new stimuli, leading in turn to a new pattern of responses. The classiﬁcation of these stimuli in the form of changes in the uses of capital (or the stock of capital in the long run) are indeed reﬂections of the ‘‘system’s knowledge of its environment’’ (McQuade & Butos, 2005, p. 340). Finally, damage to one part of the capital structure will certainly reduce the system’s ability to classify and generate better response patterns to price inputs in the immediate run, but the signals generated by the damage and the attempts to work around it in the short run will lead to ‘‘relearning’’ and reconstruction of the map (i.e., the creation of new capital). For example, in the immediate aftermath of the capital destruction of Hurricane Katrina on the US Gulf Coast, existing capital was repurposed for new uses (i.e., adjustments in the model) and new, often lower quality, capital was brought into being (i.e., adjustments in the map).4 As the capital structure as a system operates in the external environment of the market, the key interconnectedness within that structure are the prices of capital goods and the proﬁt and loss signals they produce. The interconnectedness of those signals ensure effective classiﬁcation and reactivity. The capital structure would therefore appear to qualify as an ‘‘adaptive classiﬁcation system’’ by the criteria laid out by McQuade and Butos. It is important, if obvious, to note that their generalization of the argument of

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The Sensory Order offers no insight into whether Hayek himself saw these connections explicitly. However, the fact that the insights of The Sensory Order can be generalized and then reapplied in ways consistent with Hayek’s thinking is certainly suggestive that he was ‘‘on to something.’’ In a later section, I offer some textual evidence to support that he did indeed see the analogies we have been exploring.

FURTHER ANALOGIES BETWEEN MIND AND CAPITAL Seeing capital as an instance of an adaptive classifying system as generalized from Hayek’s theory of mind enables us to explore a few other analogies between mind and capital. Multiple Classiﬁcation and Multiple Speciﬁcity One such analogy is found in the concepts of ‘‘multiple classiﬁcation’’ and ‘‘multiple speciﬁcity.’’ In the same way that multiple speciﬁcity describes the ability of any given piece of capital to be used to produce a variety (although less than an inﬁnite variety) of outputs, Hayek’s description of the multiple classiﬁcation process of the mental order refers to the ways in which any given stimulus can lead to a variety of possible responses. In both cases, the relationship between the capital/stimulus and the output/response is not a linear one. That relationship depends on the other capital/stimuli that work/ appear jointly with the good/stimulus in question. Hayek’s description of the ‘‘model’’ as ‘‘trying out’’ various possible responses and selecting the one that is best can be seen as the mind sorting out how the particular combination of stimuli it is processing are best understood. As with Feser’s orange example, the same stimulus can fall into various categories, and trying to determine which categories which stimuli ﬁt into and how best to classify the particular combination of stimuli that appear at any given time is the sort of multiple classiﬁcation that Hayek is referring to. In his discussion of capital mobility, Hayek (1941, p. 328) writes in a way that suggests the parallel to the mind: The problem of mobility becomes, however, still more complex by the fact that, in view of the extremely intricate relationships of complementarity between different capital goods, it is practically impossible to speak of the mobility of a particular capital good in isolation. What effect any particular sort of change will have on its value will always depend not

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only on the alternative uses to which it can be turned, but also on the degree of mobility of the other resources with which it might co-operate in its former and in its alternative uses.

Just as the value that capital goods will produce will depend upon the relationship between their alternative uses and those of the capital goods complementary to them, so does the way in which any sensory stimulus is classiﬁed depend on the context of other stimuli it comes with. Similarly, Lachmann (1956, p. 58) writes of capital as ‘‘nodal points’’ in the move from inputs to outputs and points out that the same capital good can generate very different ﬂows of value in different situations. The capital-theoretic ideas of complementarity and capital combinations appear to translate fairly straight-forwardly to Hayek’s work on the mind. The vision of capital that emerges from the Austrian approach is one that emphasizes the way in which heterogenous resources are combined into production plans by entrepreneurs. These plans are integrated by the very complementarity of the elements envisioned by the entrepreneur, and the importance of any one element of that plan depends upon its place within the entire structure. The very same input will take on a different importance in different contexts. The multiple speciﬁcity of inputs means that owners of capital often engage in multiple classiﬁcation as they respond to market signals by considering alternative uses of speciﬁc capital and alternative combinations of capital that might generate proﬁts. Structure The most obvious way in which Hayek’s view of mind as the way in which an organism orders the external world bears a resemblance to capital theory is its similarity to Lachmann’s insistence on viewing capital as a structure. The opening chapter of his 1956 book is titled ‘‘The Order of Capital.’’ Early on in the argument, he rejects the notion of capital as either a ﬂow of income or as a ‘‘stock’’ of material goods. Much as Hayek argues that minds ‘‘order’’ the physical world for organisms, the order of capital is part of ‘‘the complex interaction of economic forces from which the entrepreneur takes his orientation’’ (Lachmann, 1956, p. 4). More speciﬁcally, as I noted at the outset, Lachmann (p. 4) argues that the purpose of the book is to study the changes which this network of capital relationships, within ﬁrms and between ﬁrms, undergoes as the result of unexpected change. To this end we must regard the ‘‘stock of capital’’ not as a homogenous aggregate but as a structural pattern. The Theory of Capital is, in the last resort, the morpohology of the forms which this pattern assumes in a changing world.

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In the same way that Hayek’s deﬁnition of an ‘‘order’’ included not just the presence of various elements, but that those elements have certain relationships with each other, so does Lachmann’s use of ‘‘morphology’’ in describing the order of capital suggest that it is not just the ‘‘counting’’ of inputs that makes a capital structure, but that those inputs stand in particular relationships to each other, i.e., they comprise a ‘‘structural pattern.’’ Lachmann (1956, p. 59), in fact, deﬁnes structure precisely this way: ‘‘A structure is a complex of relationships which exhibit a coherent pattern. The relationships exist between entities. It is probable that when these entities undergo change, so will the relationship between them: probable but not necessary.’’ Though he places less emphasis on it than Lachmann did later, this notion of capital as a structure is also present in Hayek’s The Pure Theory of Capital. The second paragraph of the book claims that ‘‘the central aim of this study is to make a systematic survey of the interrelations between the different parts of the material structure of the process of production, and the way it will adapt itself to changing conditions’’ (Hayek, 1941, p. 3). He elaborates a few pages later (p. 6): The problems that are raised by any attempt to analyze the dynamics of production are mainly problems connected with the interrelationships between the different parts of the elaborate structure of productive equipment which man has built to serve his needs . . . The fact that this stock of capital is not an amorphous mass but possesses a deﬁnite structure, that it is organised in a deﬁnite way, and that its composition of essentially different items is much more important than its aggregate ‘‘quantity,’’ was systematically disregarded . . . [S]uch hints [about the integration of capital] were not followed up by a careful analysis of the way in which the different parts were made to ﬁt together.

Capital for Hayek, like his later theory of mind, was a matter of explaining a structure or an orderly pattern of events, where the individual events stood in particular relationships to each other such that the combination of events and their relationships produced the observed pattern. The recurrance of the words ‘‘structure,’’ ‘‘order,’’ ‘‘relationships,’’ and ‘‘complexity’’ in Hayek’s work on both capital and on mind is highly suggestive of some linkage between them.

Relational Orders Deepening that suggestiveness is the idea that these are ‘‘relational orders.’’ In the structures of both mind and capital, the importance of any of the

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elements of the order depends upon the relationship between that element and the other elements. We have seen this in the case of the mental order where the particular response from the organism will depend upon the whole set of stimuli that impinge on it. Any given stimulus might produce very different results if it is accompanied by different other stimuli. Hayek’s whole discussion of multiple classiﬁcation explores these issues. In the theory of capital, this point is one of the most central Austrian contributions. Both Hayek and Lachmann stress the idea that capital must be understood as part of an entrepreneurial plan in which the complementarity of those capital inputs is what deﬁnes that set of inputs as a ‘‘plan.’’ In this way, the term ‘‘plan’’ serves the same purpose for the Austrian theory of capital as the word ‘‘order’’ does for Hayek’s theory of mind: each captures the coherent and complementary interrelationships of the various elements of the capital structure and brain, respectively. Within Austrian capital theory, there is almost no way to talk about the importance of any single capital good without seeing it in the context of the complementary inputs that comprise the plan of which it is a part. Although we can, analytically, attempt to talk about the marginal product of a particular capital good, even the good’s marginal product will depend upon the complementary contributions of the other inputs in the process. Lachmann (1956, p. 3, emphasis in original) argues that: It is hard to imagine any capital resource which by itself, operated by human labor but without the use of other capital resources, could turn out any output at all. For most purposes capital goods have to be used jointly. Complementarity is of the essence of capital use. But the heterogenous capital resources do not lend themselves to combination in any arbitrary fashion. For any given number of them only certain modes of complementarity are technically possible, and only a few of these are economically signiﬁcant.

Hayek (1941, pp. 328–329) makes a very similar argument about the ‘‘mobility’’ of capital, where he notes that you cannot assess the value or mobility of a good based on its physical attributes such as its individual durability, rather you have to understand ‘‘the position of the good in the whole process.’’

DID HAYEK RECOGNIZE THE ANALOGY? So far, I have avoided the question of whether this analogy is one that Hayek himself recognized. Though published after The Pure Theory of Capital, the essential argument of The Sensory Order was laid out in a

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student paper of Hayek’s in 1920. So the question of whether Hayek recognized the analogy is also bound up in the interesting question of which set of ideas might have been the inspiration for the other, as it seems possible it could go either or both ways. Although I have not had time to explore the archives, there is only one mention of this relationship in Hayek’s published work. In an essay he wrote on the occasion of the 25th anniversary of the publication of The Sensory Order, he (Hayek, 1982, p. 291, emphasis added) notes the essentials of his theory of mind and what might have inspired the framework he brought to it: Mind thus becomes to me a continuous stream of impulses, the signiﬁcance of each and every contribution of which is determined by the place in the pattern of channels through which they ﬂow within the pattern of all available channels – with newly arriving afferent impulses, set up by external or internal stimuli, merely diverting this ﬂow into whatever direction the whole ﬂow is disposed to move. Stimuli and responses thus become merely input and output of an ongoing process in which the state of the organism constantly changes from one set of dispositions to interpret and respond to what is acting upon it and in it, to another set of such dispositions. In my own mind – perhaps naturally, since not long before I wrote ‘The Sensory Order (1952), I published the results of many years’ work on ‘‘The Pure Theory of Capital (1941) – I liked to compare this ﬂow of ‘‘representative’’ neural impulses, largely reﬂecting the structure of the world in which the central nervous system lives, to a stock of capital being nourished by inputs and giving a continuous stream of outputs – only fortunately, the stock of this capital cannot be used up.

So this is some evidence that the mind-capital analogy is not coincidental, but very much a part of Hayek’s thinking.

IMPLICATIONS FOR THE THEORY OF THE FIRM Does viewing the capital structure as an analogy to the mind and as an instance of an adaptive classifying system have any payoff in terms of understanding the social world? I will offer some brief and tentative thoughts on some implications it might have for the theory of the ﬁrm. In general terms, much of the literature in that area in the last few decades has focused on the ﬁrm as a site of organizational learning. In addition, several important contributors to that line of thought have linked their work to the Austrian theory of capital.5 If the analogy explored in this chapter deepens our understanding of Austrian capital theory, it may well have some implications for how we understand ﬁrms. I will suggest two possibilities below.

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Adaptive classifying systems are organized learning structures. Clearly this is true of the mind, and it is true of the capital structure in the sense that it responds to external stimuli in ways that cause it to adapt and better come to ‘‘know’’ its environment as the capital structure is responsive to changes in human wants and the objective facts of the world. Thinking of the capital structure in this way might help us to deepen our understanding of ﬁrms as sites of organized learning. First, it is worth asking whether ﬁrms are instances of adaptive classifying systems. If that answer is yes, then we have a fruitful line of inquiry. But even if it is no, there may still be interesting analogies between the ways in which the brain ‘‘learns’’ and the capital structure ‘‘learns’’ and ﬁrms ‘‘learn.’’ The focus on ‘‘routines’’ in the ﬁrm has echoes of these other learning systems. The second possibility is to see within the ﬁrm analogies to the ideas behind the map and the model. Firms need both a map, in the sense of a longer-term, more permanent picture of its overall learning and a model, in the sense of something that provides more immediate and ‘‘anticipatory’’ kinds of feedback as to its relationship to its environment. One might see the balance sheet and the budget as analogies to the map and model in this way. The balance sheet provides a more stock-oriented sense of the ‘‘semipermanent’’ state of the ﬁrm. It represents the ﬁrm’s assets and liabilities and in that sense provides the contours of what is possible. The budget is analogous to the ‘‘model’’ as it provides a way of ‘‘trying out’’ various options for the use of capital and making a decision about which direction to pursue.6 It is ‘‘anticipatory’’ as it is based on the ﬁrm’s expectations about its actions over the next period of time. Budget models are also a key tool through with managers attempt to make decisions about the allocation of capital within the ﬁrm. Over the shorter run, changes to the budget register interactions with the external environment and those ‘‘stimuli’’ may well affect the balance sheet over time, in much the same way as the model-map relationship in adaptive classifying systems. As the predictive accuracy of the budget model is born out by market responses, there will be feedback to the ﬁrm’s balance sheet as it may need to recalculate the value of various assets in light of these market results. If the budget model was accurate, then the balance sheet may need little reworking as current estimates of the value of capital remain largely valid. However, if the market results differ signiﬁcantly from what was anticipated, then revaluation of the balance sheet and, by implication, capital, may be necessary. These implications for the theory of the ﬁrm are, again, very speculative, but might well prove to be fruitful lines of inquiry.

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CONCLUSION: MIND, CAPITAL, AND METHODOLOGICAL DUALISM One crucial difference between the structure of capital and the structure of the mental order is that the former, at least to some degree, is the result of human intentionality, while the latter, being the very source of human intentionality, is not. Clearly, each individual entrepreneurial combination of capital is the product of human design. The entrepreneur must consciously and intentionally create a plan for the use of resources that integrates complementary capital goods. This is what Lachmann (1956, p. 54) calls the ‘‘plan complementarity’’ of capital. It is both subjective (i.e., the complementarity is in the eye of the entrepreneur) and the result of intentional human action. He distinguishes this from ‘‘structural complementarity,’’ which refers to the way in which the various plan-embedded capital goods ﬁt together across the whole economy. Structural complementary is not subjective in the same sense, and it is an emergent phenomenon. It is ‘‘objective,’’ or perhaps ‘‘inter-subjective,’’ in that it is a feature of the structure itself, not the subjectively perceived plan of the entrepreneur. Structural complementarity emerges because it is the task of the market to ensure that the whole variety of complementary capital combinations embedded in entrepreneurial plans are themselves integrated into an overall capital structure that is highly complementary. That integrated structure of complementarity comes about ‘‘indirectly’’ through the market rather than directly by the entrepreneur. The mental order is, as noted above, more akin to structural complementarity as it emerges in an unplanned way through the physical processes of the brain. The brain, like the market, contains feedback processes that indirectly turn individual events into a more or less integrated structure. Much as the biological processes of the brain lead to the emergent phenomena of the mind and consciousness, so do the individual capitalusing plans of entrepreneurs get translated via the market into the emergent phenomenon of a more or less integrated capital structure.7 What drives the analogy between the mental and capital structures is the notion of spontaneous order (and, as argued here, the idea that both are adaptive classifying systems). Both structures are complex, emergent phenomena. In the case of capital, the spontaneous order is a human one, emerging from human action but not human design. With the mind, it is a spontaneous order in nature, akin to the structuring of crystals that Polanyi (1958, p. 43ff) discusses. In both cases, however, there are feedback processes that

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enable the interaction of individual elements to produce complexity that is of an order of magnitude greater than could be produced by any individual element. Recalling that capital is a social phenomenon while mind is, ultimately, a natural one returns us to Caldwell’s intepretation of Hayek’s ‘‘shift’’ from the dualist conception of the social and natural sciences to the continuum of simple and complex phenomena. It is worth noting, as Koppl (this volume) argues, that this shift need not imply a rejection of the methodological dualism that underlies the social/natural science distinction. One can, conceivably, make important distinctions between simple and complex phenomena and how to study them while still believing that natural and social phenomena, whether simple or complex, should be approached very differently. Rather than one distinction replacing the other, we might have a 2 2 matrix of different possibilities, with natural-social along one axis and simple-complex along the other (Koppl, this volume). The case at hand illustrates the need for these sorts of distinctions. Capital is a social phenomenon and needs to be studied using the methods appropriate to the study of human phenomena. The whole subjectivist approach associated with Austrian economics is appropriate for such study. The mind, by contrast, being rooted in, but not reducible to, the physical processes of the brain is, ultimately, a product of nature and should be studied as such. The methods appropriate to the natural sciences are those required to understand the emergence of the mind. Recognizing that both capital and mind are adaptive classifying systems only means that we must treat them as complex phenomena; it, by itself, says nothing about where each sits on the natural-social continuum. Approaching capital and mind using different methodologies is appropriate even though both are complex phenomena in Hayek’s sense of the term. The fact that both are complex phenomena does suggest that we might wish to bring similar analytical frameworks for studying both (e.g., viewing them as adaptive classifying systems), but it does not replace or override the natural/social distinction in guiding us how to proceed in doing the actual work. Recognizing that human intentionality undergirds the emergence of the structure of capital implies the appropriateness of the use of subjectivist methodologies that can start explanations with those intentions, while the physical interactions that comprise the mental order of necessity eliminate references to human intentionality. So, as Koppl argues, rather than replacing the natural-social distinction, the simple-complex continuum overlays it in important ways.

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The argument I have presented is largely, though not completely, an argument by ‘‘suggestion.’’ The analogy between Hayek’s theory of mind and the Austrian theory of capital is, I believe, a very strong one, especially when both are viewed as examples of adaptive classifying systems. My claim has been only that such an analogy exists and that it is fruitful enough to explore in more detail. The suggestiveness of the mind-capital analogy ﬁts in with broader interpretations of Hayek’s work. The most fundamental characteristic shared by the mental order and the capital structure is that they are complex phenomena in the way Hayek uses that phrase. It is not surprising that these analogous modes of thought would be seen in Hayek’s work in the 1940s and 1950s, because, as Caldwell (2004) argues, he was beginning to distinguish between simple and complex phenomena rather than focusing on the natural/social distinction. And the one piece of textual evidence we have suggests that the parallels between mind and capital were not accidental. However, the analogies between capital and mind end, as all analogies must at some point, when we recognize that one is a social phenomenon and one is a natural phenomenon and that, despite their similarities, they would appear to call for differing methodological approaches in attempting to study them. Thus, this speciﬁc analogy not only allows us to see how Hayek’s shift in emphasis toward complex phenomena was put into motion, it also reminds us that such a shift does not obliterate the distinction between social scientiﬁc and natural scientiﬁc phenomena.

NOTES 1. As Koppl (this volume) argues, the switch to the simple/complex continuum need not substitute for the natural/social science continuum, but might well complement or supplement it. I shall return to these issues later in the chapter. 2. Rather than ‘‘re-present’’ it might be more accurate to say that the model ‘‘pre-presents’’ the current environment. 3. See Nelson and Winter (1982) for the origins of this work. 4. Examples of the former include the ways in which existing buildings that had little or no damage were used for new purposes and examples of the latter would include the construction of tents or other temporary structures to replace damaged buildings. 5. See the pioneering contributions of Penrose (1959) and Richardson (1972). On the links to Austrian capital theory, see Lewin (1999), Sautet (2000), and Foss and Ishikawa (2007). 6. See Lewin (1998) for more on the ﬁrm, budgets, and the discovery process of the market.

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7. The philosopher John Searle (1998, p. 112ff ) makes a parallel argument about ‘‘social meaning’’ as an emergent phenomenon. Like the complementarity seen in the capital structure as a whole, the meanings that institutions or objects take on in a society are not the results of anyone’s intention. They are emergent. Individuals can engage in acts of ‘‘intentionality’’ but social meaning is trans-individual.

ACKNOWLEDGEMENT Earlier versions of this chapter were presented at the Southern Economic Association in 2004 and in 2005 at ‘‘The Austrian School of Economics: An International Conference’’ sponsored by the Wirth Institute for Austrian and Central European Studies. I thank participants at both conferences for comments. I also deeply thank an anonymous referee for the extremely helpful suggestion of using ‘‘adaptive classifying systems’’ as an overarching framework. Work on this chapter was also completed while I was a Visiting Scholar at the Social Philosophy and Policy Center at Bowling Green State University.

REFERENCES Caldwell, B. (2004). Hayek’s challenge. Chicago: University of Chicago Press. Feser, E. (1999). Hayek’s solution to the mind-body problem (http://www.hayekcenter.org/ friedrichhayek/feserseminar.html). Foss, N. J., & Ishikawa, I. (2007). Towards a dynamic resource-based view: Insights from Austrian capital and entrepreneurship theory. Organization Studies, 28, 749–772. Hayek, F. A. (1941). The pure theory of capital. Chicago: University of Chicago Press. Hayek, F. A. (1952). The sensory order. Chicago: University of Chicago Press. Hayek, F. A. (1967). Notes on the evolution of systems of rules of conduct. Reprinted in Studies in Philosophy, Politics, and Economics. Chicago: University of Chicago Press. Hayek, F. A. (1982). The sensory order after 25 years. In: B. W. Walter & S. P. David (Eds), Cognition and thee symbolic processes (Vol. 2). Hillsdale, NJ: Lawrence Erlbaum Associates. Kirzner, I. (1966). An essay on capital. New York: Augustus M. Kelley. Koppl, R. (Ed.). (this volume). Scientiﬁc hermeneutics: A tale of two hayeks. In: Advances in Austrian Economics (Vol. 11). Bingley, UK: Emerald Group Publishing Limited. Lachmann, L. M. (1956). Capital and its structure. Kansas City: Sheed Andrews and McMeel. Lewin, P. (1998). The ﬁrm, money, and economic calculation: Considering the institutional nexus of market production. American Journal of Economics and Sociology, 57(October), 499–512. Lewin, P. (1999). Capital in disequilibrium. New York: Routledge. McQuade, T., & Butos, W. (2005). The sensory order and other adaptive classifying systems. Journal of Bioeconomics, 7, 335–358.

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Menger, C. (1981 [1871]). Principles of economics. New York: New York University Press. Nelson, R., & Winter, S. (1982). An evolutionary theory of economic change. Cambridge, MA: Belknap Press. Penrose, E. (1959). The theory of the growth of the ﬁrm. Oxford: Oxford University Press. Polanyi, M. (1958). Personal knowledge: Towards a post-critical philosophy. Chicago: University of Chicago Press. Richardson, G. B. (1972). The organization of industry. Economic Journal, 82, 883–896. Sautet, F. (2000). An entrepreneurial theory of the ﬁrm. New York: Routledge. Searle, J. R. (1998). Mind, language, and society. New York: Basic Books.

THE FIRM IN DISEQUILIBRIUM: A MARKET PROCESS VIEW OF FIRM ORGANIZATION AND STRATEGY Peter Lewin ABSTRACT When understood as an inevitable inconsistency of individual plans, disequilibrium is not only a necessary condition for the existence, and hence understanding, of the market process as we know it, it is also the glue connecting three other ‘‘Austrian’’ themes. In equilibrium hetero geneity of resources would have no strategic signiﬁcance, speciﬁc and private knowledge would be much less problematic, and no proﬁts net of contractual rent payments would be earned. In the real world of disequilibrium ﬁrm differences are not a mystery, rent is not an indication of inefﬁciency or monopoly power, and there is room to analyze, admire, reward, and consult about successful business strategy. Rent appropria tion comes from ownership of valuable resources. And a successful strategy, one that earns enhanced rents, is one that acquires ownership of valuable and value-creating resources. Such a strategy is dependent for its success on superior vision (or luck), something which cannot exist in equilibrium.

Explorations in Austrian Economics Advances in Austrian Economics, Volume 11, 167–192 Copyright r 2008 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1529-2134/doi:10.1016/S1529-2134(08)11009-2

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INTRODUCTION Economists are at long last emerging from the stage in which price competition was all they saw. In capitalist reality . . . it is not that kind of competition which counts but the competition from the new commodity, the new technology, the new source of supply, the new type of organization . . . competition which . . . strikes . . . existing ﬁrms . . . at their foundations and their very lives. This kind of competition is . . . much more effective than the other . . . and [is] . . . the powerful lever that in the long run expands output. (Schumpeter, 1962 [1942], p. 84)

The Firm from a Process Viewpoint Recent work has focused attention on those aspects of the ﬁrm which might be helpful in seeking to understand how modern business organizations arise and function in the market process (see, e.g., the papers in Foss & Klein, 2001; Chiles, Bluedorn, & Gupta, 2007; Foss & Ishikawa, 2007; Foss, Foss, Klein, & Klein, 2005, 2006; Roberts & Eisenhardt, 2003). This chapter seeks to identify and further examine those aspects. An interesting, not widely noted, feature of these contributions is that they can all be seen to derive, directly or indirectly, from the Austrian theory of capital. Austrian capital theory, beginning with Carl Menger, through Eugene von Bo¨hm-Bawerk, Ludwig von Mises, Friedrich Hayek, Ludwig Lachmann, Murray Rothbard, and Israel Kirzner up to the present, presents us with a distinctive vision of the economic process, from which mainstream economics and other areas of research have, consciously and unconsciously, borrowed (Lewin, 1999). Furthermore, many current works on the theory of the ﬁrm, economic organization, and business strategy use ideas that bear a striking (no doubt mostly unconscious) similarity to ideas found in the evolved Austrian capital-theoretic approach. Placing this research in relation to its similarity and connection to Austrian capital theory, and market process theory more generally, may add an interesting perspective, one that will hopefully help to further research in this area. I have divided these ‘‘Austrian’’ contributions into four related categories which I consider sequentially below, namely, disequilibrium, heterogeneity, knowledge, and rent. � Disequilibrium is the key. It is an implication that emerges out of a consideration of Hayek’s and Lachmann’s work – closely related to capital theory (Chiles et al., 2007; Foss et al., 2006; Foss & Ishikawa, 2007).

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� The heterogeneity of resources, explicit in Austrian capital theory from Menger to Lachmann, is a theme repeated frequently in modern work on economic organization and strategic management. Heterogeneity is relevant only in disequilibrium.1 � Hayek’s insights into the nature of dispersed knowledge in society has proven crucial to the development of many approaches to economic organization. Dispersed knowledge is relevant only in disequilibrium. � Finally, the Austrians have a distinctive view of the concept of rent, a concept much used (abused) in the theory of the ﬁrm and the strategicmanagement literature. It is related to the problem of appropriation of surplus value, which is an aspect also of value-imputation from Austrian capital theory (ﬁrst considered in detail by Friederich Wieser). There is an important distinction between rent and proﬁt (Lewin, 1999; Mathews, 2006a, 2006b). Proﬁts are earned only in disequilibrium. I conclude by attempting to gather the threads into a summary view drawn from these contributions. We begin with a discussion of disequilibrium.

DISEQUILIBRIUM The Meaning of Equilibrium Following the work of F.A. Hayek (1937) equilibrium is here conceived as a situation in which individual knowledge and expectations, and the actions based on these, are compatible with the ‘‘data,’’ where the ‘‘data’’ for one individual include the actions of other individuals. Scratching the surface of any of the alternative deﬁnitions that could be offered indeed reveals that it is impossible to think of equilibrium in economics without bringing in the perceptions of individuals (Lewin, 1999, Chapter 2; Lewin, 1997a, 1997b). After all, we are dealing with human actions and these are determined by the perceptions of the actors. So, in the case of the supply and demand of a single well-deﬁned market, the price will not be observed to change when all individuals are fulﬁlling their mutually related plans to buy and sell, and where such plans are not fulﬁlled we may expect these plans to be revised. This is widely recognized, though the formal technical treatments of modern economics are often apt to lose sight of it. There is no doubt, however, that Hayek’s insights have been accepted in principle and have been variously endorsed in the literature (Lewin, 1999, pp. 17–18).

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Nevertheless, current economic approaches consider equilibrium not so much as a state of affairs in the world, as an axiom of economic analysis. In using equilibrium in this way, economists are really using it as a synonym for ‘‘rational action,’’ or, more tautologically, for ‘‘purposeful action.’’ Individuals can be seen to be always in equilibrium if one construes the constraints, including the time constraints, widely enough to explain any action as a constrained maximization subject to those constraints. Any action can be explained by reference to the fact that the individual is ‘‘doing the best s/he can’’ given the time available, the knowledge s/he has, the physical and ﬁnancial resources available, etc. This ‘‘Chicago-School approach’’ is not without its considerable payoffs in deriving many important insights (see Becker, 1992 for a survey). It gives short shrift, however, to an examination of the implications of the differences in knowledge and expectations across individuals that one arguably has to look to in explaining important and sustained differences in economic performance or organization across ﬁrms. Subjective values and expecta tions turn out to be crucial for this. If everyone knew the ‘‘true’’ value of everything, if there were no room for differences in opinion, there would be no market process as we know it. The market process must be the result of this Hayekian disequilibrium; that is, the result of manifest, and inevitable, differences in the perceptions, hence valuations of economic resources. Out of these differences the trial and error process that we call competition emerges, in which the perceptions of most are falsiﬁed, at least in part. The question then arises; if we are in a state of perpetual disequilibrium, in which the market process is continually sorting out the more from the less accurate (prescient) perceptions, that is, if we are continually mistaken about things, how is successful action possible at all?

The Individual Plan and the Existence of Social Institutions The answer (Lewin, 1997a, 1997b, 1999, Chapter 3), lies in unpacking the notion of the individual plan. Examination of the epistemology of the individual plan reveals that it must be based on three different kinds of knowledge (see Table 1) – (1) knowledge of the natural world (facts and ‘‘laws’’ of nature, the law of gravity), (2) knowledge of the social world (people stop at red lights), and (3) knowledge of speciﬁc facts and events (his mother is a ﬁlm star, about which we can all agree; my product will be a best seller, about which we most certainly may not agree). Many (most?) social laws are known tacitly, knowledge about how others are going to act in

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Table 1.

Action Depends on Different Type of Interrelated Knowledge.

Type of Knowledge

Type 1 laws Type 2 Type 3 facts

Example

Expectations Converge to Equilibrium?

– Natural

Things are expected to fall when dropped

Yes

– Social laws – Speciﬁc and events

People stop at red lights His mother is a ﬁlm star; My product will be a big seller

Yes Often not

various circumstances. Each individual plan is informed by these three types of knowledge and contains some contingencies. However, the set of contingencies imaginable is strictly limited (bounded rationality) and, in this sense, all plans must be open-ended. The passage of time always brings with it some new knowledge, sometimes important, sometimes trivial, and the experience is never exactly as we imagined it would be in every detail (O’Driscoll & Rizzo, 1996). Plans are also multilayered. We plan at many different levels simultaneously. We plan our commute to and from work every day, we plan our weekly appointments, and we plan for our children’s college opportunities. Every individual has a complex and tacit structure of plans. Obviously some plans are more likely to succeed than others. We hardly stop to notice the success of the majority of our plans. We commute successfully every working day, manage to meet our weekly appointments, etc. We do notice when they are unsuccessful and we are late for work or forget an appointment. That is a situation of plan disappointment, a situation of disequilibrium in which the frustrated plan of one person implies the frustration of all those plans of others which depend on it. Clearly disequilibrium plays an important role in regulating our lives, in reorienting our actions, so that we do not forget the next appointment, or leave home a little earlier in order to make the train. That most of our ‘‘routine’’ plans do not end in disappointment is due in no small measure to the existence of knowledge types 1 and 2, the latter implying social institutions, designed and spontaneously evolved, that provides a mechanism for coordinating plans. They do so by providing shared categories, like the way we keep time; by providing common rules of conduct, like the way we greet each other or decide who goes through a door ﬁrst; and in multiple other ways, some only dimly perceived or not perceived at all. The market itself is an evolved social institution with evolved rules, norms, and customs governing individual behavior and so is the business ﬁrm. These social institutions rest on shared knowledge that

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condition actions so that people tend to behave much in the way we expect most of the time, thus ensuring that most of our plans are, indeed, coordinated. We cope with the complexity and change in the world by converging on institutions. For example, once the arrival of a new range of products, made possible by the developments of a new technology, has been digested, new categories of classiﬁcation tend to be developed, into which these products are grouped. The categories emerge spontaneously out of individual attempts to communicate the attributes of the new products. A good example is the product set associated with the personal computer. A whole range of products exist, whose inner workings remain a mystery to the vast majority of people, but whose purposes need to be explained by way of new categories of performance (the refresh rate on a monitor, the download speed of a wireless connection). Shorthands develop to provide an increasingly informed public with a way to tailor their expectations when choosing between products. They enhance predictability by enhancing the interpretability of information. Of course, these relatively predictable elements change with time and it is no accident that conscious innovation involving product differentiation is often referred to using the phrase ‘‘category killer.’’

Equilibrium within Evolutionary Change About some things, some speciﬁc events, however, there is no predicting. These are the intricate speciﬁcs of each historical situation. Plans can never be coordinated in every detail. In that sense we are never in complete equilibrium. Nevertheless, in peaceful, lawful societies behavior is ordered. Hayek, in his later work, spoke less of equilibrium and more of order. The (extended) order of society is the result of the component orders which we call institutions. Many of them are ‘‘spontaneous orders.’’ They represent equilibria of a sort, in that they are states of convergence around which expectations are formed and conform. In this sense, we may say that the social process is composed of equilibrating and disequilibrating sub processes. Economic growth, the arrival of new and better products and services and better methods of production is the result of unpredictable, disequilibrating processes. There is no overall tendency for expectations to cohere in these particular processes. They are ‘‘non-expectable’’ and thus non-convergent.

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The degree of predictability of any event is related to the extent to which it tends to exhibit repeatable, typical, or recognizable characteristics. Many routine events fall within the ‘‘very predictable’’ range, hence the emergence of ‘‘routines.’’ However, in the realm of the innovative activities of the ﬁrm in the market, many events fall very deﬁnitely outside of this range. New methods of production, new producer and consumer goods and services, new methods of organization, all embody and depend on new knowledge to a high degree and their emergence is intimately related to, and crucially dependent on, a divergence of expectations, which leads to a variety of implicit experiments. But, for this process to be coherent these experiments must play out within a framework of stable institutions, like the rule or law and property rights, that coordinate the expectations of most other things, so that, for example, peace is maintained and contracts are honored. They constitute the ‘‘rules of the game’’ as it were, even though the outcome of the game itself is intrinsically unpredictable, and must be for a dynamic society. Paradoxically, those societies that are in one sense most dynamically unstable (experience rapid and incessant change) are in another sense the most stable (exhibit stable laws and respected property rights, and customs and norms that condition human behavior in a predictable way). Those societies that experience constructive change are thus those societies best able to peacefully absorb change. This has obvious implications for the economics of transition (for example, North, 2005). Indeed, we may say, therefore, that predictability in one sphere is the necessary ingredient for coping with its absence (novelty) in another sphere (Loasby, 1994). The amazingly wide range of ever emerging products and the persistent improvement in methods of production, are the results of a multitude of continual experimentations that would be completely out of place in a world of perpetual (Hayekian) equilibrium.2

HETEROGENEITY OF RESOURCES The Productivity of Roundabout Methods of Production Carl Menger, the founder of the Austrian School, pointed out that production depends crucially on time. There is a time structure to the pro duction process as men take the fruits of nature and fashion them into products more useful to their purposes. The ﬁrst order of goods are consumption goods, second and higher order goods are capital goods which are used to make other capital goods or (ultimately) consumption goods.

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Goods proceed from higher to lower order along a ‘‘supply chain’’ and emerge with time as consumption goods. This observation is hardly novel. Adam Smith, for example, very clearly identiﬁes the need for an accumulation of resources to maintain the workers while the work was in progress (Smith, 1776 [1982], p. 343). Production takes time. Menger afﬁrms that the ‘‘more’’ time it takes the more value will be added; but, this is not only because of natural growth, it is also, and more relevantly, because the more time is available, the more can be learned about how to do things more productively and the greater the division of labor that can be achieved. This is the germ of the idea spelled out in much more detail by Menger’s disciple Eugene von Bo¨hm-Bawerk in his three-volume work on Capital and Interest (1959) that the more ‘‘roundabout’’ production is, the more productive it is likely to be. Bo¨hm-Bawerk postulates that wisely chosen roundabout methods of production are more productive than ones of shorter duration. This postulate is related to the intuitive idea that a higher level of savings leads to a higher level of sustainable consumption for the economy. A larger accumulated fund of savings for sustaining workers over a longer period of time allows for more productive, but more indirect (roundabout), production methods yielding a greater consumption value. So one needs to balance the gains in consumption value against the costs of ‘‘waiting’’ longer for that value, a balance that is captured in the interest rate, which balances impatience (or time preference) against the rewards for waiting. For any set of known productive techniques of equal value the shortest will be chosen; so if one is going to move to a technique which has a longer duration, one, necessarily, will require some compensation for the lengthening of the process unless waiting is irrelevant. This idea became a hallmark of the Austrian theory of capital, the area of study for which the Austrian school is most renown. It is an idea that is quite intuitive and was expressed by Bo¨hm-Bawerk in different places in his voluminous work. In the process of capital accumulation, ‘‘lengthening’’ the production process could result in learning and thus an improvement in technology. Capital accumulation and technological change are kept conceptually separate in most modern economic theorizing, but this is a relatively recent development. Clearly Adam Smith saw them as inextricably connected as did Menger (Lewin, 2005). Bo¨hm-Bawerk considered the capital stock to be composed of heterogeneous items of varying speciﬁcity that ﬁtted into a complex mosaic of production in a way not easily understood but clearly inﬂuenced by the fruits of the division of labor.

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Changing Technology and the Heterogeneity of Capital Ludwig Lachmann is the modern Austrian scholar most well known for capital theory. He saw much to admire in Bo¨hm-Bawerk. He considered his proposition about the productivity of roundabout methods of production to contain an essential insight, one of enduring and underappreciated relevance. But he sought to cast it in a more accessible and defensible form. He considered the whole idea of trying to measure capital or its ‘‘length’’ to be misguided. Instead of thinking about the capital stock we should think about the capital structure. Like Hayek before him, he seems to have been much inﬂuenced by the Joseph Schumpeter’s views of the dynamic market process. Like Schumpeter, Lachmann envisages production as a process driven by the entrepreneur who forms new and continually changing capital combinations. Within these combinations the individual capital items (resources)3 stand in complementary relationship to one another. They are joint inputs into the achievement of a production plan in the broadest sense. When the plan fails, in part or in whole, the entrepreneur has to adapt by making substitutions. Thus substitutability and comple mentarity are not so much attributes of capital resource inputs (as in neoclassical economics with its emphasis on equilibrium) as they are of states of the world. Complementarity is a feature of stability, substitution is a feature of change. Together they describe two aspects of the capital structure (broadly understood), its resilience and its ﬂexibility (Lachmann, 1947, 1978 [1956]). When substitutions have to be made, the entrepreneur must change the capital combination in a manner constrained by the physical (technical) and institutional constraints. Some resources will have only one use and will be rendered useless by the change. Their value will fall to zero. These, as explained, are completely speciﬁc resources. Most resources will have more than one use (they are characterized by multiple speciﬁcity). The more adaptable a resource the greater its value in alternative uses. A resource that has to be sold for scrap in the face of change has limited uses, while a resource that can be used in a variety of alternatives (an opera house can be turned into a movie theater) is more resilient. Economic progress and capital accumulation take the form of an increasing complexity of the capital structure. This is a recasting of Bo¨hm-Bawerk’s essential truth. Production becomes more roundabout by becoming more complex – the capital structure comes to embody more elements with more complex interactions. In place of, or equivalent to, increasing roundaboutness, we have increasing complexity. Though there is

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no simple way to measure complexity one may plausibly argue that modern scholars will readily understand this assertion. It seems natural then to turn attention to the question of how modern organizations and societies at large develop and cope with increasing complexity in production.

Quantity and Structure One might say that there exist two broad, and exclusive, approaches to capital theory. The ﬁrst, tracing from Adam Smith, but more so from Carl Menger, may be thought of as a structural (or compositive) approach. The second, tracing from David Ricardo (1973 [1821]), having been incorporated into most modern economic approaches, may be thought of as a quantitative approach (Lewin, 2005). We have suggested that the former, a legacy of the Austrian tradition, is more relevant to an understanding of the modern business environment. Consider the relationship between quantities and structures. A structure of things can be described by a list of items that stand in a certain orientation to one another. Complex structures are composed of many items with many possible interactions. A structure as opposed to a list (which could be unmanageably detailed and devoid of meaning) is distinguished by the fact that one can infer properties about the whole list from a description or observation of just a few component (or typical) parts together with an articulation of the principles of interaction. Quantities are formed by aggregating commensurable items. Structures can be aggregated (quantiﬁed) if the elements of the structure can be counted (valued) and if their orientation is constant, or, in other words, if substantial redundancy exists in the structure, so that similar principles of interaction are present in many different parts of the structure and these remain constant. Sometimes certain types of interaction are considered irrelevant and are ignored, while the focus is turned to interactions at other levels. If the latter are ﬁxed while the former are irrelevant, aggregation may be facilitated. For example, if differences between ﬁrms (their internal structures as described by the interactions of their component parts) are considered to be irrelevant, while the interactions between ﬁrms is considered to be describable (hence quantiﬁable), as in the neoclassical case of perfect competition or monopoly for example, then aggregating ﬁrms (or their estimated values) may provide a meaningful conceptual result. However, if such interaction is not describable, when neoclassical perfect competition or monopoly is not a defensible or helpful description, and, by implication, the neglect of

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intra-ﬁrm interactions is not defensible, the result will have dubious meaning and relevance. By recognizing the importance of structure as a phenomenon to be investigated in and of itself, economists could indeed broaden and enhance the value of their investigations. A rich and growing literature on economic organization illustrates the unlimited insights to be mined. A recent example considers the question of interactions at various levels within structures. If interaction patterns are such that they occur more at some levels than at others, we may make use of the phenomenon known as modularity to gain a better understanding of the structure – its behavior and development (see Garud, Kumaraswamy, & Langlois, 2003 for a general treatment). Modularity is a ubiquitous property of many types of structures like electronic systems, biological systems, social systems (like ﬁrm hierarchies) and, presumably, capital structures.

Modularity as a Roundabout Method of Production Taking structure seriously leads to an investigation of principles involved in understanding and designing structures. This refers to both the structure of production itself and the structure of organization for production. Production is a set of activities or tasks that has to be organized (coordinated). It should not be surprising that speciﬁc organizational structures are related to the logic of speciﬁc production structures. Clearly organizations design production, but, in a less obvious but equally true sense, production designs organizations (Langlois, 2002). The nature of decision-making, information-sharing, design responsibility, etc. must accord with the logic of the structure of the production for the product being produced. The contrast between the vertically integrated production organizations of the 1920s and the largely decentralized organizations of the digital age has much to do with considerations of this nature. Modularity is a helpful concept in this context. Much depends on what capabilities are available already in the market and can be purchased (already modularizedproviding external knowledge economies) and what has to be produced internally because new capabilities are called for. So the degree of vertical integration may change with circumstances as these considerations vary over time and space (Langlois & Robertson, 1995). Modularity is implied by decomposability. A system is (wholly or partially, nearly) decomposable if the inner components of the subsystem interact exclusively (or almost exclusively) with each other and not at all

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(or very little) with components outside of the subsystem. In other words, interaction is encapsulated or modularized. In social systems interaction is a matter of coordination of actions. ‘‘The basic idea of coordination is simple; the effectiveness of one activity depends on what other and related activities are being performed and how . . . a central principle of organizational design is to divide the work among components in such a way as to minimize needs for coordination’’ (Simon & Augier, 2003, p. 40). Modularization is a way to do this. So, in the ﬁrst instance, we may say that modularization is a way of dealing with complexity in the performing of production tasks by economizing on the need for communication, a way of economizing on information. Clearly, this is an aspect of the division of labor. Productive resources are organized (internally or in the market) into modules that specialize in the performance of certain necessary tasks. But insofar as the module is selfcontained, and can be replaced easily with a similar one without disrupting the entire production project, the knowledge required by those performing tasks in other modules need not include any knowledge about the workings of the one being substituted. Indeed each module needs knowledge pertinent only to its own set of specialized tasks, plus a minimum of knowledge necessary to allow it to connect to other modules in the structure. Each structure is thus describable as an architecture of (many or few) modules that interface according to a given standard. So the use of modularization is a way of economizing on knowledge by effecting a division of knowledge (Hayek, 1945), a theme we shall return to later. In terms of, and augmenting, Lachmann’s capital-theoretic framework, a module is a specialized combination of heterogeneous, complementary capital resources. A module is a synergistically speciﬁc component of the capital structure. But modularity is more than this. Modularization provides the ﬁrm or the market with dynamic capabilities (Teece, Pisano, & Shuen, 1997). In the absence of change (equilibrium) modularization would not be necessary. The system architecture once in place need not be changed. Individual components can simply be replaced by identical substitutes when necessary. There is no vulnerability or need for redundancy. Stability is inherent in a static environment. In a dynamic system, however, one in which changes in technology are sought after and require continual upgrades to various parts of the system, modularity is crucial. This is perhaps the starkest shortcoming of a static neoclassical perspective on the ﬁrm. The modern ﬁrm is not simply an allocator of known resources possessing known capabilities in order to maximize shareholder value. In the modern economy the ﬁrm must actively plan for, and design its organization to accommodate and aggressively

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achieve continuing changes in production methods, organization, product design and quality, new products, etc. ‘‘The potential for technological change is enhanced when modules are independently upgradeable and can be designed to be so. [Also] modularity improves adaptability and reduces the risks of rapid obsolescence’’ (Garud & Kumaraswamy, 2003, p. 49). A prototypical example is the use of ‘‘object oriented programming’’ in software product design, where subcomponents of a program are designed as separate stand-alone ‘‘objects’’ that can be separately upgraded over time. This is both an example of, and a metaphor for, modularity more generally (Baetjer, 1998). But these beneﬁts come at a price! Designing a system upfront to be modular is more difﬁcult and takes more resources than simply designing the system to achieve the immediate tasks at hand, ignoring the need for future adaptation and change. In this sense we may consider it a species of Bo¨hm-Bawerk’s more roundabout production and of Lachmann’s progressively more complex evolving capital structure. Of course modularity is not always a result of conscious design. Modularity is also, perhaps even more so, a characteristic of spontaneously evolved systems like markets. And design and evolution interact insofar as more resilient designs tend to survive the competition of the marketplace where those that survive are often more complex and roundabout.

Firm Differences and the Economics of Organization are

Related to Heterogeneity

Aggregation of the capital stock is a condition necessary for doing modern neoclassical growth economics, in order to account at an aggregate level for the contributions of the various categories of productive inputs to economic growth. But in order to arrive at such an aggregation one must forego investigation into the morphology of the capital structure. The neoclassical theory of the ﬁrm is thus not really a theory of the ﬁrm, but rather a theory of industry structure, in which there are no real ﬁrms. The inner workings of the ﬁrm are assumed away (as explained earlier). In fact, the neoclassical industry, and, indeed, the whole economy, can be described as a remarkably simply modular productive structure. Each ﬁrm is identical and produces a common homogeneous output, using combinations of individually homo geneous resources (land labor and capital), employed in identical constant returns-to-scale production functions. Each ﬁrm constitutes an identical, and redundant, production module. Any level of the economy, ﬁrm,

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industry, and economy, looks identical except for size. The ‘‘aggregate’’ production function is a mere ‘‘blow up’’ of the individual micro production functions. There is no room for the consideration of organizational structure – actions and decisions are subsumed away. Many strands of modern economic and strategic-management thought have sought to remedy this shortcoming in one way or another. Lachmann’s approach invites application to an examination of the ﬁrm as a living economic organization in the spirit of much of this work. Heterogeneity, and the complementarity and multiple speciﬁcity that it implies, are relevant only in conditions of disequilibrium. In equilibrium where no unexpected changes occur the capital structure will be perfectly sustainable requiring no changes. In this way, heterogeneity and change are intimately related. In fact, only if ex ante values (as seen by someone in the market) turn out to be different from ex post values, will heterogeneity matter. ‘‘Matter’’ in this context relates to the question of strategic behavior, including organizational design, by decision-makers in the production process broadly understood. If the values of all resources always turn out as expected, their heterogeneity would have no strategic signiﬁcance. No decision maker would be able to discover a way to combine known or newly created resources in a manner that conferred a competitive advantage to her or him. But in the absence of equilibrium, the heterogeneous nature of resources signiﬁcantly reﬂects the fallible decisions of the past as well as the possibilities and constraints of the future. And that is why ﬁrms are different, and that is why there is room for strategic action.4 Heterogeneous resources give rise to differing expectations of their worth as conceived in various possible capital combinations. Those expectations that turn out to be correct give rise to proﬁts. So, in a fundamental sense, it is the heterogeneity of expectations, that matters more than the heterogeneity of resources as such.

KNOWLEDGE Knowledge is Tacit and Dispersed Hayek published what is perhaps his most famous journal article in 1945 (Hayek, 1945). This much-cited article has elicited many interpretations and applications. It arose out of the Socialist-Calculation-Debate of the 1930s. Two key ideas relevant to the economics of organization are dispersed knowledge and tacit knowledge. Hayek asserts that the totality of

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knowledge used by a modern market economy is far beyond anything that could be perceived by a single human mind or even a central-planning committee of minds. This is true because of the very nature of knowledge. Knowledge is necessarily widely dispersed across the individuals of the economy. There is a necessary division of knowledge that underlies the complex division of labor in the economy. The impossibility of centralizing knowledge is the result of more than the computational difﬁculties of centralizing decentralized information (data). Information requires inter pretation to be useful as knowledge, and to accurately and usefully interpret information collected from local sources, out of context, is impossible. Individuals, pursuing their everyday specialties, make use of the special ‘‘knowledge of the particular circumstances of time and place,’’ knowledge acquired painstakingly, over extended time, often unconsciously. That is, much of this knowledge is tacit knowledge, knowledge of which we are not (or not completely) aware (Polanyi, 1974). Tacit knowledge is knowledge that we have about how to do things (like riding a bicycle) that is not knowledge we can articulate in any useful detail (you cannot provide the instructions about how to ride a bicycle to someone who wants to learn how). In addition, in the absence of a market, and therefore a market process, most of this knowledge, acquired in the pursuit of commercial goals, would simply not exist. Suppressing the market would suppress the generation of productive knowledge. All kinds of centralized direction suffer to some extent from these problems. The centrally directed economy suffers the most, but regulation of all kinds must solve this Hayekian ‘‘knowledge problem.’’ And the business ﬁrm is no exception. Every ﬁrm faces a mini-knowledge problem (Minkler, 1993).

The Firm and the Knowledge Problem There is a large and ever-growing literature on this problem of managing knowledge that is drawn, directly or indirectly, from Hayek’s insights. They are, in the ﬁrst instance, concerned with appropriate incentive-alignment; trying to ensure that those who have control over resources have the incentive to use them in the interest of the resource owners (the ﬁrm). Making the most important (indispensable, speciﬁc) member of the team ‘‘the owner’’ (residual claimant) is one way of trying to do this (Klein, Alchian, & Crawford, 1978). Jensen and Meckling (1992) pay careful attention to decision-rights and the rights to alienate those decision-rights.

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As Richard Langlois explains, granting alienability is a form of modular ization more extensive than the granting only of control ‘‘since the owner with alienability needs to engage in less explicit coordination with others to use the asset effectively under all circumstances . . . it is alienability that solves both the problem of knowledge decentralization and the problem of incentives: the asset may be placed under the control of the person whose knowledge best equips him or her to use it, and alienability disciplines the owner’s use of the asset by making its value (to which the owner has a residual claim) measurable on a market’’ (Langlois, 2002, p. 37). There is also a whole other level of the Hayekian knowledge problem concerned not only with knowledge management, but also with knowledge development. Knowledge assets, in one form or another, are vital to the competitive performance of ﬁrms. And knowledge is an ever-changing phenomenon. Firms in the knowledge economy have to manage not only to use their knowledge and other resources correctly, they have also to manage in such a way as to encourage the continual proﬁtable development of new knowledge. The problem extends beyond allocation to ‘‘discovery.’’ Hayek argued that competition should be seen as a ‘‘discovery process’’ (Hayek, 1978) and much of what ﬁrms do to remain competitive is to discover knowledge of how better to produce goods and how to produce better goods. There is an inextricable research element involved in production. The problem of organizational design must consider then how best to organize production not only to align incentives for appropriate resource usage but also for appropriate resource development and creation, that is, for learning (Nonaka & Takaeuchi, 1995). New knowledge obviously cannot be had before its time, its fruits cannot be predicted, so the revenues attributable to knowledge-creating assets must be extremely uncertain. There is ample room for different assessments and outcomes. In the event, valuable knowledge is unlikely to be distributed evenly across competitors, so resource heterogeneity is hardly a mystery or a rare event in this (disequilibrium) framework. Having developed knowledge assets, ﬁrms need to consider how best to protect them from alienation by others, and how best to replicate them internally for purposes of growing (Liebeskind, 1996; Winter, 1995). Competitive advantage derives fundamentally from resource heterogeneity. As explained in the previous section, resource heterogeneity derives from the nature of knowledge and the expectations to which it gives rise (as distinct from physical heterogeneity). Firms do things differently and do different things because they have developed the knowledge (much of it tacit) to do it ‘‘their way.’’ Knowledge is not simply replicable across individuals and

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organizations. Much of it becomes embodied in routines that withstand the test of time and competition (Nelson & Winter, 1982). Further, there is inescapable causal ambiguity (Lippman & Rumelt, 1982). Even successful players may not fully understand the secrets of their success. Inimitability of some resources is thus a twin-edged sword (Winter, 1995). On the one hand, it affords the resource-owner a measure of protection from competition by replication. Making resources inimitable is an insulating mechanism – whether by making them difﬁcult to copy, or by obtaining an exclusive property right over them (patent, copyright). On the other hand, inimitability may inhibit the ability of the ﬁrm to grow by replicating its successful resources and resource combinations. The ideal for the ﬁrm, therefore, is to develop (or otherwise acquire) resources that it knows how to replicate, but are relatively difﬁcult for others to do so. This not only protects the value of existing resources, but encourages the accumulation and discovery of new ones. The knowledge of how to replicate is, then, itself an inimitable resource. The value of the ﬁrm is no more nor less than the value of the resources that comprise it. And the value of these resources at any time depends exclusively on their perceived ability to produce products that consumers value. This is the ﬁrst proposition of (Austrian) capital theory. Strategies to enhance the value of the ﬁrm by enhancing the value of the resources it controls (by inhibiting their replicability, or enhancing the appeal of the products they produce) are important aspects of the strategy equation. To this, however, must be added considerations of how any enhanced resourcevalue may be appropriated and by whom. To this ﬁnal topic we now turn our attention.

RENT AND APPROPRIATION Rent through Austrian Eyes Austrian capital theory begins with Carl Menger (1871), who emphasized that the value of productive resources (higher order goods) derive from their contributions to the value of the prospective outputs of consumer (ﬁrst order) goods. This proposition (called Menger’s Law by Israel Kirzner) inverted the classical cost-of-production theory, most clearly developed by David Ricardo, according to which consumption goods are to be valued by the value of the resources used to produce them. Menger showed that cost derives from value and not the other way round. Menger’s Law provides us

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with the universal logic of present value, whereby the value of any asset (and hence the maximum price that the valuer will pay for it) is imputed from the value of the expected product attributed to its use in production, suitably discounted. Discounting is necessary because of time preference, the premium of present utility over future utility. Other things equal, a dollar now is worth more than a dollar sometime in the future – the premium being greater the further into the future we look. Bo¨hm-Bawerk (1959 [1921]) provided a path-breaking analysis of the nature of interest and time preference and their relation to the productivity of resources. He showed that the more productive an asset is perceived to be (in terms of value) the higher will be the price that people are willing to pay to buy it, or the higher the rental rate they will pay to rent it. Frank Fetter (1977) extended Bo¨hm Bawerk’s insights and Murray Rothbard (1977) provided the deﬁnitive syntheses. This rental rate is to be understood as the price of the services of the asset. All productive assets earn rent, explicitly if rented or implicitly if employed by the owner. The wages of labor are the rents earned by human capital. From the perspective of the economy as a whole, adopting, as it were, a ‘‘God’s eye’’ view, the value of resources, at any point in time, can be seen as the discounted total of the (estimated) income stream attributable to them. In other words, the value of any economic resource is logically the present value of any income stream that can be attributed to the use of that resource in production. That is the maximum price that anyone appraising that resource would be prepared to pay for it. We may leave aside the question of how it is possible to attribute to any resource an income ﬂow. Clearly, as discussed earlier, insofar as resources must invariably be used in combination, it is no simple matter to impute to any single resource a value for its individual contribution – this is the ubiquitous imputation problem. And the estimation of the value of any production plan is in itself a speculative matter. The point is that anyone considering the purchase of any resource cannot avoid (perhaps implicitly) referring to the value that this resource is expected to add to economic production. Even if the resource is purchased for resale, ultimately its value must derive from some potential productive use. Imagine for a moment, that no ambiguity or uncertainty whatsoever attaches to the production processes in the economy. All individuals possess the same hard knowledge of what resources can do and, therefore, what they are worth. In such a world, when a resource is rented its rental rate must reﬂect the value of the current addition it makes to the value of production (its value-marginal-product), or else the owner would be reluctant to rent it

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to the ﬁrm; and where the resource is not rented but is owned by the ﬁrm, the implicit ‘‘cost’’ of using the resource must reﬂect that same value. Thus there is no ‘‘surplus value’’ to be had, since all values are known and become incorporated into the (implicit and explicit) prices of resources. Nevertheless, in the sense advanced here, ‘‘rents’’ are earned by the factor owners. ‘‘Rents’’ refers here to the income streams attributable to the resource inputs in the productive process. Resources can generally be conceived of as a stock of potential productive services. Rents are the prices paid for these services. Rents are the prices of the ﬂow of services emanating from the stock of resources (Penrose, 1995 [1959]; Dierickx & Cool, 1989). The price of the any resource stock is the discounted present value of the prices of the services it yields. In this framework rent is nothing more nor less than the rental price of the service of a productive input. As Murray Rothbard has explained: We are using ‘‘rent’’ to mean the unit price of the services of any good. It is important to banish any preconceptions that apply the concept of rent to land only. Perhaps the best guide is to keep in mind the well-known practice of ‘‘renting out.’’ Rent, then, is the same as hire: is the sale and purchase of the unit service of any good. It therefore applies as well to prices of labor services (called ‘‘wages’’) as it does to land or any other factor. The rent concept applies to all goods, whether durable or nondurable. In the case of a completely nondurable good, which vanishes fully when ﬁrst used, its ‘‘unit’’ of service is simply identical in size to the ‘‘whole’’ good itself. In regard to a durable good, of course, the rent concept is more interesting, since the price of the unit service is distinguishable from the price of the ‘‘good as a whole’’ . . . The price of the ‘‘whole good,’’ also known as the capital value of the good, is equal to the sum of the expected future rents discounted by . . . the rate of interest. (Rothbard, 1970 [1962], pp. 417–418)5

This conclusion is not changed at all when we drop our assumption of perfect and certain knowledge. In the real world where the future is irredeemably uncertain, the value of any productive resource will still reﬂect the discounted value of its expected future rental stream. Certainly, different people will have different estimates of these rental streams and, therefore, will appraise differently the value of the resources that yield them. The market process of production and exchange will work in such a way that resources tend to move to those who appraise them most highly. As mentioned earlier, a ﬁrm may employ resources in production by owning or renting them. If a ﬁrm decides to purchase a resource it must do so because, in its estimation, the additional value to it of the future incomes streams attributable to the use of that resource meet or exceed the price paid for it. Similarly a ﬁrm will not rent a resource unless, in its estimation, the value

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added to production, by combining that resource with others in the production process, meets or exceeds the rental rate asked. Once again this is not to deny or minimize the uncertainties or indeterminacies involved in the imputation problem. There may be signiﬁcant bargaining problems associated with the inability to neatly apportion contributions to indivisible resources (Alchian & Demsetz, 1972) but none of this disturbs the conclusion that resource earnings are rents and that the value of these resources must derive from some way of estimating their contribution to production. This framework suggests the following conclusions: 1. There is no categorical distinction between the earnings of some resources and others, they are all rents. 2. The value of any productive resource is the discounted value of the rent streams that can be attributed to it. There is no valid ‘‘cost of production’’ theory for the determination of value. All value derives from the value of ﬁnal outputs to consumers. It follows then that there are no ‘‘unearned’’ rents in the sense of Ricardo or in the sense of any ‘‘monopoly rents.’’ All rents reﬂect the ‘‘value contributed’’ to the production process.

Recent Developments The use of the concept ‘‘rent’’ (deriving from Ricardo) is confused and inconsistent in both the standard economic model of perfect competition and in the strategy literature, a confusion that arguably would be banished by use of the simpler Fetter-Rothbard approach (deriving from Menger and Bo¨hm-Bawerk). This has recently been realized (though not very explicitly) in three remarkable articles that address both strands of literature (economics and strategy) by Makowski and Ostroy (2001) and Lippman and Rumelt (2003a, 2003b, see also Lewin & Phelan, 2002 and Mathews, 2006b). The two articles by Lippman and Rumelt in particular evidence a notable, independent rediscovery of some perspectives outlined in this paper. All three articles aim at a conscious break with the past, with the standard model of perfect competition (generally referred to as neoclassical economics). Makowski and Ostroy provide an intriguing reformulation of ‘‘perfect competition’’ devoid of the usual heroic assumptions of full information, many buyers-sellers, no innovation or changes in technology,

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etc. and in so doing arrive at a vision of the world of competition as a rivalrous process in which proﬁts are earned in disequilibrium. Competition is ‘‘perfect’’ when all possible value that can be created is created and is fully appropriated by someone. So, in the familiar case of a perfectly discriminating monopolist, no value-creating opportunity is left unexploited and ‘‘competition’’ is actually ‘‘perfect.’’ Paradoxically, but logically, all other perfectly competitive cases are variations of this theme in which full appropriation occurs. It follows that the price-taking condition of the standard model is not needed and bargaining, negotiation, and strategizing can occur. Lippman and Rumelt’s two companion articles acknowledge the relevance of Makowski and Ostroy’s work, and of the Austrian tradition, to their own. But none of these three articles shows a clear perception of Hayek’s notion of equilibrium, and its relevance for the nature and role of knowledge in the market processes they describe, or of the Fetter-Rothbard theory of rent. Yet, especially in Lippman and Rumelt’s work, the similarity is striking. For example, there is no residual part of revenue that is not attributable to a resource. The payments to resource are what we . . . deﬁne as simple rents – they are neither Ricardian, transfer, differential, quasi, nor economic rents. (2003a, p. 903) Rent is a payment for the services of a factor of production (one pays for an apartment or a car). (2003a, p. 904) Given a durable resource, the simple rent is the total payment received by the owner of that resource. The value of the resource is the discounted value of future simple rent payments. The economic [differential] rent is a portion of the simple rent payments and depends upon the analyst’s deﬁnition of ‘‘alternative use.’’ Given a speciﬁed alternative use, economic rent is the difference between the present simple rent payment and the simple rent payment that would be received in that alternative use. Such alternative payments are out-of-equilibrium conjectures based upon various assumptions about what might change (and what might not) to force the resource into its alternative use. (2003a, p. 917; cf. Lewin & Phelan, 2002) The capitalized stream of payments for the services of a resource is its value, the total payments . . . for all resources in a ﬁrm is the value of the ﬁrm. The objective is to maximize its wealth by adjusting the ways in which it uses and combines resources and by its purchase and sale of resource. (2003a, p. 924) Business management and strategy concerns the creation, evaluation, manipulation, administration, and deployment of unpriced specialized scarce resource combina tions . . . the strategy problem [is] one of discovering or estimating the value of various resource combinations. New wealth can be created by trade in resources as long as there

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are hitherto unexamined combinations. (2003b, p. 1069, abstract, it is not clear why attention is conﬁned to unpriced resources)

These articles are not without blemish (some misconceptions and terminological quibbles exist – opportunities for further research and fruitful dialogue). They do, however, represent a remarkable move toward a dynamic Austrian-type vision. In that vision competition is an open-ended discovery process in which the earnings of proﬁts (most plausibly under stood to be a residual earned after the payment of all contractual paymentsrents) are possible because the ex ante prices of resource turn out to be different from their ex post values. As Ludwig von Mises has lucidly expressed it, What makes proﬁt emerge is the fact that the entrepreneur who judges the future prices of the products more correctly than other people do buys some or all of the factors of production at prices which, seen from the point of view of the future state of the market, are too low. Thus the total costs of production – including the interest on the capital invested – lag behind the prices which the entrepreneur receives for the product. This difference is entrepreneurial proﬁt. (Mises, (1980), p. 109; see also Sautet, 2000)

CONCLUSION Of the four categories of contributions surveyed here two are integral parts of the attempts of the past few decades to remedy the limitations of the neoclassical theory of the ﬁrm, namely heterogeneity of resources and the nature of knowledge. These attempts are to be found in various literature strands including notably transactions-cost economics, the economics of organization, game theory, and strategic management and organization, especially in its RBV variety. Confusion and inconsistency concerning the concept of ‘‘rent’’ persists and, until the recent work of Lippman and Rumelt, the simpler, more plausible and more likely-to-be-consistent approach deriving from the Austrian tradition and deﬁnitively expressed by Fetter and Rothbard, was completely neglected, and is nowhere acknowledged outside of narrowly Austrian research. It is in regard to the concept of equilibrium, however, that the Austrian vision stands to make its most valuable contribution (see Table 2). Hayek’s approach to equilibrium is almost never used explicitly and, even as theorists strive mightily to ﬁnd a distance from the perfect-competition model, the allure of equilibrium theorizing remains untarnished. It seems to be an unspoken article of faith that disequilibrium theorizing is not possible, or is somehow undesirable. Yet, as argued in this chapter, when understood as

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Table 2.

The Importance of Disequilibrium.

Heterogeneity

Knowledge

Rents

Are the earnings of resources (capital goods) and have to be estimated and are often contracted; the residual after payment of rent is proﬁt Are the earnings of Is shared in common. resources (capital Expectations converge – goods) and are are identical known with certainty; there is no residual after payment to rent (no proﬁt)

Disequilibrium

Is dispersed and Resource (capital-good) partially tacit, is never capabilities and values collectible, gives rise have to be estimated – to disparate entrepreneurial expectations judgment is exercised in creating productive capital combinations

Equilibrium

Has no operational relevance – resource (capital-good) values and capabilities, are known with certainty – no entrepreneurial judgment is necessary

an inevitable inconsistency of individual plans, disequilibrium is not only a necessary condition for the existence, and hence understanding, of the market process as we know it, it is also the glue connecting the other three categories of consideration. In Hayekian equilibrium heterogeneity of resources would have no strategic signiﬁcance, speciﬁc and private knowl edge would be much less problematic, and no proﬁts net of contractual rent payments would be earned. In the real world of disequilibrium ﬁrm differences are not a mystery, rent is not an indication of inefﬁciency or monopoly power, and there is room to analyze, admire, reward, and consult about successful business strategy. Rent appropriation comes from owner ship of valuable resources. And a successful strategy, one that earns rents and proﬁts, is one that acquires ownership of valuable and value-creating resources. Such a strategy is dependent for its success on superior vision (or luck), something which cannot exist in equilibrium.

NOTES 1. This chapter also contains a discussion of the role of modularity in facilitating successful action in disequilibrium and in particular a discussion of the relationship between structures and quantities (aggregates). 2. As a referee points out an implication of this is Hayek’s (1973) point that to satisfy some expectations it is vital that other expectations be disappointed.

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3. The notion of a capital good is interchangeable with the notion of an economic resource if we cast a wide enough net to include human capital. Then we may say that producers combine resources in order to use the services of those resources to produce some desired good or service. 4. To be sure, situations may exist where resource combinations promise to yield a surplus of known value whose distribution among the resource owners is up for grabs and therefore invites ‘‘strategic’’ behavior. Since there is no disagreement as to the value of the surplus, the disagreement over the distribution may not (though it may) affect the employment of resources in speciﬁc combinations. There are no real ‘‘discoveries,’’ there is no innovation or entrepreneurial action. Whatever we mean by ‘‘strategic’’ then, we should like to analyze a world in which both types of disagreement (over the distribution and the size and nature of the surplus exist). I return to this later. 5. Also: ‘‘We have been using the term rent in our analysis to signify the hire price of the services of goods. This price is paid for unit services, as distinguished from the prices of the whole factors yielding the service. Since all goods have unit services, all goods will earn rents, whether they be consumer’s goods or any type of producers’ goods. Future rents of durable goods tend to be capitalized and embodied in their capital value and therefore in the money presently needed to acquire them’’ (Rothbard, 1970 [1962], pp. 502–503).

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